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Foundation Fundamentals

8th Edition

The following is a sample chapter. For the full text,
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Chapter 1: What Is a Foundation?

Carnegie Corporation of New York, the Chicago Community Trust, the Duke Endowment, Rockefeller Brothers Fund—what's in a name? The answer is: not much, if you're looking for a grantmaking foundation. These four institutions are among the nation's top grantmaking foundations, but none has the word "foundation" in its name. Conversely, many nonprofit organizations with "foundation" in their name do not make grants.

The difficulty of identifying grantmaking foundations by name alone causes confusion and leads to misunderstanding about the scope and activities of the foundation field. This is where the Foundation Center comes in. The Center enables those looking for grants to identify grantmaking foundations that might be good prospects, and it analyzes growth trends and giving patterns in the field as a whole and among the various types of foundations.

Defining a Foundation

The Foundation Center distinguishes two main types of grantmaking foundations—private and public—based largely on the federal tax regulations that apply to them. The most common distinguishing characteristic of a private foundation is that its funds come from an individual, a family, a corporation, or some combination of related parties. We use the term "public foundation" to refer to a public charity that has grantmaking as a primary purpose. Like other public charities, public foundations generally receive their funding from multiple unrelated donors, which may include private foundations, individuals, and government grants. Further, they must continue to seek funding from diverse sources in order to retain their public charity status.

Historically, most of the government and media scrutiny of foundations has focused on private foundations, which lack the built-in accountability that fundraising from multiple sources gives public foundations. The determination as to whether a charity is private or public is made by the Internal Revenue Service (IRS). Under the Tax Reform Act of 1969, different rules and regulations apply to those nonprofits found by the IRS to be "private foundations."

A nonprofit that has been established under state law must obtain recognition as a charitable organization from the IRS in order for contributions to it to be tax deductible. Section 501 of the Internal Revenue Code covers many types of organizations that are exempt from federal income tax. And Section 501(c)(3) specifically covers tax-exempt organizations that are "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes . . ." and thus are eligible to receive contributions that are tax deductible to the donor.

An organization that meets the definition of Section 501(c)(3) is then measured against Section 509(a) of the Internal Revenue Code, which declares that unless it meets one of four criteria, it is presumed to be a private foundation. Those considered "not a private foundation" are:

Organizations described in Section 170(b)(1)(A), which covers churches; schools, colleges, etc.; hospitals, medical research institutes, etc.; supporting organizations to educational institutions; governmental units; and publicly supported organizations (including community foundations);

Organizations that normally receive more than one-third of their support from gifts, grants, fees, and gross receipts from admissions, sales, etc., and normally receive not more than one-third of their support from investment income;

Supporting organizations, which, although not publicly supported, are controlled by and operated in close association with a public charity; or,

Organizations operated exclusively for testing for public safety.

PRIVATE FOUNDATIONS

Because of their narrow base of support, private foundations are subject to federal laws and regulations intended to assure that they serve the public good. These rules include, among other things, a minimum annual distribution requirement, an excise tax on investment income, limits on the proportion of a for-profit enterprise they may own, and restrictions on grantmaking for certain kinds of recipients and activities.

The calculations required to administer these regulations are fairly complex. For instance, private foundations must make "qualifying distributions" of at least 5 percent of the average market value of their assets in any fiscal year by the end of the following year, a rule often referred to as "the payout requirement." Qualifying distributions include not only grants, direct charitable activities, and assets acquired directly for the active conduct of exempt functions, but also the administrative expenses required to operate those programs; they do not include such costs as those incurred in managing the foundation's investments. The calculation for the payout requirement is likewise complex, being based not only on the average asset value over the prior year, but also on the foundation's payout over the past five years (with any cumulative payout carry-forward being applied to the current year). In addition, certain "set-asides" of funds for future use count toward the payout requirement for that year.

The rules also require that private foundations annually file Form 990-PF with the IRS. These "information returns" are available to the public and can be useful for researching foundations' finances, board members, and grants, when this information is not available elsewhere. The Foundation Center's web site provides free access to Forms 990-PF through its 990 Finder feature.

The IRS differentiates between private foundations and private operating foundations, based on the different regulations that apply to them. The Foundation Center also breaks down the private foundation and private operating foundation designations into "independent" and "corporate," based on whether they or their donors are individuals or corporations. In 2005, the nation's private grantmaking foundations held $506 billion in assets and their grants totaled over $33 billion.

Independent foundations (often called "family foundations") are the most prevalent type of private foundation, comprising nearly 89 percent of those in the Foundation Center's database. Established by an individual or family through gifts or bequests, these foundations are extremely varied in size, style of operating, and grantmaking interests.

