Private Foundations and an “Underpayment” of their Required Minimum Distribution

What Private Foundations need to know about having an “Underpayment”

In our blog post “The 5% Rule for Private Foundations: A Closer Look” we explored the basics of private foundations' minimum distribution requirements. This often leaves foundations with either an “overpayment” or an “underpayment” due to the fluctuating value of assets and investment returns. In this post, we’ll dive deeper into the concept of “underpayment”—a situation that can have significant implications for foundation compliance and operations.

A Quick Recap on the 5% Rule

The IRS mandates that private foundations distribute a minimum of 5% of their assets each year. This requirement, commonly known as the “5% Rule,” aims to ensure that foundations are actively supporting charitable causes rather than merely accumulating wealth. The calculation of this 5% payout amount can be intricate, factoring in allowable expenses, taxes, and prior years’ overpayments or underpayments. The ultimate figure is the minimum amount the foundation must distribute in grants to meet IRS standards.

Identifying an Underpayment: How Can You Tell?

After the calculations for the year’s required grant payout are completed, if a foundation’s actual grant distributions fall short of the required amount, this shortfall is classified as an “underpayment.” This means the foundation hasn’t met its full distribution obligation for that tax year and will need to address this discrepancy.

Underpayments can occur due to a range of factors, including:

• Unanticipated fluctuations in the value of the foundation’s assets.

• Administrative or financial planning oversights.

• Unexpected expenses that impact the overall budget.

The key takeaway? Regular monitoring of grant distributions throughout the year can help foundations avoid or quickly identify potential underpayments.

The Implications of an Underpayment on Minimum Distributions

An underpayment of the minimum distribution carries over to the following year, increasing the amount that the foundation needs to distribute in grants. In other words, if a foundation fails to meet its 5% requirement in one year, it will need to make up for it by adding the shortfall to the minimum distribution required for the next year. Conversely, an overpayment would have the opposite effect, reducing the required distribution in the following year.

Addressing Underpayments: IRS Guidelines

The IRS allows private foundations a grace period of 12 months to rectify any underpayment. For example, if a foundation underpays in the 2024 tax year, it has until the end of the 2025 tax year to “catch up” on the shortfall. During this time, the foundation must ensure it distributes at least the underpaid amount in grants to remain in compliance.

Penalties for Uncorrected Underpayments

Failing to correct an underpayment within the allotted 12-month period can lead to steep penalties. The IRS typically levies a penalty tax of 30% on the undistributed amount if the underpayment remains uncorrected. Furthermore, if the shortfall still isn’t resolved within a specified period—often within 90 days of the initial penalty—a second tax equal to 100% of the remaining underpaid amount may be imposed. These penalties serve as a strong incentive for foundations to monitor and promptly address any underpayment issues.

Best Practices to Avoid Underpayments

To avoid underpayments, private foundations should aim to exceed the 5% distribution threshold where feasible, as doing so not only supports compliance but also furthers the foundation’s charitable mission. Here are some best practices to consider:

• Plan ahead: Set annual grantmaking goals that account for potential market fluctuations and unexpected expenses.

• Regularly monitor investments: Keeping a close eye on asset values and estimated distributions can help in planning accurate and timely payouts.

• Work closely with a specialist: An experienced specialist in the private foundation field can assist in calculating the precise distribution amount and help ensure compliance with IRS rules.

How Ally Can Support Your Foundation

At Ally, we specialize in helping private foundations accurately calculate and plan their grant distributions. We understand the complexity of compliance requirements and are here to help your foundation maintain smooth operations while fulfilling its mission to serve the community.

With expert guidance, careful planning, and timely grant distributions, your foundation can not only meet IRS requirements but also maximize its impact on the charitable causes it supports. Reach out to us to learn how we can help your private foundation avoid underpayments and achieve sustainable, impactful grantmaking.

The content of this website has been prepared by Ally Foundation Services for informational purposes only and does not constitute legal, financial or tax advice.