What Happens If a Private Foundation Misses Its 5% Distribution? (and how to fix it)

Private foundations are expected to actively support charitable causes rather than simply accumulate assets in their endowment. To enforce this, the IRS requires foundations to make annual charitable distributions—commonly known as the 5% payout—based on the size of their investment holdings. While the actual calculation under the tax code involves a few adjustments, the shorthand is accurate: roughly 5% of a foundation’s assets must be spent each year for charitable purposes. For board members, understanding this rule is essential, because falling short of the minimum distribution can bring steep IRS penalties and create compliance risks for the foundation.

How the 5% Is Calculated and When It’s Due

The 5% distribution requirement—technically called the distributable amount—is based on the average value of a foundation’s non-charitable-use assets from the prior year. These are the assets not directly used to carry out the foundation’s mission, such as the invested endowment of stocks, bonds, mutual funds, and other investments. Assets used in charitable work are excluded; for example, $10,000 worth of computers and office furniture would not be part of the calculation.

The official computation is performed on the foundation’s annual Form 990-PF and includes several adjustments, such as a 1.5% reduction for cash deemed held for charitable purposes and a credit for the investment-income excise tax. As a rule of thumb, however, the math is straightforward: multiply 5% by the average value of non-charitable-use assets from the prior year. For instance, the distribution requirement due by December 31, 2025 would be based on the average non-charitable-use assets held during 2024. Applying the 5% rate to that figure gives the approximate minimum payout that must be made by the end of 2025. In practice, this means a foundation has about one year to satisfy its annual distribution obligation.

What Expenditures Count Toward the Requirement

A wide range of expenditures can satisfy the payout requirement, and the law defines these as qualifying distributions. The most common are grants to public charities, along with all reasonable administrative expenses necessary to operate the foundation’s charitable programs. Direct charitable activities carried out by the foundation itself—such as running a scholarship program—also count. In certain cases, grants may even be made to non-charitable entities, but only if the funds are used for charitable purposes and the foundation follows a strict verification process known as expenditure responsibility.

In addition, amounts spent to acquire assets used directly for charitable purposes—such as computers, office equipment, or even a building dedicated to program operations—qualify toward the 5% payout. Program-related investments (PRIs) also count. A PRI is an investment made primarily to accomplish charitable purposes, such as a below-market loan to a nonprofit housing project; any financial return is incidental to advancing the foundation’s mission. By contrast, investment management expenses do not count toward the payout requirement, though they do reduce net investment income for purposes of calculating the 1.39% excise tax.

If a foundation distributes more than its required amount in a given year, the excess may be carried forward for up to five years to offset future requirements.

What Happens If the Requirement Is Missed

When a foundation does not make enough qualifying expenditures by the required due date, the IRS imposes a first-tier excise tax of 30% on the shortfall. This tax is not a one-time penalty. It is imposed each year that the deficiency remains uncorrected, meaning the cost of noncompliance compounds until the foundation cures the problem.

If the deficiency continues, the consequences escalate. Once the IRS becomes aware of the shortfall and determines that the foundation is not on a path of self-correction, it may begin enforcement proceedings. At that stage, the law authorizes a second-tier excise tax of 100% on the remaining undistributed amount. This second-tier penalty applies only after the IRS issues a notice of deficiency and the “correction period” expires. The correction period is generally 90 days from the date of the notice, though extensions may be granted. In practice, this means that if the IRS believes the foundation is unwilling or unable to fix the problem voluntarily, the full 100% tax can be imposed on top of the recurring 30% first-tier tax until the issue is resolved.

To illustrate the timing, consider a distribution requirement due by December 31, 2025, which is calculated from the average value of non-charitable-use assets held during 2024. If the foundation fails to make enough qualifying expenditures by the end of 2025, the 30% excise tax attaches immediately after the deadline passes. The foundation then has another 12 months to correct the shortfall before the 30% is imposed again, and this cycle will continue annually until the payout obligation is fully satisfied.

Correcting Shortfalls

If a foundation falls short of its annual payout requirement, the most direct remedy is to increase charitable expenditures. In most cases, that means awarding additional grants until the gap is closed.

However, before rushing to make new grants, it is important to confirm that all qualifying expenditures have been counted. Many boards assume that only grants apply to the 5% payout requirement, but as noted earlier, the definition is much broader. Reasonable administrative costs that directly support charitable activity typically qualify as well—such as staff payroll, rent and utilities for program space, travel for site visits, etc. If these expenses were overlooked or undercounted, the shortfall may be smaller than it first appeared—or it may even disappear entirely once everything is properly documented.

When a true gap remains, the most practical solution is to simply accelerate or expand giving. A foundation can move forward grants originally planned for the next year, increase the size of pending awards, or authorize a small round of discretionary grants to mission-aligned organizations.

Timing is critical. A grant only counts once the foundation has parted with control of the funds. In practice, this means mailing checks before year-end and keeping proof of mailing, or initiating wires and ACH transfers early enough for them to settle within the year. Waiting until January—even if the funds were budgeted—can inadvertently cause or enlarge a shortfall. Clear records of authorization, payment dates, and grantee acknowledgments help support the foundation’s true expenditures and avoid questions later.

To prevent problems from arising in the first place, many boards choose to distribute slightly more than 5% each year. Building in this margin helps cushion against forgotten expenditures that might otherwise create technical noncompliance. A final year-end check in December that all payments have actually gone out usually prevents surprises and keeps any corrections straightforward.

Conclusion

The 5% payout rule is one of the most important ongoing obligations for private foundations. While the calculation involves some technical adjustments, the principle is straightforward: each year, approximately 5% of the endowment must be directed toward charitable purposes. Falling short can trigger steep penalties, but in most cases the issue can be corrected by making additional grants. With regular monitoring, timely payments, and a small annual cushion, foundations can stay comfortably ahead of the requirement and keep their focus where it belongs—supporting their charitable mission.

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