Cummings & Lockwood Estate Planning FAQs

A private foundation is a type of charitable organization.  Both tax-exempt private foundations and public charities are both known as “501(c)(3)s” (because they are both exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code), and both qualify to receive contributions that are deductible for income, gift and estate tax purposes.  However, a private foundation usually receives its funding from one or a few private sources, while most public charities receive on-going public support for their programs and activities.  The principal activity of a private foundation tends to be making grants to public charities and awarding scholarships to individuals.  It may, however, operate a direct charitable program, such as a museum, arboretum, homeless shelter, or Meals on Wheels program, in which case it may be appropriate for the foundation to seek recognition from the Internal Revenue Service as a “private operating foundation.”

A foundation can be created as a corporation or as a trust.  Generally, it is easier to form and administer a trust than a corporation.  If you establish the foundation as a trust, then certain powers (such as termination and amendment powers) should be included in the trust agreement to make the trust as flexible as possible.  The trustees should also be given the power to incorporate the foundation in case that later becomes desirable.

Normally, the corporate form is chosen when a foundation is expected to engage in activities that expose its managers to a greater risk of liability, such as providing services or goods to or holding facilities open to the public.  The trust form is often used when a foundation will carry out its tax-exempt purposes by making grants to other charitable organizations.  However, the choice between a trust or corporation may depend on how comfortable you are with corporate governance procedures and, possibly, also on the number of individuals you wish to have participate in governing the foundation.

There are few restrictions on who may serve as a trustee, director or officer of a foundation (a “foundation manager”).

If a foundation is incorporated under Connecticut, Florida or New York law, it must have at least three directors.  An individual may serve as both a director and an officer and may hold multiple offices.  However, New York law requires, and it is generally better practice for, different individuals to serve as president and as secretary.

If a foundation is formed as a charitable trust, an individual, including the individual who formed the trust, may serve as the sole trustee and control all functions of the foundation, including distributions.

However, there may be advantages to naming several trustees.  Consider the following:

• Would you like to have your children or other family members become involved in the process of philanthropy?  This is an opportunity for you to involve them in the joys of participatory philanthropy while you are still alive and able to guide them.
• Would the process of selecting charitable recipients of foundation grants benefit from the involvement of persons with different backgrounds and areas of expertise?
• Do your professional advisers share your interest in the foundation?  If so, would their professional expertise coupled with their knowledge of your family’s goals and objectives be helpful in guiding the foundation?
• If you plan to focus the foundation’s grants on one or two charities, would it be helpful to have members of their boards serve as trustees of your foundation?

Yes.  If you want to limit the ability of future foundation managers to change your foundation’s focus, you can restrict the foundation’s charitable purposes in its organizational documents and restrict the power of future foundation managers to amend those purposes.  You can also impose legally binding restrictions on the foundation’s use of your contributions at the time you make your gifts.

If you intend to benefit a particular public charity or charities, then you might want to consider creating a supporting organization instead of a private foundation.  A supporting organization is organized and operated exclusively to benefit certain identified public charities.  It is itself classified as a public charity (rather than as a private foundation) because of its relationship with and responsiveness to the public charities it was created to support.  However, a supporting organization cannot be controlled, directly or indirectly, by the persons who create and fund it or their family members.  Since a supporting organization is a public charity, contributions you make to it qualify for more favorable treatment under the income tax charitable deduction rules.  In addition, most of the so-called “excise tax” rules (discussed below), which are applicable to private foundations, do not apply to supporting organizations.  However, the organizational and operational requirements for a supporting organization can be as or more cumbersome to deal with, and certain excise tax rules applicable to supporting organizations are actually more restrictive, than the private foundation excise tax rules.

Yes.  A foundation’s annual net investment income (such as, interest, dividends and capital gains) is subject to a 2% excise tax that is, in effect, a tax on the foundation’s income.  Each year (other than its initial tax year) in which a foundation’s charitable distributions equal or exceed its average historic giving ratio plus 1% of its net investment income for the year, this 2% tax on income is reduced to 1%.

