A private foundation is a nonprofit organization whose directors and officers and their relatives are primary financial supporters of the organization. OR the directors and officers are insiders (family members or business associates) that wish to retain control of the nonprofit. (Otherwise, the IRS may require that a majority of the directors be unrelated by close family or business, and officers cannot be related–although often they do not.)
The IRS divides the nonprofit world into two groups—private foundations and public charities. You are assumed to be a private foundation unless you can show that you are supported in large part (at least one-third) by the general public (rather than the directors, officers, and their families). If the plan for your organization calls for general public support, you have 5-7 years to prove that indeed this is where your support comes from. Even though the directors and officers and their families give most or all of the money in the beginning (“seed money”), you can still be considered a public charity during the 501c3 application process. Do not check the private foundation or private operating foundation box at signup if your long-term plan is for public support even though you are putting in all or most of the money in the beginning. However, you can bring in unlimited amounts of public charity money and still be a private foundation if you wish, for example because you want your board to consist primarily of individuals related by family or business. BUT unless your private foundation will be giving its money to other 501c3’s (like the Bill and Melinda Gates Foundation), you will be classified as a “Private Operating Foundation” (please see below).
HERE’S WHAT THE IRS HAS TO SAY ABOUT PRIVATE FOUNDATIONS:
***Private foundations: Organizations that are exempt under section 501(c)(3) are private foundations unless they are public charities: that is, churches, schools, hospitals, governmental units, entities that undertake testing for public safety, organizations that have broad financial support from the general public, or organizations that support one or more other organizations that are themselves classified as public charities.
How does a private foundation 501c3 differ from a public charity 501c3? A private foundation is the broader, typically less desirable, cousin of the public charity. In fact, all 501c3 organizations are initially assumed by the IRS to be private foundations, unless they prove that they meet the requirements to be upgraded to public charity status.
A private foundation is, most commonly, an organization established to take one principal source of funding and use it to advance a particular purpose by making grants to public charities that support that purpose.
Primarily, private foundations do not carry out the charitable activities themselves, but act through making grants to other 501c3 organizations, especially public charities. A typical example of a private foundation would be a family setting up a private foundation to handle one million dollars and use it to make grants to public charities established for the prevention of animal cruelty.
One benefit of a private foundation is that the board of directors can be composed entirely of family members, whereas public charities sometimes are required to have a majority of unrelated members. In the above example, this would allow the funding family to maintain control over the use of its funds, rather than using a public charity, where they give over control to those running the charity.
For this reason, some organizations prefer to remain a private foundation, an action that is permitted by the IRS even in cases where the organization operates as if it were a public charity. However, this comes with a few disadvantages…
Private foundations are prone to misuse, largely because they can easily be used for self-profiting tax evasion and investment strategies. For this reason, the IRS has developed a set of detailed rules to govern these foundations and to have certain requirements it believes will keep their operations in check.
Private foundations are required to donate a set percentage of the fair market value of their investment assets each year – generally 5%. If they fail to do so, a penalty tax will be imposed. Moreover, private foundation 501c3 organizations are taxed 1-2% on the interest from their investment assets each year.
There are also penalty taxes imposed on several other transactions, such as self-dealing transactions, certain taxable expenditures, investments which jeopardize their charitable purposes, and taxes on certain stock holdings.
Otherwise, private foundations are very similar to public charities. Donations made to them are tax-deductible, and contributions received by them are tax-exempt.
***Private operating foundation: A type of private foundation that lacks general public support (although it can have public support, even be supported entirely by public support), but makes qualifying distributions directly for the active conduct of its educational, charitable, and religious purposes. “Directly for the active conduct” means that the distributions are used by the foundation itself to carry out the programs for which it is organized and operated. Grants made to assist other organizations or individuals are normally considered indirect.
Here is a way of looking at the difference between private foundations and private operating foundations: the private foundation typically makes grants to other 501c3’s, who perform the nonprofit mission, whereas the private operating foundation, on the other hand, performs the nonprofit mission itself.
This is a hybrid of a private foundation and a public charity. A private operating foundation uses at least 85% of its adjusted net income or minimum investment return (whichever is lower) for the operation of its own charitable activities. A typical example would be a museum or preservation of a historical farm, or any organization operating as a public charity but wanting to maintain family control and so remaining a private operating foundation.
A private operating foundation may seem like the best of both worlds, but it is important to remember that it comes with significantly higher regulations and the requirement that financial tests be met each year to prove it is not functioning merely as a private (non-operating) foundation (In addition to the 85% test mentioned above, a private operating foundation must meet one of three other tests each year, essentially requiring that either 65% of its assets be directly devoted to exempt purposes, or 67% of its minimum investment returns be donated directly to exempt purposes, or “substantially all of its support” be received from the general public and five or more exempt organizations that are not private foundations).
It is generally easier for a private operating foundation to obtain outside funding, especially because private foundations can satisfy their annual donation requirements discussed above by making grants to other 501c3 organizations, including to private operating foundations. Note that private operating foundations do not have this annual donation requirement – instead they must meet the tests described above.
For organizations that want to be controlled by one family, and/or funded primarily by one source, that want to carry on their own work, and might also be seeking funding from the public and from other 501c3’s, the private operating foundation may be a good idea. For those who will be controlled and/or funded by one primary source and would prefer making donations to other 501c3’s over actually performing tax-exempt activities, the private foundation will suit their interests better.