Private Foundations and the Excise Tax on Net Investment Income

Date July 26, 2021
Authors Amy L. Dalen

At the end of 2019, the Taxpayer Certainty and Disaster Relief Act of 2019 (“the Act”) was signed into law. One of the provisions that this legislation contained was a simplification to the excise tax on net investment income that is assessed against private foundations for tax years beginning after December 20, 2019. Prior to the Act, private foundations either paid tax at a rate of two percent (2%) or one percent (1%). To qualify for the one percent (1%) tax rate, a foundation needed to meet certain distribution requirements during the tax year. Under the Act, private foundations now pay an excise tax equal to 1.39% of their net investment income.

Net Investment Income

Net investment income is broadly defined under the Internal Revenue Code (“IRC”) as gross investment income plus capital gain net income, less any allowable deductions. Gross investment income generally includes interest, dividends, rents, and royalties, though income that is taxed under the unrelated business tax provisions is excluded from the excise tax. Capital gain net income includes capital gains and losses from the sale of investment assets. To the extent that any investment assets are donated to the foundation, gain or loss is calculated by using the donor’s adjusted basis.

Expenses that are typically allowed as deductions against investment income are any ordinary and necessary expenses that were paid for the production of the investment income, or the management, maintenance, or conservation of the investment property. A foundation can allocate a portion of its operating expenses, including salaries, professional fees, and occupancy expenses, that may be attributable to the foundation’s investment activities. While there is no required allocation method, the allocation should be reasonable and used consistently from year to year.

Taxable vs. Tax-Exempt Private Foundations

The rules detailed above apply to both taxable and tax-exempt private foundations, with some caveats. A tax-exempt private organization is a charitable organization that does not meet the definition of a public charity. Most individuals are familiar with a tax-exempt private foundation that is funded by one donor or family. A taxable private foundation is an entity that no longer meets the charitable requirements of a tax-exempt private foundation, and therefore it has lost its tax-exempt status. These taxable entities are subject to the excise tax on net investment income to the extent the excise tax plus any unrelated business income tax for the year exceed the entity’s regular income tax liability for the year.

Planning for the Excise Tax

Private Foundations should be aware of the excise tax and ensure that they are making estimated tax payments if the total tax liability exceeds $500. To ensure an accurate excise tax calculation, foundations should make sure they properly characterize the income they receive during the year. If income relates to a charitable activity performed by the foundation, it should not be included in net investment income. Foundations should also pay close attention to how they are allocating their operating expenses between net investment income and disbursements for charitable purposes. Since there is no required method for allocation, the foundation should spend some time coming up with a reasonable method for allocation and should use this same method consistently from year to year.

The HBK Nonprofit Solutions Group works with many private foundations to plan for this excise tax. Please reach out to a member of the HBK Nonprofit Solutions Group for more information.

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