Private Foundations in the Banking Industry

Many banks consider setting up private foundations because of the advantages they can provide. Private foundations can provide key PR benefits, help improve a bank’s standing in the community, provide an opportunity for members of the community to serve in a board role, and can control timing of charitable contributions.

In this episode of Issues of Interest, BNN tax principals Adam Aucoin and Nick Porto discuss the intricacies of setting up and managing private foundations for banks. They talk through potential benefits, highlight potential pitfalls, and provide practical advice for avoiding common mistakes.

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Transcript

Adam Aucoin: Hi everyone. Welcome to season two of issues of Interest, BNN's podcast for the banking and financial services industry. Our team is proud to have brought our listeners a full season of the show and thank you all for listening. If you need to catch up, you can find all the past episodes in your preferred streaming platform and on our website, and you can find that link below in the show notes. Now onto today's episode. I'm your host today, Adam Aucoin, tax principal at Baker Newman Noyes. I'm here with Nick Porto, who is also a tax principal at BNN. Hello, Nick.

Nick Porto: Hey Adam. Thanks for having me on the podcast. I'm excited for today's topic.

Adam Aucoin: It is riveting, is about foundations and is one of Nick's areas of expertise. And again, this is a topic where we brought in other people in the past on this podcast because there's niche expertise here, and Nick's here to help us cover foundations related to financial institutions. You know, things that banks might want to do to consider setting one up, pitfalls, things to watch out for, and kind of all that fun stuff. So just to get us started, Nick, can you tell us a little bit more about what foundations are and if someone's interested in setting up a foundation, what they would need to do?

Nick Porto: Sure. Absolutely. I'd be happy to. So private foundations are a type of tax-exempt charitable entity under Section 501. This allows them to receive tax deductible donations from the general public, which includes banks and their employees. Private foundations are a separate legal entity that can be set up by a bank and run by a board of directors or some designated individuals from the bank if they have specific people they have in mind. 

There are a couple different types of private foundations, but the most common one that I see in the banking world are private, non-operating foundations. Essentially what this means is that they exist almost solely and exclusively to take in assets and then eventually pay that out for charitable purposes. In order to create one, you'll need to engage an attorney to create the entity type. Usually, they're either set up as a corporation or a trust, and then you can work with either the same attorney or CPA like myself and my team to apply using Form 1023 for 501 status with the IRS. If the application is submitted to the IRS within 27 months of the date of legal creation, that 501 status is retroactive to the date the entity was legally set up if it was approved by the IRS. So essentially what this means is that you can set an entity up today and make tax deductible donations to it before it's even been granted 501 status by the IRS. Sometimes some organizations like to do this to have that timing lag, since it typically takes the IRS six to eight months to review applications. Obviously, there is some risk in doing that. If the IRS were to, for whatever reason, reject the application, there might be some unwinding you have to do, but if you're working with someone who's filed 1023s or has some experience filing those, they should know what to look for and avoid any unwanted questions by the IRS.

Adam Aucoin: Something that's good advice for all of us. In general, try to avoid unwanted questions from the IRS no matter what facet of text we're looking into. Absolutely. Great information there. Continue on that path and expand down that road. The next step might be kind of annual filing compliance. Can you give an idea of what that might look like for a foundation?

Nick Porto: Yeah. So, the annual filing compliance for a private foundation is in the form of a Form 990-PF tax return filing that's due four and a half months after year end. So that's different than the corporate or trust year end dates. It is an extra month or calendar year ends. That means the return is due May 15 instead of April 15. A foundation needs to file that form every single year, even if there is no activity and even if it has not been yet granted 501 status by the IRS. It's very important to file that form and make sure you don't miss any years. There are some fairly sizable penalties for late filing returns, and failure to file a 990-PF for three consecutive years will result in the IRS automatically revoking that tax exempt status. So, you definitely don't want to forget the filings. A foundation's net investment income is subject to a 1.39% excise tax, so that would be on its interest, dividends, capital gains, rents, etcetera, less any related expenses. Capital gains, whether they're short term, long term, doesn't matter. They're all taxed at that 1.39% tax rate, and there is no corresponding state tax. Although some states do have an annual filing requirement in the form of an annual report. And sometimes there's a filing fee associated with that. For instance, New Hampshire has a $75 filing fee. Massachusetts has a small filing fee based on income. And generally speaking, on an annual basis the foundation will need to distribute out for charitable purposes 5% of the average fair market value of its assets - every single year. There is a one-year grace period to satisfy that distribution requirement. So, in other words, if the foundation were set up on January 1 of 2024, and it was funded with $100 and it does nothing else during the year, it would have until December 31 of 2025 to pay out that 5%. So, five dollars, in this example. Distribution requirement can be met by grants to public charities or other entities if certain administrative procedures are followed, which we'll talk about in a little bit, I'm sure. And also, some administrative expenses. So legal accounting fees, some of those can be allocated to meet that 5% payout requirement, too.

