(a) What Are Investment Assets?

The minimum investment return is calculated based on “the excess of the fair market value of all assets of the foundation, other than those that represent future interests or expectations and exempt function assets.”⁶ Although referred to as an “investment return,” neither the tax code nor the regulations define the word investment for this purpose. Instead, all assets are included in the calculation unless they are specifically excluded. The included assets are reduced by acquisition indebtedness with respect to those assets, plus a cash reserve for operations presumed to equal 1½ percent of the total includable assets.

Successful calculation of MIR thereby depends on distinguishing investment assets from exempt function assets. This concept of exempt function versus investment is an important key to understanding MIR. If the foundation holds an asset as an investment, 5 percent of its value is payable annually for charitable purposes, even if it is not producing any current income. This method is different from the rules for calculating the excise tax on investment income, under which income from a few types of assets is excluded from tax.⁷

The typical PF investment portfolio of stocks, bonds, certificates of deposit, and rental properties usually forms the basis for calculating the distributable amount. Funds of all sorts—current, deferred grants, capital, endowment, and similar types of reserves—are all includable in the formula. If a property is used for both investment and program purposes, its value is allocated between the dual uses,⁸ such as an office building used by the PF for program, administrative, and investment activities.

(b) Future Interests or Expectancies

Certain assets provide beneficial support to the PF in an indirect fashion. Assets over which the PF has no control and in which it essentially holds no present interest are not included in the MIR formula. These assets most often are not actually in the possession, nor are they included in the financial records or statements, of the foundation. Excludable expectancies for MIR purposes include:⁹

• Charitable remainders and other future interests in property created by someone other than the PF itself, until the intervening interests expire or are otherwise set apart for the PF. If the foundation is able to take possession of the property at will or to acquire it readily upon giving notice, the property is included. The rules of constructive receipt for determining when a cash-basis taxpayer receives an item of income are relevant.
• Present interests in a trust, usually called a charitable lead trust. Until the Tax Court overruled the IRS, income from any such trusts was includable in the adjusted net income impacting private operating foundations.¹⁰
• Pledges of money or other property to the PF, whether or not the pledges are legally enforceable.
• Property bequeathed to the PF is excluded while it is held by the decedent's estate. If the IRS treats the estate as terminated because the period of administration is prolonged,¹¹ the assets are treated as PF assets from the time of such IRS determination.
• Options to sell property that are not readily marketable and are without an ascertainable value. Listed options to buy or sell common stocks that are traded on a security exchange are includable as investment assets.

(c) Exempt Function Assets

Income need not be imputed to property held by and actually used by the foundation in conducting charitable programs. Such assets are called exempt function assets, and are not usually held for the production of income (although they do produce income in some cases), but instead are “used (or held for use) directly in carrying out the foundation's exempt purpose.” To be excluded, such assets must actually be in use; cash earmarked for purchase of artwork, for example, is not an exempt function asset. The most common type of assets excluded from the MIR formula follow:¹²

• Administrative offices, furnishings, equipment, and supplies used by employees and consultants in working on the foundation's charitable projects are not counted. However, the same property, if also used by persons who manage the investment properties or endowments, is allocated partly to investment property.
• Buildings, equipment, and facilities used directly in projects are clearly not counted as investment property. Examples include:
  • Historic buildings, libraries, and the furnishings in such buildings.
  • Collections of objects on educational display, such as works of art or scientific specimens, including artworks loaned to other organizations.¹³
  • Research facilities and laboratories, including a limited-access island held vacant to preserve its natural ecosystem, history, and archaeology.¹⁴
  • Print shops and educational classrooms.
  • Property used for a nominal or reduced rent by another charity. The amount that is nominal is not specified in the regulations. The asset test for private operating foundations says a rental property leased to carry out an exempt purpose property is considered to be exempt property if the rent is less than the amount that would be required to be charged in order to recover the cost of property purchase and maintenance.¹⁵
  • Operation of a sheep ranch.¹⁶
  • Stock holding in a corporation engaging in curatorial activities and management of legacy of an artist (the foundation's founder).¹⁷
• Reasonable cash balances are considered to be necessary to carry out exempt functions. One and one-half percent of the included investment assets is presumed to be a reasonable cash balance, even if a smaller cash balance is actually maintained.¹⁸ If the foundation's programs require a higher amount to cover expenses and disbursements, the PF can apply to the IRS to permit a higher amount.¹⁹
• Program-related investments and functionally related businesses²⁰ that further the foundation's exempt purposes are not considered investment assets. The primary motivation for making these investments is not the production of income. Examples include a low-rent indigent housing facility and student loans receivable. Stock of a restaurant and hotel complex operated by a separate taxable corporation within a historic village and an educational journal are given as examples in the regulations.²¹ Such properties are also treated as related businesses.²²

An artist left his for-profit corporation in which he operated his “artistic enterprise” to a private operating foundation. The corporation had managed the artist's business, handling fabrication, shipment, sale, reproduction, and licensing of the work. Upon the transfer to the POF, the corporation changed its activities to a curatorial focus to foster an understanding of the broad scope of his work, advance scholarship of his work, and manage the artist's legacy. The value of the corporation was excluded from MIR calculation as a functionally related asset.²³

A private foundation owned a sheep ranch, and conducted educational research and development programs intended to enhance the quality and increase the production of range sheep in the western United States. The PF sought to develop and introduce into the market sheep with genetically desirable traits and further educational and scientific inquiry concerning the production of sheep. It sold culled sheep to slaughterhouses, along with wool, though the activity was operated at a significant loss. The foundation took the position that no portion of the ranch was held for the production of income or for investment. The IRS ruled in their favor that the ranch was an exempt function asset.²⁴

By definition, a functionally related business is one that is not unrelated.²⁵ Thus, the value of a business run by volunteers is not counted as an investment asset for this purpose.²⁶ A business in which the performance of service is a material income-producing factor, such as a retail shop, is not an unrelated business if substantially all of the work (about 85 percent) is performed without compensation.²⁷ A capital-intensive business, such as leasing of a parking lot, is treated as an unrelated business even if the management is donated and, by reference, its value would be included.²⁸ An unrelated business fragmented from within a larger aggregate of exempt activities does not, however, necessarily cause inclusion of the associated related-activity assets. Notwithstanding the fact that advertising sold for a journal creates taxable unrelated business income, the overall publication program can be considered a functionally related business.²⁹ The larger complex of a medical research foundation's publication program determines its character as a related business.

An interesting example of a functionally related business formed to conduct programs to “help low-income individuals create wealth and take control of their lives” has been provided in a private ruling.³⁰ The “business” provided consulting services to other foundations, including assistance in selecting investment opportunities, due diligence such as financial analysis, business plan and credit analysis, and tools to monitor such investments. The business also acted as a placement agent to locate investors and government funding for community development venture capital funds. Asset management services, such as setting up and administering a screen for investments in publicly traded companies whose activities supported the mission, were to be provided and included a public mutual fund. The ruling acknowledged that the business itself was not an exempt organization and would be subject to normal income tax. Importantly, the IRS ruled that the business was functionally related and not subject to the excess business holdings rules, because it promoted the mission.

