Private foundations receive certain tax incentives to encourage philanthropic giving, including income tax savings, tax-free growth of assets, capital gains tax savings and estate tax savings, among others.

They also come with serious conditions to qualify for those tax breaks—though for the right client, private foundations can be useful and surprisingly nimble financial vehicles, advisors say.

“Contributions to private foundations do provide a tax deduction, although they can be more limited than a contribution to a public foundation or charity,” said Dan Peterson, associate financial advisor at Ameriprise Financial in Hauppauge, N.Y., adding that private foundations provide more control and flexibility regarding how charitable dollars are spent and what causes are supported.

“Private foundations involve additional complexity, board constitution, administration, tax return filings as well as other important considerations,” said Jeff Wagner, senior partner at LVW Advisors in Rochester, N.Y. “A qualified CPA should be engaged to do the annual Form 990 filing, advise on risks of triggering excise taxes and new tax developments.”

The income tax deduction arising from a charitable donation to a foundation may differ from that to a public charity. “For instance, donations of cash and long-term capital gain publicly traded stock generally result in a fair market value deduction, as is the case when making such donations to a public charity,” said Jeff Haskell, chief legal officer at Foundation Source, a provider of management services for private foundations. But “a donation of real estate or other types of securities to a private foundation typically will result in only a basis deduction. Such donations to a public charity typically would result in a fair market value deduction.”

“If they’re going to contribute non-cash assets, they should think about donating assets for which the basis is equal or very close to the fair market,” said Jennifer Bruckman-Gorak, deputy legal officer with Foundation Source. “If they’re going to contribute publicly traded securities for which they’re expecting a fair market value deduction, donors must ensure that it’s stock as opposed to bonds, options and so on, and that it’s long-term capital gain property.”

One strategy is to use both a private foundation and a donor-advised fund to maximize fair market value deductions. “Assets donated to a private foundation or a DAF are removed from the donor’s estate, creating the equivalent of an estate tax deduction,” said Don Evans, president and CEO of the Crewe Foundation in Salt Lake City.

Among other conditions, foundations, unlike public charities, pay a nominal tax on net investment income, which generally comprises passive income and realized capital gains, Haskell said.

Currently, a private foundation is also required to make qualifying distributions of at least 5% of the aggregate fair market value of all the foundation’s assets valued annually. A 30% tax on the undistributed amount is assessed to any private foundation that fails to meet this requirement.  

Current legislative proposals would limit a foundation’s ability to satisfy its annual 5% payout requirement with grants to donor advised funds (DAFs) or compensation paid to certain insiders. “Also, such proposals include provisions that would eliminate the excise tax on net investment income for foundations that either increase their charitable distributions to 7% in any given year or sunset within 25 years of formation,” Haskell said.

Size and duration can be confusing. “A common misconception is that it’s necessary to have a large endowment—$5 million or more—to justify the setup and maintenance of a private foundation. We’ve found that initial endowments of $250,000 are enough,” Evans said, “especially when future gifts are anticipated.”

According to the National Center for Charitable Statistics, more than 70% of foundations have less than $1 million in assets, Haskell added.

Primarily, donors have to know how to keep a private foundation in compliance with the IRS. Among other concerns, the IRS restricts  “self-dealing” involving property, leases, loans, credit and compensation. Private foundations must use care regarding excess business holdings and “jeopardy investments” that compromise a foundation’s charitable purposes, advisors say.

“The other misconception is that private foundations are only for long-term giving. Private foundations may be set up in response to a specific crisis or disaster to meet a more short-term need,” Peterson said.