Private foundations contribute a staggering $105.21 billion to public charities annually, representing $1 out of every $5 donated. Internal Revenue Code Section 4942 requires private nonoperating PFs to make “qualifying distributions” equal to 5% of their non-charitable assets annually, though studies show many exceed this requirement. But today’s generosity can 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 the calculation than you might think. Surprisingly, adhering to the minimum 5% distribution will have a greater monetary impact over the long run than distributing a larger amount today.
Qualifying Distributions
Grants to qualified public charities typically comprise the bulk—but not all—of qualifying distributions. They also include:
- Reasonable and necessary administrative expenses incurred in the conduct of the PF’s charitable activities
- Costs of direct charitable activities
- Amounts paid to acquire assets used in carrying out charitable purposes
- Set-asides for future charitable purposes, with direct Internal Revenue Service approval
- Program-related investments
Administrative expenses—including salaries, professional fees and supplies that are incurred for grant-making—qualify. But investment management fees don’t (unfortunately) and neither do the portion of salaries or PF expenses allocated to investment oversight. If a PF runs its own direct charitable programs or maintains a charitable facility, these costs count, too.
PRIs, which allow a PF to recycle distributed dollars and use assets creatively to achieve its mission, are often structured as below-market interest-rate loans. They count but be careful. Any principal repayments from a borrower will constitute a refund of a previously issued grant and increase the 5% distribution requirement in the year the principal is repaid.
Calculating the 5% Minimum
First, the PF must calculate the average value of its assets for the year. This excludes any debt incurred in acquiring investments and any charitable-use assets, such as a building that houses the PF, furnishings and equipment. Other assets are treated as follows:
- Cash is valued by averaging the amount on hand on the first and last days of each month.
- Marketable securities are based on a monthly average using any reasonable method.
- Alternative assets may be valued annually, and real estate appraised every five years.
The average asset value is then reduced by 1.5% (as an allowance for operating cash) and the resulting 98.5% is multiplied by 5%. This figure is further reduced by any excise or income taxes the PF paid during the year. It’s also adjusted to account for any outflows or inflows from PRIs to reach the final required distribution amount, called the “distributable amount.”
Payout Period
PFs have 12 months after the end of their tax year to satisfy the payout requirement. While this may seem straightforward, it often trips people up.
Why the confusion? Some PFs do grantmaking concurrently with their average asset calculations, essentially “working ahead” regarding their IRS-required distributions. Of course, it’s impossible to match the payout precisely because the average asset value, including the final month, won’t be known until next year. Sometimes, this leads to suboptimal practices—such as spending time estimating the moving average asset value or delaying grants until late in the year when visibility is higher. These can be easily avoided by grantmaking in the subsequent year.
If a PF makes sufficient qualifying distributions to satisfy the current year’s requirement (based on the prior year’s assets), additional qualifying distributions may be applied to reduce next year’s distributable amount or carried forward for five years. If grants are large enough in one year, there may be no required distributions the following year.
On the other hand, if a PF is making grants at the subsequent year-end to meet its true required distribution (based on the prior year’s asset values), there’s great urgency. If a PF fails to make the required distribution within the 12-month grace period, the IRS imposes a 30% penalty on the shortfall.
As an aside, there’s no minimum distribution requirement in the year a PF is established. Plus, in the founding year, the initial distribution is prorated for the partial year. For example, if a PF is founded on Nov. 1 of this year, the 5% rate is applied to 2/12ths of this year’s average assets, and the deadline for making the required distribution isn’t until Dec. 31 of next year.
Exceeding the Minimum
PFs often wonder if they could have a greater impact by granting more than the required 5% each year. The answer is yes—but only initially. For example, a $30 million PF granting 7% would distribute $2.1 million in Year 1, eclipsing the $1.5 million if the PF withdrew 5%. But by Year 20, the 5% distribution has overtaken the 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 in a given period plus the ending remainder value. Consider two $30 million PFs with 70% stock/30% bond portfolios sizing up their efforts 30 years hence. The one distributing 7% of its value each year has a TPV of $86 million, while its counterpart distributing only 5% produces a surprisingly greater TPV, at $106.4 million worth of good, according to our projections. While adhering to the minimum distribution may not be the right approach for every PF, it’s worth contemplating for those looking to maximize their financial impact in perpetuity.
Other Ways to Increase Impact
Here are a few more creative strategies for PFs to consider:
- Run scholarship programs or provide emergency assistance directly to individuals who have experienced hardships like natural disasters.
- Reduce the 1.39% excise tax on net investment income by harvesting capital losses to offset net realized gains (note that PFs can’t carry forward capital losses to use in future years) and by making in-kind grants of appreciated securities to charity to avoid realizing the capital gains.
- Make grants to donor-advised funds (DAFs) as part of the qualifying distributions. This comes in handy when receiving a sizable contribution that triggers a much higher payout the following year. If the PF doesn’t want to overwhelm current grantees, and may not have time to identify new recipients, a grant into a DAF may be a solution.
- Activate “the other 95%” of the portfolio by incorporating impact investments, PRIs or environmental, social and governance factors into the PF’s investment approach.
PF distributions aren’t one-size-fits-all. Some PFs distribute more to solve near-term problems, support nonprofits with declining funding sources, or spend down assets over a given time frame. However, for PFs seeking to maximize their long-term monetary impact, adhering to the minimum 5% distribution may 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 decision. Bernstein does not provide tax or legal advice.
Christopher Clarkson is the National Director of Planning, Foundation & Institutional Advisory in the Wealth Strategies Group at Bernstein Private Wealth
