Friday April 26, 2024
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7.2.7 Tax on Net Investment Income
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Tax on Net Investment Income
Calculating Net Investment Income: Sec. 4940(c) of the Internal Revenue Code provides the guidelines for calculating net investment income.
1% Excise Tax Reduction Requirements: Some private foundations will be eligible for a 1% excise tax reduction, under Sec. 4940(e), if they meet certain distribution requirements.
Definitions: "Gross investment income" is defined as "the gross amount of income from interest, dividends, rents, payments with respect to securities loans, and royalties, but not including any such income to the extent in computing the tax imposed by Sec. 511 unrelated business taxable income (UBTI)."
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While private foundations are generally exempt from income tax, the net investment income of a private foundation--including dividends, interest, royalties and net capital gains--is subject to a 2% tax that must be paid in quarterly installments. Under certain circumstances, a foundation may be eligible for a 1% reduction on the tax.
Calculating Net Investment Income
Sec. 4940(c) of the Internal Revenue Code provides the guidelines for calculating net investment income. Gross investment income plus net capital gains, minus ordinary and necessary expenses, equals net investment income.
1% Excise Tax Reduction Requirements
Some private foundations will be eligible for a 1% excise tax reduction, under Sec. 4940(e), if they meet certain distribution requirements. To be eligible, the private foundation must meet two requirements. These are:
- the amount of the qualifying distributions meet or exceed the sum of
- an amount equal to the assets of the foundation for the particular taxable year, multiplied by the average percentage payout for the base period, plus
- 1% of the net investment income of the foundation; and
- the foundation was not liable for tax imposed for failure to distribute income for any year in the base period.
Definitions
"Gross investment income" is defined as "the gross amount of income from interest, dividends, rents, payments with respect to securities loans, and royalties, but not including any such income to the extent in computing the tax imposed by Sec. 511 unrelated business taxable income (UBTI)." Sec. 4940(c)(3).
"Capital gains and losses," for the purposes of calculating net investment income, are taken into account only on the "sale or disposition of property used for the production of interest, dividends, rents, royalties, and property used for the production of income included in computing the tax imposed by Sec. 511 (UBTI)." Sec. 4940(c)(4)(A).
However, capital losses are allowed to be taken into account only to the extent they fall short of capital gains, with no carryover allowed. Sec. 4940(c)(4)(B).
"Ordinary and necessary expenses" are those that are paid or incurred for the production or collection of gross investment income or for the management, conservation or maintenance of property held for the production of such income. Sec. 4940(c)(3)(A).
"Qualifying distributions" are defined under Sec. 4942(g) of the Internal Revenue Code as the amounts spent on religious, scientific, educational and/or other charitable purposes listed in Sec. 170(c)(2)(B), including program-related investments. Monies set aside for specific charitable purposes, and used to purchase charitable-use assets are also considered "qualifying distributions." Contributions to operating foundations and foundations controlled by any disqualified person are not "qualifying distributions."
"Average payout percentage" is the average of the percentage payouts for tax years contained in the base period. This amount can be determined by dividing the amount of the foundation's qualifying distributions in a taxable year by the assets of the foundation for the same taxable year. Sec. 4940(e)(3)(B).
"Base period" is defined as the five taxable years preceding the current taxable year. Sec. 4940(e)(4).
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Case Studies on Tax on Net Investment Income
Lucky Lucy Lindstrom's Flood Recovery Plan:
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 has learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market. After reading in her favorite charity's weekly enewsletter about the need for housing in a low-income area that had been destroyed by a flood, Lucy called Clara Johnson, the charity's gift planner.
Lucy had invested $1,000,000 in stock in a renewable energy company with the name Northern Long Shot, Inc. This company designs and manufactures energy solutions for companies across the far north. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy thinks that this stock should be sold as soon as possible, but she would like to receive a deduction this year. In addition, she thought that the $5,000,000 could be placed in a private foundation to make loans to low-income individuals who otherwise could not afford to rebuild their homes. Since she wanted to have direct influence over the program, Lucy called her attorney Susan White to discuss a potential major gift to a private foundation for low-income housing loans.
Would this plan work? Can the private foundation receive the gift and sell the Northern Long Shot, Inc. stock? May the funds be used to offer housing loans to low-income individuals? Is there a better plan?
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