Thursday March 28, 2024

7.2.3 Minimum and Qualifying Distributions

Minimum and Qualifying Distributions

5% Distributable Amount Calculation:  The 5% minimum distribution amount is calculated using the average fair market value for the preceding year of all foundation assets that are not directly used for charitable purposes.

Qualifying Distributions:  Distributions that count toward the 5% minimum distribution requirement are known as "qualifying distributions."

Expenditure Responsibility:  A private foundation's distribution to any organization not classified as a public charity is a qualifying distribution only if the private foundation exercises "expenditure responsibility."

Scholarships and Grants to Individuals:  Sec. 4945(g) allows a private foundation to give money to individuals if the decision to give money is made on an objective and nondiscriminatory basis and pursuant to a program approved in advance by the IRS.

Distributions to Donor Advised Funds:  Private foundations commonly establish donor advised funds (DAFs) to receive their required annual minimum distributions.

Penalty for Failure to Make Minimum Distributions:  If a private foundation fails to satisfy the minimum distribution requirement, an excise tax of 30% is imposed on the amount that the foundation should have distributed but did not.
Most private foundations do not conduct charitable activities but instead manage money and distribute it to other charities. To ensure that private foundation money does not remain in bank accounts unused, each year a private foundation is required to distribute at least 5% of its assets for charitable purposes. This is known as the "minimum distribution" requirement.

5% Distributable Amount Calculation


The 5% minimum distribution amount is calculated using the average fair market value for the preceding year of all foundation assets that are not directly used for charitable purposes (generally, this means the private foundation's investments) reduced by the amount of any debt incurred to acquire those assets and reduced by an allowable cash reserve (1½% of assets less debt).

Example 7.2.3A

During Year 1, the Franklin Foundation, a private foundation, had an average of $2,000,000 in money market and stock funds and no debt. Its allowable cash reserve is $30,000 or 1½% of its Year 1 average investment assets. To determine its minimum distribution amount in Year 2, the Franklin Foundation subtracts its allowable cash reserve of $30,000 from its end of Year 1 $2,000,000 investment assets and then multiplies the result by 5%. The Franklin Foundation's Year 2 distributable amount is $98,500.

Qualifying Distributions


Distributions that count toward the 5% minimum distribution requirement are known as "qualifying distributions." Reasonable and necessary administrative expenses are qualifying distributions. Generally, distributions to public charities, including donor advised funds at public charities, are proper qualifying distributions. Distributions to nonprofit organizations that are not public charities (including other private foundations) require that the private foundation exercise expenditure responsibility. Distributions to individuals and foreign charities may be qualifying distributions but only if specific conditions are satisfied.

Example 7.2.3B

The Franklin Foundation's Year 2 distributable amount is $98,500. During Year 2, the Franklin Foundation had $15,000 in reasonable administrative expenses and distributed $65,000 to public charities and $25,000 in qualifying distributions to individuals. The Franklin Foundation satisfied its minimum distribution requirement in Year 2 because its qualifying distributions were $105,000, $6,500 more than was required.

Expenditure Responsibility


A private foundation's distribution to any organization not classified as a public charity is a qualifying distribution only if the private foundation exercises "expenditure responsibility." Expenditure responsibility means that the private foundation is responsible to:
  • See that the grant is spent solely for the purpose for which it was made;


  • Obtain full and complete reports from the grantee on how the funds were spent; and


  • Make full and detailed reports with respect to the expenditure to the Internal Revenue Service.


Sec. 4945(h).

On a practical level, exercising expenditure responsibility generally requires a private foundation to take the following steps: First, a private foundation must make a pre-grant inquiry before making a grant where expenditure responsibility is required. The purpose of the pre-grant inquiry is to ensure that the grantee will use the grant for proper exempt purposes. Second, a grant agreement must then be executed wherein the grantee agrees to repay any unused portion of the grant, provide reports to the private foundation on the use of funds, maintain records and receipts of expenditures, make its books and records available to the private foundation, not to use the funds for prohibited lobbying or political purposes, not to use the funds to make grants to individuals, and not to use the funds for any non-charitable activity. Next, the private foundation must obtain follow up reports from the grantee indicating how the funds were used, what progress the grantee is making in achieving the purpose for which the grant was made and confirming that all terms of the grant agreement terms were followed. Finally, the private foundation must report to the Internal Revenue Service that it made an expenditure responsibility grant. Reg. 53.4945-5(b).

