Foundations and trusts are two legal structures commonly used in philanthropy and estate planning. While they share some similarities, they also have distinct differences that affect their governance, management, and tax treatment. Understanding these differences is essential for donors and beneficiaries who want to create effective and efficient philanthropic vehicles.
In this article, we will compare and contrast foundations and trusts, exploring their definitions, purposes, governance, management, tax treatment, and advantages and disadvantages.
Trusts and foundations may be used to manage and protect large and complex estates.
Definitions
A foundation is a non-profit organization created by an individual, a family, or a corporation to support charitable, educational, religious, or other public purposes. Foundations can be either public or private, depending on their sources of funding and governance structure.
A public foundation receives its funding from multiple sources, such as the government, the public, or other organizations, and must have a broad base of support. Examples of public foundations include community foundations, which serve a particular geographic area and support various causes, and operating foundations, which conduct charitable activities directly.
A private foundation, on the other hand, is funded by a single source, usually an individual or a family, and has more control over its operations and grantmaking. Private foundations are subject to stricter regulations than public foundations, such as minimum payout requirements and restrictions on self-dealing and excess business holdings.
A trust, on the other hand, is a legal arrangement where a trustee holds and manages assets for the benefit of one or more beneficiaries. Trusts can be either revocable or irrevocable, depending on whether the grantor can change or terminate the trust.
Revocable trusts, also known as living trusts, allow the grantor to retain control over the trust assets and amend or revoke the trust at any time. The grantor can also serve as the trustee and the beneficiary of the trust during their lifetime. However, upon the grantor’s death, the trust becomes irrevocable, and a successor trustee takes over.
Irrevocable trusts, on the other hand, cannot be changed or terminated once created, except under limited circumstances. The grantor must transfer the assets to the trust and relinquish control over them. The trustee then manages the assets according to the trust’s terms and distributes the income or principal to the beneficiaries as specified.
Purposes
Foundations and trusts serve different purposes, although they can overlap in some cases. Foundations are primarily designed to support charitable or public causes, such as education, health, the arts, the environment, or social services. Foundations can make grants to other non-profit organizations or individuals, conduct research, advocacy, or other activities that advance their mission.
Foundations can also provide a platform for family philanthropy, where members of the same family can pool their resources, share their values, and engage in charitable activities together. Family foundations can serve as a legacy for future generations and provide a sense of purpose and unity for the family members.
Trusts, on the other hand, are primarily used for estate planning and wealth transfer purposes. Trusts can help individuals to manage their assets during their lifetime, avoid probate, minimize taxes, and provide for their heirs or beneficiaries after their death. Trusts can also protect assets from creditors, divorce, or other risks and provide flexibility and privacy in managing one’s affairs.
Trusts can be tailored to the grantor’s specific needs and goals, such as providing for a disabled child, funding education or healthcare expenses, or supporting a charitable cause. Trusts can also be used to transfer assets to future generations while minimizing estate taxes and preserving family values and traditions.
Governance
Foundations and trusts have different governance structures and requirements, which affect their operations, management, and accountability.
Foundations are governed by a board of directors or trustees, which oversees the foundation’s activities, sets its policies and goals, and ensures compliance with legal and regulatory requirements. The board members are typically volunteers who have expertise in the foundation’s mission and operations, and who are not compensated for their services.
Private foundations must have at least one independent director who is not related to the founder or major donor, to ensure independence and avoid conflicts of interest. In the United States, private foundations must also disclose their financial information and grantmaking activities to the IRS and the public, and meet minimum payout requirements of 5% of their assets annually. Most other countries such as Germany have similar payout requirements for foundations.
Public foundations, such as community foundations, have a broader base of support and may have more diverse governance structures, such as committees or advisory boards, to involve stakeholders in their decision-making process. Public foundations must also comply with more stringent rules regarding their sources of funding, grantmaking, and charitable activities.
