Structured Philanthropy: Private Foundations and Selected Alternatives

Transcription

1 Structured Philathropy: Private Foudatios ad Selected Alteratives A ceter of excellece buildig bridges from thought to actio, creatig practical, applicable strategies to help beefit you ad your family To give away moey is a easy matter i ay ma s power. But to decide whom to give it, ad how large ad whe, ad for what purpose ad how, is either i every ma s power or a easy matter. Ad hece it is that excellece herei is rare ad praiseworthy ad oble. Aristotle, Nicomachea Ethics, Book II Itroductio Families of meas ad social visio ofte establish idepedet structures to fulfill their charitable goals, as they do i pursuit of their overall capital maagemet, wealth trasfer, ad other legacy goals. Some charitable goals are simple ad immediate ad may be accomplished with little effort or overhead. Others require plaig ad ogoig admiistratio ad should be implemeted with eyes wide ope (for example, door-cotrolled foudatios). Naturally, doors wat to get results by meas they ca uderstad ad maage with the fewest complicatios. I gettig oto the straightest lie from visio to results, some relevat questios for a would-be door to cosider iclude: Philathropic purpose(s): What do you wat your gift to accomplish for society? Persoal purpose(s): What do you wat to accomplish for your family? How much time, effort, ad capital are you willig to commit? Whe do you wat to fud the pla? Do you wat other family members to have iput or make decisios? How much ogoig cotrol do you wat for yourself or family members? What assets should you give? How importat are tax cosideratios? Hawthor Istitute Cotributor Michael J. Moroe, J.D., CPA Seior Wealth Strategist michael.moroe@hawthor.pc.com We begi with a hypothetical family situatio, followed by a brief overview of private foudatios, oe choice for door-cotrolled charitable etities. We look at selected private foudatio alteratives, icludig door-advised fuds, Type III supportig orgaizatios, ad charitable lead trusts. These structures are ot private foudatios but rather have foudatio-like attributes, at least i part. Private foudatios have played a importat role i society ad door families, but they come with complicatios ad tax challeges that have caused some doors to choose simpler vehicles such as door-advised fuds. 1 1 See Time to covert?, Wall Street Joural, November 9, 2009.

2 Structured Philathropy The Hypothetical Example of Costace Threepwood, Her Family, ad Their Cocers We begi with the hypothetical sceario of Costace Emsworth Threepwood, 2 a 66-year-old heiress, ad her husbad, Clarece, age 70. They have two childre. Their aual icome more tha supports them. Their assets cosist chiefly of $40 millio of ivestmets; their residece, Bladigs, i the Hudso Valley regio; a small Mahatta apartmet; ad a collectio of valuable artwork that Costace iherited log ago from her mother but does ot really like or ejoy. She retais the artwork at Bladigs because sellig it would be complicated ad taxable. She would prefer to doate the artwork to charity for the tax beefits because her so iformed her that it has sigificat value. Costace is active i the commuity ad cosiders herself charitable-mided. She has thought about earmarkig a substatial portio of her estate for charity through her will, but she has had difficulty makig cocrete decisios regardig charitable ad legacy plaig. Her aual charitable gifts total about $300,000, mostly i favor of te local orgaizatios i fairly cosistet amouts. Kowig that she ad Clarece ejoy a high icome, she believes charitable gifts provide meaigful tax savigs. Gift to Costace s Alma Mater Costace recetly met with a developmet officer of Decrepit Uiversity, Costace s beloved alma mater, ad was shocked to hear herself agree to make a $1 millio gift to the uiversity s capital campaig. She ad Clarece decided they are wealthy eough to part with $1 millio i this special istace. Costace was determied to formalize a pledge so that the uiversity could commece its iitial project to refurbish its presidet s residece ad the faculty club. Soo after, Costace atteded a local fudraisig gala. Durig dier she listeed itetly as her tablemate, a veture capital billioaire, described the various orgaizatios, causes, ad relatives supported by his family foudatio. Creatig a Charitable Foudatio Costace determied that she ad her family would create ad maage a charitable foudatio of their ow. The foudatio would egeder a sese of missio ad commo purpose amog family members. It would fud importat causes, begiig with her gift to the uiversity. It would provide her so the meas to supplemet his icome as a writer-professor. She could rid Bladigs of the artwork, makig it the foudatio s problem, ad achieve a ice tax deductio as well. A family foudatio seemed to be the complete aswer. The ext day Costace phoed her log-time adviser, Mortimer Rumpole, Esq., istructig him to set up the foudatio. Rumpole cautioed Costace. I her ewfoud ethusiasm for istitutioalized philathropy, as her billioaire acquaitace called it, she may ot have cosidered simpler plas tha a private charitable foudatio. Nor has she determied whether her family shares her collaborative visio or agrees o the 2 The family ames are take from P.G. Wodehouse s hilarious Edwardia-era short stories about life at Bladigs Castle. Sice Wodehouse s lawyers are buffoos, Rumpole is Joh Mortimer s barrister character who wis every time. 2 hawthor.pc.com

