What are private foundations?
Private foundations are tax-exempt organizations under Section 501(c)(3) of the federal tax code. Foundations support charitable purposes with financial support from a small number of donors, such as an individual, members of a single family, or a corporation. As a result, they are often loosely grouped into three unofficial categories: corporate, family, and independent foundations - with family being the most prevalent. Private foundations can be “operating” foundations where they operate internal charitable programs or, much more commonly, “non-operating” foundations that focus on external grantmaking. While referred to as foundations, community foundations engage in grantmaking but are actually public charities and depend on the public for a majority of funding – often through active fundraising. Private non-operating foundations are the focus of this report, although operating and community foundations are also critical contributors to the state’s philanthropy. Examples from Colorado of each type of foundation are presented in table 1.
Private foundations represent one approach to carrying out a philanthropic mission. The dedication of funds to philanthropy is incentivized by the U.S. tax code. Private foundations, and those who fund them, receive tax benefits. Tax benefits associated with private foundations come from a number of main sources. Some of the following tax benefits accrue directly to the donor, while others primarily benefit the foundation itself.
Contributions to a foundation are tax deductible in the year of the donation up to a prescribed limit. The value of the tax deduction grows with the income level and marginal tax rate of the donor.
Contributing appreciated assets (whether financial or physical) rather than cash to a foundation provides an additional source of tax savings since the donor avoids capital gains taxes that would be due upon sale of the assets.
Contributing to a foundation through a bequest can reduce estate tax liabilities at the state and federal levels.
Assets gifted to the foundation experience largely tax-free growth and compounding even upon sale. The smaller tax drag, or reduction of investment returns due to taxes, is a substantial benefit that allows the donor’s funds to have a larger impact over time than in the absence of the foundation.
Foundations typically avoid local property taxes on sometimes substantial property holdings.
While most private foundations are created by individuals, families, or corporations, two of the largest foundations in Colorado, The Colorado Health Foundation and The Colorado Trust, were established, respectively, with assets generated from the conversion of a nonprofit health system and hospital to for-profit status. Of the seven conversions occurring in Colorado, only three resulted in the ultimate creation of non-operating private foundations. The other four conversions resulted in one social welfare organization and three public charities (community foundations). A report from Grantmakers In Health highlights the unique nature of conversions, since “their assets are not derived from private wealth or corporate generosity, but from financial transactions involving nonprofit health care organizations.” Since a nonprofit organization does not have owners, the proceeds from the sale of nonprofits generally must “be used for charitable purposes similar to those of the original nonprofit entity.” Table 2 details the health care conversions that occurred in Colorado.
Similar to individuals and families, for-profit companies create and use private foundations, referred to as corporate foundations, to carry out philanthropic activities. While the foundation’s funding comes from the corporation, the foundation acts as a separate legal entity although often with overlapping leadership. Examples of corporate foundations based in Colorado include the Charles Schwab Foundation, Gates Industrial Corporation Foundation, Leprino Foods Company Foundation, The Ovintiv Foundation (formerly Encana Corporation), Prologis Foundation, Western Union Foundation, and VF Foundation.
To ensure that private foundations in the United States. provide public benefits in return for the tax benefits received, Congress has required them since 1969 to make minimum annual distributions to the nonprofit sector. Current regulations subject private foundations to a “payout requirement,” which refers to a 5 percent minimum distribution of non-charitable-use assets. Qualified distributions in this payout requirement include grantmaking activities and program-related investments (PRIs) to nonprofits, but also the administrative costs related to the private foundation’s charitable activities.
The 5 percent payout requirement is a simple concept that is more complicated in practice and provides multiple mechanisms that private foundations can alter to change how much cash is actually distributed to the nonprofit sector in any given year. The law permits private foundations to carry forward into future years credits for previous charitable distributions in excess of the required 5 percent payout requirements. Therefore, a private foundation that distributes an amount in excess of legal minimum in one year can distribute an amount below the minimum mandated in another year and still be compliant with public regulations.
Similarly, a private foundation that fails to distribute the required payout is not in violation of the law if the shortfall is made up in the following year. Failure to meet the payout requirement, however, results in an excise tax liability on the shortfall; the private foundation must also distribute the shortfall in the following year or face an additional penalty. The following presents an example of a foundation’s annual distribution (payout) requirement and distribution.
Annual Payout Example of The Colorado Health Foundation
To demonstrate how payouts work, we can look to the state’s largest foundation – The Colorado Health Foundation.[1] In 2019, the foundation’s “Net value of noncharitable-use assets” totaled $2.58 billion. The “minimum investment return” for those assets over the year is expected to be 5%, or $129.14 million, which becomes the basis for determining the distributable amount. After minor adjustments for taxes paid on investment income and previously distributed amounts recovered, the distributable amount for The Colorado Health Foundation in 2019 totals $127.40 million. The foundation primarily fulfilled the 2019 “distributable amount” through grants and contributions ($95.15 million), operations and administration ($15.01 million), direct charitable activities ($5.95 million), program-related investments ($4.2 million), and acquisition of assets ($28,613). Excess distributions from previous years, specifically 2016 and 2018, satisfy the remaining distributable amount of $7.07 million (see Figure 1, for details).
In 2019, the foundation distributed 4.93% of noncharitable-use assets from a tax reporting perspective and 4.66% based on actual spending. While the ways in which foundations comply with annual distributable amounts can be complicated, the intent is to ensure that resources are being used for charitable purposes.
[1] For more details, see: The Colorado Health Foundation’s Guide to the Form 990-PF for 2019 and 2019 Spending Payout Per Form 990 PF (available at: https://coloradohealth.org/about-us/financials)