A private foundation is a 501(c)(3) nonprofit entity created and controlled by a limited group—often a single family or corporation—with the primary purpose of funding charitable activities. Unlike public charities, which receive broad public support, private foundations usually rely on a single major source of funding and emphasize grantmaking or direct charitable operations.
How to Set Up a Private Foundation
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Obtain an Employer Identification Number (EIN): You must apply for an EIN through the IRS, which can be done online, by fax, or mail. The online application is the quickest, often providing the EIN immediately. This number is essential for tax filings and bank accounts. More information is available on the IRS EIN page.
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File IRS Form 1023: To gain federal tax-exempt status as a private foundation, you need to file Form 1023, “Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code.” This detailed form requires thorough information about your foundation’s structure, governing documents, financials, and charitable purpose. Engaging legal and financial professionals can help avoid errors that might delay approval.
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Comply with State Requirements: After receiving federal tax-exempt status, register your foundation with state agencies. This may include applying for state tax exemptions, charitable solicitation registration, and submitting annual reports. Requirements vary by state but often involve the Attorney General’s office or a charity division.
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Fund the Foundation: Contributions to the foundation can include cash, appreciated securities, real estate, or other assets. Maintaining detailed records of all donations is critical for tax reporting and compliance.
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Establish Governance: Appoint a board of directors or trustees responsible for oversight, grant approval, and regulatory compliance. Adopt governance policies addressing conflicts of interest, grantmaking procedures, investments, and recordkeeping. Open bank and investment accounts in the foundation’s name to manage assets properly.
Understanding Private Foundation Compliance
Maintaining private foundation status involves adhering to specific IRS rules designed to ensure assets are used for public benefit, not private gain.
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5% Distribution Rule: Foundations must annually distribute at least 5% of the average fair market value of their non-charitable assets to qualified charities or charitable operations. This minimum payout ensures active use of funds for charitable purposes.
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Self-Dealing Restrictions: Transactions between the foundation and “disqualified persons” (e.g., substantial contributors, foundation managers, or their families) are prohibited to prevent personal benefit. Prohibited transactions include sales, leases, loans, furnishing goods or services, and excessive compensation. Violations carry significant excise taxes.
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Excess Business Holdings: Foundations and disqualified persons combined generally cannot own more than 20% of a business to avoid misuse of tax benefits.
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Jeopardizing Investments: Investments must be prudent and not place the foundation’s assets at unreasonable risk, ensuring the foundation’s ability to fulfill its charitable mission.
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Taxable Expenditures: Expenditures like lobbying, political campaign activity, grants to individuals for non-charitable purposes, or non-charitable organizations may trigger penalties.
Private Foundations vs. Donor-Advised Funds (DAFs)
| Feature | Private Foundation | Donor-Advised Fund (DAF) |
|---|---|---|
| Control | High; grantors retain control over investments and operations. | Low; sponsoring organizations have final authority. |
| Setup Cost | High; includes legal and filing fees. | Low; minimal setup fees. |
| Administrative Burden | High; requires regular filings and board oversight. | Low; sponsoring organization handles compliance. |
| Privacy | Public disclosure of Form 990-PF. | Generally anonymous to the public. |
| Investment Control | Full, within IRS guidelines. | Limited to sponsoring organization’s options. |
| Grant Timing | Must meet 5% annual payout. | No required payout schedule. |
| Tax Deduction Limits | 30% AGI limit for cash; 20% for appreciated stock. | 60% AGI limit for cash; 30% for appreciated stock. |
| Legacy Potential | Supports multi-generational involvement and legacy. | Less direct control over legacy or family involvement. |
Common Mistakes to Avoid
- No clear mission or purpose defined.
- Underestimating ongoing administrative and compliance costs.
- Failing to meet the 5% distribution requirement.
- Engaging in prohibited self-dealing transactions.
- Poor record keeping and documentation.
- Not consulting legal and tax professionals.
Frequently Asked Questions
Q: How long does it take to establish a private foundation?
A: Typically 6 to 18 months or longer depending on IRS processing and state registration requirements.
Q: Can I pay myself or relatives from the foundation?
A: Direct personal benefits are prohibited, but reasonable compensation for legitimate services aligned with IRS rules is allowed with proper documentation.
Q: What is the minimum funding required?
A: While no legal minimum exists, experts recommend $1 million to $5 million in assets for sustainability. Smaller amounts may be better suited for Donor-Advised Funds.
Q: Do I have to be wealthy to start a private foundation?
A: Though many private foundations are created by high-net-worth individuals, the costs and compliance usually make it more practical for those with significant assets.
For more detailed guidance on establishing and managing private foundations, visit the IRS Private Foundations page.
Sources:
- Internal Revenue Service (IRS): Private Foundations https://www.irs.gov/charities-non-profits/private-foundations
- Council on Foundations: What is a Private Foundation? https://www.cof.org/what-private-foundation
- Investopedia: Private Foundation Definition https://www.investopedia.com/terms/p/privatefoundation.asp
- NerdWallet: Donor-Advised Fund vs. Private Foundation https://www.nerdwallet.com/article/investing/donor-advised-fund-vs-private-foundation