Most independent foundations have very small—or no—endowments. Often called "pass-though" foundations, they make grants from periodic gifts into the foundation. Many of today's large foundations began as pass-through foundations and subsequently received a major bequest upon the death of the donor. The number of "born large" foundations has increased during the past couple of decades, as individuals who have made substantial fortunes at a relatively young age endow their foundations early on. While endowed private foundations may exist in perpetuity, the donor or the governing board may decide to "spend out" the assets over a set time period or in connection with a triggering event, such as the death of the donor.

Fewer than 4,000 of the 69,569 independent foundations in the Center's database employ staff. The vast majority of unstaffed foundations report few or no administrative expenses. They are often managed by the donor, the family, and/or the trustees. The larger the foundation and the more complex the giving program, the more likely a private foundation is to employ staff.

Independent foundations' grantmaking activities range from gifts to local charities or educational institutions with which family members are associated to the multi-faceted, issue-driven grant programs—often dubbed "strategic philanthropy"—more likely to be practiced by larger, staffed foundations. They may operate programs locally, regionally, nationally, and/or internationally. Although their principal activity is grantmaking, they may also accomplish their mission through foundation-run programs (termed "direct charitable activities" by the IRS) or even through program-related investments, which is a specific type of grant/loan to a nonprofit.

Operating foundations, like other independent foundations, receive their assets from an individual or a small group of donors. However, most accomplish their charitable purposes largely by operating their own programs, rather than by making grants. The Foundation Center collects basic financial information on all private operating foundations. It creates more extensive profiles on the almost two-thirds that also make grants, which are usually for purposes related to the programs they operate.

Many of today's operating foundations started as independent foundations and increasingly began using their funds to operate charitable programs directly or to invest in "charitable assets," such as a building to be used as a nonprofit training center. When an independent foundation's charitable programs are mainly carried out not through grants but through direct charitable activities, it may apply to the IRS for reclassification as a "private operating foundation." A private operating foundation has different payout requirements and greater deductibility of new donations, allowing it to raise funds to help support its charitable activities.

Corporate foundations (also called company-sponsored foundations) generally receive their assets from a publicly held company rather than an individual or family. Although often closely tied to the company, a corporate foundation and the company that established it are separate legal entities. A corporate foundation often maintains a small corpus relative to its grants program, with the supporting company funding the bulk of its giving through annual gifts to the foundation. The company may augment the foundation's assets in some years to enable it to make grants from its corpus during years in which profits are down, it is expanding company operations, or it decides to cut back on gifts to the foundation for other reasons. This permits the foundation to maintain a reasonably steady grants program, despite business fluctuations.

Like independent foundations, corporate foundations often operate grantmaking programs in such areas as the arts, community development, education, or human services. However, their giving tends to focus on communities in which the parent company has operations, on company employees, or on activities that will raise awareness of the company in target markets, rather than on "strategic philanthropy." For example, many corporate foundations provide scholarships for children of employees and encourage employee involvement in charitable activities through employee matching gifts and programs that support employee volunteering.

Many companies make grants, provide sponsorships, or give in-kind gifts without using the foundation mechanism. Some make contributions both directly and through a non-operating or operating foundation. While corporate foundations and operating foundations must adhere to the private foundation rules, corporate direct giving programs have no IRS classification and are not subject to public disclosure requirements. Nonetheless, the Foundation Center collects information about corporate direct giving programs, when available, because of their significance to the overall fundraising strategies for a great many U.S. nonprofits.

Corporate operating foundations have recently become popular as the means through which pharmaceutical companies distribute significant quantities of their medicines to people who cannot afford them. In-kind donations of products are reported on the Form 990-PF as part of the "total giving" of these foundations. Over the years, corporate foundations have occasionally reported gifts of works of art, land, or other non-cash items. However, these new operating foundations appear to have been set up by pharmaceutical companies for the explicit purpose of donating medicines. In the past decade, approximately a dozen of these foundations have been established. The value of their combined donations in 2005 came to more than $3.3 billion.

PUBLIC FOUNDATIONS

A public foundation is a public charity that operates a grants program as one of its primary purposes. Because their funds come from multiple sources, public foundations have less arduous legal constraints. Like other public charities, they are required to file Form 990 with the IRS on an annual basis.

The IRS does not have special rules for public foundations, so grantmaking public charities (as they are sometimes called) can be difficult to identify, but a growing number of public charities operate grantmaking programs.

