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By Sonja K. Johnson, Esq., Morrison &
family foundations have long been a popular vehicle for high net worth
individuals to take advantage of valuable tax planning opportunities while
maintaining ongoing involvement with the foundation's charitable giving activities. This structure allows donors to enjoy the
current benefit of a charitable tax deduction (as well as avoiding capital
gains with respect to the gifted property) while retaining some degree of
control over the donated assets and the foundation's activities. For individuals who wish to donate certain closely
held securities - such as an interest in a company owned largely by the donor
and his or her family - the continued involvement afforded by the family
foundation donee may be particularly appealing.
However, it is important for such donors to understand the special
requirements imposed on private foundations that may impact the recipient foundation's
ability to retain the donated securities.
This article discusses the two primary considerations in this context:
minimum annual distributions (the portion of its assets that a private
foundation must distribute each year) and excess business holdings (rules
governing the maximum share of a company that a private foundation may hold).
Annual Distributions: Rules and Potential Recipients
A private foundation is required to make a certain
amount of "qualifying distributions" each year from its non-charitable-use
assets to avoid the imposition of an excise tax. The amount of qualifying distributions
required to be made by a foundation is determined in large part by the
foundation's "minimum investment return."
The minimum investment return is 5% of the fair market value of the
foundation's assets that are not being used for exempt purposes, reduced by
acquisition indebtedness with respect to those assets and a reasonable cash
reserve.1 Thus, a substantial donation to a private
foundation can significantly increase the foundation's required minimum annual
A foundation that makes its required distributions
for each year will avoid imposition of the excise tax. A foundation that does not make the required
distributions is subject to an initial excise tax of 30% of the deficit for
each year it goes uncorrected.2 However, a foundation will not incur a
penalty unless it fails to pay out the required distributions for the taxable
year to which the distributions relate by the close of the following taxable
year. An additional 100% tax is imposed
if the foundation fails to correct the deficiencies within 90 days of receiving
IRS notification of the problem.3 Both the initial and the additional excise
taxes are in addition to the required distributions.4
Given these significant penalties, it is important
for private foundations to satisfy their minimum annual distribution
requirements. However, this may pose
particular challenges where the majority of a foundation's holdings are illiquid
assets such as closely held securities.
If the foundation has insufficient cash or other assets, it will
essentially be forced to distribute a portion of the closely held securities
each year to meet its distribution requirements. While some donors may have no objection to
this arrangement, others - particularly those donating ownership interests in
private companies in which they or their families maintain significant
involvement - may be concerned that such distributions would undermine the retained
influence over the securities that the foundation gift was intended to afford.
In general, a grant by a foundation is a qualifying
distribution if it is made in pursuit of a charitable purpose and the
foundation does not retain control over the use of the distributed funds.5 Unless a foundation uses assets for direct
charitable work (which is unusual for family foundations and in any event would
require selling assets such as closely held securities) or for "set‑asides" (a
process by which funds are earmarked for specific projects),6 this means it must make
its annual distributions to other charitable entities. Such entities may include: public charities;
government entities; designated funds (restricting donations to a particular
public charity named upfront by the donor) or donor advised funds (allowing the
donor advisory privileges regarding the distribution and investment of funds)
under the umbrella of a community foundation; supporting organizations
(operating for the benefit of a public charity); or, under certain
circumstances, other private foundations.
Donors wishing to retain some influence over closely
held securities that must be granted to other entities to satisfy minimum
annual distribution requirements might see donor advised funds or other private
foundations as appealing candidates for distributions. However, donor advised funds have come under
increasing scrutiny and regulation by the IRS in recent years, are discouraged (for
purposes of "parking" illiquid assets) by many community foundations, and are
subject to the excess business holdings rules discussed below. Thus, donor advised funds are generally not
ideal candidates for satisfying a foundation's minimum grant requirements. Other private foundations are generally even
less appropriate recipients of such distributions, as a private foundation that
receives a grant from another foundation must make minimum distributions in the
following year equal to its own minimum distributions plus the amount of the
grant.7 The recipient foundation may not satisfy this
requirement through grants to a third private foundation, so making
distributions to another foundation often merely delays a grant to a different
type of entity by one year.
