An In-Depth Look at Qualifying Distributions for Private Foundations
Private foundations play a pivotal role in philanthropy, channeling significant resources towards various charitable causes. To ensure these foundations actively contribute to the public good, the IRS mandates annual charitable expenditures known as qualifying distributions.
Distribution Requirements
Grantmaking private foundations must distribute approximately 5% of the fair market value of their non-charitable use assets from the preceding year. This rule ensures that foundations are actively using their resources to further charitable goals. For example, if a foundation has an average asset value of $2 million in 2023, it must distribute approximately $100,000 by the end of 2024. The official 5% calculation is performed and reported on Form 990-PF.
Types of Qualifying Distributions
Qualifying distributions mostly consist of grants to public charities but can include various expenditures made to carry out a foundation’s charitable mission. Foundations can carry forward excess distributions beyond the 5% minimum to offset future requirements, providing flexibility in years with lower asset values or unexpected financial difficulties. Occasionally, foundations may recover funds initially designated as qualifying distributions, such as reclaimed grants or repaid program-related investments. These recovered amounts increase the foundation’s distribution requirement for the recovery year.
Failure to meet the annual 5% minimum distribution requirement results in a 30% excise tax on the undistributed amount, with additional penalties if the shortfall is not corrected promptly.
What Counts as a Qualifying Distribution?
The following expenditures count as qualifying distributions, assuming they are incurred for charitable purposes:
• Public Charities: Grants made to most 501(c)(3) public charities.
• Non-Charities: Grants for charitable purposes to non-tax-exempt organizations qualify if the foundation adheres to IRS rules, including expenditure responsibility.
• Foreign Charities: Grants to foreign charities qualify if they meet IRS equivalency determination or expenditure responsibility requirements.
• Donor-Advised Funds (DAFs): Grants to donor-advised funds generally count as qualifying distributions. However, if foundation insiders have advisory privileges over the DAF, the private foundation must make additional obligatory disclosures on its tax return.
• Eligible Individuals: Foundations can make grants to individuals for reasons such as disaster relief, medical emergencies, and economic aid. These distributions must adhere to IRS regulations to ensure they are used for charitable purposes and not personal gain. Scholarships and educational grants to individuals also qualify if specific IRS guidelines are followed.
• Reasonable Administrative Expenses: Necessary costs such as staff salaries, office rent, and training qualify.
• Direct Charitable Activities: Costs for programs directly benefiting the public qualify as qualifying distributions. This includes a wide range of activities such as operating a museum to preserve and exhibit cultural artifacts, feeding the hungry through food distribution programs, and conducting scientific research that contributes to public knowledge and well-being.
• Charitable Use Assets: Assets used for charitable purposes, such as buildings or equipment dedicated to charitable activities, qualify.
• Program-Related Investments: Acquisition of investments aimed at accomplishing the foundation’s exempt purposes, rather than generating income, generally count as qualifying expenditures. Examples include providing low-interest loans to affordable housing projects to increase the availability of homes for low-income families or investing in an alternative energy startup if the motivating reason is to help the environment rather than profit.
Common Qualifying Distributions
Aside from grants to public charities, the most common qualifying distribution is reasonable and necessary administrative and operating expenses. Common examples in this category include office supplies, postage, bank fees, staff and director compensation, office rent, legal and accounting fees. An expense is generally considered legitimate as long as it is incurred to carry out the foundation’s charitable mission and it fits within the statutory guidance of being a “reasonable and necessary” expense.
What exactly is a reasonable and necessary expense? Although there is no concise and definitive answer to this question, the meaning is discernable. If an expense furthers the foundation’s charitable mission and other foundations are incurring similar expenses in both nature and amount, then the expense is most likely legitimate.
Accounting for Qualifying Distributions
All qualifying distributions are governed by the cash basis method of accounting, even if the foundation typically uses the accrual method. This is especially relevant for grant checks written towards the end of the year. Any grant check mailed and postmarked by December 31 is counted as a qualifying distribution for the year—it does not matter when the check is deposited by the recipient. Contrary to what some people might prefer to believe, simply backdating a check does not allow the transaction to count for the previous year; the governing determinant is the date the check is mailed.
Foundations can also make qualifying distributions by issuing grants in the form of in-kind publicly traded securities. The foundation is credited with a qualifying distribution for the fair market value of the asset, avoiding capital gains tax while still meeting distribution requirements. This technique can be useful when the foundation has received a highly appreciated security donation.
What Does Not Count as a Qualifying Distribution?
• Non-Charitable Expenses: Any expenditure not directly or indirectly related to the foundation's charitable mission does not qualify as a qualifying distribution. This includes costs that benefit private interests, personal expenses of staff or board members, or any spending that does not support the foundation's charitable activities. Ensuring all expenses align with the foundation's philanthropic goals is crucial to maintaining compliance and avoiding penalties.
• Investment-Related Expenses: Costs such as investment management and brokerage fees, as well as portions of salaries related to overseeing investments, do not qualify.
• Federal Excise Tax: Payments made for federal excise tax do not qualify as a distribution. This tax is imposed on the net investment income of most private foundations. Additionally, any penalty excise taxes, such as those for taxable expenditures or failure to meet the distribution requirement, do not count as qualifying distributions.
• Grants to Other Private Foundations: When a private foundation makes a grant to another private foundation, specific IRS rules determine whether this counts as a qualifying distribution. Generally, a grant from one private foundation to another does not automatically count as a qualifying distribution unless the expenditure responsibility rules are followed.
• Repayment of Borrowed Funds: While expenditures made from borrowed funds generally count as qualifying distributions, the repayment of these borrowed funds does not. When a foundation borrows money to make grants or for other charitable purposes, those expenditures can be counted towards the distribution requirement. However, the subsequent repayment of the borrowed funds, including principal and interest, is not considered a qualifying distribution. This repayment is viewed as a financial obligation rather than a charitable activity and therefore does not fulfill the distribution requirements imposed on private foundations.
• Certain Supporting Organizations: Grants to certain supporting organizations are restricted and must comply with specific IRS rules. These organizations, classified as 509(a)(2) public charities, have a legal relationship with other public charities. Private foundations must exercise expenditure responsibility for grants to these organizations if disqualified persons control the supporting or supported organization, and for Type III supporting organizations that are not functionally integrated. Failure to adhere to these rules results in the grants not counting towards the 5% distribution requirement and being considered taxable expenditures, subject to excise tax.
By understanding and strategically managing qualifying distributions, private foundations can maximize their impact while complying with IRS requirements, thereby avoiding penalties and excise taxes.
Seeking expert guidance? We're here to help!
At CPA KPA, we're passionate about magnifying the positive impact of 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!
