Despite being exempt from federal income tax under Internal Revenue Code Section 501(a) as organizations described in Internal Revenue Code Section 501(c)(3), private foundations are subject to an excise tax on their net investment income under the special tax rules that apply to private foundations. Generally, the tax is 2 percent of the foundation’s net investment income. The tax may be reduced to 1 percent in certain circumstances if the foundation makes a certain level of distributions.
This tax has been getting attention in Congress. The America Gives More Act of 2014, which was passed by the U.S. House of Representatives on July 17, 2014, would simplify the private foundation tax on net investment income by replacing the current two-tier tax with a single rate of 1 percent. On Feb. 26, 2014, Rep. Dave Camp, R-MI, the chairman of the U.S. House of Representatives’ Ways and Means Committee, released a discussion draft of a Tax Reform Act of 2014. Included among the reforms impacting tax-exempt organizations is a provision simplifying the current tax on a private foundation’s net investment income by replacing it with a single, 1 percent tax rate. The draft law, however, would expand the tax so it applied not only to private non-operating and private operating foundations, but also to “exempt” operating foundations, which currently are excluded from the tax.*
Because of the uncertainty of any future tax reform, private foundations are best served through a clear understanding of the current structure of the net investment income tax, the difficulties involved with determining the amount of tax under the tiered system, the requirements for making estimated tax payments, and the possibilities for tax planning in this area.
Imposition of Tax on Net Investment Income. Under the private foundation rules, a private foundation is subject to a tax each year equal to 2 percent of its net investment income ( I.R.C. § 4940(a)). Net investment income is the amount by which the private foundation’s gross investment income and capital gain net income exceed the deductions allowed (I.R.C. § 4940(c)(1)).
A private foundation’s gross investment income includes interest, dividends, rents, royalties, and payments with respect to securities and loans, as well as income from similar sources, such as annuities, notional principal contracts, and other similar investment income. These types of income are subject to tax regardless of source. This means that this type of income is subject to tax whether it is earned on investment assets or exempt function assets.
For purposes of determining the private foundation’s capital gain net income, certain rules apply. First, gain or loss from the sale or other disposition of property is not taken into account as capital gain net income if it is already taken into account for purposes of computing tax imposed under the unrelated business income tax rules of Internal Revenue Code Section 511. Second, losses from the sale or other disposition of property are allowed only to the extent of gains from sales or other dispositions of property, and no capital loss carryovers or carrybacks are permitted (I.R.C. § 4940(c)(4)(A), (C)).
Allowed deductions are all of the ordinary and necessary expenses paid or incurred for the production or collection of gross investment income or for the management, conservation, or maintenance of property held for the production of such income, with certain modifications (I.R.C. § 4940(c)(3)(A)). These expenses include that portion of the private foundation’s operating expenses that are paid or incurred for such purposes (Treas. Reg. § 53.4940-1(e)(1)(i)). Operating expenses include compensation of officers, other salaries and wages of employees, outside professional fees, interest, and rent and taxes on property used in the private foundation’s operations. If the foundation’s officers or employees engage in activities on behalf of the private foundation for both investment purposes and exempt purposes, the compensation and salaries paid to such officers or employees must be allocated between the investment activities and the exempt activities (Treas. Reg. § 53.4940-1(e)(1)(i)). As a general rule, a private foundation cannot deduct the expenses attributable to its grant-making or other charitable activities.
Reduction of Excise Tax from 2 Percent to 1 Percent. If a private foundation meets certain requirements, the excise tax imposed on its net investment income in a particular tax year will be reduced from 2 percent to 1 percent (I.R.C. § 4940(e)(1)). The purpose of this reduction in the excise tax rate is to permit a private foundation that maintains a certain level of distributions to benefit from the reduced tax rate. It essentially permits the private foundation to distribute 1 percent of its net investment income to charitable organizations rather than pay a tax of such amount to the federal government.
To qualify for this reduction, the private foundation must meet both of the following requirements.
- The amount of the private foundation’s qualifying distributions for the tax year at issue equals or exceeds the sum of:
- an amount equal to the value of the private foundation’s assets for that year multiplied by the average percentage payout for the base period, and
- 1 percent of the private foundation’s net investment income for that year.
