How to Start a Foundation: What You Need to Know About IRS Compliance 

Starting a foundation is a powerful way to make a lasting impact on causes close to your heart. Whether you want to support local nonprofits, offer educational scholarships, or provide charitable grants, the desire to give back is the driving force behind many foundations. 

However, creating a foundation also involves more than just passion—it requires a deep understanding of the legal and financial responsibilities, especially regarding Internal Revenue Service (IRS) compliance. Properly navigating IRS regulations will help keep your foundation’s investment assets in good standing, allowing it to grow and fulfill its mission for years. While it may seem overwhelming, compliance with IRS requirements is a manageable process with the right preparation.

Understanding Foundation Types

The first step in starting a foundation is understanding the difference between a private foundation or nonprofit corporation and a public charity. These two nonprofit organizations have distinct characteristics that affect how the IRS views them. 

Public Charities 

Public charities are typically organizations that receive their financial support from a broad base of donors, including individuals, corporations, and government entities. They often engage directly in charitable activities like running educational programs, providing direct relief to those in need, or operating museums and cultural institutions. 

Because they depend on public support, the IRS requires them to pass certain tests to ensure they continue to receive a substantial portion of their income from the general public. They also have to file an IRS Form 990 annually, which provides detailed information about their finances, operations, and activities. And while public charities can engage in fundraising activities, there are limits on how much they can spend on lobbying or political activities to maintain their tax-exempt status. 

Private Foundations 

Private foundations, on the other hand, are typically funded by a single individual, family, or corporation. They primarily support charitable activities through grants to other nonprofit organizations, though some may also engage in direct charitable activities. Many private foundations start as family foundations, allowing you to involve family members in and fund your philanthropic efforts. 

Private foundations have more flexibility in choosing how to support charitable causes since they do not need to meet public support tests. However, this flexibility comes with stricter oversight from the IRS. 

• Excise Taxes: Private foundations must comply with specific rules to avoid excise taxes. These include regulations against self-dealing, requirements for minimum annual distribution of funds, and limitations on certain types of investments. 
• Annual 990-PF Filing: Unlike public charities, private foundations must file a Form 990-PF, which details their assets, grants, expenses, and investments. This form is crucial for transparency and helps the IRS ensure that the foundation’s activities align with its charitable mission. 
• Minimum Distribution Requirement: Private foundations are required to distribute at least 5% of their assets annually for charitable purposes. This rule is designed to ensure that foundations actively use their funds to further charitable causes, rather than merely accumulating wealth. 

Why Classification Matters

The classification as a public charity or a private foundation significantly impacts how the IRS monitors your foundation’s activities and what is expected in terms of compliance. For example, a private foundation might find it easier to maintain its classification, but the trade-off is more stringent IRS oversight and complex reporting requirements. Public charities, while enjoying some advantages in terms of donor tax benefits and less intense scrutiny, must maintain a broader funding base to meet the public support tests. 

Deciding on Tax-Exempt Status 

One of the main advantages of creating a foundation is obtaining tax-exempt status. For many organizations, obtaining 501(c)(3) tax-exempt status offers significant advantages that can help them thrive and effectively pursue their missions: 

• Tax Savings: With 501(c)(3) status, foundations do not pay federal income taxes on their earnings, allowing more resources to go directly toward their charitable activities.
• Donor Incentives: Contributions made to a 501(c)(3) organization are tax-deductible for donors, making it easier to attract substantial donations and establish long-term relationships with benefactors. 
• Grant Eligibility: Many government and private grant programs are only open to organizations with 501(c)(3) status. This designation can therefore unlock additional funding opportunities for your foundation. 
• Public Trust: Achieving 501(c)(3) status signals legitimacy and commitment to charitable work, which can help your foundation build trust with donors, volunteers, and the broader community. 

Why 501(c)(3) Status Is Often Preferred 

Foundations often prioritize 501(c)(3) status over other potential classifications because it directly supports their ability to gather donations, make grants, and engage in charitable work. The IRS compliance requirements tied to this status ensure that the foundation’s resources are dedicated to the public good, enhancing trust with donors, grantors, and the general public. 

