Question: How does a private foundation calculate its 5% payout requirement?
What is the five percent payout requirement?
Each year, every private foundation must make eligible charitable expenditures that equal or exceed approximately five percent of the value of its endowment. The purpose behind the minimum payout requirement contained in Internal Revenue Code Section 4942 is to prevent foundations from simply receiving gifts, investing the assets, and never spending any funds on charitable purposes. The basic rule can be stated simply, but its calculation is complex.
While the word "payout" is convenient, it is somewhat misleading. The Tax Code section that creates the rule does not contain the word. "Payout" suggests grants or contributions paid out to other charities. Although these grants normally comprise more than 93 percent of the expenditures of most foundations, many other expenses can also be used to meet the minimum payout requirement. In short, the five percent payout rule does not need to be satisfied solely with grants.
Within what time period must the five percent be paid out?
Private foundations have until the end of the following tax year in question to satisfy the minimum payout requirement. For example, a new foundation could pay out nothing during its initial tax year and then satisfy the first year's minimum by applying retroactively the first expenditures in the second year. Similarly, any foundation can satisfy last year's payout requirement retroactively with this year's qualifying payments.
How is asset size calculated for purposes of the five percent rule?
For purposes of calculating the payout, the size of the endowment is a 12 month average of the endowment’s fair market value for the tax year in question. The technical term for endowment or assets used by the IRS and the Form 990-PF tax return is "noncharitable use assets." Note that the endowment includes only noncharitable use assets (cash, stocks, bonds, and other investments). Charitable use assets (assets used in carrying out charitable purposes) do not count in calculating the payout. Examples of charitable use assets are a building that houses the foundation, fixtures, and other capital equipment such as furniture and computers. The measurement is not taken either at the beginning or the end of the year. The 12 month average allows for fluctuation that occurs in investment markets.
The foundation should decide (with its accountant and counsel) which method of calculating a monthly market value makes sense. The measurement can be taken on the first or the last day of the month, or the values can be measured on the first and last days and averaged. Any method can be chosen as long as it is reasonable and applied consistently. Once a fair market value is determined for each month, all 12 amounts are added together and then divided by 12 to obtain the value to which the five percent applies. If the foundation is new or changing accounting years so that the tax year in question is a partial tax year, appropriate adjustments should be made. For example, if the tax year is only seven months long, add up seven monthly averages and then divide by seven (the payout will be 7/12 of five percent).
How is the payout actually calculated?
As noted above, determining payout is complex. In fact, there is no clear definition of payout. There is a clear definition of the "distributable amount," which is the minimum a foundation must meet to avoid penalty. The five percent calculation is only one of many that bring you to the final calculation of the distributable amount; in most cases, the distributable amount will be quite close to five percent.
Once the foundation has calculated the 12 month average fair market value of its endowment, at least two other adjustments are permitted. First, the law presumes that any foundation needs to have cash on hand to conduct business; thus, the endowment value for the year may be reduced by 1.5 percent for "cash deemed held for charitable purposes." Second, after calculating the five percent figure, the foundation may claim a credit against the payout amount for any taxes paid during the year, namely the one or two percent excise tax on investment income. The final figure is called the "distributable amount." Qualifying distributions equal to this distributable amount must be made to satisfy the payout requirement.
For the 2007 tax year, Foundation X’s 12 month average fair market value of its net total endowment equals $1 million. During 2007, it paid excise tax payments on its investment income of $1,000. Thus, the distributable amount for Foundation X is calculated as follows:
|Cash held for charitable purposes (deduct 1.5%)
|Multiply by 5%
|Credit for excise tax paid
In this example, the actual distributable amount for which qualifying distributions are required is 4.825 percent of the foundation’s average assets (4.825 percent of $1 million = $48,250).
In short, the "five percent payout rule" is only a rough approximation. A foundation does not need to meet its payout solely through grants. In most years, the actual payout percentage needed to meet the distributable amount is likely to be slightly less than five percent because of additional adjustments written into the law.
What is carryover?
If, in any tax year, a foundation exceeds its minimum payout requirement (i.e., its qualifying distributions exceed its distributable amount), the excess may be "carried over" to help satisfy future year payouts (up to five years). Thus, it is possible that the payout—or qualifying distributions—in one year may be so great that no expenditures at all are necessary in the following year (or years) to meet the payout requirement. The carryover amount is calculated every year as part of the process for completing the Form 990-PF. There is no need to apply for a ruling or any other complicated procedure.