T A X A B L E F O U N D A T I O N S

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1 T A X A B L E F O U N D A T I O N S Sarah D. McDaniel, Andrea Sanft, Beth Smith and Paul Stam 2016 While limited liability companies (LLC) have been used for years to house funds earmarked for philanthropy, attention and discussion has been generated about the efficacy of such a vehicle as a charitable entity in and of itself. By way of background, a private foundation can be organized as a trust, a not-for-profit corporation or an LLC. Recently, people have been using the LLC structure outside of the private foundation construct to house future philanthropic dollars. It is important to understand the legal and tax differences between LLCs that are not private foundations and private foundations in order to make an educated decision about which entity to choose to fulfill one s charitable intent. A 501(c)(3) entity is a US legal entity organized and operated exclusively for religious, charitable, scientific, literary and/or educational purposes and is one of the most common types of nonprofit organizations exempt from most federal income taxes. A 501(c)(3) organization may be either a public charity or a private foundation. A public charity receives a substantial portion of its funding from broad public and/or the government and largely disburses grants or provides services directly in furtherance of its charitable purposes. A private foundation receives a substantial portion of its funding from a few private individuals and largely disburses grants to other non-profit organizations, including public charities and other private foundations (subject to additional oversight). Private foundations fall into two main categories operating and non-operating. Operating foundations conduct charitable activities, whereas the more common nonoperating private foundation makes grants to other 501(c)(3) organizations. The following are the legal and tax implications of using a non-operating private foundation. The Annual Distribution Requirement: A private foundation must make annual qualifying distributions of roughly 5% of the foundation s net asset base. Qualifying distributions include grants to other 501(c)(3) entities, program related investments and administrative expenses. Excise Taxes: Mandatory Distributions: As mentioned earlier, a private foundation is exempt from most federal income taxes. However, there is a 2% excise tax on a foundation s net investment income, such as dividends, interest, royalties, rents and capital gains (less ordinary and necessary expenses incurred by the foundation for the collection of such income or for the management, conservation or maintenance of income-producing property). The excise tax is reduced to 1% if annual distributions exceed a certain amount, generally, the average of the foundation s charitable distributions over the preceding five tax years. Prohibited Acts: In addition, two-tier punitive excise taxes are imposed on certain prohibited acts (in addition to the excise tax), including: Self-Dealing: Certain direct or indirect financial transactions between a private foundation and disqualified persons (defined generally as substantial contributors, substantial owners, related entities, foundation managers and directors, and their family members) trigger a tax (from 5% to 200% of the amount involved) on the disqualified person and any other foundation manager or director who participated in the self-dealing transaction. Undistributed Income: A 30% excise tax will be imposed on the amount of undistributed income if the foundation fails to meet the minimum distribution requirement referred to earlier. Excess Business Holdings: A 10% tax will be imposed if the foundation owns greater than 20% of a publically held enterprise or 35% of a privately controlled enterprise. If the excess business holdings are not disposed of within a certain period of time, a 200% tax will be imposed.

2 Jeopardizing Investments: Certain transactions or investments are deemed to jeopardize the charitable purpose of the foundation. An excise tax of 10% will be imposed on any jeopardizing investment in each year and an additional 25% tax may be imposed if the investment is not sold. While no investment is improper per se, the IRS has suggested transactions that will be closely scrutinized, including : Trading in securities on margin; Trading in commodities futures; Investments in working interest in oil and gas wells; Trading in options; The purchase of warrants; and Selling short. Taxable Expenditures: An excise tax will be imposed on expenditures that are not in furtherance of the foundation s exempt purposes, for example, lobbying and political activities, and grants to individuals or non-exempt organizations. An initial tax of 20% of the improper expenditure is imposed on the foundation and an additional 5% on any foundation manager who participates knowingly in the improper payment. Unrelated Business Taxable Income (UBTI): UBTI applies when a non-profit benefits in commercial activities that are unrelated to the purpose of the non-profit and was introduced in 1950 to penalize a non-profit for engaging in such activities. If too much UBTI is generated, a non-profit may lose its tax-exempt status. Public Disclosure: Form 990-PF must be filed annually and is publically available. A great deal of information is readily available including: Asset values; Names of directors and employees with their compensation; and Names of recipients of grants with the dollar amounts distributed. Global Reach: There are restrictions and heightened scrutiny of charitable donations outside the US. Future Growth: While investment returns are mostly tax-exempt, future asset growth is limited to contributions from few donors and investment performance. Deductibility: Contributions generate an income tax deduction for the donor; however, deductions for contributions to private foundations are limited, generally, to 30% of adjusted gross income. Further limitations apply depending upon the type of property contributed. For example, the deduction for appreciated capital gain property is limited to cost basis and 20% of adjusted gross income. However, qualified appreciated stock (generally long term appreciated publicly traded stock) is deductible at fair market value. A LLC is a US legal entity with a business structure that has characteristics of both a corporation and a partnership. Like a corporation, a LLC provides a liability shield for its members. Like a partnership, a LLC is a pass-through whose income taxes are payable by the members (unlike a corporation, which is taxable at the corporate level). LLCs can have a single member and do not need to be organized for profit. So why then would a donor sacrifice eligible income tax deductions and forgo a charitable entity growing virtually tax free? To consider the potential lost funds not available for charitable purposes, we compare a hypothetical taxable entity distributing 5% per year with a tax-exempt entity also distributing 5% per year. For calculation purposes, Federal and state level taxes have been applied to the taxable case. For both cases, an asset base of $10 million has been used with the following allocation: 50% equities; 35% cash and fixed income; and 15% alternatives. The following monte carlo analysis illustrates a ten year cash flow model of a private foundation under the two hypothetical scenarios:

