A private foundation can be an excellent vehicle for philanthropic, estate and income tax planning. There also are pitfalls that private foundations can encounter if the managers are not being prudent in overseeing the foundation’s activities.
Noncash contributions can be very advantageous for both the donor and the foundation. By gifting stocks instead of the proceeds from a sale, donors avoid capital gains income and the foundation gets the benefit of future growth. However, when contributing stock to a private foundation, make sure the stock has appreciated in value. If stock is contributed with a loss, the donor only gets the market value for the contribution and the foundation’s basis is the market value as well.
When tangible personal property is contributed and put to an “unrelated use” of the foundation, the amount of the charitable deduction for the donor is only the donor’s tax basis in the property and not it’s fair market value (per Internal Revenue Code (IRC) Section 170). “Unrelated use” includes any activity not related to the foundation’s exempt purpose or function and includes the future selling of the property, for instance at a charity auction.
Investments & Business Holdings
Private foundation managers must be prudent in their investments and business practices. Having a diverse portfolio is expected to help effectively manage risk. Although diversifying is a requirement, there are exceptions to how quickly a private foundation needs to diversify its portfolio. The exceptions take into account whether an investment is inherited or gifted to the foundation instead of purchased directly and whether the market is strong or not.
Being prudent means not investing in enterprises that lack a reasonable business sense. These jeopardizing investments include: trading in securities on margin, trading in commodity futures, investing in working interests in oil and gas wells, buying puts, calls and straddles, buying warrants and selling short. Even though these investments are not seen as normally good investments, you don’t need to dump them immediately if they were acquired by the foundation through a gift. The facts and circumstances of how they were acquired and the type of investments play a major role in whether or not the investments are considered jeopardizing and how quickly the foundation needs to let go of them.
Holding too much of an investment is considered too risky for private foundations. There’s a penalty on excess business holdings that starts at 10 percent on the excess business holdings in the year the excess holdings occur. Beginning in 2018, there’s a new exception that allows a private foundation to be the sole owner of an operating business and not be subject to an excess business holdings penalty if it meets certain qualifications (per IRC §4943(g)).
Private foundations are taxed at a 2 percent rate on their net investment income, which is reported on Form 990PF. The net investment income tax can be reduced from 2 to 1 percent if certain distribution requirements are met. Private foundations also are subject to taxes on any unrelated business income (UBI) that’s reported on Form 990T.
Expenses of private foundations are split between charitable and investment purposes. Evaluating your expense allocations annually is important in determining your true net investment income. When calculating the net investment income for the year, capital transactions need to be carefully evaluated. Not only do net capital losses not get carried over to the next tax year, they don’t reduce the current year’s investment income beyond a net zero capital gain. So, planning to reduce your capital gains as low as possible without having net capital loss is key.
In 2018, two new taxes may be imposed on private foundations that have employees.
Parking and other qualified transportation fringe benefits that are paid on an employee’s behalf and are not an allowable deduction under IRC §274(a)(4) are now includable on Form 990T and taxed at the UBI rates.
In addition, any covered employee who is paid more than $1 million in remuneration or receives an excess parachute payment from the foundation or a related organization will be subject to further reporting and taxes on Form 4720.
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