3 Structured Philathropy causes the family foudatio should support. Heedig these cautios, Costace set aside a afteroo to discuss her ideas with Clarece, daughter Mildred, ad so Frederick durig the childre s aual summer visit. Their coferece brought may thigs to light. The Family Millie, 35, is a pediatricia i Sa Diego. She ad her husbad, Atoy, a pharmaceutical executive, have three childre uder the age of 12. They ejoy a good icome but o free time. Millie is closely ivolved with her hospital s youth welless cliic, providig hours of ucompesated care per moth to childre of low-icome families. She ad Atoy also devote persoal effort, travel time, ad some moey to a similar cliic ear Johaesburg, South Africa, Atoy s birth place. From Millie s poit of view, a family foudatio s most valuable use would be to support the Sa Diego ad Johaesburg cliics. Though she ad her mother are close, Millie is skeptical that their charitable priorities coicide at all. She also feels she lacks the time to participate meaigfully i the foudatio s maagemet. Freddie, 39, is a Ivy League-educated art historia ad critic of ackowledged ability, though his chose professio puts at his disposal the low icome geerally ejoyed by writer-teacher itellectuals. A part-time professor, he lives i Philadelphia ad is a cofirmed city-dweller. I cotrast to his sister, Freddie is well-disposed to the basic idea of a family-ru foudatio ad to havig a role i it, icludig a paid role. Beyod the salary, he sees the foudatio as providig a meas to promote artistic excellece by idetifyig ad supportig promisig artists through scholarships ad academic aid. Clarece is a retired civil egieer whose passio is horticulture. His tireless work has trasformed 20 of the 95 acres at Bladigs ito a required stop for like-mided visitors. Clarece s visio for a family foudatio is to edow the trasformatio of Bladigs ito a oprofit ceter for the preservatio ad extesio of his gardes, as well as for research, study, ad teachig of all thigs horticultural. This would evetually iclude the residece as well, sice the childre are ulikely to wat it. His worst ightmare is that Bladigs will be purchased ad developed for profit. Costace (though ot Rumpole) was take aback by the diversity of visios uleashed by her childre ad her husbad. She sees great merit i everyoe s ideas ad is ope to supportig them to the extet feasible, effective, ad affordable. Issues There are several primary, or strategic, issues i this hypothetical sceario. First, ca Costace afford to fud these goals? Is her foudig visio of the family uited i a cooperative charitable edeavor realistic, give the diversity of their circumstaces? Is a sigle-structure pla, such as a family-cotrolled foudatio, the best choice from a tax stadpoit? Should oe or more additioal or alterative arragemets be cosidered? 3

4 Structured Philathropy Should grat-makig activities be coducted through the same etity as active or asset-itesive activities? Assumig that Costace shares Clarece s desire to preserve Bladigs as a operatig oprofit horticulture ceter, is it realistic to expect that such a edeavor could or would be admiistered effectively from afar by the childre followig their parets deaths or icapacity? Would it be wise to cosider aother structure such as cooperative charitable partership or joit veture with oe or more local orgaizatios? Several techical tax issues are also preset, icludig: There is potetial for self-dealig. A foudatio s paymet of Costace s persoal pledge to the uiversity (if she has already made oe) is iadvisable because it may costitute self-dealig. 3 The paymet would clearly be self-dealig if the uiversity could have eforced the pledge agaist Costace persoally uder applicable state law. The foudatio s paymet would costitute a use of its icome or assets for her beefit by relievig her of a persoal obligatio to pay the pledge. Icome tax deductio for gifts of tagible property is geerally limited to basis. A gift of tagible assets to a private foudatio results i the door receivig a icome tax deductio of the lower of each asset s market value or tax basis, uless the foudatio is a active operatig foudatio. 4 Doors of such property to a ooperatig foudatio may suffer a substatial loss of a aticipated icome tax deductio if the property has appreciated i value. Grats by a U.S. foudatio to a foreig charity require special care. A U.S. idividual caot receive a U.S. icome tax deductio for a gift to a charity uless that charity was created uder the laws of the Uited States, a state, or a U.S. possessio. 5 A idividual ca, however, effect gifts to foreig charities through U.S.-based charities such as frieds of fuds ad iteratioal door-advised fuds. U.S. private foudatios ca do likewise, but they ca also make grats directly to foreig charities if they follow certai procedures discussed below. Grats to idividuals require special care. Grats by a private foudatio to idividuals for study, travel, ad similar purposes are taxable expeditures subject to a excise tax pealty uless the foudatio adopts appropriate policies ad preclears its gratmakig process with the Iteral Reveue Service (IRS) prior to makig ay such grats. 6 Idividuals are ot tax exempt per se, o matter how eedy or deservig, ad the statutory policy is that grats to idividuals must be closely regulated because of the potetial for abuse. 3 Iteral Reveue Code (IRC) Sectio 4941(d)(1)(E); Private Letter Rulig (PLR) IRC Sectio 170(e)(1)(b) 5 IRC Sectio 170 (c)(2)(a) 6 IRC Sectio 4945 (d)(3); Treas. Reg. Sectio hawthor.pc.com

5 Structured Philathropy Private Foudatios ad Selected Alteratives Followig is a brief review of private foudatios ad other charitable arragemets that provide some or may of the same beefits as foudatios ad which may be acceptable alteratives i a give istace. Private Foudatios Most private foudatios fall ito two categories: operatig ad all other. Most family foudatios fall ito the other category ooperatig etities that do ot directly carry out charitable activities. Istead, these ooperatig gratmakig foudatios make distributios that fud the programs ad activities of operatig charities. Private operatig foudatios traditioally devote most of their icome ad assets to operatig charitable programs directly. Examples of operatig foudatios are privately ru museums, libraries, ad youth programs. All private foudatios are 501(c)(3) tax-exempt etities. Private foudatio status is a catch-all: a charitable etity is a private foudatio uless ad util it demostrates that it is a public charity. That is, it is a public charity either by the ature of its activities (for example, churches, schools, hospitals, govermetal uits) or by the proportio of its support it receives from the geeral public or govermetal etities (for example, the Red Cross, Uited Way). 7 Therefore, a private foudatio, i our view, is defied less by what it is tha what it is ot. The policy uderlyig the public/private distictio i the tax code is to provide more liberal tax treatmet for publicly supported charities, which are deemed more likely to be resposive to public as opposed to private iterests. Doors establish private foudatios to realize certai advatages, amog them: to maitai a level of cotrol over the maagemet ad distributio of charitable capital that caot be achieved with other vehicles; to istitutioalize philathropic activity idefiitely withi the family ad/or a closely regulated group of like-mided trustees; to publicly associate the family s ame with charitable edeavors; to brig childre ad later geeratios ito the philathropic process i a orderly fashio; to educate childre regardig the family s values ad to help them develop a philathropic esprit guided by those values; to employ childre ad other family members, either part- or full-time; to facilitate charitable gifts that would ot be tax deductible if made directly by a idividual to certai doees; ad to obtai curret tax deductios for gifts while beig able to decide later how to disburse fuds for charitable purposes. 7 IRC Sectio 509(a)(1) ad 170(b)(1)(a) 35

