Building a Legacy: Setting Up Family Foundations

A family of four run through tall grass with their arms spread open as the golden sun sets near the ocean.

For families with wealth, family foundations can be the perfect vehicle to bring passion and philanthropy together in a multigenerational legacy. The how's and why's of setting up a family foundation can get a little confusing, so this paper will take you through the steps of setting up a family foundation and why it can be important.

The Basics of Family Foundations

Family foundations are the ultimate in leaving a family legacy. They account for more than half of all private foundations and range from small foundations with hundreds of thousands of dollars to billion-dollar philanthropies.

There are public and private foundations, but what is a family foundation? A family foundation is a vehicle for mission-driven charitable giving that is founded on family assets; it often employs family members and largely follows the same rules as other private foundations. Family foundations act to preserve family wealth over generations and, often, as beneficial tax shelters. Sources for funding family foundations can include commercial and residential real estate, jewelry, art, publicly and privately held stock, even patents and intellectual property rights.

The Carnegie Foundation is perhaps one of the most visible examples of what a successful family foundation can do over time. Drawn of the vast wealth of steel magnate Andrew Carnegie, the foundation funds libraries and learning centers around the country with the Carnegie legacy. Countless people’s lives have been improved from programs and grants from the Carnegie foundation.

Launching a Legacy: Common Catalysts

What are the triggers for starting a family foundation?

A foundation can be set up at any time during life or even after death. However, the catalyst comes when families believe that their personal wealth has far exceeded their needs for their lifetimes, and it makes sense to think about the next generation and beyond. There are certain inflection points in careers, however, where family foundations are advantageous.

Selling a Business

Foundations are funded through donations of private and public stock (and other assets) that grow tax-free under the foundation. When a business owner sells but remains a substantial shareholder, foundations are tax-advantaged vehicles for donating shares to reduce both income tax and estate tax liabilities. When stock in a private foundation is sold, it is done with a minimal excise tax of 1.39% compared with a capital gains tax of 20% for higher earners.

Lifestyle-Changing Windfall

When someone receives a large inheritance or any large financial windfall, a private foundation can be a good way to preserve the new money and significantly reduce tax liabilities. Some advisors have even suggested that lottery winners who suddenly come into large sums of money would do well to consider setting up a mission-driven charitable foundation to avoid common problems that come with sudden wealth.

Retirement Foundations

Foundations can also be used as a clever way to reinvent yourself in retirement as a philanthropist, giving back by teaching what you have learned over the years. This option is especially attractive to those who have made considerable wealth in their professions and have had substantial interest but little time to make charitable contributions. Assets that are contributed to a family or private foundation are excluded from federal or state estate taxes.

Benefits and Drawbacks of Family Foundations

There are benefits and drawbacks to virtually any financial arrangement. The key is to approach starting a foundation for the right reasons so that your values align with your decision in the years to come.

The benefits behind foundations fall broadly into two categories: non-financial and financial. The non-financial reasons are perhaps the most important: They are the emotional basis for the long-term value of the fund, the raison d’etre.

Non-Financial Benefits

Create a Legacy

A family foundation provides a legacy passed along future generations. There are tangible and intangible benefits to passing along the family name in a form or charitable enterprise. Having the clout of a charitable foundation behind a name tends to open more doors, making it easier to do the work of the foundation. It also helps to put structure around giving. By establishing a foundation with a clear vision, families can focus on the causes they care about while passing on those that don’t align with their goals.

Make a Lasting Impact

One of the most uplifting benefits behind family foundations is being able to focus on causes that are most dear to the family and help make the world better on a local or global basis. When families focus their philanthropic efforts—as opposed to ad hoc giving—they can often make a bigger impact for the causes they care about. The largest jump in charitable giving in 2018 (latest available data) went to causes related to the environment and animals; arts culture and humanities; international affairs nonprofits and health causes, according to Nonprofit Source.