While public charities, government entities and designated
funds are all eligible recipients of minimum annual distributions, they
generally offer a donor little retained influence, in part because these
entities may be more likely to sell the granted assets. Therefore, supporting organizations may be the
most appealing type of grant recipient if a private foundation is required to
distribute assets such as closely held securities. The public charity supported by a supporting
organization generally has significant control over the organization. However, supporting organizations often offer
donors the opportunity to maintain some involvement, such as by serving on the
organization's board of directors, so in many cases this allows at least some
degree of influence over the granted securities.8
Even if a private foundation has other substantial
resources for satisfying minimum annual distributions, a significant gift of
privately held securities can also pose concerns under the excess business
holdings rules to which private foundations (and donor advised funds, as noted
previously) are subject. In general,
these rules limit the percentage of a company (measured both in terms of
ownership and voting interests) that a private foundation may hold for an
extended period without incurring excise taxes.
A private foundation and its "disqualified persons"
(as discussed below) together may own no more than 20% of the voting or
ownership interest in a business enterprise.
There are two exceptions to this rule: (i) the foundation and disqualified
persons may own up to 35% if a third party effectively controls the management
and policies of the business enterprise; and (ii) a de minimis exception to the excess business holdings rule applies
if the foundation, together with all other private foundations under common
control or primarily funded by the first foundation's disqualified persons,
owns less than 2% of the voting stock and not more than 2% of the value of all
outstanding shares of all classes of stock.
An initial excise tax of 10% of the value of the
excess holdings is imposed on the foundation for each year a violation goes
uncorrected.9 An additional tax of 200% of the value of the
excess holdings is imposed on the foundation if it fails to correct the offense
within 90 days of receiving IRS notification of the problem.
"Disqualified persons" with respect to a
private foundation include:
(i) substantial contributors to the foundation,
meaning an individual (which is deemed to include the individual's spouse) or
entity that has donated an amount over $5,000 that exceeds 2% of the
foundation's total contributions;10
(ii) the foundation's managers (including officers,
directors, trustees and others with similar powers and responsibilities);
(iii) 20% owners of substantial contributors (where
a contributor is a corporation, partnership or other entity);
(iv) family members (including spouses, ancestors,
children and their spouses, grandchildren and their spouses, and great
grandchildren and their spouses)11 of substantial
contributors, of 20% owners of substantial contributors, and of foundation
(v) corporations and partnerships in which 35% or
more of the voting power or profits interest is owned by the four types of
disqualified persons set forth above;
(vi) trusts and estates
with respect to which 35% or more of the total beneficial interest is held by
the first four types of disqualified persons set forth above;
(vii) other private foundations that are effectively
controlled by a majority of the same persons who control the foundation in
(viii) other private foundations that have received
substantially all of their contributions from the same person(s) (or the family
members of such persons) who funded the foundation in question.12
This extensive attribution of disqualified persons'
holdings makes it especially difficult for some private foundations to retain
gifts of closely held securities. Particularly
where an individual wishes to donate a substantial interest in a family-owned
company to a foundation, the ownership interests of the foundation's
disqualified persons may be so substantial that even without counting the
foundation's own holdings, the foundation's attributed holdings exceed the
allowable 20% (or 35% if applicable) limit.
Thus, the foundation would be limited to the 2% de minimis limit set forth above and would have to dispose of all
securities exceeding a 2% interest in the company.13
In order to avoid excise taxes, a foundation
generally must dispose of its excess business holdings within five years of
receiving the assets. Under certain
circumstances, the IRS may grant a five-year extension for such disposition.14 Recipients of excess business holdings may
include any of the charitable entities described with respect to minimum annual
distributions. Again, however, donor
advised funds and other private foundations are also subject to the excess
business holdings rules, so these are generally not good candidates for
dispositions of excess holdings.15 Thus, a foundation's options for retaining a
significant gift of closely held securities, or even for granting such
securities to another entity that will allow the original donor some continued
influence over their use, can be fairly limited.
For individuals wishing to donate interests in
privately held entities such as family-owned companies, a known, controlled
private foundation often holds certain appeal.
