Private foundations contribute a staggering amount $105.21 billion in public charity annually, representing $1 out of every $5 donated. Section 4942 of the Internal Revenue Code requires non-operating private PFs to make “qualifying distributions” equal to 5% of their non-charitable assets each year, although studies show many exceed this requirement. But today's generosity may have consequences for tomorrow. So how can PF managers maximize the impact of their qualifying distributions? The first step is to understand the rules – and there's a lot more to calculus than you might think. Surprisingly, meeting the minimum distribution of 5% will have a greater monetary impact in the long run than distributing a larger amount today.
Qualifying distributions
Grants to qualified public charities typically include most—but not all—of the qualifying distributions. They also include:
- Reasonable and necessary administrative expenses incurred in carrying out FP's charitable activities
- Costs of direct charitable activities
- Amounts paid to purchase assets used in carrying out charitable purposes
- Set aside for future charitable purposes, with direct approval of the Internal Revenue Service
- Investments related to the program
Administrative expenses—including salaries, professional fees, and supplies incurred in awarding grants—qualify. But investment management fees do not (unfortunately) and neither does the portion of salaries or PF expenses allocated to investment oversight. If a PF runs its own direct charitable programs or maintains a charitable structure, these costs are also counted.
PRIs, which allow a PF to recycle disbursed dollars and use assets creatively to achieve its mission, are often structured as loans with below-market interest rates. They count, but be careful. Any repayment of principal by a borrower will constitute a refund of a previously issued grant and will increase the distribution requirement by 5% in the year the principal is repaid.
Calculation of the minimum 5%.
First, the PF must calculate the average value of its assets for the year. This excludes any debt incurred on the purchase of investments and any assets for charitable use, such as a building housing the PF, furnishings and equipment. Other assets are treated as follows:
- Ready money is estimated by measuring the amount available on the first and last days of each month.
- Marketable securities are based on a monthly average using any reasonable method.
- Alternative assets can be assessed annually, and real estate is assessed every five years.
Then, the average value of assets is reduced by 1.5% (as compensation for cash) and the resulting 98.5% is multiplied by 5%. This figure is further reduced by any excise or income tax the PF has paid during the year. It is also arranged to account for any outflows or inflows from the PRI to arrive at the final required distribution amount, called the “distribution amount”.
Payment period
PFs have 12 months after the end of their tax year to comply with the payment requirement. Although this may seem straightforward, it often trips people up.
Why the confusion? Some PFs make grants concurrently with their average asset calculations, essentially “working ahead” with respect to their IRS-required distributions. Of course, it is impossible to match the payment exactly because the average value of the assets, including the last month, will not be known until next year. Sometimes, this leads to sub-optimal practices – such as spending time to estimate the moving average value of assets or delaying grants until the end of the year when visibility is highest. These can easily be avoided by making grants in the following year.
If a PF makes enough qualifying distributions to meet the current year's requirements (based on prior year assets), additional qualifying distributions may be applied to reduce the next year's distribution amount or carry over for five years. If the grants are large enough in one year, there may be no distribution needed the following year.
On the other hand, if a PF is making grants at the end of the following year to meet the actual required distribution (based on the previous year's asset values), there is great urgency. If a PF fails to make the required distribution within the 12-month grace period, the IRS imposes a 30% failure penalty.
As an aside, there is no minimum distribution requirement in the year a PF is created. Plus, in the year of incorporation, the initial distribution is prorated for the partial year. For example, if a PF is established on November 1 of this year, the 5% rate applies to 2/12 of this year's average assets and the deadline to make the required distribution is not until December 31 of the following year. .
Exceeding the minimum
PFs often wonder if they can make a bigger impact by giving more than the required 5% each year. The answer is yes – but only initially. For example, a $30 million PF yielding 7% would distribute $2.1 million in Year 1, eclipsing $1.5 million if the PF withdrew 5%. But by the year 20, the 5% distribution has exceeded 7%, which will remain higher thereafter.
To measure a PF's financial impact over time, we use a metric called Total Philanthropic Value, which is the sum of cumulative distributions over a given period plus terminal residual value. Consider two $30 million PFs with 70% stock/30% bond portfolios increasing their efforts after 30 years. One that distributes 7% of its value annually has a TPV of $86 million, while its counterpart that distributes only 5% produces a surprisingly larger TPV, worth a cool $106.4 million, according to our projections. While adhering to the minimum distribution may not be the right approach for every PF, it is worth considering for those looking to maximize their financial impact in perpetuity.
Other ways to increase impact
Here are some more creative strategies PFs should consider:
- Run scholarship programs or provide emergency assistance directly to individuals who have experienced hardships such as natural disasters.
- Reduce the 1.39% excise tax on net investment income by carrying forward capital losses to offset net realized gains (note that PFs cannot carry forward capital losses to use in future years) and making grants-in-kind of securities rated for charity to avoid realizing capital gains.
- Give grants to donor advised funds (DAF) as part of qualifying distributions. This is useful when you receive a significant contribution that triggers a much higher payout the following year. If the PF does not want to overwhelm current grantees and may not have time to identify new recipients, a grant to a DAF may be a solution.
- Enable the “other 95%” of the portfolio by incorporating impact investments, PRI or environmental, social and governance factors into PF's investment approach.
PF distributions are not suitable for everyone. Some PFs distribute more to solve short-term problems, support nonprofits with declining funding sources, or spend assets over a period of time. However, for PFs looking to maximize their long-term monetary impact, adhering to a minimum distribution of 5% can be advantageous. One thing is certain: understanding the rules governing qualified distributions and evaluating the long-term financial implications can help PF managers maximize their impact. Remember that you should speak to your tax or legal advisor before making any decisions. Bernstein does not provide tax or legal advice.
Christopher Clarkson is National Director of Planning, Foundation and Institutional Advisory in the Wealth Strategies Group at Bernstein Private Wealth