Building a Private Foundation as an Exit Strategy

For many business owners, selling their business is far more than a financial transaction. It is the conclusion of a long business life, with the effort, time, successes and hurdles of past decades being rewarded in what is likely a substantial payout.

So, what’s next? Some may wonder if being involved in future philanthropic efforts are the right choice for them. Others know they want to make some sort of charitable impact during their retirement years, but may be uncertain on what to do exactly.

One of the tools that may deserve consideration is establishing a private foundation at the time of the business exit. It serves as a powerful tool in lessening your tax exposure and becomes the base of charitable giving that can last forward through multiple generations of your family.

What is a Private Foundation?

A private foundation is a specialized type on nonprofit organization that is controlled and funded by a single source. In this example, the sale of the business funded the private foundation, and the foundation is controlled by the business owner( and/or their family/heirs).

When one normally thinks of a nonprofit organization (i.e. a local food bank or pet shelter), that is a public charity that may depend on many donors to help fund the mission of their nonprofit. A private foundation is a private endowment controlled by a single donor, designed for long-term giving decided by that single donor or their heirs.

The Mechanics of a Private Foundation

When creating a private foundation, the business owner that provided the funding has enormous autonomy. They can decide such factors as:

-Foundation Board Selection: You can appoint yourself, your spouse, and your children to the board of directors.

-Investment Authority: You decide how the foundation’s assets are invested ( stocks, real estate, mutual funds, etc.). Additionally, you could hire a person on behalf of the foundation to make such investment decisions.

-Mission Control: You determine exactly which causes to support and in what manner( outright gifts, matching grants, scholarship endowments, etc.)

The majority of private foundations are non-operating. This means that they do not engage in running the charitable efforts directly, such as running a soup kitchen. They use the investment returns from the principal of the business sale to  make ongoing grants to causes of the foundation’s choice.

The IRS requires that a private foundation give away a minimum of 5% of its value each year to support charity. The remaining amount stays invested, allowing the foundation to grow and provide future granting in perpetuity.

The IRS also requires transparency. Every private foundation must file an annual Form 990-PF that lists every grant made, the names of the board members, and the total assets of the foundation. Additionally, foundations pay an excise tax each year on their net investment income.

Additionally, a private foundation can hire family members to engage in the philanthropic work of the foundation, such as managing grant applications and vetting charities. There are IRS rules to guard against instances of “self-dealing” , so that those family members who are hired are paid a reasonable salary, and that no family members( including the foundation founder) are able to use assets from the foundation for their own personal benefit. 

The Tax Advantages of a Private Foundation

Timing is of key importance. The private foundation must exist as a legal entity prior to the business owner selling their business. The gift of the ownership shares into the private foundation must occur prior to a binding sales agreement being signed.

When the buyer makes the purchase, they are buying the ownership shares directly from the private foundation. The foundation receives the full untaxed value of those ownership shares.

For the business owner, this provides the benefit of:

• Capital Gains Tax Elimination: This avoids the federal capital gains tax as well as the Medicare surtax on the owners’ personal tax bill. The foundation pays 0% capital gains tax on the business sale.

• Immediate Income Tax Deduction: The business owner receives a fair market value(FMV) deduction for the year of the gift. There are some restrictions depending upon if the gift is publicly traded stock vs. closely held/private stock. There is also the opportunity to carry-forward the deduction into future years depending upon Adjusted Gross Income (AGI) limits of the business owner.

• Estate Tax Reduction: Assets within a private foundation are not part of the taxable estate of the business owner.

Final Thoughts

Deciding if establishing a private foundation as part of a business exit can be a complicated process. Understanding the costs and benefits of doing so requires knowledgeable experts who can help you map out the tax advantages, the legal costs of creating a private foundation, and your own drive in determining what your future charitable giving would look like. At Generosity Nexus, we have the track record to help take the complexity out of a complex process.

Don’t hesitate to schedule an appointment to learn more about how we can help you.