Many taxpayers search intensely at year-end for tax-savvy strategies to mitigate or reduce their tax burdens, but why should that only apply to individuals, trusts or for-profits? There are excellent tax strategies to implement for your private non-operating foundation in order to lessen the tax impact and pass along more to charity! There are also strategies in which you, as the creator, benefit tax-wise when proactively engaging in planning opportunities aligned to your private foundation. The overall benefit is a win-win as you potentially save income taxes, the foundation saves excise taxes, and the charities reap the benefit of increased funding.
A few ways to structure transactions in order to minimize excise taxes or increase your grant-making activity include:
MINIMUM DISTRIBUTION REQUIREMENT
Every year, private foundations must distribute 5% of the fair market value of their assets to charity. There are certain strategies that can come into play with regard to this calculation.
- Remember to allocate direct and indirect expenses incurred to carry out the foundation’s charitable purpose. Contemplate accelerating deductions paid by the foundation in years where distributions to charity were low (or investment income was high). When the foundation allocates expenses toward its charitable giving, it has the same impact as when the foundation writes a check to the charity. The allocated expenses are utilized to fulfill the 5% requirement. For example, if the foundation hires a consultant to perform due diligence on grants in order to investigate and evaluate the charity’s performance, such consulting fees would be allocated towards the 5% distribution requirement.
- Invest in Program Investments, as they are a win-win for private foundations. PRI’s are actually just like an outright grant to charity and can be used towards the 5% requirement. PRI’s are investments that support charitable activities and yet might include a low rate of return. Examples of PRI’s are low interest or interest-free loans to impoverished children, a high-risk investment in a low income housing project within a targeted area, or a low interest loan to a minority small business.
- Have the private foundation donate highly appreciated stock to the charity to satisfy the 5% requirement and avoid paying excise tax on investment income. This strategy is truly a “win-win.” The private foundation will avoid paying the 2% or 1% excise tax on the appreciation (or the difference between the fair market value and the cost basis of the stock/donor’s cost basis, if donated). Additionally, the foundation gets the stepped up valuation when it donates it to charity. The qualifying distributable amount that goes towards the foundation’s 5% requirement is the average of the high/low price traded on the day of donation and not the foundation’s cost basis.
- Distribution to a Donor Advised Fund. A donor advised fund is another charitable vehicle typically managed by a public charity or community foundation. However, the strategy here is when a donor has both vehicles in place and understands how to formalize charitable giving most advantageously. The key incentive is that private foundations can make grants to a DAF owned by the founder of the private foundation as part of its 5% qualifying distribution.
- Utilize the foundation’s excess distribution carryover. The 5% distributable requirement calculation is a moving target during any given year, as the market valuation which determines this amount fluctuates daily. The good news is that, because of this, the foundation is given an additional year to distribute the current requirement before the onerous penalty kicks in for noncompliance. So when a foundation distributes more than its minimum requirement, an excess distribution carryforward will result. This carryforward is laddered by year and will remain available for five years. If not utilized in the five years, it will expire. Many foundations do not pay attention to this excess amount or realize that it can be used towards the current distribution requirement.
- Real Estate. When real estate is among the holdings of a private foundation, consider the down-swing in the market and secure the lower appraisal on the property. That would reduce the 5% distribution requirement.
Reducing the foundation’s excise tax from 2% to 1%.
- Consider accelerating distributions to charitable organizations in order to reduce the excise tax rate from 2% to 1%. Private foundations are exempt from income tax; however, they are subject to a 2% excise tax on net investment income. This rate of 2% can be reduced to 1% if the qualifying distributions exceed the current year average monthly fair market value of investments, multiplied by the average distribution ratio (or the rolling average of distributions divided by the assets fair market value) over the past five years, plus 1% of current year net investment income. If the foundation’s investment income is significantly high during the year (i.e., large capital gains), monitor the distributions in order to ensure that the current year qualifying distributions or the grants made to charity exceed this level.
- Don’t bother engaging in the calculation to reduce the excise tax to 1% in the year of formation; it is not available. The reduction also is not available for the five-year period in which the foundation was subject to penalties for not distributing the minimum requirement to charity.
- Use it or lose it! Net losses cannot be offset against other investment income in order to reduce the foundation’s excise tax liability for the year. Additionally, net capital losses are not carried forward to future years. In order to avoid this, it is important to monitor the foundation’s portfolio holdings to make sure that net losses do not occur and to have gain positions offset losses at year-end to prevent forfeiting the benefit of losses. If gains are not available within the portfolio, consider making a donation of highly appreciated low-basis stock.
- Employment. Reasonable salaries can be paid to family members, trustees and directors who work for the private foundation. It is best to have a compensation policy in place as well as comparable data, industry surveys and formalized documentation to support the compensation. When the roles and responsibilities of employees are geared toward the foundation’s charitable activities, such salary can be allocated towards the 5% distribution requirement.
Donations to the private foundation
- Consider a donation to the private foundation of highly appreciated stock held long-term. The personal charitable deduction for donating highly appreciated stock to the foundation is the fair market value (average of the high for the day). The main tax advantage is that the taxpayer avoids paying income tax on the appreciation.
If the private foundation grants this donated stock to a public charity in order to satisfy its 5% minimum distribution requirement, the private foundation avoids paying excise tax on the appreciation while the taxpayer also avoids the gain.
So, as we approach year-end, tax efficiency is a long-standing benefit for all, including private foundations. While the rules relating to private foundations are complex and less than obvious, there are still methods to save on excise taxes and maximize charitable giving.