What are qualifying distributions for private foundations?
In general, private foundations must satisfy their annual 5% minimum distribution requirement with “qualifying distributions”. This mostly consists of grants to public charities but ultimately includes a variety of expenditures made to carry out a foundation’s charitable mission. The following expenditures count as qualifying distributions assuming they are incurred for charitable purposes:
• Grants made to public charities
• Grants made for charitable purposes to non-tax-exempt organizations with the foundation exercising expenditure responsibility
• Reasonable and necessary administrative and operating expenses
• Expenses incurred to directly operate charitable programs
• Certain grants to individuals including scholarships as well as award and prize programs
• Certain grants to foreign charities
• The purchase of charitable use assets
• The acquisition of program-related investments
• Qualifying amounts set aside for distribution (must meet certain requirements)
Aside from grants to public charities, the most common qualifying distribution is reasonable and necessary administrative and operating expenses. What are some common examples in this category? It is normal for foundations to incur expenses such as office supplies, postage, bank fees, staff and director compensation, office rent, legal and accounting fees–really the list could go on and on and on. An expense is generally considered legitimate as long as it is incurred to carry out the foundation’s charitable mission and it fits within the statutory guidance of being a “reasonable and necessary” expense.
What exactly is a reasonable and necessary expense? Although there is no concise and definitive answer to this question, the meaning is discernable. If an expense furthers the foundation’s charitable mission and other foundations are incurring similar expenses in both nature and amount, then the expense is most likely legitimate.
All qualifying distributions are governed by the cash basis method of accounting even if the foundation typically uses the accrual method. This is especially relevant for grant checks written towards the end of the year. Any grant check mailed with sufficient time to be collected and postmarked by December 31 is counted as a qualifying distribution for the year—it does not matter when the check is deposited by the recipient. Contrary to what some people might prefer to believe, simply back dating a check does not allow the transaction to count for the previous year; the governing determinant is the date the check is mailed.
Private foundations can also make qualifying distributions by issuing grants in the form of in kind publicly traded securities (or any asset or property). The foundation is credited with a qualifying distribution for the fair market value of the asset and no kind of income tax is imposed regardless of appreciation over tax basis. By making grants of highly appreciated public securities, foundations can avoid the tax on capital gains while still being credited with a qualifying distribution for the fair market value of the asset. Many large public charities readily accept the donation of publicly traded securities. This technique can be particularly useful when the foundation itself has received a public security donation that is already highly appreciated (note that private foundations take over the donor’s cost basis for donated property). The foundation can simply turn around and grant the appreciated security to a public charity and sidestep the unfavorable tax effects of selling the security.
Grants made to organizations controlled directly or indirectly by the private foundation or its disqualified persons customarily do not count as qualifying distributions (there are some exceptions). Additionally, grants provided by one private foundation to another private foundation generally do not count as qualifying distributions unless the recipient foundation is a private operating foundation.
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