The 5% Rule for Private Foundations: A Closer Look

Rules for Private Foundations: The 5% Rule

Private foundations play a vital role in philanthropy, providing financial support to a variety of charitable causes. To ensure that these private foundations fulfill their charitable missions, the IRS established the 5% rule. In this post, we'll take a deep dive into this rule and explain how it's calculated.

What is the 5% Rule?

Private foundations are mandated by IRS regulations to make an annual minimum distribution equivalent to approximately 5% of the value of their assets for charitable purposes.

The History of the 5% Rule

The 5% rule traces its roots back to the Tax Reform Act of 1969. Prior to this legislation, private foundations faced fewer regulations, and some were criticized for hoarding their assets rather than actively contributing to charitable causes.

To address this concern, Congress introduced the 5% rule, requiring private foundations to distribute a minimum of 5% of their average net assets annually for charitable purposes. This marked a significant shift in the oversight and accountability of private foundations.

Calculating the Minimum Distribution Amount Needed to Remain Compliant

Step 1: Determine the Investment Assets

Start with the fair market value of all the foundation's assets, including cash, stocks, bonds, real estate, and other investments. Exclude program-related investments and certain administrative assets.

Step 2: Calculate the Average

Take the average fair market value of these assets over a specific time frame, usually the full fiscal year (which can be, but does not have to be, the calendar year).

Step 3: Apply the 5% Requirement

Deduct a 1.5% “cash allowance” on the above figure. Then multiply this net figure by 5% (0.05). This gives you the minimum distribution amount required for the year.

Step 4: Deduct the Excise Taxes

Deduct the taxes that are due on the Net Investment Income for the year. These taxes are calculated at a flat rate of 1.39%.

Step 5: Deduct the Cumulative Overpayments from prior years / Add the Cumulative Underpayments from prior years

As discussed in further detail below, there will always be Overpayments or Underpayments. Overpayments reduce the amount that is required to be paid out this year, whereas Underpayments increase the amount that is required to be paid out this year.

Step 6: Deduct the Eligible Expenses

The Minimum Distribution Amount includes not only Grants but also a portion of the operating expenses of the private foundation that are deemed to be essential for the grant making process - these are called the “Eligible Expenses”. And since the Minimum Distribution Amount includes both Grants and Eligible Expenses, in order to figure out what should be paid out in Grants, the Eligible Expenses should be deducted first.

Once the above steps are taken, the resulting figure is the amount that needs to be distributed in Grants. However, these distributions can take other forms such as Program-Related Investments.

Example:

Now, let’s put some real numbers to the above. Let’s say that a private foundation has assets which, when averaged over the course of the fiscal year, came out at $40 million. Let’s also say that the Eligible Expenses were calculated at $200,000; the Net Investment Income was $2 million, and thus the taxes due on that income (at a tax rate of 1.39%) are $27,800; and finally, a cumulative Underpayment is being brought into this year of $500,000.  Here is what it would look like:

• Average Value of Assets - $40,000,000

• Less: Cash Allowance of 1.5% - ($600,000)

• Net Assets - $39,400,000

• 5% of Net Assets - $1,970,000

• Less: Taxes Due – ($27,800)

• Plus: Cumulative Underpayments $500,000

• Less: Eligible Expenses – ($200,000)

• Amount that needs to be paid out in Grants in order to be fully compliant: $2,242,200.

As mentioned above, the “Payout” includes not only Grants but also Eligible Expenses.  In the above example the total “Payout” is therefore $2,442,200, which equates to 6.20% of “Net Assets” (which in the example was $39,400,000). The reason that this is higher than 5% is due to the Cumulative Underpayments brought into this year.

Considering Overpayments vs Underpayments

Private foundations will always have either an Overpayment or Underpayment, as it is impossible to accurately predict the future average value of Assets over any twelve month period. These variances accumulate over time and should be taken into consideration when calculating the current year’s Minimum Distribution Amount, particularly in the case of an Underpayment. This ensures that the private foundation is not left playing catch up in subsequent year(s), and further avoids any doubts regarding its commitment to upholding the philanthropic intentions outlined by IRS regulations.

The Overpayment or Underpayment is reflected on the publicly available tax return, so it is important to understand how this is calculated. Overpayments reduce the amount that is required to be paid out this year, whereas Underpayments increase the amount that is required to be paid out this year.

Additional Considerations

I personally consider it best practice to try and project forward for the rest of the year when calculating the required Payout. Using the Asset values of the previous year(s) as the basis of the calculation can often result in an Underpayment; particular in Bull Market conditions when the foundation’s investments are increasing in value, or when the foundation is actively receiving contributions.

Ending the year with an Underpayment, although not ideal, still allows a private foundation to remain in compliance with IRS rules as long as that Underpayment is paid out, as a minimum, by the end of the following year. For a deeper dive into this please read our post “What you need to know about having an “Underpayment” of grants”.

Finally, and perhaps most importantly, it is worth highlighting that 5% is simply the minimum that a private foundation needs to pay out in Grants and Eligible Expenses.  If a private foundation wishes to maximize its impact in the community in the shorter term, then there is no rule that says that a private foundation can’t pay out more than the minimum if it wants to.

Conclusion

While the 5% rule can be confusing and at times overly complex, it serves some very important purposes by guaranteeing that private foundations actively engage in philanthropic activities, preventing private foundations from accumulating wealth indefinitely, and enhancing transparency and public trust in private foundations by requiring them to disclose their grant-making activities. Though it is impossible to accurately predict the future value of a foundation’s assets, the steps outlined above serve as a roadmap for determining the Minimum Distribution Amount.

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.