Community foundations are the oldest and best-known group of public foundations. Their origins go back almost a hundred years, when banks and trust companies set up community foundations by pooling the numerous small trusts they managed, thus creating a central source of charitable funds that could be systematically focused on community development and other needs in their local area. It was not until the Tax Reform Act of 1969, however, that federal law clearly set community foundations apart from the more prevalent independent foundation form by declaring them "not a private foundation" and conferring favorable tax status on them, as public charities. Currently more than 800 community trusts or foundations across the United States serve specific geographic areas, whether it be a city, region, or state. A number of these also administer funds intended to benefit other geographic areas, including some outside the United States.

Modern community foundations receive contributions from a great variety of sources, including private foundations. Their endowments may be composed of an assortment of individual funds (which may bear the donors' names), funds restricted to certain program areas (such as public school education), and unrestricted funds that the foundation can use to initiate new efforts or supplement existing ones. Several banks or investment firms normally manage community foundation investments, but most have their own staff to run the grantmaking or direct charitable programs and to attract additional resources to the foundation. Their grantmaking activities are usually overseen by the governing board or by a distribution committee representative of various community interests. Community foundations frequently administer donor-advised funds contributed by individuals who wish to designate their fund's recipients, and some of the newer community foundations are predominantly made up of such funds. Increasingly, living donors play an active role in determining grant recipients for community foundations of all sizes and ages.

Other public foundations encompass a range of grantmakers that raise and dispense funds around a particular community of interest. Community foundations, however, are the only public foundations currently included in the Center's statistical analyses, such as the annual Foundations Today series and the online FC Stats, because they are the only type of public foundation for which enough reliable information has been consistently available over time to permit trends to be documented. However, as the Center identifies and adds other types of grantmaking public charities into its database, it will be possible to produce reports on additional categories of public foundations and their work.

Increasingly, public foundations have been established to receive funds and make grants for special populations or for specific subject areas. Many public foundations start as a fund within a community foundation, and they often focus on a special population or area of need in their geographic area. Women's funds, for instance, have been established in communities across the country to raise money and make grants to benefit women and girls. Other public foundations focus their giving on the arts, health, the environment, social change, or any number of issues at a local, regional, national, or international level. Some public foundations receive funding primarily from a racial/ethnic, identity-based, or religious community, but their grantmaking programs may extend beyond this particular community of interest.

Donor-advised funds originated within community foundations as a means to allow donors to establish a relatively small individual fund and to retain the right to direct gifts to eligible recipients. The donor receives a tax deduction for a contribution to a donor-advised fund and, as the name implies, gives up formal control of its investment or distribution. Donor-advised fund services are increasingly being offered by other types of public charities, such as federated giving programs, universities, and other existing charitable institutions. During the 1990s, a number of financial institutions also adopted this model as a means to help their clients manage their philanthropic giving, as well as their investments. Fidelity, Vanguard, and Schwab, among others, established public charities, often called "commercial gift funds," to handle donor-advised funds exclusively. Their assets are in the billions of dollars, and their giving is in the hundreds of millions of dollars.

How Did Foundations Evolve?

Philanthropy dates back to ancient times, but legal provision for the creation, control, and protection of charitable funds (forerunners of U.S. foundations) was first codified in 1601 by England's Statute of Charitable Uses, which granted certain privileges to private citizens or groups of citizens in exchange for support or performance of charitable acts intended to serve the public good. Since then, legal doctrines in the common law countries have generally preserved this status for most types of charitable entities, including foundations, churches, hospitals, and schools, and have afforded them tax exemption, so long as they serve a charitable purpose.

THE ORIGINS AND DEVELOPMENT OF PRIVATE FOUNDATIONS

Most early foundations in the United States were established for the benefit of a particular institution, such as a hospital or school, or to meet a specific social need, such as relief for the poor. Early in the 20th century, a new kind of foundation began to emerge in the United States. Exemplified by Carnegie Corporation of New York (established in 1911) and the Rockefeller Foundation (established in 1913), "general-purpose" foundations are usually endowed independent or family foundations with broad purpose statements that enable them to address major social issues. They may focus their grantmaking on one or more areas for a period of time, but their governing boards have considerable latitude to change their focus as social conditions change. Modern-day general-purpose foundations may be limited by their charters to specific issues or geographic areas, but within those limitations they may periodically review and adapt their grantmaking strategies or programs.

