When does 5% not equal 5%?

A simple guide for the perplexed on private foundation payout

BY DAN PETEGORSKY

Super-smart researcher and analyst Dan Petegorsky explains why the “required 5% payout” for foundations isn’t what it appears, in particular because their own expenses count towards the requirement.

It is common knowledge that private foundations are required to pay out 5% of their assets each year, but what does this actually mean? A short answer would be some 5% of X (defined below) must be used for expenditures for public benefit.

What tends to be less well known is how and why private foundation payout numbers just don’t seem to add up when people look at foundation tax filings.

How do we get to what’s called the payout rate? The answer is relatively straightforward (with a few wrinkles), though the terminology and the details of the precise calculations can indeed be mystifying:

• “Assets” doesn’t mean the total net assets figures that show up on Part I of the 990PF form, and
• “Payout” doesn’t mean just the amount the foundation spends in grants.

So how does the IRS determine how much a foundation is actually supposed to pay out?

Instead of “payout” the IRS uses the term “Distributable Amount” (Part X, Line 7). That amount is based not on taking 5% of all the foundation’s assets, but of what it calls the “Net value of noncharitable-use assets” (Part IX, line 5). Since assets can include things like the offices and equipment the foundation uses in furtherance of its charitable activities, we’re mainly talking about the market value of the foundation’s investments. And the foundation subtracts 1.5% to allow for cash it uses for charitable activities. The IRS calls this 5% the “Minimum investment return” (Part IX, line 6). The following examples are from the 2023 Form 990PF of the Evelyn and Walter Haas Jr Fund:

To get from there to the amount the foundation is required to distribute, the IRS deducts the 1.39% federal excise tax the foundation pays on its investment income, and certain business expenses (Part X, lines 2a-c), and then adds in things like any grants that they have counted in the past but have been returned (Part X, line 4).

So that’s how you get to what we colloquially call their payout requirement (Part X, line 7).

How does the IRS figure out if the foundation has actually distributed what it was supposed to?

As noted above, “payout” doesn’t just mean grants. The term the IRS uses is “Qualifying Distributions” (Part XI). What else goes into “qualifying distributions” besides grants? In the simplest terms, the main elements are:

• Expenses related to the grantmaking activities of the foundation, reported on Part I lines 13-23, “including necessary and reasonable administrative expenses, paid by the foundation for religious, charitable, scientific, literary, educational, or other public purposes, or for the prevention of cruelty to children or animals” (from the IRS 990PF instructions, p. 16). These can include the usual categories any nonprofit incurs: salaries and benefits, occupancy expenses, other professional fees, and travel and event expenses – e.g., for board meetings. (These qualifying distributions do not include the costs of managing investments.)

Clearly there are many judgment calls involved in foundation spending decisions, particularly deciding whether these expenses are necessary and directly “relate to activities that constitute the charitable purpose(s) of the foundation.”

These expenses are called “Distributions for charitable purposes,” and are detailed on the first page of the 990PF, in Part I, column (d), lines 13-26, with the total carried over to in Part XI, line 1(a).

• Program related investments. This is a larger topic, but basically these are investments that align with the foundation’s purpose and that generate below market returns. They are allowed to be counted just like grants, and are summarized in Part XI line 1(b), with details on Part VIII-B.

The IRS form does not itself report what the foundation’s actual “payout rate” would be. Instead, Part XII reports how much the foundation’s Qualifying Distributions have either exceeded or fallen short of the Distributable Amount. In a nutshell:

• If they’ve given out more than the minimum, they’re allowed to carry over that amount into the next years (for as long as 5 years) in case they fall short in the future (Line 9).
  Since the Haas, Jr. Fund consistently distributes more than the required amount, this amount grows from year to year.
• By contrast, if the foundation has fallen short of the requirement, then Line 6(f) shows the amount of “undistributed income” they’re required to make up in the following year. If they then fail to distribute that amount they’re required to pay a 30% excise tax on the amount they fall short, which then gets even steeper if they still fail to pay up. (More about the surprising dollar totals in “undistributed income” to come – a critical compliance matter and trapped value problem – ripe for a future examination.) The following example is from the 2023 Form 990PF of the Lilly Endowment.

First, Part XII, line 1(d) shows the amount the foundation is required to distribute in 2023. Note, however, that Line 2(c) shows that in 2022 they had fallen some $1.4 billion short of meeting that year’s requirement:

So before applying any of their 2023 qualifying distributions (Line 4) to meet the 2023 requirement, the foundation first needs to make up for the 2022 that shortfall, leaving just $125.5 million to meet the 2023 requirement:

The result is that the foundation carried forward an even greater amount of undistributed income – $2.1 billion – that it needs to make up in 2024 (Line 6f):

That’s the fine print. And what about the payout rate? Using IRS terminology, it equals Qualifying Distributions divided by Net value of noncharitable use assets. So for our two examples:

ABOUT THE AUTHOR: Dan Petegorsky is a consultant to the Institute for Policy Studies and other infrastructure leaders. He is formerly the policy director for the National Council for Responsive Philanthropy. You can read more of his writing here: https://ips-dc.org/ips_author/dan-petegorsky/