This text is a result of my huge experience earned through establishing many family foundations for my clients. It concerned mostly foundations established in the Principality of Liechtenstein.
As part of the procedure of establishing these specific legal entities, many questions, doubts and expectations from their founders arise. Most of these questions concern quite typical and repetitive legal or tax issues. Therefore, I decided it is worth summarizing them in such a practical article, which I hope will be helpful for people considering establishing a family foundation. Before making a decision, you will be able to confront the issues that need to be resolved during the foundation establishment procedure.
One note at the beginning: the majority of those information also applies to the procedure of establishing a family foundation in other countries where such a legal entity is provided, such as the Netherlands, Switzerland or Malta. The reference to a family foundation in the Principality of Liechtenstein is due to the fact that it is one of the best jurisdictions in the world for establishing such a foundation and that my practice is largely concerned with establishing family foundations in that country.
Why would a family foundation be established?
A family foundation is established in order to increase the security and stability of one’s property in threat of jeopardy. It might be:
- Disputes within the family – that is disputes and conflicts between the future heirs of this property, or simply differences in opinion, so significant that they make it impossible to make an unanimous decision on the way of managing a family business (for example)
- The general economic risk – business risks are always associated with financial risks, including for personal property (e.g. liability of a member of the board of a capital company for the company’s tax liabilities). Truism is – but true and often forgotten – that with economic activity in large sizes or in sectors with cross-cutting risks, the risk is also increasing. The family foundation is to minimize or exclude such risks.
- Risk of political instability – consisting in the fact that the country in which we live, conduct business or has property suddenly, for political reasons, will abandon the rule of law and our assets will be (for example) confiscated or subject to securing property for an indefinite period by unlawfully operating prosecutor’s office or tax authorities.
- Geopolitical risk – that is the risk of events on an international scale (such as the war in Ukraine) that may significantly affect the situation of a neighboring country (such as Poland) where the founder’s property is located. Then the purpose of the foundation is to transfer at least some of the assets (liquid assets, such as cash) to a country far away from the source of geopolitical threats and with greater legal and political stability (such as Liechtenstein or Switzerland).
In practice, the decision to set up a family foundation is usually the sum of all the above-mentioned motivation. You can clearly see, however, that this decision is mostly being made by people who have already experienced above-mentioned threats.
Vaduz Castle, the official residence of the Prince of Liechtenstein, with Alps mountains in background
What is a family foundation?
A family foundation is a legal entity, the essence of which the founder transfers (during his lifetime or posthumously by way of a will) his property to him definitively, without any remuneration or equivalent in the form of shares in the foundation (such in a family foundation simply no) or rights to this property. This way, after the foundation is established and the property is transferred, the foundation with legal personality becomes the owner of the property.
Importantly, the role of the founder in the procedure of establishing a foundation is not limited only to the transfer of the founding property to the foundation, but usually consists the fact that it gives the foundation’s statute, sets the foundation’s goals, the number and type of foundation’s bodies, the way of managing the foundation’s assets and circle of beneficiaries. All this, according to their expectations, is limited only by the provisions of the law.
Most often it works in a way that the founder gives the foundation’s statute and regulations, appoints the first organs, sets the goals and rules for managing its assets, and sets the group of beneficiaries or the rules for their definition. Usually the founder retains control of the foundation until his death. After the founder’s departure, the rules established by him continue to apply and are binding on entities participating in the foundation (managers, auditors or beneficiaries, protectors, asset management companies or banks, etc.).
In other words, the concept of the foundation is that you will dispose of your property by transferring it to a separate legal entity while maintaining certain control and influence over that property. However, this is an influence not of ownership (ie “like the owner”), but resulting from the goals of the foundation and the principles of its operation set out by the founder in the statutory documents. The goals of the foundation and everything that the founder established in the foundation’s statutory documents are subject to special legal protection in the Principality of Liechtenstein.
What legal bodies does a family foundation have?
The regulations governing the establishment of a family foundation grant a great deal of freedom in building its internal structure. It can be a monistic structure with one body – managing / constituting (board of directors) or a structure with two or more bodies such as: management board, family board (resp. Supervisory board), board of auditors, protector etc. In practice, everything here depends on the will of the founder.
The founder may or may not be granted with certain essential competences as long as he/she is still alive, e.g. the power to amend the statute, appoint / dismiss the board, or dismiss / liquidate the foundation.
Importantly, it is a practice in all countries where foundations exist that their functioning is in one form or another subject to supervision by state authorities (e.g. a court or a special supervisory authority over this market segment). This increases the security of such a solution and introduces additional protection against, for example, disloyal or dishonest actions of the foundation administrator. In most of the countries I know, the director of the foundation can only be a licensed entity. They are usually lawyers, tax advisers or auditors, i.e. persons practicing the profession of public trust.
Who are the beneficiaries of a family foundation and how are they defined?
Beneficiaries of a family foundation are basically those entitled to receive benefits from the foundation. In most of the jurisdictions known to me, where family foundations operate, the founder has considerable freedom in defining the group of these people. In order to better understand how beneficiaries can be defined in the founding documents of a family foundation, it is worth distinguishing the most frequently used benefit classes and the methods of their determination:
- Personal names – that is, beneficiaries indicated by their first and last names.