6 Structured Philathropy The pricipal disadvatages of private foudatios iclude: Private foudatio must avigate aroud a array of expesive potetial federal excise tax pealties for various ifractios (Table 1, page 7). Doors to ooperatig (gratmakig) foudatios face more restrictive icome tax deductio limitatios for their gifts tha if the same were made to a operatig foudatio or a public charity (Table 2, page 8). Door Tax Deductios Gifts by a idividual to a ooperatig foudatio are tax deductible oly to the extet of 30% of the door s adjusted gross icome (AGI) for the year. 8 For gifts of qualified appreciated stock, the limit is 20% of AGI. 9 Further, a door s deductio for gifts of tagible property to a ooperatig foudatio is capped at the lower of cost basis or market value. 10 I all cases, deductios limited by AGI ca be carried over five additioal years subject to the same percetage of AGI limits. By cotrast, the geeral aual limitatio o the charitable deductio for gifts to operatig foudatios is 50%/30% of AGI. This is the same tax treatmet afforded gifts to public charities. This is a major tax distictio betwee regular ooperatig foudatios ad operatig foudatios. The charitable icome tax deductio for gifts by idividuals to public charities is limited to 50% of a idividual s AGI for the year. This meas a idividual caot give away 100% of his icome ad expect to erase his etire icome tax bill. The exceptio is that the limitatio o the idividual s tax deductio is lowered to 30% of the idividual s AGI if the gift is i the form of property, such as stocks, real estate, or artwork, that would have geerated log-term capital gai icome if the property had bee sold rather tha doated. This is so eve though the gift is made to a public, 50%-type charity. The uderlyig statutory policy seems to be that sice the door gets a double tax beefit for such gifts, valuig the deductio at the property s full market value ad beig relieved of ay log-term capital gai tax, the AGI-based limitatio is stricter. Aother distictio, relevat to would-be doors of tagible property such as real estate ad artwork that has appreciated sigificatly i value, is that doors of such assets to ooperatig foudatios could lose a substatial portio of their expected deductio because of the reductio rule applicable to these gifts. The rule essetially limits the amout that ca be deducted to the door s cost basis. (Table 2, page 8 displays the icome tax deductio limitatios applicable to gifts by idividuals.) I our hypothetical example, if Costace ad Clarece desire a market value-based icome tax deductio for cotributios of artwork or acreage cotributed to a family foudatio, their advisor should advise them of these limitatios. 8 IRC Sectio 170(b)(1)(B) 9 IRC Sectio 170(b)(1)(D) 10 IRC Sectio 170(e)(1)(B)(ii) 62 hawthor.pc.com

7 Structured Philathropy Table 1 Pealty Excise Taxes Applicable to Private Foudatios ad Disqualified Persos (DQPs)* Trasgressio: Self-Dealig Pealty o the Self- (IRC Sectio 4941(a) ad (b)) Dealig DQP* Pealty o the Maager Trasactios betwee the foudatio ad a DQP iclude: Iitial Tax: Iitial Tax: sale, exchage, or leasig of property; 10% of the amout 5% of the amout ivolved trasfer of foudatio icome or assets to or for the use ivolved each year the each year the trasactio of the DQP; trasactio is ucorrected. is ucorrected. ledig or credit arragemets, with limited exceptios; Additioal Tax: Additioal Tax: If the trasactio is ot If the trasactio is ot furishig of goods or services, with exceptios; ad corrected, 200% of the corrected, 50% of the paymet of compesatio or reimbursemet of expeses amout ivolved. amout ivolved. by the foudatio to a DQP, uless ecessary ad reasoable. Trasgressio: Failure to Distribute Icome (IRC Sectio 4942) Pealty o the Foudatio Failure to make qualifyig distributios of the foudatio's Iitial Tax: 30% of the udistributed amout, each year "distributable amout" (geerally 5% of ivestmet assets, less it remais udistributed. certai expeses) Additioal Tax: 100% of the udistributed amout. Trasgressio: Taxable Expeditures (IRC Sectio 4945) Pealty o the Foudatio Pealty o the Maager Taxable expeditures are distributios: Iitial Tax: 20% of the Iitial Tax: 5% of the for political lobbyig of to or ifluece attemptig a to electio; ifluece a electio; amout ivolved each year amout ivolved each to a to or to a idividual other tha to pay for travel or study, the trasactio is year the trasactio is awarded i a odiscrimiatory maer uder procedures ucorrected. ucorrected. approved i advace by the IRS; Additioal Tax: If the Additioal Tax: If the to is ot the to ay orgaizatio that is ot a public charity, uless the trasactio is ot trasactio is ot fuds are used for a charitable purpose ad the distributig corrected, 100% of the corrected, 50% of the foudatio either obtais a equivalecy determiatio or amout ivolved. amout ivolved. exercises "expediture resposibility." Trasgressio: Jeopardizig Ivestmets Pealty o the Foudatio Pealty o the Maager (IRC Sectio 4944) Foudatio maager(s) make a ivestmet havig kowigly Iitial Tax: 10% of the Iitial Tax: 10% of the failed to follow prudet ivestmet stadards, thereby amout ivolved each year ivested amout each jeopardizig the foudatio's tax-exempt purpose. or part-year util year or part-year util corrected. corrected. Additioal Tax: 25% of the Additioal Tax: 5% of the ivested amout if ot ivested amout if ot corrected. corrected. Trasgressio: Excess Busiess Holdigs (IRC Sectio 4943) Pealty o the Foudatio Foudatio holds more tha 20% of a busiess eterprise. Limit Iitial Tax: 10% of the value of the excess holdigs is 35% if eterprise is cotrolled by o DQPs. (Does ot apply each year the excess exists util corrected. to holdigs of ay etity if more tha 95% of the etity's icome Additioal Tax: 200% of the excess busiess holdigs is passive ivestmet icome, for example, may family limited as of the ed of the "taxable period." parterships.) * Disqualified persos, defied i IRC Sectio 4946(a)(1), iclude, amog others: substatial cotributors: geerally, doors of more tha $5,000 if their cotributio is also more tha 2% of * Disqualified persos, the defied foudatio's i IRC Sectio cotributios 4946(a)(1), iclude, received amog durig others: the year (IRC Sectio 507(d)2)(A)); foudatio maagers: officers, directors, trustees, ad persos i similar positios, also, certai key substatial cotributors: geerally, doors of more tha $5,000 if their cotributio is also more tha 2% of the foudatio's cotributios received durig the year employees; ad (IRC Sectio 507(d)2)(A)); spouses ad lieal acestors of the above persos, descedats of the above persos, ad those foudatio maagers: descedats' officers, directors, spouses. trustees, ad persos i similar positios, also, certai key employees; ad spouses ad lieal acestors of the above persos, descedats of the above persos, ad those descedats' spouses. Source: Hawthor 37

