With 2018 coming to a close, now is the time for private foundations to start thinking about their year-end tax strategies.
Tax reform has been a focus this year because most provisions became effective January 1, 2018. While there are very few changes specific to private foundations, the Moss Adams Not-for-Profit Practice has summarized some of the key tax laws and opportunities that do.
Minimum Distribution Requirement
Internal Revenue Code (IRC) Section 4942 imposes a minimum distribution requirement on nonoperating private foundations and an excise tax on foundations that fail to meet this requirement.
- 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.
Such distributions must be made by the end of a foundation’s succeeding tax year. For example, if the undistributed requirement for 2017 was $500,000, qualifying distributions of $500,000 must be made by the end of the 2018 tax year.
Foundations will want to calculate whether they’ve met the minimum distribution requirement for prior years by the end of the 2018 tax year. If not, they should make final qualifying distributions before the last day of the tax year to avoid the excise tax.
Foundations may also want to consider incorporating the current year and future years’ minimum distribution requirements into their planning strategies.
Reduced Tax Rate
We’ve gone 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 in the current tax year to cut its tax liability. Strategic planning and projections can help determine how this could affect future years.
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 the 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 a tax year. Such losses can’t go below zero for private foundations, however, regardless of whether they’re set up as corporations or trusts.
This means if capital losses exceed capital gains in a tax year, the excess may not offset gross investment income in that year. The excess can’t be carried back or carried forward to offset gains in prior or future tax years either.
A foundation will want to review its portfolio to determine whether it would be beneficial to trigger capital gains before the end of the year to offset excess capital losses.
Depending on the circumstances, a foundation could repurchase the sold assets or buy replacement investment assets, which would result in a stepped-up tax basis that would reduce the future gain when the investment asset is eventually sold. Alternatively, a foundation 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.
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.
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 prior tax law, a foundation paid 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 was structured.
Final tax reform legislation now requires UBI activities be reported separately rather than netted with tax paid on the net of each activity. This means foundations need to track UBI activities separately and track net operating losses (NOLs) by activity rather than in total.
Guidance was released in IRS Notice 2018-67 to provide interim and transition rules relating to the new UBI tracking and reporting requirements. It specifies foundations may use a reasonable, good faith interpretation, including the North American Industry Classification System 6-digit codes, pending issuance of proposed regulations.
As it relates to interests in partnerships as investing activities of a foundation, a foundation can aggregate its UBTI from its interest in a partnership with multiple trades or businesses—including those conducted by lower-tier partnerships—if the de minimis or control tests are met, as detailed below:
- De minimis test is met if a foundation and its disqualified persons, controlled entities, or related supporting organizations directly hold no more than 2% of the profits or capital interest in a partnership.
- If the de minimis test isn’t met, the control test may still apply if a foundation and its disqualified persons, controlled entities, or related supporting organizations directly hold no more than 20% of the capital interest and don’t have control or influence over the partnership.
Further, a foundation with many investment partnership interests may aggregate together as one UBI activity any interests that meet the de minimis or control test. These tests can be applied to debt-financed activities of partnership interests as well.
Corporate Tax Structure
Tax reform created a more simplified corporate tax rate structure, lowering the rate to a flat 21% tax rate for all corporations as well as lowering the tax-rate brackets for trusts. Because of this, foundations that generate UBTI may stand to benefit.
Certain disallowed fringe benefits provided to employees are now subject to reporting as UBTI by foundations. The cost of providing these benefits on behalf of employees remains nontaxable to employees but now creates a Form 990-T reporting requirement and mandates the 21% corporate rate for any private foundations offering them.
Fringe benefits affected by this change include the following:
- Qualified transportation—bus passes and , for example
- Qualified parking—the cost of parking spaces if leased from a third-party parking provider, which also includes employees’ pre-tax payment for parking passes and parking facility costs
- On-site athletic facilities—if facility use is limited to upper management or highly compensated employees
Although there’s currently no guidance, the IRS is required to provide guidance on the calculation of qualified parking facility costs, such as paving, striping lines, maintaining parking spaces, allocating lot security, and lighting. For more information, check out our Alert.
Net Operating Losses
Final tax reform affects NOLs in a number of ways:
- The carryforward period is indefinite rather than limited to twenty years.
- The opportunity to carryback losses has been removed for those losses generated in years starting after December 31, 2017.
- Losses generated are now limited to offset taxable income in a given year to 80% of taxable income rather than 100%.
- Losses generated before January 1, 2018, can be used to offset 100% of taxable income and other UBI activities until exhausted.
Foundations with alternative investments or interest in foreign organizations may now be subject to the IRC Section 965 transition tax. IRS Notice 2018-67 includes guidance clarifying that for a private foundation, Subpart F income is a dividend reportable as net investment income subject to the 1% or 2% excise tax, and if debt-financed, may instead be reportable as UBTI. This applies to foundations having a calendar year 2017 or fiscal year beginning in 2017.
Additionally, a one-time IRC Section 965 transition tax may be payable with a foundation's 2017 UBI tax return.
Newman’s Own Exception
The Bipartisan Budget Act of 2018 was signed into law on February 9, 2018. Included in the act is an exception to the excess-business-holdings rule that states the tax on excess business holdings of a private foundation doesn’t apply to independently operated, philanthropic business holdings after December 31, 2017. Generally, three tests must be met in order to qualify for this exclusion:
- Ownership of 100% of the voting stock is held by the foundation at all times throughout the year and was acquired by means other than purchasing.
- All profits go to charity.
- The foundation is an independent operation in terms of , employee, or trustee positions.
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 as well as one of the following alternative tests:
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.
We’re Here to Help
Moss Adams provides a range of services to not-for-profits that can help address tax compliance and consulting issues. A private-foundation planning analysis is capable of looking up to 20 years into the future and can help you plan for you for your minimum distribution requirements.
Planning Analysis Benefits
- Gain insight into 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 strategy, contact one of our tax professionals or email us.