Purpose and Scope
Charitable giving has become an important goal of many entrepreneurs who have accumulated substantial wealth in closely held businesses. Among the many philanthropic vehicles available, the private foundation stands apart for its capacity to support multigenerational family involvement and lasting legacy creation. That capacity comes at a cost, however. To prevent abuse of the tax-exempt system, Congress has enacted a strict and severe excise tax regime that applies to foundations, their managers and related persons. Entrepreneurs who plan to direct significant wealth to charity through a private foundation must understand these constraints, or they may find themselves compelled to divest the family business or abandon the private foundation vehicle altogether.
Even foundations without family control can struggle to maintain ownership of closely held businesses. Paul Newman’s Newman’s Own company illustrates the problem: the private foundation that owned it faced a forced divestiture until Congress enacted a narrow legislative reprieve. Other foundations will not be so fortunate.
Private foundation excise tax rules are extensive and complex. The objective here is to highlight key considerations for advisors working with entrepreneurial clients focused on long-term charitable giving. Early identification of structural issues is a critical first step.
Formation and Basic Compliance
Private foundations may take several entity forms; trusts and nonprofit corporations are most common. If the corporate form is selected, formation in Ohio requires filing Articles of Incorporation with the Ohio Secretary of State. The articles must name a statutory agent and include language satisfying IRS regulations governing an organization’s exempt purposes. The incorporator may then appoint the initial directors and adopt a Code of Regulations. An Employer Identification Number must be obtained from the IRS, requiring the Social Security number of a responsible party such as a member or director, and a fiscal year must be selected at that stage.
If the foundation will have paid employees, additional federal and Ohio withholding obligations apply, including registration with the Ohio Business Gateway for state income tax withholding and, if the foundation employs four or more persons for at least twenty weeks per year, Ohio Unemployment Compensation tax registration. A bank account may be opened once the EIN is secured, and funding may begin immediately, provided that contemporaneous written acknowledgment is furnished for all contributions.
If contributions will be solicited from persons outside the membership and director base, the foundation must register with the Ohio Attorney General for charitable solicitation; other states impose varying requirements. Assuming tax-exempt status is sought, the usual course, the foundation must file Form 1023 with the IRS within 27 months of formation to secure retroactive exemption to the date of formation. The IRS issues a determination letter following its review.
Ongoing compliance obligations include filing Form 990-PF annually (due May 15 for calendar-year foundations, and required even before the determination letter issues), maintaining records of all grants together with signed grant agreements and annual reports from recipients, filing a Certificate of Continued Existence with the Ohio Secretary of State every five years, and maintaining a corporate book with meeting minutes or written consents. These obligations demand sustained attention and close coordination among counsel, accountants and foundation managers.
Overview of the Private Foundation Excise Taxes
Private foundations are broadly defined as entities organized exclusively for charitable purposes and funded primarily from a limited number of sources, in contrast to public charities whose support derives primarily from the general public. The five excise tax regimes are: taxes on self-dealing, taxes on failure to distribute income, taxes on excess business holdings, taxes on investments that jeopardize charitable purpose, and taxes on taxable expenditures. Within the private foundation category are private operating foundations, entities that directly conduct programs furthering their exempt function rather than merely investing and making grants. These entities must satisfy an income test and one of three alternative tests (asset, endowment, or support). A machine shop providing on-the-job training to persons with disabilities is a familiar example. Private operating foundations are exempt from certain of the problems described below. Most private foundations, however, invest in securities and make grants to public charities from income and capital.
The excise tax rules apply to three groups: the foundation itself, foundation managers (the officers responsible for day-to-day operations) and disqualified persons. Disqualified persons include trustees, directors, officers, the foundation’s creator, substantial contributors, members of the families of the foregoing and entities they control.
