Even with the stock market down for three consecutive years and nonprofit organizations struggling to garner private funding, clients still are showing increased interest in charitable vehicles that allow for ongoing donor involvement. People are attracted not only by the tax benefits and philanthropic aspects, but also by the opportunities to work with family members toward a common goal.

When an individual wants to establish a charity, the typical choices are private foundations, donor-advised funds, publicly supported charities and supporting organizations (see “Entities at a Glance,” page 87). To help a client choose, an advisor needs to understand the client's goals — and know which type of charitable entity is best suited to them.

Generally, practitioners must determine: why a client wants to create a new charitable organization, what income tax benefit is expected, what the new charity will do, how it will be funded initially and over time, how it will be operated, who will administer it, and how much control the client wishes to retain (see “Questions for Clients,” page 86). The different circumstances and intentions of two hypothetical clients — we'll call them “David“ and “Susan” — illustrate how various charitable structures can be used, as well as their attractions and limitations. But first, we'll review some basic tax considerations in charitable giving.

TAX DEDUCTIONS

Most clients want tax breaks for charitable donations, and are likely to receive them. But the tax benefit can vary greatly depending on the nature of the organization.

Generally, lifetime gifts by a U.S. donor to a domestic tax-exempt charitable organization, a 501(c)(3), can qualify for income and gift- tax deductions, and testamentary transfers can qualify for an estate tax deduction.1 All 501(c)(3)s are private foundations, unless they qualify as public charities, which requires that they conduct certain activities (such as churches, schools and hospitals), raise public support, or maintain a special relationship with another public charity.2 For gift and estate tax deductions, it does not matter whether a 501(c)(3) is a private foundation or a public charity. But the client's income tax benefit may be affected.

The income tax deduction for gifts to public charities and to special types of private foundations, including private operating foundations and conduit foundations,3 is more generous than the deduction for gifts to most private foundations. With a public charity deduction, a donor can offset up to 50 percent of his adjusted gross income (AGI)4 with cash gifts, and up to 30 percent of AGI with gifts of capital assets that, if sold, would produce long-term capital gain.5 The deduction for such property gifts generally is based on the property's fair market value.6

With a private foundation deduction, the amount of income that can be offset is limited to 30 percent of AGI for cash gifts and 20 percent for gifts of long-term-capital-gain property.7 The deduction for the latter is limited to its basis, unless the property is qualified appreciated stock (unrestricted publicly traded securities for which market quotations are readily available).8 In that case, the deduction would be based on fair market value. The percentage limitations are interrelated, so 50 percent of AGI is the maximum amount that can be offset in any year. Donors can carry forward any excess charitable deductions for up to five years.9

To secure the maximum income tax deduction when funding a grant-making private foundation, the client can give qualified appreciated stock equivalent to 20 percent of AGI and cash equivalent to 10 percent of AGI to the private foundation, and long-term capital gain property and cash, each amounting to 10 percent of AGI, to public charities. The property gifts would be deductible based on their fair market value, and the client would not be taxed on the unrealized gain.

EXCISE TAXES

The hallmarks of a private foundation are private funding and the client's ability to control the foundation. Special excise tax rules apply to all types of private foundations to curb activities with a potential for abuse.

The excise tax on self-dealing prohibits foundations from engaging in most transactions with a “disqualified person,” regardless of how fair or beneficial the transaction might be to the foundation. A disqualified person is defined in the Internal Revenue Code as an officer, director, trustee, substantial donor, a family member of any of these individuals or a trust, partnership or corporation in which one or more of them have certain interests.10 Public charities are subject to a similar excise tax on transactions that provide an excess benefit to a disqualified person.11

Other excise taxes apply when private foundations lobby, hold certain business interests, or make investments that jeopardize their charitable purpose. Foundations also are required to pay a 1 percent or 2 percent tax on their net investment income, distribute at least 5 percent of their investment assets for charitable purposes annually, and follow special procedures for grants to individuals and organizations other than domestic public charities.12

DAVID'S DILEMMA

David, a client, says: “I want to create a foundation to take care of my annual charitable giving. I would use $1 million of unrestricted General Electric stock that would generate long-term capital gain if sold. This is my only charitable gift. My AGI will be $5 million. I want a $1 million income tax deduction. I have no carry-forward deduction.”

He can satisfy both his income tax and charitable goals by creating and funding a private foundation. His $1 million of qualified appreciated stock will offset 20 percent of his AGI, so his gift will be fully deductible the year it's made.

When you ask David how he plans to run the foundation, he says he just wants to pick charities and have someone write and mail the checks for him. He therefore should consider a donor-advised fund (DAF) operated by a sponsoring public charity, such as an institutional gift fund or community foundation. His gift to the sponsoring charity would be accounted for as a separate fund, and David would have the right to recommend, but not direct, which grants are made from his fund. The sponsoring charity would own, administer and invest the fund, and write the grant checks. Sponsoring charities tend to be attentive to a donor's recommendations, but will not make grants that fall outside their guidelines.