- Generic Beneficiary, defined according to a certain characteristic, e.g. the founder’s descendants or the founder’s relatives in the first and second lines.
- Conditional beneficiaries – who will acquire the right to receive certain benefits only when they meet a certain condition, eg graduate from master’s studies.
- Discretionary beneficiaries, ie those who will become beneficiaries entitled to specific benefits from the foundation, only on the basis of a decision of the foundation’s body, authorized to make such decisions on the basis of the foundation’s documents.
Above the rules for determining the group of beneficiaries may be interconnected and subject to further modifications. For example, a friend of the founder (named beneficiary) by name and surname will be indicated as the beneficiary together with the information that the beneficiaries may be his children (generic beneficiaries), but not further descendants.
An important supplement to the rules defining who will be the beneficiary of the foundation should be the specification of what benefits the beneficiaries can expect from the foundation. This should usually be the task of the founder, who, when establishing the foundation, can and should indicate precisely what are the goals of the foundation in relation to its assets (rules for the management of these assets) and what benefits, when and under what conditions, the beneficiaries may receive. These rules, whether in the form of regulations, by-laws or letter of wishes, constitute binding instructions for the foundation’s governing bodies after the death of the founder and play an important role in ensuring the stable functioning of the property transferred to the foundation.
However, I would like to add that in practice, such direct payments or benefits to beneficiaries are rare. The essence of the foundation is not to pay the beneficiaries cash benefits, but to stabilize the family property by involving family members in the management and decision-making of this property. However, this is done on the principles set out by the founder in the statutory documents.
What is the property protection effect to be ensured by a family foundation?
The first protective effect of a foundation is that it is a legal person separate from the founder and civil claims against the founder may not, as a rule, be directed to the foundation. Individual countries where such legal forms exist usually provide for a certain transitional period, where the donor’s creditors may submit claims to the foundation regarding the founder’s property. In Fr. Liechtenstein, this period is from 1 to 5 years (if the founder shows bad faith). The burden of proof is on the creditor.
The second effect is that the donor’s transfer of his property to the foundation, with the appropriate design of this transfer, may check that he will not leave an inheritance. This will exclude possible inheritance disputes and ensure that this property will fulfill its function in a compact form, regardless of any differences of opinion between potential heirs.
Finally, it is worth adding that the element that determines the additional legal security offered by the family foundation is that it is located in a country such as Fr. Liechtenstein, with a high level of rule of law and legal culture. This is extremely important in a situation where in the country of origin of the founder there is legal instability and a lack of respect for the legal principles. Which manifests itself in aggressive and arbitrary actions, e.g. by tax authorities or the prosecutor’s office. On the practical side, it consists in the fact that all matters – whether tax or criminal – to which the foundation will be a party, and where, for example, applications for, for example, security against the foundation’s assets, should be conducted with the participation of competent administrative authorities and courts in Fr. Liechtenstein.
*How to donate the assets to the family foundation?
Essentially, the number of basic options for such transfer is limited and amounts to a donation or sale. Both methods have their own legal and tax conditions and require an individual approach, but in a simplified way, they are used as follows:
- Donation – consists in the initial transfer of assets to the foundation by the founder or donation at a later stage. It has negative consequences in terms of acting to the detriment of creditors and consequences in the law of inheritance. Usually it concerns private property, not intended for business activity (cash, private real estate, movable property).
- Sale – it is used rather for property intended for business activity. Used when there is a risk of acting to the detriment of creditors, but there are problems such as the need to determine the market price, payment with the object of sale, etc.
- Contribution linked with a donation – used when the property transferred to the foundation is an enterprise. Then, an in-kind contribution of such an enterprise to a capital company may be tax-neutral according to tax regulations. In return for the contribution, the future founder receives shares in the company. Then he passes on the above-mentioned stakes to the foundation as a donation.
One cannot forget about the risk of treating the founder’s actions as acting to the detriment of creditors. This may have consequences provided for in Art. 300 of the Criminal Code and the consequences provided for in the provisions of the Civil Code regarding the protection of creditors (including the so-called actio pauliana). That is why it is so important to make a decision on establishing a family foundation when the legal or tax risk has not materialized yet. Submission of the foundation and transfer of property to it is of course possible in a situation where we are already in a legal or tax dispute, but then the facts and the above-mentioned should be analyzed more carefully. legal regulations to be aware of the risks we bear and to adjust the planned activities.
Can the use of a family foundation be associated with a tax risk?
The goal of a family foundation is not, as a rule, tax optimization, but to increase the security and stability of certain assets. This has its consequences and can even complicate the tax situation, as the property that was previously owned by one family member (founder) becomes the property of a legal person – a family foundation.
However, looking from a broaden perspective, it is a properly planned family foundation that can bring tax benefits in the long term. However, this requires an individual approach and a prior assessment of the planned operations, family assets and even the personal situation of the founder and his family. Basically, I see two main tax risks with regard to the establishment and operation of family foundations:
- Exit Tax;
- Controlled foreign company regulations (also known as “CFC regulations” – where the CFC is derived from controlled foreign company).
