Year-End Planning: Private Foundations
As 2011 winds to a close, it’s time to review your private foundation’s charitable grants. Making grants before year-end can help your organization save on taxes, while supporting your organization’s charitable goals.
Making Distributions for Charitable Purposes (and to Avoid Penalties)
Private foundations must make qualified charitable distributions each year in an amount equal to 5% of their net investment assets. The required grants must be made within a two-year period — either during the tax year itself or in the following year. Thus, at the end of each year, you should confirm that your distribution requirements have been met for both the current and the prior year.
Qualified distributions include more than just grants. Disbursements for charitable purposes include:
- Grants to public charities and private operating foundations that conform to the foundation’s charitable purpose.
- Reasonable and necessary administrative expenses incurred in implementing such charitable purpose.
- Other expenses incurred directly in carrying out the foundation’s charitable purpose.
- Grants to individuals for travel, study, or other similar purpose, so long as the following requirements are met:
- the grant is awarded on an objective and nondiscriminatory basis
- the purpose of the grant is to achieve a specific charitable purpose, and
- the foundation received formal advance approval from the Internal Revenue Service (IRS).
It is extremely important that the minimum distribution requirements are met. If the minimum distributions are not made before the end of the year, the organization is subject to a 30% penalty on the amount not distributed. The foundation will also not be eligible for the reduced excise tax rate for five years. It should be noted that the IRS has been active in assessing these penalties.
Additional Distributions Could Lower Your Excise Tax Rate
A private foundation that meets certain distribution requirements can cut its excise tax in half.
The taxes paid by private foundations are considered an excise tax, rather than an income tax. This excise tax is applied only to the foundation’s investment income, which includes interest, dividends, net capital gains, rents, royalty income, and income from pass-through investments.
Private foundations are typically taxed at a rate of 2% of the foundation’s net investment income. However, a foundation can qualify for a reduced rate of 1%, cutting their taxes by half, if it:
- meets the minimum qualified distribution requirements for the prior five years, and
- makes current-year distributions in excess of its five-year average.
If these requirements are met, the foundation will be taxed at the lower 1% rate. This makes proper planning vital in controlling your foundation’s tax liability.
Strategies for Addressing Capital Gains and Losses
For foundations in a net capital gain situation:
There are planning opportunities available to foundations with net capital gains. First and foremost is the “loss harvesting” strategy, where the foundation sells investments which have unrealized losses to offset the realized gains.
Before triggering gains to generate cash for grants, the foundation should instead consider making grants with the appreciated property itself. The full fair market value of the property counts towards meeting the minimum distributions requirements, while at the same time excise taxes are avoided.
For foundations in a net capital loss situation:
If a foundation sells investments which result in a net capital loss, the loss is not allowed to offset other types of investment income (such as interest and dividends). In addition, net capital losses do not carry forward to offset capital gains in future years.
Given this, managing capital gains is essential for a foundation. Proper management of capital gains and losses can reduce taxable income, help the foundation remain eligible for the “safe harbor” estimated tax method and perhaps also eliminate the requirement in certain states that the organization obtain a financial statement audit.
This memo gives a broad overview of the planning opportunities and requirements of private foundations. If you would like additional information or have any questions or concerns about year-end planning for your private foundation, please contact Laura Wright, Tax Services Manager at Frank, Rimerman + Co. LLP, at [email protected]