When advising hedge fund principals on the formation of a private foundation, advisors need to consider a number of issues beyond those faced by the typical ultra-affluent client.
A critical question for fund principals is whether they can invest in their own funds, since principals usually consider their fund to be the best investment for foundation assets. It's also typically where they have most of their money.
The broader range of investments available to private foundations, and the potentially superior investment performance they bring, is one of the primary advantages of a private foundation over donor-advised funds and other charitable structures. While there are a number of potential obstacles for a private foundation to invest in the principal's fund, they can usually be overcome.
The principal is a "disqualified person" with respect to his foundation. His spouse, ancestors and descendants are disqualified persons, along with the foundation managers (officers, directors and trustees), and entities in which the principal, his family, and foundation managers collectively have more than a 35% interest. That may mean the fund itself is a disqualified person. Section 4941 of the Internal Revenue Code prohibits self-dealing between a private foundation and a disqualified person. Self-dealing is broadly defined, and unless an exception is made, an investment by the foundation in the principal's fund qualifies.
Self-dealing, however, can be avoided in several ways. First, many funds allow a waiver of fees for charitable organizations. If the foundation does not pay a fee, there is no self-dealing. The regulations also make clear that fees can be paid to a disqualified person that owns an investment counseling business if the fees are not excessive. There is a strong position, therefore, that charging standard hedge fund fees to the foundation does not constitute self-dealing.
Fund managers also need to be aware of the rules regarding ownership and suitable investments.
Section 4943 limits how much of a business can be owned by a private foundation. In general, the foundation is permitted to own 20% of the profits interest of a partnership, reduced by the percentage of profits interest owned by all disqualified persons. If the fund principal, all other disqualified persons and the private foundation collectively own less than 20% of the profits interest of the fund, this is not an obstacle. There is also a 2% de minimis rule, which in all instances will allow the foundation to own up to 2% of the profits interest of the fund.
Section 4944 prohibits private foundations from investing in a way that would "jeopardize the carrying out of any of its exempt purposes." To determine if a portfolio has any "jeopardy" investments, the portfolio and the fund's investment strategy have to be viewed as a whole. For example, a foundation that is fully invested in a single fund is not necessarily putting the portfolio injeopardy due to a lack of diversification. The investment may be perfectly appropriate, for example, if it's a single long-short fund or a global macro fund whose underlying portfolio is diversified. If the single fund were a distressed debt or arbitrage fund, on the other hand, it would cause greater concern.
Fund principals also need to consider tax issues. While private foundations are generally tax exempt (they do pay a 2% tax on their investment income, which can be reduced to 1% in certain circumstances), they pay tax at corporate or trust rates, depending on the form of organization, on any unrelated business income (UBI). UBI includes debt-financed income, so the returns generated by a leveraged fund may be subject to tax, greatly reducing the foundation's effective rate of return. Many hedge funds have either a master-feeder structure or a parallel fund that is designed for tax-exempt organizations and foreign investors. Wherever possible, that is the preferred investment vehicle to be used by the foundation.
Foundation Operations
Before forming a foundation, fund principals need to understand some of the restrictions imposed by the IRS on foundation operations. This is particularly important since these rules could prevent principals from using the foundation to replace their existing charitable giving vehicles.
A private foundation is required to make "qualifying distributions" of at least 5% of its net worth (excluding assets used directly for charitable purposes) each year. The funds can be expended directly on charitable works, but more often take the form of donations to other operating charities. This requirement can impact the fund's investment decisions, since enough liquidity must exist to make these mandatory payments annually.
It should be noted that a distribution from one private foundation to another is not useful since it generally does not constitute a qualifying distribution. This is noteworthy because many fund principals make small annual donations to their colleagues' private foundations. Also, donations from one foundation to another constitute "taxable expenditures" and are subject to a penalty unless the foundation exercises "expenditure responsibility," which requires a pre-grant inquiry, a formal grant agreement and reports on how the donated funds are spent. Sending $5,000 from one foundation to another is simply not practical because it entails a significant administrative burden.
Grants to foreign charities also require expenditure responsibility, making them more burdensome than domestic charity grants.
