What are the tax benefits of a private foundation?
Establishing a private foundation is a meaningful way for donors to support charitable causes while also taking advantage of various tax benefits. By giving to a private foundation, donors can unlock powerful tax incentives that include immediate income tax deductions, tax-free growth of assets, and the avoidance of capital gains tax and estate and gift taxes.
Immediate Income Tax Deductions
One of the most significant benefits that donors can take advantage of when contributing to a private foundation is the potential for substantial tax savings, including the opportunity to receive immediate income tax deductions. Both federal and state tax laws allow donors to claim these contributions as an itemized deduction on their income tax returns, albeit with certain limitations in place. However, it is important to note that contributions to private foundations offer less favorable deduction limits compared to public charities. For instance, cash contributions can be deducted up to 30% of the donor's adjusted gross income (AGI), while contributions of appreciated property, such as stocks, can be deducted up to 20% of AGI. If contributions exceed these limitations, a five-year carryforward of the excess contribution is available.
This tax incentive markedly reduces the donor's overall tax liability, enhancing the financial attractiveness of charitable giving. Take for example, a donor in a combined state and federal income tax bracket of 45%. Upon contributing a dollar to their private foundation, they are entitled to an immediate income tax deduction, effectively reducing their taxable income by a dollar. This reduction subsequently decreases the amount of tax they owe by 45 cents, given that their tax rate is 45%. Consequently, the net cost to the donor for their charitable donation is merely 55 cents, after factoring in the 45-cent tax savings. In essence, the donor is saving 45 cents in taxes for every dollar donated, thereby making their philanthropic gesture not only generous but also financially savvy.
Tax-Advantaged Growth Within Foundations
The ability to experience tax-advantaged growth on assets held within a private foundation is a significant benefit, making it an attractive option for donors. This tax-advantaged status applies to various types of investment income, including interest, dividends, and capital gains. While private foundations are subject to a 1.39% excise tax on net investment income, this rate is considerably lower than typical income or capital gains tax rates, allowing the foundation to retain the majority of its investment returns for charitable purposes.
However, it’s important to note that private foundations are required to distribute at least 5% of their net asset value annually for charitable purposes. This mandatory distribution places ongoing pressure on the foundation's endowment, making it challenging to grow the foundation’s assets significantly in real terms, particularly after accounting for inflation. While investment income and reinvested earnings benefit from the tax-advantaged environment, the combined effects of the excise tax, inflation, and the annual payout requirement can limit the foundation’s ability to increase its endowment over time.
Despite these challenges, the foundation's favorable tax treatment plays a crucial role in magnifying the power of compounding returns. Reinvested earnings also benefit from this environment, ensuring that not only the initial contributions grow tax-advantaged, but so do the returns generated from those contributions. Over the long term, this structure can still lead to substantial growth in the foundation’s assets, provided its investment strategy effectively balances the need for distributions with long-term growth objectives.
Minimizing Capital Gains Tax on Publicly Traded Securities
Donating long-term appreciated public securities to a foundation is a strategic way to minimize your capital gains tax liability while maximizing your charitable impact. When you contribute assets such as stocks, mutual funds, or bonds that you have held for more than one year, you can typically deduct the fair market value of the donation from your income taxes and potentially eliminate the 20% capital gains tax and the 3.8% Medicare surtax on net investment income. It's important to note that donations of publicly traded assets allow for a deduction at their fair market value, whereas non-publicly traded assets are generally limited to a deduction based on the cost basis, which is the original purchase price.
Let’s take a closer look at an example to fully understand the potential tax benefits of donating appreciated public stock directly to a charitable foundation. In this scenario, we have a donor who is considering selling a stock worth $100,000 that has a cost basis of zero. If sold at the individual level, the gains would be subject to a combined 23.8% tax rate, which includes a 20% capital gains tax plus a 3.8% Medicare surtax on net investment income. So if the donor decides to sell the stock himself, he would be faced with a tax bill of $23,800 (23.8% of $100,000). This is a significant chunk of the stock’s value, and it would leave the donor with only $76,200 to donate to charity.
Now, let’s consider the alternative scenario where the donor contributes the stock directly to a foundation. In this case, the foundation can sell the stock without incurring capital gains tax. However, the foundation will pay a 1.39% excise tax on the net investment income. From the $100,000 proceeds of the stock sale, the foundation would pay $1,390 in excise tax (1.39% of $100,000), leaving $98,610 earmarked for charitable purposes. Although this amount is reserved for charitable giving, the donor retains control over how the foundation ultimately distributes it. This is significantly higher than the $76,200 that would remain if the donor sold the stock and donated the after-tax proceeds. This approach allows the donor to maximize their charitable impact while also potentially benefiting from a tax deduction based on the fair market value of the donated stock.
While the 1.39% excise tax on net investment income is applicable, it is notably more favorable when compared to typical capital gains tax rates of 20%. This lower tax rate significantly enhances the appeal of contributing appreciated assets directly to a private foundation, as demonstrated in the above example.
Estate and Gift Tax Advantages for Donors
Lastly, high-net worth individuals who make contributions to a charitable foundation can reap significant benefits with respect to estate and gift taxes. By contributing assets to a private foundation, these assets are then excluded from the donor's estate, rendering them exempt from both federal and state estate taxes—a notable benefit, especially given the current federal estate tax rate of 40%. This rate can significantly deplete an estate's value. As of January 1, 2023, the federal estate tax exemption amount is $12,920,000 per individual or $25,840,000 for married couples. This makes donating to a foundation an especially appealing option for high-net worth individuals with assets exceeding these thresholds. However, it is important to note that many states also impose their own estate taxes, often with much lower exemption thresholds than those set by the federal government. Consequently, even those with more modest estates may find that making a charitable contribution to a foundation can alleviate the burden of state-level estate taxes.
Traditional IRAs, 401(k)s, and similar retirement accounts are particularly advantageous assets to donate to a private foundation when settling a decedent’s estate. These accounts are considered “income in respect of a decedent” (IRD), meaning they retain their character as taxable income when distributed to non-charitable beneficiaries such as children or other heirs. Under current tax law, most non-spousal heirs are required to fully distribute inherited IRA and 401(k) accounts within 10 years of the account owner’s death, as mandated by the SECURE Act of 2019. This compressed distribution schedule can result in significant income tax liabilities for heirs, as the distributions are added to their taxable income, potentially pushing them into higher tax brackets. By instead designating a private foundation as the beneficiary of these accounts, the decedent’s estate avoids income tax on the distributions entirely, as private foundations are tax-exempt entities. This strategy not only maximizes the value of the donation for charitable purposes but also eliminates a significant potential tax burden for the decedent’s heirs, preserving more of the estate for philanthropic and legacy goals.
Conclusion: A Legacy of Giving and Saving
In summary, private foundations offer donors a unique opportunity to support charitable causes while reaping significant tax benefits. These benefits, which include immediate income tax deductions, tax-free growth of assets, avoidance of capital gains tax, and exemption from estate and gift taxes, can result in a substantial charitable legacy that can be passed down to future generations.
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