Minimum Distribution Requirement (MDR)

What are the minimum distribution requirements (MDRs) for private foundations and how do they work?

Private foundations are required to pay out 5% of their assets each year for charitable purposes, which is calculated based on the prior year’s average assets. Of note, we’ve found that our clients often grant more than the minimum—an average of 6.6% of assets in 2022. The distribution requirement includes both grants and expenses. In any year that a private foundation exceeds the 5% distribution, they can carry forward the excess distribution for up to five years. In years when their endowment investments have higher gains, the distribution requirement will go up the following year. With the additional philanthropic dollars, foundations can make more distributions in the current year by supporting other areas of giving or being responsive to unexpected situations or crises. A foundation may also want to distribute more than 5% if they’re planning to add additional assets, such as having a liquidity event, selling a business, receiving an inheritance, or donating appreciated securities.

LEARN MORE >>

Expenses

Can expenses count toward the MDR? If so, how do you best leverage them?

Foundations can pay for all legitimate and reasonable expenses incurred in carrying out the charitable purpose of the foundation, which include any fees that help the foundation become more effective. Examples include joining donor networks, marketing, conferences, and workshops. In the year of creation, that includes any administrative, legal and accounting expenses in connection with the formation of the foundation. Expenses and salaries need to be deemed fair and reasonable, especially when it comes to compensating family members. Use this checklist developed by our legal team to help with compensation guidelines.

What are some examples?

One of our clients is a husband and wife that have a foundation in New York. They decided to have their annual board meeting in Jamaica. They told us they were going to discuss grantmaking strategies and look at their investment policy. They wanted the foundation to pay for their travel, accommodations and food while they were there. We advised them that the IRS would not approve it. If there had been a component where they were surveying local organizations looking to make grants there, this could possibly have worked. But that’s not what they were planning to do. Contrast that with another client, a foundation with four generations of the family involved. They lived across the country, so every year they would fly to one central location for the board meeting. They would also incorporate a family vacation with the board meeting that included non-board members. This worked because they were meticulous in separating the expenses that were foundation-related from personal and vacation expenses.

LEARN MORE >>

Program-Related Investments (PRIs)

How do foundations leverage PRIs as part of their overall charitable giving strategy?

When people think of private foundations, they often think about cutting checks to public charities. But that’s not the only way to give. A PRI is an alternative way to support charitable causes in the form of a loan, loan guarantee or equity investment. There are several advantages to PRIs. First, you can reuse the same dollars for the benefit of multiple charities because as the funds roll back in, they can be redistributed. And PRIs also count toward satisfying your annual MDR, just like a traditional grant would. There are also benefits to recipients. With a PRI, there’s the ability to raise a larger pool of funds than may be possible through grants alone and get financing for a project that may be considered too risky by a traditional commercial lender. If a charity has a PRI, they can potentially attract other lenders to a project by having a lead funder take on early risk.

What are some examples?

We had a foundation whose goal was to survive in perpetuity. They were already supporting nonprofits with traditional grants, but they didn’t want to spend down their assets. We introduced them to the concept of PRI loans. They went to the nonprofits they had been funding and asked, “What if instead of $5,000 one-time grants, we could make $25,000 or $50,000 PRI loans that could be paid back over a few years?” In the last two years, they’ve granted about 20 PRI loans and they’re all coming back—many with interest.

LEARN MORE >>

Alternative Investments

What should foundations be aware of when it comes to alternative investments?

Foundations can invest in any type of asset, but there are certain prohibited transactions. In particular, a private foundation is not allowed to engage in the transfer of assets, the sale, borrowing of money, or anything of a financial nature between itself and its insiders. The insiders that are easy to identify are officers, directors, substantial contributors to the foundation, and close family members of these individuals. Where it gets tricky is that self-dealing also encompasses transactions with companies that are more than 35% owned by individuals who are considered insiders. So, when a foundation and an insider are co-invested in an alternative asset, it’s very important to be aware of the ownership levels of the insiders before the foundation adds its money to the pool.

Foundations also need to consider liquidity in their investments as it relates to their annual MDR, which they’re supposed to meet in making grants or other charitable distributions throughout the course of the year. That 5% amount is determined based on your investment asset average from the prior year. You need to make sure that you have a steady cash flow in order to meet those distribution requirements because a private foundation that holds an illiquid asset still has to meet the distribution requirement attributed to that ownership.

