For U.S. federal tax purposes, a private foundation is either a private nonoperating foundation or a private operating foundation.

Both foundations are exempt from federal income taxes under Section 501(c)(3); however, they are subject to different rules from public charities. 

A nonoperating foundation is known as a “grant-making” charitable foundation because it does not conduct direct charitable activities like a public charity. Instead, the foundation generally makes cash donations to other public charities in the form of grants. Nonoperating foundations do not rely on the general public for funding. Most of the financial support comes from one family.

In most cases, a family’s wealthy benefactor is the individual who decides to create a nonoperating foundation. The other persons involved with running the foundation (board members, officers, employees, etc.) are also members of the same family.

Example of a Private Nonoperating Foundation

Jane Doe is a wealthy private equity fund manager and is married with three children. Jane Doe wants to set up a nonoperating foundation to support 501(c)(3) public charities that focus on the welfare of children. 

In 2022, Jane opened the family foundation, where she, her spouse, and her three adult children serve on the board. The foundation has no other board members, officers, or employees. Jane’s charitable contributions to the foundation totaled $1,500,000 in cash for the 2022 tax year. Jane may claim the charitable contribution on her Schedule A (Itemized Deductions) up to 30% of her adjusted gross income (AGI). The foundation distributed $120,000 of grants to several 501(c)(3) public charities in 2022. The foundation itself did not conduct any direct charitable activities.  

Visit our YouTube channel for a video tutorial on preparing an initial year Form 990-PF for a private nonoperating foundation.

Rules for Nonoperating Foundations

Some of the conditions a nonoperating private foundation must follow include:

  1. Annual Tax Return. The private foundation must file an annual Form 990-PF (Return of Private Foundation), which discloses the foundation’s revenues, expenses, charitable disbursements, investment income and expenses, balance sheet, calculation of the federal excise tax on investment income, and disclosures related to the foundation’s activities. 
  2. Self-Dealing Restrictions. Private foundations are subject to strict rules regarding prohibited transactions with disqualified persons.
    1. A disqualified person includes trustees, directors, officers, substantial contributors, family members of other disqualified persons, business owners that own more than 20% of a company that is a substantial contributor, and corporations or partnerships where more than 35% of the entity is owned by a disqualified person.1 
    2. Prohibited transactions include selling, exchanging, or leasing property, lending money or extending credit, and furnishing goods or services. 
    3. Prohibited transactions do not include compensation paid to a disqualified person for personal services that are reasonable and necessary in carrying out the exempt function. 
  3. Minimum Distributions. Each year, a private foundation must pay out an amount equal to 5% of its net assets in qualifying distributions, otherwise the foundation is subject to a penalty.2 The qualifying distributions include grants to qualified charities plus an allocation of the foundation’s expenses. This rule ensures that foundations distribute funds to charities rather than accumulate assets in perpetuity. 
  4. Excise Taxes on Net Investment Income. Nonoperating foundations are exempt from federal income taxes on contributions; however, the foundations are subject to a 1.39% excise tax on net investment income.3

The IRS website contains more information on the tax & operational rules of private foundations.

Unrelated Business Taxable Income Considerations

Tax-exempt organizations are subject to regular corporate income taxes on any Unrelated Business Taxable Income (UBTI) earned by the charity. Private foundations that conduct activities or hold investments that generate UBTI must file a Form 990-T (Exempt Organization Business Income Tax Return) to report the income and pay the taxes. Form 990-T is required in addition to the Form 990-PF.

Visit our YouTube channel for a video tutorial on preparing Form 990-T for a private nonoperating foundation. 

  1. IRC Section 4946(a)(1) ↩︎
  2. IRC Section 4942(a) ↩︎
  3. IRC Section 4940(a) ↩︎