Crossing the Generational Divide

One of the great challenges faced by high-net-worth families is raising motivated, thoughtful, and productive children. Within three generations most families go from rags to riches to rags again. It may be counterintuitive, but many of the families that overcome this challenge and preserve their wealth for multiple generations do so by giving some of it away. Planned philanthropy and a robust private foundation are critical tools used by high-net-worth families who successfully transfer both their values and their sense of purpose to the next generation.

Philanthropy can take many forms. Donating one's labor, joining a board of directors or simply making a donation to a worthy cause are all included under this umbrella. It is all too easy, however, for a family to donate a great deal of money and energy to charity without actually advancing their goals or the causes they support. High-net-worth families are bombarded with charitable requests, and making small donations to everyone who asks often leaves donors with no sense of purpose or fulfillment. Often a new client's tax return shows tens or hundreds of thousands of dollars in charitable giving, yet they still cannot explain which causes are truly important to them. Sometimes a client will have a broad category of causes they support, like the environment, human rights or cancer research. Even with such an overarching theme, a shotgun approach to giving never seems to accomplish anything except an ever-growing list of charities seeking money.

High-net-worth families benefit most from philanthropy, and they achieve the most good when their efforts are coordinated and systematic. A charitable mission statement is the first step in bringing order to the chaos of charitable giving. First and foremost, the mission statement gives the family an opportunity to decide which causes they want to support. In my experience it is best to start by asking the question, "If you could change anything about the world, what would it be?" That question usually leads to the cause, not the charity, to which the family wants to devote its time, energy and money. There may be more than one, but there should be no more than three causes on the agenda at any time.

Once the cause is agreed upon the family can move forward with creating an action plan, which allows a family to decide exactly what it is going to do to start changing the world. If that sounds ridiculous, it is not. If the family is not committed to and motivated by the cause they have selected, they have not found the right cause. A family with resources and commitment can accomplish a great deal with a proper action plan, but they also can be wasted if they are unfocused. For example, if the family wants to fight global warming, will they do so by supporting energy efficiency, renewable energy, reforestation programs, limiting population growth or by some other approach? Maybe they will move forward on more than one of these fronts, but it would be very difficult to effectively support all of them at the same time.

Finally, with a cause selected and an action plan adopted, the family and its advisors can begin locating existing charities to support. Vetting the potential donee charities is a serious undertaking. How long has the charity been in existence and how well organized is it? Who founded it, and who is running it now? Is it financially stable, or barely surviving year to year? What percentage of donations is actually used to implement the charitable mission, as opposed to administrative or fundraising expenses? What other organizations do similar work? Do they coordinate their efforts, and if not why not? If a grant is made, how will those funds be used? Will any reports be generated to show how those funds were used? If you commit to a multiyear grant, will the charity be able to organize a multiyear effort to efficiently use those funds? What metrics will be used to measure the success of the charity?

Developing and implementing a thorough charitable mission statement takes commitment, but it also makes far more effective use of the donated funds. What's more, this process should not be stagnant. The mission statement should be a living document, constantly revisited, reviewed and revised.

At every stage of developing and implementing the mission statement described above, there is an opportunity to engage younger family members and instill in them values that will lead to a productive life. This process allows a child to see what hard work and commitment can accomplish. These experiences and lessons can deeply impact a young person. The goal is not necessarily to raise a child who will devote their life to philanthropy, but rather to teach a child about life and business through philanthropy. The skills learned through this process are even more critical where there is a family business to pass on.

When it comes time to implement the mission statement, the structure most commonly selected is a private foundation. As discussed below, there is a certain amount of complexity and legal formality associated with forming and operating a private foundation. That formality, however, provides opportunities for a family to teach children and grandchildren about the family values that produced their wealth in the first place. It also provides a structure for children to meet and develop relationships with the family's team of advisors.

Participating in the operation of a family foundation exposes younger generations to a number of important issues including: modern portfolio theory; asset allocation; taxation; accounting; budgeting; state and federal reporting; the role of a board of directors; how to choose and evaluate advisors; the role of various corporate officers; how to select a grant recipient, how to review the use of that grant and how to hold the recipient accountable; what other family members value; and perhaps most importantly, a family foundation provides a forum for a child to explore what they value. In general, the earlier a child becomes involved with a foundation, the better. Even children as young as six or seven years old can benefit from participating in this process.

