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Tax News You Can Use

Hands On Philanthropy: Private Operating Foundations

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Tax News You Can Use | For Professional Advisors

 

Jane G. Ditelberg

Jane G. Ditelberg

Director of Tax Planning, The Northern Trust Institute

A private operating foundation (POF) is a privately supported charitable organization that devotes its resources to the active and direct conduct of tax-exempt activities. This is in contrast with most private foundations whose charitable activity is making grants to other organizations. POFs are typically created by donors who wish to engage directly with the community, who wish to manage charitable activities directly or who wish to invite others to contribute to their charitable entity.

There are tax advantages to qualifying as a POF instead of a general (or grant-making) private foundation. POFs typically conduct direct charitable programming, but are not public charities because they are either supported by a limited group of donors or include the donors of the funds in positions that control operations, such as trustee or director. Examples of POFs include those that conduct medical research and those that operate private museums, animal sanctuaries or libraries, including The Getty Foundation, the Carnegie Endowment for International Peace and the Bill and Melinda Gates Foundation.

How does a non-profit obtain POF status?

A newly formed charitable entity (trust or not-for-profit corporation) can apply for POF treatment as part of its initial application for tax-exempt status by completing part VII of IRS form 1023 with the additional information related to POF status. Existing tax-exempt entities can later apply for POF status by filing IRS form 8940. Status will be confirmed when the entity receives its determination letter that grants its tax-exempt status.

What are the requirements to qualify as a POF?

To qualify for POF treatment, the entity must meet the income test and one of three alternative standards for its assets. The income test requires that at least 85% of either the entity’s adjusted net income, or its minimum investment return (whichever is less), is used directly for the active conduct of its exempt activities. For this purpose, adjusted net income includes gross income reduced by deductions computed as if the entity were a corporation, with important modifications, such as the exclusion of long-term capital gain. Minimum investment return in this context is 5% of (a) the fair market value of the assets of the organization not used directly for exempt purposes, which is then (b) reduced by all debt incurred for the purchase of those assets.

The second prong of the test requires meeting one of the following criteria:

  1. Asset Test: At least 65% of the organization’s assets are used for the active conduct of its charitable activities or a functionally related business, either directly or through a subsidiary at least 80% owned by the organization; or
  2. Endowment Test: At least two-thirds of its minimum investment return is distributed for the active conduct of its tax-exempt activities; or
  3. Support Test: At least 85% of its financial support (other than gross investment income) comes from the general public or five or more other exempt organizations, not more than 25% of its financial support (other than gross investment income) comes from any one exempt organization and not more than 50% of its financial support comes from gross investment income.

These tests make sure that the organization is not primarily an endowment but actively conducts its own tax-exempt activities, and either uses its own assets and investment income to conduct charitable activities or has financial support from the public (through donations, fees, memberships, etc.) or other tax-exempt organizations.

Example 1:

Frances has amassed a significant collection of sports memorabilia that she displays in her home in specially designed presentation cases. She would like for the collection to be maintained, in place, and her home used as a museum after her death. Would a POF work for this purpose?

Frances could donate the home, her collection, the specialty display cases and other articles in the home to a foundation. She would also need to donate some cash, because for POF status, the collection and the property would need to be held and used for the organization’s charitable purpose (sports museum), rather than sold to generate cash to get the museum started. Revenue from tickets and sales of items such as t-shirts and posters featuring images of the collection would constitute public support. If the foundation used 85% of its income for its charitable purposes (operating the museum), and the assets used in its charitable activities (the home and the collection) constitute at least 65% of its assets, then it could qualify as a POF.

What are the tax advantages of POF status?

POFs are subject to most of the tax rules applicable to private foundations that are not POFs – but there are two exceptions. First, a POF is not subject to the excise tax for failure to distribute income under section 4942 of the tax code, a penalty that starts at 30% of the undistributed amount and can rise to 100% if the error is not corrected promptly. While a grant-making private foundation can count the amount it uses for direct charitable activity against the 5% income distribution requirement, the POF’s income test could be met by devoting 85% of its adjusted gross income to charitable purposes, which may be less than 5%. Second, donors to POFs may claim charitable income tax deductions for donations to POFs up to 50% of their adjusted gross income, instead of the 30% limit for donations made to grant-making private foundations.

