What is the 5% rule for private foundations?
The 5% rule for private foundations is an annual distribution requirement. The Internal Revenue Code requires private foundations to spend approximately 5% of their endowment each year mainly in the form of grants to public charities and the operating expenses of running a foundation. This annual distribution requirement is sometimes referred to as a private foundation's "minimum investment return". The foundation must make qualifying distributions in order to satisfy the 5% minimum distribution requirement.
The purpose behind the 5% minimum distribution requirement is to prevent foundations from building up their endowments via compound interest and investment returns without spending a meaningful amount of money towards charitable grant making (prior to 1969 there was no minimum distribution requirement).
The calculation of the required distribution is moderately complex and is based on asset values from the prior year. There are different requirements for finding the fair market value of various holdings such as cash on hand, public securities, real estate, and charitable use versus non-charitable use assets (e.g., the value of an office printer used for the foundation’s charitable operations would be excluded from the calculation). In performing the calculation, there is a subtraction equal to 1.5% of the fair market value of all foundation assets and a deduction for federal tax paid. The final result of the calculation provides the minimum distribution requirement–it is consistently just a little bit less than 5% of the average value of a foundation’s prior year assets. The calculation is disclosed on the foundation's annual tax return (Form 990-PF) and must be distributed for charitable purposes before the end of the following tax year in order to stay compliant.
Here is a visual representation of the calculation
If a foundation spends more than the 5% minimum distribution requirement then the excess amount is carried forward for up to five years offsetting the required amount in future years. If a foundation fails to distribute the required amount it faces harsh financial penalties. If the foundation does not make corrective distributions in time, the penalties can culminate in the revocation of the foundation’s IRS-recognized tax status resulting in total dissolution.
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