What Is a Private Foundation?
A private foundation is a nonprofit or charitable organization, created with funds from a single donation, called an endowment, by an individual, family, or business. Trustees or directors manage and disburse the funds according to the mission communicated by the founders.
A private foundation does not raise money through public fundraising campaigns but rather relies on the investment income from its endowment to fund its activities. For this reason, a private foundation is tax-exempt but does not qualify as a public charity as defined by the Internal Revenue Service (IRS).
Key Takeaways
- Private foundations are classified as 501(c)(3) organizations by the Internal Revenue Service (IRS) and are tax-exempt.
- Private operating foundations and private nonoperating foundations are two categories of private foundations.
- Universities and hospitals are excluded entities, according to IRS classification, which means that they are not considered private foundations.
How a Private Foundation Works
In the eyes of the Internal Revenue Service (IRS), private foundations are classified as 501(c)(3) organizations, which are tax-exempt, as are donations to them. They generally fit into two categories: private operating foundations and private nonoperating foundations:
- Private operating foundations directly run the charitable activities or organizations that they fund with their investment income. Tax regulations require that they must spend either at least 85% of their adjusted net income or their minimum investment return, whichever is less, on their activities annually.
- Private nonoperating foundations disburse funds to other charitable organizations whose goals match their own. In this case, the IRS requires that the foundation disburse an amount "equal to the foundation’s minimum investment return with certain adjustments.” While they can also operate programs, that isn't their main function. This is the most common type of private foundation.
There is a limit on the business holdings of a private foundation, which is generally “up to 20% of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by disqualified persons.” Also, the investments made by private foundations must not put at risk the execution of the organization’s exempt purpose.
Private Foundations and the IRS
If any organization qualifies as 501(c)(3), it is by default considered to be a private foundation by regulators unless it is better classified under a different category that is explicitly excluded from being called a private foundation. Examples of excluded entities include universities and hospitals.
Although they are exempt from income taxes, most domestic private foundations are subject to an excise tax on their net investment income. There also may be taxes for some foreign private foundations that draw gross investment income from U.S. sources.
The IRS has other rules regarding private foundations. For instance, there are restrictions barring self-dealing or acting for personal benefit rather than for the interests of beneficiaries, between the foundation and substantial contributors. In other words, the administrators of a foundation cannot use their positions to enrich themselves at the expense of the foundation’s beneficiaries.
Most private foundations are created to fund charitable programs and activities that are aligned with the foundation’s mission or philanthropic endeavor. Usually, the money is donated through gifts and grants.
Tax Savings
There are three main tax-saving advantages available to donors to private foundations:
- Estate tax—Money donated to a private foundation is not included in a donor’s estate, thus making any donated assets free from state or federal estate taxes. Wealthy individuals can fulfill their philanthropic desires while saving money on estate taxes.
- Income tax—Any individual who donates to a private foundation receives an income tax deduction for the amount that they contribute, allowable up to 30% of the donor’s adjusted gross income (AGI).
- Capital gains tax—Donors may sidestep capital gains taxes if they give away highly appreciated assets, such as stock or real estate, instead of cash to a private foundation.
Donating to a private foundation often provides an opportunity to take tax deductions and may lower your tax bill.
Types and Examples of Private Foundations
There are many kinds of IRS-approved private foundations, and each differs in how it is governed and funded. The various kinds are not necessarily legal classifications.
- Family foundation—This is created by family members who operate and govern the organization for the benefit of a philanthropic cause or causes. An example is the Walton Family Foundation, which works in three areas: “improving K–12 education, protecting rivers and oceans and the communities they support, and investing in our home region of Northwest Arkansas and the Arkansas-Mississippi Delta.”
- International foundation—This is a private foundation, usually based outside the U.S., that makes grants and engages in cross-border philanthropic endeavors. An example is the Mastercard Foundation, which works largely in its home base of Canada and in Africa “to advance learning and promote financial inclusion in developing countries and to support Indigenous youth.”
