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

Navigating Private Foundation Minimum Distribution and Underpayment

In our post “The 5% Rule for Private Foundations: A Closer Look” we mentioned that a private foundation will always have an overpayment or an underpayment, simply because it is impossible to estimate what the average values of investments will be.

In this blog post we will explore the underpayment in a little more detail.

A quick overview of the 5% Rule

The IRS imposes a rule whereby 5% of the private foundation’s assets must be distributed annually.  The calculation of exactly how much should be paid out is somewhat complicated and involves deducting Eligible Expenses, Taxes, and the cumulative overpayments or underpayments from prior years before getting to the figure needed to be paid out in Grants.

How do I know if there is an underpayment?

After performing the above calculations for what should be paid out in grants, if the actual amount paid out in grants is less than the amount calculated, then there is an underpayment which will need to be carried over to the following year.

Underpayment of Minimum Distribution

An underpayment of minimum distribution occurs when a private foundation fails to distribute the required minimum amount within a tax year. This can happen for various reasons, such as poor financial planning, administrative errors, or unforeseen circumstances.

What do I need to do about the underpayment?

The strict rules imposed by the IRS are that whatever that underpayment is, it must be paid out in grants and eligible expenses by the end of the following year.  So in other words, the IRS always allows 12 months to catch up on underpayments.  For example, if the underpayment occurs in the 2024 tax year, then the foundation will have until the end of the 2025 tax year to pay that underpayment.

You may have heard your CPA talking about the “minimum distribution” for the year.  In all likelihood, this underpayment from the prior year is what they were referring to when they used this term.

How will this affect the 5% calculation?

In the aforementioned calculations, an underpayment will increase the amount that needs to be paid out in grants (whereas an overpayment will reduce the amount that needs to be paid out).

Are there any penalties involved?

If a private foundation fails to correct the underpayment within twelve months it can face a tax penalty. The penalty is generally calculated at a rate of 30% of the underpayment amount. If the foundation does not correct the failure within a specified period (usually 90 days after the initial tax is assessed), an additional tax of 100% of the remaining undistributed amount is imposed.

What is best practice around underpayments?

Best practice is simple: try to minimize or completely eliminate underpayments by always paying out at least the 5% so that your private foundation is not only compliant, but to also fulfill its mission of providing much-needed funding to the wonderful nonprofits in your community.

How can Ally help?

We can help your private foundation calculate the amount that should be distributed in grants. 

Having that information to hand will allow you to properly plan and budget for the coming and future years, and will reduce the likelihood of your private foundation having any issues with regard to underpayments.

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.