If you’re involved with a private foundation, you’ve likely encountered the “5% payout rule.” This well-intentioned but often perplexing regulation governs charitable giving by private foundations. In this blog post, we’ll explore the origins, rationale, and practical considerations of the 5% payout rule.
The Historical Context of the 5% Payout Rule
The 5% payout rule was established as part of the Tax Reform Act of 1969 to ensure private foundations provide meaningful financial support to charitable causes while preserving their long-term viability. The rule requires private foundations to distribute 5% of the fair market value of their assets annually for charitable purposes. Initially, calculating this minimum distribution proved challenging, leading to a revised version in 1976—the rule we know today.
Why 5%?
The 5% figure aims to strike a balance between sustaining foundations’ endowments and meeting present-day charitable needs. It is based on historical market returns averaging around 8%, with 3% allocated for inflation and 5% for charitable distributions. This ensures a consistent flow of resources for nonprofits while safeguarding the foundation’s future.
How is the 5% Payout Rule Calculated
The 5% payout rule requirement is based on a 13-month average of the foundation’s asset values. It includes both grant payments to qualifying 501(c)(3) organizations and eligible operating expenses. Understanding which expenses qualify is critical. Eligible expenses typically cover activities directly tied to charitable purposes, such as due diligence, record-keeping, and administrative support. Investment fees, however, are excluded.
If you’ve recently formed a private foundation, you’re not required to meet the 5% minimum distribution requirement in your first tax year unless that year is a full 12-month period. The 5% payout rule applies to each full tax year after you receive tax-exempt status, so if your first year is short—for example, you incorporate in July and your fiscal year ends in December—you won’t have to meet the payout requirement until the following year. But if your first year runs a full 12 months, the clock starts ticking right away. Either way, you’ll want to begin planning early to ensure qualifying distributions are made on time to avoid the steep excise taxes imposed for failure to meet the requirement.
Challenges in Meeting the 5% Requirement
Foundations often grapple with meeting the exact 5% threshold. Overpayments and underpayments are common, with any shortfall carried over to subsequent years. While minor deviations are acceptable, persistent underpayments could invite regulatory scrutiny and hinder the foundation’s charitable impact.
Contemporary Debates and Criticisms
Despite its benefits, the 5% payout rule has faced criticism. Some advocate for higher payout requirements or changes to how qualifying expenses are calculated, arguing that administrative costs and grants to donor-advised funds should not count toward the 5%. However, foundations argue that higher payout mandates could undermine long-term charitable giving, especially as investment returns trend lower.
Tax Implications and Recent Updates
Private foundations must also navigate excise taxes on investment income, now set at a simplified flat rate of 1.39% following the Further Consolidated Appropriations Act of 2020. While this change reduces administrative complexity, understanding its impact on the payout calculation remains vital.
A Practical Example
To illustrate, consider a fictional “Do Gooder Foundation” with $1 million in assets. Using a 13-month average asset value, its 2020 payout target would be approximately $51,125. Any slight underpayment could be carried forward, with adjustments made the following year. This example highlights the intricacies of meeting the 5% requirement and the importance of meticulous planning.
Conclusion
The 5% payout rule is a cornerstone of private foundation governance, balancing immediate charitable contributions with the preservation of future giving capacity. Understanding its nuances can help foundations maintain compliance and maximize their philanthropic impact. For tailored advice, consult qualified legal and accounting professionals.
Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C. licensed to practice in Washington and Arizona. Ellis advises nonprofit and socially responsible businesses on federal tax and fundraising regulations nationwide. Ellis also advises donors concerning major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.