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.