Qualifying for the Reduced Rate on NII

Sec 501(c)(3) tax-exempt private foundations are subject to a 2% excise tax on net investment income (NII), under Sec. 4940. This tax is truly an excise tax, as it is one of the few taxes imposed on private foundations not meant to discourage or punish the entity for a tax law violation. The tax was designed to fund exempt organizations oversight; there has been (and continues to be) discussion on whether the funds the tax raises are used only to offset the cost of enforcing the sanctions.

Over the past 10 years, the funds raised by the tax have increased, while the number of related IRS audits has decreased. In 1984, Congress noticed that, historically, the excise tax collected exceeded the total costs of administering the exempt organization program and provided a way for foundations to pay a reduced rate (1%). With careful planning, a private foundation can take advantage of the reduced rate.

Definition

In general, Sec. 4940(c) defines NII as gross investment income plus net capital gain, less expenses directly attributable to producing, managing and collecting such income. Gross investment income includes, under Sec. 4940(c)(2), dividends, interest, rents, royalties and payments on securities loans.

Reduced Rate

To qualify for the reduced rate, the foundations current-year distributions must exceed a minimum. Under Sec. 4940(e)(2), the minimum equals the average fair market value (FMV) of current-year noncharitable assets, multiplied by the average payout (as a percentage of asset value) for the past five base years, plus 1% of current-year NII.

Example: Y Foundation has a 5% average distribution ratio for the past five years, $1 million of current-year NII and $25 million average FMV of current-year assets. It would need to distribute at least $1.26 million (($25 million x .05) + ($1 million x .01)) to be eligible for the 1% rate.

Problems

Foundations encounter several problems in planning to meet the reduced-rate requirements. First, the calculation of the average FMV of assets is a monthly average that includes assets held through the last day of the year. Also, a foundation does not always know how much NII it will have for the year, nor does it know the degree to which the FMV of its assets will change.

Additionally, the foundation must also have complied with the Sec. 4942 minimum-distribution requirements for all base-period years, which require a minimum annual distribution of 5% of the average FMV of investment assets during the current year (reduced by the tax on investment income). Despite these obstacles, it is still possible to plan to qualify for the reduced rate.

One of the most important variables is the average FMV of the foundations investment assets. Thus, it is critical for the organization to maintain accurate, timely information on its asset values, especially given the fluctuations in the securities markets over the past two years. However, with the use of technology, the burden of tracking the value of securities has been reduced. Many accounting/bookkeeping programs offer software designed to download information directly from various sources.

The amount and timing of grant payments also plays an important role in qualifying for the reduced rate. Because of the averaging of distributions over a five-year base period, a foundation may want to reduce its current-year distributions to make it easier to qualify for the reduced rate in a subsequent year. The same result could also be achieved by staggering distribution payment dates to straddle more than one tax year. In this manner, the foundation will potentially qualify for the reduced tax rate every other year. This technique would result in the foundation generating distributions in excess of the annual amount required under Sec. 4942 in certain years, which would then be carried over to the subsequent year and used to meet the Sec. 4942 requirement.

Because NII includes net capital gain, a foundation should try to distribute appreciated capital gain property to grantees in lieu of cash. This technique serves two purposes. First, it reduces the capital gain the foundation recognizes, because the assets are not sold, and the FMV of such distributed securities is a qualified distribution. Second, a foundation cannot carry forward or back any capital losses.

With careful planning, a foundation can lower its tax burden on NII on a regular basis, by qualifying for the reduced tax rate.

From Mario A. Gonzales, CPA, and David Faje, CPA, Chicago, IL