This is the second post in an ongoing series on private foundation issues. For the first post on self-dealing issues, click here, and check back in upcoming weeks as we discuss other issues like jeopardizing investments and specialized grantmaking considerations.

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Unlike public charities, private foundations are required to satisfy an annual payout requirement each year. This requirement was put into place under Section 4942 in 1969, in response to Congressional concerns about grantmaking foundations accumulating contributions and income without making distributions that provided current benefit to the public. This post will explain some key concepts around the payout requirement, and show that foundations may have more options than they realize.

Are All Foundations Covered by Requirement? No, only non-operating foundations are subject to this requirement. An operating foundation, which carries out direct charitable programs and activities (and in many respects resembles a public charity, aside from funding sources), has its own set of tests to meet and as such does not have to meet the mandatory annual payout requirement.

What Is the Required Payout Amount? Foundations generally have to pay out about 5 percent of the market value of their assets, excluding any assets used directly by the foundation in accomplishing its exempt purposes.

What Counts Toward the Payout Amount? Only “qualifying distributions” count toward the minimum payout amount. In general, a qualifying distribution includes any amount paid by the foundation to accomplish its 501(c)(3) purposes, such as the following:

• Grants. This type of payment is the quintessential qualifying distribution, and how many foundations meet the bulk of their requirement. However, grants to an organization controlled (directly or indirectly) by the foundation or by a disqualified person, and grants to another private non-operating foundation, will not count unless the grantee meets certain redistribution requirements (known as the “out-of-corpus rules”). In addition, grants to certain supporting organizations won’t count as qualifying distributions.
• Foundation expenses. Expenses incurred by the foundation to directly carry out its own charitable programs and activities, and reasonable and necessary administrative expenses, count as qualifying distributions (though investment expenses are one category that does not count).
• Asset purchases. A foundation’s purchase of assets for use in carrying out its exempt purposes will count as a qualifying distribution. Also, amounts spent to make property improvements can count, if made to accomplish charitable ends.
• Program-related investments. Investments that meet the program-related investment (“PRI”) requirements count as qualifying distributions. This means they must be made for the primary purpose of accomplishing the foundation’s charitable purposes; not have as a significant purpose the production of income or appreciation of property; and not have any political or lobbying purpose. They can take the form of low- or no-interest loans, equity investments and more, but the most important thing to remember is that they are made to carry out the foundation’s mission (e.g., a loan to business to help establish a new charitable job training program) and not to produce income and grow the foundation’s endowment.
• Qualified set-asides. Money set aside by a foundation for specific charitable projects, rather than being spend currently, can be a qualifying distribution in certain circumstances.  A specific charitable project would include situations where relatively long-term grants must be made to ensure the continuity of particular projects (e.g., a plan to erect a building). Generally, the foundation either must demonstrate that the project can be better accomplished by a set-aside than by the immediate payment of funds (which requires a ruling by the IRS), or specific cash-distribution requirements for the set-aside period.

How Long Does a Foundation Have to Meet the Payout? A foundation has until the end of the next taxable year to meet its distribution requirement.  With the exception of the set-asides discussed above, the payout requirement applies on a cash (rather than accrual) basis.

For questions on qualifying distributions or other private foundation issues, contact us at kschauble@leafferlaw.com or bseidel@leafferlaw.com.