Taxation of Private Non-Operating Foundations
Steven Singer, CPA
IRS Section 501(c)(3) is the section of the tax code that defines
nonprofit, charitable (as broadly defined), tax-exempt organizations; 501(c)(3)
organizations are further defined as public charities, private operating foundations,
and private non-operating foundations. I wanted to take this opportunity to describe
how the IRS taxes private non-operating foundations.
Investment income (e.g. dividends, interest & net capital gains) is usually
subject to an excise tax of 2%. The percentage can be reduced to 1% of net investment
income if your current year's qualifying distributions (e.g. amounts the Foundation
makes to other 501(c)(3) charitable organizations) less (l% of your net investment
- The yearly ratio for the five previous years of (the amount of qualified distributions)
- (98.5% of the year's average monthly fair market value of assets held by the Foundation)
added together and divided by five
- average distribution ratio x
- 98.5 % of the average fair market value of current year's assets held by the Foundation
- plus 1% of the current year's investment income
If you thought that your legislator had nothing better to do, just consider how long
it took them to come up with this absurd formula.
The Foundation is required to make minimum qualifying distributions to other 501(c)(3)
organizations. Failure to do so may result in an additional excise tax of 30% of
the amount not distributed. This % ratchets up to more than 100% of undistributed
amounts if IRS issues a deficiency notice or repeated failure to distribute income.
If applicable, The Foundation may correct this situation by making additional qualifying
distributions of the previous year's undistributed income in the following year.
The Minimum distribution amount is:
- 4.925% of the current year's monthly average fair market value of the Foundation's
- the current year tax on investment income
Basis of Contributed Securities
Contributions of appreciated securities to the Foundation increase the individual's
charitable deduction. However, the basis of the security in the hands of the Foundation
is the donor's cost basis. As a result, when the Foundation sells the asset, they
pay tax on difference between the FMV on date of sale and the donor's cost basis.
Reducing the Distribution Ratio - Option 1
By reducing the distribution ratio, the Foundation may make smaller qualifying distributions
and still qualify for the lower 1% excise tax rate.
Increasing Distributions in Years That You Have High Investment Income - Option 2
By increasing your qualified distributions to other 501(c)(3) organizations in years
that you are anticipating high net investment income, you can also reduce the current
tax rate to 1%.
For example, if you choose to make $5,300,000 in the current year, you can reduce
the rate to 1% and make smaller qualifying distributions in the next couple of years
when investment income is lower and be taxed at the higher 2% rate.
Qualifying Distributions-Set Asides
You can also accomplish making additional qualified distributions by "borrowing"
from future qualified distributions. If you "set aside" funds and make commitments
to other 501(c)(3) organizations for future grants, these grants can qualify in
the current year. However, since they are "borrowed" they are not allowed when the
cash donation is made in future years.
Capital Losses and Capital Loss Carryforwards
Foundations are not allowed capital loss carryforwards. Net capital losses for the
current year also are not available to offset current year net investment income.
Therefore, timing is critical to make sure that capital gains can be offset with
2006 Pension Act - Qualifying Distributions
On August 17, 2006, the 2006 Pension Act was passed that may impact the types of
qualifying distributions that the Foundation makes to other charitable organizations.
A private foundation may not count as a qualifying distribution any amount paid
to (i) a Type III supporting organization that is not a functionally integrated
Type III supporting organization or (ii) any other supporting organization if a
disqualified person with respect to the foundation directly or indirectly controls
the supporting organization or a supported organization of such supporting organization.
The grant to such supporting organizations will also be a taxable expenditure unless
expenditure responsibility is exercised.
Supporting organizations are legitimate public charities whose legal structure is
formed under the auspices of a parent public charity (the parent is the "supported"
organization). Supporting organizations are one of three types (I, II or III) relating
to the degree of control the parent has over the supporting organization. The type
can be hard to determine from public documents such as the organization's 990, so
additional information from the grantee may be required. Some supporting organizations
are known as "functionally integrated" with the parent, such as a blood bank operated
with a hospital or an endowment operated under a college. Foundations would immediately
be prohibited from making a grant to any Type III supporting organization that is
not "functionally integrated." Foundations would also be prohibited from giving
grants to Type I or II supporting organizations if foundation insiders also control
the supporting organization's parent.
If you wish to learn more about these exemptions and how they apply in your
situation, please contact
Steven Singer at 510-797-8661 or email him at