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.