Private foundation 5% payout and 1.39% excise tax

A private foundation is a 501(c)(3) organization funded mainly by one person, family or company. In exchange for the tax benefits its donors receive, the law asks two things of it every year: pay a small tax on its investment income, and actually distribute money for charitable purposes. Both are computed on the Form 990-PF.

The 1.39% excise tax on net investment income

Section 4940 imposes a tax of 1.39% on the net investment income of a domestic private foundation that is exempt under section 501(a). The rate was 2% until a 2019 law change lowered it for tax years beginning after December 20, 2019.

Net investment income is gross investment income (interest, dividends, rents, royalties and similar income) plus capital gain net income, minus the ordinary and necessary expenses of producing it. Tax-exempt interest on government bonds is left out, and so is income already taxed on Form 990-T as unrelated business income.

A few points to keep in mind:

• Exempt operating foundations that meet the requirements of section 4940(d)(2) may owe no tax.
• Taxable private foundations and section 4947(a)(1) nonexempt charitable trusts pay a modified 1.39% tax under section 4940(b).
• Estimated tax. If the foundation expects its section 4940 tax (minus credits) to be $500 or more, it must make estimated tax payments during the year. For a calendar-year foundation, the first deposit is generally due by May 15. Form 990-W is used to figure the installments.
• Extensions don't defer payment. Any balance is due by the return's original due date, even with a Form 8868 extension.

The 5% minimum investment return

The payout rule starts with the minimum investment return, computed in Part IX of the 990-PF. It is 5% of the fair market value of the foundation's noncharitable-use assets (essentially its investments), after two subtractions.

Which assets count

Include assets held for investment or the production of income, even if the income is spent on charity. Leave out assets used directly in charitable activities, such as a building the foundation uses to run a program. Property used 95% or more for charitable purposes is treated as entirely charitable-use; below that, the use is allocated. Pledges and future interests in estates and trusts are excluded.

How values are measured

• Securities: the average monthly fair market value, using any reasonable method applied consistently (for example, month-end closing prices).
• Cash: the average of monthly balances, using the first and last day of each month.
• Other assets: valued annually. Real estate can be valued every five years with a certified, independent appraisal.
• Blockage discounts on securities are limited to 10% and must be explained.

The two subtractions

1. Acquisition indebtedness on the assets, meaning debt incurred to acquire or improve them.
2. Cash deemed held for charitable activities, generally 1.5% of the net asset value. A foundation that can show it needs more cash for current charitable expenses can use a larger amount with an explanation.

For a short tax year, the 5% is prorated by days.

The distributable amount

The distributable amount (Part X) is the minimum investment return, minus the section 4940 excise tax and any income tax (such as unrelated business income tax) for the year, plus recoveries of amounts previously treated as qualifying distributions, such as a grant returned to the foundation.

Qualifying distributions

Qualifying distributions (Part XI) are amounts spent or set aside for charitable purposes. They include:

• Grants to public charities and other charitable recipients
• Reasonable administrative expenses of carrying out charitable activities, such as staff time spent reviewing grants
• Program-related investments, such as a below-market loan to a charity
• Amounts paid to acquire assets used directly in charitable activities
• Set-asides for a specific project to be paid within 60 months, which require either advance IRS approval (the suitability test) or meeting the cash distribution test

Expenses of producing investment income, such as investment management fees, are not qualifying distributions. A grant to another private foundation counts only if that foundation passes the money through as its own distribution out of corpus by the end of its next year.

The deadline and the 30% tax

The distributable amount for a year must be paid out as qualifying distributions by the end of the following tax year. The instructions put it plainly: the 2025 distributable amount must be distributed by the end of 2026.

Qualifying distributions are applied first to the prior year's undistributed income, then (by election) to earlier years or to corpus, and then to the current year. Whatever is still undistributed at the start of the second year faces an initial tax of 30% under section 4942(a), reported on Form 4720. If the shortfall still isn't distributed by the end of the correction period, an additional tax of 100% applies.

Carrying over excess distributions

If qualifying distributions for a year are more than the distributable amount, the excess becomes a carryover available for the next five years. It is applied oldest first, and only to the extent a later year's distributable amount isn't already covered by that year's own distributions. Unused carryovers expire after five years. A foundation can't use a corpus election to manufacture a new excess.

Private operating foundations

A private operating foundation runs its own charitable programs (a museum, a research center) rather than mainly making grants. It must spend at least 85% of the lesser of its adjusted net income or its minimum investment return directly on the active conduct of its exempt activities, and also meet an assets, endowment or support test (Part XIII). Operating foundations aren't subject to the 30% tax on undistributed income and skip the distributable amount computation, though they still compute the minimum investment return. Excess distributions can't be carried into a year in which the foundation is an operating foundation.

Getting the numbers right

Most problems come from late valuations, forgotten cash accounts, or treating investment fees as charitable spending. Track qualifying distributions during the year against an estimate of the distributable amount so you have time to make up a shortfall. Our payout calculator gives a quick estimate.

990IRS.com is a private company, not the IRS. This page is general information, not legal or tax advice for your organization. Example organizations and figures are hypothetical.