Do Foundations Pay Taxes? Tax Rules for Private Foundations

Private foundations are often associated with philanthropy and charitable giving, but their tax obligations can be more complex than many assume. While they typically receive tax-exempt status, they may still be subject to certain taxes on specific income and activities.

Understanding the tax rules that apply to private foundations is essential for compliance and avoiding penalties.

Tax-Exempt Classifications

Private foundations qualify for tax-exempt status under Section 501(c)(3) of the Internal Revenue Code, which exempts them from federal income tax on most revenue. To maintain this status, they must operate exclusively for charitable, educational, religious, or scientific purposes and cannot distribute earnings to private individuals or shareholders. Unlike public charities, which rely on broad public support, private foundations typically receive funding from a single source, such as an individual, family, or corporation.

They must also meet strict regulatory requirements, including the IRS mandate to distribute at least 5% of their average net investment assets annually for charitable purposes. Failure to do so results in penalties, including excise taxes on undistributed income.

State tax exemptions vary. Some states automatically recognize federal tax-exempt status, while others require separate applications for exemptions from income, sales, or property taxes. In California, tax-exempt organizations must file Form 3500 or 3500A to obtain a state income tax exemption. Texas grants automatic exemption for federally recognized 501(c)(3) entities but requires additional filings for sales tax exemptions.

Unrelated Business Income

While private foundations are tax-exempt, they must pay taxes on income from business activities unrelated to their charitable mission. The IRS imposes the Unrelated Business Income Tax (UBIT) on revenue from commercial operations that do not directly support a foundation’s exempt purpose.

For income to be classified as unrelated business income (UBI), it must come from a trade or business that is regularly carried on and not substantially related to the foundation’s mission. For example, if a foundation owns a parking lot and charges fees to the public, the revenue would likely be considered UBI unless the parking lot directly supports the foundation’s charitable work. Similarly, a foundation operating a bookstore that sells general-interest books rather than mission-related materials may be subject to UBIT.

Certain types of income are exempt from UBIT. Dividends, interest, royalties, and rental income from real property are generally not taxed unless they come from debt-financed property. If a foundation borrows money to purchase an office building and rents out space, a portion of the rental income may be taxable. The IRS determines the taxable portion based on the percentage of the property that is debt-financed.

Excise Taxes and Similar Levies

Private foundations are subject to excise taxes designed to regulate their activities and ensure compliance with federal tax laws. One of the most significant is the net investment income tax, commonly known as the foundation excise tax. Under Section 4940 of the Internal Revenue Code, this tax applies at a flat rate of 1.39% on a foundation’s net investment income, which includes interest, dividends, rents, and capital gains, minus allowable deductions.

Other excise taxes target self-dealing, excessive holdings, and improper distributions. The self-dealing tax under Section 4941 penalizes transactions between a foundation and its disqualified persons, which include substantial contributors, board members, officers, and their family members. Even routine transactions, such as leasing office space from a board member or purchasing goods from a donor’s company, can trigger a 10% tax on the amount involved, increasing to 200% if not corrected promptly.

The excess business holdings tax under Section 4943 prevents foundations from controlling for-profit businesses. If a foundation and its disqualified persons collectively own more than 20% of a business entity, it must divest the excess holdings within five years or face a 10% tax on the value of the excess interest.

Filing Requirements

Private foundations must file Form 990-PF annually, detailing financial activities, governance, and grant distributions. Unlike the Form 990 used by public charities, Form 990-PF requires a complete balance sheet, revenue and expense statement, and a list of grants made during the year. Foundations must also disclose compensation paid to officers, directors, and key employees.

The deadline for filing Form 990-PF is the 15th day of the fifth month after the foundation’s fiscal year ends. For organizations following a calendar year, this means the return is due by May 15. Extensions are available through Form 8868, granting an additional six months, but estimated tax payments on investment income must still be made quarterly if applicable. Late filings can result in penalties of $20 per day, capped at $10,000 for small foundations and $100 per day for larger ones, with no maximum if the delay is deemed willful.

Consequences of Non-Compliance

Failing to meet tax and regulatory obligations can result in financial penalties and even loss of tax-exempt status. The IRS enforces compliance through escalating sanctions, beginning with monetary fines and potentially leading to revocation of tax-exempt status in severe cases.

One of the most severe penalties is the tax on undistributed income under Section 4942, which applies when a foundation fails to meet its annual 5% payout requirement. The initial tax is 30% of the undistributed amount, increasing to 100% if the shortfall is not corrected. Similarly, violations of self-dealing rules can result in a 10% tax on the transaction amount, with an additional 200% penalty if not rectified. Repeated violations, such as persistent failure to file Form 990-PF or engaging in prohibited political activities, can lead to the IRS revoking tax-exempt status, forcing the foundation to pay corporate income tax on all future earnings.