Reduce your private foundation’s tax liability by exploring distribution and tax planning opportunities

The term tax-exempt can be misleading. Although not-for-profit organizations are able to obtain an income tax exemption from the IRS and other state tax authorities, taxes on payroll, property, and sales are still collected. Additionally, private foundations are required to pay tax on their investment earnings.

The ultimately low tax rate faced by private foundations often means tax planning isn’t a priority. However, through various distribution and planning opportunities, a foundation can reduce its tax burden while increasing its impact on not just the community it serves, but its own vitality.

This article is the second in a series taking an in-depth look at topics important to private foundations, including self-dealing, excess business holdings, and private operating foundations.

Calculating net investment income

The investment income excise tax applies to most domestic tax-exempt private foundations. Taxable net investment income is calculated by deducting direct expenses from gross investment income. Both terms are defined in the following tables.

To the extent a private foundation’s gross investment income exceeds the allowable deductions, its net investment income becomes subject to a 2% tax under IRC Section 4940(a). Organizations not subject to this tax:

• Certain electing grant organizations exclusively organized and operated to make grants to educational organizations
• Exempt operating foundations organized and operated like public charities

Cutting your taxes in half

Private foundations have the opportunity to annually reduce this tax liability from 2% to 1%. This might not seem like much when a foundation only sees a $500 reduction, but as its endowment grows and investment income increases, this 50% reduction can represent hundreds of thousands of dollars.

A private foundation focused on reducing its tax rate can do so by ensuring its payout ratio — calculated by dividing total qualifying distributions by the value of noncharitable use assets — exceeds the average payout ratio for the past five years plus 1% of its net investment income.

This means a foundation can reduce by 50% its current year income tax liability by adjusting the timing of grants and charitable expenses to increase qualifying distributions in excess of the prior year’s payout ratio.

This isn’t a sustainable strategy for most private foundations, however, because qualifying distributions would need to annually grow at a rate that would likely begin to deplete a foundation’s corpus.