LEARN MORE >>

Direct Charitable Activity (DCA)

What is a DCA? How does it differ from traditional foundation activities?

A DCA allows private foundations to carry out their own programs instead of giving through a charitable organization. Private foundations, their directors, officers and even staff members are in a unique position to leverage their skills to address a particular problem directly.

What are some examples?

One of our clients noticed that a lot of local children who lived in non-English speaking households were struggling with their reading. The directors saw an opportunity to jump in. They started hosting reading workshops and trainings to focus on the entire family and partnered with libraries to bring books to families. They saw an impact on literacy and overall school readiness. Another client wanted to provide business attire for people who were recently released from prison and who were looking to get back into the workforce. It was pretty successful, but then they saw that tattoo removal was something that could be a huge benefit too. At Foundation Source, we can help you come up with a well-thought-out and impactful program.

LEARN MORE >>

Grants to Individuals (GTIs)

Can you explain the strategy around granting to individuals and ways to execute it?

Private foundations generally make donations to charitable, IRS-approved organizations. But private foundations are also allowed to provide funds to individuals or families who fall into certain charitable classes. During COVID, we saw a lot of clients supporting hard-hit families. One foundation wanted to support local restaurant workers who had either been laid off or had a significant reduction in hours and were struggling to pay their bills. They were able to make over 100 small grants in 2020. The recipients had to document their need. We had another client who wanted to go to Walmart and pay for the groceries of random shoppers. However, the IRS wouldn’t necessarily see that as charitable without having a documented need of each shopper. So that wasn’t something that the foundation could do without IRS penalties. A well-thought-out GTI can be a wonderful and personal approach to a foundation’s overall mission.

LEARN MORE >>

Scholarships, Awards and Prizes

Scholarships are another form of grants to individuals. Can you share some examples of how clients have used them to stand out?

One of our clients wanted to have a scholarship program for kids who are often not considered for scholarships: C students. Over the years, there were countless success stories from these recipients as they went off to do amazing things.

Can you give us a brief overview of awards and prizes, which are another high-impact private foundation strategy?

Prize philanthropy recognizes achievements or drives developments that benefit society. In recent years, this type of philanthropy has become more popular amongst a wider segment of donors. This type of giving is also considered grants to individuals and in some cases may require advance approval from the IRS. If you want to avoid the process of obtaining advance approval, your award program must fulfill several criteria. First, you can’t impose any conditions on how the awardee spends the award. Then, no award may be given to a disqualified person, such as a family member. There must be a broad charitable class. Lastly, you need to develop a mechanism for getting the word out to ensure that there’s broad participation in the program.

LEARN MORE >>

International Grantmaking

What are the options for grantmaking internationally?

Generally, private foundations give to IRS-approved organizations, which are inherently domestic U.S. organizations. But many foundations have an interest in supporting international causes and there are a few mechanisms to do that. The easiest option is if a foreign organization has a U.S.-based “Friends of” organization that is a recognized 501(c)(3) public charity. Another fairly simple option would be to make a gift through a domestic partner who works with a particular foreign organization. They act almost like a donor-advised fund for international programs and they facilitate the support to foreign organizations, while the private foundation has the simplicity of giving to a U.S. public charity.

Another option would be to obtain what’s called an equivalence determination, which is a legal opinion that the intended recipient, the foreign organization, is actually the equivalent of the IRS-approved public charity. These determinations can typically be relied upon for a few years, and the public foundation can make repeat gifts. Then the last option would be to exercise what’s known as expenditure responsibility, which is an IRS-mandated documentation process that verifies the granted funds are used for charitable purposes.

LEARN MORE >>

Next-Generation Engagement

Because multi-generational family meetings can be challenging, what ideas and best practices do you recommend that lead to better family foundation outcomes?

In our recent client survey, we asked foundations to share their current priorities and challenges. They cited their number one priority was getting the next generation involved in giving. Interestingly, they also cited this as their number one challenge. When multi-generations in a family have different interests and concerns, there are a few ways to approach this opportunity. The families that have the most success are the ones who experiment to provide younger family members with a bigger role and voice while they are coming up the learning curve.

