The federal tax laws require that private foundations distribute a certain amount each year for charitable and administrative purposes. That amount is equal to 5 percent of the value of the foundation's net investment assets.
The assets against which the 5 percent is measured include the foundation's investment assets, but not program-related investments or other assets that are used directly in carrying out the foundation's charitable mission. For example, if the foundation owns the building that houses its offices, the value of the building is excluded from the 5 percent calculation to the extent the building is used directly for charitable activities and related administrative functions. The tax regulations contain instructions for valuation of the investment assets. For example, a foundation must use the average of the monthly values of publicly traded securities held during the year.
Any amount, including most grants and program-related investments, that the foundation distributes for its charitable purposes counts toward the 5 percent. In addition, reasonable and necessary administrative expenses that relate to charitable activities count. The tax that foundations pay on their investment income does count, but expenses relating to management of investments do not count. A grant or program-related investment paid to a Type III non-functionally integrated supporting organization, to a Type I or Type II donor-controlled supporting organization, or to another private foundation or to an organization that is controlled by the foundation, generally does not count. Special rules apply to payments to foreign organizations. With the approval of the IRS, amounts set aside for use in a future year will, under certain limited circumstances, count as distributions in the year of the set-aside.
A foundation must make the required distributions by the end of the year following the year on which the 5 percent calculation is based. For example, a foundation with $1 million in assets in 2009 must make at least $50,000 of qualifying distributions by the end of 2010.
Excess distributions may be carried forward for up to five years to meet future distribution requirements. Excess distributions may not be carried back to satisfy distribution for previous years.
If a foundation does not distribute the required amount by the deadline, it is subject to an initial penalty equal to 30 percent of the shortfall. It must also distribute the shortfall or be subject to a penalty equal to 200 percent of the shortfall.
Certain private foundations that actively conduct charitable activities (as opposed to making grants) may qualify as "private operating foundations," which are subject to somewhat different distribution requirements. Operating foundations receive some of the benefits of public charity status, including some favorable tax deduction rules for contributions they receive.