Grantors setting up a private foundation must choose an entity form — nonprofit corporation or trust. The decision has lasting implications. We share common questions and answers to help weigh key factors.
Here’s a concise list of common questions and answers that highlight the key factors to think about when establishing a private foundation.
Is it easier to set up a private foundation as a nonprofit corporation or as a trust?
Both entity forms require a governing document. A corporation requires you to file a certificate of incorporation with the secretary of state. Some states have more favorable laws and regulations for nonprofit corporations, so the state of incorporation should also be given consideration. By-laws must be created, and these provide more specific guidance about the operations of the nonprofit corporation.
In contrast, the need to register a trust varies from state to state as the legal jurisdiction is based on the nexus of the grantor.
Whether nonprofit corporation or trust, the governing document should include language highlighting the entity’s charitable purpose and reference Sec 508(e) of the IRC, which restricts the activities to exempt purposes.
Which entity form provides more flexibility?
A private foundation set up in corporate form provides more flexibility than a trust, with all the discretion left to the board of directors. Directors can change the by-laws, move the situs of the corporation to a different state, and even redefine the charitable purpose of the foundation. Many families find this level of flexibility appealing since it allows the foundation to evolve and adapt to the changing needs of the community and changing perspectives of the family over generations. Founders worried about mission drift can make restricted gifts to the foundation, limiting the charitable purpose to specific areas.
A private foundation set up in corporate form provides more flexibility than a trust.
Which entity form provides more control?
A private foundation set up in trust form is more restrictive than one set up as a nonprofit corporation. Changing the trust requires court approval to amend the governing document and, in many states, also involves the attorney general. The cy près doctrine allows a court to change the purpose of the foundation, but only if the charitable purpose is shown to be impossible to meet or unlawful—a high bar. Trust form provides more protection for founders concerned about the “hijacking” of their foundation and its mission by future generations.
How does perpetuity play into the decision between nonprofit corporation and trust?
There is currently no limit on the perpetual life of a corporation, for-profit or nonprofit. However, many states have laws against perpetuity for trusts. Forever is a long time, and in most instances, either entity form will serve the time horizon of the founders and their successors.
What about taxes?
It’s especially important to consider the entity form for foundations recognizing unrelated business income tax (UBIT). Tax rates for trusts are usually higher than those for corporations. The UBIT comes into effect when a foundation carries out a trade or business unrelated to its tax-exempt purpose. This commonly occurs when a founder donates business interests into a foundation as part of their overall estate plan.
It’s especially important to consider the entity form for foundations recognizing unrelated business income tax.
Foundations also should consider debt-financed income, also subject to UBIT, that may result from investments in specific partnerships and LLCs.
Private foundations pay an excise tax of 1.39% on investment income, which includes interest, dividends, and capital gains, but that tax obligation is not impacted whether the foundation is set up as a nonprofit corporation or a trust.
What about liability?
Nonprofit corporations limit liability for officers and directors. Trustees are fiduciaries and are held to a higher standard than the general business judgment rules that apply to corporations. Officers, directors, and trustees may delegate investment management authority and administration of the foundation to professional advisors. In addition, director, trustee, and officer insurance is available to provide added liability protection, regardless of entity form.
Is a nonprofit corporation or trust better for foundation succession planning?
It depends. Each foundation is unique and can be created and managed in a way that is consistent with the founders’ vision. The key is to think through goals and objectives before forming and funding a private foundation. As it relates to succession planning, the discussion often focuses on flexibility versus control and who may be willing and capable to steward the foundation. We also advise clients to consider these ideas:
- Goals and motivations – Why are you creating this entity, and what do you hope to get from it?
- Funding and investment considerations – What assets will fund your foundation, and are there any implications based on what you’re contributing?
- Structure and management – How much control and involvement do you want to have now and in the future? Who else, if anyone, is going to participate, and how will they contribute?
We often find that clients haven’t considered the many facets of the process and need time to reflect on these questions. Rushing into the process leads to poor results, with funds invested that cannot be pulled back into one’s personal balance sheet. Partnering with a team of experts—including a strong attorney, CPA, and investment advisor—increases the odds of setting up the right entity the right way the first time. Take time on the front end—it will lead to more conviction and joy down the road.
Rushing into the process leads to poor results, with funds invested that cannot be pulled back into one’s personal balance sheet.
As always, if you have questions about establishing a foundation and which option is best for you, feel free to reach out to our Wealth Management team—we’re happy to help.