For instance, you can have them join board and committee meetings as observers, sit on junior boards or give them end-to-end responsibility for a discretionary fund. While these are all proven methods, they’re not the only ones. It may come as no surprise that many families with significant wealth have strong leaders with strong opinions. A best practice for these individuals is to be willing to hear from other factions within the family. They should be prepared to welcome different approaches and outcomes than the ones they envision. While this can be challenging and uncomfortable to work across generations with different points of view, the rewards are plentiful. When families are intentional about including every individual and giving them a platform that makes them feel seen and heard, it fosters a shared sense of trust, stronger intergenerational relationships and a lasting legacy.

LEARN MORE >>

Foundation Best Practices

Do you recommend a website for a private foundation?

Yes. Only about 10% of private foundations have a website. Some foundations may feel like a website is a “nice to have” or that they are too small to justify one. But with a customized website, a private foundation can clearly articulate their mission and funding focus to streamline the grant application process. By outsourcing website building expertise to trusted experts, private foundations can focus on doing their best work without having to worry about ongoing maintenance.

LEARN MORE >>

What are some best practices on how philanthropists can prevent fraud?

The steps involved in preventing bad actors from getting grant funding intended for good works can be daunting. However, the right technology can not only automate much of this work, but alleviate risk associated with human error. There are also a few key features to look for—including accounts locking after a certain number of failed attempts. Sometimes the number of failed attempts before lockout is determined according to an algorithm that’s looking at various factors like location or device. With Impactfully, which is our proprietary, cloud-based SaaS platform built as an essential software solution for grantmakers, one of the included features is an email notification that alerts someone when their contact information has changed. There are also “watchdog” organizations like CharityWatch, Charity Navigator, Give, and GiveWell, which can help you beware of scams, fraudsters and fake charities trying to trick well-intentioned donors. Please note that it’s important when considering these tips that if you’re managing grant disbursements using your in-house staff, they should check the process they’re using with their legal counsel. If you’re already outsourcing these tasks or planning to, ensure they’re following these best practices.

TO LEARN MORE, CLICK HERE.

What are the basic compliance rules that every board member must know about, particularly when it comes to self-dealing?

The IRS’s self-dealing rules govern transactions between the foundation’s insiders known as disqualified persons and private foundations. Notably, the self-dealing rules prohibit even those transactions that would be beneficial to a foundation, such as a disqualified person’s sale of property to a foundation at a below- market sweetheart price. In addition to knowing the types of transactions that could result in a violation, it’s also important to know the exceptions to the rules so that you’re not unnecessarily limiting yourself or the foundation. Because self-dealing rules only apply to transactions with disqualified persons, the crux of the matter is to understand who and what is a disqualified person. They are those who are actually serving on the foundation, such as the foundation’s officers, directors and trustees, as well as substantial contributors to the foundation, businesses in which the disqualified persons collectively have a significant ownership stake, and certain family members. Remember, it’s not just human beings who can be considered disqualified persons, but entities too.

LEARN MORE >>

And of ultra-wealthy investors:

Our private foundation experts back you up at every turn, so you can confidently engage with your clients and prospects on the topic of philanthropy. We keep you ahead of the competition and help you consolidate and retain assets currently held elsewhere.

And because most private foundations are family affairs, they can help you develop extended family relationships, which is key to avoiding these statistics:

Benefit to Your Clients

The benefits of working with us include:

• Clients can start a private foundation with less than $1 million in assets.
• Comprehensive foundation support services all under one roof.
• Real-time compliance monitoring by top professionals.
• An online platform, built from the ground up for the specialized needs of private foundations, providing charity research tools, streamlined granting, and transparency into foundation activities.
• Excellent, responsive client service, as evidenced by our 98% client retention rate.

Working With Us

Our nationwide team of Regional Managing Directors is available to answer questions about private foundations, brainstorm client solutions, and participate in meetings and conference calls. They are supported by an internal team of tax and legal professionals, philanthropic directors, and business development professionals.

To find the business development team serving your area, visit https://foundationsource.com/team/#sales-team.