(d) Dual-Use Property

In many cases, a PF owns and uses property for managing or conducting both its investments and its charitable projects. In such situations, an allocation between these two uses must be made. For assets used 95 percent or more for one purpose, the remaining 5 percent is ignored. An office building housing the foundation would be allocated based on the functions performed by the persons occupying the spaces, as illustrated in the following example:

In such a situation, 25 percent of the building's value would be treated as an investment asset. In a very large foundation, the formula may be more complicated. A third category, administration, may have to be included in the formula when the staff is sophisticated and separate personnel, accounting, and central supply departments serve the investment and program groups. For property that is partly used by the foundation and partly rented to others, the IRS has ruled that an allocation based on the fair rental value of the respective spaces, rather than the square footage, is appropriate.³¹

(e) Assets Held for Future Use

An asset acquired for use in the future may be treated as exempt function property when the foundation has definite plans to commence such use within a reasonable period of time (usually one year). Sometimes it takes a number of years to piece together a project using hard assets such as land, buildings, and equipment. When a PF has future plans for use of property and “establishes to the satisfaction of the Commissioner” (i.e., obtains IRS approval) that its immediate use of the property is impractical, an asset held for future use is excluded. Definite plans must exist to commence use within a reasonable period of time, and all of the facts and circumstances must prove the intention to devote the property to such use. The concepts are similar to set-asides.³² Money to be used to remodel or acquire furnishing for such property is not excluded. Acquisition of future charitable-use property is also treated as a qualifying distribution.³³

Property acquired with the intention of using it for exempt purposes may be treated as exempt function property from the time it is acquired, even if it is temporarily rented. The rental status must be for a reasonable and limited period of time and only while the property is being made ready for its intended use, such as during remodeling or acquisition of adjacent pieces of property. IRS approval is not necessary if the property conversion takes only one year. However, if the property is rented for more than a year, it is treated as investment property during the second year and thereafter until it is devoted to exempt purposes. This change is also taken into account for qualifying distribution purposes. Property reclassified as investment property would be treated as a negative distribution or added back in when calculating the annual distributable amount.³⁴

(f) Acquisition Indebtedness

The formula for calculation of the minimum investment return allows a reduction in includable assets by the “amount of any acquisition indebtedness with respect to such assets (determined under §514(c) without regard to the taxable year in which the indebtedness was incurred).”³⁵ The regulations repeat this phrase and provide no additional guidance for determining eligible debt for this purpose.³⁶ Thus, a foundation looks to the tax code, which says “acquisition indebtedness equals the unpaid amount of debt incurred by a foundation in acquiring or improving a property.”³⁷ The most common type of acquisition debt incurred by a foundation is a mortgage on investment real estate. A margin account created to purchase securities would constitute such debt, but private foundations seldom borrow on margin because of the jeopardizing-investment prohibitions³⁸ and treatment of the income as unrelated business income.³⁹

Some foundations with significant portfolios of marketable securities do enter into security-lending transactions to enhance the return on those investment assets. The foundation lends its securities to a financial institution in return for cash collateral equal to the value (or more) of the securities. The foundation retains its right to receive dividends or interest from the securities and is also entitled to invest the cash it holds as collateral. IRC §514(c)(8)(C) states that “for purposes of this section an obligation to return collateral security shall not be treated as acquisition indebtedness.” IRC §4942(e)(1)(B) refers to IRC §514(c) to define acquisition indebtedness and says the collateral security debt is not acquisition debt. This exclusion stems from the fact that the unrelated business income rules do not tax payments with respect to securities loans or income from investment of the collateral security.⁴⁰

Effective in 2001, generally accepted accounting standards began to require reporting of both the securities and the cash collateral as foundation assets. The obligation to repay the cash is reflected as a liability for financial statement purposes so that the foundation's net assets reflect only the value of the securities it has lent. To calculate the minimum investment return, however, the collateral security loans are not acquisition indebtedness. To alleviate this unfair result, the IRS privately ruled that the collateral received in connection with a security lending transaction can be excluded as an investment asset.⁴¹

The significant decline in the value of marketable securities during the fall of 2008–2009 presented a unique problem to private foundations. To raise sufficient cash funds to meet their minimum distribution requirements, some foundations were faced with the difficult possibility of selling securities at a significant loss. When such a PF expects that the values will be recouped, it might consider borrowing against, or margining, its security portfolio. The decision to borrow raises two questions. First, for purposes of calculating its minimum investment return: Is the debt acquisition indebtedness that reduces the value of the PF's investment assets? Undoubtedly, it should be. The second question is: When it is treated as acquisition indebtedness for this purpose, is the income earned from the margined securities treated as unrelated business income? The IRS has privately ruled that such indebtedness is “transitory debt” incurred to enable an organization to satisfy its spending requirement and is not treated as borrowing to acquire an investment asset.⁴²

(a) Valuation Methods

Any “commonly acceptable method of valuation” may be used, as long as it is reasonable and consistently used. Valuations made in accordance with the methods prescribed for estate tax valuation are acceptable.⁴⁴ Presumably, the rules governing valuation of charitable gifts would also be acceptable. The opinion of an independent appraiser is required only for real estate that the PF wishes to only value once every five years rather than annually. For all other assets, the PF itself can establish a consistent method for making a good-faith determination of the value of most of its assets.

(b) Date of Valuation

Different asset valuation dates are prescribed for different kinds of assets:

Cash is valued on a monthly basis by averaging the amount of cash on hand on the first and last day of each month. Assets valued annually can be valued on any date, as long as approximately the same date is used each year.⁴⁵ Conceivably, real estate valued every five years should be valued on approximately the same date every fifth year, but no precise date is prescribed. For valuation of property newly acquired by a foundation, the price actually paid for property of a sort valued annually should serve as its value for the year of purchase, absent abnormal acquisition circumstances. Real estate received as a gift, as a transfer from an estate or trust, or purchased by the foundation may technically be valued on any date of the year after acquisition of the property. As a practical matter, however, the acquisition date often becomes the date used for MIR valuation purposes because an appraisal is prepared on that date for the donor or transferor.

(c) Partial Year

The average value of an asset held by the foundation for part of a year is calculated by using the number of days in the year that the asset was held as the numerator, and the number of days in the tax year (usually 365) as the denominator. The includable value is thereby reduced to equate to the partial-year holding period. For example, for a $100,000 piece of real estate acquired on July 1, the includable amount would be as follows:

A new foundation begins its first year on the day it is created, not the day it first receives assets. Assume that the preceding example applied to a new foundation created on March 1 that received the gift of real estate on July 1. Note the payout percentage for this foundation would be less than 5 percent, due to the short year. The formula for calculating the includable amount of the real estate value would instead be:

(d) Readily Marketable Securities

Securities for which a market quotation is readily available are valued monthly on any day of the month, using any reasonable and consistent method.⁴⁶ Securities include (but are not limited to) common and preferred stocks, bonds, and mutual fund shares.⁴⁷ The monthly security valuation method applies to the following:

• Stocks listed on the New York Stock Exchange, the American Stock Exchange, or any city or regional exchange in which quotations appear on a daily basis, including foreign securities listed on a recognized foreign national or regional exchange.
• Stocks regularly traded in a national or regional over-the-counter market, for which published quotations are available.
• Locally traded stocks for which quotations can be readily obtained from established brokerage firms.