Adam Aucoin: Right. Again, all really good information and things that you have to think about a little bit differently in the foundation world versus the tax world and having to make some of the distributions and actually essentially use the foundation for what’s intended for, not just hold cash and investments. I’ll add, too, these forms in general aren't like your typical tax return, like a Form 1040. They're not going to look exactly similar. I think there's probably a lot more information and context to 990 in general. So, some additional complexities and considerations, again, which is why people should work with an attorney or Nick and his team, or somebody along that line, someone who has seen these before and knows what they're doing.

Nick Porto: Yeah, absolutely. There's a lot of yes, no questions that you wouldn't see on a typical tax return. And sometimes there are narratives that they require as well.

Adam Aucoin: Yeah, exactly. I know even just sitting on a different board for a nonprofit, when I look over that 990, I have to almost reset my mindset to think of it differently because it's a lot more informational. So building on that, though, and more reasons to make sure you're working with trusted advisors, is just pitfalls in general. Do you have anything you think banks should look out for in general?

Nick Porto: Yeah, there can be quite a lot of pitfalls in the private foundation world, because private foundations are usually funded by a narrow source. In other words, they're only funded by a single donor or a handful of donors, and not broadly from the general public. There are a lot of rules that they must follow, and they are more heavily scrutinized than your typical 501 public charity because those organizations tend to have a community board and a broad funding source. So, the rules around private foundations can be pretty complex with lots of pitfalls, exceptions, and if this do that and whatnot. But for brevity’s sake, I'll just talk about two types of prohibited transactions at a very high level that can be fairly easy to fall into. 

The first is what's known as taxable expenditures. Essentially, a private foundation cannot make a grant to an entity that is anything other than a 501 public charity or government instrumentality without conducting what's known as expenditure responsibility. So, chambers of commerce, for profit entities, other private foundations, lion’s, non-US entities, and the like, all may be running a charitable program. You know, I see chambers of commerce or VFWs funding some type of charitable event or program. Your private foundation cannot make a grant to that initiative without following expenditure responsibility. Expenditure responsibility isn't hard to do, but it does usually require a couple of additional steps. For instance, it usually requires the foundation to first obtain some information on what the charitable purpose is, you know, what that program is that they're wanting to support. And sometimes it will involve having that prospective grant recipient sign a grant agreement to stipulate exactly what the funds are going to be used for. And it also requires progress reports to be provided on how those funds are used. It's not always obvious what type of entity an organization is, so it can be easy to pay out a grant to a non-qualified source if you aren't doing proper due diligence first. So usually, I recommend asking for things like the IRS determination letter to verify some type of 501 status. And if the recipient doesn't have that, then go into these additional steps.

Adam Aucoin: Right. So don't just go to a GoFundMe and fund it and think it's okay. It needs a few extra steps.

Nick Porto: Yeah, exactly. And GoFundMe is one of those ones that can definitely get tricky, because usually it's funding support for an individual in those instances, and that can be a no no in the private foundation world as well.

Adam Aucoin: Yep.

Nick Porto: Additional things to be mindful of is in this taxable expenditure area is that grants for lobbying or any type of political activity are strictly prohibited. You can actually lose your 501 status pretty quickly by doing that. What happens if you do make one of these grants to an organization without doing expenditure responsibility when you needed to? If that happens, the grant is subject to a 20% penalty, can get that abated if it's your first time doing that, making a mistake, and you do also have to correct the transaction. What that means is the foundation typically has to be made whole. So, you either have to try to get that money back from the perspective grant recipient, from the entity that you paid that money to, that you weren’t supposed to, or typically what I see is the bank just reimbursing the foundation.

Adam Aucoin: Right, yeah. 20% can be a steep penalty too. Thats one of the higher ones I think we see in general in taxation. It’s really meant to make people do their due diligence and curb that appetite that might be out there to do something that maybe you shouldn’t be doing as a foundation. Something to not take lightly, right?

Nick Porto: Yeah. And maybe you're just not doing everything to the T one day, or you're rushing or something like that. It's easy to fall into. And those penalties can accelerate as well for repeated acts or it's not corrected. Definitely want to make sure that transactions corrected. 