Scholarships and Grants to Individuals


Sec. 4945(g) allows a private foundation to give money to individuals if the decision to give money is made on an objective and nondiscriminatory basis and pursuant to a program approved in advance by the IRS. In addition, any such distribution of money to an individual must fall into one of three categories: (1) scholarship or fellowship grants described in Sec. 117 and used for study at an educational organization; or (2) prizes or awards described in Sec. 74(b) where the recipient of such prize or award is selected from the "general public;" or (3) grants that have the purpose of achieving a specific objective, producing a report or similar product, or improving or enhancing a literary, artistic, musical, scientific, teaching or other similar capacity, skill or talent of the grantee.

Distributions to Donor Advised Funds


Private foundations commonly establish donor advised funds (DAFs) to receive their required annual minimum distributions. By making qualifying distributions to a DAF, the private foundation does not need to currently designate specific grant recipients and may accumulate funds (inside the DAF) so that a large gift may be made in a future year. A private foundation's transfer of money to a DAF is a "qualifying distribution," however, only if the foundation does not "impose any material restriction or condition" that prevents the public charity from "freely and effectively" using the assets in the DAF for exempt purposes.

Penalty for Failure to Make Minimum Distributions


If a private foundation fails to satisfy the minimum distribution requirement, an excise tax of 30% is imposed on the amount that the foundation should have distributed but did not. If the failure to make minimum distributions is not corrected, the private foundation is subject to an excise tax of 100% of the amount that the foundation should have distributed but did not. Sec. 4942.

Example 7.2.3C

Private Foundation had an average of $10,000,000 in investment assets during Year 1. Also during Year 1, Private Foundation had $100,000 of acquisition indebtedness and paid $14,500 in excise and income taxes. Private Foundation's Distributable Amount in Year 2 is $473,075.

Year 1 Gross Investment Assets $ 10,000,000
Less Acquisition Indebtedness (100,000)
Less Allowable Cash Reserve (1½% of Investment Assets Less Acquisition Indebtedness) (148,500)
Net Value of Investment Assets 9,751,500
Minimum Investment Return (5% of Net Value of Investment Assets) 487,575
Less Year 1 Excise and Income Taxes (14,500)
Year 2 Distributable Amount (Minimum Investment Return Less Year 1 Excise and Income Taxes) $ 473,075

Case Studies on Minimum and Qualifying Distributions

Lucky Lucy Lindstrom's "Hurricane Grants" Idea:   Lucky Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor (RIA) and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucy was so successful in these markets that she now only manages her own large personal portfolio.

Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market. Lucy had invested $1,000,000 in a "penny stock" company. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy was delighted with her gain and decided to give the $5,000,000 in stock to a charitable foundation to help those in need.

Lucy discussed several options with her attorney and her favorite charity. One of the options that Lucy was very interested in was a private foundation (PF). She asked her attorney for reasons to select a private foundation. Her attorney noted that private foundations are more expensive to operate, appreciated gifts are deductible only to 20% of AGI, deductions for gifts of real estate to a PF are limited to basis, there is usually a 2% excise tax on investment income and the PF is subject to various rules on self-dealing, minimum distributions and excess business holdings. However, a private foundation would give Lucy full control. This is important to Lucy since she wants to make grants for disaster relief directly to those in need.

Lucy said, "Wow! There are a lot of negatives about private foundations. So why set up a private foundation? And if I fund a private foundation, can I make grants to people who suffered so greatly in a hurricane?"