Five principal excise tax regimes govern private foundation activity: minimum distribution requirements, excess business holdings, self-dealing, whether direct or indirect, taxable expenditures, and jeopardizing investments. Each regime imposes a first-tier excise tax and, if the violation is not corrected within the applicable taxable period, a second-tier tax that is often confiscatory. Because the penalties are nondeductible and the correction process itself carries risk, voluntary correction, and above all prevention, is the only practical approach.
Excess Business Holdings: The Central Problem for Entrepreneurs
Where a private foundation, together with disqualified persons, owns in the aggregate more than 20% of the equity of any business enterprise, the foundation must divest the excess. The framework is straightforward in its severity: the combined holdings trigger an annual first-tier excise tax of 10% of the value of the excess. An exception exists where the foundation’s actual ownership does not exceed 2% of the entity. Upon application to the Commissioner, the standard five-year divestiture period may be extended for good cause, though approval is not guaranteed and extensions beyond ten years are rare in practice.
Failure to divest within the applicable period results in the 10% annual tax escalating to 200% of the value of the excess holdings if the violation remains uncorrected at the close of the taxable period. Moreover, if a disqualified person acquires those holdings from the foundation, even at fair market value, and even though the foundation ends up with cash rather than stock, that acquisition is itself subject to the self-dealing excise tax unless it occurs during the period of estate administration, is conducted at fair market value, results in at least equivalent liquidity for the foundation, and is approved by the probate court.
Notably, private foundations are permissible S corporation shareholders, although their allocable income is subject to the unrelated business income tax. This does not, however, relieve the foundation of its divestiture obligations under the excess business holdings rules.
The Newman’s Own Exception
The Newman’s Own exception was enacted after Paul Newman’s foundation, the 100% owner of his salad dressing company, faced a forced divestiture and received a legislative reprieve. A private foundation may own 100% of a business if: (1) the foundation owns 100% of the voting stock; (2) it acquired that stock other than by purchase; (3) all profits of the business enterprise are distributed to the foundation within 120 days of the close of the taxable year; and (4) the business is operated independently from the foundation. I.R.C. Even when all four requirements are satisfied, the foundation must maintain sufficient liquidity to meet its 5% annual payout obligation with respect to the fair market value of its interest in the business. Most family foundations will not satisfy these requirements, and the exception should not be treated as a planning fallback.
Donor Advised Funds and Supporting Organizations
The Pension Protection Act of 2006 materially curtailed what had been a potential workaround by extending the private foundation excess business holdings rules to donor‑advised funds and to certain categories of supporting organizations. As a result, these vehicles generally cannot be used to sidestep the excess business holdings rules in cases involving closely held business interests.
Self-Dealing Rules and Indirect Transactions
Self-dealing prohibitions are sweeping and apply even where transactions are conducted at arm’s length and at fair market value. Prohibited acts between a private foundation and disqualified persons include sales or exchanges of property, lending or extension of credit, leasing of property, providing goods or services and payment of compensation except as permitted by the personal services exception. The rules capture not only direct transactions between the foundation and a disqualified person but also indirect transactions, including dealings conducted through entities owned by the foundation or by family members.
Critically, these restrictions apply from the date of death even before the foundation is formally constituted. On the day the entrepreneur dies, dealings with estate assets in contemplation of funding the foundation are treated as dealings with the foundation itself. Transactions between companies owned by the estate, and between those companies and family members, are subject to the full excise tax regime before anyone has filed a single organizational document.
One important statutory exception covers the payment of reasonable compensation for necessary personal services. Family members may continue to operate businesses owned in whole or in part by the foundation and receive reasonable compensation for doing so, without triggering self-dealing liability. This exception does not extend to other intercompany transactions such as purchases, rent, or borrowing.
The Estate Administration Exception: A Critical Planning Tool
For entrepreneurs, the biggest hurdles, whether the foundation is funded during lifetime or after death, are the excess business holdings tax and the self-dealing tax. The estate administration exception found at Treasury Regulation §53.4941(d)-1(b)(3) is the principal relief mechanism, and it is imperative for families to realign ownership during estate administration before this window closes.