The quotation system can be one of a variety of methods, again as long as a consistent pattern is followed. The following examples are given in the regulations.⁴⁸

• The classic method averages the high and low quoted price on a particular day each month, which could be the first, fifth, last, or any other day.
• A formula averaging the first-, middle-, and last-day closing prices for each month.
• The average of the bid and asked price for over-the-counter stocks or funds on a consistent day, using the nearest day if no quote was available on the regular day.

Portfolio reports generated by a computer pricing system and prepared monthly for securities held by a financial institution are customarily used. The bank's or investment advisor's system must be accepted as a valid method for valuing securities for federal estate tax purposes. The foundation has a responsibility to inquire of the bank as to its method of valuation and to obtain evidence that its system is approved. Banks commonly have certification from bank examiners, and investment advisory firms have their license renewals from the Securities and Exchange Commission. In the author's experience, the IRS has not required proof that the bank's system has specific IRS approval, even though the regulations require it.

Blockage discounts of up to 10 percent are permitted to reduce the valuation of marketable securities when a foundation can “show that the quoted market prices do not reflect FMV”⁴⁹ for one or more of the following reasons:

• The block of securities is so large in relation to the volume of actual sales on the existing market that it could not be liquidated in a reasonable time without depressing the market.
• Sales of the securities are few or sporadic in nature, and the shares are in a closely held corporation.
• The sale of the securities would result in a forced or distress sale because the securities cannot be offered to the public without first being registered with the Securities and Exchange Commission.

Essentially, a foundation is permitted to use the price at which the securities could be sold by an underwriter outside the normal market. The blockage discount is limited to 10 percent for unrestricted listed securities, but otherwise is unlimited.⁵⁰ Where the foundation's shares represent a controlling interest, the price at which shares of others are sold is not necessarily an accurate value of the shares.⁵¹ The IRS has privately ruled that a foundation that failed to apply blockage discounts may do so currently, as well as retroactively, to compute its required distributions.⁵²

Valuation of so-called alternative investments, such as hedge funds, offshore partnerships, and funds-of-funds investments, for purposes of calculating the foundation's minimum investment return, is often a challenge. The regulations require that a consistent method for valuing the property be followed on an annual basis. Hedge funds and partnerships often hold several types of investments, including marketable securities and options that would be valued monthly if held outside of the partnership loans subject to annual valuation. Unless the fund is itself readily marketable, such as a publicly traded partnership, such investments should be valued annually. What if, however, the foundation gets valuations more than once a year? Can the quarterly valuations, for example, be averaged throughout the year? The author is not aware of specific guidance on this question. Because the purpose of the market value calculations is to arrive at the foundation's payout requirement, it seems logical that a nonmarketable fund could be valued more often than once a year, as a portion of the assets in the partnership have daily and monthly valuations available. The regulations do address the question in regard to a “holding company” that is effectively controlled by the “issuer.”⁵³ Listed securities held by a company (presumably, this can also apply to a partnership) controlled by the private foundation and its disqualified persons (DPs) are required to be valued monthly.⁵⁴

Stock traded on the Over-the-Counter Bulletin Board (OTCBB) is qualified appreciated stock for purposes of allowing a contribution deduction for the value of the shares rather than the deduction being limited to basis.⁵⁵ The IRS noted that the regulations on readily available market quotations were written before the Internet disclosed values. Correspondingly, securities traded on the OTCBB constitute readily marketable securities for monthly valuation purposes.

(e) Cash and Other Assets

The calculation of average cash balances adds together the 12 beginning and 12 ending month-end balances for all accounts and divides the result by 24. By comparison, the formula for calculating the average value of securities, instead, adds together 12 valuations on the date chosen by the foundation (usually the last trading day of the month) and divides the result by 12. Thus, a foundation cannot easily manipulate its cash balance. Note that although an imputed amount of cash, 1½ percent of all investment assets, is excluded in calculating the mandatory payout, the actual cash balances are included to arrive at total investment assets. The hypothetical amount of cash provided in Part X of Form 990-PF, 1½ percent of the total fair market value of investment assets, may result in a number that is actually more than the average amount of cash average of the foundation's cash balances during the taxable year.⁵⁶

All other assets are valued annually, using a reasonable and consistent method, on the bases described in the following paragraphs. The valuations can be made on any day so long as the foundation values those assets on approximately the same day each year.

Common Trust Funds. Foundation funds invested in a common trust fund⁵⁷ can use the fund's valuation reports. Fund participants typically receive periodic valuations of their interests from the fund manager throughout the year and can calculate the average of these valuation reports. If the fund issues valuations quarterly, the simple average of the four reported valuations is an acceptable measure of the fund's value for this purpose. If valuations are issued monthly, the sum of 12 months of value would be divided by 12.

Real Estate. The regulations say real estate and mineral interests may be valued on a five-year basis if the value is determined by a certified appraisal. Otherwise, real property can be valued annually based on an independent source of value, such as the local tax assessment authority. Particularly for a PF with modest parcels of real estate, this method might be used to avoid the cost of independent appraisals.

A certified, independent appraisal made in writing by a qualified person who is not a disqualified person with respect to, or an employee of, the foundation is required if the PF chooses to value its investment real estate every five years.⁵⁸ An appraisal is considered certified only if it includes a statement that, in the opinion of the appraiser, the values placed on the land appraised were determined in accordance with valuation principles regularly employed in making appraisals of such property using all reasonable valuation methods. More frequent valuations can also be made when circumstances dictate, as, for example, when real estate has declined substantially in value (starts a new five-year period). The rules do not require revaluation during the five-year period, even when the valuation has increased materially.⁵⁹

Mineral interest valuations are customarily based on reserve studies conducted by petroleum evaluation engineers. Although there is no mention of oil properties in the IRS literature on the subject, minerals are treated as real property for most purposes and are traditionally updated every five years following the rules for real estate.

Some foundations simply use a three- to four-year moving average of capitalized annual revenue as the measure of the worth of their minerals rather than engaging outside valuation experts for this purpose.

The income approach for valuing mineral interests was rejected by the Tax Court in an estate tax valuation case. Instead, the court relied on a petroleum engineer representing the IRS as providing a correct valuation due to his knowledge and experience in valuing oil and gas mineral interest properties.⁶⁰

Other Types of Assets. Valuations of other types of assets must be updated annually, again following a reasonable and consistent method. Independent appraisals are not required.

The Tax Court disagreed with the IRS opinion that the gift tax value of an interest in a limited liability company (LLC) was measured by the proportionate value of assets held by the entity and no discount for lack of marketability and control was permitted for each interest.⁶¹ The IRS argued that since the LLC was treated as a disregarded entity for tax purposes, the donees received part of each asset. The decision turned on the nature of the ownership interest for state law purposes in New York, which considers an LLC an entity separate and apart from its members.