The second pitfall that I wanted to point out is what's known as self dealing. Self dealing is actually unfortunately a pretty common one that I see just due to the nature of some of the initiatives that I see financial institution led foundations wanting to support. So self dealing is probably the most complex private foundation subject that covers many different types of transactions. So for the purpose of this, I'll just say that self dealing is a type of prohibited transaction between the foundation and a foundation insider, also known as a disqualified person. This can include the bank or bank employees, and the transaction types between the two parties usually include sales, loans, rents, etcetera. One of the most common ones that I see involves sponsorship payments to golf tournaments or some other charitable event that comes with tickets to the event, and then bank employees then attend the event. This results in a 10% penalty that has to be paid by the self dealer. So it's not the foundation that pays that 10% penalty, it's whoever attended that event. Again, a lot of times I'll see the bank just pay this, so their bank employee doesn't have to pay that 10%. And then the foundation needs to be reimbursed for the entire amount of that sponsorship payment, not just the amount that represents the value of the ticket. What I often see is that the foundation paid the quote, unquote sharable portion of the ticket. Because usually those tickets, you know, the sponsorship payment is an amount in excess of the value of the attending event, and then the bank pays the cost of the tickets. So the golf attendance or whatnot, the regulations actually specifically prohibit this type of transaction. Even if that bifurcation occurs, the entire amount is still tainted. So when funding sponsorships through a foundation, generally that means that no one can attend the event again, although there are some exceptions to this. But if it is important to have bank representatives attend the event, I generally recommend that the bank make that sponsorship payment directly. And one last thing I'll say on this is that repeated violations of either taxable expenditures or self dealing transactions can result in the foundation losing its tax exempt status. And also, foundation managers, that is, the board members of the foundation or even the bank itself, can end up subject to penalties for willful or repeated violations. If you do slip up every once in a while, that's fine. But if you've been apprised of rules and just ignore them, IRS could take exception and actually assess penalties on the individual themselves.

Adam Aucoin: And good examples of some pitfalls there and things to be on the lookout for. And certainly, one thing we're not telling people do is not to be on the golf course, right. We know in bankers in general, that's one place where they're going to go and do their business development, CPAs as well. It just might be a good idea to think about what you're sponsoring and what you're doing, or do you need to send people out there? And if you do pay through the bank, probably a good chance you've sponsored a whole or done something where this is more of an advertising expense than a charitable contribution anyway, on the bank tax side. So you actually might get some benefit from it being an advertising expense and not part of that charitable contribution limitation. Again, just a few things to think about. 

So to continue on that path, though, there’s two prongs here. When we look at bank foundations, too, we have the foundation itself, which is what Nick and his team work on. And then I still work on the corporate side of things, which has got the corporate income tax. And there’s some interplay here. Quickly on the corporate side, I just want to go through a few things when looking at benefits and pitfalls. So kind of looking at the advantages, the biggest one that we spend most of our time talking about is the ability to donate appreciated securities to the foundation. And the benefit there on the corporate tax side is that gain on that appreciated security is deductible as a charitable contribution and the gain does not get taxed. It gets taxed later in the foundation side at the believe the 1.39%. Correct, but would not be taxed on the corporate income tax side. So you have a pretty good savings between that 21% federal tax and maybe even 7, 8, 9% state tax and that 1.39% at the foundation level. But I think we often see, too, is these donations of appreciated securities. A lot of times, that's the initial funding of these foundation. So, 1256 whatever securities donated, and it will give a big initial funding to the foundation. And then there's tax planning that goes with that, too, because on the corporate income tax side, charitable contributions are limited to 10% of taxable income before dividends received deduction in the current charitable contribution. So sometimes when you have that big donation of the fair market value of appreciated security, you might trip that 10% limitation. And we have to think about the ability to use that charitable contribution in the future, because there's a five year carry forward window before it expires. So just a little bit of planning that goes on there. But the donations of appreciated securities and the ability to save some taxes that way, definitely from the tax side, where we spend a lot of time thinking about it. 

A couple other things that we look for in terms of advantages. Sometimes some people like the ability to time their charitable deductions a little bit. They might be able to give to the foundation in one year and get the donation on the corporate tax side, and then it might allow them to distribute it out at a different timing or over a period of years from the foundation. So, it can give you some wiggle room in terms of ability to time the charitable deductions, and then the other ones are really kind of more intangible value. You could get press from these things. You build up some goodwill within the community and really provide you a chance to get back to the community, which is what we find. Our financial institutions are very focused on the community, which they should be, as a community bank in the line of those intangibles. One other one we look at, too, is sometimes it's a good stepping stone for board members as well. You might have somebody who you're interested in being part of the bigger board for the bank, but maybe at first you bring them onto the board of the foundation, and then you can later bring them into the board of the bank, too. Right now, I think we often see the boards are pretty close to the same or made up of some similar board members. But it could be an opportunity to bring more people from the community to be involved and give them a seat at the foundation board as well. 