More than ever, today's independent or family foundations are a diverse group of institutions that conduct their charitable work in myriad ways, reflecting the values and goals of their donors, the strategic oversight of their governing boards, and the environments in which they operate. As a consequence, their operating styles are also quite varied. They range from "checkbook" style foundations, which make grants in essentially the same way an individual philanthropist might, to large, staffed foundations operated on the model of the early general-purpose foundations. These larger entities not only make grants but might also conduct substantial operating programs, such as commissions to build knowledge about a particular field or technical assistance programs for their grantees.

Independent foundations began to attract congressional scrutiny soon after the Carnegie and Rockefeller foundations were created. The U.S. Commission on Industrial Relations of the U.S. Congress (called the Walsh Commission for its chairman) launched the first investigation of independent foundations in 1915, looking into charges that wealthy capitalists were using the foundation form to protect their economic power, but no major legislation or restrictions resulted. Two subsequent world wars and the Great Depression produced a relatively quiet period for foundations, as Congress focused on other issues.

The 1950s ushered in a period of growth in the field, spurred by the creation of new wealth and a tax structure favorable to foundation formation. Independent foundations again became the target of congressional criticism. First the Select Committee to Investigate Foundations and Other Organizations (the Cox Committee) in 1952 and then the Special Committee to Investigate Tax-Exempt Foundations and Comparable Organizations (the Reece Committee) in 1954 looked into allegations that the large foundations were promoting "un-American activities" and Communist subversion of the capitalist system. The Cox Committee's Final Report found that, ". . . on balance, the record of foundations is good," and the very negative majority report from the Reece Committee hearings was generally discredited. Again, no major restrictive legislation resulted.

An open-ended investigation of foundations initiated in 1961 by Congressman Wright Patman, chairman of the Select Committee on Small Business, and a 1964 study of foundations by the Treasury Department ultimately led to a whole new legal and regulatory framework for foundations in the Tax Reform Act of 1969. This Act created the private foundation designation and included company-sponsored foundations in the rules governing them. It set forth special rules that, among other things, prohibit certain transactions between foundations and "disqualified persons," including their donors and managers, as "self dealing"; restrict foundation ownership and control of private businesses; limit the percentage of an individual's annual income that can be donated to a private foundation as a tax-deductible contribution; regulate foundation giving to individuals, other foundations, and non-exempt organizations; and ban grants or other activities to influence legislation or support political campaigns.

The 1969 Act also required a private foundation to distribute for charitable purposes either all of its "adjusted net income" or a percentage, to be set each year, of the market value of that year's assets, whichever was higher. This "payout requirement" was later set at 5 percent of the average market value of that year's assets, to be paid out by the end of the following year. Finally, the legislation called for foundations to file two annual information returns with the IRS (Form 990-AR and 990-PF), to make the forms available for inspection by the public, and to file copies of the forms with charity authorities in the state where the foundation is incorporated. (Beginning in 1982, foundations have been required to file only one form, a revised Form 990-PF.) Legislation passed in 1998 and finalized in 2000 requires private foundations to provide a "take-home copy" of their current tax return to any individual who makes a request in person or in writing. If a foundation's Form 990-PF is widely available on the Internet, that satisfies the disclosure requirement, so this requirement has become obsolete.

At the time of its passage, the Tax Reform Act of 1969 was assumed to spell the end of private foundation formation. This prediction seemed to be borne out by the sharp decline in foundation birth rate in the 1970s. To the surprise of many, the 1980s brought renewed growth in private foundation establishment rates, a trend that gathered momentum throughout the 1990s and has continued into the 21st century.

With the new surge in foundation formation and explosive growth in foundation resources has come renewed scrutiny of private foundations, along with other nonprofit organizations. Starting in 2004, in response to media stories of possible abusive or unethical practices by individual charities, the U.S. Senate Finance Committee conducted a series of hearings on oversight and reform. In its testimony, the IRS identified several areas of questionable practice, including misuse of donor-advised funds and supporting organizations and widely varying practices for setting executive compensation. These hearings led to the passage of the Pension Protection Act of 2006, which included a number of charitable reform measures for private and community foundations. The Act aimed to provide certain charitable giving incentives while introducing tighter restrictions on supporting organizations and donor-advised funds. The Act also doubled the penalty excise taxes for private foundations with excess business holdings and, for the first time, applied the private foundation excess business holdings rule to donor-advised funds and certain supporting organizations.