Shares of a closely held business or an interest in a partnership can be valued on any day of the year. Generally, the month of valuation should be used consistently from year to year and is often the year-end of the business or partnership. The fair market value of the entity's assets, earning history, goodwill, and other valuation factors germane to the industry in which it operates are taken into account following estate tax valuation methods. Due to the excess business holdings rules⁶² and income tax consequences⁶³ of such investments, a foundation often owns a minority interest in such properties. If so, the valuation might be reduced by a discount attributable to lack of marketability. The terms of a partnership or stockholders' agreement might supply the valuation method. The foundation that purchases interests in partnerships organized and managed by financial institutions should expect and, if not readily offered, request the value of the interest to be provided annually. In the authors' experience, valuation of such assets is often quite challenging.

Valuation of computers, office equipment, and other tangible assets used in managing the investment activity can be obtained from the local newspaper's classified advertisements for used equipment, or by obtaining a quotation from a used office furniture dealer. There is no prescribed method for valuing leasehold improvements to the foundation's leased office space. A practical method would be to use the unamortized cost basis of the improvements. Other assets capitalized for accounting purposes, such as custom-designed software or reference library books, might be similarly valued.

The value of a whole life insurance policy is its cash surrender value.

Notes and accounts receivable are included at their net realizable value or their face value, discounted for any uncollectible portion. A note receivable for which monthly principal payments are received by the foundation arguably might be valued based on the average of month-end principal balances. The regulations that say the value of “Other Assets” should be determined annually do not say they should be valued “once annually.”

Collectibles held for investment purposes, such as gold, paintings, and gems, are valued under estate tax valuation rules. Under those rules, the value equals the amount a willing buyer, under no special compulsion to buy, would pay the foundation to acquire the asset. Reports of auction sales of comparable items or the opinion of dealers of such items could be used to document valuation used for this purpose.

Cryptocurrencies present unique valuation issues because their value fluctuates significantly daily. The total U.S. dollar (USD) value of bitcoin supply in circulation between November 20, 2017 and September 4, 2018, as calculated by the daily average market price across major exchanges, ranged from $50,000,000,000 to a high of $300,000,000,000 and back down to $121,000,000,000.⁶⁴ On September 10, 2018, a search on IRS.gov/eo for cryptocurrencies yielded no results. A search for bitcoins yielded the following:

Virtual Currencies. The sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability. This guidance applies to individuals and businesses that use virtual currencies. International investigations span a wide range of activities such as abusive tax schemes, narcotics, nonfilers, money laundering, and terrorism funding.

A private foundation holding bitcoins or other cryptocurrencies must adopt a reasonable method for valuation until IRS guidance is issued. The regulations provide assets other than readily marketable securities for which quotations are available, and cash should be valued annually.⁶⁵ It seems reasonable, however, given the significant daily fluctuation in value, to recommend a monthly value averaged over the year as being more accurate, or to consider daily values as being most correct.

(a) Controversial Addition

Despite the fact that IRC §4942(d) literally does not, Part XI of Form 990-PF, the instructions to the form, and the regulations before 2004 required that income paid or payable by certain trusts be added to the distributable amount of all foundations. Since 1982, this addition has been applicable only to private operating foundations in calculating their adjusted net income. Prior to 1982, all foundations were required to distribute either their adjusted gross income, including such income it received from split-interest trusts, or the hypothetical minimum investment return, whichever was higher. To preserve the principal value of their assets, foundations convinced Congress in 1982 to lower the annual distribution requirement solely to the minimum investment return, adjusted as shown previously for the excise tax and recoveries of amounts previously claimed as qualifying distributions. So, for most foundations, the inclusion of split-interest trust issue became moot. Nonetheless, until 2004 the IRS continued to prompt addition of distributions, actually paid or payable, from split-interest trusts.

The Ann Jackson Family Foundation challenged the IRS and convinced the Tax Court that the regulation was an “unwarranted extension of the statutory provision.”⁷⁰ Interestingly enough, another section of the regulations pertaining to distribution requirements provides that the corpus of a split-interest trust is not counted as an investment asset for purposes of calculating the foundation's minimum investment return.⁷¹

During the period of uncertainty, a foundation that was a beneficiary of a split-interest trust faced a dilemma of following the IRS instructions and Form 990-PF or the Ann Jackson Tax Court decision. In 2004, the IRS announced it was recommending modification of the regulations. Foundations that previously added trust amounts to their mandatory payout amount were allowed to amend prior returns to recalculate any excess qualifying distributions they would be entitled to. As discussed in §15.6(a), adjustments of an excess distribution carryover can be made retroactively to years for which the statute of limitations has passed. For some foundations, the recalculation could go back to 1982, when the law was changed.

(b) Distribution Deadline

The distributable amount that must be paid out each year is equal to the calculated amount based on the preceding-year asset values,⁷² with adjustments shown earlier. For example, a foundation must, before September 30, 2013, distribute the amount calculated and shown on its September 30, 2012, year-end return. This one-year time lag essentially allows a new foundation two years in which to establish its grants systems and to earn the income required to be distributed. A new foundation has no distribution requirement in its first year. Additionally, the MIR percentage for a short year is prorated according to the number of months in the year, and assets held less than a year are similarly prorated.⁷³ A cash-distribution test may further reduce this amount for a new foundation with plans qualifying for set-aside.⁷⁴

The distributable amount is calculated each year on Form 990-PF. A summary schedule entitled “Undistributed Income” is also completed to compare the qualifying distributions⁷⁵ to the required amount. Though a foundation is penalized if it underdistributes, a five-year carryover is allowed for excess distributions.⁷⁶ A foundation that changes its fiscal year-end (which, incidentally, it can do automatically by filing Form 990-PF within 4½ months of the end of the short year) must pay out the distributable amount by the end of the short period.

The payout percentage is essentially 0.4166 percent per month (5 percent/12). For the year in which a foundation is created or changes its fiscal year, the partial-year percentage is determined by the number of days it was in existence for the year.⁷⁷ Assume that a foundation changes its financial reporting year-end from September 30 to December 31. The change of year requires no permission and is accomplished by simply filing a short-period Form 990-PF return for the three months ending in December.⁷⁸ The percentage applied to calculate its minimum distribution requirement for the next succeeding full calendar year, calculated based on a three-month year, would be 1.67 percent (5 percent × 3/12). Caution: Although the reduced percentage could be thought of as an advantage, the normal 5 percent payout attributable to its last full year ending in September will have to be distributed within the three months of its short tax year.