A DAF is a contractual arrangement that varies from one sponsoring charity to the next. Before funding a DAF, David should review the charity's minimum fund size, minimum grant size, annual distribution requirements, maximum number of grants and grant advisors, as well as grant restrictions (such as purpose, geographic boundaries and eligible receipients). Some sponsoring charities require that part or all of the fund balance remaining at the end of the period for making recommendations be distributed to them; others distribute the balance as provided by the donor when the DAF is initially funded, or as recommended by the last advisor for the fund. When a charity also permits investment recommendations, the donor's options are usually limited to allocating the fund among a few pre-selected mutual funds. Finally, the services and fees of sponsoring charities vary.

Alternatively, David can create a private foundation and delegate the administrative tasks to his investment advisor, accountant, attorney, family members or to a financial institution or business that administers foundations.

David also should consider a DAF if he wants his grants to be anonymous. In contrast, federal law requires foundations to report their grants on annual returns that are available to the public. (Copies of returns filed with the Internal Revenue Service are accessible on the Internet at www.guidestar.org.) If both anonymity and control are important to David, he can fund a foundation, make grants to a DAF, and recommend anonymous grants from the DAF.

If David decides to use restricted stock to make his charitable gift, he can fund a DAF operated by a public charity to secure a deduction based on the stock's fair market value. If the sponsoring charity will not accept gifts of restricted stock, David can give the stock to his foundation. His deduction would not be limited to basis in the stock, if the foundation meets the criteria for a conduit foundation for the year of the gift. To qualify, his foundation must redistribute an amount equivalent to the stock's value at the time of the gift, by the 15th day of the third month of the year following the tax year in which it received the stock.13 For example, if the foundation has a fiscal year ending in November and is funded in December 2003, it will have until Feb. 15, 2005 to sell the stock and distribute the proceeds to David's DAF or other qualified charities he selects.

If securities laws allow David's restricted stock to be freely traded, his deduction would be based on the stock's fair market value, whether or not his charity is a conduit foundation.14

SUSAN'S STORY

“Susan” has quite different goals. She says: “I want to create a shelter for battered women. I will contribute some low-basis land that I have owned for many years. My friends will be on the board and help with fundraising.”

It sounds like a public charity might fit the bill. Susan is not prohibited from controlling her charity, but there may be some practical constraints on her ability to do so. For example, raising public support is usually easier with a broad-based board of directors. In addition, if Susan wishes to be compensated for her services, it is helpful to have independent board members decide whether to employ her and how much to pay her, and to document that her compensation is fair.

Susan's entity can qualify as a public charity if at least one-third of its total support can be attributed to gifts, contributions and grants from the public.15 A donor's entire gift will be included in determining the charity's total support, but only that portion of the gift that does not exceed 2 percent of total support can be counted as public support.16 This means that Susan's charity may have trouble qualifying as publicly supported if most of its funding comes from a few individuals and private foundations. Support from public charities is not subject to the 2 percent cap, so major donors may wish to help support Susan's charity by recommending grants to it from their DAFs.17

If public support constitutes less than one-third of all the support Susan's charity receives, it still can qualify if the public portion is at least 10 percent, it operates active charitable and fundraising programs, and its board of directors is not dominated by any major donor.18 If Susan's charity decides to charge a fee for services, it may be required to satisfy a more difficult public support test.19

If Susan is unwilling to spend time fundraising and can fund the women's shelter privately, her charity can qualify as a private operating foundation.20 Gifts to private operating foundations are treated like gifts to public charities, so Susan's deduction for her land gift will be based on its fair market value. She may receive reasonable compensation for operating the shelter as the foundation's employee.

To qualify as a private operating foundation, a charity must satisfy an income test and one of three alternative tests based on its assets, endowment or support. As a rule of thumb, a charity generally can qualify as a private operating foundation if it spends at least 3.33 percent of its net investment assets each year to conduct an active charitable program. Net investment assets do not include program assets, such as the shelter and its furnishings.

Susan alters the situation by saying, “Community Services Organization (CSO), a public charity, also wants to establish a shelter for battered women, but does not have the funds to do so. CSO wants to work with me on the shelter if I provide the funding.”

Susan's charity should be able to qualify as a supporting organization21 — a type of public charity that benefits or performs the functions of, and that maintains a close relationship with, another public charity.

