One might think that because a private foundation is a nonprofit charitable organization it is exempt from all tax. However, while private foundations are exempt from income tax, most are subject to a one or two percent “excise tax” on net investment income. This tax must be reported on Form 990-PF, Return of Private Foundation, and must be paid annually at the time of filing that return or in quarterly estimated tax payments.
Internal Revenue Code section 4940 imposes an excise tax of 2% on the net investment income of most domestic tax-exempt private foundations. The tax can be reduced to 1% for private foundations that meet certain distribution requirements.
So what exactly is net investment income?
Net investment income is the amount by which the sum of the gross investment income (the total amount of income from interest, dividends, rents, payments with respect to loans, and royalties) and the capital gain net income exceeds the allowable deductions.
How can I lower my net investment income tax from 2% to 1%?
You can reduce the excise tax on net investment income from 2% to 1% if the qualifying distributions, or grants and contributions, made during a taxable year equal or exceed the required threshold. This threshold is:
- The foundation’s total assets for such taxable year multiplied by the average percentage payout for the base period plus
- One percent of the foundation’s net investment income for such year.
Basically, if a foundation gives out more this year (as a percentage of assets) than it did on average over the prior five years (the base period), it may qualify for the 1% excise tax rate.
For example, if a foundation’s assets are $1,000,000 at the beginning of the taxable year, the percentage payout for the base period is 8% and net investment income is $100,000, the amount required to be distributed in order to qualify for the 1% tax would be $81,000.
- Assets of $1,000,000 x percentage payout of 8% plus
- 1% of net investment income of $100,000.
Why wouldn’t I want to lower my excise tax to 1% versus 2%?
While it seems obvious to try and reduce your private foundation’s excise tax liability, your private foundation should consider not only the short term effects but also the effects in the long term. The two-tier tax rate provides both an incentive in the short term and a disincentive in the long term to increasing distribution levels.
For example, if a foundation has plans to make $50,000 in distributions, choosing the option to pay 1% tax on $100,000 versus 2% tax on $100,000 would require an additional $31,000 in distributions in order to qualify for the 1% tax, but only save the foundation $1,000 in excise tax. The short term tax savings could make it significantly harder to qualify for the 1% tax rate in the long term due to the substantial increase in qualified distributions.
Is there any way I can set up a Private Foundation that pays no tax?
Unfortunately no, all private foundations are subject to excise tax, whether it be 1% or 2%.
Even though the considerations and calculations of qualifying distributions seem complicated, it is important to calculate and be aware of your foundation’s qualified distribution threshold. This will help you determine if it makes sense to pay the higher 2% tax or pay more in distributions in order to qualify for the lower 1% tax. For assistance in calculating and monitoring your threshold please contact us at 858-558-9200.