A foundation that is required to accumulate its income or prohibited from distributing its capital or corpus by its governing instruments in effect and unchanged since May 26, 1969, is not subject to the normal payout rules.⁷⁹

(a) Direct Grants

Charitable grants paid directly to publicly supported charitable organizations,⁸⁸ for general support or for a wide range of specific charitable purposes, comprise by far the bulk of qualifying distributions made by private foundations. A grant can also be paid to an instrumentality of a national, state, local, or foreign government. Grants to accomplish a charitable purpose to any type of exempt or nonexempt organization anywhere throughout the world can qualify, if the proper procedures are followed.⁸⁹ Also qualified is a grant to a limited liability company whose sole member is a public charity.⁹⁰ Although a PF is not prevented from making such grants, payments to three particular types of organizations are not treated as qualifying distributions:

1. A grant to another PF does not count unless the recipient PF redistributes the funds or is an unrelated private operating foundation (POF).
2. A controlled organization, either private or public, also does not count unless the funds are properly redistributed.
3. A grant to a Type III supporting organization that is not “functionally integrated” with its supported organization(s).⁹¹

The addition of Type III functionally integrated supporting organizations (SOs) to this list came as an unwelcome surprise to many PFs, and the SOs accustomed to their grants, in 2006. IRS Publication 78, traditionally used by PFs to identify public charities, does not display their §§509(a)(1), (2), or (3) classification. That classification is shown only on the determination letter issued in recognition of tax exemption, but until mid-2006, the letter did not disclose a §509(a)(3) organization's “type.”⁹² To compound the problem, the IRS Business Master File misclassifies a significant number of public charities with “Code 17,” indicating supporting organization status. Therefore, it can be difficult for a foundation to identify supporting organizations not eligible to receive qualifying distributions. The IRS acted quickly to address this identity problem by adopting procedures and issuing temporary regulations.⁹³ The IRS issued guidance that allows a PF to rely on the IRS Business Master file or a certification of its public charity type from the supported organization.

Additionally, if a foundation chooses to grant funds to a Type III non-functionally integrated supporting organization, the grant is not a qualifying distribution for payout purposes and expenditure responsibility must be exercised.⁹⁴

(b) Controlled Grantees and Redistributions

Payments to a controlled charitable grantee are not qualifying distributions unless the grantee doesn't keep or redistribute the funds. The recipient organization (or donee, in the language of the regulations) is controlled by the PF or by one or more of its disqualified persons when any of such persons can, by aggregating their votes or positions of authority, require the recipient organization to make an expenditure, or prevent it from making an expenditure, regardless of the method by which control is exercised or exercisable.⁹⁵ Control for this purpose is determined on an organizational level without regard to restrictions placed on the grantee. It is acceptable for the foundation to designate the grantee programs it chooses to support, but not to direct the fashion in which a program is operated. Requiring the creation of a separate fund or special budgetary controls is acceptable, but there must be no material restriction on how the recipient uses the funds to accomplish its own exempt purposes.⁹⁶ Funds cannot be earmarked for lobbying, a specific individual grant, or other expenditures that the foundation itself would not be permitted to make.

Redistribution by the controlled organization or related foundation is accomplished where, not later than the close of the first taxable year after the donee organization's taxable year in which such contribution is received, the donee organization makes a distribution equal to the full amount of such contribution. Additionally, the donee may not count the distribution toward satisfying its own requirement, but instead must treat its re-granting of the money as a payment out of corpus. The donor foundation must obtain adequate proof that the redistribution was accomplished. The donee should provide a report describing the names and addresses of the charitable organizations to which it redistributed the funds. Most important, the donee must declare that it did not claim its re-grants as qualifying distributions.⁹⁷

Reporting Issues: The redistribution is critical to allow a donee to receive a full fair market value deduction for non-cash property donations. Part VII, Line 7 of the PF's Form 990-PF must reflect amounts treated as distributions out of corpus to qualify as a “conduit foundation.” A foundation was granted an extension of time for making that election when the well-regarded and experienced tax return preparer failed to disclose the election on its return.⁹⁸ The failure caused the deduction to be limited to the property's tax basis.⁹⁹

In a somewhat long and complicated private ruling, another foundation was granted an extension of time to make the election. The rationale for granting the extension included submission of evidence that:

• The foundation acted reasonably and in good faith.
• The grant of relief would not prejudice the interests of the government.
• The foundation made the request for relief before the failure to make the regulatory election was discovered by the IRS.
• The foundation exercised reasonable diligence taking into account its experience and the complexity of the return reporting issue and was unaware of the necessity for the election.
• The foundation reasonably relied on a qualified tax professional who failed to include the election in the return it prepared on behalf of the foundation or to advise of the requirement to make the election.¹⁰⁰

Excess distribution carryovers may be treated as a distribution out of corpus to satisfy the redistribution requirement for a grant to another private foundation or controlled grantee. Excess distributions can also be treated as being made out of corpus to allow a donor an enhanced contribution deduction for certain gifts of property.¹⁰¹

(c) Community Foundation Grants

The significant increase in the value of private foundation investment portfolios in the late 1990s created ever-increasing minimum distribution requirements for many foundations.¹⁰² For such a foundation that has difficulty choosing grant recipients, a grant to a community foundation may be treated as a qualifying distribution if the right steps are carefully taken. Most important, the grant must be a completed gift, or disposition, of the property by the PF, with no strings attached. The PF must retain no ultimate control over the property; although it can retain the privilege of making suggestions, it can place no material restrictions or conditions on the transferred assets.¹⁰³ The IRS has responded to a number of requests for approval of such grants.

The donor-advised funds held in community foundations are subject to restrictions and procedures to prevent their operating to benefit their creators. The IRS outlined proposals regarding three important aspects of activity for a donor-advised fund under §4958(f)(7) with a view to defining “incidental benefit,” including factors already addressed in the private rulings. The latest pronouncement contains concepts similar to those applicable to private foundations¹⁰⁴ and also refers to IRC §4958(f)(7), which imposes a tax on excess benefit transactions.¹⁰⁵

In one acceptable situation, a community foundation sought approval for creation of a designated fund within itself to re-grant funds for economic development.¹⁰⁶ The ruling found that “unconditional” grants by private foundations to the fund were qualifying distributions. In a series of complicated rulings concerning the Kansas City Royals baseball team, grants to the community foundation established to support the team were considered to be qualifying grant distributions.¹⁰⁷ It is important to note that a ruling about a foundation considering such a community foundation grant did not reach a conclusion about whether the transfer constituted a qualifying distribution.¹⁰⁸ The ruling did reach a conclusion that assets representing 10 percent of a PF's assets granted to the community foundation would become a component part of the receiving public charity and not be classified as a separate fund that is a private foundation. The basis for the decision is the long list of factors evidencing that a terminating PF releases control over assets it places in a public charity.¹⁰⁹ The ruling applied transition rules written for community trusts in existence before November 1976 that were unable to meet all of the requirements of the then-issued community trust regulations.¹¹⁰ The standards imposed on the asset transfer are intended to divest the private foundation of any control or discretion over the fund it creates. In brief, the following facts must exist:

• The trust is a publicly supported organization.
• The community trust's governing body is composed of members who may serve a period of not more than 10 years.
• No person may serve within a period consisting of the lesser of five years or the number of consecutive years the member has immediately completed serving.
• The transferor private foundation may not impose any material restriction or condition that prevents the transferee public charity from freely and effectively employing the transferred assets, or the income derived therefrom, in furtherance of its exempt purposes.
• Whether a restriction or condition is material depends on the facts and circumstances. Some of the more significant facts are as follows:
  • Whether the transferee public charity or participating trustee is the owner in fee of the assets received.
  • Whether such assets are to be held and administered by the public charity in a manner consistent with one or more of its exempt purposes.
  • Whether the governing body of the public charity has ultimate control over the assets and income.
  • Whether and to what extent the public charity's governing body is organized and operated independently from the transferor.

