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.
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.
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.