Private Foundation Distribution Rules Under Section 4942

Private foundations are charitable organizations often funded by a small number of sources, such as an individual, a family, or a corporation. Federal tax law, specifically Internal Revenue Code Section 4942, requires these entities to distribute a portion of their assets for charitable purposes each year. This rule ensures that a foundation’s funds are actively used to support its exempt mission. The regulations balance the foundation’s ability to exist long-term with the public’s interest in benefiting from its resources.

Calculating the Distributable Amount

A private foundation’s annual distribution requirement is based on its “distributable amount.” The process begins with determining the “minimum investment return” (MIR), which is 5% of the total fair market value of the foundation’s assets not used directly for its exempt purpose. This calculation prevents a foundation from holding large, unproductive assets without making corresponding charitable payouts.

For securities with readily available market quotations, the foundation must use a monthly average of the fair market value. For other assets like real estate, a good faith valuation is required, which may involve independent appraisals. Property used directly for the foundation’s charitable activities, such as a museum building or administrative offices, is excluded from this calculation base.

Once the 5% MIR is calculated, adjustments are made to find the final distributable amount. The foundation subtracts acquisition indebtedness related to its investment assets and certain taxes paid, such as the excise tax on net investment income under Internal Revenue Code Section 4940. The resulting figure must be paid out in qualifying distributions by the end of the following taxable year.

Making Qualifying Distributions

Once a foundation determines its distributable amount, it must meet this target by making “qualifying distributions.” These are specific expenditures the IRS recognizes as fulfilling the foundation’s charitable purpose. Direct grants to public charities, such as schools or hospitals recognized as tax-exempt under Internal Revenue Code Section 501(c)(3), are the most common type and the primary way most foundations meet their payout requirement.

Other expenses also count toward the distribution requirement. These include reasonable and necessary administrative costs related to charitable activities, such as salaries and professional fees. The costs of operating a direct charitable program, like a food bank or research project, are also qualifying distributions, as are amounts paid to acquire an asset used directly for a charitable purpose.

Not all expenditures qualify. For instance, grants made to another private non-operating foundation or to an organization controlled by the foundation or its major donors may not qualify unless specific pass-through rules are met. These restrictions prevent foundations from moving money between related entities without it reaching an active public charity. If a foundation distributes more than its required amount in a given year, the excess can be carried over for up to five subsequent years.

The Tax on Undistributed Income

Failure to meet the annual distribution requirement results in tax penalties. The law imposes a two-tier excise tax on a foundation’s “undistributed income,” which is the amount the distributable amount for a given year exceeds the qualifying distributions made. This structure is designed to encourage compliance and prompt correction of any shortfalls.

The first-tier tax is 30% of the undistributed income for each year the distribution shortfall remains uncorrected. This tax is assessed for each taxable year within the “taxable period,” which begins on the first day of the taxable year and ends when the IRS assesses the tax or mails a notice of deficiency. This initial tax serves as a financial incentive for the foundation to avoid shortfalls.

If the foundation fails to correct the shortfall after IRS notification, a second-tier tax of 100% of the remaining undistributed income is imposed. This is assessed if the foundation does not make the necessary qualifying distributions within a “correction period.” Foundation managers who knowingly refuse to agree to the correction can also be held personally liable for a separate tax, reinforcing individual accountability.

Correcting a Distribution Shortfall

When a private foundation fails to meet its distribution requirement, it can correct the error. The process is governed by the “correction period,” which begins on the first day of the taxable year in which the shortfall occurred and ends 90 days after the IRS mails a notice of deficiency for the first-tier tax.

To correct the failure, the foundation must make qualifying distributions sufficient to make up for the entire shortfall from the prior year. These corrective distributions are treated as being made from the undistributed income of the earlier year. The foundation must document these distributions and report them on its annual tax return, Form 990-PF.

A timely correction prevents the imposition of the 100% second-tier tax on the undistributed income. This resolves the compliance issue for the year in question, although the foundation will still be liable for the initial 30% first-tier tax on the original shortfall.