8 Structured Philathropy Structured Philathropy Table 2 Table Charitable 2 Icome Tax Deductio Bases ad Icome-Based Limitatios for Gifts by Idividuals Charitable Icome Tax Deductio Bases ad Icome-Based Limitatios for Gifts by Idividuals Type of Charity 50% Charities 30% Charities Type of Charity Public Charities, 50% Charities Private Operatig Public Foudatios Charities, Private 30% Nooperatig Charities Foudatios Private Operatig Foudatios Private Nooperatig Foudatios Type of Asset Cotributed Percetage of Percetage of Type of Asset Cotributed Deductible at at Portio of AGI AGI Limit Limit Deductible Deductible at at Portio of AGI AGI Limit Limit Cash FMV 50% FMV 30% Cash FMV* 50% FMV 30% Ordiary Icome Property Ordiary Icome Property Cost 50% Cost 30% (if sold (if sold would would produce produce ordiary ordiary icome) icome) Cost 50% Cost 30% Short-Term Short-Term Capital Capital Gai Gai Property Property Cost Cost 50% 50% Cost Cost 30% 30% Log-Term Log-Term Capital Capital Gai Gai Property: Publicly Publicly Traded Traded Securities Securities FMV FMV 30% 30% FMV FMV 20% 20% Private/Notraded Securities Securities FMV FMV 30% 30% Cost Cost 20% 20% Tagible Tagible Property Property Put Put to Related to Related Use Use FMV 30% Cost 20% by by Charity Charity FMV 30% Cost 20% Tagible Property Property Not Not Put to Put Related to Related Cost 50% Cost 20% Use Use by by Charity Charity Cost 50% Cost 20% * Fair Market Value Source: Hawthor Aother distictio, relevat to would-be doors of tagible property suchas real estate adartworkthat has appreciated sigificatlyi value, isthat doors of such assets to ooperatig foudatios could lose a substatial portio of their expected deductio because of the reductiorule Excise Tax applicable o Foudatio totheseicome gifts. The rule essetially limits the amout that ca Private be deducted foudatios to the door s are exempt cost basis. from icome tax but must pay a excise tax of 2% (Table 2 displays the icome tax deductio limitatios applicable to gifts by idividuals.) I our hypothetical example, ifo Costace their et ad ivestmet Clareceicome. desire a market For a particular tax year, the tax is reduced to 1% value-based icome tax deductio for cotributios if the foudatio of artwork pays or acreage out a sufficiet cotributed amout of qualifyig distributios. 11 to a family foudatio, their advisor should advise them of these limitatios. Foudatio s Dealigs with Isiders Excise Tax o Foudatio Icome Private foudatios are exempt from icome Doors, tax but trustees, must pay maagers, excisead taxmembers of of their families are disqualified 2% o their et ivestmet icome. For apersos particular (DQPs). tax year, 12 As the such taxthey is reduced must be tocareful i their dealigs with the 1% if the foudatio pays out a sufficiet foudatio, amout of qualifyig its icome, distributios.11 or its assets. Self-dealig ca result i harsh tax pealties o the idividuals ivolved. Oe possible oobvious form of self-dealig occurs Foudatio s Dealigs with Isiders whe the foudatio pays off a DQP s eforceable persoal charitable pledge Doors, trustees, maagers, ad members of their families are disqualified persos (DQPs).12 As such they must be(plr careful ). i their That dealigs is the with use the of the foudatio s assets for the beefit of a DQP. foudatio, its icome, or its assets. Self-dealig Thus, Costace ca resultthreepwood i harsh taxis likely to receive cousel from her attorey that pealties o the idividuals ivolved. Oe she possible should oobvious pay the pledge formto of the selfdealig occurs whe the foudatio pays off a DQP s eforceable persoal uiversity from her ow fuds ad ot look to the family foudatio to satisfy it. charitable pledge (PLR ). That is the use of the foudatio s assets for the beefit of a DQP. Thus, CostaceA Threepwood foudatio may is likely reimburse to receive boa fide expeses of a DQP or compesate a DQP cousel from her attorey that she should for pay persoal the pledge services to the which uiversity are reasoable ad ecessary to carryig out the from her ow fuds ad ot look to the family foudatio to satisfy it. exempt purpose of the private foudatio if the compesatio (or paymet or reimbursemet) is ot excessive, accordig to IRC Sectio 4941(d)(2)(E). Abset this statutory carve-out, all such paymets would be pure self-dealig. Uder this statutory stadard, if a family foudatio s activities were to iclude distributios 11 The mechaics of the computatio are such that i its first year a foudatio caot qualify for the reduced rate. Foudatios ofte select a short iitial first year to avoid this result, particularly if appreciated assets are cotributed ad are to be sold soo after. The gai, if recogized i the secod tax year, could qualify for the reduced rate. 12 IRC Sectio 4946a 7 28 hawthor.pc.com