As mentioned above, participating in the operation of the private foundation introduces the younger generation to various existing family advisors. Working for the foundation helps to build strong and independent relationships between the advisors and the children, so as they enter adulthood there is continuity. Children often reject their parents' advisors, but the foundation creates an opportunity to build trust early on, and this allows an advisor, or at least his company, to work with a family for multiple generations. Assuming the advice is good, this creates tremendous efficiencies for the family.

In general, lawyers and accountants advise clients on the proper structure and operation of a foundation, but any advisor can broach the topic of planned philanthropy. Although that discussion should initially focus on the charitable mission statement, families often like to jump ahead and want to better understand how private foundations are formed and operated. With that in mind, the following is a broad overview of the rules governing private foundations.

Operating And Non-Operating Foundations
Private foundations fall generally into one of two categories: operating or non-operating. A foundation that simply uses its endowment to make grants is a non-operating foundation, while a foundation which itself actively conducts charitable activities is an operating foundation. So, for example, giving money to a charity that supports reforestation is the act of a non-operating foundation, while buying raw land and hiring people to plant trees is the act of an operating foundation. The vast majority of foundations are non-operating, but there are distinct advantages to being an operating foundation.

From a tax perspective, contributions to an operating foundation will generally be deductible by individuals to the extent of 50% of their adjusted gross income (AGI), as is the case with contributions to public charities. Gifts of cash to non-operating foundations are generally deductible only to the extent of 30% of AGI. There are also advantages when appreciated property is being donated. Generally speaking, gifts of appreciated property to an operating foundation are deductible to 30% of AGI, and the amount of the deduction is its fair market value. Gifts of appreciated property to non-operating foundations, on the other hand, are generally limited to 20% of AGI and the donor can only deduct his or her basis in the property. There is an exception for gifts of appreciated publicly traded stock to a private non-operating foundation, which entitles the donor to a fair market value deduction.

The operating/non-operating distinction is not relevant for purposes of the federal estate or gift tax. Gifts and bequests to charitable organizations are 100% deductible for federal estate and gift tax purposes regardless of whether the recipient organization is a non-operating foundation, operating foundation or public charity. Non-operating foundations are also required to annually distribute 5% of their average net investment assets, while operating foundations have a slightly lower distribution requirement.

Formation, Registration And Reporting
A private foundation must be formed with reference to both state and federal laws, most often as either a corporation or a charitable trust. If the family intends to involve a number of people in the administration of the foundation, or if the foundation will conduct significant activities, a corporation is generally the better choice. A corporate structure is more flexible since there is both a board of directors as well as any number of officers whose duties and authority can be easily delineated. It is more cumbersome for a trustee to delegate responsibility, although it can be done. A trust, however, often has fewer state registration and reporting requirements than a corporation. If everything will be decided by the patriarch or matriarch of the family, a trust works quite well.

Regardless of which form is chosen, the governing documents of a foundation are required to contain certain provisions including a statement of the foundation's charitable purposes, which must fall within the broad categories set forth in Section 501(c)(3) of the Internal Revenue Code as "religious, charitable, scientific, testing for public safety, literary or  educational or fostering national or international amateur sports competition . . . or the prevention of cruelty to children or animals." Those documents also must prohibit the foundation from lobbying for or against specific legislation (subject to very limited exceptions). Similarly, a foundation can never endorse or campaign against candidates, or otherwise intervene or participate in any campaign for public office.

A private foundation must apply for a determination letter from the Internal Revenue Service on IRS Form 1023. An exemption letter generally follows within six months of filing with the Internal Revenue Service, but this can take longer. Form 1023 must be filed within 27 months of the creation of the foundation. Once the determination letter is obtained, it relates back to the date of the foundation's formation. In addition to the federal registration, many states require that private foundations register with both its secretary of state and attorney general.

A private foundation must file an annual return with the Internal Revenue Service on Form 990-PF. All foundations are required to make the returns available for public inspection at the foundation's office. State reporting requirements may also apply.

Taxation Of Foundations
The IRS determination letter will allow the foundation to avoid federal tax on its earnings, subject to some minor exceptions. First, the foundation will be subject to a minimum excise tax, generally at the rate of 2%, on its net investment income. Net investment income, in general, equals ordinary income and capital gains reduced by capital losses and the ordinary and necessary expenses incurred in the production of investment income. The foundation must make quarterly estimated payments of this excise tax. Second, the foundation will be subject to tax at full graduated rates on its unrelated business income (UBI). UBI generally consists of active business income and certain debt-financed income, including income earned from margin trading. Lastly, the foundation will be liable for wage withholding, including FICA taxes, if it has any employees.

