What Is a Private Foundation?

A private foundation is a type of nonprofit organization that is typically funded by a single source, such as an individual, a family, or a corporation, and is managed by a board of directors or trustees. Unlike public charities, which raise money from the general public and often operate programs directly, private foundations usually distribute grants to other nonprofits or run their own charitable programs. They are governed by the rules in the Internal Revenue Code, specifically Section 509(a), which distinguishes them from public charities.

Private foundations are a popular tool for philanthropy because they offer the donor significant control over how funds are used. The founder can set the mission, choose the causes, decide which grants to make, and even involve family members in governance. Common examples include the Ford Foundation, the Bill & Melinda Gates Foundation, and the Walton Family Foundation, though there are also tens of thousands of smaller family foundations across the United States.

How Private Foundations Differ From Public Charities

The distinction between a private foundation and a public charity is not just about size. The IRS uses a "public support test" to determine which category an organization falls into. Public charities must demonstrate that a significant portion of their funding comes from a broad base of public sources, such as individual donations, government grants, or fees for services. Private foundations, on the other hand, are usually funded by a small number of donors, often just one.

This difference in funding structure leads to a number of practical consequences:

  • Tax deductibility of contributions. Donations to private foundations are tax-deductible, but the limits are lower than for public charities. Individuals can generally deduct cash contributions to public charities up to 60% of adjusted gross income, while the limit for private foundations is 30%.
  • Operational rules. Private foundations must follow stricter rules, including minimum distribution requirements, self-dealing prohibitions, and limits on business ownership.
  • Public disclosure. Private foundations must file Form 990-PF annually, which is publicly available. The form discloses financial details, grants made, and compensation of officers and directors.

Key Rules Private Foundations Must Follow

Private foundations operate under a set of rules designed to ensure they serve a genuine charitable purpose. These rules are spelled out in Sections 4940 through 4945 of the Internal Revenue Code. Violations can result in significant excise taxes, so it is important for anyone running or advising a foundation to understand them.

Minimum Distribution Requirement

Private foundations must distribute at least 5% of the value of their net investment assets each year for charitable purposes. This can include grants to other nonprofits, certain operating expenses, and reasonable administrative costs. The requirement is intended to ensure foundations remain active and do not simply sit on their assets indefinitely. Many foundations distribute more than the minimum to demonstrate impact.

Self-Dealing Rules

Self-dealing occurs when a disqualified person, such as a foundation manager, a major donor, or a family member of either, benefits from a transaction with the foundation. Examples include selling property to the foundation, lending money, or providing services for unreasonable compensation. These transactions are generally prohibited, even if the foundation is getting a fair deal, and violations trigger excise taxes on both the disqualified person and the foundation itself.

Excess Business Holdings

Private foundations are restricted in how much interest they can hold in a business. Generally, a foundation and its disqualified persons together can own no more than 20% of a business enterprise, with some exceptions. The rule prevents foundations from being used to control private companies for the benefit of insiders.

Jeopardy Investments

Foundations are also restricted from making investments that jeopardize the foundation's ability to carry out its charitable purpose. While this rule is not as restrictive as it sounds, foundations are expected to exercise ordinary business care and judgment when investing.

Taxable Expenditures

Private foundations generally cannot spend money on activities that are not related to their charitable purpose, such as lobbying, influencing elections, or making grants to individuals without proper procedures in place. Grants to individuals must follow specific rules, including a process to ensure the funds are used for the intended charitable purpose.

Pros and Cons of Setting Up a Private Foundation

Setting up a private foundation is a serious decision, and it is not right for everyone. Here are some of the main advantages and disadvantages to consider.

Advantages

  • Control and flexibility. The founder can shape the foundation's mission, strategy, and grantmaking priorities.
  • Family involvement. A private foundation can serve as a vehicle to involve multiple generations in philanthropy, teaching younger family members about giving back.
  • Legacy planning. A foundation can continue long after the original donor has passed away, providing a lasting charitable legacy.
  • Tax benefits. Contributions to the foundation are generally tax-deductible, and the foundation itself is exempt from federal income tax.

Disadvantages

  • Cost and complexity. Setting up and running a private foundation involves legal fees, accounting costs, and ongoing administrative work. Many families hire a small staff or work with a foundation service company to handle compliance.
  • Regulatory burden. The strict IRS rules require careful recordkeeping, annual filings, and an awareness of penalties for non-compliance.
  • Public scrutiny. Because Form 990-PF is public, donors should expect their charitable activities, compensation, and even investment returns to be visible to anyone.
  • No investment tax benefits. Unlike donor-advised funds, private foundations generally must pay a small excise tax on net investment income.

Alternatives Worth Considering

Before creating a private foundation, it is worth comparing it to other giving options. Donor-advised funds are a popular alternative because they offer similar tax benefits, including a deduction at the time of contribution, but with much lower administrative costs. Commercial sponsor organizations manage the fund, and donors can recommend grants over time. However, the donor has less legal control and the fund is technically the property of the sponsoring organization.

Charitable remainder trusts and charitable lead trusts are other options that combine charitable giving with estate or income planning. These vehicles are more complex but can be powerful tools for specific situations, such as providing income to family members while benefiting charity.

Getting Started

For those who decide a private foundation is the right fit, the process generally involves drafting articles of incorporation, applying for tax-exempt status with the IRS using Form 1023, setting up a board of directors, and creating a governance structure. The foundation will need a separate bank account, its own recordkeeping, and a plan for the annual 5% distribution. Many founders also work with an investment advisor who understands the unique rules foundations must follow.

Private foundations can be an incredibly powerful way to put wealth to work for the public good, but they are not the right choice for every donor. Anyone considering one should consult with a tax professional, an estate planning attorney, and ideally someone with experience in the foundation world before making a decision.