During the period of estate administration, certain transactions otherwise treated as self-dealing are permitted if four conditions are met: (1) the transaction occurs before the estate is considered terminated for federal income tax purposes; (2) it is conducted at fair market value; (3) it is approved by the probate court; and (4) the private foundation receives assets that are at least as liquid as those it otherwise would have received. This framework is deceptively straightforward in practice.
The “at least as liquid” requirement applies at a granular level, creating difficult questions about whether a particular asset swap satisfies the standard, for example, whether a closely held operating business received in exchange for another is truly at least as liquid as what the foundation gave up, and whether courts look to the underlying assets or the nature of the ownership interest in making that determination.
Once the estate is closed, this exception no longer applies, and the family and the foundation are exposed to the full excise tax consequences of any subsequent dealings. Because of the word “indirect” in the self-dealing rules, transactions at the company level during the administration period should also be approved by the probate court. This will require explanation to the judge as to why intercompany dealings appear on the probate docket—but as a matter of sound practice, all such transactions, including purchases, rent, and borrowing, should be specifically disclosed and approved.
Disproportionate Distributions and Business Realignment
Entrepreneurial estates frequently contain multiple business and real estate assets, and beneficiaries often desire different assets than those best suited for a private foundation. A disproportionate distribution among beneficiaries and the foundation is, however, treated as a deemed sale between the foundation and disqualified persons. That deemed sale can be direct or indirect: a disproportionate distribution of a first-tier entity results in a disproportionate distribution of any second-tier entity in which it holds an interest and may thus constitute an indirect act of self-dealing. Any such realignment must occur during the period of estate administration, with probate court approval and at fair market value, and the foundation must be at least as liquid after the transaction as before.
Waiting until after the estate is closed to realign ownership is dangerous. One solution is to avoid co-ownership with the foundation of any closely held business altogether but achieving that goal through disproportionate distributions triggers the deemed-sale problem just described. The estate administration exception can again be critical, provided the liquidity requirement can be satisfied.
Post-administration redemptions of foundation-owned business interests present their own complications. The family will eventually want to redeem the shares owned by the foundation for cash or a combination of cash and a note. That transaction is an indirect act of self-dealing and is difficult to accomplish after the estate closes. A redemption is generally exempt from the prohibited transaction rules only if all securities of the same class are redeemed, but in most cases the family wishes to redeem only the foundation’s shares, necessitating reliance on the estate administration exception. IRS guidance supports this position in Private Letter Ruling 2014-46-024 (Nov. 14, 2014) and Private Letter Ruling 2017-23-005 (June 9, 2017), which approved a blocker LLC structure permitting distribution of promissory notes to a private foundation without triggering self-dealing if the foundation did not control distributions; notably, such rulings are not precedential under I.R.C. § 6110(k)(3).
Assuming the exception is available, using a promissory note to fund the redemption is problematic because it would constitute a prohibited lending arrangement between a disqualified person and the foundation. Applying the rationale of PLRs 2014-46-024 and 2017-23-005, however, a blocker structure may be employed. Under one approach, the estate forms a new LLC, contributes to it the promissory notes received on the redemption (in exchange for 98% non-voting and 1% voting units), an independent party simultaneously contributes cash for 1% non-voting units and purchases the voting units from the estate, and the estate then distributes the 98% non-voting units to the foundation. Because the foundation does not control distributions from the LLC, no self-dealing issue arises. This structure requires probate court approval, and the underlying redemption must be at fair market value.
Illustrative Example: Excise Tax Exposure and Mitigation
The following hypothetical illustrates the complexity these rules create in practice.
D is single with a $50,000,000 gross estate. D’s will leaves 45% of the net estate in equal shares to two children and 55% to a private foundation to be established by the executor and funded after death. The estate includes: $5 million in cash; Family Business #1 (100% owned by D, $12 million); a Commercial Building LLC ($3 million); Family Business #2 (100% owned by D, $8 million); a residence ($1.3 million); a second home ($700,000); a 33% interest in Business #3 (total value $10 million, with each child owning one-third of the remainder); a 33% interest in a commercial building associated with Business #3 ($4 million, same ownership); farm property ($5 million, leased to a tenant farmer); and $1 million in miscellaneous property. The two children are to serve as co-executors and as trustees of the foundation.
