Is a Private Foundation Right for You?

Individuals and families with wealth often include charitable giving in their financial plans. According to a study by the Indiana University Lilly Family School of Philanthropy, roughly 85% of wealthy households give to charity each year, compared with 49% of the general population.

However, even among the wealthy, approaches to giving vary widely. While some prefer to offer support via direct donations to public charities, those who wish to effect large and lasting change may go so far as to set up a giving vehicle such as a private family foundation to further their philanthropic goals.

From articulating your charitable goals to making your first contribution, here's what it takes to get a private foundation off the ground.

It's common for a foundation to spend between 2% and 5% of its assets annually on management and upkeep—primarily in three areas:

1. Investment management: Some founders assume they can manage a family foundation's investments themselves, but these entities are subject to unique investment and tax constraints that, if managed improperly, can jeopardize the foundation's tax-exempt status. Unless you're an investment manager by trade, it's probably best to outsource this work to a professional.
2. Record-keeping: It's also vitally important to keep thorough records of the family foundation's operations, including fees and expenses, funding and income statements, granting history, and meeting minutes. The IRS takes these sorts of legal and tax documents seriously, and so should you.
3. Taxes: All private family foundations—regardless of whether they have taxable income and/or grant activity to report—must file a tax return with the IRS. What's more, if a foundation's annual investment income exceeds its deductible operating expenses, it may be subject to a 1.39% excise tax on its net investment income. The reporting requirements for private family foundations are complex, so taxes are another area where hiring professionals is recommended.

Giving via a private family foundation allows you to significantly broaden your charitable reach.

Typically, only donations to a federally recognized 501(c)(3) charity are tax-deductible. However, grant-making via a private foundation allows you to support charitable initiatives that lack 501(c)(3) status—be it another individual, a foreign nonprofit, or a noncharitable organization—while also capturing the tax deduction on any gifts you make to the foundation within the funding limits outlined above.

Be aware, however, that private family foundations must publicly disclose all charitable contributions and grants in their annual tax filings. Foundations do not offer privacy to their creators or benefactors.

It's also important to note that private family foundations are required by law to disburse at least 5% of their assets annually in the form of charitable grants and related operating expenses—regardless of market conditions. While mandatory grant-making during periods of market decline could significantly diminish your charitable assets, sustained giving helps support your charitable mission year after year.

Depending on a family's giving goals, a private family foundation isn't the only strategic giving vehicle to consider. In fact, a donor-advised fund (DAF) can meet all or most of their goals without the time commitment, administrative responsibility, costs, or privacy considerations that come with a foundation.

The potential advantages of DAFs include:

• Costs: A DAF account has no setup costs, low or no minimum contributions, and relatively low administrative fees.
• Deductibility: DAFs are 501(c)(3) public charities, meaning contributions to them qualify for the more favorable tax-deduction limits of 60% of AGI for cash gifts and 30% of AGI for appreciated assets (versus 30% and 20%, respectively, for private foundations).
• Gift valuation: The tax deduction you receive for donations to a DAF is based on the fair market value of all appreciated assets (not just stocks, as is the case with private family foundations).
• Investment management: You can invest your contributions in one of several predefined investment pools, or you can appoint an independent advisor to manage a customized portfolio.
• Grant timing: There's no annual minimum grant-making requirement for DAFs. Contributions are irrevocable and must be used for a qualified charitable purpose, but you decide when to recommend grants and can choose to hold off in certain years so you can make a greater impact in others. Plus, there's no capital gains tax on investment income, which helps to maximize your charitable giving potential.
• Record-keeping: All administrative tasks, including record-keeping and grant processing, are managed by the DAF sponsor.
• Privacy: DAF sponsors are required by the IRS to publicly report aggregate granting activity, but this does not include individual account information.

That said, important differences between DAFs and private family foundations include:

• Limits on grants: Unlike private foundations—which can work with nearly any entity, private or public, to accomplish its charitable objectives—DAFs can make grants only to federally recognized charities.
• Lifespan: Many DAF sponsors limit the number of successor generations to the DAF. It's important to get a clear understanding of the sponsor organization's restrictions regarding successors, if any, and whether there are rules on DAFs lasting in perpetuity.

However, that's not to say you must choose between a donor-advised fund and a private family foundation.

A family might decide to establish a private foundation to realize specific charitable ambitions and use a donor-advised fund for other aspects of their philanthropy. What's more, both allow you to involve family members in creating a charitable giving strategy to achieve your philanthropic goals.