9 Structured Philathropy for Freddie Threepwood s special program, ad Freddie s work o the foudatio s behalf were ecessary, there should be o problem with his receivig a reasoable salary from the foudatio. Other Pealty Excise Taxes I additio to self-dealig pealties, operatig ad ooperatig private foudatios ad, depedig o the facts, the idividuals ivolved are subject to other pealty-type excise taxes. These taxes are levied o the foudatio ad/or their isiders for ifractios icludig failure to distribute eough to qualifyig charities, ivestig foudatio assets i a maer that jeopardizes its tax-exempt purpose, makig distributios to oqualified recipiets, ad for causig the foudatio to hold too great a percetage of certai closely held busiesses. These excise tax rules apply to operatig ad ooperatig foudatios alike ad are summarized i Table 1 (page 7). 13 Distributios to Foreig Charities As oted above, there are several ways U.S. private foudatios ca make qualifyig distributios i support of foreig charities. For example, some U.S. public charities operate frieds of fuds ad door-advised fuds that support overseas orgaizatios. Effectig grats through such fuds could be a practical solutio for domestic private foudatios i supportig foreig charitable activities. U.S. charities operatig iteratioal fuds iclude Uited Way Iteratioal, the Kig Baudoui Foudatio Uited States, ad the Iteratioal Commuity Foudatio. Frieds of fuds ad iteratioal door-advised fuds have admiistrative expertise i pregrat diligece, moitorig, ad reportig ad ca sigificatly reduce the headaches experieced by U.S. doors ad gratmakers. Ulike idividuals, domestic private foudatios are authorized to make distributios directly to foreig charitable orgaizatios, if they follow certai procedures. Failure to comply with these rules reders grats by a U.S. private foudatio to a foreig orgaizatio taxable expeditures subject to excise tax pealties uder IRC Sectio I additio, such grats would fail to be qualifyig grats for purposes of the miimum distributio rules, subjectig the foudatio to IRC Sectio 4942 excise tax for failure to make the required distributio. To avoid these harsh results, the U.S. private foudatio makig direct grats has three optios: obtai a good faith determiatio from a qualified tax practitioer that the foreig orgaizatio is the equivalet of a U.S. public charity; For a iformative read o real-life potetial for the applicatio of pealties to private foudatios, see 14 Uder Treas. Reg. Sectio (a)(5) 39

10 Structured Philathropy exercise expediture resposibility with respect to the grat to esure its use for exclusively charitable purposes 15 ad require the foreig charity to maitai the grat fuds i a separate accout 16 ; or ascertai that the foreig orgaizatio has received a rulig from the IRS recogizig it as a U.S. operatig foudatio or public charity (that is, a 50% charity). 17 Optio 1, obtaiig a equivalecy determiatio, ca be time-cosumig ad expesive. However, if the U.S. foudatio s coectio with the foreig orgaizatio is aticipated to be ogoig ad substatial, a effort to obtai a good-faith equivalecy determiatio may be warrated. Optio 3 is usually ruled out because it is ucommo for foreig charities to have obtaied a IRS determiatio letter. Ofte, the most practical course appears to be for the U.S. foudatio to eter ito a agreemet with the foreig orgaizatio to follow expediture resposibility procedures. This meas that the U.S. foudatio must, uder IRC Sectio 4945(h): see that the grat is spet solely for the purpose for which it is made; obtai full ad complete reports from the gratee o how the fuds are spet; ad make full ad detailed reports with respect to such expeditures to the IRS. Foudatio Distributios to Idividuals A private foudatio may make grats to eedy idividuals, disaster victims, etc., if such grats are i furtherace of the foudatio s exempt purpose. Grats to eedy idividuals must be made accordig to objective, odiscrimiatory criteria. Eligible idividuals must be draw from a class sufficietly broad as to ot be pretargeted as selected idividuals ad thereby serve private purposes. I additio, special rules apply to grats to idividuals for study, travel, ad similar purposes. Such grats are ot authorized ad costitute taxable expeditures, uless the foudatio obtais IRS approval of the foudatio s procedures ad decisio-makig process with respect to such grats. Approval must be obtaied prior to the makig of ay such grats. 18 Thus, i our hypothetical example, Freddie Threepwood s desire to provide fiacial assistace to deservig artists appears to fall uder the study ad similar purposes provisio of the IRC but must be carried out by the family foudatio i compliace with the procedural rules. 15 Treas. Reg. Sectio (b) 16 Treas Reg. Sectio (c)(1) 17 IRC Sectio 4945(d)(4)(A) 18 The Seate Report o the 1969 Tax Reform Act icludes a statemet that these requiremets were added to crack dow o the use of tax-deductible fuds i fiacig vacatios abroad ad paid iterludes betwee jobs hawthor.pc.com