Develop Future Changemakers

An overlooked benefit of a family foundation is teaching and developing the next generation. Foundations can be an excellent vehicle for instilling both big-picture values while offering an outlet for helping younger generations learn practical lessons that come with managing wealth and managing organizations. Each member of the foundation will gradually learn more about the foundation’s mission in some way. The most involved members often choose to make it their lives’ mission, too.

Financial Benefits

If the non-financial reasons make the case from the heart, the financial benefits to starting a family foundation speak to the wallet. The four major benefits of foundations lie behind their tax advantages.

Reduce Taxable Income

Contributing to a family foundation can offer an immediate income tax deduction of up to 30 percent of adjusted gross income (AGI), a move that can significantly decrease income tax liability for the year any contribution is made. Families get the tax benefit upfront, but can take their time making charitable contributions from the fund. One key requirement is they make a minimum distribution each year for charitable purposes. That amount is roughly 5% of the previous year's assets, allowing for some adjustments.

Avoid High Capital Gains

In addition to reducing income-tax exposure, donations to a private trust can also circumvent high capital gains tax rates. When donating stock that has appreciated to a private foundation, for example, the donor can deduct the full fair-market value of the stock and not pay capital gains tax. Outside of a foundation, capital gains rates are 15 percent or 20 percent for assets held for at least one year, depending on income. However, when a foundation sells appreciated stock, it pays 1.39% excise tax on the capital gains.

Because donors can realize only the cost basis of real estate donations to private charities (as opposed to fair-market value when donated to a public charity), real estate donations make financial sense in more limited circumstances for private foundations.

Grow Assets Tax Efficiently

The compounding growth of stocks combined with the tax advantages of paying just 1.39 percent excise tax instead of capital gains taxes under a private foundation can quickly add up over time and makes the foundation a viable growing legacy.

Take the case of Jane, a high-net-worth individual starting a foundation. If she contributes $250,000 to her private foundation a year for five years and earns 8 percent per year, his foundation will have about $1,429,000 after excise taxes and minimum annual distributions of 5 percent to charitable activities. Contrast this to $1,380,000 had she invested in a taxable account and paid capital gains taxes along the way.

Eliminate Potential Estate Taxes

In 2020, a federal estate tax of 40 percent applies to assets worth $11.58 million or greater. Additionally, states may have their own estate tax rates. Of the 12 states that charge an estate or inheritance tax, the minimum threshold is often much lower but tax rates generally lower, too.

Nonetheless, donors can significantly reduce their tax exposure during estate settlements when contributing financial holdings to a private foundation. The benefit of donating to a private foundation kicks in after the federal exemption. If Jane’s mother’s estate was valued at $50 million at the time of her death, she could leave it all to Jane, who would pay 40 percent on $28.4 million, or $11.37 million in federal estate taxes alone. If Jane’s mother donates the taxable balance to Jane’s private foundation, she could leave $11.58 million for Jane directly and donate the balance to his foundation and avoid estate tax.

Family Foundation Basics

  • Foundations are funded with cash, publicly traded securities, private stock, real estate or other family-controlled assets.
  • Family members and others can serve as paid administrators and paid board members.
  • The IRS requires that foundations disperse 5 percent of their assets every year; family members and their appointed advisors can decide how those assets are spent.
  • All private foundations must annually file a 990-PF IRS form and a 1023, where applicable.

Caveats to Consider

Though setting up a foundation is not expensive, running a family foundation requires regular maintenance. The foundation managers must keep detailed records of all transactions and grants, while also staying abreast of the ever-changing requisite IRS requirements and filings.

Further, the IRS recently said it was increasing scrutiny of private foundations. Excessive salaries, unsecured loans to family members, interest-free loans to family members are a few of the red flags that auditors target.

Finally, familial matters may also come into play when setting up a family foundation. Do certain family members have greater roles in the organization? Are some family members paid by the foundation for their work while others are unpaid volunteers? The human factor and emotional response can loom large if a definite structure isn’t immediately apparent and articulated.

