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In this article, we will provide an overview of the annual minimum distribution requirements and the new excise tax on investment income for private foundations.

Prior to 2019, private foundations had to pay an excise tax of 1 or 2 percent on their net investment income. Now, for tax years starting in 2020, the excise tax is a flat 1.39% of the foundation’s net investment income, with quarterly estimated tax payments still potentially required.  Private foundations who have had more than $1,000,000 of net investment income in any of the three prior tax years, must pay estimated taxes based on their current year tax, using the new 1.39% rate.

Net investment income includes interest, dividends, rents, royalties, and capital gains. It is important to note that if appreciated assets are donated to the foundation and sold by the foundation, the capital gain included in net investment income is the difference between the original donor’s cost basis and the sale price. Expenses directly related to investment income are deductible and reduce the net investment income subject to the tax. For foundations, revenue from contributions is not included in net investment income. In addition to the excise tax calculation, private foundations are required to make qualified charitable-purpose distributions each year. The minimum amount foundations are required to distribute is 5% of the fair market value of their assets that are not used for exempt purposes. Assets taken into account for the calculation of the required minimum distribution generally include cash, marketable securities, and other assets not held for a specific charitable purpose.

The amount required to be distributed is calculated based on the asset values for the current tax year, but foundations have until the end of the following year to distribute the full amount required. Any required distributions not made by then face a 30% excise tax in addition to still having to pay the required distribution amount remaining. On the flip side, if a foundation pays out more than the required distribution amount, the excess will carry forward to be applied against future required minimum distributions.

Qualifying distributions include amounts paid to accomplish the foundation’s charitable purpose, including making grants to other qualifying charitable organizations. Expenses related to investment income are not qualifying distributions.

If you have any questions regarding the distribution requirement or need assistance with excise tax calculations, please do not hesitate to contact your L&B professional at (858) 558-9200.

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