So then kind of looking at pitfalls quickly. Two things we look out for is when you have the foundation, what we see sometimes is the banks might have a pledge to give so much each year. Usually, it is that 10% limit. They might give 10% of pretax earnings or after tax earnings to the foundation each year, which can be great. But it’s one of those things to look out for too, because you have to think about your charitable deduction limitation. That 10% might not be exactly the same calculation as what you might have pledged, just because book income and taxable income are two different things. And there’s some differences there. Sometimes we have to plan around that accordingly to make sure you can meet your goals and maximize what you're doing on the tax side. Other things too, is again, one of the bigger advantages is the ability to donate appreciated securities. Some banks don't have a lot of appreciated securities. Depending whether you're grandfathered under some rules, you might not have any equities. You might be looking at just having a bond portfolio or something like that. And that's a lot tougher to donate and, you know, have appreciated to the same value. So again, sometimes limited quantity of appreciated securities is another reason to consider the best formation, the best use. You have your cash in a charitable giving and then two other quick things, compliance, cost and time. Again, this is a separate legal entity and it does have its own filing. So, there'll be a little bit of compliance costs and a little bit of time, maybe some legal costs too, to keep it up and running. Hopefully, the advantages of this and the ability to get back to the community and be involved in the community far outweigh that. But there's a little bit just to keep in mind. And the other one I bring up too, is on the last pitfall. I won't even call pitfall. It's kind of a pitfall and opportunity. But the state tax credits in New Hampshire and Massachusetts. New Hampshire has the CDFA program. Massachusetts has the community investment tax cut credit program, where you give to certain organizations, and they give you back so much in a tax credit. 75% for New Hampshire, 50 for Massachusetts. Those to get the value of the tax credit, those donations need to be made through the bank. I won't be able to use the tax credits in the foundation, and I don't think there's probably some rules there, too, because there's a piece of that donation that's actually really an ordinary expense as opposed to a charitable contribution because of the value of the credit as well. So just something to keep in mind there too, to make sure you’re maximizing those credits when you’re getting them. That was all I had on the corporate tax side. 

So, I think with that, we’ve covered a lot of ground already today and it’s probably time to wrap up. But anything else, Nick, that you can think of that people should be thinking of or be walking away with from this conversation, just give one last chance to plug anything else we haven't covered?

Nick Porto: Yeah, absolutely. So just a couple of things very quickly. So, one thing that I think is worth mentioning is that a lot of financial institutions set up, foundations want to engage in scholarships. So those would be scholarships paid to individuals. The foundation can absolutely do that. It just needs to request approval from the IRS first. So that can either be done with the original 1023 application at the time that the foundation is set up, or there's a subsequent filing that can be done with Form 8940 that you can apply to the IRS to provide scholarships to individuals just by basically outlining the scholarship plan and program. 

And I know that a lot of private foundation rules can sound complex. I know we talked a lot about penalties, which can always be a little bit scary. Definitely these rules can be a little convoluted, but I think it's important to remember that usually there's a way to accomplish what the foundation's goal is. It just may not be a linear path. So you’ve heard that adage of its better to ask for forgiveness than permission? I think in the foundation world its usually the opposite. So, if you’re working with a visor who knows these rules, its usually a good idea to ask first and just bounce something off us. Happy to look up if you’re not sure what an entity might be, if they’re qualified and you’re not happy to look those up. Happy to discuss any proposed transaction that you think about entering. So working with a tax advisor who can help navigate those rules before entering into a transaction is definitely the way to go.

Adam Aucoin: Great. Yeah, good point. And again, I think it goes to show that when you have things like private foundations, that they're very powerful tools. You just need to make sure you're working with your team in general and able to plan accordingly. But again, as I said, very powerful tools to be able to maybe get some tax savings on the corporate side. But really, to me, the bigger issue of this is being involved in your community, making sure you're spotlighting it, you're giving back and helping other organizations helping everything else to make the community grow and be better and be a good corporate citizen in general too. So again, very powerful tools and something that is often worth considering, especially if you have appreciated securities and something that I think gets considered. If the tax rate were to change, you might want to think about the timing of those things as well. Definitely comes into play. So yeah, just to wrap up real quick, it was great to chat with you, Nick. We definitely covered a lot and we're always here and happy to help, but thank you for coming on.

Nick Porto: Yeah, thanks for having me. This was a lot of fun.

Adam Aucoin: All right, thank you, Nick. And as just a reminder to our listeners, the BNN banking team is constantly monitoring and sharing updates and developments. So, stay tuned for more articles, podcasts and resources from our team. Thank you all. Goodbye.

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