However, donors should carefully assess the potential recipient
foundation's other assets, as well as the other holdings that the foundation
will be deemed to own through its disqualified persons. Depending on the circumstances, the
foundation may be required to dispose of a substantial portion (if not all or
nearly all) of such gift within a relatively short period of time. In such case, donors might at least consider charitable
organizations that would be appropriate candidates for subsequent grants from
the foundation. On the other hand, certain
donors might find it advisable to consider a different charitable recipient altogether-and/or
a different type of gift for the family foundation.
* * *
Morrison & Foerster's Trusts and Estates group provides
sophisticated planning and administration services to a broad variety of
clients. If you would like additional
information or assistance, please contact Patrick McCabe at (415) 268-6296 or
© Copyright 2011 Morrison &
Foerster LLP. The views expressed in this article are those of the author only,
are intended to be general in nature, and are not attributable to Morrison
& Foerster LLP or any of its clients. The information provided herein may
not be applicable in all situations and should not be acted upon without
specific legal advice based on particular s
I.R.C. § 4942(e)(1);
Treas. Reg. § 53.4942(a)-2(c)(3)(iv).
The amount of the required distributions is also increased by certain
additional amounts set forth in I.R.C. § 4942(f)(2)(C), and reduced by the
sum of the foundation's unrelated business income taxes, and excise taxes paid
on investment income for the year.
I.R.C. § 4942(a)(1).
 I.R.C. § 4961(a);
I.R.C. § 4963.
§ 53.4942(a)-1(a)(3). It should
also be noted that a foundation can seek abatement of the excise tax in certain
circumstances where the failure to make the required distributions is due to an
incorrect valuation of its assets. (I.R.C. § 4942(a)(2).)
I.R.C. § 4942(g);
Treas. Reg. § 53.4942(a)-3(a)(2).
Set-asides are generally not
recommended for satisfying a foundation's distribution requirements because
they involve significant administrative overhead and IRS involvement. See
I.R.C. § 4942(g)(2); Treas. Regs. §§ 53.4942(a)-3(a)(2); 53.4942(a)-3(b)(1).
I.R.C. § 4942(g)(3). This requirement does not apply to private
operating foundations, but most private foundations do not meet this
qualification (instead being characterized as non-operating foundations)
because operating foundations function more like public charities, directly
engaging in extensive charitable work rather than primarily making grants.
 Foundations considering a
grant to a supporting organization should identify whether the potential
recipient is a Type I, Type II or Type III supporting organization
(distinguished by their relationships and functions with respect to the
supported public charity and the types of control that the public charity may
exercise over the supporting organization), as grants only qualify for minimum
annual distributions if made to Type I, Type II or "functionally integrated"
(serving a direct function of the supported public charity) Type III
organizations. See I.R.C. § 4942(g)(4); Council
on Foundations, Distributions from a
Private Foundation to a Supporting Organization, at
In certain instances where a
foundation is unaware that a purchase of an interest has caused an excess
business holding, the foundation has 90 days from the date it knows, or has
reason to know, of the event to reduce its holdings to an acceptable level.
Where a trust makes grants to
a private foundation, the trust's grantor is treated as the contributor.
Interestingly, an individual's
siblings are not treated as his or her family members for these purposes.
This is defined as the same
persons or members of such persons' families having made at least 85% (with
each person contributing at least 2%) of the total contributions and bequests
that have been received by each foundation throughout its existence.
It is worth noting again that
even this exception is limited to a total 2% interest that may be held by a
private foundation and any private foundations that are disqualified
persons with respect to it. Therefore, a
donor cannot circumvent this problem by donating securities in the same company
to multiple foundations that are under common control or have been primarily
funded by the same or related persons.
Such an extension is only
available where (a) the foundation can demonstrate that it has made diligent
efforts to dispose of the excess holdings during the first five years but was
unable to do so due to the size, complexity or diversity of the holdings, (b)
the foundation submits a plan for disposition of the excess holdings to the IRS
and state attorney general (or similar official) prior to the end of the
initial five-year period, and (c) the IRS determines that the plan can
reasonably be carried out within the five-year extension period.
In addition, distributions to
non-functionally integrated Type III supporting organizations (as discussed
previously) do not constitute dispositions of excess business holdings.
Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients. If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.
© Copyright 2011 Morrison & Foerster LLP. This article is published with permission of Morrison & Foerster LLP. Further duplication without the permission of Morrison & Foerster LLP is prohibited. All rights reserved. The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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