3 10 YEAR ENDING PORTFOLIO VALUE WITH 5% ANNUAL DISTRIBUTION IN $ MILLIONS TAX-EXEMPT TAXABLE DIFFERENCE 95th percentile th percentile th percentile YEAR ENDING PORTFOLIO VALUE WITH 5% ANNUAL DISTRIBUTION % PROBABILITY OF: TAX-EXEMPT TAXABLE DIFFERENCE money remaining preservation of capital maintain purchasing power The benefit of the tax-exempt status may range from $700,000 to $4.7 million depending on whether the portfolio experiences a 5th percentile (bad case scenario) or a 95th percentile (good case scenario) outcome respectively. Also, the benefit of the tax-exempt status might be a higher probability of the portfolio preserving capital and maintaining purchasing power. Additionally, a 5% distribution on a higher base means more money is given to charity. The differences in outcome are predominantly the effect of paying taxes and the loss of compounding on the taxes paid. The following additional considerations may favor the selection of an LLC for charitable purposes over a non-operating private foundation: 1. Tax benefits are not a significant concern. Therefore, no issue arises if donations exceed the allowable deductible amount currently (or beyond the five years of carry forwards). 2. The donor s obligation to pay income taxes via the pass-through tax system effectively allows the LLC assets to grow effectively tax-free. 3. If a charitable donor wants an enforceability clause in a grant agreement, it may be construed that funds would flow back to donor if the charity does not comply. In the private foundation scenario, this may negate the tax benefits of the donor s gift; however, with an LLC, there is more flexibility. 4. Limited liability through the separation of business and personal from social endeavors. 5. Flexibility with regard to: a. Size and timing of distributions; b. Type of assets contributed; c. Recipient of funds (can be non-profit and for-profit entities consistent with state law); d. Type of causes supported; and e. Type of investments made. 6. Anonymity with regard to:

4 a. Employees; b. Officers; c. Compensation; d. Recipients of funds; and e. Size of disbursements. 7. Potential for enhanced or self-sustainability through investment in commercial enterprises to expand and earn income (that is, the LLC investments are not subject to the jeopardy transactions and investments rules previously discussed). The question concerning charitable intent when choosing a LLC over a non-operating private foundation may be addressed by items one, two, three and seven. For example, despite there being little to no tax benefit to the donor, assets are earmarked for charitable purposes. Further, the pass through structure penalizes the donor in favor of the LLC which grows tax free. Additionally, a potential conflict of interest between the donor and the entity is alleviated as the enforceability clause will not potentially generate adverse tax consequences to the donor. Finally, a LLC may attract more capital from investors seeking for-profit investing than a non-profit private foundation would. Greater investment may allow for an expanded scale of impactful charitable work and create greater potential for the entity to be self-sustaining. The question concerning the entity s ability to adapt to a changing charitable environment when choosing a LLC over a non-operating private foundation may be addressed by items four, five and six. For example, with limited liability, a donor might pursue more speculative endeavors not permitted by tax-exempt organizations in fear of potential adverse consequences. There is a potential for discovering unforeseen approaches and outcomes that might advance a charitable cause. Additionally, the fact that the LLC can invest in nearly anything and benefit nearly any type of recipient means the goals of the donor and the needs of the ultimate recipients of the funds may be aligned. For example, a charitable group installing a clean water system in a remote village in Africa may need few funds in the planning stages but significant funds in several years when construction begins. The LLC is not forced to make a 5% distribution every year and can invest in investments timed to create liquidity when the target recipient actually needs the most funds. Finally, free of potential compensation constraints, group comparisons and benchmarking, a LLC can identify, recruit and retain the most advantageous human capital to strategize, run and execute the charitable intent. It is important that the discussion of charitable intent and efficacy does not solely focus on the choice of one legal structure over another. Rather, both structures, as well as others in combination, may enhance charitable impact.

5 Important Disclosure Important: The projections or other information generated by the Wealth Strategies Analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results generated by a Monte Carlo analysis will vary with each use and over time because each portfolio simulation is randomly generated. Since the future cannot be forecast, actual results will vary from the information shown for the future, including estimates and assumptions. The results may vary with each use and over time. It is possible that these variations may be material. The degree of uncertainty normally increases with the length of the future period covered. As a result, Morgan Stanley Smith Barney LLC cannot give any assurances that any estimates, assumptions or other aspects of the following analyses will prove correct. They are subject to actual known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from those shown. Hypothetical results have inherent limitations and do not reflect actual performance, trading or decision making. The results vary and reflect material economic or market factors such as liquidity constraints or volatility, which have an important impact on decision making and actual performance. This material was written as of the date noted and is being provided to illustrate concepts which applied at that point in time. The material is being provided for informational purposes only and may have been affected by subsequent changes in laws which are not reflected herein. This material has been prepared for informational purposes only and is subject to change at any time without further notice. Information contained herein is based on data from multiple sources and Morgan Stanley Smith Barney LLC ( Morgan Stanley ) makes no representation as to the accuracy or completeness of data from sources outside of Morgan Stanley Smith Barney LLC. It does not provide individually tailored investment advice. Be aware that the particular legal, accounting and tax restrictions, margin requirements, commissions and transaction costs applicable to any given client may affect the consequences described, and these analyses will not be suitable to discuss with every client. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. Tax laws are complex and subject to change. This information is based on current federal tax laws in effect at the time this was written. Morgan Stanley Smith Barney LLC, its affiliates, Financial Advisors or Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters Morgan Stanley Private Wealth Management, a division of Morgan Stanley Smith Barney LLC. Member SIPC