2022 Tax Planning Guide for Private Foundations
The CPA KPA 2022 Tax Planning Guide for Private Foundations provides information and planning tips to help navigate complex tax and compliance issues. Please note that the discussion below is tailored to private non-operating foundations, oftentimes referred to as grantmaking foundations or family foundations.
Ensure 5% Minimum Distribution Requirement has been Satisfied
Private foundations are subject to an annual minimum distribution requirement towards charitable endeavors that is roughly equal to 5% of assets (the 5% rule). The minimum distribution amount is calculated on Form 990-PF, the annual tax return for private foundations. To verify the amount required to be distributed in 2022, refer to the foundation’s 2021 Form 990-PF, Part XII (Undistributed Income), Line 6f, Column d.
The minimum distribution requirement is satisfied by "qualifying distributions". This mostly consists of grants to charities but ultimately includes any expense made to carry out the foundation’s charitable mission. All private foundations have some level of operating expenses (e.g., payroll, office expense, etc.); in general, these expenses help satisfy the minimum distribution requirement. Other qualifying distributions include expenditures on directly operated charitable programs, the purchase of charitable use assets, and the acquisition of program-related investments. Foundations that fail to meet the annual distribution requirement must pay a punitive excise tax.
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 charitable disbursement 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 meet the minimum distribution requirement by issuing grants in the form of in kind publicly traded securities. 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 security. 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.
Ensure Estimated Taxes have been Paid
Generally, private foundations must pay estimated tax on their net investment income on a quarterly basis in equal installments. For calendar year private foundations, the due dates to pay estimated taxes are May 15, June 15, September 15 and December 15. If the foundation underpays any installment, it may be subject to a penalty even if its total estimated tax payments for the year are adequate. It is worth noting that no estimated tax payments are required if a foundation’s total tax liability for the year is less $500.
There are several methods available to private foundations to ensure they pay enough estimated tax throughout the year to avoid penalties. The most common method is the safe-harbor method but it is not available to "large" foundations (i.e., those with net investment income of $1 million or more in any of the last three years). Under the safe-harbor method a foundation must make estimated tax payments equal to its total tax from its prior year tax return. This method cannot be used if the foundation’s prior tax year was less than 12 months or the foundation had no tax due on its prior year return.
All estimated tax payments must be made electronically via the Electronic Federal Tax Payment System (EFTPS). EFTPS is the standard system used by businesses and other legal entities (including individuals) to make payments to the federal government. The IRS does not allow private foundations to mail a physical check to pay estimated tax.
Excise Tax on Net Investment Income
Private foundations pay a flat rate tax on net investment income of 1.39%. Net investment income generally includes interest, dividends, net capital gains (if positive), rents, and royalties less any allowable deductions. All classifications of income are taxed at the same flat rate; the special rules for items like qualified dividends do not apply. There is one exception to this flat rate; any income subject to the unrelated business income tax (UBIT) provisions is taxed at the general corporate rate of 21%.
Allowable Deductions Against Investment Income
Private foundations may deduct against investment income all ordinary and necessary expenses incurred for investment purposes. The most common investment expense is advisory fees paid to portfolio managers but any direct investment expense qualifies as a deduction. If an expense qualifies as a deduction against investment income then it cannot also count as an exempt charitable expense and be used to satisfy the 5% minimum distribution requirement.
It is not unusual for certain operating expenses to be incurred for both investment purposes and for exempt charitable purposes. In this case, the private foundation should use a reasonable method to allocate operating expenses between investment activities and exempt charitable activities. Some common expenses that might require allocation include expenses like legal and accounting fees and compensation paid to foundation officers. The portion of expenses allocated to investment activities provides an investment expense deduction. The portion allocated to exempt charitable purposes is applied towards satisfying the annual 5% distribution requirement. Private foundations should systematize their accounting procedures to keep track of which expenses directly relate to the production of investment income versus exempt charitable activities, and which expenses require allocation.
Capital Gains and Losses
There is no special tax rate for net capital gains. Instead, net capital gains are taxed at the regular net investment income tax rate of 1.39%. Capital losses can be used to offset capital gains. However, net capital losses are not allowed as a deduction against other net investment income such as dividends and interest, nor can the losses be carried forward to subsequent years. As such, foundations should try to time the realization of capital losses alongside the realization of capital gains so the losses offset the gains.
Before the end of the year, it is a good idea for private foundations to review their investment portfolios to determine whether any capital sales should be made. If a foundation is in an excess capital loss position, it may be beneficial to sell a security with a gain to soak up the capital loss. The cash proceeds from the sale can be used to repurchase the same security thereby resetting the tax basis at a higher level (when this position is sold in the future the higher tax basis reduces the potential gain). If the foundation is in an excess capital gain position, capital loss harvesting can be carried out to offset the reportable capital gains.
It is worthwhile to note that private foundations are subject to the wash sale rules. A wash sale occurs when a security is sold at a loss and a substantially identical security is acquired within 30 days before or 30 days after the sale date. With wash sales, the loss recognized from the security sale is disallowed and cannot be used to offset other capital gains. Instead, the wash sale loss will be added to the basis of the repurchased securities. Wash sales can be avoided by purchasing a replacement security that is not substantially identical or by simply waiting out the 30-day time period to buy back the security.
Unrelated Business Income Tax (UBIT)
Unrelated business income is income earned by a private foundation that is not related to its exempt charitable purpose and is not investment income. Unrelated business income is frequently generated by alternative investments like hedge funds, private equity, privately-held businesses, debt financed investment property and publicly traded partnerships. It can also be generated by the private foundation itself if it has activities that generate revenue (e.g., selling advertising space on the foundation’s website). Unrelated business income is taxed at the general corporate tax rate, which, for 2022, is a flat rate of 21%.