Trusts, on the other hand, are governed by the trust agreement, which sets forth the grantor’s instructions and the trustee’s duties and powers. The trustee is responsible for managing the trust assets, making distributions to the beneficiaries, and complying with the trust’s terms and legal requirements.
The trustee can be an individual or an institution, such as a bank, a trust company, or a law firm. The trustee must act in the best interests of the beneficiaries, avoid conflicts of interest, and follow the prudent investor rule, which requires the trustee to make investment decisions that are reasonable and appropriate for the trust’s objectives and risk tolerance.
Trusts do not have a board of directors or a governing body, although the grantor may appoint a trust protector or an advisory committee to oversee the trustee’s actions and ensure compliance with the trust’s terms and objectives. The trustee must also disclose the trust’s financial information and activities to the beneficiaries and comply with tax and legal requirements.
Management
Foundations and trusts also have different management structures and requirements, which affect their day-to-day operations, grantmaking, and investment strategies.
Foundations typically have staff or volunteers who manage the foundation’s programs, grantmaking, and administration. The staff members may have expertise in the foundation’s mission and goals, such as education, health, the arts, or social services, and may work full-time or part-time.
The foundation’s grantmaking process may involve soliciting proposals from non-profit organizations, conducting site visits and due diligence, and making grants based on the foundation’s criteria and priorities. The foundation may also provide technical assistance, capacity building, or other support to the grant recipients, to ensure the effectiveness and sustainability of their programs.
Foundations must also invest their assets prudently and diversify their portfolio to minimize risks and maximize returns. The foundation’s investment strategy may vary depending on its risk tolerance, liquidity needs, and mission-related goals. The foundation may also use socially responsible investing (SRI) or impact investing strategies, to align its investments with its mission and values.
Trusts, on the other hand, rely on the trustee to manage the trust assets and make distributions to the beneficiaries according to the trust’s terms. The trustee’s investment strategy may vary depending on the trust’s objectives, time horizon, and risk tolerance, as well as the trustee’s expertise and resources.
The trustee may use a variety of investment vehicles, such as stocks, bonds, mutual funds, real estate, or alternative investments, to diversify the portfolio and achieve the trust’s goals. The trustee must also monitor the portfolio’s performance, rebalance the portfolio as needed, and report to the beneficiaries on the trust’s financial status and activities.
Tax Treatment
Foundations and trusts also have different tax treatments, which affect their income, deductions, and tax liabilities.
In the United States, foundations are tax-exempt organizations under section 501(c)(3) of the Internal Revenue Code, which means that they do not pay federal income tax on their earnings, and donors can deduct their contributions to the foundation on their tax returns, subject to certain limitations. However, foundations must pay a 1-2% excise tax on their net investment income, which includes dividends, interest, and capital gains, and may incur other taxes, such as unrelated business income tax (UBIT) or state and local taxes.
Other countries with foundation laws follow similar guidelines, e.g., in the UK where foundations are commonly referred to as charities, and in Switzerland and Lichtenstein where they are known as Stiftungen.
Foundations must also comply with various tax rules and regulations, such as the public support test, the private foundation excise tax rules, and the excess business holdings rules, to maintain their tax-exempt status and avoid penalties and sanctions.
Trusts, on the other hand, are not tax-exempt entities but may be subject to various taxes, such as income tax, estate tax, gift tax, or generation-skipping transfer tax, depending on the trust’s structure and purpose.
Revocable trusts, also known as living trusts, are treated as grantor trusts for income tax purposes, which means that the grantor is responsible for paying taxes on the trust’s income, deductions, and credits. However, irrevocable trusts, which are often used for estate planning, may be taxed as separate entities and subject to different tax rates and rules.
Trusts may also be subject to state and local taxes, such as state income tax or property tax, depending on the trust’s jurisdiction and assets. Trusts must also comply with various legal and tax requirements, such as the duty of loyalty, the duty of care, the duty to inform, and the duty to account, to avoid liability and disputes.