A cautious private foundation making a grant to a community trust could also follow these criteria to ensure that its grant is treated as a qualifying distribution to an uncontrolled entity.

A question was added to the 2011 Form 990-PF asks, “Did the foundation make a distribution to a donor advised fund over which the foundation or a disqualified person had advisory privileges?¹¹¹ The goal was to avoid allowing a PF to transfer funds and “park” them in a donor-advised fund (DAF) to meet its mandatory annual payout. Watch for distribution requirements placed on such funding. A report of their study of the responses to the question was sent to Congress, but no action has been reported as of February 24, 2020.

(d) Noncash and In-Kind Grants

A qualifying grant can be paid in either cash or property. The fair market value of the property is counted as a qualifying distribution. Because the tax basis of property the foundation receives as a gift retains the same basis as that of the donor, some private foundations have assets with a value significantly higher than the tax basis. These appreciated noncash assets held for investment purposes, particularly marketable securities or real estate, provide a tax-planning opportunity. The excise tax on investment income is not imposed on the unrealized gain inherent in the property that is distributed in the form of a charitable distribution. This significant tax advantage makes it important for a foundation to consider distributing appreciated property to a grantee, rather than selling the property to be able to give the grantee cash.¹¹² The value of distributed property must be reduced by any amount previously treated as a qualifying distribution. For example, when a building purchased by the foundation for use in its own exempt activities was subsequently donated to another charity, only the current fair market value (FMV) in excess of its cost in the property was counted.¹¹³

An unanswered question is whether a foundation counts in-kind grants, such as the rent-free use of space, as qualifying distributions. This issue is whether noncash lending of foundation property or forbearance of income produces an expenditure that can be counted for qualifying distribution purposes. Say, for example, the foundation lends office space to a charity rent-free. For financial reporting purposes, the fair market value of the rent is treated as a charitable disbursement.¹¹⁴ Similarly, a no-interest loan made to another charity or to an indigent person and a loan of an object from the foundation's art collection to a museum have economic value. Because no income tax deduction is allowed for such gifts, the IRS says they cannot be counted as qualifying distributions.¹¹⁵ However, there is no official guidance on this subject, and one could argue that an in-kind gift reportable for financial purposes should be counted.

(e) Distributions to Foreign Recipients

Payments in support of charitable programs conducted outside the United States can also be counted as qualifying distributions. The difficulty with such grants lies in documenting the charitable nature of the activities. Foreign organizations may seek IRS determination that they qualify as §501(c)(3) organizations, but few do so. Instead, U.S. foundations that want to support foreign recipients follow one of two routes:

1. They obtain adequate documentation to evidence that the foreign entity is “equivalent to” and would qualify as a U.S. public charity if it sought such recognition.
2. They exercise expenditure responsibility.

The details required to make this choice are discussed in §17.5(c).

(f) Direct Charitable Expenditures

Amounts paid to accomplish a charitable purpose, including a portion of the foundation's reasonable and necessary administrative expense, are eligible to be treated as qualifying distributions. The following are examples of the types of nongrant expenditures that can be counted as qualifying distributions.

The purchase of exempt function assets¹¹⁶ used, or held for use, in conducting a foundation's programs, rather than for investment purposes, is treated as a charitable disbursement. The full purchase price of an exempt function asset is counted as a qualifying distribution even if part or all of the purchase price is borrowed. Amounts expended to improve and furnish the property can also be counted.¹¹⁷ Depreciation does not count: it would be redundant because the entire acquisition cost is counted.¹¹⁸

Conversion of an asset previously held for investment purposes, an active business property, or a future exempt purpose, to use as an exempt function asset, is counted. For example, a building rented to commercial tenants might be converted to rent-free use (it could be part or all of the building) by a public charity. The distribution amount is equal to the fair market value on the date of conversion. The date on which the foundation approves the plan for conversion, rather than the date the physical change or occupancy is completed, is the effective date of change.¹¹⁹ The precise conversion date should be planned to take full advantage of the inclusion of the value of the property, which may exceed the mandatory payout amount for the year, as a qualifying distribution. Documentation in the minutes of those who govern the foundation can be important to evidence the conversion.

Whether an asset is used (or held for use) in carrying out an exempt purpose is a question of fact.¹²⁰ The entire asset is treated as exempt-use property if at least 95 percent of the total use is exempt function. When the exempt-purpose use is less than 95 percent, a proration must be made between the exempt use and investment/production of income use. The correct classification of assets affects the calculation of minimum investment return¹²¹ and the resulting mandatory payout requirements. Assume that a foundation acquires a building for its own use to house its program and administrative functions. The building has space for expansion that will be rented for the foreseeable future. In the year of acquisition, the foundation is entitled to report a qualifying distribution equal to a portion of the acquisition price and related improvements it makes to the property, in the year acquired. The qualifying charitable distribution will be the percentage of the building devoted to administrative and charitable programs. That portion held for investment purposes, either rented to others or housing the investment management department, can be depreciated for excise tax purposes.¹²² Assume further that the foundation holds the property for three years and then donates the property to another charitable organization. The foundation can report an additional qualifying distribution equal to the increase, if any, in the fair market value of the property over that amount originally treated as a qualifying distribution.¹²³

The actual date a foundation converts an asset is sometimes unclear when improvements must be made to the property. Assume that a foundation buys a building that it intends to donate to a school as an academic facility. It is expected that the remodeling may take at least two years. For financial reasons, the foundation borrows the money to make the acquisition. Title to the property is not transferred to the school until the renovations are complete, two years after the date the property is acquired. Although it was not until the title transferred that the school actually began to use the property, the date the asset is considered to be devoted to exempt use is the date the foundation adopted the plan.¹²⁴ Because the property was effectively committed to exempt use on the date of purchase, that date is the date of conversion of the property.¹²⁵

The date of dedication to exempt purposes may be difficult to pinpoint when a foundation receives property through a donation. The foundation may need some time to evaluate its capability to devote assets to exempt purposes by preparing financial projections and other strategic plans addressing the viability of the choice. One ruling described a bequest from a person who died in 1998.¹²⁶ The property, including residences, artwork, and furnishings, was distributed over a period of time. As a fact, the ruling stated that artwork was distributed on January 12, 2000, and that the foundation took possession of all of the assets by May 2000. The ruling said, “At that time it decided that instead of selling [the assets], it would use them for charitable programs operated either by the foundation or by other charitable organizations.” One presumes this statement refers to May 2000. In classifying the assets for §4942 purposes, the ruling does not mention the character of the artwork between January and May 2000. A foundation anticipating receipt of assets that potentially may be classified as exempt function will wish to do as much advance planning as possible to avoid any period of uncertainty. The fact that the terms of a gift stipulate that the property must be used as a charitable rather than an investment asset may mean that no conversion countable as a qualifying distribution can occur.

