2017 Private Foundation Tax Planning Guide

With 2017 coming to a close, now is the time for private foundations to start thinking about their year-end tax strategies.

Although tax reform continues to be a focus for the Trump administration, there are very few proposed changes that would affect private foundations. To help you develop a plan that works for your foundation, the Not-for-Profit Practice at Moss Adams has summarized some of the key tax laws and opportunities specific to private foundations.

Minimum Distribution Requirement

Internal Revenue Code Section 4942 imposes a minimum distribution requirement on nonoperating private foundations and an excise tax on foundations that fail to meet this requirement.

Qualifying Distributions

  • 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
  • Acquisition costs of 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

Qualifying distributions are determined on the cash receipts and disbursements method of accounting, regardless of the accounting method used in maintaining the foundation’s books and records. Foundations should calculate whether they have met the minimum distribution requirement for the tax year. If not, they should make any final qualifying distributions before the last day of the tax year to avoid the excise tax. Foundations should also consider incorporating future years’ minimum distribution requirements into their planning strategies.

Reduced Tax Rate

We’ve gone yet another year with no change in the tiered tax structure for private foundations. Under current tax law, which remains the same, a foundation can reduce its tax rate on net investment income from 2% to 1% if both of the following are true:

  • It makes qualifying distributions during the tax year of an amount at least equal to the fair market value of its assets for the year multiplied by its average percentage payout for the previous five years plus 1% of its net investment income for the year.
  • It wasn’t liable for the excise tax for failure to distribute income for any of the previous five years.

A private foundation may want to review its activities and consider accelerating amounts deductible under the minimum required distribution to the current tax year in order to cut its tax liability. Strategic planning and projections can help determine how this could affect future years.

Excess Distributions

A private foundation that’s distributed more than its minimum required distribution in a previous year may have an excess distribution carryforward, but it must be used within five years. Having a strategic plan in place can be invaluable in determining what steps a foundation can take to increase the use of any carryforwards.

Capital Gains and Losses

Net capital gains are added to net investment income used to calculate a foundation’s excise tax.

Capital losses from the sale (or other disposition) of investment property can reduce capital gains recognized during the tax year, but it can’t go below zero for private foundations set up as corporations rather than trusts. This means if capital losses exceed capital gains in a tax year, the excess may not offset gross investment income in that year, nor can it be carried back or carried forward to offset gains in prior or future tax years.

Your foundation should review its portfolio to determine whether you want to trigger capital gains before the end of the year to offset excess capital losses. Depending on the circumstances, your foundation could then repurchase the sold assets or buy replacement investment assets, which would result in a stepped-up tax basis that will reduce the future gain when the investment asset is eventually sold. Alternatively, you may want to trigger losses to offset capital gains.

Privately Held Stock and Highly Appreciated Property

Some exceptions notwithstanding, donors are limited in the charitable deductions allowed for certain privately held stock and highly appreciated property. Donating property encumbered with debt may require a donor to pay a self-dealing tax, and a foundation is forbidden from entering into a sale or exchange with a disqualified person, even if the sale price is less than the full market value.

Liquidity Issues

A private foundation may face a liquidity dilemma if it holds a large amount of privately held stock or other non–income producing assets. If these assets are held for investment, they’re included in the minimum required distribution calculation and may not produce sufficient income to satisfy the foundation’s annual payout requirements. This issue should be considered prior to accepting gifts, and the illiquid holdings should be reviewed annually for liquidity concerns.

Appreciated Asset Grants

A private foundation could consider granting an appreciated asset, such as a publicly traded security, to a public charity instead of selling the asset and granting cash. By doing this, the foundation would avoid the excise tax on the security’s inherent capital gain while still making a grant equal to the asset’s fair market value.

Gift Acceptance Policy

Foundations should periodically review their gift acceptance policy to ensure it covers illiquid gifts and unusual bequests so they’re prepared to address donors who propose these types of gifts, especially at year-end.

Alternative Investments

Foundations with alternative investments generally receive Schedule K-1s annually. These provide necessary information for your tax compliance and planning needs. The investments may generate unrelated business income that may need to be reported on a Form 990-T, could generate state tax liabilities or filing requirements, or could trigger one or more foreign disclosure filings, such as Forms 926, 8865, or 8621.

