What is the 5% rule for private foundations?
The 5% rule, also known as the minimum distribution requirement, applies to private non-operating foundations. Under this rule, a private foundation must annually distribute at least 5% of the value of its non-charitable-use assets to maintain its tax-exempt status and avoid penalties. This rule ensures that foundations actively support charitable causes instead of simply accumulating wealth. Before this rule was established in 1969, foundations were not obligated to make annual distributions, allowing them to accumulate wealth without necessarily supporting charitable endeavors.
To determine the required annual distribution, private foundations must perform a moderately complex calculation based on the fair market value of their assets. This calculation involves averaging the fair market value of assets over the foundation’s fiscal year. Valuation requirements vary, with public securities valued at their average monthly value and real estate requiring an appraisal at least once every five years. Additionally, only investment and savings holdings are included in the calculation, while assets used directly for charitable purposes, such as a building housing foundation staff or an office printer, are excluded from consideration.
The calculation process allows for certain deductions, such as federal excise taxes paid on investment income, and includes a 1.5% subtraction of the average annual value of the foundation's assets as a representation of a cash reserve. As a result, the final minimum distribution requirement is close to, but not exactly, 5% of the foundation’s average invested endowment for the year. The official calculation must be disclosed on the foundation's annual tax return, Form 990-PF, and the required qualifying distributions must be completed by the end of the following fiscal year.
Here is a visual representation of the calculation
To meet this requirement, private foundations can incur various types of expenses that contribute to their charitable activities and grant-making efforts. These expenses primarily fall into two categories: grants to public charities and operational expenses directly related to charitable activities. Grants to public charities involve providing financial support to other qualified nonprofit organizations aligned with the foundation's mission. These grants can fund programs, projects, or initiatives that address societal needs and promote positive change.
Operational expenses encompass costs incurred by the foundation to manage and execute its charitable programs. Examples of these expenses include staff salaries for employees who work directly on grant-making or program activities, office expenses tied to charitable work, and professional fees for legal, accounting, or consulting services that support charitable operations. However, certain costs, such as investment expenses and investment management fees, typically do not count toward the 5% requirement.
If a private foundation ends up distributing more than the required 5% minimum, it can carry forward the excess amount for up to five years, allowing flexibility in meeting the distribution requirement in future years. On the other hand, failure to distribute the mandatory 5% amount incurs severe financial penalties. If the shortfall is not corrected, the IRS imposes a 30% excise tax on the undistributed amount. The tax continues annually until the deficiency is remedied. Furthermore, persistent non-compliance could endanger the foundation's tax-exempt status and, in extreme cases, lead to the dissolution of the foundation as a recognized charitable organization.
In summary, the 5% rule aims to strike a balance between preserving foundation assets for long-term impact and ensuring a consistent flow of funds to address immediate charitable needs. By requiring ongoing charitable engagement, the rule ensures that foundations serve the public good in the here and now, even as they maintain and potentially grow their endowments to sustain future philanthropic activities.
Seeking expert guidance? We're here to help!
At CPA KPA, we're passionate about magnifying the positive impact of private foundations. Feel free to reach out to us anytime at 888-402-1780 for a complimentary and obligation-free conversation. You can also conveniently submit your questions and inquiries through our contact page. Let's connect today and explore how we can help your foundation have a lasting and meaningful impact!