The value of an exempt function asset previously counted as a qualifying distribution must be added back if the foundation sells the property.¹²⁷ If the asset is instead donated to another charitable organization, the difference between the amount previously claimed and the value at the time of the grant can be treated as a qualifying distribution. The author has found no guidance on whether, when a foundation receives an exempt function–type asset as a gift, a conversion to such use occurs after the foundation receives the property.

Administrative expenses expended by the foundation in conducting its exempt activities, rather than managing its investments, are includable as qualifying distributions. The design of Form 990-PF prompts a foundation to allocate its expenditures between those associated with its investments and those associated with its charitable programs.¹²⁸ Expenses directly attributable to grant-making activity might include program officer salaries and associated costs, computerized grant-tracking systems, and grantee technical assistance. An allocable portion of the organizational administrative costs not solely pertaining to grants, including personnel costs, professional advisors, facilities, and other expenses, must be allocated on some reasonable basis between grants administration and management of investment properties. Legal fees paid in a suit involving an exempt charitable trust seeking to clarify its beneficiaries were treated as a qualifying distribution, for example.¹²⁹ Legal, accounting, state registration, and other fees and expenses paid in connection with creation and qualification of a new private foundation as a tax-exempt organization can also be treated as disbursements for charitable purposes.

For years beginning after 1984 and before 1991, a limitation was placed on the amount of administrative expense added to qualifying distributions. During that time, no more than 0.65 percent of a foundation's net investment assets over a three-year period could be claimed. During 2003, legislation to limit inclusion of certain expenses was considered in the Congress, and such sentiment might return.

Legal and accounting fees and other expenses approved by the court as reasonable and paid in connection with implementation of a mediation agreement and assets transfer resulting from a dispute among the directors of a private foundation concerning its charitable objectives and management were found to be a qualifying distribution.¹³⁰

Self-sponsored charitable program expenses (of a sort a private operating foundation must incur) paid directly by the traditional private foundation also count. Examples of direct charitable activity are numerous, including operating a museum or library, running a summer camp for children, conducting research and publishing books, and preserving historic houses. Charitable projects can be carried out in any location. There is no constraint against a private foundation conducting activities outside the United States.¹³¹

Individual grants count as qualifying distributions as they are paid under a program meeting the nondiscrimination requirements.¹³² A four-year scholarship award is counted as funds are paid. An academic grant that included funds for child care for the recipient's child was found to qualify if such spending enabled the grantees to continue research.¹³³

Program-related investments that satisfy the jeopardizing investment and taxable expenditure rules,¹³⁴ including interest-free or low-interest loans to other exempt organizations or individuals, also are counted as qualifying distributions.

A plan to design, construct, and lease a public arena to house a hockey rink, pro shop, coffee shop, day care center, conference center, gymnastics facility, and athletic medicine center was found to be a charitable program.¹³⁵ The foundation's objective was to promote the health and welfare of its community and lessen the burdens of local government by furnishing an amenity available to the general public without regard to race, creed, race, or color; local officials supported the plan. The IRS ruled that the expenditures would be treated as qualifying distributions. Additionally, rental revenues would not constitute unrelated business income whether or not the project was subject to acquisition indebtedness.¹³⁶ Further, it declared that the facility will not constitute a “business enterprise.”¹³⁷ Questions that the ruling answers include:

• Is the facility a program-related investment for purposes of the jeopardizing-investment rules?¹³⁸
• Is the facility a functionally related activity, the assets of which are not treated as investment assets for purposes of calculating the mandatory payout?¹³⁹

Loan program to provide funds to service providers of education, health, housing, or other social services that are unable to qualify for commercial loans and more financially secure for-profit organizations was deemed to qualify as a program-related investment. The loans would be used for programs supporting the foundation's direct charitable activities. Loans may be made to high-risk borrowers and to intermediaries they encourage to support the program. Borrowers are prohibited from using funds to influence legislation or for any other noncharitable purpose. Full-time staff will provide technical assistance and oversight for the program.¹⁴⁰

(g) Set-Asides

Money set aside or saved for specific future charitable projects, rather than being paid out currently, can be considered to be qualifying distributions in the year earmarked for the project.¹⁴¹ Such funds are treated as a foundation liability and are charged against that liability, rather than being counted again, when they are actually paid out in a subsequent year.¹⁴² The amount set aside need not be increased by income earned on the funds, but the income and set-aside funds are included in the asset base for purposes of calculating the minimum investment return.¹⁴³ There are two very different types of set-asides. For the first type, the foundation must have plans to use the money within 60 months after it is set aside for a specific project, and must meet a suitability test. Prior IRS approval is required for this type before reserved funds can be claimed as a qualifying distribution.¹⁴⁴ In a second type, the organization must simply satisfy a mathematical test.

(a) Active Charitable Programs

The most significant attribute of a POF is sometimes the most difficult quality to possess. To qualify as a POF, the foundation must focus: it must be significantly involved in its own projects in a continuing and sustainable fashion. To be involved might mean the foundation purchases goods and services to operate a museum, to conduct scientific research, to develop low-income housing, or to conduct some other charitable program. A POF maintains a staff of researchers, teachers, curators, or other program specialists. Its staff can be partly or wholly made up of volunteers and can include its funders or trustees, if their work involvement is genuine.

The typical operating foundation acquires and maintains program assets used in its programs: buildings, artworks, research facilities, and the like. A POF might buy, restore, and rent historic houses to preserve them. It would engage realtors, architects, contractors, and other specialists needed to acquire and fix up the property. It would pay utility, maintenance, and insurance costs; engage property managers; and pay administrative expenses necessary to operate the properties. Optimally, a POF is identified in the public eye with and by its projects. The regulations provide the following examples.¹⁹⁰

Ghetto Improvement Project. An organization is created to improve conditions in an urban ghetto. Ten percent of its income is spent to conduct surveys of the ghetto's problems. The remaining 90 percent is used to make grants to other nonprofit organizations doing work in the ghetto. Because only 10 percent of its funds is directly expended, it cannot qualify as a POF. If, instead, it spent a larger percentage of the money directly to analyze the results, develop recommendations, publish the conclusions of its studies, and hire community advisors to assist business developers and other organizations working in the area, it might qualify.

Teacher Training Program. An entity is formed to train teachers for institutions of higher education. Fellowships are awarded to students for graduate study leading toward advanced degrees in college teaching. Pamphlets encouraging prospective college teachers and describing the POF's activity are widely circulated. Seminars for fellowship recipients, POF staff, consultants, and other interested parties are held each summer, and papers from the conference are published. A majority of the organization's money is spent for fellowship payments, resulting in a comprehensive program that qualifies as active.

Medical Research Organization (MRO) or an Agricultural Research Organization (ARO). An MRO is created to study heart disease. Physicians and scientists apply to conduct research at the MRO's center. Its professional staff evaluates the projects, reviews progress reports, supervises the projects, and publishes the resulting findings. Note that a medical research organization may instead be able to qualify as a public charity.¹⁹¹ The ARO (not in regulations since this category was created in 2018) affiliates with a land-grant or public agricultural college. See requirements in Chapter 11.

