With 2019 coming to a close, now is the time for private foundations to think about their year-end tax strategies.
Tax reform continues to be a focus this year because most provisions became effective January 1, 2018. Below are some of the key tax laws and opportunities that affect private foundations.
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.
Qualified distributions include the following:
- Expenses incurred directly in carrying out a foundation’s charitable purpose
- Reasonable and necessary administrative expenses incurred while implementing a 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 a 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 to maintain a 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 2018 was $500,000, qualifying distributions of $500,000 must be made by the end of the 2019 tax year.
Foundations will want to calculate whether or not they’ve met the minimum distribution requirement for prior years by the end of the 2019 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
Charities Helping American Regularly Throughout the Year (CHARITY) Act (S. 1475) was reintroduced in the US Senate May 2019. The act encourages charitable giving, expands the IRS charitable rollovers to include donor-advised funds (DAFs), and attempts to simplify the private foundation excise tax to a flat rate.
However, there’s yet to be a 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:
- The foundation 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.
- The foundation 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. However, such losses can’t go below zero for a private foundation, regardless of whether it’s set up as a corporation or trust.
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 forward to offset gains in prior or future tax years either.
A foundation will want to review its portfolio to determine if it would be beneficial to trigger capital gains before the end of the year to offset excess capital losses to avoid losing the benefit of these losses.
Depending on the circumstances, a foundation could repurchase the sold assets or buy replacement investment assets. This 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
A foundation should periodically review its gift acceptance policy to ensure it covers illiquid gifts and unusual bequests so it’s prepared to address donors who propose these types of gifts, especially at year-end.
A foundation with alternative investments generally receives a Schedule K-1 annually. This form provides necessary information for your tax compliance and planning needs. Alternative investments may do any of the following:
- Generate unrelated business income that may need to be reported on a Form 990-T
- Generate state tax liabilities or filing requirements
- Trigger one or more foreign disclosure filings, such as Forms 926, 8865, or 8621
A foundation should seek assistance in determining what income tax liabilities it may be subject to, what filings may be required, and whether or not 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 each unrelated trade or business activity be reported separately rather than netted with tax paid on the profitable activities. This means a foundation needs 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 that a foundation may use a reasonable, good-faith interpretation, including the North American Industry Classification System six-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 that has multiple trades or businesses—including those conducted by lower-tier partnerships—if the de minimis or control tests are met and the partnership interest was held as of August 21, 2018:
- 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.
- The control test is met 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 more than one investment partnership interest may aggregate together as one trade or business any interests that meet the de minimis or control test.
Corporate Tax Structure
Tax reform created a 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. Foundations that generate UBTI may stand to benefit from this change.
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 corresponding tax for any private foundations offering them.
Fringe benefits affected by this change include the following:
- Qualified transportation—bus passes and van pools, for example
- Qualified parking—the cost of parking spaces owned or leased from a third-party parking provider, which also includes employees’ pretax payment for parking passes and parking facility costs
- On-site athletic facilities—if facility use is limited to upper management or highly compensated employees
Notice 2018-99 provides interim guidance to help taxpayers compute the increase in their UBTI under Section 512(a)(7). It suggests any reasonable method may be used but includes a safe-harbor approach as part of a four-step methodology set forth in the notice for qualified parking provided in spaces owed by the foundation or leased from a third-party.
For example, if a foundation pays a third party $5,000 for the year for parking spots provided to foundation employees, the foundation has UBTI of $5,000 to include on Form 990-T. The result is the same if the foundation allows employees to purchase these same spots with pretax earnings.
However, if the amount the taxpayer pays to the third party for parking spaces or transit passes exceeds the Section 132(f)(2) monthly limitation, which for 2018 was $260 per employee and increased to $265 per employee for 2019, that excess amount must be treated by the taxpayer as compensation and wages to the employee.
The notice provides that for a parking facility owned or leased by the taxpayer, the lost deduction is related to the expense related to the facility. These expenses include, but aren’t limited to, the following:
- Repairs and maintenance
- Property taxes
- Snow or leaf removal and other landscape costs
- Utility costs
- Parking lot attendant expenses
- Rent or lease payments or a portion thereof
Depreciation isn’t an expense for this purpose.
The notice doesn’t provide a specific method for determining the amount of an employer’s expenses associated with the parking facility. This means that when the lease and overhead expenses aren’t bifurcated between the office space and parking facility, any reasonable method may be used to allocate the associate costs. For more information, read our Alert.
Net Operating Losses
Tax reform affected NOLs in several ways:
- The carryforward period is indefinite rather than limited to 20 years.
- The opportunity to carryback losses has been removed for those losses generated in years starting after December 31, 2017.
- New losses generated are limited to offsetting taxable income in a given year to 80% of taxable income rather than 100%, and can only be used to offset taxable income from the trade or business that generated the NOL.
- Losses generated before January 1, 2018, can be used to offset 100% of taxable income from any source, including qualified transportation and parking benefits, until exhausted.
The US Department of the Treasury and the IRS issued final regulations for global intangible low-taxed income (GILTI), which taxes US shareholders and controlled foreign corporations (CFCs) on their share of intangible income if that income was subject to a low local tax rate.
For reporting purposes, GILTI is considered a deemed dividend and therefore generally excluded from UBI. However, even if the inclusion isn’t UBI and doesn’t create an income tax liability, additional international filings may be required—such as Form 5471—for taxable years after December 31, 2017. For private foundations, the deemed dividend created by the GILTI inclusion is subject to net-investment income tax.
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 board, 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 or not it qualifies as a private operating foundation. Two annual tests are required for operating status, an income test as well as one of these 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 two and a half 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
A planning analysis can help your foundation:
- 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 can provide a full 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 your Moss Adams professional.