Parents often wonder what will go on among their children after they’re gone—will their children get along and work out their differences or go their separate ways? Sometimes even with the best of intentions, adult children decide it’s best for the family not to mix work and play, including in the context of operating a family private foundation (PF).
The Basics
A PF is a type of tax-exempt charity that’s typically funded and controlled by an individual, family, corporation or other small group. Most PFs make grants to public charities (PCs), qualified individuals and government entities for charitable purposes and accumulate an endowment to fund their charitable grant making. Contributions to a PF are generally tax deductible.1
When setting up a charitable grant-making vehicle, donors typically consider donor-advised funds (DAFs) and PFs. Whereas a PF is a stand-alone legal entity, a DAF is an account established with a sponsoring organization that’s usually qualified as a PC. The donor to a DAF enters into a contract with a sponsoring organization (such as a local community foundation), and that contract will govern how the account is managed, including what contributions it can receive (for example, cash or publicly traded securities) and what investments can be made with the account’s funds. A donor has grant recommendation privileges, but not actual legal control, over the account.
While both DAFs and PFs are excellent charitable giving vehicles,2 PFs often appeal to donors who desire to maintain control over their assets, both with regard to their grants and their investments. A PF can hire employees to run its operations, including family members and friends, provided the PF navigates the self-dealing rules.3 A PF may accept and often hold hard-to-value assets indefinitely, such as a closely held business interest. While some DAFs are able to accept hard-to-value assets, they often require an immediate liquidation event after contribution to the account. In addition, donors can control how the PF’s assets are invested, including in alternative investments, closely held business interests, intellectual property such as licenses and trademarks or artwork.4 While DAFs are legally allowed to invest similarly, usually sponsoring organizations of DAFs limit the menu of investments because of the additional liability and administrative work needed to facilitate such a transaction. Because a PF is a stand-alone entity managed by parties selected by the donor, it provides much more flexibility to control the investment of the PF’s assets.
Next Gen Takeover
Transitions can be hard, and transitioning a PF to the next generation is no exception. The ideal situation for transitioning a PF to the next generation involves a PF with a large and experienced group of engaged family members, friends and trusted advisors ready to take the helm when the time is ready, having participated in the administration of the PF for years. This ideal isn’t always the case.
Your client may have one adult child who’s interested in the mission of the PF, engaged in philanthropy and at a point in their life that they’re able to take on the work of the PF. Meanwhile, the other adult child is too busy, not at a place in their life where they can devote time to the PF or simply not interested. Or perhaps the four adult children involved in the PF each have their own ideas of philanthropy, charitable giving and the future of the PF, and they can’t agree on a unified approach. In these instances, what happens?
Three Options
There are three options most commonly used by family PFs in these circumstances:
Option 1: Everyone agrees to coexist. Anyone who’s ever shared a room with a sibling or close friend knows that sometimes you just have to agree to disagree and draw a line of tape across the room —this is your half and this is mine. This kind of division happens all the time in life as a way to settle disputes—one-half of the pizza with anchovies and one-half without.
It’s possible for multiple parties to continue to govern the PF together but arrange for each to separately administer, invest and distribute their “portion” of the assets. This is often a solution when siblings want to participate in the PF but each wants total control over their “portion.”5 This solution works when siblings, friends or those administering the PF get along but want to give each other some independence. The simplest form of this type of relationship allows for each party to choose which charities receive up to $X based on the budget for that particular year. For example, if the PF’s total grants’ budget for the year is $100,000 and there are four parties involved, then each party is able to direct distributions of $25,000. In reality, the PF is a single entity that must operate as such, but each party is agreeing essentially to direct the distribution of a portion of the assets.
PF managers can go a step further and apply this logic to investments as well; however, depending on the amount and the current investments, this can be a bit tricky when trying to balance or properly diversify a portfolio or meet minimum investment thresholds.
