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Private Foundations - Understanding the 5% Distribution Requirement

Aug 12, 2015

A non-operating private foundation must spend or annually pay out a minimum specified amount for charitable purposes. This minimum distribution requirement of qualifying distributions prevents foundations from simply receiving charitable gifts, investing those assets, and then not spending these funds in furtherance of a charitable endeavor. Qualifying distributions include any amounts paid to accomplish the foundation’s tax-exempt purpose, including reasonable and necessary administrative expenses, as well as amounts paid to acquire assets used or held for charitable use and program-related assets.

What is the 5% payout requirement?

Section 4942 of the Internal Revenue Code requires a non-operating private foundation to annually distribute a minimum amount of its funds, equal to approximately 5% of the average fair value of a foundation’s non-charitable use assets for the year (generally, cash and investments). Should a foundation fail to distribute the required minimum amount in the allotted time frame (discussed later), the foundation may be subject to a 30% excise tax on the amount under-distributed. For each subsequent year the foundation fails to distribute the shortfall, it will be subject to a 100% excise tax on that shortfall.

What are charitable vs. non-charitable use assets?

The IRS allows that not all of a foundation’s assets are strictly for charitable purposes and that the bulk of a foundation’s assets (such as investments and cash held for investments) exist to generate revenues that will be used to carry out the foundation’s mission. Therefore, there must be some portion of the foundation’s assets that permit the foundation to functionally carry out the mission (such as working cash for grant payments, etc.), and the IRS allows 1.5% of a foundation’s non-charitable-use assets to be held as charitable use assets. For example, the IRS determines charitable and non-charitable-use assets as follows:

Average monthly fair value of securities     $89,082,031
Average monthly cash balances            611,664
Fair value of other financial assets            241,659
              Total $89,936,354
Cash deemed held for charitable use (1.5%)  (1,349,045)
Calculated net value of non-charitable use assets $88,587,309 

In this example, the IRS has determined that the foundation’s charitable use assets equal $1,349,045 and the foundation’s non-charitable use assets equal $88,587,309.

How does the value of non-charitable use assets factor into the 5% requirement?

The IRS presumes that a foundation will earn a minimum investment return of 5% of the net value of non-charitable use assets, and so begins the path to determining a distributable amount. In the example above, the foundation’s non-charitable use assets are $88,587,309 x 5% = $4,429,365 of presumed investment return. The minimum distributable amount is then calculated as follows:

Minimum investment return (5% of the non-charitable-use assets)   $4,429,365
Less: excise tax on net investment income and income taxes   1,447,737
Minimum required distributable amount     $4,369,393 

How much time does a foundation have to meet the minimum required distribution amount?

The IRS allows a foundation a one-year grace period to distribute the required minimum amount. For example, a foundation with a year-end of December 31 will have one full year from its year-end to distribute the required minimum amounts as shown in the table below:

Minimum required distributable amount 2014      $4,369,393
Amounts required to be distributed from 2013*   1,447,737
               Total required 2014 distributions   5,817,130
Charitable distributions during the year ended 2014   (4,232,305)
Amounts under distributed and required to be distributed by December 31, 2015 $1,584,825

* This represents a deficiency from the prior year.

What happens if a foundation exceeds the required 5% distribution?

If, in any year, a foundation exceeds its minimum distribution requirement, that excess may be carried over to help satisfy the minimum distributions of future years, up to five years. Thus, it is possible that the qualifying distributions in one year will be so great that no actual expenditures may be required to meet the minimum distribution requirement of a future year.

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