Operating A Foundation
A foundation can make grants to other charitable institutions provided they qualify under Section 501(c)(3) of the Internal Revenue Code. A foundation also can make grants for charitable projects not necessarily connected with another charitable entity. If the foundation is to make grants to non-U.S. charitable organizations or directly for charitable purposes outside the U.S., certain procedures must be adopted and additional supervisory requirements apply. These additional procedures and requirements are intended to establish that the funds going offshore are applied for the intended purposes, and are referred to as "expenditure responsibility." Foundations can grant scholarships or fellowships to individuals, but the Internal Revenue Service must pre-approve the process by which recipients of those grants are selected.

Private foundations are subject to a code of conduct that is enforced through the imposition of federal excise taxes. Each of the excise taxes described below has two rates. The lower rate is applied on an annual basis when any of the prohibited activities occur. The higher rate applies only if, after notice by the IRS, the foundation remains in violation of the applicable rule.

(i) Tax on Self-dealing (10% of the dollar amount involved and, if not corrected, 200%). The foundation is generally prohibited from engaging in financial transactions with disqualified persons. Disqualified persons include the grantor, members of the grantor's family, any officer or director of the foundation and entities that are controlled by such persons. This rule is designed to prevent insiders from deriving personal benefit from the foundation. For example, a foundation is generally prohibited from selling property to or buying property from a disqualified person, even if the sale price favors the foundation. There are limited exceptions to this rule. The most important exception is that paying reasonable compensation to a disqualified person is not considered to be an act of self-dealing.

(ii) Tax on Failure to Distribute Income (30% of the distribution shortfall and, if not corrected, 100%). A non-operating foundation must make charitable expenditures each year equal to at least 5% of its net investment assets. This is designed to ensure that the foundation is, in fact, using its funds for charitable purposes and not simply accumulating its funds. Once this amount is determined for a given year, the foundation has a full additional year in which to make the required distribution. For example, assuming a foundation has a calendar fiscal year, the deadline with respect to payment of the year 2007 minimum distribution is December 31, 2008.

The 5% distribution requirement is only a minimum requirement and additional charitable distributions can be made by the foundation at any time. What's more, there is a carry forward provision for excess distributions, so distributions in excess of the 5% requirement can be carried forward and can be used to offset the minimum distribution requirement for the next five years.

(iii) Excess Business Holdings (10% of the excess business holdings and, if not corrected, 200%). Generally speaking, a foundation cannot own more than 20% of an active business (corporation or partnership). If family members (and other disqualified persons) own an interest in the same business, the 20% limit is reduced by the percentage owned by disqualified persons. There is an important exception to this tax, which permits a foundation a five-year period to dispose of excess business holdings received by gift or bequest. An extension of the five-year grace period can be obtained for large gifts or bequests, which cannot easily be sold.

(iv) Tax on Jeopardy Investments (10% of the investment and, if not corrected, 25%). The foundation must invest its assets to assure that corpus held for charitable purposes is not unduly jeopardized. No particular kind of investment is a jeopardy investment, per se. Rather, each investment must be evaluated in the context of the portfolio as a whole. There is very little guidance on what constitutes a jeopardy investment, and any reasonably balanced portfolio that is intended to generate appropriate total returns is likely to pass muster under the jeopardy investment rules.

(v) Tax on Taxable Expenditures (20% of the taxable expenditure and, if not corrected, 100%). Taxable expenditures usually occur when a foundation fails to fulfill its reporting or recordkeeping responsibilities, even if the funds themselves are used to advance a  charitable goal. For example, if a foundation awards scholarships to individuals without following an established procedure qualified by the Internal Revenue Service, it is a taxable expenditure. Similarly, if the foundation makes grants to foreign organizations or for foreign charitable purposes without maintaining adequate supervisory authority it is a taxable expenditure. This tax also applies if the foundation uses its funds for an impermissible purpose, such as funding a political campaign.

Planned philanthropy through a private foundation can be a powerful tool for high-net-worth families. By focusing the family's resources, the impact of its giving is greatly magnified. Perhaps more importantly, it provides an ideal structure for helping these families address one of their most daunting problems: how to raise motivated, thoughtful and productive children. Involving younger generations in the family's philanthropy provides a forum to help prepare them for productive careers, whether in philanthropy, the family business or the world at large. Using a private foundation to teach business skills and family values is often what differentiates families that successfully preserve their wealth for multiple generations and those that do not.