A supporting organization cannot be controlled, directly or indirectly, by “disqualified persons.”22 This means that Susan can have a minority vote and participate in her charity's administration and operation, but she cannot have veto powers, and CSO cannot appoint her to act on its behalf.23 She also cannot control her charity indirectly through persons or entities within her control. The Service has ruled that a charity is indirectly controlled if a disqualified person's employees can control it.24 The IRS has unofficially extended this ruling to include a disqualified person's attorneys, accountants, investment advisors and other professional business advisors.

Individuals usually create either “Type I” or “Type III” supporting organizations. A Type I supporting organization is controlled by one or more of the charities it supports, whereas a Type III is not.

Susan's charity should be organized in corporate form. If she creates a Type I supporting organization, CSO must have voting control. If she forms a Type III supporting organization, Susan can choose independent individuals and entities to control the board, but CSO should elect at least one officer or director.25 In addition, if her charity is a Type III organization, it will have to demonstrate that, but for its involvement, CSO would operate a shelter itself.26

MORE TWISTS

David also can create a supporting organization to operate his grant-making program. He can create a Type I supporting organization that is controlled by and supports a public charity that is itself a grant-making organization, such as a community foundation. David's organization would make grants to the community foundation and the public charities it supports.

Alternatively, David can create a Type III supporting organization as a charitable trust, and select independent trustees to control it. His trust must name the charities it can support. As long as the recipients can enforce the trust and compel an accounting under state law, David will not be required to appoint any of those charities as a trustee.27 Generally, no new charities can be added at a later date, but there is no limit on the number that can be named initially, and the trust may vary the amount distributed to each charity annually.28 In addition, if a DAF is one of the named recipients, the trust can make limited distributions to the DAF that it may use to make grants to organizations not named in the trust.

To qualify as a Type III supporting organization, David's trust must distribute at least 85 percent of its net investment income annually,29 and at least one-third of the total amount distributed each year must go to charities that will be attentive to how the trust is invested and to whether it has engaged in any activity prohibited for a private foundation.30 A charity's attentiveness is usually determined by the size of the distribution relative to its resources, but evidence of actual attentiveness is also important. This could include correspondence from the charity confirming the significance of the support provided and its review of the trust's annual reports.

Until recently, a Type III supporting organization was considered by some to be a desirable alternative to a private foundation, despite its limitations and rather complicated ongoing qualification requirements. Yet the Service's recent challenges to the use of a donor's professional advisors as independent trustees and to the funding of such organizations with interests in family-controlled business entities make the Type III supporting organization more a choice of last resort than a true alternative to a private foundation.

Choosing the right charitable entity depends on the client's income tax goals and charitable intentions. A client who wants to carry on an active charitable program and seek support from the public will not want to create the same kind of entity as a client who wants to create a private endowment fund for future grants to other charities. A knowledgeable advisor can help create the charitable entity that will best enable a client to meet his goals.

Endnotes

  1. IRC Sections 170, 2522, 2055 and 508(d).
  2. IRC Section 509(a).
  3. IRC Sections 170(b)(1)(A)(vii) and 170(b)(1)(E).
  4. IRC Section 170(b)(1)(F). The percentage limitations are based on adjusted gross income computed without regard to any net operating loss carry-back.
  5. IRC Section 170(b)(1)(A), (C) and (E).
  6. IRC Section 170(e)(1)(A), but see 170(e)(1)(B) regarding tangible personal property.
  7. IRC Section 170(b)(1)(B) and (D).
  8. IRC Section 170(e)(1)(B) and (e)(5).
  9. IRC Sections 170(d) and 170(b)(1)(B), (C) and (D).
  10. IRC Section 4946(a).
  11. IRC Section 4958.
  12. IRC Sections 4941-4945.
  13. IRC Section 170(b)(1)(E)(ii).
  14. Rule 144 or 145 of the Securities Act of 1933, and PLRs 200322005-011, 200322018, 9746050 and 9734034.
  15. IRC Section 170(b)(1)(A)(vi).
  16. Treas. Reg. Section 1.170A-9(e)(6).
  17. See PLR 200037053, which held that gifts to DAFs are public support to the sponsoring charity. By logical extension, grants from DAFs are grants from the sponsoring charity.
  18. Treas. Reg. Section 1.170A-9(e)(3).
  19. IRC Section 509(a)(2); Treas. Reg. § 1.509(a)-3.
  20. IRC Section 4942(j)(3).
  21. IRC Section 509(a)(3).
  22. IRC Sections 509(a)(3)(C) and 4946.
  23. Treas. Reg. Section 1.509(a)-4(j)(1).
  24. Rev. Rul. 80-207, 1980-2 C.B. 193.
  25. Treas. Reg. Section 1.509(a)-4(i)(2)(ii).
  26. Treas. Reg. Section 1.509(a)-4(i)(3)(ii).
  27. Treas. Reg. Section 1.509(a)-4(i)(2)(iii).
  28. Treas. Reg. Section 1.509(a)-4(d)(4).
  29. Treas. Reg. Section 1.509(a)-4(i)(3) (iii)(a); Rev. Rul. 76-208, 1976-1 C.B. 161.
  30. Treas. Reg. Section 1.509(a)-4(i)(3) (iii)(a) and (d); PLR 8617119; GCM 36326.

