A great privilege of significant wealth is the ability to help others. Many families are not satisfied simply with responding to gift requests; they prefer to define philanthropic objectives and actively manage their philanthropic activities. Many decide to create a private family foundation, but, as with everything in life, this approach has its pros and cons.

Starting a foundation is like starting any corporation, with the added burden of submitting IRS Form 1023 to apply for tax-exempt status. Unless a family member has expertise in this area, legal fees will result. The foundation also files Form 990-PF annually to report its activities and financial results to the IRS. This can be done internally or by a tax accountant.

Tax deductions in 2012 for a gift to a private foundation are limited to 30 percent of AGI for cash and 20 percent for appreciated stock, compared to 50 percent and 30 percent, respectively, in these categories for gifts directly to public charities. Carry-forwards of the excess are available for five years. Foundations must make annual grants of at least 5 percent of their asset base or pay an excise tax of 30 percent on the shortfall. Foundations pay a 2 percent tax on investment income. This may be reduced to 1 percent if the foundation has made grants in excess of 5 percent for each of the past five years (or every year since formation if the foundation is less than five years old).

Activities not consistent with the charitable focus of the foundation are prohibited, including unrelated business income from investments. The IRS also scrutinizes transactions such as payroll to family members or benefits received from grantees, which may be viewed as prohibited self-dealing. Penalties range from the imposition of excise taxes to the loss of the foundation’s tax-exempt status.

Many families determine that all of this is a small price to pay for the long term benefits of a private foundation. A private foundation allows a family to commit significant resources to charity now, add to it later and receive current-year tax deductions for each contribution, without having to “give it all away” immediately. The family can use the foundation to manage its charitable giving for generations to come, making it a solid tool for passing down family values to future generations. Most foundations invest their assets in an attempt to cover the required annual distributions, taxes and operating expenses. As such, the foundation may also serve as a training ground to teach wealth management to younger family members. Finally, the family retains control of the foundation assets so they will always be used to further the family’s own philanthropic objectives.

BCA does not provide legal, tax or accounting advice. Donors are encouraged to consult their attorney or CPA regarding their individual situation. This article is based on information believed to be reliable as of October 1, 2012, but BCA makes no representation or warranty as to its completeness.