To be tax-free, trusts need to be set up in jurisdictions without income taxes and capital gains taxes. We here at The Dubai Navigator can help you with that.
Advantages and Disadvantages
Foundations and trusts have different advantages and disadvantages, which may affect the grantor’s decision to use one or the other.
Foundations offer several advantages, such as:
Perpetuity: Foundations can exist indefinitely, allowing the grantor to create a lasting legacy and support causes beyond his or her lifetime.
Flexibility: Foundations can support a variety of charitable purposes and organizations, and can adapt to changing needs and priorities over time.
Control: Foundations allow the grantor to retain control over the foundation’s mission, governance, and investments, and to involve family members or other stakeholders in the foundation’s activities.
Tax Benefits: Foundations offer tax benefits to donors and may allow the grantor to reduce his or her estate tax liability.
However, foundations also have some disadvantages, such as:
Cost: Foundations require a significant amount of time, resources, and expertise to establish and maintain, including legal and accounting fees, staffing, and administrative costs.
Oversight: Foundations are subject to strict legal and regulatory oversight, including annual reporting requirements, excise taxes, and compliance with anti-terrorism and anti-money laundering laws.
Limited Distribution: Foundations must distribute a minimum of 5% of their assets annually, which may limit their ability to accumulate and grow their assets over time.
Accountability: Foundations must be accountable to the public and the national tax authorities, and may face scrutiny and criticism for their grantmaking decisions and operations.
Trusts also offer several advantages, such as:
Estate Planning: Trusts are better suitable for estate planning purposes, such as avoiding probate, minimizing estate taxes, and providing for the grantor’s family members and beneficiaries.
Asset Protection: Trusts can provide asset protection for the grantor’s assets, such as protecting them from creditors, lawsuits, or other claims.
Privacy: Trusts offer more privacy than foundations, as they are not required to disclose their financial information or grantmaking activities to the public.
Customization: Trusts can be customized to meet the grantor’s specific needs and objectives, such as providing for special needs beneficiaries, supporting educational or religious institutions, or preserving family values and traditions.
However, trusts also have some disadvantages, such as:
Complexity: Trusts can be complex and difficult to
establish and manage, especially if they involve multiple beneficiaries, assets, and jurisdictions, and may require the assistance of legal and financial professionals.
Control: Trusts may limit the grantor’s control over the trust’s assets and distribution, especially if the trust is irrevocable or involves third-party trustees or beneficiaries.
Taxation: Trusts may be subject to various taxes and tax rules, such as income tax, estate tax, gift tax, or generation-skipping transfer tax, which may reduce the trust’s net value and limit its distribution. These taxes can be avoided by choosing the right country to set up your trust.
Trustee Fees: Trusts may require the payment of trustee fees, which can be a significant expense over time, and may affect the trust’s financial performance and distribution.
Trusts are also not universally recognized by all countries. Especially popular in countries with British- and American-based law, trusts are often not effective in civil law countries such as France, Italy, or Germany. If you intend to use a trust to hold assets located in civil law countries, the assets may not be protected. In those cases more complex estate planning solutions are needed, usually involving multiple layers of asset-owning companies (special purpose vehicles) and trusts. Contact us for details.
Conclusion
Foundations and trusts are two common forms of charitable and estate planning vehicles that offer different benefits and drawbacks depending on the grantor’s goals and circumstances. Foundations are tax-exempt entities that allow for perpetual giving and control, but require significant resources and oversight. Trusts, on the other hand, offer flexibility and customization, but may involve more complexity, taxation, and fees.
Ultimately, the choice between a foundation and a trust depends on the grantor’s specific needs, preferences, and resources, and should be made after careful consideration and consultation with legal, financial, and tax professionals. Whether the grantor chooses a foundation, a trust, or another form of charitable or estate planning vehicle, the ultimate goal should be to achieve his or her philanthropic and personal objectives while minimizing risks and maximizing benefits.
We are here to support you finding cost-effective solutions to secure your estate. Checkout our offers, or contact us for free.
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