- The private foundation was not liable for any tax under the private foundation minimum distribution rules for failure to meet its minimum distribution requirements during any year of the base period (I.R.C. § 4940(e)(2)).
For purposes of these requirements, the term “average percentage payout” for the base period is the average of the percentage payouts for the tax years in the base period. The percentage payout, with respect to any particular tax year, is determined by dividing the amount of the qualifying distributions made by the private foundation during the tax year by the value of the assets of the private foundation for that tax year as determined for purposes of the minimum distribution rules. When making this calculation, if the excise tax is reduced from 2 percent to 1 percent in any given year, the amount of the private foundation’s qualifying distributions during such tax year must be reduced by the amount of the reduction in excise tax (I.R.C. §§ 4940(e)(3), 4942(e)(1)). The base period with respect to any tax year is the five tax years preceding such tax year (I.R.C. § 4940(e)(4)(A)).**
Basically, to qualify for the reduction in the excise tax rate (from 2 percent to 1 percent), the private foundation must make a required amount of qualifying distributions. The calculation for determining whether the private foundation has made the required amount of qualifying distributions can be summarized by the following formula:
(Amount of Foundation’s Assets for Tax Year) x (Average Percentage Payout for Base Period)
1 Percent of Foundation’s Net Investment Income for Tax Year
Required Amount of Qualifying Distributions
If the private foundation’s qualifying distributions for the current year (which must be made on or before the last day of the current year) equal or exceed the required amount of qualifying distributions as calculated using the above formula, the private foundation qualifies for the reduction in net investment income tax from 2 percent to 1 percent.
Tax Planning. Because the formula for determining qualification for the reduction in the excise tax rate relies in part upon the average fair market value of the private foundation’s assets during the year (including the value on the last day of the year), it can be difficult to plan to make enough distributions to qualify for the reduction in tax. These difficulties may be minimal, however, if the value of the foundation’s assets does not usually fluctuate significantly during the year.
Because of the difficulty in planning for a reduction in the tax, some private foundations explore other options for reducing the tax. One option that might be appropriate in certain circumstances is a distribution of appreciated property to a qualifying charity in advance of a sale so that gain is not recognized by the private foundation. The distribution of appreciated property to a qualifying charity is not a realization event and will be counted at the property’s fair market value for the purposes of the private foundation minimum distribution rules.
Estimated Tax Payments. The rules regarding the timing and amount of estimated tax payments for private foundations are the same rules that apply to corporations, regardless of whether the private foundation is organized as a corporation or a trust (I.R.C. § 6655(g)(3)). A private foundation may be subject to making estimated tax payments, not only for the excise tax on its net investment income, but also for the tax on any unrelated business taxable income.
If a private foundation expects its aggregate tax to be less than $500, the foundation may simply attach a check or money order annually to its Form 990-PF or Form 8868 or may voluntarily make a deposit by electronic funds transfer (I.R.C. § 6655(f)). If the foundation expects its tax to be $500 or more, it must make quarterly estimated payments of the excise tax on its net investment income (as well as any unrelated business taxable income) using depository receipts (I.R.C. § 6655(c)(1)).
Under final regulations issued in late 2010, private foundations must deposit all depository taxes (including excise taxes) electronically using the Electronic Federal Tax Payment System (EFTPS) (Treas. Reg. §S 1.6302-1, 31.6302-1(h)). For deposits made by EFTPS to be timely, the foundation must initiate the transaction at least one business day before the date when the deposit is due.
The first deposit must be made by the 15th day of the fifth month following the end of the taxable year, which for calendar-year foundations is May 15th (I.R.C. § 6655(c)(2)). The second, third, and fourth payments must be made on the 15th day of the sixth, ninth, and twelfth months, respectively (I.R.C. § 6655(c)(2)). If any due date falls on a Saturday, Sunday or legal holiday (as determined by the District of Columbia legal holidays), then the next business day is substituted (I.R.C. § 7503). Penalties are imposed for failure to deposit taxes on time (I.R.C. § 6656(a), (b)).
Penalties for Underpayments of Estimated Tax. A private foundation that does not pay the proper estimated tax when due may be subject to a penalty for the period of any underpayment (I.R.C. § 6655(a), (b)). The foundation must determine the amount of the penalty on Form 2220 (Underpayment of Estimated Tax by Corporations) and attach the form to its Form 990-PF. The IRS does not have the authority to waive the penalty for underpayment of estimated taxes.
