Taxation of Private Non-Operating Foundations

Steve Singer, CPABy 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

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 income) exceeds:

  • The yearly ratio for the five previous years of (the amount of qualified distributions) divided by
  • (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.

Minimum Distributions

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 assets less
  • 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.

Planning Opportunities

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 capital losses.

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