Philanthropic reasons abound why a donor might establish a private foundation for charitable giving, several short- and long-term tax benefits also make such an entity appealing.

“Savvy investors and their advisors know that there are ways to pursue their philanthropic goals that can also provide attractive tax and financial benefits, but they need help understanding their options and how those options can enhance how they are already investing and giving,” said Jennifer Bruckman-Gorak, J.D., deputy legal officer at Foundation Source. “Foundations offer three potential tax benefits: reduced income tax liability in the year contributions are made, avoidance of capital gains tax on the sale of appreciated assets donated to or purchased by the foundation and reduction or elimination of federal and/or state estate taxes.”

The famous tax breaks of private foundations kick in only with certain kinds of funding.

“Private foundations shouldn’t be set up only for tax avoidance techniques,” said Erin Hadary, partner at Moneta in Denver. “I generally advise my clients to first have a charitable purpose. The reason should [also] be based on the donors’ desire to be in control and hands-on in the management.”

“It’s generally well known that donations made to private foundations create income tax deductions. Less commonly known is that only gifts to private foundations of publicly traded stock and cash generate fair market value income tax deductions,” said Don Evans, president and CEO of Crewe Foundation, Salt Lake City, adding that gifts to private foundations of real estate and privately held stock only allow for cost basis deductions and at the rate of 20% of AGI. “Careful consideration should be taken as to which assets are used,” Evans said.

“The deduction is limited to 30% of AGI for cash and limited to 20% for long-term capital gain property,” Hadary added. She also said that to qualify for an income tax charitable deduction, an irrevocable transfer to an eligible recipient must take place.

There is also a tax advantage on the growth of assets inside a private foundation. “Instead of the regular income tax, private foundations pay a 1.39% excise tax on net investment income,” Hadary said. “Over the years, the private foundation’s value may be able to exceed the total amount of the contributions, despite making regular charitable grants.”

The IRS reduced the excise tax on private foundation net investment income beginning in 2020 from a 2% two-tiered taxation system, Evans said. The IRS also released Publication 5313 stating an increased focus in 2022 on the examination of high-income taxpayers, “especially for private foundations,” Evans said. “We highly encourage the practice of engaging a third-party private foundation administrator.” 

Conditions regulating private foundations can be complex. Among other concerns, the IRS restricts certain deals (aka “self-dealing”) involving property, leases, loans, credit and compensation. Private foundations have an annual 5% payout requirement and must use care regarding excess business holdings and “jeopardy investments” that compromise a foundation’s charitable purposes.

“It’s very rare in today's landscape that a high-net-worth family doesn’t consider the use of a charitable foundation [in] liquidity events,” Evans said. “It’s vitally important that donors plan well in advance of any potential sale or liquidity event to avoid step transaction rules and potentially lose the bypass of capital gains tax at the time of sale.”

Any assets donated to a private foundation or a DAF are removed from the donor’s estate, creating the equivalent of an estate tax deduction.

“Many private foundations are created with less than $3 million to $5 million and, at this level, the administrative work associated with maintaining the fund ... can be significant and may not be worth the clients’ efforts,” said James G. McGrory, a partner with Armanino LLP in Philadelphia. “Clients who want to contribute at a level of less than this should instead consider the benefits of a donor advisor fund.”