Example 2:

Catherine would like to convert her existing $5,000,000 private foundation to a POF to found and support a sanctuary for feral cats. She plans to spend $2,000,000 to purchase a farm and erect a building containing space for offices, medical treatment and supply storage as well as various structures to provide physical shelter in inclement weather. The remaining assets will be invested as an endowment and the estimated income of $120,000 per year will be used to for food, medical treatment, utilities and other expenses of maintaining the property and animals.

This organization will not meet the asset or support test of the second prong. However, its minimum investment return (5% of its non-program assets) is $150,000 per year. If at least 85% of that amount is expended on its exempt activities each year, the trust will pass the first prong income test and the second prong endowment test and qualify as a POF. This means that Catherine would be able to take a charitable income tax deduction of up to 50% of her adjusted gross income for her contribution, instead of the 30% that would be allowed if the organization was a private foundation.

If Catherine donated $500,000 in 2024 (when the marginal income tax rate is 37%), here is how the tax benefit would stack up, assuming she had adjusted gross income of $750,000:

The amount that Catherine cannot deduct in 2024 can be carried forward, but that delays the benefit of the deduction. Contributing to a POF instead of a private foundation results in additional tax savings of $55,500 in 2024.

Is an exempt operating foundation the same as a POF?

Some POFs can also qualify as exempt operating foundations (EOFs), which can be beneficial because EOFs are not subject to the tax on net investment income. In addition, other private foundations may make grants to EOFs without complying with the usual private foundation requirements of due diligence prior to making a grant, a written contract outlining the permitted uses of the grant and annual accounting of the grant.

To qualify as an EOF, the entity must have been publicly supported for at least 10 years, and its governing body must be broadly representative of the general public and have fewer than 25% of its governing body (e.g., trustees or directors) who are disqualified persons. In addition, none of its officers may be disqualified persons. For this purpose, “disqualified persons” includes substantial contributors to the organization, owners of equity interests in entities that are substantial contributors and family members of these individuals.

Returning to our example above, Catherine’s cat sanctuary is not eligible to be an EOF. It would take 10 years of receiving substantial contributions from persons other than Catherine and her family to meet the threshold test, and Catherine, as a substantial contributor, could not be an officer. In addition, the governing board would have to consist of at least three people who are not related to Catherine or her family members to be able to serve on the board. This is not a very realistic option for Catherine under the facts in our example. However, if her organization drew the attention of other animal charities and started receiving donations from at least five exempt organizations, after ten years it would be eligible to be an EOF if Catherine were willing to step down as an officer and she recruited members of the general public to serve with her on the board.

Where do I start to create a POF?

The hallmark of a POF is a direct charitable activity. A donor who intends to create a POF needs to understand how the charitable programming will be conducted and how it can economically support itself. For Catherine in the above example, the cat sanctuary itself may not generate any funds to support its programming, unlike Frances museum, which can charge admission and sell souvenirs related to its mission. If its endowment erodes, Catherine will need to appeal to the public and to other charitable organizations for contributions to sustain the operations or make significant ongoing contributions herself. As a disqualified person, Catherine’s ability to enter into transactions with the organization or to be paid for her services as director of the organization will be subject to limitations in the same manner as it would for a regular private foundation.

POF’s are administratively more complex to operate than regular private foundations, but in situations like Frances’, where it would be challenging to distribute 5% of the value of the home and the collection every year to avoid penalties with a private foundation, it can be a workable solution. It is also useful when the founder wishes to have more control than they would if their donation were made to an existing public charity. Finally, for those making contributions during life, like Catherine, the income tax charitable deduction may be greater.

Donors considering the creation of a POF should seek expert legal and tax advice regarding the requirements to create a valid entity and a determination from the IRS of tax-exempt status, whether as a private foundation, a POF or an EOF.

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  1. According to a 2018 survey by the Planned Giving Design Center, about 9% of private foundations are POFs. What is a private operating foundation, and should we consider using this option? - NCFP
  2. For the methodology to determine adjusted net income, please see https://www.irs.gov/charities-non-profits/private-foundations/income-modifications-adjusted-net-income-of-private-operating-foundations

Disclosures

© 2024 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.

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