Private Foundations: Achieving Maximum Use of Excess Qualifying Distributions

The carryover for excess qualifying distributions presents a planning opportunity that private foundations should use to their advantage.

Distributing Income

A private foundation must make qualifying distributions equal to its "minimum investment return" for any given tax year. In general, its minimum investment return is 5% of the fair market value (FMV) of its investment assets, less the excise tax imposed on its net investment income.

A private foundation has two tax years to make qualifying distributions—the year for which the distributable amount is calculated and the succeeding tax year. If the foundation does not meet this distribution requirement, a 15% tax would be imposed on income remaining undistributed as of the first day of the second (or any succeeding) tax year.

Excess Qualifying Distributions

Qualifying distributions in excess of the year's distributable amount become "excess qualifying distributions" and reduce the distributable amount of any year during the "adjustment period," which is the five tax years following the tax year in which such excess was created. Excess qualifying distributions are applied against the distributable amount after current qualifying distributions. If the foundation has excess qualifying distributions carried forward from more than one tax year, it would use them on a FIFO basis.

When a private foundation continually makes qualifying distributions in excess of its distributable amounts without using the carryover in some manner, it loses an important tax benefit. To avoid this, the foundation may either reduce current distributions and allow more of the carryovers to apply against the current distribution requirement, or qualify the foundation as a passthrough or conduit entity.

Use of Carryovers

Using the carryovers by deferring current qualifying distributions may be impractical, because the foundation may not be able to presently carry out its charitable mission. Of course, donors who otherwise would have contributed to the private foundation could provide funds to charities directly. Direct loans to charities by a private foundation are generally discouraged, as they can raise the issue of whether the loan constitutes a qualifying distribution.

Passthrough Approach

The Code provides increased income tax deductions for individuals who make charitable contributions to a private foundation that qualifies as a passthrough or conduit foundation:

• Cash contributions are deductible up to 50% of the donor's adjusted gross income (AGI);
• Contributions of appreciated long-term capital gain property are deductible up to 30% of AGI; and
• The total FMV of contributed long-term capital gain property is deductible. Under the general rule for contributing long-term capital gain property (other than qualified appreciated stock) to a private nonoperating foundation, a donee must reduce the deduction by the amount that would have been long-term capital gain had the property been sold instead of donated.

A donee may carry over charitable gifts in excess of the deductibility limits to the succeeding five tax years.

A deduction equal to the total FMV of long-term capital gain property may encourage donors to contribute such property (other than qualified appreciated stock), such as closely held stock and other business interests or investments. Under the regulations, an individual's investment, later transferred to a private foundation without consideration, generally is excluded from application of the jeopardy investment tax provisions.

These benefits are distinct advantages compared to those offered by the usual private nonoperating foundation. In addition to the potential economic advantages for the recipient organization, passthrough status may encourage potential donors by offering larger deductions for their contributions than would otherwise be available.

To achieve these benefits, the foundation must qualify as a passthrough foundation for a particular tax year by:

• Making qualifying distributions in an amount equal to (or in excess of) all contributions received by the 15th day of the third month following the close of the year and
• Not having any undistributed income from the prior or current year (Sec. 170(b)(1)(E)(ii)).

A private foundation may, however, elect to apply unused excess qualifying distributions from the preceding five tax years (available as a carryover), as the amount distributed for this purpose. For example, if the aggregate excess-distribution carryover exceeds the amount of current charitable contributions received, a foundation may not need to make any distributions to achieve passthrough status.

Several additional benefits of passthrough status exist for a foundation. The foundation needs to distribute, by the 15th day of the third month following the end of its tax year, only an amount equal to all contributions of noncash property received during the year. This distribution will be sufficient to secure a deduction equal to full FMV for donors of long-term capital gain property. Availability of the full FMV deduction would not be affected if the foundation retains cash contributions. However, the percentage limit on this deduction would be 20% of the donor's AGI. (A foundation electing passthrough status may choose to use its excess-distribution carryovers in lieu of satisfying the distribution requirement with current distributions.)

Conclusion

Excess qualifying distributions by private foundations offer a dramatic opportunity for enhanced charitable contribution deductions, thereby benefiting both donors and their charitable recipients. Many tangible benefits are available. Responding to excess distributions with the passthrough approach provides donors with the flexibility to maximize charitable deductions, maintain significant control over the foundation's investment decisions and fulfill charitable goals at the same time.

From Martin E. Greif, CPA, New York, NY