QUESTIONS FOR CLIENTS

To assess intentions, start by asking:

  • Why do you want to create your own charity — for a charitable purpose? to secure an income tax deduction? for an estate tax deduction? to leave a legacy? to share charitable goals and values with family members?

  • What will your charity do? Will it operate its own service program? Or will it make grants to other charities (U.S. or foreign) or to individuals in the form of scholarships, prizes or other aid?

  • How will your charity be funded? Will it solicit support from others? Is a charity of this size viable? Will it be economic to administer?

  • Who will operate the charitable program? Who will handle the administrative tasks? For a grant-making program, who will select the grant recipients and document the grants? Will the charity have employees or volunteers? Will it engage the services of consultants or other independent contractors?

  • How important is control to you? Do you want to be able to remove and replace the charity's trustees or directors at will? Do you want anyone else to have that power after your death? What is your succession plan for this charity?

  • How will you fund the charity? Will you use cash, unrestricted marketable securities or other property? How much income tax deduction can you use (taking into account other charitable gifts and any excess charitable deduction carried forward from prior years)? What income tax deduction will the new gift generate? How much tax savings will it generate?

  • Will the charity enter into any transactions or arrangements with you, your business or your family members?
    Nancy P. Marx

ENTITIES AT A GLANCE

PRIVATE FOUNDATION

Qualification: IRS recognition as a 501(c)(3)

Disadvantages:

  • income tax deduction limits
  • excise tax rules for private foundations apply

Advantages:

  • client control
  • with right grantmaking procedures, can make grants to any entity and to individuals selected by the foundation
  • can run and staff own programs
  • family involvement permitted (can employ family members to run programs or pay them for legal, accounting and investment advisory services)

PRIVATE OPERATING FOUNDATION

Qualification: IRS recognition as a 501(c)(3) and a private operating foundation

Disadvantages:

  • must directly conduct a charitable activity and expend certain amounts on it annually in order to qualify
  • excise tax rules for private foundations apply

Advantages:

  • income tax deduction as a public charity
  • client control
  • distribution requirement may be lower than for a private foundation
  • may also make grants
  • can hire own staff and consultants
  • family involvement permitted

CONDUIT FOUNDATION

Qualification: IRS recognition as a 501(c)(3) and satisfaction of redistribution requirement

Disadvantages:

  • must redistribute gifts by the 15th day of the 3rd month of the tax year following receipt
  • excise tax rules for private foundations apply

Advantages:

  • income tax deduction as a public charity for years that the private foundation qualifies as a conduit foundation
  • client control
  • family involvement permitted
  • useful for financing a donor-advised fund with property that the sponsoring charity will not accept, but which the conduit foundation can sell for cash within the required redistribution period

DONOR ADVISED FUND

Qualification: Confirm sponsoring charity has IRS recognition as a 501(c)(3) public charity

Disadvantages:

  • no client control
  • can recommend only grants, and possibly allocation of assets among pre-selected investment funds
  • may be limitations on grants and grant advisors
  • no other family involvement permitted

Advantages:

  • income tax deduction as a public charity (if sponsoring charity is a public charity)
  • the rules for excess benefit transactions apply
  • easy to create
  • distribution requirement usually less than for a private foundation
  • no administrative responsibility for the client, but the donor-advised fund pays an administrative fee

PUBLICLY SUPPORTED PUBLIC CHARITY

Qualification: IRS recognition as a 501(c)(3) that is not a private foundation because it is publicly supported

Disadvantages:

  • must satisfy a public support test on an ongoing basis
  • usually requires fundraising and an active charitable program
  • public solicitation may be subject to state regulation
  • client control is not prohibited, but may be sacrificed when others assist with administration and governance in order to operate the program and attract public support

Advantages:

  • income tax deduction as a public charity
  • the rules for excess-benefit transactions apply
  • some lobbying permitted

SUPPORTING ORGANIZATION

Qualification: IRS recognition as a 501(c)(3) that is not a private foundation because it supports and has a close relationship with one or more public charities

Disadvantages:

  • client control, direct or indirect, is prohibited
  • qualification requirements for Type III supporting organizations can be complicated, limiting and difficult to satisfy
  • grantmaking is more limited than in a private foundation

Advantages:

  • income tax deduction as a public charity
  • the rules for excess-benefit transactions apply
  • some lobbying permitted
  • client can participate in administration
  • family involvement permitted
    Nancy P. Marx