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.

Read the full Spring issue of Insights, the HBK Nonprofit Solutions quarterly newsletter.

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.

On July 18, 2019, Ohio Governor Mike DeWine signed the Ohio budget into law. There were an estimated $700 million in across the board tax cuts. The changes include:

• For pass-through entities, the $250,000 business income tax deduction and 3% flat tax remains. However, the tax break was eliminated for lawyers and lobbyists.
• The elimination of the state’s bottom two income brackets and a corresponding 4% cut to the remaining five brackets for personal income tax.
• Required remittance of sales tax for sellers with gross receipts of at least $100,000 from sales into Ohio or engage in 200 or more separate sales. The bill also requires Marketplace facilitators to collect.
• The Film Tax Credit has been broadened to cover post-production work and Broadway-style productions.
• All state manufacturers will be able to apply for a “job retention” tax credit. To qualify, manufacturers need to make a capital investment equal to 5% of tangible property at the facility site, or $50 million, whichever is less.
• Ohio will piggyback off the federal Opportunity Zone program with a state income tax credit equal to 10% of an investment into a qualified fund up to $1 million every two years.

Other measures include:

• Raising the age to buy cigarettes from 18 to 21.
• Creating a new tax on vape products of 10 cents per milliliter.
• Creating a tax credit for property owners worth up to $10,000 for lead paint removal.

Please contact Suzanne Leighton of the HBK Tax Advisory Group at SLeighton@hbkcpa.comfor more information on how these changes to state law could affect your business.

The passage of the Tax Cuts and Jobs Act (TCJA) resulted in a complete makeover of the forms used to prepare individual income tax returns. Apparently “filing on a post card” is possible; for some, the new Individual Income Tax Return will indeed be as simple and straightforward as filling out a two-sided post card-sized form. For many others, however, the new form will be accompanied by one or more of six new schedules.

The first page of the new form is informational. It lists the taxpayer’s filing status, name, address, social security number and dependents. It also includes a signature area for the taxpayers and the tax preparer.

The second page of the new form contains the information used to compute the tax due for the year; it has been significantly simplified from prior year forms. If additional information needs to be reported, the TCJA has provided the following schedules to be used:

• Schedule 1 should be included in any tax return where the taxpayer receives income from capital gains (reported on Schedule D), ordinary gains (reported on Form 4797), business income (reported on Schedule C), rental and pass through income (reported on Schedule E), or any other type of income typically referred to as “Other Income.” This form will also report any adjustments to income, such as the deductible part of self-employment tax (reported on Schedule SE), the self-employed health insurance deduction, the deduction for contributions to an IRA and the student loan interest deduction.
• Schedule 2 will be included in any tax return where the taxpayer is subject to the Alternative Minimum Tax (reported on Form 6251) or needs to make an excess advance premium tax credit repayment.
• Schedule 3 will be used to claim nonrefundable credits such as the foreign tax credit (reported on Form 1116), any residential energy credits, general business credits or child and dependent care expenses.
• Schedule 4 will be used to compute other taxes such as self-employment taxes (reported on Form SE), additional taxes on IRAs, net investment income taxes (reported on Form 8960), household employment taxes (reported on Schedule H) and any Section 965 taxes due.
• Schedule 5 will be used to report any estimated tax payments as well as any payments made with an extension. This schedule will also be used to claim any refundable credits that the taxpayer is entitled to other than the earned income credit, such as the American opportunity credit or the additional child tax credit.
• Schedule 6 should be included for any taxpayers who have a foreign address or wish to designate a third- party designee to discuss their return with the IRS.

In addition to these new schedules, taxpayers should be prepared to fill out many of the standard, familiar forms and schedules when completing 2018 returns.

Taxes can be complex, and it is important to understand how these changes might affect filings. The examples included in this article are not all-inclusive and not intended as a substitute for the value and knowledge of consulting with a tax specialist. Please contact a member of the HBK Tax Advisory Group with your questions and concerns. We’re here to help.