Tax Planning for Private Foundations

By Jeremy Bottlinger, CPA, Wallace, Plese + Dreher LLP, Chandler, Ariz.

Editor: Michael D. Koppel, CPA/PFS/CITP, MSA, MBA

Exempt Organizations

Tax planning is often used by for-profit entities and individual taxpayers to ensure they structure transactions in a manner that minimizes tax liability. However, tax planning can and should also be used by not-for-profit entities. In particular, private nonoperating foundations should employ tax planning techniques to lower the entity's excise tax rate from 2% to 1%. The potential tax savings that would result from proper tax planning would be better used to further the foundation's exempt purpose.

Private nonoperating foundations must pay federal excise taxes at a rate of either 1% or 2% on net investment income. To avoid paying the 2% rate, private foundations must ensure that their current-year qualifying distributions (grants, donations, etc.) exceed the rolling average of distributions divided by assets from the preceding five years, plus 1% of current-year net investment income. The best way to accomplish this is for the foundation to distribute a consistent percentage (distributions ÷ average non-charitable-use assets) of the foundation's non-charitable-use assets each year. The foundation can manipulate both the numerator (qualifying distributions) and denominator (non-charitable-use assets) by implementing tax planning techniques throughout the year and by performing a calculation during the final month of the foundation's fiscal/calendar year to determine if the foundation has made sufficient distributions.

Each year, a private foundation must distribute 5% of the foundation's average non-charitable-use assets. However, foundations are able to make up shortfalls in qualifying distributions up to one year after the end of the current year end. Non-charitable-use assets consist of assets that are not integral to the operation of the foundation, such as cash—although 1.5% of the foundation's cash balance is deemed to be a charitable-use asset—and investments (stocks, bonds, real estate, mutual funds, etc.), whereas assets such as computers, desks, vehicles, and buildings are considered charitable-use assets.

To determine the required minimum qualifying distributions, the foundation must calculate the average value of each type of non-charitable-use asset. Each type of non-charitable-use asset, however, can be valued on a different date during the month, allowing the foundation to artificially inflate or deflate the value of non-charitable-use assets. Cash must be valued as of the final day of the month, but investments can be valued on any day the taxpayer chooses. Once that date is chosen, it must be consistently applied going forward.

Net investment income for private foundations is the amount by which the sum of gross investment income and capital gain net income exceeds deductions allowed in Sec. 4940(c)(3). Gross investment income is defined to include interest, dividends, rents, and royalties. Allowable deductions are the ordinary and necessary expenses paid or incurred in connection with the production of the gross investment income. These expenses can include:

  • Advisory fees;
  • Commissions;
  • Depletion;
  • Interest;
  • Taxes (but not the excise tax of either 1% or 2% on net investment income);
  • Compensation of officers or other employees; and
  • Rent.

When an expense is incurred for both the operation of the charity and for the production of investment income, it must be appropriately allocated between the two. For instance, if an employee acts in an investment advisory role and also performs routine daily activities such as accounting, bookkeeping, or grant-making, then his or her time must be apportioned between investment and operating expenses.

By setting the valuation date of investments on a day other than the final day of the month—which is the mandatory valuation date of cash—for example, on the 15th of the month, the exempt organization could artificially increase or decrease its average non-charitable-use assets. If the exempt organization were to buy or sell investments on the day before the end of the month, the foundation would decrease or increase the amount of cash on hand as of the valuation date. If the foundation then purchased or sold investments on the 14th—in the example, a valuation date of the 15th has been chosen for investments—the amount of investments would increase or decrease on the valuation date. In essence, the non-charitable-use assets would be manipulated to be counted twice, thus increasing the denominator, resulting in a lower percentage being used to determine the threshold required for current-year distributions to qualify for the 1% rate on net investment income.

By consulting a tax adviser, the foundation can determine the appropriate course of action to follow so that it pays only the 1% excise tax rate. Although the difference in the tax rate is only 1%, it can save a considerable amount of money for even a smaller nonoperating private foundation, which can be used to further its exempt purpose.


Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or

Unless otherwise noted, contributors are members of or associated with CPAmerica International.

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