The problems are immediate and numerous. The foundation will receive approximately $27.5 million, representing roughly 55% of each estate asset. Neither child wants either residence. If the foundation becomes an owner of any operating business, it has five years to divest or face the excess business holdings tax. Any purchase of foundation assets by a child, even at fair market value, is a prohibited transaction. A redemption of any business interest is likewise prohibited without satisfying stringent conditions. Each child wants different assets, but disproportionate distributions are deemed sales subject to the self-dealing tax. Intercompany transactions between foundation-owned and disqualified-person-owned entities are indirect self-dealing. And while the foundation may be an S corporation shareholder, its allocable income would be subject to UBIT.
The executors initially propose splitting assets so that the foundation receives the two commercial buildings, the farm, Family Business #2, all cash, and half of the miscellaneous property, while the children retain Family Businesses #1 and #3. They also propose that the family borrow from the foundation’s cash at fair market interest, lease office space from its buildings at fair market value, and allow Family Business #1 to continue supplying Family Business #2 as it always has. Counsel explains that virtually every element of this proposal triggers excise taxes: the asset split is a deemed sale, the borrowing is prohibited, the lease is a prohibited transaction, and the intercompany supply relationship is an indirect act of self-dealing.
The estate administration exception offers a path forward for the asset realignment and the redemptions, provided each transaction is at fair market value, approved by the probate court, and leaves the foundation at least as liquid. The blocker structure sanctioned in PLRs 2014-46-024 and 2017-23-005 provides a mechanism for funding redemptions with promissory notes. Paying the children reasonable compensation to manage Family Business #2 is expressly permitted. But the intercompany supply relationship between Family Business #1 and Family Business #2, once the foundation owns Business #2, will be an indirect prohibited transaction going forward unless the foundation-owned entity has no practical alternative or can demonstrate severe financial hardship. That constraint must be addressed before the estate closes.
Practical Implications for Advisors and Families
Private foundation excise taxes are not mere transactional nuisances. The second-tier taxes effectively mandate correction and may require the unwinding of transactions at substantial cost, and the unwinding process itself can generate additional excise tax liability. Entrepreneurs sometimes treat taxes, even excise taxes, as a cost of doing business. In the private foundation context, that calculus fails: the penalties are too severe to absorb and too costly to ignore.
Best practices for advisors include the following. First, inventory business assets early in the planning process and model post-death ownership outcomes before any documents are drafted. Second, document client intent and warn heirs of the structural constraints they will face; heirs are not always privy to conversations with the decedent and will bear the consequences of inadequate planning. Third, coordinate estate, corporate, and charitable planning so that realignment decisions are made before the estate is funded and closed. Fourth, use the estate administration period deliberately and proactively to accomplish all necessary ownership realignments with probate court approval. Fifth, identify and address long-term intercompany dealings between foundation-owned and family-owned entities before the estate closes—because once it does, no exception may remain available.
Conclusion
Private foundations remain powerful and flexible vehicles for entrepreneurial philanthropy, uniquely suited to multigenerational legacy creation. But they demand disciplined planning whenever closely held businesses are involved. Advisors must anticipate excess business holdings exposure, self-dealing risks, and liquidity constraints well before funding occurs. With careful use of the estate administration exception, proactive ownership realignment and, where necessary, the blocker structures sanctioned in IRS private letter rulings, many of the most serious pitfalls can be avoided. Without that planning, families may be forced into unwanted divestitures or into costly excise tax corrections that undermine both their charitable and family objectives. The stakes are too high, and the excise taxes too punishing, to address these issues after the fact.
For more information or to discuss how private foundation rules may impact your business and estate planning strategy, contact KJK attorney Sebastian Pascu at SCP@kjk.com.