3.6.0 IRC Section 4942—Mandatory Distributions

3.6.1 General

A portion of the regulatory scheme for private foundations is aimed at preventing the foundation from merely acting to accumulate wealth or hold unproductive assets without meaningful support for real charitable enterprises. This practice is regulated by IRC §4942, which mandates minimum distributions for charitable purposes.

3.6.2 Distribution Requirements

  1. Except for private operating foundations, described in 3.6.3, a private foundation must distribute all undistributed income by the close of the next tax year. [IRC §4942(a)] If, during any year in the five preceding years, the private foundation has made qualified distributions from income or corpus that exceeded the amounts required to be distributed, the amount that needs to be distributed is reduced by that excess. [IRC §§4942(g)(2)(D) and (E)]

  2. Undistributed income is not merely income earned, but is calculated based upon a set of rules that guarantee active charitable contributions.

    1. The term undistributed income means, with respect to any private foundation for any taxable year, the amount by which the distributable amount for such taxable year exceeds the qualifying distributions made for such time out of the distributable amount. [IRC §4942(c)]

    2. The term distributable amount means, with respect to any private foundation for any taxable year, an amount equal to the sum of the minimum investment return plus adjusted net income, reduced by the sum of private foundation excise taxes paid by the private foundation. [IRC §4942(d)]

    3. The term minimum investment return is five percent of the excess of the aggregate fair market value of all foundation assets other than assets used directly for the foundation’s exempt purpose, in excess of any acquisition indebtedness with respect to those assets. [IRC §4942(e)(1)]

    4. The term adjusted net income means the excess of the gross income for the taxable year over the sum of the deductions that would be allowed to a corporation subject to corporate income tax. [IRC §4942(f)]

  3. If a private foundation had investment assets valued at $1 million, subject to acquisition indebtedness of $100,000, it would need to distribute for charitable purposes 5 percent of $900,000, less excise taxes paid on its investment income. It does not matter if the investment portfolio earns any income. Thus, if the foundation’s assets are invested in common stocks paying a 3 percent dividend, the private foundation will need to make distributions from corpus in order to bring the distributions up to the 5 percent level.

  4. These distributions must be qualifying distributions within the meaning of the rules. The term qualifying distributions is defined in IRC §4942(g).

    1. Any amount paid to accomplish one or more of the exempt purposes of the organization is treated as a qualifying distribution. This includes payments to publicly supported charities or private operating foundations, as well as expenditures for the direct conduct of charitable activities.

    2. Any amount paid to acquire an asset used or held for use directly in carrying out the exempt purposes of the organization is treated as a qualifying distribution.

    3. In addition, a private foundation may set aside funds for an identified project. The private foundation must notify the Internal Revenue Service and obtain prior approval. The amount set aside must be paid for a specific project within the next five years, and the organization must establish that it can better accomplish the project through a set-aside than through the immediate payment of funds, or that the project will not be completed before the end of the taxable year of the foundation in which the set-aside is made. Thus, the foundation could set aside funds for a large project and use 3, 4, or 5 years of distributions to fund a single large project down the line.

3.6.3 Excise Taxes

  1. If a private foundation fails to make the required distributions, it is subject to a first tier tax of 15 percent of the undistributed income for the year. If the undistributed income is not distributed, a second tier tax is imposed at the rate of 100 percent of the undistributed income. Thus, the private foundation must make the required distributions or lose all of the undistributed money to the Internal Revenue Service.

  2. IRC §4942(a)(2) does provide an exception if the failure to distribute was based solely on an incorrect valuation of the assets where the incorrect valuation was not willful and was due to reasonable cause. The private foundation can notify the Internal Revenue Service of the failure and make a distribution to correct the failure.

3.6.4 Private Operating Foundations

  1. General

    IRC §§509(a) and 170(b) classify charitable organizations as private foundations and non-private, or publicly supported, charities. As discussed, IRC §170 provides for the deduction of charitable contributions. So-called private operating foundations receive more favorable treatment with respect to charitable deductions than do the other private foundations. Other rules and regulations affecting private foundations apply to private operating foundations, such as the self-dealing rules under IRC §4941 and the excess business holding limitations under IRC §4943. [See 3.7.0] The minimum distribution requirements of IRC §4942 do not apply. Perhaps for this reason, the classification of private operating foundation is contained not in IRC §170 or IRC §509(a), but in IRC §4942(j)(3).

  2. Income Test

    A private operating foundation is an organization that makes qualifying distributions of substantially all (at least 85 percent, Treas. Reg. §53.4942(b)-1) of the lesser of its adjusted net income or its minimum investment return directly for the active conduct of the charitable purpose for which it was set up (the income test) and that meets one of the three alternative tests. Thus, a private operating foundation might be able to spend less money than a private foundation subject to the minimum distribution requirements, but it would have to utilize the funds for the direct and active conduct of operations rather than merely pay the money to another charity.

  3. Alternative Tests

    In addition to satisfying the income test, the private operating foundation must meet one of three alternative tests.

    1. The asset test is satisfied if substantially more than half [at least 65 percent, Treas. Reg. §53.4942(b)-2(a)] of the private foundation’s assets are directly related to charitable activities or functionally related charitable businesses.

    2. The endowment test is satisfied if the private foundation normally makes qualifying distributions in an amount not less than two-thirds of its minimum investment return for the active conduct of its exempt activities.

    3. The support test is satisfied if substantially all of the support received by the private operating foundation (excluding gross investment income) is normally received from the general public or from five or more non-related exempt organizations, not more than 25 percent of the support may be derived from any one exempt organization, and not more than one-half of the support received by the organization is from gross investment income.

      Example 3.3

      A typical private operating foundation might be an art, historical or cultural museum. If a foundation has only one substantial asset (the museum and its art collection) and the foundation uses most of its income for the operation of the art museum, the foundation would qualify as a private operating foundation.