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.
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
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
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
Operating A Foundation
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.
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.
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.
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.
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.
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.
Stephen Liss is an attorney at the law firm of Withers Bergman LLP, with a private client practice focusing on domestic and international estate planning, planned charitable giving and tax exempt organizations.
This article was not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.