A private foundation is an organization
that is exempt under IRC § 501(c)
(3), but does not meet the requirements to be
considered a public charity. This is generally
because the private foundation is either not
operating an activity that would qualify as a
private charity, or the source of funds is limited to
a family group, and therefore the organization is
unable to show sufficient support from the general
public. When an organization
is classified as a private
foundation, it must comply
with several complicated
rules governing its assets
and activities. This article
addresses one of the most
important of those rules: the requirement to make annual
qualifying distributions to
avoid significant excise taxes.
Overview
In general, a private foundation is required to
distribute annually an amount equal to the
foundation’s “minimum investment return” in order
to avoid the excise tax for a failure to distribute
income. The minimum investment return generally
calculates to 5 percent of the net fair market value
of the foundation’s assets, with some exceptions.
Only distributions that meet the definition of a
“qualifying distribution” will count toward the
requirement. However, if a foundation qualifies as
a “private operating foundation,” it is not subject to
this distribution requirement.
Minimum Investment Return
A private foundation’s minimum investment return
is generally defined under IRC § 4942(e)(1) as 5
percent of the net value of
the foundation’s income producing
assets. Assets used
directly by the foundation
in carrying out its exempt
purpose are not included in
the net value. Whether or
not an asset is used to carry
out the foundation’s exempt
purpose depends on the
facts and circumstances, and
generally requires that the
foundation have a charitable activity.
For example, a private foundation that purchases
a building to carry out its future plans of operating
a museum should be able to exclude the value
of the building from the foundation’s minimum
investment return calculation. However, if the
private foundation does not have plans in place to
create a museum, or purchased the building solely for the purpose of generating rental income, the
value of the building should not be excluded.
There may be instances where assets are used
for both direct charitable and non-charitable
purposes. In those instances only a portion of
the asset value will be included in the minimum
investment return calculation. When at least 95
percent are used in direct charitable activities,
assets can generally be fully excluded from
the calculation.
The timing of the value is also important when
calculating the minimum investment return.
Cash accounts will generally be valued as a
monthly average balance, whereas other assets
may be valued on any day of the year, assuming
the same day is used consistently each year.
Real property may qualify for a special rule
that allows the private foundation to obtain an
appraisal every five years.
Private foundations should look at valuations
carefully to ensure they are accurate. While an
excise tax may apply if the valuations used are
later determined to be too low, IRC § 4942(a)
(2) prevents the imposition of this excise tax,
provided the foundation did not act willfully
and made a good faith effort to ascertain
accurate values.
What Are Qualifying Distributions?
Qualifying distributions are generally
administrative expenses, payments to other
exempt organizations, or amounts set
aside for a specific project that has a
charitable purpose:
• Administrative expenses tend to be
expenses that are reasonable and necessary
to accomplish the exempt purpose of the
foundation. Legal and accounting fees
generally qualify, as do state registration
fees, trustee fees, and banking fees. To the
extent any of the administrative expenses
of the foundation are incurred partly for the
foundation’s charitable purposes and partly
for other purposes, the foundation will need
to allocate the expenses between purposes.
Allocation is done on Page 1 of Form 990-PF.
There is no defined method for allocation,
though allocations should be reasonable
and consistently applied each year. We
recommend looking at each administrative
expense separately to determine the most
accurate method of allocation. For instance,
trustee fees may be allocated based on
hours spent reading grant applications
versus monitoring investments. In contrast,
legal fee allocations may be based on the
specific matter they pertain to—for example,
drafting internal governance documents or
giving an opinion on whether an investment
strategy is aligned with the foundation’s
charitable purpose.
• Payments to other exempt organizations
may be qualifying distributions as long as
the designated organization is not controlled
directly or indirectly by the foundation or its
disqualified persons, with some exceptions.
In addition, payments to other private
foundations will generally not qualify unless
the foundation receiving the payment is a
private operating foundation. Interestingly,
payments made to foreign organizations
may be considered qualifying distributions
if the foundation has made a good faith
determination that the foreign organization
is not considered a private foundation.
• Amounts set aside for a specific charitable
project can be a qualifying distribution
when the amount set aside will be used on
the project within five years. In addition,
the foundation must either show that the project is better accomplished by setting
aside funds instead of making immediate
payments during the term of the project,
or meet a mechanically defined cash
distribution test that generally principally
applies to foundations applying the setaside
rule shortly after organizing as a
private foundation.
Ordering of Qualifying Distributions
Qualifying distributions made during
a current year will first reduce any
undistributed income—that is, of the
minimum investment return—from the
immediately preceding year if the private
foundation was subject to the income
distribution requirements for that year. To
the extent that there are excess qualifying
distributions for the current year, the private
foundation can elect to apply the excess to
undistributed income from years prior to the
immediately preceding year. If the election
is not made, or there is no undistributed
income for prior years, the current year
qualifying distributions will reduce
distributable income for the current year.
Any excess qualifying distributions are
deemed “distributions of corpus,” which may
reduce distributable income in future years.
IRC § 4942 Excise Taxes
If a private foundation does not make sufficient
qualifying distributions to distribute the entire
minimum investment return for the year, the
undistributed amount carries forward to the
following year. The private foundation must
then make sufficient qualifying distributions to
cover the undistributed amount from the prior
year, or a 30 percent excise tax will be imposed
on the amount that remains undistributed as
of the first day of the third taxable year after
the amount was required to be distributed. The
excise tax will continue to apply each year until
qualifying distributions are sufficient to offset
the undistributed amount subject to the excise
tax. (See example below.)
IRC § 4942 Excise Taxes:an Example
The Smith Family
Foundation calculates
a minimum
investment return
of $10,000 during
tax year 2019, but does not make
any qualifying distributions. The
minimum investment return for tax
year 2020 calculates to $12,000,
and the foundation makes qualifying
distributions of $5,000 by the end
of tax year 2020. The qualifying
distributions of $5,000 first offset
the distributable amount from
tax year 2019, leaving a balance
of $5,000, against which the 30
percent excise tax is assessed in tax
year 2021. The foundation will need
to make qualifying distributions
of at least $17,000 during tax year
2021, and apply excess qualifying
distributions to undistributed
income from 2019 in order to avoid
the excise tax in tax year 2022.
Conclusion
Private foundations need to be aware of their
distribution requirements and the excise
tax that could be assessed if the qualifying
distributions they make are insufficient to meet
those requirements. HBK Nonprofit Solutions is
well versed in those requirements and regularly
consults with nonprofits on adhering to
qualifying distribution rules. To discuss the rules,
or for a better understanding of how they could
impact your private foundation, we encourage
you to reach out to HBK Nonprofit Solutions.
