Do you know if your private foundation made its required charitable distributions this year? Does it need to make any estimated tax payments? How are those calculated?
Private foundations have minimum distribution requirements. They also pay a tax on net investment income, which can be reduced if the foundation meets certain requirements. These two calculations are often confused and confusing.
What does a private foundation have to distribute?
Private foundations are required to make qualified charitable distributions of 5% of the average fair market value of its assets each year. Qualifying distributions are typically in the form of grants paid to public charities. Grant administration expenses, as well as a portion of certain dual purpose expenses, such as legal and accounting fees, can also qualify as charitable distributions.
The average fair market value of assets does not include any assets that are used for charitable purposes (such as a building owned by the foundation that is used as an art museum). Depending on the type of asset, the market values may be determined monthly (such as for marketable securities), annually, or by appraisal, depending on the type of asset.
Since the foundation cannot know for certain what the actual fair market value of its assets is until after the end of the year, the IRS allows for additional time to make these distributions. At the end of each tax year, the foundation calculates the 5% distribution requirement based on the average fair market values and compares this amount to the actual charitable distributions made during the year. If the foundation has distributed more than the 5% amount, the excess can be carried forward for up to five years to offset future distribution requirements. If the foundation has distributed less than the 5% amount, it must distribute the shortfall by the end of the following year. If it does not, it will face significant penalties for undistributed income.
What is net investment income and how is it taxed?
Investment income includes interest, dividends, capital gains, investment partnership income, and similar items. Capital losses can reduce capital gains, but not other types of investment income. Capital losses do not carry forward to a future year. Expenses such as custodian fees, investment advisory fees, partnership related expenses, foreign taxes paid on dividends, and similar items reduce investment income. It is the net investment income that a foundation pays excise tax on.
The excise tax rate on net investment income is 2%, but it can be reduced to 1% if the foundation meets certain qualifications. In order to qualify for this reduced tax rate, the foundation looks at the charitable distributions and average fair market value of assets over the previous five years to calculate an average distribution ratio.
Let’s look at an example:
Year Qualifying Charitable Distributions Average FMV of assets Ratio/Percentage
2018 $1,000,000 $10,000,000 10.00%
2017 $700,000 $10,000,000 7.00%
2016 $500,000 $10,000,000 5.00%
2015 $350,000 $7,000,000 5.00%
2014 $350,000 $7,000,000 5.00%
The average of the five years’ percentages is 6.4%.
In order to qualify for the reduced 1% excise tax on investment income in 2019, the foundation would need to make charitable distributions of 6.4% of the average fair market value of its assets in 2019. Let’s assume an average fair market value of $10M in 2019. 6.4% of this average is $640,000. To further complicate matters, the 1% net investment income excise tax is added to this amount. Assuming net investment income of $1M in 2019, the 1% tax would be $10,000. The foundation would therefore need to distribute $650,000 during 2019 in order to qualify for the 1% tax.
This test for the reduced excise tax is calculated each year. A foundation either meets the test and pays a 1% tax, or it does not meet the test and instead pays a 2% tax. Amounts must be actually paid during the year in order to be considered a qualifying distribution.
When and how is the excise tax paid in?
Excise tax payments are due in quarterly estimated tax payment installments, with 25% of the estimated tax due with each payment. Foundations with more than $1M of net investment income in any of the previous three years must pay in excise tax based on the current year’s net investment income. Foundations that don’t meet this threshold can use the prior year’s tax as the basis for the current year estimated tax payments. Tax payments are made through the Electronic Federal Tax Payment System (EFTPS), either online or by phone. This federal payment system requires advance registration.
If you have any questions regarding the distribution requirement or need assistance with excise tax calculations, please do not hesitate to contact your L&B professional at (858) 558-9200.