Computation of Estimated Taxes. A private foundation must estimate its excise tax liability based upon its estimated net investment income to determine how much estimated tax to pay each year. A private foundation uses Form 990-W to compute the timing and amounts of the estimated tax installment payments. (This form also is used, separately, to compute the timing and amounts of the estimated tax installment payments attributable to the foundation’s unrelated business taxable income, if any.) The federal tax laws provide four methods for computing the amount of a quarterly installment of estimated excise tax, and a foundation may select the method producing the lowest amount.
Under the first method, the amount of the installment is simply 25 percent of the amount of the tax for the entire current taxable year. A foundation using this method has the disadvantage of not knowing what the tax will be for the entire year when the installments are due. If the foundation fails to correctly estimate the installments, it will be liable for penalties for the underpayment of estimated taxes.
With the second method, the amount of the installment is 25 percent of the tax shown on the return for the preceding taxable year. This method may not be used if the foundation’s prior taxable year was less than 12 months or the foundation had no tax due with its prior return. Also, a large foundation, which is defined as a foundation whose net investment income was $1 million or more for any of the last three taxable years immediately preceding the current year, may only use this method for determining the amount of the first installment of the current taxable year. A small foundation using this method can avoid any penalties for underpayment of estimated tax by paying 100 percent of the prior year’s tax liability in equal quarterly installments. Most foundations that have difficulty estimating the current year’s tax liability will rely on this safe harbor.
The third method requires the foundation to determine its required installment payment based on 100 percent of the tax on the annualized taxable income for the period before the installment due date (I.R.C. § 6655(e)(2)(A), (C)(i)). The fourth method is the same as the third method except it uses the adjusted seasonable income (I.R.C. § 6655(e)(3), (g)(3)(C)). If a foundation uses the third or fourth method for computing an installment payment and later uses the first or second method to compute an installment in the same year, the installment must be increased by any tax savings from the use of the third or fourth method in computing the prior installment (I.R.C. § 6655(e)(1)).
Because a large private foundation may not use the second method for the second, third, and fourth installments, the estimated tax must be projected based on the actual income and deductions earned through the end of each quarter. The number of months used to make the projections depends on whether the foundation chooses the regular periods under Internal Revenue Code Section 6655(e)(2)(A) or the alternative periods under Internal Revenue Code Section 6655(e)(2)(C)(i), as modified by Internal Revenue Code Section 6655(g)(3).
Estimated Tax Challenges Facing Private Foundations. A private foundation can face a number of challenges when calculating its estimated tax payments. For example, the private foundation may expect to pay the 1 percent tax instead of the 2 percent tax. As previously discussed, the foundation may not be able to ensure that it qualifies for the 1 percent tax rate because the qualification for the reduced rate depends upon asset values as of the end of the year. If the foundation estimates its taxes using the 1 percent rate and then fails to qualify for the reduced rate, the foundation will face penalties for the underpayment of estimated taxes.
Determining the estimated net investment income from certain types of investments, such as hedge funds and other investment partnerships, can be difficult. Some investment funds provide the required Schedule K-1 several months after the end of the tax year, but also provide quarterly information, including dividends and interest and realized gains and losses. These quarterly reports can assist the foundation in estimating its net investment income attributable to the investment. Other investment funds, however, may issue reports only on an annual and delayed basis making it difficult for the foundation to estimate its net investment income throughout the year and preventing an accurate determination of the estimated taxes the foundation should pay throughout the year.
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*An exempt operating foundation is a special type of private operating foundation. Usually, these foundations devote their assets to operating a charitable program (such as a museum or library) but cannot meet the public support test for classification as a publicly supported organization. To qualify as an “exempt” operating foundation, the organization must be a private operating foundation, must be publicly supported for at least 10 taxable years, must have a governing body that is broadly representative of the general public and that has no more than 25 percent of its members be disqualified persons with respect to the foundation, and must have no officers who are disqualified persons.
** If the foundation has not yet been in existence for five taxable years, the calculation uses the number of previous years in existence. Thus, a foundation cannot qualify for the reduction in its first year because it has no previous taxable years.