Private business owners who are philanthropically inclined may consider a number of philanthropic vehicles, including donor-advised funds (DAFs), supporting organizations, and private foundations. While each of these vehicles has its advantages, a private foundation allows the donor to retain more control than any other vehicle, which private business owners may find attractive.

Private foundation donors, and those they appoint, can exercise control over the assets, investments, expenditures, governance, and grantmaking of the foundation, subject to the limitations applicable to private foundations.

Because Congress wants to ensure that private foundations are not overly involved in the ownership of private businesses, there are rules that limit the extent to which private foundations can hold private business interests. In addition, the tax implications of giving interests in a private foundation may be less favorable than the implications of giving interests to a public charity, such as a DAF.

Given these limitations, does it make sense for private business owners to consider private foundations at all? In short, yes. Selecting the correct vehicle is important, especially if the donor is considering leaving a legacy in perpetuity. After all, forever is a long time.

Excess business holdings

A private foundation’s ability to hold interests in a private business is limited pursuant to the “excess business holdings” rule. Generally, there are three ways a private foundation may hold interests in a private business:

• The de minimus exception
• The general limitations
• The Newman’s Own exception

The de minimus exception allows a private foundation to hold up to 2% of a private business, regardless of how the remaining business interests are held.

If the foundation holds more than the 2% de minimus amount, the ownership is subject to the general limitations. The general limitations apply to the aggregate ownership of a defined group consisting of the private foundation and all its disqualified persons (including the donor, the donor’s spouse, the donor’s ancestors and descendants, officers and directors of the foundation, and any business entity in which anyone in this group is a substantial owner). This defined group is not permitted to hold in the aggregate more than 20% of any business enterprise. If control of the business enterprise is effectively held by third parties outside this defined group, the limitation increases to 35%.

Foundations in violation of the excess business holdings rule may have a grace period to address the excess holdings. If the violation results from a gift or bequest, the foundation has five years to reduce its business holdings to permissible levels. The IRS may extend the five-year period if the foundation can demonstrate diligent efforts to dispose of the excess. Foundations that do not reduce their excess holdings to permissible levels could be subject to significant penalties.

Finally, a private foundation may hold interests in a private business under what is known colloquially as the “Newman’s Own” exception, which allows a private foundation to own 100% of the interests in a business under certain circumstances. There are three requirements to meet this exception.

1. The private foundation must own 100% of the voting stock, and this stock must be acquired by gift or bequest (not purchase).
2. Within 120 days following the close of the tax year, the business must distribute the net operating income to the foundation.
3. Both the business and the foundation must be operated independently, such that the foundation’s donor and the donor’s family cannot have control over the business or the foundation. This does not prevent the donor or the donor’s family from serving on the foundation’s board of directors, provided they do not constitute a majority.

Tax implications

Funding a private foundation with interests in a private business may result in less favorable tax treatment compared with business owners who gift business interests directly to public charities. Generally, presale charitable planning can provide tax benefits.

First, for the interests transferred to charity, the business owner may avoid capital gain recognition on the sale. Second, the business owner may be entitled to an immediate charitable income tax deduction, which can help offset the income tax liability generated by the sale. If the business owner makes a gift to a public charity, such as a DAF, the value of the income tax deduction may be equal to the fair market value of the contributed shares. However, if the business owner makes a gift to a private foundation, the value of the deduction may be limited to the business owner’s basis in those shares.

There are, however, potential non-tax disadvantages to presale charitable planning, particularly if the interests are being contributed to a public charity. If the business interests are donated but the sale of the business does not go through, the charity remains an owner of the business. The charity may be able to sell back the shares, but this may not always be practical. In addition, the appraisal of the business interests could reflect valuation discounts relating to minority interests and lack of marketability, thus reducing the value of the charitable deduction. Further, some business owners are reluctant to introduce a new owner into the transaction for fear of adding complexity to the deal.

Conclusion

Private business owners with a philanthropic bent should consider which vehicle best meets their goals in carrying out their legacy. Public charities provide the most favorable tax benefits, while private foundations allow donors to retain the most control. Owners also should consider which assets should be used to fund the selected charitable vehicle. If a private foundation is selected as the appropriate vehicle, consideration should be given regarding whether it is best to fund with interests in the company or with other assets, such as appreciated securities or net sale proceeds.