- Corporate foundation—This is an organization created and supported by a corporation as a separate legal entity, though tied to the company, that is designed to give back to society, especially local communities. An example is the Prudential Foundation, an arm of the life insurance company, which makes “grants to nonprofit organizations that help close the financial divide by creating inclusive workplaces and communities and accelerating economic mobility for all,” including in its home base of Newark, N.J.
Instead of forming a corporate foundation, some companies choose to set up a corporate giving program, which may dole out money in cash or grants to charitable organizations.
The Largest U.S. Private Foundation
The largest private foundation in the United States is the Bill & Melinda Gates Foundation, which had an endowment of $75.2 billion as of the end of 2023. The foundation budgeted $8.3 billion in direct grantee support for 2023 alone.
The goals of this foundation are to expand educational opportunities and access to information technology in the U.S. and to reduce extreme poverty and enhance healthcare worldwide.
Some of its activities include bringing access to financial services, such as savings accounts and insurance, to people living in extreme poverty around the world, as well as funding improved sanitation, agricultural development, and other important initiatives in the developing world.
Private Foundations vs. Public Charities
Both private foundations and public charities do good works, but they operate in different ways, and each has its own set of tax laws. A public charity usually raises its funds through donations from the public, while a private foundation is funded by investing its endowment, sometimes including new contributions from a limited group of donors.
Federal law requires a public charity to either receive one-third or more of its assets from contributions from the general public or meet the 10% facts and circumstances test given by the IRS.
Benefits of a Private Foundation
The benefits of private foundations include:
- Greater control over charitable giving
- Greater consistency in charitable giving over time, as the foundation can last in perpetuity
- Creating a visible and lasting legacy for the founding individual, family, or corporation
- Eligibility for a variety of tax savings
- No need to constantly seek donations from the public
Disadvantages of a Private Foundation
The disadvantages of private foundations include:
- Costly to start in terms of both money and time
- Onerous regulatory and record-keeping requirements
- Lower deductibility limits on donations than for public charities (30% of adjusted gross income for cash gifts and 20% for gifts of appreciated assets vs. 60% and 30%, respectively)
- Less favorable treatment of gifts of appreciated property than for public charities (valued at cost basis as opposed to fair market value)
- Excise taxes levied on excess business holdings
What Is the Difference Between a Private Foundation and a Nonprofit?
A nonprofit is usually a charitable organization with a particular goal that it uses its revenue to fund. A nonprofit may offer services and grants and receive donations from governments, individuals, and foundations. Nonprofits are tax-exempt operations and may be connected to science, the arts, education, religion, or other specific areas.
A private foundation is run and usually funded by an individual, a family, or a corporate sponsor, and it may create grants for other charities or entities. In addition, a private foundation is a tax-exempt 501(c)(3) charitable organization, meaning that it does not qualify as a public charity under the public support test. However, many nonprofits are also set up as tax-exempt 501(c)(3) organizations.
What Is the Minimum Size of a Private Foundation?
According to Foundation Source, a company that specializes in setting up private foundations, $5 million used to be the quoted figure, due to the cost and complexity of creating and running it. The company says more efficient processes make it feasible to create a foundation with an initial endowment of less than $1 million.
How much it costs to set up a private foundation varies by the type of foundation being created.
Can Private Foundations Pay Salaries?
A private foundation can pay salaries to employees who work at a specific job at the foundation. These may include legal or financial advising, grant writing, portfolio management, and similar tasks that are crucial to the organization.
The IRS recognizes salaries from a private foundation only if the payments are not excessive and the services provided to the compensated employee are “reasonable and necessary to carry out the foundation’s exempt purposes.”
The Bottom Line
For a wealthy family or a company, creating a foundation for a good cause is a way to give back to the community. Because they are tax-exempt, there is a complex process for setting them up and operating them properly. However, they have many benefits beyond the satisfaction of doing good for others. These include a variety of tax benefits for wealthy families.