One of the important differences between a public charity and a private foundation is the 5% rule which requires the foundation to spend at least 5% annually of non-charitable use assets acquired during the previous year. The reason for this requirement is to guarantee that private foundations distribute money for their charitable purposes. The payouts can be through grants or grant-related expenses. A report from the nonprofit attorneys from San Luis Obispo’s Toews Law Group, Inc. answers some of the questions that help foundations satisfy this rule.
Frequently asked questions include:
- Why 5%
- How is the amount calculated?
- What is the deadline for distributing funds?
- What are the best ways to distribute funds?
- Is there a penalty if we don’t meet the 5% rule?
- What if our policy is to distribute more than 5% annually?
Foundations are expected to use their assets in support of their charitable purposes. Section 4942 of the Internal Revenue Code
The U.S. government expects foundations to use their assets to benefit society and it enforces this through section 4942 of the Internal Revenue Code, which requires private foundations to distribute 5% of the fair market value of their endowment each year for charitable purposes.
How is the amount calculated?
How the required 5% of an asset is calculated depends on the asset. For example, cash balances can be calculated monthly by averaging the amount of cash on hand on the first and last day of the month, but real estate is based on the fair market value obtained using an independent appraisal on a five-year basis. An entirely different calculation is used for real estate held less than one tax year.
If you are setting up a new foundation or reviewing the organization’s disbursement policy, it’s a good idea to get professional legal guidance from well-established advisors, such as the attorneys for nonprofits from San Luis Obispo’s Toews Law Group, Inc.
What is the deadline for distributing funds?
Disbursements need to take place by the end of the tax year for funds received during the previous year. If the organization’s tax year ends December 31, 2021, at least 5% of the assets received during 2020 need to have been paid out by December 31.
A newly formed foundation may have longer to pay out the first year’s distributions.
What qualifies toward the pay out amount?
Grants are the most common qualifying distribution, however there are restrictions on organizations that qualify. For example, grants to an organization controlled by the foundation, or to another private foundation, may not qualify.
Other qualifying pay outs include foundation expenses incurred to directly carry out its charitable programs, assets purchased for use in carrying out the foundation’s purpose, program related investments and money set aside for specific charitable projects.
Determining what qualifies for the 5% rule can be complicated and it’s wise to consult with an experienced attorney for nonprofits.
Is there a penalty if we don’t meet the 5% rule?
Yes. Failing to meet the minimum distribution requirement is subject to an excise tax of 30% of the undistributed amount. An added penalty is that the foundation does not qualify for a reduction of excise tax for up to five tax years.
What if our policy is to distribute more than 5% annually?
A foundation can decide to distribute any amount over the 5% requirements. Distributions that exceed the 5% rule can be carried forward for up to five future years.
Rely on expert guidance
The attorneys for nonprofits in San Luis Obispo, provide counsel for setting up private foundations for a variety of purposes. The law firm also advises on alternatives to a private foundation, provides counsel management, legal, and tax issues from structuring the board of directors and executive committees to acknowledging contributions and finding liability insurance.
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This information has been prepared by Toews Law Group, Inc. for informational purposes only and is not legal or tax advice. The transmission of this information is not intended to create an attorney-client relationship. Contacting us does not create an attorney-client relationship. Consult an attorney for advice regarding your individual situation.