(Picture of the attendees of a Moores Rowland Asia Pacific conference in October 2019)
A Foundation is a relatively new concept to common law jurisdictions. What follows is a quick review of Trusts vs Foundations vs Wills.
Note that this is a somewhat complex subject and professional advice is always suggested. This is only an introduction to a deep and nuanced space.
Until 1969, the term private foundation was not defined in the United States Internal Revenue Code. Since then, every U.S. charity that qualifies under Section 501(c)(3) of the Internal Revenue Service Code as tax-exempt is a “private foundation” unless it demonstrates to the IRS that it falls into another category such as public charity. Unlike nonprofit corporations classified as a public charity, private foundations in the United States are generally subject to a 1% or 2% excise tax or endowment tax on any net investment income.
The US-based Foundation Center uses a more specific definition of private foundation which hinges in part on the existence of an endowment: a private foundation is a nongovernmental, nonprofit organization, which has a principal fund managed by its own trustees or directors. Hopkins (2013) listed four characteristics that make up a private foundation, also including an endowment as a condition for private foundations:
- It is a charitable organization and thus subject to the rules applicable to charities generally;
- Its financial support came from one source, usually an individual, family, or company;
- Its annual expenditures are funded out of earnings from an endowment or investment assets, rather than from an ongoing flow of contributions;
- It makes grants to other organizations for charitable purposes, rather than to its own programs.
A private foundation is typically set up as a non-profit corporation that bears the name of its donors, but may alternatively be established as a trust. Donors specify the charitable purpose of the foundation (example: grants for cancer research, scholarships for the needy, support of religious goals) . During their lifetime, they may continue their charitable giving by making tax deductible contributions to the foundation. The foundation may also be funded with a bequest from the donors’ will or trust or receive funds as the primary or secondary beneficiary of a qualified plan or IRA.The IRS reports that there were 115,340 private foundations in the U.S. in 2008, of which 110,099 were grantmaking (non-operating) and 5,241 were operating foundations. Approximately 75% of the private foundations file annually with the IRS.
Once a foundation has been classified by the Internal Revenue Service as a private foundation, there are ways to describe it based on how the foundation is funded and governed. There are three types of private foundations: Family foundations, Private Operating foundations, and Corporate Foundations.
What is a Trust?
The trust concept has existed in common law jurisdictions from as early as the 12th century. The term ‘trust’ is used to describe the relationship which exists when a person (the trustee) holds assets on behalf of another person or group of people (the beneficiaries).
A trust is therefore not a separate entity, but a relationship. A trust begins when a person (the settlor) transfers assets (the trust fund) to a trustee or trustees, who will hold those assets and preserve or where appropriate enhance their value until such time as all or part of the trust fund is distributed to one or all of the chosen beneficiaries.
Whilst the legal title to the assets is held by the trustees, the beneficiaries have a beneficial interest in the trust fund. The trustees therefore hold the assets on behalf of the beneficiaries.
There are various types of trust – for example, the settlor may wish for the trustees to pay income to one person during their lifetime, or they may wish to give the trustees discretion to make decisions on paying out income and capital (usually with guidance from the settlor on how they should exercise that discretion in the terms of a letter of wishes).
Trusts have formed the basis of succession planning for families for many years, allowing trusted professionals to administer wealth after the lifetime of a settlor and thereby ensure that his or her family continue to be looked after long after they have passed away.
A trust can therefore delay the time at which children become entitled to family wealth – it can prevent significant wealth passing to children or indeed adults before they are responsible enough to use the money wisely.
Separating assets from an individual’s personal wealth may also provide advantages in terms of protection from personal debts and other threats, and can in some cases provide tax savings depending on the laws of the settlor’s resident jurisdiction.
For most, the trust concept increasingly appeals for the reasons trusts were initially created: asset protection, succession and estate planning.
Below is an extract from a 2012 article in Accounting Today. The article focused on vehicles to charitable giving.
In the early years, contributions were often funded with cash.
According to a report from Financial-Planning.com in June 2011, there appears to be a large increase in the percentage of contributions that are coming from what are known as complex assets. Complex assets may be those with low basis or even significant liquidity issues, such as a closely held business or real estate. With the long-anticipated possibility of higher income and capital gains tax rates, contributions of complex assets could become even more popular.
FOUNDATIONS VS. TRUSTS
Gift trust accounts started as a way to get private foundation-like flexibility for less-than-ultra-wealthy charitable contributors. Now, large firms market their gift trust accounts as a supplement to a private foundation strategy. And while it does give you the same force and effect from both the gifting and the tax portion of the gift, there are some things that wealthy clients can do with foundations that you cannot do with a charitable gift trust.
First is the name of the entity. Some of your very wealthy clients simply want to see their family name and values connected to a charitable entity that lasts in perpetuity. The gift trust of a large mutual fund family is not about to change its name to accommodate your wealthy clients.
A second benefit to the private foundation over a gift trust account is the ability to appoint the board of directors and the leadership for the entity. I have many clients whose primary concern is that their wealth not cause their offspring and grandchildren to be trust-fund babies who may have less motivation to succeed in life. These clients are keenly focused on their values, and want to make sure that these values are instilled in next generations in as many ways as possible. One such way is to ask for their participation in private foundation management to witness this piece of the family values that grandpa wants to preserve for the generations.
Another trend in the private foundation space is government scrutiny. IRS audits are on the rise, and those using their private foundations to provide salaries and other personal benefits to friends and families are under closer scrutiny from taxing authorities than ever before. While there are bona-fide reasons for a private foundation to have salaries and other operating expenses, they are subject to a reasonableness test if ever audited at the private foundation level.