In response to calls for self-regulation of the sector and with encouragement from the Senate Finance Committee, in 2004 Independent Sector, an association of grantmaking and grantseeking charities, convened a Panel on the Nonprofit Sector. The Panel engaged hundreds of representatives of nonprofit organizations and foundations in a thorough examination of the sector's governance, transparency, and ethical standards. In 2005, the Panel issued a series of reports to Congress and the nonprofit sector with recommendations on a wide range of issues, such as compensation, financial audits, and abusive tax shelters. The Panel has continued to work on unfinished reform issues, including recommendations for revising Tax Forms 990 and 990-PF. Taken together, the inquiries undertaken by Congress, the IRS, and the sector itself constitute the most comprehensive review of the governance, regulations, and operations of the charitable community in three decades.

A BRIEF HISTORY OF CORPORATE FOUNDATIONS

Corporate contributions to nonprofit organizations date back to the 1870s, when railroad companies began supporting the development of Young Men's Christian Associations (YMCAs) at their divisional and terminal points to provide accommodations for their workers, and until World War I, the YMCA was the only major recipient of corporate contributions. The war prompted a major national fundraising drive aimed at corporations by the American National Red Cross, as well as the YMCA. It also led to the creation of "war chests" in local communities, which evolved into Community Chests following the war, with corporations leading the way in their support. The Revenue Act of 1935 greatly increased the corporate income tax, but it also provided, for the first time, a charitable deduction for corporate contributions.

Although a few corporate foundations existed prior to World War II such as the Bausch & Lomb Foundation and the Chicago Sun-Times Charity Trust, the higher corporate tax rates of the 1950s led to a boom in the creation of new ones. Also in the 1950s, regulation was increased to prevent the use of the foundation mechanism for private enrichment or business purposes.

Formation of corporate foundations slowed considerably in the 1970s, due both to the Tax Reform Act of 1969 and to the state of the economy. But with federal cutbacks in funding for social services, education, and the arts in the early 1980s, the call went out for private sources, notably business, to pick up the slack. In an unsuccessful bid to increase company giving levels during this time, the tax deduction limit for corporate charitable contributions was increased from 5 to 10 percent of a company's pretax earnings. Nonetheless, starting in the 1980s, the number of new corporate foundations has continued to grow.

THE COMMUNITY FOUNDATION MOVEMENT

The community foundation movement dates back to the establishment of the Cleveland Foundation in 1914. The idea of centralizing the governance of numerous separate trusts that were dedicated to charitable purposes in the community was welcomed by local trust offices, and community trusts or foundations were set up across the country, mostly at the initiative of banks and trust companies or chambers of commerce. The movement lost momentum during the Great Depression, but following World War II, it was revived by leaders in the community planning arena as a suitable means of strengthening their cities and regions.

The rate of community foundation formation increased dramatically when the 1969 Tax Reform Act regulations were finally issued in 1976. These clarified the significant new advantages that community foundations had over private foundations, including fewer limitations on their grantmaking, exemption from the excise tax on net income of private foundations, and greater deductibility of gifts as a proportion of donors' pretax income. Soon thereafter, a number of independent foundations began matching-gift, technical assistance, and "pass-through" grant programs to encourage the growth of the movement in communities across the United States (and some, around the world). In the 30 years since 1977, the field has grown from 170 community foundations to 832, a remarkable 389 percent increase.

Recent History

The 20th century saw the development of a foundation field in the United States. It was a century of innovation, witnessing the emergence of the general-purpose foundation, the corporate foundation, and the community foundation and other types of public foundations. A legal and regulatory framework for the field was created, and an infrastructure of organizations and associations to document its dimensions and activities, advocate policy, promote public understanding, and study practices grew up around it. The stock market's exuberance at the end of the century created an unprecedented boom in philanthropy, and at the millennium, it seemed to many that the "Golden Age of Philanthropy" had arrived.

The economic downturn at the start of the 21st century slowed the remarkable growth of the foundation field but in no way staunched either its long-term prospects or its potential for innovation. At the time of the writing of this chapter, in fact, Foundation Center estimates of 2006 inflation-adjusted giving by the nation's more than 71,000 grantmaking foundations surpass the previous record set in 2001. The overall number of foundations has also grown by roughly 10,000 since the beginning of this century. The often-referenced "intergenerational transfer of wealth" suggests that, over the next several decades, many more foundations will be established, and the resources of existing foundations will continue to grow.

More foundations and higher giving levels in no way represent the full impact of the nation's foundation community. A growing grantmaker focus on effectiveness and measurable outcomes and the willingness of some foundations to take on major social challenges will undoubtedly continue to drive the field's agenda. An increasingly global perspective on giving characterizes the priorities of growing numbers of foundations, as global warming, pandemics, and terrorism bring home issues that know no borders. It appears inevitable that U.S. foundations will continue to make unique and vital contributions to communities here and around the world.

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