Foundations should seek assistance in determining what income tax liabilities they may be subject to, what filings may be required, and whether any estimated income tax payments should be made before year-end.

Unrelated Business Taxable Income (UBTI)

Under current tax law, a foundation pays tax on the net of all taxable unrelated business income (UBI) activities at either the corporate or trust income tax rates, depending on how the foundation is structured. 

Tax Reform

Proposed tax reform would require that UBI activities be reported separately rather than netted with tax paid on the net of each activity. If this proposed change were to result in a formal change to tax law, foundations would need to track UBI activities separately and track net operating losses (NOLs) by activity rather than in total.

Proposed tax reform could also create a lower and more simplified corporate tax rate structure, which would benefit foundations that are set up as corporations and generate UBTI.

Net Operating Losses

Under current tax law, if a foundation generates UBTI and an NOL was generated for 2016 or is projected for 2017, the foundation will want to consider whether the loss should be carried forward to future years or carried back to prior years. Refunds can be claimed for taxes paid on a prior-year Form 990-T by filing an amended return, or the loss can be carried forward to offset future UBTI.

Tax Reform

Proposed tax reform could affect net operating losses in a number of ways:

  • Make the carryforward period indefinite rather than limited to twenty years
  • Remove any opportunity to carryback losses
  • Limit losses to offset taxable income in a given year to 90% of taxable income rather than 100%

Private Operating Foundation Status

Similar to public charities, private operating foundations provide better tax treatment for donors than private foundations and aren’t subject to the minimum required distribution.

If a foundation directly conducts charitable activities, it should evaluate whether it qualifies as a private operating foundation. Two annual tests are required for operating status: an income test and an asset, endowment, or support test. Both tests must be met in three of the four most recent tax years or in the aggregate over those four years.

Private foundations seeking to qualify as a private operating foundation should project if they’ll pass the tests and determine if any steps are required before or after year-end.

Conversion to a Public Charity

A foundation should consider converting to a public charity if it finds itself:

  • Consistently receiving contributions from multiple donors—not just the individual or corporation that founded the foundation
  • Holding fundraising events
  • Meeting the support test as an operating foundation

Public charities provide a more favorable charitable contribution deduction threshold. They also aren’t prohibited from engaging in certain activities with disqualified persons from which private foundations are disallowed.

Conduit Foundation Status

A private foundation qualifies as a conduit foundation for the purpose of donor deduction limits if the foundation makes qualifying distributions within 2.5 months of tax year-end equal to 100% of the contributions received in that same year.

Once qualified as a conduit foundation, donors can adhere to the adjusted gross income limitation of 50% imposed on cash contributions to public charities—rather than the 30% limit for private foundation contributions.

The requirements for treatment as a conduit foundation must be met on an annual basis, and the foundation must have no undistributed income remaining for the tax year in which the status is applied.

Program-Related Investments

In April 2016, the IRS issued final regulations that provide guidance to private foundations on program-related investments (PRIs).  This guidance added nine examples to Section 53.4944-3(b) that make the process of investing easier for the tax-exempt sector.

These examples demonstrated that PRIs may:

  • Accomplish a variety of exempt purposes
  • Fund activities in one or more foreign countries
  • Earn a high potential rate of return
  • Take the form of an equity position in conjunction with making a loan as well as other provisions to qualify as a PRI

Rely on Professionals

Moss Adams provides a range of services for not-for-profits that can help address tax compliance and consulting issues. To help you plan for your minimum distribution requirements, we can also prepare a private foundation planning analysis capable of looking up to 20 years into the future to help you:

  • Gain insight on what it will take, based on your foundation’s goals, to meet payout requirements, reduce your excise tax burden to the lower 1% rate, and comply with applicable regulations
  • Run minimum distribution requirement estimates based on a variety of selection criteria, such as investment return rates or large contributions to the foundation
  • Estimate and utilize excess distribution carryover, especially amid volatile markets

This analysis provides you with a 360-degree view of your foundation’s minimum distribution requirements environment, helping you better manage your distributions as your investment and donor mix evolves. We can also help you navigate the challenges of investing your foundation’s assets.

If you have questions about how to apply any of this information to your foundation or need help with planning, contact one of our tax professionals or email us.