While 501(c)(3) status is the most common for charitable foundations, other tax-exempt options may be available depending on your foundation’s goals, resources, and activities. For example, 501(c)(4) status is available to social welfare organizations that may engage in more lobbying activities, while 501(c)(6) status is designated for business leagues and trade associations. However, these alternatives come with different restrictions and benefits. 

Key IRS Requirements for Starting a Foundation 

Compliance with IRS requirements begins at the application stage and extends throughout the life of the foundation. Navigating these regulations ensures your foundation remains in good

standing and can maintain its tax-exempt status, helping you focus on your mission. Here are some of the main steps to get you started. 

Initial IRS Compliance Steps 

To obtain 501(c)(3) tax-exempt status, foundations must submit an application to the IRS. This process typically involves filing Form 1023, a comprehensive document that provides detailed information about the foundation’s purpose, structure, and operations. Smaller foundations with anticipated annual gross receipts of less than $50,000 may qualify to use the streamlined Form 1023-EZ. This shorter version simplifies the application process but requires the same attention to detail to ensure eligibility. 

In your application, you’ll need to establish your foundation’s purpose and demonstrate that it serves a charitable cause, such as charitable giving or supporting grant-making public charities. Be prepared to provide thorough foundational documents, including articles of incorporation and bylaws that outline the foundation’s mission, governance structure, and operational rules. The IRS will review these documents to ensure they align with the rules governing tax-exempt organizations. To help ensure a quick approval, clearly state your foundation’s charitable purposes in these documents, as vague or unclear language could delay or derail your application. 

Finally, you’ll need to obtain an Employer Identification Number (EIN) for your foundation. This number functions like a Social Security number for your foundation, allowing it to file tax returns, move funds, open bank accounts, and hire employees if necessary. It is required for 501(c)(3) applications and is a general best practice for any foundation. 

Ongoing IRS Compliance Obligations 

Once your foundation is established and receives its tax-exempt status, maintaining compliance with IRS regulations becomes an ongoing responsibility. Expect to keep up with annual reporting, manage excise taxes, and adhere to rules on certain activities and transactions as well as make certain documents available for public inspection. 

• Annual IRS Reporting Requirements: Private foundations are required to file Form 990-PF, Form 990-EZ, or Form 990-N (depending on size) annually, providing a detailed overview of their financial activities, including grants, assets, and expenses. 
• Excise Taxes on Investment Income: Your foundation will be subject to an excise tax on its net investment income, which is generally set at 1-2%. This tax is intended to encourage private foundations to actively distribute their funds for charitable purposes rather than accumulate investment income without deploying it towards their mission. 
• Rules on Self-Dealing, Private Benefit, and Excess Business Holdings: The IRS enforces strict rules against self-dealing, which prohibits transactions between the foundation and its insiders (e.g., directors, officers, or substantial contributors). Foundations also have to avoid providing undue benefits to private individuals or entities and are limited in the extent to which they can hold equity in businesses, known as excess business holdings. 

Penalties for Non-Compliance 

Failure to comply with IRS regulations can have serious consequences, ranging from monetary fines to losing your foundation’s tax-exempt status. The IRS takes compliance seriously, and penalties can affect both your foundation’s operations and its ability to receive donations. 

One of the most common compliance violations is engaging in prohibited transactions, such as self-dealing. These transactions involve the improper use of foundation assets to benefit directors, officers, or other insiders of public foundations. The IRS imposes severe penalties for such actions, including fines and possible loss of tax-exempt status. 

Another common issue is poor recordkeeping. Accurate and thorough records are essential for maintaining IRS compliance, as they allow you to document how your foundation’s assets are being used for charitable purposes. Failing to keep proper records can lead to penalties or audits by the IRS. 

Common IRS Compliance Pitfalls 

Navigating IRS regulations can be challenging for those starting a foundation, especially for those new to the world of nonprofit compliance. Mistakes made in the early stages can lead to costly delays, and penalties, and even jeopardize a foundation’s tax-exempt status. Here are some of the most common IRS compliance pitfalls and tips for avoiding them: 

Unclear Charitable Purposes 

One of the most frequent errors is failing to clearly define the foundation’s charitable purposes. The IRS requires that a foundation’s activities serve a recognized charitable purpose, such as education, relief of the poor, or community development. When a foundation’s mission statement is too vague or broad, the IRS may question whether its activities genuinely qualify for tax-exempt status, potentially leading to delays or rejection of the application. 