WHO TO TARGET:

New Foundations

Individuals who may be interested in setting up a new foundation include clients or prospects who:

• Need a tax-management strategy in anticipation of the sale of a business, an inheritance, or a legal/domestic settlement.
• Have a large holding of highly appreciated stock that would incur capital gains taxes if sold.
• Have an under-diversified asset position generating little or no income.
• Anticipate an intergenerational transfer of wealth or a family business.
• Desire to avoid taxes on the sale of assets or upon death.
• Want full ownership and control over their charitable dollars.
• Have a history of giving or an articulated desire to fund philanthropic programs.
• Want to build a family legacy that can be passed down to future generations in perpetuity.

WHO TO TARGET:

Existing Foundations

Existing foundations that could be a good fit for our services typically have:

• Foundation assets of at least $1 million (sometimes less).
• Family members who are directly involved in operating the foundation, and few or no paid staff.
• Foundation members who are geographically dispersed.
• Burdens from administrative requirements.
• Concerns about being compliant with IRS regulations.
• Transitions in foundation operations or governance:
  • Change in foundation leadership.
  • Desire to engage the next generation.
  • Sudden growth in foundation assets.
  • New philanthropic focus.
  • Retirement of a trusted advisor or key staff member.
  • Divorce or other family issues that require the foundation to be divided into separate entities.

Preparing for a Client Meeting

To help you prepare for a client conversation about philanthropy, we’ve created a resource on “Tips for the Talk.” These pro tips will help you have productive client conversations about charitable giving.

Tips for Mission Development

Should your foundation wish to articulate a mission, consider the following.

1. TAKE YOUR TIME

There’s no rush to determining a mission. If you’re unsure of where to focus your charitable efforts, begin by supporting a wide variety of causes to find out what really motivates and excites you and your leadership team.

If you’re just starting out, ask yourselves:

• Do you share any interests, passions or concerns? Searching for common ground can help determine your focus.
• Do you hope to effect change locally, regionally, nationally or globally?
• In addition to supporting causes with funding, do you also want to participate in hands-on volunteering (direct charitable activities) such as serving in a soup kitchen or tutoring children in need?

As your foundation gains philanthropic experience, consider:

• Where is your foundation making the most impact?
• What causes hold your interests?
• Do you want to focus your giving in a single area or address multiple issues?
• Do you want to support causes that honor the interests and wishes of your founders? Or causes that align with your leadership’s areas of expertise?

2. INVOLVE THE NEXT GENERATION

If your foundation is expected to operate beyond its current generation, involve younger members in your mission development. Engaging them will likely increase their interest in the foundation as well as add new perspectives and ideas to consider.

3. BE CLEAR, WHETHER DETAILED OR BRIEF

An effective mission statement can be very brief or detailed. Either way, be sure it’s worded clearly so your foundation’s internal and external audiences can easily understand it.

At minimum, include a description of the change you want to see (or the impact you want to make). More detailed statements may also include a description of how your foundation will effect that change. Here are some examples:

BRIEF: American Diabetes Association
To prevent and cure diabetes and to improve the lives of all people affected by diabetes.

DETAILED: Eat. Learn. Play. Foundation
Committed to unlocking the amazing potential of every child by fighting to end childhood hunger, ensuring students have access to a quality education, and providing safe places for all children to play and be active.

4. ALLOW ROOM FOR GROWTH

Craft your mission with language broad enough for your charitable focus to be modified or expanded down the road. Doing so can particularly benefit foundations that are set up in perpetuity; as times change, future generations may want or need to adapt accordingly. A broad mission can help a foundation to more nimbly address current and emerging issues.

Andrew Carnegie understood this concept. When he established The Carnegie Corporation in 1911, he wrote flexible guidelines to allow future generations to adjust the foundation’s work to new and emerging needs. His mission to promote “the advancement and diffusion of knowledge and understanding” drove the development of the U.S. library system. A half century later, the same mission led his successors to support the educational children’s television program, Sesame Street. Because of his foresight, Carnegie’s funds continued to “advance knowledge” not only through libraries but also through a combination of broadcast media and edutainment programming.

Take care, however, to not go too broad. If your mission includes a sweeping phrase like “improve society,” it might be too general to offer helpful direction for the foundation, and possibly prevent the foundation from effecting measurable change in any specific area.

