A foundation is an entity that is established as a nonprofit corporation or a charitable trust, with a principal purpose of making grants to unrelated organizations or institutions or to individuals for scientific, educational, cultural, religious, or other charitable purposes. This broad definition encompasses two foundation types: private foundations and public foundations. The most common distinguishing characteristic of a private foundation is that most of its funds come from one source, whether an individual, a family, or a corporation. A public foundation, in contrast, normally receives its assets from multiple sources, which may include private foundations, individuals, government agencies, and fees for service. Moreover, a public foundation must continue to seek money from diverse sources in order to retain its public status.

The best way to identify private foundations is to refer to the formal determination made by the Internal Revenue Service. Under the rules first set forth by the Tax Reform Act of 1969, those nonprofits determined by the IRS to be "private foundations" are treated differently from other nonprofits. To understand the differences between private and public foundations, it is helpful to trace the path that leads to an IRS determination letter. A nonprofit that has been legally established in one of the 50 states must obtain recognition as a charitable organization from the IRS in order for contributions to it to be tax deductible. Section 501 of the Internal Revenue Code covers many types of organizations that are exempt from federal income tax. It covers those tax-exempt organizations that are "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes...."

An organization that meets the definition of Section 501 (c) (3) is measured against Section 509(a) of the Internal Revenue Code, which declares that a 501(c)(3) organization is presumed to be a private foundation unless it can demonstrate that it meets at least one of the four criteria:

• It is an organization described in 170(b)(1)A: churches, schools, colleges, etc.; hospitals, medical research institutes, etc.; support organizations to public colleges or universities; certain governmental units; publicly supported organizations;
• It is an organization that normally receives more than one-third of its support from gifts, grants, or fees and gross receipts from admissions, sales, etc. and normally receives not more than one-third of its support from investment income;
• It is a supporting organization that is not publicly supported but is organized for and controlled by another public charity;
• It is an organization organized and operated exclusively for testing for public safety.

Most grantmaking foundations apply for Section 501(c)(3) status. Those that do not meet the requirements for classification as "not a private foundation" are, by default, private foundations. Thus the IRS defines a private foundation by exclusion: a private foundation is a nonprofit organization that does not meet one of the four criteria for exclusion. The IRS does not have a separate classification for "public foundations," so public charities that are significant grantmakers can be difficult to identify using IRS definitions and resources.

The tax laws for private foundations include, among other things, a minimum distribution requirement, an excise tax on investment income, and a limit as to the proportion of a for-profit enterprise they may own, the "excess business holdings" rule. Private foundations must make "qualifying distributions" of at least 5 percent of the average market value of their investment assets in any given fiscal year by the end of the following year, a rule often referred to as "the payout requirement." The excise tax, normally 2 percent of net investment income, or 1 percent in special circumstances, counts as a credit toward the 5 percent minimum.

Although they are complex, the definitions of foundations contained in the Internal Revenue Code determine not only the way a foundation must operate but also the information it must make publicly available. All private foundations must file the Form 990-PF, which is a valuable source of information about their finances, board members, and grants. The Center acquires the Forms 990-PF from the IRS as they are processed and adds them on a continuous basis to a database identifying virtually all private foundations.

Because the IRS has no separate designation for them, public foundations follow the same reporting guidelines as other public charities. Public charities with gross receipts over $25,000 in any year must file an information return with the IRS for that year, using the Form 990. The Forms 990 for public foundations are indistinguishable from those for non-grantmaking public charities, so they are not a useful means of identifying public foundations.

Private foundations typically carry out their philanthropy by making grants to public charities. Private foundations are precluded from making grants to political campaigns or organizations that exist to influence legislation and voting.

Foundation Management Associates e-Philanthropy solution assures that all grant applicants comply with this standard via an electronic link with the Internal Revenue Service database of over 750,000 IRC 501(c)(3) public charities. There is no need to request IRS determination letter from your grant applicant. We do the work of checking it out for you.

Foundation Management Associates provides expertise on the rules and regulations governing private foundations, and monitors foundation activity daily. This lets individuals focus on the rewards of a private foundation, charitable giving. Some of the rules which apply include:

• Donations to a private foundation may only be used for charitable purposes and certain administrative expenses.
• Typically, donations to a private foundation are tax deductible up to 30% of adjusted gross income for cash and up to 20% of AGI for appreciated securities, with a five-year carry forward. Individuals should consult with their tax advisor.
• A private foundation must donate 5% of its average net assets from the preceding year to charitable causes. (This may include some administrative expenses.) Foundation Management Associates calculates the required distribution for you electronically on a daily basis and posts it to the foundation web site.
• Non-operating private foundations, which account for 94% of all foundations, primarily exercise their philanthropy by making grants to 501(c)(3) public charities.
• Private foundations are precluded from giving money to political campaigns or organizations that exist to influence legislation and voting.
• The IRS strictly prohibits self dealing. Disqualified individuals (the donor, lineal descendants and antecedents, e.g., parents and children, and people under their employment) may not engage in transactions with the foundation, except to make donations to it, or, under limited circumstances, to receive fair market value compensation for services. Examples of self dealing include:
  • Purchasing items from or selling items to the foundation.
  • Personal use of foundation assets or income.
  • Borrowing money from the foundation.
  • Retaining foundation assets (e.g., paintings) on private premises.

Typically, donations to a private foundation are tax deductible up to 30% of adjusted gross income for cash and up to 20% of AGI for appreciated securities, with a five-year carry forward. Individuals should consult with their tax advisor.

They differ both in control and flexibility. Contributors to a donor advised fund make irrevocable contributions to a nonprofit organization that administers the fund and makes decisions regarding fund investments. Contributors may recommend eligible charities as recipients for grants, but the fund's governing body is free to accept or reject the recommendations.

With a private foundation, there is greater flexibility and control. Private foundations can typically accept and hold a much wider variety of assets, such as 144 restricted stock and hedge funds, and the founder retains control over how the assets are invested. In addition, the founder retains control over the charitable donations and other foundation disbursements. Foundations are also able to hire staff, reimburse expenses, and set up structured giving programs, such as scholarships.

Most charities that receive grants from foundations must annually satisfy a public support test that demonstrates that a significant portion of their support comes from a broad cross-section of the general public. A large grant from one private foundation to a relatively small charity can "tip" the grantee out of public charity status into private foundation status. Generally this is not the concern of the foundation, but rather, something that the public charity should pay attention to.

The law requires more due diligence and recordkeeping for grants to individuals. The rules are even more restrictive for company foundation scholarships that are limited to corporate employees and their family members. Foundation Management Associates can help you navigate through these special legal requirements necessary for scholarships, fellowships, disaster relief, economic relief, prizes and awards - with particular attention to company scholarship programs.

All private foundations must pay an annual 2% (or 1%) tax on net investment income. Foundation Management Associates can help you understand how this tax is calculated and how a family foundation can qualify to pay only 1%.

All family foundations must satisfy an annual minimum distribution rule equal to 5% of net investment assets. Foundation Management Associates can help you understand in more detail how this rule affects your foundation. We can take you through a step by step calculation of this requirement and we provide clear definitions for: average net investment assets, minimum distribution return, distributable amount and qualifying distributions (what expenditures count in meeting the 5% rule).