How to Avoid It: Before applying for tax-exempt status, take the time to craft a clear and specific mission statement that outlines your foundation’s charitable purpose. Ensure that all activities align with this purpose to satisfy IRS requirements. Consulting with a legal professional can help ensure that your foundation’s mission and activities are articulated in a way that meets IRS standards. 

Incomplete or Late Filings 

Failing to submit required documents on time, such as Form 1023 for tax-exempt status or annual Form 990-PF, can result in penalties and loss of good standing. Late filings can also

affect donor trust and public perception as transparency is key to maintaining a positive reputation with supporters. 

How to Avoid It: Create a detailed compliance calendar that tracks important filing deadlines, including annual returns, renewal requirements, and state filings. Also, consider investing in accounting software or working with a nonprofit accountant to streamline financial tracking and reporting. 

Improper Record-Keeping 

Many new foundations neglect the importance of maintaining thorough records of their financial transactions, grants, and board decisions. Poor record-keeping can complicate the process of filing accurate tax returns and responding to IRS inquiries. It can also result in difficulties during audits, which can be both time-consuming and costly. 

How to Avoid It: Set up a system for organizing and storing all financial records, grant agreements, meeting minutes, and correspondence with the IRS. Good record-keeping is essential for accurate reporting and can be invaluable during audits. Also, develop internal controls and policies to ensure that all financial transactions are properly documented and authorized. 

Misunderstanding Rules on Self-Dealing and Compensation 

Engaging in transactions that the IRS classifies as self-dealing is a common mistake for private foundations, particularly when it comes to compensating board members or engaging in business dealings with insiders. Even well-meaning actions, like reimbursing a board member for expenses without proper documentation, can be considered a violation. 

How to Avoid It: Make sure your board members, officers, and key staff understand what constitutes self-dealing and how to avoid it. Provide training or consult with a nonprofit lawyer to review potential transactions. Establish written policies that outline compensation practices, reimbursement procedures, and conflict of interest rules to minimize the risk of violations. 

Failure to Meet Minimum Distribution Requirements 

Private foundations are required to distribute at least 5% of their assets annually for charitable purposes. Failing to meet this requirement can result in excise taxes and potential scrutiny from the IRS. 

How to Avoid It: Work with financial advisors to plan for the required 5% annual distribution, ensuring that funds are allocated to support your foundation’s mission each year. Regularly review your foundation’s investment strategy to ensure that it aligns with your spending goals and maintains sufficient liquidity for required distributions.

When to Seek Professional Guidance 

While it’s possible to navigate the IRS compliance process on your own, it can be complicated and time-consuming. Seeking help from an experienced attorney who understands nonprofit law can save you time, ensure your foundation is structured correctly, and help you avoid common compliance issues. 

A legal team can also assist with ongoing compliance, such as filing annual tax returns, managing financial records, and ensuring that your foundation stays in good standing with the IRS. Professional guidance can be invaluable if you’re unsure about which type of charitable foundation to create or how to handle specific compliance requirements. 

Chisholm Law brings a wealth of experience in IRS compliance and nonprofit law, guiding foundations through every stage of their journey. With a deep understanding of the regulatory landscape, Chisholm Law can help you establish a foundation that is both compliant and positioned for long-term success. 

Start Your Foundation with Chisholm Law’s Help 

Starting a foundation is a rewarding experience, but ensuring that it complies with IRS regulations is essential to its long-term success. At Chisholm Law, we’re committed to helping you through every step of the process, from filing for tax-exempt status to establishing and ensuring ongoing IRS compliance. 

Our team can assist with drafting your foundation’s organizational documents, filing your tax-exemption application, and navigating the complex regulations that apply to private foundations. With our support, you can focus on achieving your business or foundation’s philanthropic goals without worrying about legal pitfalls. 

Contact Chisholm Law today to schedule a free consultation, and let us help you build a solid foundation for your family name and your charitable endeavors. 

*Past results do not determine future outcomes