While it may seem like 2015 is just getting into full swing, the end of the year will be upon us before you know it. Now’s the time for private foundations to start thinking about year-end tax planning strategies to help reduce the excise taxes they may be required to pay.
As a starting point, three issues take center stage: minimum distribution requirements, excess distribution carryovers, and excise tax on your net investment income. Let’s take a look at each of the three and what you can do to keep more of your foundation’s assets devoted to your mission rather than taxes.
Minimum Distribution Requirements
One reason to take time now to review your foundation's planned activities for the rest of the year is to avoid being assessed excise tax for failure to make the minimum payout of qualifying distributions required by Internal Revenue Code Section 4942.
First of all, it's helpful to review what expenditures are considered “qualifying distributions.” Here’s a list:
- Expenses incurred directly in carrying out the foundation’s charitable purpose
- Reasonable and necessary administrative expenses incurred while implementing the foundation’s charitable purpose
- Contributions, gifts, and grants paid to individuals and other organizations to accomplish a charitable purpose
- Costs to acquire assets used in the foundation’s charitable activities in the year the assets are acquired or converted to a tax-exempt use
- Increases in program-related investments
With a handle on what a qualifying distribution is, the next question becomes: what’s the minimum amount of distributions required by the IRS? The minimum payout is 5 percent of the net value of noncharitable-use assets. This is a formula-driven equation with a few factors to consider, but it generally amounts to 5 percent of the average fair market value of the foundation's assets for the year.
The minimum payout must be distributed by the end of the next tax year. This means that for calendar-year filers in 2015, the minimum amount must be distributed by the end of 2016. If distributions don’t meet or exceed the minimum, the penalty can be 30 percent of the shortfall. Additionally, the foundation must still make the required distributions, or even harsher penalties could apply.
It's important to note that qualifying distributions are calculated on the cash method of accounting—so eleventh-hour accruals of expenses aren’t allowed. That’s why it’s especially important to look at your giving plan for the remainder of the year now, while there’s still time to make adjustments.
What happens if you've distributed more than the minimum? In this case, your foundation is allowed to carry the excess amount of distributions forward, where they can offset a future year’s minimum payout. This can be a substantial benefit, because it allows flexibility in those years where planned distributions would otherwise be below the minimum requirement. Note that a carryover must be used within five years or it expires, so planning is the key to putting these carryovers to their best use.
Reduced Tax Rate
Generally, private foundations pay a 2 percent excise tax on their net investment income. A foundation can reduce this tax rate from 2 percent to 1 percent if it meets both of the following criteria:
- Its qualifying distributions during the tax year are at least equal to the following calculation: Multiply the fair market value of the foundation’s assets for the year by its “average distribution ratio” for the previous five years. To this figure, add 1 percent of the foundation’s net investment income for the year. The distribution ratio is the ratio of qualifying distributions to the net value of its noncharitable-use assets.
- The foundation wasn’t liable to pay excise tax for failing to distribute income in any of the previous five years.
The idea behind these requirements is that foundations generally receive a tax rate reduction if they continue to make distributions proportionally higher than the year before. While the formula noted above might sound daunting to those not in love with their calculator, implementing a tax strategy to take advantage of the reduced rate might be easier than expected.
We're Here to Help
Review your foundation's planned activities for the remainder of 2015 and 2016 to see how they fit in with the rules and requirements noted above. To help you plan, we can prepare a private foundation planning analysis that peers up to 20 years into the future to help you gain insight on what it would take to meet your payout requirements while reducing your excise tax burden to the lower 1 percent rate. This analysis provides you with a 360-degree view of your foundation's distribution requirement environment and helps you better manage these requirements as your investment and donor mix evolve.
For more information on our private foundation planning analysis or for insight on your foundation’s tax position, contact your Moss Adams professional.