Rebalance Investment Portfolio
Private foundations should rebalance their investment portfolios on a regular basis in order to maintain their desired asset allocation. Seeing that the tax on investment income is just 1.39%, the tax cost of rebalancing is generally quite low. Nonetheless, gains should not be triggered rashly. Many foundations sell assets in order to raise cash to meet their annual minimum distribution requirements; this provides an excellent opportunity to perform an undercover portfolio rebalancing. The foundation should favor selling the holdings that are above their asset allocation parameters; this brings the portfolio back into closer alignment with the foundation’s desired asset allocation.
Portfolio reviews provide a convenient occasion to check to make sure the foundation is complying with the excess business holdings rules as well as the jeopardizing investment rules. The excess business holding rules establish business ownership ceilings for private foundations and their disqualified persons (foundation insiders), preventing them from owning large controlling stakes in businesses. The jeopardizing investment rules essentially prohibit foundations from making reckless and imprudent speculations with their investment portfolio. Please see the following links for a more in-depth discussion of the excess business holding rules and the jeopardizing investment rules.
Ensure Books and Records are Current
It is mandatory for private foundations to keep accurate books and records. Unfortunately, it is not uncommon for foundations without a dedicated bookkeeper to let their books fall behind. This is less than ideal because accounting information is only useful if it is up to date. Foundations should have a system in place to make sure all transactions are entered and categorized properly; this is an easy and common task to outsource to a third party.
If a foundation is handling its own accounting, it should regularly verify that the cash balance on its books ties to the monthly bank statements. Also, before year end, the person in charge of the books should consider whether any entries should be made for any checks, expenses or other transactions that were missed or that haven’t cleared.
The accounting system of private foundations should be able to note which expenses are related to investment income and which relate to charitable activities. Foundations should also distinguish between expenses made for general grantmaking purposes versus those made to operate any direct charitable programs. If some expenses relate to both grantmaking programs and directly operated charitable programs (e.g., an employee who works in both areas), the foundation should use a reasonable method to allocate the expenses.
Having up to date and accurate books and records can help foundation leaders be more aware of potential conflict of interest issues and maintain compliance with the self-dealing rules. In general, the self-dealing rules prevent foundations from carrying out any transactions with disqualified persons (foundation insiders). However, there are some very specific carve-outs for certain activities and arrangements such as reasonable compensation paid to directors, officers, and managers of the foundation. Please see the following link for a more in-depth discussion of the self-dealing rules.
Donation Acknowledgement Letters
If a private Foundation receives a donation of $250 or more, it must provide a written acknowledgement to the donor. Please see the following link, donation acknowledgment requirements, for a more in-depth discussion of the required procedures. A good year-end best practice is to verify that all required donation acknowledgment letters have been properly issued.
Substantial Contributor Tracking
Private foundations are required to track substantial contributors, which in general is anyone who contributes more than $5,000 to the foundation and the amount contributed is more than 2% of the foundation's total lifetime contributions received. New substantial contributors must be disclosed on the foundation's annual tax return (Form 990-PF). As such, the foundation should have a procedure in place to keep track of the total contributions it has received over its lifetime and separately track the total contributions of any contributors who might meet the definition of a substantial contributor in the future.
Private foundations with paid staff must comply with all applicable payroll laws and regulations just like all other for-profit and non-profit employers. Fortunately, in the present day and age payroll processing companies can help tremendously with this type of compliance and oftentimes offer end-to-end assistance. Nevertheless, the individual private foundations are ultimately responsible to make sure the rules are properly followed. Private foundations should verify that the following items are all being dealt with correctly:
• FICA taxes (Social Security and Medicare)
• Federal, state and local income tax withholding
• Unemployment insurance (FUTA + state unemployment insurance)
• Worker’s compensation insurance
Independent Contractor Payment Compliance
Private foundations must report to the IRS certain payments they make to independent contractors. If, by the end of the year, a foundation has paid $600 or more to any non-corporate consultants, law firms, accounting firms, directors or trustees, or other independent contractors, then the foundation should generally file form 1099-NEC by January 31 of the following year. There is an important exception for payments made to incorporated businesses, these do not need to be reported.
The requirements for when to file form 1099-NEC are quite complicated. Fortunately, there are many sources on the web relating to this topic. In general, the same rules that apply to other for-profit and non-profit entities also apply to private foundations.
For foundations that issue only a few forms 1099-NEC, it is undoubtedly easiest to file by postal mail. The IRS offers a PDF version of form 1099-NEC on its website with detailed instructions. The IRS also provides an option to file electronically through the Filing Information Returns Electronically (FIRE) system but you must create a special account before getting started. It is also possible to hire a company to file these forms for you.
Do people donate to charity for the tax deduction?
The primary reason people give to charity is not to take advantage of tax deductions. Very simple arithmetic shows this cannot be true.
The Truth About Overhead Ratios
The overhead ratio is a useful tool for private foundations carrying out due diligence in their grant making process. Evaluating the effectiveness of nonprofits is very difficult and analyzing overhead is just one piece of the puzzle. Every nonprofit charity needs a balanced amount of overhead to operate its charitable programs and to invest in crucial systems, talent, and training.
Effectiveness for Private Foundations—the Obscured North Star
It is said that effectiveness should be the North Star for private foundations—unfortunately this guiding light is difficult to follow. Foundation leaders must blend together art and science to course correct and help inform where future resources should be deployed.