11 Structured Philathropy Although the legal ad compliace costs, maagemet resposibilities ad the excise tax risks of private foudatios deter some families from creatig or cotiuig foudatios, others have foud these costraits a acceptable price to pay for the degree of discretio ad cotrol available to private foudatios. A door who kows the geeral rules, respects their purpose, ad cosults with a tax advisor whe i doubt ca use a private foudatio to good effect. 19 Doors who evertheless wish to pursue aother route have several possible optios, some of which are discussed i the ext sectio. Alterative: Door-Advised Fud A door advised fud (DAF) is ot a separate charity but rather a segregated fud maitaied by a sposorig public charity such as a commuity foudatio. With or without advice from the idividual doors, a DAF ca make qualifyig distributios to public charities, its ow sposorig orgaizatio, ad to aother DAF. If it exercises expediture resposibility as described earlier, a DAF ca also make a distributio to a private ooperatig foudatio. 20 The Pesio Protectio Act of 2006 created a tax defiitio of DAFs ad imposed some ew limitatios. A DAF has three defiig characteristics, accordig to IRC Sectio 4966(d)(2)(A) 21 : The fud is idetified o the books of the charity by referece to gifts of a specific door or doors. The fud is owed ad cotrolled by the sposorig public charity. The door or a appoitee reasoably expects to have advisory privileges with respect to charitable distributios from the fud. Distributios to Foreig Charities Allowed A U.S. door-advised fud is authorized to make distributios to foreig charitable orgaizatios if it exercises expediture resposibility or obtais a equivalecy determiatio as described above. 22 Due to the admiistrative hassles ad potetial excise tax risks, however, may DAF sposors will be reluctat to accommodate requests to make distributios to orgaizatios outside the Uited States. Distributios to Idividuals Not Allowed A DAF caot make a distributio to ay idividual for ay purpose. 23 This prohibitio exteds eve to reimbursemet of a door s expeses icurred i activities o behalf of the fud. The pealty o the door or advisor receivig such 19 Joseph P. Toce, Tax Ecoomics of Charitable Givig (New York: Thomso/Reuters, 2013). 20 IRC Sectio 4966(c)(1)(B) 21 Eve though it may otherwise look like ad be called a DAF, a fud is ot a DAF if it ca make distributios oly to a sigle charitable orgaizatio. Nor is ay fud a DAF if it ca make grats to ay idividual for study, travel or similar purposes usig the procedural rules for such grats described earlier (IRC Sectio 4966(d)(2)(B)). 22 IRC Sectio 4966(c)(1) 23 IRC Sectio 4966(c)(1)(A) 11 3

12 Structured Philathropy a excess beefit is 25% of the amout ivolved plus, if ot corrected, a secod tier tax of 200%. The pealty o the fud maager is 10% of the paymet subject to abatemet. 24 Note that by cotrast private foudatios are ot pealized for payig reasoable compesatio to, or reimbursig reasoable expeses of, cotributors ad related idividuals who provide services to the foudatio. As cocers Freddie Threepwood i our hypothetical example, a DAF would be a iappropriate vehicle either to provide assistace directly to aspirig artists or to compesate him i ay way, eve for bus fare. Although the tax rules goverig them have become stricter sice the 2006 Pesio Protectio Act, DAFs remai a popular alterative to ooperatig foudatios i the view of may doors. DAFs provide several actual or potetial advatages over private foudatios: DAFs are easy, quick, ad iexpesive to establish. Gifts to a DAF are gifts to the sposorig public charity, for which doors receive more favorable tax deductios, particularly for gifts of tagible property ad certai securities (Table 2, page 8). Tax deductible gifts to a DAF, like gifts to a private foudatio, ca be frot-loaded; ulike traditioal ooperatig foudatios, however, DAFs have o aual miimum distributio requiremets. (However, the Treasury Departmet is curretly studyig whether to impose distributio requiremets o DAFs.) Sice public charities eed ot disclose their doors idetities, a DAF ca provide door aoymity. Most door cotributios to private foudatios are publicly disclosed i tax filigs. DAFs relieve doors of the burde of fuds maagemet ad admiistrative fuctios through a platform which, while ot free, ca be more cost-effective per dollar of capital tha with a private foudatio, especially smaller foudatios. May sposorig charities such as commuity foudatios also provide gratmakig advice to doors seekig guidace i makig effective distributios. These advatages otwithstadig, door families who wat to retai full legal cotrol of charitable capital idefiitely will likely fid DAFs usuitable. DAF fuds are cotrolled by the sposorig charity, ot by the door or ay other idividual, who possesses solely advisory rights. The door caot legally have the fial say i distributio decisios. I additio, the sposorig charity may isist o termiatig all advisory rights after oe or two geeratios. 24 IRC Sectio 4958(a) 12 2 hawthor.pc.com

13 Structured Philathropy Alterative: Charitable Lead Trust A charitable lead trust (CLT) ca fuctio as a temporary substitute for a traditioal family foudatio. A CLT ca also fuctio as a efficiet fudig adjuct i a pla where a private foudatio or a DAF is the primary doative structure. I either case, a CLT ca ehace family wealth trasfer goals ad play a role i a pla for short- or log-term family philathropy. A CLT is a irrevocable trust that pays a charity a defied auity or uitrust amout, at least aually, for a defied period of time. At the ed of the charitable lead term, the trust s remaiig assets, if ay, are trasferred to ocharitable beeficiaries, usually the grator s childre. Eligible charitable recipiets durig the lead term may iclude publicly supported orgaizatios, DAFs, ad private foudatios. CLT plaig is commoly tax-drive, with primary emphasis o gift ad estate tax maagemet. Hawthor has writte recetly o the use of CLTs i itrafamily wealth trasfer plaig, ad why they ca be particularly useful i these times of uusually low iterest rates. 25 Distributios to Foreig Charities Allowed A CLT is expressly authorized to make distributios to foreig charitable orgaizatios. 26 At least oe commetator has stated that the expediture resposibility rules do ot apply to such distributios. 27 Distributios to Idividuals Not Allowed A CLT s lead iterest must be payable to exempt orgaizatios. 28 The CLT istrumet ca leave it to family members to decide which charities are to receive what portio of the amout distributed each year from the trust. 29 This spray power ca add a great deal of flexibility to the pla. Family members ca be give trustee powers to select charitable recipiets, or they ca be give lesser DAF-like advisory rights. The grator should, with plaig, be able to participate as a co-trustee i charitable distributio decisios without causig the trust assets to be a grator trust or icludible i the grator s estate. 30 However, if lead paymets are made to a private foudatio of which the CLT grator is a director or trustee, the assets of the CLT could be icluded i the grator s estate. 31 IRS has ruled that CLT assets will ot be icluded i the grator s taxable estate if the foudatio segregates fuds received from the CLT ad the CLT grator has o power to direct the foudatio with respect to those fuds See the July 2012 Hawthor white paper, Charitable Lead Trusts: A Uderappreciated ad Uderutilized Plaig Tool. 26 IRC Sectio 642(c)(1) 27 Thomas J. Ray, Jr., Charitable Gift Plaig: a Practical Guide for the Estate Plaer (Chicago: America Bar Associatio, 2007), Ch IRC Sectio 642(c)(1) 29 Rev. Rul , CB, IRC Sectio 674(b)(4); PLR IRC Sectio 2036(a)(2); Rifkid v. U.S., 5 Cl. Ct. 362, 84-2 USTC (1984) 32 PLRs , ,

