Private Foundation Investment Rules Explained

Private foundations are charitable organizations, often established by an individual, family, or corporation to support charitable activities. In exchange for their tax-exempt status, the Internal Revenue Service (IRS) imposes regulations on their financial operations, especially investments. These rules ensure a foundation’s assets are used for its charitable mission and not for speculative purposes or to benefit private interests.

The Minimum Distribution Requirement

Private foundations are subject to an annual payout requirement under Internal Revenue Code Section 4942, which mandates they distribute a certain amount for charitable purposes. This rule ensures that a foundation actively uses its wealth for public good rather than accumulating it. The core of this regulation is the “distributable amount,” set at 5% of the total fair market value of the foundation’s assets not used directly in its exempt function.

The asset base for this 5% calculation includes investments like stocks, bonds, and real estate, and is determined by averaging their monthly fair market values. This method prevents a foundation from using a single, unrepresentative valuation date. Certain assets are excluded from this calculation, such as office equipment or buildings used to conduct the foundation’s charitable programs.

To meet the payout requirement, a foundation must make “qualifying distributions.” These are most often grants to public charities but can also include the costs of running the foundation’s own charitable programs or purchasing assets for charitable use. Certain reasonable and necessary administrative expenses also count toward this requirement.

Investment management fees do not count as qualifying distributions. Instead, these expenses can be used to reduce the foundation’s net investment income, which lowers its excise tax liability. Failure to meet the minimum distribution requirement results in a two-tier excise tax, with an initial tax of 30% on the undistributed amount. If the deficiency is not corrected, a second-tier tax of 100% can be imposed.

Prohibited Jeopardy Investments

Internal Revenue Code Section 4944 prohibits “jeopardizing investments,” defined as any investment showing a lack of ordinary business care and prudence. This rule forces foundation managers to adopt a conservative approach to portfolio management, balancing growth with capital preservation. The goal is to prevent risky investments from endangering the foundation’s ability to fulfill its charitable mission.

Whether an investment is jeopardizing is determined on a case-by-case basis when the investment is made. The IRS does not provide a definitive list of prohibited assets but identifies certain types that receive closer scrutiny. These include trading on margin, short sales, commodity futures, and speculative instruments like puts, calls, and straddles.

An important exception is for program-related investments (PRIs), which are not subject to these restrictions because their primary purpose is charitable. Additionally, assets received by a foundation as a gift or bequest are not subject to these rules. This allows donors to contribute a wide range of assets without triggering a potential violation.

Violating this prohibition triggers a two-tier excise tax. The first-tier tax imposes a 10% penalty on the foundation based on the investment amount and a separate 10% tax on any manager who knowingly participated, capped at $10,000. If the investment is not sold, a second-tier tax of 25% is imposed on the foundation, with an additional 5% tax on the manager, capped at $20,000.

The Excess Business Holdings Rule

The excess business holdings rule, found in IRC Section 4943, prevents a private foundation and its insiders from controlling a for-profit commercial enterprise. This regulation ensures the foundation’s focus remains on its charitable mission rather than business operations. The rule applies to a foundation’s interest in any “business enterprise,” which is any activity ordinarily conducted for profit, but excludes those that generate passive income.

The restrictions center on the combined ownership of the foundation and its “disqualified persons.” A disqualified person is a term for individuals and entities with close ties to the foundation. This group includes:

• Substantial contributors
• Foundation managers
• An owner of more than 20% of a business that is a substantial contributor
• Family members of the above individuals (spouses, ancestors, children, grandchildren, and their spouses)
• Corporations, partnerships, or trusts in which disqualified persons collectively own more than a 35% interest

The general rule permits a private foundation and its disqualified persons to collectively own up to 20% of a corporation’s voting stock. A 35% limit applies if the foundation can show that an independent third party has effective control of the business. A de minimis rule also allows a foundation to hold up to 2% of the voting stock and value, regardless of the holdings of its disqualified persons.

When a foundation acquires business holdings through a gift or bequest, the law provides a five-year grace period to dispose of any excess holdings. This allows the foundation time to sell the asset in an orderly fashion. Failing to do so results in an initial excise tax of 10% on the value of the excess holdings, followed by a potential 200% tax if they are not disposed of.

Navigating Self-Dealing in Investments

The rules against self-dealing under IRC Section 4941 prohibit most financial transactions between a foundation and its disqualified persons, as defined in the previous section. The purpose is to prevent individuals with influence over the foundation from using its assets for personal benefit. These regulations apply to investment activities and all other financial interactions.

Self-dealing rules operate on a strict liability basis, meaning a transaction is prohibited regardless of whether the terms were fair to the foundation. The mere act of engaging in a prohibited transaction is enough to trigger penalties. Foundation managers must be vigilant in identifying disqualified persons and ensuring no prohibited transactions occur.

Specific acts of self-dealing related to investments include:

• The sale, exchange, or leasing of property between a foundation and a disqualified person.
• The lending of money or any other extension of credit between the two parties.
• The furnishing of goods, services, or facilities, unless provided on the same basis as to the general public.
• The payment of compensation, unless it is reasonable and necessary for personal services that carry out the foundation’s exempt purposes.

The penalty structure for self-dealing targets the individuals involved. The initial tax is imposed on the self-dealer at a rate of 10% of the amount involved. A separate tax of 5% of the amount involved, capped at $20,000, may be imposed on a foundation manager who knowingly approved the transaction. If the transaction is not corrected, a second-tier tax of 200% is imposed on the self-dealer, with a 50% tax on the manager, capped at $20,000.

Understanding Program-Related Investments

Program-Related Investments (PRIs) offer a unique opportunity to use assets for both financial and charitable ends. A PRI is an investment made primarily to achieve a charitable purpose, where the production of income is not a significant motivating factor. These investments are exempt from the jeopardy investment rules, allowing foundations to support innovative projects that may carry higher financial risk.

To qualify as a PRI, an investment must satisfy three IRS requirements:

• The primary purpose must be to accomplish one or more of the foundation’s exempt purposes, such as a charitable, educational, or scientific goal.
• The production of income or appreciation of property cannot be a significant purpose, meaning financial return is secondary to the charitable objective.
• The investment cannot be used for political lobbying or to support a candidate for public office.

PRIs can take many forms, including low-interest loans to other nonprofits or equity investments in social enterprises. For instance, a foundation might make a below-market-rate loan to a nonprofit building affordable housing. A major benefit of making a PRI is that the entire amount of the investment counts toward satisfying the foundation’s 5% minimum distribution requirement for the year it is made.