State law concerns. Under state law, PF managers (whether trustees or directors) have a fiduciary responsibility to the PF as a whole. Because the PF is a single entity, the investment policies of each portion of the PF and their implementation need to be coordinated to ensure that the total portfolio represents a prudent, diversified investment portfolio and that the total portfolio doesn’t violate the excess business holdings rules or the jeopardizing investment rules.6 Some level of coordination is required because managers need to agree on a distribution policy for each portion of the PF that would ensure that, together, they’ll make sufficient qualifying distributions7 and that neither violates the taxable expenditure nor self-dealing rules.8
Separate but together. If one sibling makes distributions for non-charitable purposes causing the PF to lose its Internal Revenue Code Section 501(c)(3) status, the whole PF loses its status. If one sibling makes distributions for non-charitable purposes causing the PF to incur a penalty tax under the PF excise tax rules or a termination tax under IRC Section 507, the PF as a whole is liable for the taxes and all of the PF managers could be held personally liable. If siblings don’t want to be responsible for each other’s actions or to have their portion of the PF’s assets put at risk by the actions of others, then they shouldn’t administer a PF in this fashion.
We can get along. This option works well for many family PFs—often a structure similar to this one is put in place as a way to prevent any disagreements in the future. Some PFs will even delineate amounts for the next generation (for example, the grandchildren) on either a per stirpes or per capita basis.
Option 2: Everyone takes their share of the pie to a new PF. It may become clear, over time, that a PF’s philanthropic mission is being harmed by an attempt to coordinate and navigate family relationships. All isn’t lost in such a situation—siblings may decide to distribute the PF’s assets to two or more new and distinct PFs so that each sibling manages their own PF. This is a viable solution when the PF has sufficient assets to make it worthwhile to administer multiple PFs once the assets are split.
To avoid a termination tax under Section 507(b), the process must comply with Section 507(b)(2) and Revenue Ruling 2002-28. The new PFs will be treated as if they were the original PF for purposes of the PF excise tax rules. See “A Quick Reference Guide to PF Excise Taxes,” p. 16. Because the PF will distribute all of its assets, it won’t need to exercise expenditure responsibility over the grants to the new PFs.9
Rev. Rul. 2002-28. For Rev. Rul. 2002-28 to govern how the PF excise tax and termination tax apply to a reorganization, the same individuals who effectively controlled the old PF must control the new ones. Thus, siblings need to serve together as the directors or trustees of the new PFs until the asset distribution is complete, at which time they can cross-resign as PF manager of each other’s PF. The organizational documents could also be drafted so that each sibling can remove each other at the appropriate time. If the reorganization isn’t conducted in a manner that brings it within the parameters of Rev. Rul. 2002-28, then the PF could request to obtain a private letter ruling regarding the application of the PF excise tax and termination tax to the reorganization plan.10
Beware—read the organizational documents. It’s important to analyze the organizational documents before any reorganization—it’s possible that the organizational documents limit the Section 501(c)(3) organizations that may receive distributions in the event of a dissolution. If a termination or dissolution clause excludes PFs, the organizational documents need to be amended.
Last, but not least, ensure final tax return compliance. The PF needs to file a final annual return, Form 990-PF. The return is due four and a half months from the end of the month of the date of the termination or dissolution. The new PFs would need to adopt the same fiscal year as the original PF and coordinate their returns with the original PF’s final return. For federal excise tax purposes, the new PFs would be considered continuations of the original PF. Going forward, the new PFs would need to coordinate with each other to ensure that their combined investments don’t violate the excess business holdings rules.
While for some families, this level of coordination is acceptable, for others, even this level of coordination is too much.
Option 3: A simpler route. Instead of splitting a PF into multiple different PFs, a PF could terminate and distribute its assets to one or more DAF accounts. This is a popular choice for terminating PFs because administratively, it’s fairly simple and requires no ongoing coordination. Because the charities sponsoring DAF programs are generally PCs, a PF can distribute its assets into either a new or existing DAF account for each sibling. Each sibling would have grant recommendation authority over their respective account. There would be no PF excise tax or termination tax issues so long as the sponsoring charity has been classified as a PC under Section 509(a)(1) for at least 60 months prior to the distribution from the PF to the DAF. Once the PF has distributed its assets to the DAF accounts and the PF’s final return is filed, there shouldn’t be any need for ongoing coordination between the parties, making this option a true clean break.