However, in practice, usually Exit Tax does not pose a significant threat to the establishment and operation of the foundation. The real issue is undoubtedly the CFC and here from experience I can mention two approaches to this problem:
- If the client – the founder – expects the foundation not to be subject to the CFC regulations, i.e. that it should also be a tool increasing the tax efficiency of its activities, the only solution is to create a foundation, the so-called consultation. It consists in the fact that the role of the founder is limited only to establishing a foundation and granting it the first statutory documents. Then, he has no powers other than consultative powers. This means that local licensed administrators have full power in the foundation (of course in accordance with applicable law in KS Liechtenstein and the foundation’s statutory documents), who only ask the founder for a non-binding opinion on the planned activities. This works appropriately with members of the donor’s family. Their position is only consultative. For obvious, more psychological than legal reasons, in my opinion, such a solution is decided by a young group of clients.
- The second approach is simply accepting that the foundation will be treated as a CFC. Finally, like the above-mentioned it was said, the goal of a family foundation is not to optimize tax, but to increase security. Therefore, to enjoy a certain and stable situation (including tax), it is worth simply reporting the foundation as CFC and paying the tax due once a year – as long as there are income subject to this tax. At the same time, the construction of the CFC tax means that we do not have any “additional” criminal taxation, but it is a tax intended to prevent aggressive, unjustified tax optimization. For example, if we operate through an operating company in Poland and this company pays dividends to a family foundation (collecting withholding tax on dividends earlier), then under the CFC regulations, we will not pay an additional tax again, but this withholding tax paid in Poland will be credited to the CFC tax.
- The latter approach is most often adopted by customers. And rightly so in my opinion.
Let me just emphasize that one solution to get rid of the problem of being classified as a CFC under Polish tax regulations is to establish a family foundation in a situation where the founder and his family members, due to their life choices, spend most of their time outside Poland (possible loss of residence tax) and most of their property is also located outside Poland.
It is also worth emphasizing here that the fact that our foundation will be classified as CFC still allows the use of solutions existing under Polish tax regulations, allowing for legal tax benefits (e.g. ASI or exemption for holding companies), which will increase efficiency foundation tax.
Family foundations are subject to limited taxation in most jurisdictions. This is what it is in Fr. Liechtenstein, where private foundations pay a flat tax of CHF 1,800 per year (provided they are not established in business). In other legal systems, assuming that the foundation does not conduct economic activity, but only acts as a holding entity, they also benefit from tax exemptions of the “participation exemption” type characteristic for holding companies.
Who will manage the assets of the family foundation?
Due to the fact that the purpose of the foundation is to protect and ensure the stability of the founder’s assets, the key issue in establishing a family foundation is how to manage these assets. Most often, the point is to balance the concerns of the founder and his family between the concerns of the founder and his family of entrusting property management to third parties, i.e. administrators of the foundation, and the need to ensure efficient and effective management of this property in a situation where the founder is no longer there and his heirs may have a completely different vision of managing this property. (e.g. a large manufacturing company).
In my opinion, the most effective way of shaping the principles of managing a foundation and its assets is the dispersion of competences (an equivalent of the “check and balance” principle functioning in politics). This is based on the following assumptions:
- Precise understanding of the principles of functioning of the foundation’s bodies and the principles of managing the foundation’s assets in documents created during the founder’s lifetime (eg by-laws, regulations, letter of wishes);
- Distribution of essential competences in the foundation between individual bodies, such as: foundation board, foundation board (family council), consultative board, protector / protectors, auditors etc.
- Separation of individual competences between family members and external persons professionally involved in managing family foundations. A similar solution is to “force” the above-mentioned people to cooperate in important decisions regarding the management of the foundation’s assets, such as requests that a specific transaction be approved by the family council and a positive assessment by an external auditor.
- Delegation of the management of some assets to an external, licensed “asset manager” employed for this purpose by the foundation. Such a regulated entity will be obliged by law to reliably and independently manage the foundation’s assets in accordance with the foundation’s strategy for managing its assets.
Such a balanced and dispersed management structure of a foundation should be effective and allow for a stable and conflict-free operation of the foundation and, above all, of the property under its care. At least, with experience, I can say that I don’t know a better way.
To sum it up
The information presented above does not, of course, exhaust the questions that may arise when establishing a family foundation. Questions regarding its goals, method of establishment, operation, tax consequences or principles of managing the foundation’s assets. A foundation is, on the one hand, a sophisticated and non-obvious legal instrument, and, on the other hand, an extremely flexible tool, offering many opportunities to increase legal security and the sense of stability of the family property. Like any sophisticated and specialized tool, it requires a moment of reflection and certain preparations before using it, the author of the above-mentioned the article strongly encourages.
Paweł Osiński
A lawyer specializing in serving Polish clients on German-speaking markets, incl. in Fr. Liechtenstein in Germany and Switzerland and in matters relating to the protection of property and succession of a family business.