5. BE OPEN TO SHIFTING FOCUS

While some foundations’ missions evolve in a linear fashion (broadly serving a certain cause then gradually narrowing to address a more specific need within that cause), others evolve through abrupt shifts in focus as they respond to current events or personal experiences. These foundations surprisingly find themselves addressing causes their founders may never have imagined supporting.

For example, a foundation could initially serve several unrelated causes (perhaps those of its founders’ favorite charities), then suddenly shift focus to a new cause it discovers through an unexpected circumstance such as a family illness or natural disaster. As the foundation learns about this new cause, it comes to embrace it and doubles down its support for it, eventually declaring it the focus of its mission.

6. REVISIT IT REGULARLY

View mission development as a fluid process, one that is continually revisited, perhaps annually, as your foundation progresses in its work and reflects on its achievements and impact. Adopting this approach at the outset will prevent you from crafting a mission that later becomes too confining or limited.

7. ENJOY THE JOURNEY

As writer Ralph Waldo Emerson expressed, it’s not the destination that matters but the journey. Crafting your foundation’s mission can evolve with your philanthropic endeavors and discoveries—so enjoy the process.

Philanthropic Flexibility

Donors often worry about “mission drift”—the potential for their foundation to stray far from its original philanthropic purpose as successive generations of board members come on board and begin to shape the foundation in their own image. For those who want to restrict their foundation’s charitable purpose to their original intent, a trust might seem like the more attractive option because it is “irrevocable” and exceedingly difficult for trustees or a third party to modify. However, should circumstances change, a trust’s rigidity may prove to be its fatal flaw. As demonstrated by the example of The Buck Trust (see “Donor Intent: A Cautionary Tale” below), the very same safeguards a trust provides can effectively take control over the mission away from everyone on the foundation—past or present—and leave it for the courts to decide.

Liability Risks

Because trustees owe a fiduciary duty to their beneficiaries, they are held to a more rigorous standard and a higher level of responsibility than the directors of a not-for-profit corporation. In practice, this means that trustees can be held legally liable for acts of simple negligence.

Another Option: The Hybrid Entity

After weighing the advantages and disadvantages of structuring a private foundation as a corporation or as a trust, a donor might still have a difficult time deciding between the two options. He or she may like the limited liability conferred by a corporation, but also prefer the tighter control over charitable purpose afforded by a trust. The good news is that it is often possible to have both by structuring a private foundation as a hybrid type of entity.

Here’s how it works: The foundation is initially organized as a corporation. However, that corporation has only a sole member. (Many states have not-for-profit laws that allow not-for-profit corporations to have members.)

Using this hybrid approach, the sole member would have exclusive authority to make key decisions regarding amendments to the foundation’s charitable purpose. This exclusive control would be accomplished by requiring the sole member’s consent to make any changes to the foundation’s articles of incorporation. This would then prohibit any changes to the philanthropic purpose of the corporation.

With this hybrid structure, the member-appointed directors of the foundation would be held to the standard of care applicable to corporations. However, the directors would not be able to change the foundation’s philanthropic purpose as would generally be the case with a foundation organized as a not-for-profit corporation. As a result, the corporation’s single member would exclusively maintain control to continue or reshape the foundation’s charitable purpose, affording a powerful combination of flexibility and control.

Whether you opt for a hybrid entity or a more traditional corporate structure, the work of establishing and managing a private foundation becomes substantially easier with the assistance of Foundation Source. With more than two decades of experience helping donors create, maintain, and grow private foundations, our tax, legal, philanthropic, and administrative experts handle the hard work, freeing donors to concentrate on making their visions of a better world into reality.

Notes:

• Donations to a private foundation are an irrevocable transfer, and may be used only for charitable purposes.
• The contribution of any asset that is subject to a liability can cause adverse tax consequences to the donor.
• When funding a foundation with illiquid assets, or those subject to a lock-down period, there may also be a need for cash or other liquid assets to meet the annual 5% required minimum distribution and other foundation expenses.
• A foundation can never sell assets to foundation insiders or their family members, even if the sale price is fair or advantageous to the foundation.

For more detailed information, contact us at 800-839-0054 or email us at info@foundationsource.com.