A word of caution. When distributing PF assets to a DAF or multiple DAF accounts, be careful to provide for proper estimates for final liabilities. Once the PF distributes funds to the DAF accounts, the PF can’t get those funds back to cover outstanding expenses. Typical final expenses include the cost to prepare the final Form 990-PF, the final tax bill (particularly if the PF liquidates its assets prior to transferring them) and any final investment management and legal fees. In addition, prior to distributing the assets, make sure to follow proper governance procedures, as outlined in the PF’s organizational documents, including proper board or trustee approval and notifying a state Attorney General (AG), as needed.
Final tax compliance. The PF needs to file a final Form 990-PF within four and a half months of terminating or dissolving and any final state filings showing the liquidating distribution to the sponsoring charities to fund the DAF accounts.
A hybrid approach. There are many creative resolutions if not everyone can agree on the same approach. For example, each sibling may want to do something different with their “share”—one may want to continue to run the existing PF, another may want to manage a DAF and the third may want to distribute their portion outright to a PC. This type of hybrid approach is permissible.
Preaching reminder. Whichever course is chosen, review state law, and be mindful that the state AG may need to approve transactions that involve a large proportion of a PF’s assets when it affects the ability of the PF to carry out its charitable purpose —this includes terminations, dissolutions and some reorganizations. Each state has its own threshold for if or when approval is needed. In addition, if organizational documents will be amended to change, eliminate or add a power or charitable purpose, the state AG may need to approve such changes in advance.
Family Dynamics
It’s best to be sensitive to family dynamics, even if it appears the next generation will work together harmoniously, and anticipate issues before they arise. Ways to do so include being deliberate in selecting successor PF managers, consistently training new PF members as well as existing managers and having trusted outside advisors to assist the next generation when the time comes to transition the PF. In addition, PFs should establish policies and procedures—these may be essential in keeping the next generation focused on the PF’s charitable mission. But, take comfort, because if all else fails, there are options for the PF that allow the charitable mission to live on.
Endnotes
1. The deduction depends on the identity of the donor (individual or corporation), the recipient charity (whether it’s a public charity, a private foundation (PF), a private operating foundation, etc.), the type of property that’s contributed (cash, ordinary income property or capital gains property), the adjusted gross income of the individual donor or taxable income of the corporate donor and other charitable gifts the donor made in the same year. See Conrad Teitell, Stefania L. Bartlett and Cara Howe Santoro, “Charitable Deductions for Gifts by Individuals, Partnerships and Corporations,” Trusts & Estates (October 2018).
2. For a detailed comparison of PFs and donor-advised funds, see Conrad Teitell, Stefania L. Bartlett and Cara Howe Santoro, “Creating and Operating Charitable Entities,” Trusts & Estates (October 2019).
3. Internal Revenue Code Section 4941 and see “A Quick Reference Guide to PF Excise Taxes,” p. 16.
4. While PFs are able to invest in these assets, the PF may do so only while complying with the Chapter 42 excise tax rules, which prohibit the PF from entering into prohibited acts of self-dealing, making jeopardizing investments and retaining excess business holdings. For more details, see“A Quick Reference Guide to PF Excise Taxes,” p. 16.
5. In reality, no one “owns” a portion of a PF; however, if a PF is governed by three family members, each can agree that they’re allowed control over one-third of the PF’s assets.
6. IRC Sections 4943 and 4944. See“A Quick Reference Guide to PF Excise Taxes,” p. 16.
7. Section 4942. See“A Quick Reference Guide to PF Excise Taxes,” p. 16.
8. Sections 4941 and 4945. See“A Quick Reference Guide to PF Excise Taxes,” p. 16.
9. Treasury Regulations Section 1.507-3(a)(9)(iii) (Example 2).
10. Revenue Procedure 2022-5.