The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
When choosing the proper structure for your philanthropy, the good news is that you have many options. The challenge, of course, is deciding on the vehicle that will allow you to pursue your unique philanthropic goals and that will stand the test of time. In this case, we’ll explain choosing between operating vs. non-operating foundations.
For families that have accumulated enough wealth and are focusing on philanthropy, the private foundation is a common waystation. Even having settled on that approach, though, there are decisions to make. First up is which of the two main types of a private foundation — operating or non-operating — makes the most sense for the family. In this article, we’ll address the key differences.
The primary difference between Operating vs. Non-operating Foundations is their goals. Operating foundations allocate most of their resources to actively conducting programs that benefit the public. Non-operating foundations function primarily to support other non-profits and their charitable programs via grantmaking or giving 3rd party non-profit organizations and programs.
Private non-operating foundations are more popular because of their less stringent requirements. To qualify as an operating foundation, the foundation must satisfy an income test and one of three additional tests set forth by the Internal Revenue Service (“IRS”). This is not a requirement for non-operating foundations. In addition, donors to operating foundations enjoy increased tax deductions for their donations at a rate of up to 50 percent. In contrast, donors of non-operating foundations can deduct their donations at a rate of up to 30 percent.
Private foundations are, by default, considered Non-Operating until the foundation can show that its primary function is to operate public charitable programs. To show that a Private Foundation is an operating foundation, it must first meet tests set out by the IRS. In particular, the foundation must satisfy the “income test,” plus one of the following three tests also set forth by the IRS: the “support test,” the “endowment test,” or the “assets test.”
Suppose the foundation meets the income test and one of the other three tests. In that case, it can be categorized as operating and benefit from increased tax deductions and other positive tax consequences. Unlike non-operating foundations, which must distribute 5 percent of their assets annually, private operating foundations are subject to rules that ensure that a certain minimum amount is expended in furtherance of the private operating foundation’s programs. These rules are technical and challenging to understand, but, in practice, they are usually not hard for organizations that primarily run their programs to satisfy. It is common for museums, libraries, and similar organizations that run their programs to have private operating foundation status.
The IRS looks at a foundation’s operations over the years to determine whether the foundation meets the test requirements. Each of the tests requires compliance with their needs for any three years during four years or an aggregate of all amounts of income or assets held, received, or distributed during the four years. The four-year period consists of the tax year and the three years immediately before that year. The same measurement method must satisfy both tests in any given year.
A foundation cannot be approved as an operating foundation without satisfying the income test. The income test asks whether a foundation spends at least 85 percent of its adjusted net income or its minimum investment return —whichever is less—directly on the active conduct of its charitable activities.
If the answer to this question is yes, the next consideration is whether one of the other three tests can be satisfied.
A private foundation will meet the support test if:
If a private foundation does not meet the support test, it still has two other tests it can pass to qualify as a private operating foundation.
A private foundation will satisfy the assets test if 65 percent or more of its assets:
The endowment test determines whether the foundation typically makes qualifying distributions of at least two-thirds of its minimum investment return directly in actively running charitable programs that benefit the public. In most cases, if the foundation satisfies the income test, it will also fulfill the endowment test. Only if the minimum investment return is significantly higher than adjusted net income might the endowment test yield a different result.
Private operating foundations are generally subject to more favorable rules because of their increased overhead. There are three main benefits of private functional foundation status as compared to other types of private foundations:
This type of foundation is required by federal law to:
With a non-operating foundation, you’ll be able to claim a charitable deduction of up to 30 percent of adjusted gross income (AGI) for cash donations and up to 20 percent of AGI for appreciated securities and other property. These donations have a five-year carry-forward period. Publicly traded stock may be valued at fair market value, while different property types may be valued at cost only.
Private non-operating foundations offer both unique benefits and drawbacks.
Additionally, private non-operating foundations are subject to a 30 percent excise tax on undistributed income. Undistributed income is a certain amount of money or property not spent annually for charitable purposes, such as grants to other charitable organizations. The distribution requirement is calculated from the foundation’s distributable amount. If the foundation does not meet the annual distribution, it will be subject to the tax, with a few narrow exceptions. The tax is charged for each or part of a year in which the under-distribution is not corrected. An additional surcharge of 100 percent will be incurred if the deficiency is not resolved within 90 days of receiving notice of the defect from the IRS.
This excise tax does not apply to private operating foundations. This is commonly a benefit to those foundations because operating foundations experience less regulation and requirements on spending. Still, it is essential to consider that the foundation must continue to satisfy the needs of the income test and another test. Hence, regulations on spending still exist in another way.
All non-profits, including public charities, non-operating foundations, and operating foundations, are governed by a board of directors. Private foundations differ from public charities because the financial donors and board of directors may be, and usually are, a relatively close-knit group of individuals, including family members, business associates, or other related people. In contrast, public charities must be funded by a larger group of public donors. In terms of organizational requirements, though, there is no difference between Operating vs. Non-operating Foundation
From this article, you will understand the differences and trade-offs between Private Operating and Non-operating Foundations and how this might apply to your situation.
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