Private Letter Rulings

PLR 200023050 Private Foundation Challenge Grant Approved:   A private foundation desires to create a challenge grant for a public charity. Under the terms of the grant, the funds will be deposited in an escrow account with a bank for a period of two years. If the public charity raises the required sum during that time, the challenge grant funds will be transferred to the public charity. If the public charity fails, the funds will be distributed to another public charity.

PLR 200102054 Private-Public Charity Cooperation on Scholarship Fund:   Private foundations may award scholarships, but they are subject to specific requirements under Sec. 4945(b)(3) that include advance approval by the Service. The advance approval is designed to make certain that the grants are on an objective and nondiscriminatory basis.

PLR 200103080 No Excise Tax on Grants Used for Children of Company's Employees:   A public charity currently selects scholarship recipients from a scholastic competition. Students who perform extremely well on these tests and meet other criteria are designated as finalists. Private foundation has entered into an agreement with the charity to sponsor yearly scholarships.

PLR 200121078 PF's Grant to Foreign Charity is Qualifying Distribution:   PF, a domestic 501(c)(3) organization, made grants to Foreign Orphanage. For decades, Orphanage was a home for destitute, homeless, impoverished, diseased, and underprivileged children. Orphanage's mission was to provide food, shelter, medical care, and education to its children. Accordingly, Orphanage was recognized as a charitable organization by its country's government.

PLR 200249010 Scholarship Grants Not Deemed Taxable Expenditures:   Taxpayer wants to implement a scholarship program. The scholarship program will make 52 grants annually, one in each state plus two additional grants. Each selected student will receive $10,000 for qualified education expenses. However, 10 national winners will each receive $15,000, a computer and an intern position with Taxpayer.

PLR 200332018 Scholarships May Be Awarded to Relatives of Community Foundation Officers:   M, a private foundation, and N, a supporting organization, created a program to award scholarships to students in State X. This program was designed to alleviate State X's problem of too few state residents who hold at least a college degree. The program provided recipients with scholarships for full tuition, required fees and other expenses. The program was open to any State X student who attended a State X public or private university. In addition, M and N involved State X community foundations into the scholarship program process. Specifically, community foundations throughout State X would participate in the scholarship program selection process.

PLR 200340026 Foundation's Scholarships To Registered Nurses Approved:   Foundation wants to encourage nursing school students to work for local nonprofit hospitals after graduation. If this goal can be achieved, then the quality of healthcare in the local community would greatly improve. Pursuant to this goal, Foundation proposes to form a nursing scholarship program.

PLR 200420031 Corporate Foundation Grant Procedures Approved:   Widget Foundation is a private foundation created and funded by Widget, Inc. The Foundation started a program to provide scholarships to the children of Widget, Inc., employees. Widget Foundation seeks a ruling that the scholarships it awards will not constitute taxable expenditures.

PLR 200512026 Church Renovation Set Aside Permitted:   A private foundation is required under Sec. 4942 to make qualifying distributions each year. Generally, the private foundation distributes 5% of its net assets each year.

PLR 200518012 Grandma's Creative Gifting:   Grandmother established a donor advised fund (DAF) during life. In grandmother's living trust she bequeathed all of her tangible personal property to her grandchildren in equal shares. In the trust, grandmother included a provision that should any of the grandchildren disclaim the gift, those assets would be transferred to a sub-fund of grandmother's DAF. Further, the grandchild who gave the disclaimer would have the ability to serve as an advisor of the sub-fund.

PLR 201233019 IRS Approves Foundation's Set-Aside of Funds:   ORG is tax-exempt under Sec. 501(c)(3) and classified as a private foundation under Sec. 509(a). ORG requested a set-aside of funds for the tax year ending U to fund work to develop a cure for M.

PLR 201437014 Foundation’s Grants Deemed Qualifying Distributions:   Foundation is a private non-operating foundation under Sec. 509(a) whose mission is to make grants to other Sec. 501(c)(3) organizations. Foundation was created by Grantor, who also serves as a trustee and member of its governing board.


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