14 Structured Philathropy Most CLTs are structured as ogrator trusts. A trasfer of assets to a ogrator CLT does ot yield a curret icome tax charitable deductio for the door. 33 I additio, a ogrator CLT is ot itself tax-exempt. Rather, the trust receives a icome tax deductio for its required charitable distributios. 34 With careful maagemet by the trustee, a ogrator CLT should escape tax o much or all of its icome durig the lead term because the icome will be paid to charity. Removig icome from the family s tax base i this maer ca have substatial ecoomic value, but it should ot be cofused with receivig a curret icome tax deductio for the iitial pricipal trasferred to the trust. 35 CLTs are subject to may of the same excise tax pealties that apply to private foudatios. 36 These iclude pealties for self-dealig, excess busiess holdigs, jeopardizig ivestmets, ad taxable expeditures. Alterative: Type III Supportig Orgaizatios A supportig orgaizatio (SO) is a limited-purpose public charity. It is established to support (that is, make distributios to or o behalf of) oe or more other desigated public charities. 37 SOs are ot literally publicly supported, but a SO is treated as a 50%-type public charity by virtue of its coectio with the actual public charity which it supports. For purposes of limitig a idividual s aual icome tax deductio for gifts, charitable orgaizatios are divided ito two types: 50%-type ad 30%-type. These are terms used i the trade, ot i the statutes. Cotributios most favored by tax law are those made to orgaizatios expressly described at IRC Sectio 170(b)(1)(A). These are typically referred to as 50%-type orgaizatios. If the orgaizatio is defied i Sectio 170(b)(1)(A), the the AGI limit is 50% per the fial setece of that Sectio. If a orgaizatio is a charity but does ot fall withi IRC Sectio 170(b)(1)(A), the it is a 30%-type orgaizatio for tax deductio purposes, meaig the limitatio o a idividual s icome tax deductio for gifts to the orgaizatio is 30% of the idividual s AGI. 38 The 50% ad 30% limitatios represet maximums i terms of door icome tax deductios. There are three basic types of SOs. Each type is majority-cotrolled by persos other tha the SO s substatial cotributors ad their family members, meaig that the door family must be a miority of the SO s board. Oly Type III SOs are cosidered i this paper because Type IIIs come closest to private foudatios i the degree of cotrol (which must be less tha 50% i 33 IRC Sectio 170(f)(2)(B) 34 IRC Sectio 642(c) 35 A door for whom the largest possible curret icome tax deductio is a vital cocer (for example, i a year whe taxable icome is uusually high) could structure the CLT as a grator trust. A grator CLT pla, however, etails additioal complicatios. While the value of the charitable lead iterest is curretly deductible by the door (subject to AGI-based limitatios), the grator trust rules cause the door to be taxed o all of the trust s icome thereafter util grator trust status eds (IRC Sectio ). The door s upfrot icome tax deductio is limited to at most 30% of AGI (20% if the CLT is fuded with log-term capital gai property ad the lead iterest is ot payable to a public charity) (IRC Sectio 170(b)(1)(B); Treas. Reg. Sectio 1.170A-8(c)). If the icome tax deductio caot be used by the grator durig the curret ad carryover years, the icome of the trust evertheless cotiues to be taxed to the grator. Fially, if the CLT ceases to be a grator trust, a recapture provisio causes the grator to be taxed o a amout equal to the origial deductio less the discouted value of all icome recogized durig the grator trust period (IRC Sectio 170(f)(2)(B); 1.170A-6(c)(4)). 36 IRC Sectio 4947(a)(2) 37 IRC Sectio 509(a)(3) 38 IRC Sectio 170(b)(1)(B) 14 2 hawthor.pc.com

15 Structured Philathropy ay case) that ca be retaied by their creators. (Type I, paret-subsidiary, ad Type II, brother-sister relatioships, are geerally too closely cotrolled by the supported public charity to be a attractive alterative to private foudatios i the eyes of doors who desire maximum permissible cotrol.) Type III SOs eed oly be operated i coectio with the supported public charity, a more relaxed exus stadard, i our view, tha pertais to Types I ad II SOs. We believe it was this relaxed stadard, plus some ufavorable publicity, that motivated legislators to tighte the rules relatig to SOs, particularly certai Type III SOs, i the Pesio Protectio Act of 2006 ad Treasury regulatios issued i December I our opiio, the chief advatages of SO status are: the 50% limitatio o icome tax deductios for their idividual doors; ad the ready availability of gratmakig assistace ad admiistrative ad operatioal services from the supported orgaizatio. A special rule, of possible iterest to family i our hypothetical example, eables a supportig orgaizatio to support certai ocharitable exempt orgaizatios, icludig a exempt horticultural orgaizatio, as log as the supported orgaizatio derives at least a third of its support from the public. 40 Disadvatages of Type III SOs iclude: SO substatial cotributors or family members caot be a majority of the SO goverig body. 41 SO substatial cotributors or family members caot cotrol the supported public charity. 42 A excise tax pealty applies to paymets of ay kid by the SO to the door or ay family member. 43 This precludes compesatio ad eve reimbursemet of reasoable expeses o behalf of the fud. Additioal reportig requiremets apply to ofuctioally itegrated Type III SOs. 44 The requiremets also provide that Type III SOs that are ofuctioally related to the supported charity must also make miimum aual distributios to or o behalf of the supported public charity. 45 Type III SOs caot make distributios to foreig charitable orgaizatios. 46 The Pesio Protectio Act of 2006 placed a umber of ew requiremets ad restrictios o SOs, particularly Type III ofuctioally itegrated SOs that were formerly a favorite choice of doors desirig to escape the icome tax deductio limitatios applicable to gifts to private foudatios while retaiig a level of cotrol over the SO that was acceptably close to that which could be had with a private foudatio. 39 See A Tax Beefit for Big Doors Ofte Bypasses Idea of Charity, The New York Times, April 25, Treas. Reg. Sectio 1.509(a)-4(k) 41 IRC Sectio 509(a)(3)(C) 42 IRCSectio509(f)(2) 43 IRC Sectio 4958(c)(3) 44 Treas. Reg. Sectio 1.509(f)(1)(A) 45 for example Treas. Reg. Sectio (i)(5)(ii) 46 IRC Sectio 509(f)(1)(B) 15 3

