Foundations and Charities

The exam leans on that distribution requirement to separate private foundations from the other two. Once you have that anchor, the rest of the comparison (funding source, donor deduction limits, control) falls into place.

What Sets a Private Foundation Apart?

• Typically funded by a single source (an individual, family, or corporation)
• Tax-exempt as a charitable organization recognized under the Internal Revenue Code
• Must distribute at least 5% of the fair market value of its non-charitable-use assets (assets not used directly for its exempt purpose, net of acquisition debt) annually for charitable purposes, a requirement set by the Internal Revenue Code
• Subject to an excise tax on net investment income (1.39%)
• More restrictive rules than public charities, including limits on self-dealing and excess business holdings
• Donors receive a tax deduction, but with lower adjusted gross income (AGI) limits than donations to public charities: 30% of AGI for cash, versus 60% for public charities
• Must file Form 990-PF annually

Exam Tip: Gotchas

• The 5% distribution requirement applies to private foundations only, not public charities or donor-advised funds.
• The 1.39% excise tax on investment income applies to private foundations only.
• "Which client type has a mandatory annual distribution?" The answer is a private foundation, at 5%.

How Does a Public Charity Differ?

• Public charities include statutory categories such as churches, schools, and hospitals, organizations that qualify through public support, and certain organizations that support other public charities. A public support test applies to the publicly supported categories, not to every public charity
• Also tax-exempt as a charitable organization under the Internal Revenue Code
• No minimum distribution requirement
• Donors receive more favorable tax deduction limits: up to 60% of AGI for cash contributions
• Subject to less regulatory scrutiny than private foundations
• Must file Form 990 annually (the standard return, not the -PF variant private foundations file)

What Is a Donor-Advised Fund?

• A charitable giving vehicle administered by a sponsoring organization, usually a public charity
• Donor receives an immediate tax deduction at the time of contribution
• Donor recommends, but does not control, grants to qualified charities
• No required minimum distribution or timeline for granting
• Cannot benefit the donor or the donor's family, under a prohibited-benefit rule in the Internal Revenue Code that is separate from the self-dealing rules that apply to private foundations
• Simpler and cheaper to establish than a private foundation

Exam Tip: Gotchas

A donor-advised fund (DAF) donor cannot legally compel a grant; they can only "recommend."

How Does an Endowment's Investment Tolerance Compare to an Individual Investor's?

An endowment is a permanent fund, often held by a university, hospital, or other nonprofit institution, that generates ongoing income to support the institution while preserving principal for future generations. It shares a private foundation's perpetual time horizon, which is why the exam groups the two together for this concept.

Like the endowments a foundation or charity holds, it is generally subject to the Uniform Prudent Management of Institutional Funds Act (UPMIFA) in states that have adopted it.

• An endowment's spending policy sets a predictable, known-in-advance annual liquidity need, unlike a typical individual investor, whose liquidity needs can be unpredictable
• Because of that predictable liquidity need and the perpetual time horizon, an endowment can tolerate a greater allocation to illiquid investments, such as private equity or real estate, than a typical individual investor
• This greater tolerance for illiquid investments does not carry over to concentration or diversification: an endowment still needs prudent diversification across asset classes, and greater concentration in a single stock is not part of its advantage
• UPMIFA's prudent-management standard directs a total return approach, combining portfolio income with capital appreciation, so an endowment can fund current spending while preserving purchasing power over the long term

Exam Tip: Gotchas

• An endowment's advantage over an individual investor is in liquidity tolerance and time horizon, not in concentration or reduced diversification.
• A long time horizon does not make short-term speculative investments appropriate for an endowment.

How Do the Three Compare Side by Side?

What Should You Check on Exam Day?

• If a question mentions a mandatory annual distribution or an excise tax on investment income, it is describing a private foundation.
• If a question mentions a donor who can only recommend, not direct, a grant, it is describing a donor-advised fund.
• Donor deduction limits run in the same direction as regulatory scrutiny: private foundations have the tightest limit (30% of AGI) and the most oversight; public charities and DAFs share the looser 60% limit.
• If a question compares an endowment to a typical individual investor, the endowment's advantage is a greater tolerance for illiquid investments, driven by its predictable liquidity needs and perpetual time horizon, not greater concentration or less diversification.