Alternatives to Foundations

Donor-advised funds are a common tax-advantaged alternative to a private foundation. These funds are like a private foundation in that they offer an upfront tax benefit but allow account owners to make charitable donations over time.

These funds can be thought of as charitable investment accounts, in which the donor funds an account and directs the plan sponsor to make donations to the causes they want to support. A financial fiduciary institution manages the assets and facilitates the administrative duties and federal filings.

Donor-advised funds are easy to set up and can be done in one day as they don’t require approval from the IRS. Typically there are no set up fees and have low administrative fees. Unlike private foundations that require 5 percent annual distributions, donor-advised funds do not carry a distribution requirement. They may also offer more leeway in deductions, both in terms of cash contributions (up to 60 percent of AGI) and assets (up to 30 percent of AGI).

If confidentiality is important to the donor, anonymity is possible through donor-advised funds. On the other hand, private foundations require public filings with the IRS, and that information is open to the public.

Setting Up a Family Foundation

Family foundations can be as simple or complex as families choose to make them. Broadly speaking, there are no special legal requirements other than complying with IRS rules for private foundations.

The basic steps for setting up a family foundation are fairly simple: commit to a foundation mission; file the requisite IRS forms; fund the legal entity; create a board and hire or appoint an administrator, then begin funding causes that support the mission.

Families will want to work with their financial, tax and legal advisors prior to establishing a foundation. Doing some work upfront can help avoid common errors and maximize the benefits of this structure.

Identify a Mission

A foundation’s mission is a key guidelight for all subsequent investment and provides a purpose for future generations, not to mention an IRS requirement. So what should a mission statement do? A foundation mission should be the intention of the founder, give its members a clear directive and be narrow enough to ward off unsolicited donation requests from off-mission charities.

Take the Carnegie Foundation. It “aims to build a field around the use of improvement science and networked improvement communities to solve long-standing inequities in educational outcomes”. Outsiders can glean that it funds education pursuits, especially where inequality is apparent. It also tells potential suitors that it funds education, not African wildlife conservation or Alzheimer’s research.

Establish an Entity

Before seeking tax-exempt status from the IRS, the foundation needs to establish itself as a trust or corporation. There are pros and cons of each—and the decision is best made with the help of legal and tax advisors. Once this structure is in place, the foundation can apply to the IRS for recognition as a tax-exempt charity.

Create a Board

The next step is to create the foundation’s board. Private foundations allow family members to serve on the foundation’s board. You can choose outsiders with expertise in the area of the mission of the fund or complete novices from within the family. While there is no requirement to hire professional staff, active and large foundations often do necessitate competent administrative staff to successfully execute the mission of the foundation.

Fund the Foundation

Some foundations begin with as little as $250,000 today, but a more feasible amount begins in the millions. During its first year, a private foundation does not have to make a distribution, but going forward it needs to abide by IRS rules on disbursements. At the same time families think through funding, they also need to think about how they’ll manage their assets so they can continue to fund grantmaking for years, possibly decades, to come.

Begin Grant-Making

Giving away money might sound like the easy part, but effective family foundations approach grantmaking with the same diligence as a business developing new products or a portfolio manager seeking new investments. This process entails doing due diligence on the entities or causes the foundation supports, as well as measuring the impact of those funds. For most family foundations, in fact, grantmaking is only the beginning.

Conclusion

Family foundations now account for more than half of all private foundations, which include family, independent and corporate foundations operating nationwide. The reasons for establishing a family foundation are as varied as the causes they support. While families should not let the tax benefits of a foundation drive the decision, foundations are an efficient way to maximize charitable giving and have a lasting impact on the causes that a family holds dear.

The views expressed by the author are not necessarily those of Fifth Third Bank, National Association, and are solely the opinions of the author. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank, National Association or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever. Deposit and credit products provided by Fifth Third Bank, Member FDIC.