The Challenges of Private Foundations
There are many legal and financial drawbacks associated with the creation and management of a private foundation. Most errors derive from the close relationship between a private foundation and the founder's tax obligations. Following are examples of the most common pitfalls and their explanations.
- Private inurement. Private inurement is the improper use of the net earnings from a tax-exempt organization by a related private party for nonexempt purposes. Examples of this include unreasonable compensation, unreasonable rental and borrowing arrangements.
- Self-dealing. Any person who controls and heads a foundation is referred to as a disqualified person, thus prohibiting them from completing certain transactions with a private foundation. The economic value of the transaction is irrelevant in this situation.
- Distribution requirements. Although there are different types of requirements for different foundations, the primary concept is that private foundations give away five percent of the average fair market value of their assets every year. The pitfall occurs when the foundation does not make a distinction between assets needed directly for exempt purposes and ones held to produce income.
- Excessive business holdings. The total ownership of a business by a private foundation and its disqualified persons is limited to 20 percent, although in some cases, the limit is higher. These severe limits are constructed to help preserve the charitable intent of organizations.
- Jeopardizing investments. Private foundation managers are ordered to make sure that the foundation's assets are not invested improperly.
- Excise tax. In order to cover the extra governmental costs associated with the regulation of private foundations, each foundation must pay an excise tax of two percent of their net investment income every year.
- Banned activities. Administering banned activities will cause a private foundation further taxation. Primary activities include: lobbying, making grants to organizations other than public charities or nonprofits, making grants where the grantee retains responsibility for expenditures under the grant, making grants to individuals without an Internal Revenue Service (IRS) approved plan, and partisan political activity.
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