DOT Weighs in on Budget; Two Proposals Relate to Nonoperating Foundations and Payout Rules

The U.S. Department of the Treasury released the General Explanations of the Administration’s Fiscal Year 2024 Revenue Proposals on March 9, 2023, at the same time as the President’s release of the proposed 2024 budget. There are two proposals that relate specifically to private nonoperating foundations and their payout rules. Private nonoperating foundations are generally required to annually distribute at least 5% of the average fair market value of their noncharitable use assets from the preceding taxable year. A foundation that fails to meet this minimum distribution requirement is subject to a 30% excise tax on the undistributed amount. The new proposals make changes to amounts that were previously allowed to be considered “qualifying distributions,” or amounts paid to satisfy this required 5% payout amount.

Qualifying distributions include amounts paid by a private foundation to accomplish religious, charitable, scientific or educational purposes. Mostly, they consist of grants to public charities under IRC Sec. 501(c)(3), including donor-advised funds (“DAF”). They also include reasonable and necessary administrative expenses paid by the foundation to further its charitable purposes. Reasonable and necessary payments for personal services provided to a private foundation by a disqualified person, or an “insider,” are often considered to be qualifying distributions.

Proposal #1: A distribution by a private foundation to a DAF is not a qualifying distribution unless:

1. The DAF funds are expended as a qualifying distribution (not to another DAF) by the end of the following taxable year; and
2. The private foundation maintains adequate records or other evidence showing the DAF has made qualifying distributions within the required timeframe.

The reason for this proposed change is because of the advisory privileges the private foundation has with respect to a DAF to which it contributes, and because there is no requirement for a DAF to make a further distribution of funds for a charitable purpose within any set period of time. Therefore, if qualifying distributions made by private foundations are supposed to get out into the public within a specified amount of time, it is not appropriate for a private foundation to satisfy its distribution requirement by making a distribution to a DAF that may not be paying out the funds within a reasonable timeframe.

Proposal #2: Payment of compensation to a disqualified person will not count as a qualifying distribution that satisfies the payout requirement, even if it is for reasonable and necessary personal services provided to the foundation. These payments can still be made without being considered self-dealing; however, they will not count towards the required 5% annual requirement. This new rule would not apply in the case of a foundation manager paid by a private foundation for personal services that are reasonable and necessary who is not a member of the family of any substantial contributor. Payments to such a person would still be considered a qualifying distribution.

The reason for this proposed change is to prevent private foundations from meeting their entire payout requirement by hiring family members. Qualifying distributions are intended to further a private foundation’s charitable purposes, such as grants to public charities or to help the needy, not for compensation of disqualified persons.

The objective of both proposals is to make sure that the required payout amounts of private foundations are timely going out to the public to satisfy the foundation’s charitable purpose.

Congress is conducting hearings to examine these proposals.