How to Start a Foundation: IRS Rules & Compliance Guide
Starting a foundation is a powerful way to leave a legacy. Whether the goal is to award scholarships, support local charities, or fund research, the desire to give back drives the process. However, forming a foundation involves navigating complex legal frameworks and IRS compliance regulations.
Passion fuels the mission, but proper legal structure protects the assets. Understanding the specific rules for private foundations – from formation to annual distribution requirements – helps keep the organization in good standing and focused on its philanthropic goals.
What is a private foundation?
The IRS distinguishes between public charities and private foundations. While both are typically 501(c)(3) organizations, they differ in funding sources and governance.
- Public Charities: Generally funded by the public, government grants, or a wide base of donors. They must pass a “public support test” to maintain their status.
- Private Foundations: Typically funded by a single individual, family, or corporation. They do not need to seek public funding, which offers flexibility, but they face stricter IRS oversight regarding how money is managed and distributed.
Many families choose the private foundation model for these benefits – to maintain control over investment assets and involve family members in charitable decision-making. However, this control comes with specific responsibilities, such as paying excise taxes on investment income and meeting minimum payout requirements.
Can a private foundation pay salaries?
Yes, a private foundation can pay reasonable compensation to directors, officers, and employees for personal services that are necessary to carry out the foundation’s exempt purposes.
However, the IRS scrutinizes these payments closely to prevent “self-dealing.” Compensation must not be excessive and should be based on comparable market rates for similar roles. If the IRS deems a salary excessive, it can impose significant excise taxes on both the foundation manager and the recipient.
What is the 5% payout rule?
Unlike public charities, private foundations are required by federal law to distribute a minimum amount of their assets annually for charitable purposes. This is known as the minimum distribution requirement.
- The Rule: A foundation must pay out approximately 5% of the average market value of its non-charitable-use assets (essentially its investment portfolio) each year.
- Qualifying Distributions: These include grants to public charities, administrative expenses related to grantmaking, and costs to acquire assets used for charitable purposes.
- Penalty: Failure to meet this payout requirement results in a 30% excise tax on the undistributed amount.
Are there restrictions on investments?
Yes. The IRS imposes a tax on jeopardizing investments—investments that show a lack of reasonable business care and prudence in providing for the long-term and short-term financial needs of the foundation.
Furthermore, private foundations are generally prohibited from owning more than 20% of the voting stock of an active business corporation (the excess business holdings rule). This prevents foundations from running commercial enterprises under the guise of charity.
Steps to Start a Private Foundation
The process mirrors starting a public charity but involves specific nuances in the IRS application.
- Incorporate in Your State: File Articles of Incorporation (or a Trust Declaration) with the state. The governing documents must contain specific language prohibiting self-dealing, requiring annual distributions, and restricting certain investments.
- Obtain an EIN: Apply for an Employer Identification Number from the IRS.
- Establish Bylaws and Conflict of Interest Policy: These internal rules govern how decisions are made and how conflicts are handled.
- File IRS Form 1023: This is the application for recognition of exemption. Unlike public charities, private foundations do not need to prove public support, but they must disclose detailed financial data and governance structures.
- Register for State Fundraising/Charity Compliance: Most states require annual registration with the Attorney General’s office or a similar agency.
Ready to Start Your Nonprofit the Right Way?
Do not let the complexity of IRS rules prevent you from building your legacy. Chisholm Law Firm can handle the legal filings so you can focus on the impact you want to make.
FAQs
How much money do I need to start?
While there is no legal minimum, the administrative costs (legal fees, accounting, annual filings) can be burdensome for very small funds. To ensure the foundation is cost-effective (meaning more money goes to charity than to preparation), most financial advisors suggest starting with a substantial initial contribution (often $250,000 or more) to make the administrative costs worthwhile relative to the charitable impact.
What tax benefits do foundations receive?
Private foundations are exempt from federal income tax. Additionally, donors receive tax deductions for contributions made to the foundation, although the deduction limits (typically up to 30% of adjusted gross income for cash gifts) are slightly lower than those for public charities.
Can one person run a foundation?
State laws vary regarding the minimum number of directors required. Some states allow a single director, while others require at least three. While one person or family often funds a private foundation, having a board ensures proper governance and compliance oversight.
What IRS forms apply to foundations?
The primary formation form is Form 1023. Annually, private foundations must file Form 990-PF. If the foundation has employees, it must also file payroll tax forms (such as Form 941). Unrelated business income may require filing Form 990-T.
Does Chisholm Law Firm help manage foundation compliance?
Yes. We assist with the initial formation and can provide guidance on ongoing compliance requirements, including reinstatement for organizations that have lost their status. However, we typically recommend that foundations also work with a qualified CPA for annual tax return preparation and financial audits.