If a foundation has unrelated business taxable income, it must pay tax on that income at regular trust or corporate income tax rates.  Unrelated business taxable income is income from the conduct of an active trade or business that is not directly and substantially related to carrying out the foundation’s charitable purposes (other than by producing revenue for the foundation).  A foundation can have unrelated business taxable income if it holds an interest in a partnership or limited liability company that conducts or owns an interest in other pass-through entities that conduct an active trade or business.  If a foundation owns stock in an S corporation, all of its share of the S corporation’s income and gains, and any gain the foundation recognizes when it disposes of the S corporation stock, will be subject to unrelated business income tax.  A foundation’s debt-financed income also is subject to unrelated business income tax.  The tax applies to the debt-financed portion of the foundation’s income and gains from holding or disposing of the debt-financed property, whether the foundation holds property directly (e.g., a margined securities account or mortgaged real property) or indirectly (through a partnership or limited liability company in which the foundation holds an interest).

Other very significant excise (penalty) taxes may be assessed if a foundation fails to make certain required distributions or engages in certain prohibited transactions.

We have mentioned above some circumstances that indicate when a private operating foundation or a supporting organization might be an appropriate alternative to a grant making private foundation.

Another alternative to consider is establishing a donor-advised fund (a “DAF”) with an existing public charity that sponsors a DAF program.  Since the sponsoring charity owns the assets in its DAFs, it is responsible for all investment decisions, administrative duties and reporting obligations.  As the grant adviser for the DAF you establish, you would have the right to recommend, but not to direct, grants to be made from your DAF.  Although the grant adviser can only make recommendations, the charities that sponsor DAF programs generally give full and careful consideration to the grant adviser’s recommendations.  A sponsoring charity will not, however, make grants that are prohibited by law or offensive to its charitable purpose or mission, and it may have a grant making policy that prevents it from accepting certain grant recommendations.

When choosing a sponsoring charity, you should read the description of its DAF program carefully to determine whether the program’s terms and restrictions are acceptable to you.  Some charities allow each then serving grant adviser to name successor advisers for the DAF, in perpetuity.  Others limit the number of successor advisers.  Some charities operate national DAF programs, while others, such as community foundations, tend to focus their grant making on a particular geographic area.  A sponsoring charity may also require that its DAFs be used primarily or solely to make grants that support its own programs or the programs of its affiliates.

In addition to sponsoring DAF programs, many community foundations operate “donor-designated fund” programs that allow a donor to create a fund that will provide a permanent source of support for a particular charity or charities selected by the donor when establishing the fund.  Community foundations may also offer to establish a “field of interest fund” to benefit organizations that operate programs within a donor’s selected field of interest (such as, arts and culture, or youth and families).  Each year, the community foundation selects the charities that will receive distributions from its field-of-interest funds.  When you establish a DAF, you may also require the community foundation to distribute the assets remaining at your death to a designated fund or field-of-interest fund.

Contributions made to a public charity to establish a DAF or other restricted fund are treated more favorably for purposes of the income tax charitable deduction than are contributions made to a grant making private foundation.  Using a DAF can also be helpful for individuals who “bunch” their charitable contributions to exceed the  standard deduction amount and maximize their tax savings through itemization.  With the current standard deduction, many taxpayers may no longer see tax savings from their giving.  One strategy is to pool or “bunch” multiple years of charitable contributions in one year and itemize deductions in that year.  A donor may not want to actually contribute more assets to any certain charity in one year, so that donor may wish to contribute several years of charitable gifts to a DAF at one time.  The DAF can then be used to distribute grants to various charities over time as the donor desires.

Even if you create your own foundation, your local community foundation can still be a source of important information regarding organizations and programs in your community that need your foundation’s support.  By working with your local community foundation, you can help ensure that your private foundation’s efforts and activities are efficiently coordinated with the philanthropic activities of other organizations in your community.