16 Structured Philathropy Toward Solutios Doors itet o makig charitable bequests at death should cosider makig some of those gifts durig their lifetime, to the extet they ca afford to, i order to save icome tax ad estate tax. I our hypothetical sceario, Costace s willigess to devote a substatial portio of her estate to charitable causes does ot mea, however, that she ca afford to fud all of the family s goals, or ca she do so curretly or withi ay particular time frame. A sufficietly rigorous aalysis of her ad Clarece s persoal cash flow ad capital eeds will help determie the extet ad pace of fudig durig her ad Clarece s lives. Next, Costace ad her family eed to make some decisios that oly they ca make regardig primary cocers, amely, whether ad to what extet they (particularly the childre) are willig to act i cocert i philathropic matters. The ivolvemet of the etire family, while ofte a importat compoet of a paret s visio, may ot always be a goal shared by other family members. Sice Costace s history of charitable givig seems to be of the checkbook variety, she might cosider separatig her fudig of such gifts from the fudig of other elemets of the overall pla. For example, if tax cosideratios lead Costace to decide to prefud some of her recurrig charitable gifts, she might cosider usig a dooradvised fud (a 50%-of-AGI charity) rather tha creatig ad fudig a ooperatig, gratmakig foudatio (a 30%-of-AGI charity). She could establish the fud so that she, Clarece, ad the childre could all be advisors. Or the DAF agreemet could provide that the childre would become advisors followig their parets deaths. I our view, a private foudatio ad, i most cases, foudatio substitutes discussed above ca be desiged so that differet family members are give decisio-makig authority for distributios of a defied portio of the etity s foudatio s assets or icome. Thus, if desired, the family could establish a sigle foudatio that provides for Costace ad Clarece, Millie ad Athoy, ad Freddie to use their desigated pool of fuds to accomplish their separate priorities. There is almost always more tha oe way to achieve a charitable visio. The best plas are fact- ad goal-drive, ot prepackaged, oe-size-fits-all solutios. Doors ca be cofidet that if they discer their priorities thoughtfully, pla carefully, ad implemet systematically, they ca achieve the excellet ad praiseworthy results lauded by the philosopher hawthor.pc.com

17 Structured Philathropy Cotact us at Philadelphia - Natioal Headquarters 1600 Market Street Philadelphia, Pesylvaia Baltimore Oe East Pratt Street Baltimore, Marylad Ciciati 201 East Fifth Street Ciciati, Ohio Clevelad 3550 Lader Road Pepper Pike, Ohio Detroit 755 West Big Beaver Road Troy, Michiga Pittsburgh 249 Fifth Aveue Pittsburgh, Pesylvaia Washigto, DC th Street NW Washigto, D.C Wilmigto 300 Delaware Aveue Wilmigto, Delaware

18 Structured Philathropy 218 hawthor.pc.com

19 Structured Philathropy 193

20 Structured Philathropy To esure compliace with Iteral Reveue Service Circular 230, we iform you that ay U.S. Federal Tax advice cotaied i this commuicatio is ot iteded or writte to be used, ad caot be used, for the purpose of (1) avoidig pealties uder the Iteral Reveue Code or (2) promotig, marketig or recommedig to ay perso ay tax-related matter(s) addressed herei. December 2014 Hawthor, PNC Family Wealth does ot reder legal, tax, or accoutig advice. Accordigly, you ad your attoreys ad accoutats are ultimately resposible for determiig the legal, tax, ad accoutig cosequeces of ay suggestios offered herei. We recommed that you cosult with your legal ad tax advisors regardig this commuicatio. Hawthor, PNC Family Wealth ( Hawthor ) is a trademark of The PNC Fiacial Services Group, Ic. ( PNC ). Hawthor provides ivestmet cosulig, wealth maagemet, ad fiduciary services; FDIC-isured bakig products ad services; ad ledig of fuds through the PNC subsidiary, PNC Bak, Natioal Associatio ( PNC Bak ), which is a Member FDIC, ad provides specific fiduciary ad agecy services through the PNC subsidiary, PNC Delaware Trust Compay. PNC does ot provide legal, tax, or accoutig advice uless, with respect to tax advice, PNC Bak has etered ito a writte tax services agreemet. PNC does ot provide services i ay jurisdictio i which it is ot authorized to coduct busiess. PNC Bak is ot registered as a muicipal advisor uder the Dodd-Frak Wall Street Reform ad Cosumer Protectio Act ( Act ). Ivestmet maagemet ad related products ad services provided to a muicipal etity or obligated perso regardig proceeds of muicipal securities (as such terms are defied i the Act) will be provided by PNC Capital Advisors, LLC, a wholly-owed subsidiary of PNC Bak ad SEC registered ivestmet adviser. Hawthor, PNC Family Wealth is a registered trademark of The PNC Fiacial Services Group, Ic The PNC Fiacial Services Group, Ic. All rights reserved. 2 hawthor.pc.com