Fund principals who have made legally binding pledges to charities may also find their hands tied if they opt to create a foun- dation. Under the tax code, foundation assets may not be used to satisfy such a pledge because such a payout relieves the principal of a legal debt and therefore is considered an act of self-dealing. The pledge must be legally binding for this to cause a concern, but many states, including New York, have case law that strongly favors the charity once a donor documents his intention to make a gift. It should be noted, however, that the foundation itself can make a pledge and that is the better course of action once the foundation is established. Fund principals who wish to use their foundation to award scholarships or other educational grants should also be aware that the procedure for selecting a scholarship recipient must be approved in advance by the IRS. That can be part of the initial application for exemption or it can be supplemental.
For a variety of reasons, fund principals should consider outsourcing foundation administration. There are a wide range of companies that offer these services, including accounting firms, family offices and the private client departments of larger financial institutions. It's a cost-effective way to add professional experience to the operation of a foundation. Where family members are active in the foundation, charitable activities are being performed directly, or grants are being made to non-U.S. charities, the professionalism and oversight offered by these service providers will often prove invaluable.
What's In A Name?
When forming a foundation, the principal must decide whether he wants the foundation to provide publicity or privacy. The Liss Family Foundation, for example, can help raise the principal's profile (in this case, Stephen Liss) and serve a public relations function, as well as advance the principal's charitable goals. Everyone, however, will know to whom the principal is giving. The annual tax return for a foundation, the Form 990-PF, is a public document and is available online from services like www.guidestar.org. The foundation is also required by law to make most of its records available for public inspection. The principal must decide whether this is desirable or even acceptable.
If the principal wants some privacy, foundations can also be formed that provide a certain level of anonymity. The Noble Deeds Association, for example, has a name that doesn't shed any light on the people behind the operation.
Note the name does not even include the word "foundation." If the principal is the sole member of the foundation, but is not an officer or director, he can retain effective control and provide a further level of privacy. If he knows the right people, the principal could protect his privacy further by having only trusted friends run the foundation, rather than outside professionals. Forming the foundation as a trust instead of a corporation further decreases the publicly available information.
Whether or not the fund principal wants privacy, he should carefully consider the appointment of officers and directors. Many principals instinctively name themselves to key decision-making positions, but that may not be best over the long run. Does the principal really have time to operate the foundadation? Is the principal required to travel, leaving himself unavailable to the foundation for long periods of time? Bringing in outside officers ensures that time conflicts don't impact the foundation over the long term. Having others serve as foundation officers can also serve as a buffer to the fund principal when it comes to handling donation solicitations.
Family Involvement
Private foundations are often viewed as a good vehicle for getting family members involved in philanthropy. A foundation ffers a safe environment for the next generation to meet key advisors; discuss investments and other money-related topics that are often taboo; and to explore core values. Younger family members can be given responsibility for specific foundation-related projects, which gives them an opportunity to demonstrate their abilities.
Infusing family into foundation operations is not without risk, however. If family members are being paid by the foundation, it is critical the compensation is reasonable, otherwise the payments could be categorized as self-dealing. Depending on the services rendered and the amount of compensation involved, it may be appropriate to have a compensation study done to document that the pay is reasonable. There's also the risk that family members unfamiliar with the applicable laws may violate state or federal rules governing foundations. Whether the violations were innocent mistakes or intentional, it can bring unwanted attention.
Conclusion
A wide range of issues need to be considered anytime an affluent client is establishing a private foundation. Certain issues, however, are particularly relevant for hedge fund principals and can raise challenging technical issues not posed by other clients. With proper planning, however, a private foundation can provide the ideal vehicle for fund principals to achieve their philanthropic goals.
Stephen Liss is a partner at Withers Bergman LLP with a private client practice that includes domestic and international estate planning, planned charitable giving and tax-exempt organizations. Stephen can be reached at 203-974-0390 or [email protected].
Evan Jehle, CPA, is a senior manager at Rothstein Kass Family Office Group. He provides accounting, tax and business consulting services to family offices, family-owned businesses, high-net-worth individuals and hedge-fund general partners and management companies. Evan can be reached at 212-997-0500 or [email protected].
The authors thank Michael Berry, a senior manager at Rothstein Kass, for his invaluable contributions to this article.