Required Annual Minimum Distribution Planning for Private Foundations

Shelley Chen — Tax Services

Each year, grant making private foundations are required to expend at least 5% of the value of their endowment in furtherance of their charitable purpose.

There is a common misconception that only grants made to other charities count towards meeting this requirement. While grants do typically make up the majority of distributions from most private foundations, it is important to know that many of the foundation expenses also qualify.

What is a qualified distribution?

A payment is a “qualifying distribution” if it meets one of the following criteria:

  • Grants or contributions to charities for charitable purposes
  • All reasonable administrative expenses necessary for the conduct of the charitable activities of the foundation
  • Costs of all direct charitable activities
  • Amount paid to acquire assets used directly in carrying out charitable purposes (such as computers, office furniture or a building)
  • Assets set-aside for charitable purposes
  • Program-related investments and loans

Administrative expenses

Administrative expenses, including salaries and benefits, professional fees, travel, training, supplies and overhead, can be classified as qualified distributions as long as the expenses are reasonable and necessary.

Judgment may be required in allocating expenses, as any expenses incurred in managing the foundation’s investments are not treated as qualifying distributions. Instead, these costs are deducted against the foundation’s investment income.

As an example, consider a foundation manager who spends 60% of their time making grants, 20% on selecting and managing investments and the remaining 20% on foundation administration. In this situation, 80% of the manager’s salary and benefits would be considered a qualifying distribution, while the remaining 20% would be deducted as an offset to the foundations investment income.

Generally, the cost of complying with legal, audit and tax requirements and publishing annual reports is also treated as a qualified distribution.

Assets set-aside for charitable purposes

Assets set-aside for charitable purposes also count as qualified distributions. However, set-asides are rarely made because to do so requires advance approval from the IRS. The foundation must prove to the IRS that a specific project is better funded over years (less than five years) rather than through an immediate payment.

A typical example would be the construction of a building, which may take several years from planning to completion. If the IRS approves a set-aside, the entire amount of the multi-year grant is treated as a qualified distribution in year one. Foundations should consult with a tax advisor if they are considering making set-asides because of the complex technical requirements in this area.

Program-related investments

In addition to making grants, a foundation can also make program-related investments in other charities. Program-related investments often take the form of loans to support charitable activities which meet the foundation’s exempt purpose.

Amounts distributed in the year a program-related investment or loan is made count towards the foundation’s qualified distribution requirement for that year. Keep in mind that repayment of the loan in a subsequent year works the other way, as a reduction in the level of distributions made for the year of repayment.

How does a foundation compute the required distribution?

In determining the 5% payout, you must first determine the foundation’s “endowment.” This is the monthly average value of the foundation’s investment assets over the tax year. The IRS does not prescribe an exact methodology in determining the average value, only that the foundation use a reasonable and consistent method in the calculation.

Calculating the required distribution

Once the endowment size has been determined, the foundation should make the following calculation:

  • Multiply the average asset value (or “endowment”) by 98.5%. This sets aside 1.5% of the assets for an allowed cash reserve
  • Multiply this adjusted endowment by 5%
  • Subtract assets purchased during the year (i.e. computers, furniture, equipment)
  • Subtract the excise tax paid on that year’s net investment income
  • Subtract any program-related investments made
  • Add back any repayment received for previous program-related investments

The remainder is the amount which must be distributed either through grants or administrative expenses. Excess distribution carryover

If a foundation’s qualifying distributions for the year exceed the minimum required, the excess will be carried over up to 5 years to help satisfy future payout requirements.

Investment expenses

Private foundations are subject to a 1% or 2% tax on net investment income. As mentioned previously, investment management fees (including brokerage fees, allocated salaries and other expenses) do not count toward the 5% minimum payout requirement. Instead, investment expenses reduce net investment income and thereby reduce the foundation’s excise tax liability.

When must the 5% payout be completed?

Private foundations have up to 12 months after the close of a tax year to satisfy the 5% payout for that particular year. For example, a private foundation with a tax year ending December 31, 2011 has until December 31, 2012 to complete its required 5% payout requirement for 2011.

What are the penalties if a foundation fails to meet the payout requirement?

The IRS imposes a 30% penalty on the amount that the foundation fails to distribute. While this penalty is imposed on the foundation, foundation managers should be aware that they could also be charged a penalty by the Attorney General on the grounds that the manager failed to exercise their fiduciary duty.

This article provides a broad overview of the annual payout requirements of private foundations. At Frank, Rimerman, our foundation tax, audit and investment professionals work closely with private foundations to carefully review, plan and monitor the cash flow and timing requirements to ensure the annual distribution requirements are met.

If you would like additional information or have any questions or concerns about the planning of the annual payout for your private foundation, please contact Shelley Chen, Tax Partner at Frank, Rimerman + Co. LLP, at [email protected].

Any tax advice in this communication is not intended or written by Frank, Rimerman + Co. LLP to be used, and cannot be used, by a client or any other person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer or (ii) promoting, marketing, or recommending to another party any matters addressed herein. With this communication, Frank, Rimerman + Co. LLP is not rendering any specific advice to the reader.

January 12, 2012 Article