Historical Reference Library. A library organization is established to hold and care for manuscripts and reference material relating to the history of the region in which it is located. Additionally, it makes a limited number of annual grants to enable postdoctoral scholars and doctoral candidates to use its library. Sometimes, but not always, the POF can obtain the rights to publish the scholars' work.

Senior Citizen Center. A foundation that was originally created to operate residential living quarters for seniors changes its focus. Instead, it converts the former living space into a senior citizens center to serve as a central intake and assessment point for identifying and addressing the needs of seniors in the area.¹⁹² Part of the space is rented at a reduced rate to “program partners,” other tax-exempt organizations that provide services to senior citizens. The remaining space is used for foundation programs benefiting the elderly: support group meeting rooms, a training and placement center, a resources and information room, and classrooms. The foundation reimburses (grants) the partners for expenses incurred in assisting the foundation with its own or “jointly operated” programs. The foundation sought approval of its ongoing classification as a private operating foundation. The IRS found rental of space on a low-cost basis and partnering programs with other tax-exempt organizations to be active program activity.

Conduct by Controlled Entity . Activities conducted in a newly created single-member limited liability company, treated as a disregarded entity for federal income tax purposes, can be attributed to the private operating foundation. Under a 20-year management agreement, the POF plans to take over the educational program of an accredited university that is experiencing declines in government funding. The POF would appoint a majority of the overseers of the program, purchase the program assets, and be responsible for financing the activity. Because the program will be conducted under the authority and direction of the POF, expenditures of the limited liability company (LLC) can be treated as active program expenses.¹⁹³

Set-asides of funds for a specific future project are permitted for POFs. The requirements discussed in §15.4(g) must be met for the amounts set aside to be counted as qualifying distributions.

Additional examples of active programs provided in the Form 990-PF instructions include:

• Provide goods, shelter, or clothing to indigent or disaster victims if the foundation maintains some significant involvement in the activity rather than merely making grants to the recipients.
• Conduct educational conferences and seminars.
• Operate a home for the elderly or disabled.
• Support the service of foundation staff on boards or advisory committees of other charitable organizations or on public commissions or task forces.
• Provide technical advice or assistance to a governmental body, a governmental committee, or a subdivision of either, in response to a written request by the governmental body, committee, or subdivision.
• Conduct performing arts performances.
• Provide technical assistance to grantees and other charitable organizations concerning fund-raising, reducing costs or increasing program accomplishments, and maintaining complete and accurate financial records. (This assistance must have significance beyond the purposes of the grants made to the grantees and must not consist merely of monitoring or advising the grantees in their use of the grant funds.)

(b) Grants to Other Organizations

Although one or more other charitable organizations may be involved in some manner, an operating foundation must expend a prescribed amount of its funds directly. The regulations provide that qualifying distributions are not made by a foundation directly for the active conduct unless such distributions are used by the foundation itself, rather than by or through one or more grantee organizations.¹⁹⁴

A grant to another organization is presumed to be indirect conduct of exempt activity, even if the activity of the grantee organization helps the POF accomplish its goals. However, in one instance a grant to another organization was found to qualify as direct involvement on the part of a charitable trust. The trust granted its income to a conduit organization that had been established for liability reasons to serve in a fiduciary capacity on behalf of the trust. Although the corporation operated the cultural center, its activities were attributed to the POF.¹⁹⁵

It is important to note that a POF is not prohibited from making grants to other organizations; such grants simply do not count toward satisfying the POF's distribution requirements. So long as the POF distributes the requisite annual amount for its active programs, it may, in addition, make grants to other organizations. A special limitation applies if the operating foundation's minimum investment return is less than its adjusted net income. If its active project distributions are less than adjusted gross income, more than 85 percent of the total qualifying distributions must be active.¹⁹⁶ The point is that as long as the POF meets the income and asset tests, it may spend additional amounts on any form of charitable activity it chooses.

(c) Individual Grant Programs

Payments to individuals under a scholarship program, a student loan fund, a minority business enterprise capital support project, or similar charitable effort benefiting individuals may not qualify as appropriate activity for a POF.¹⁹⁷ The facts and circumstances surrounding the project must indicate that the POF is significantly involved. Merely selecting, screening, and investigating applicants for grants or scholarships is insufficient. Grants to recipients who perform their work or studies alone, such as in pursuit of a doctoral degree, also may not be active. To be active, the work would be performed as part of a research project or in coordination with another other organization.. The administrative costs of screening, investigating, and writing, as opposed to the individual grants themselves, could possibly be treated as direct activity disbursements. Significant involvement of the POF and its staff exists when the individual grants are part of a comprehensive program.

The regulations say the test is qualitative, rather than quantitative, and give two examples of such programs. In one, the POF's purpose is to relieve poverty and human distress, and its exempt activities are designed to ameliorate conditions among the poor, particularly during natural disasters. The POF provides food and clothing to such indigents, without the assistance of an intervening organization or agency, under the direction of the POF's salaried or voluntary staff of administrators, researchers, or other personnel who supervise and direct the activity.

In the second example, a POF develops a specialized skill or expertise in scientific or medical research, social work, education, or the social sciences. A salaried staff of administrators, researchers, and other personnel supervise and conduct the work in its area of interest. As a part of the program, the POF awards grants, scholarships, or other payments to individuals to encourage independent study and scientific research projects and to otherwise further their involvement in the POF's field of interest. The POF sponsors seminars, conducts classes, and provides direction and supervision for the grant recipients.

The Elizabeth Leckie Scholarship Fund was found to maintain a significant involvement in its ongoing attempt to ameliorate poverty among persons in rural Alabama. The fund assisted needy young people in the county by providing scholarships, finding them summer jobs, and getting students involved with local civic affairs and other activities designed to educate and improve the circumstances of young people and make it possible for them to remain in the area.¹⁹⁸

Screening, investigating, and testing applicants to make sure they complied with academic and financial requirements set for scholarship recipients is insufficient activity to constitute an educational program, according to the regulations.¹⁹⁹ Mentoring and tutoring, counseling, college placement advising, arranging appointments for interning or work-study programs for the scholarship recipients, if significant time (could be volunteers) and money are spent, might allow qualification as a POF.

(d) Tests to Qualify as a Private Operating Foundation

To qualify as a private operating foundation, the private foundation must meet two tests:

1. The income test,²⁰⁰ and
2. The asset, endowment, or support test.²⁰¹

Income Test. Under this test, the POF must expend substantially all (85 percent) of the lesser of its adjusted net income or its minimum investment return (MIR)²⁰² on its actively conducted projects.

Asset Test. To meet this test, at least 65 percent of the FMV of the POF's assets must be devoted to the active conduct of its charitable activities, a functionally related business, or stock of a controlled corporation, substantially all of the assets of which are so devoted. The concepts of exempt function and dual-use assets used in calculating the MIR are followed to identify assets qualifying for this test.²⁰³ An asset that is not capable of being valued, such as a botanical garden, can be included at its historical cost.²⁰⁴

Endowment Test. For this test, the POF's annual distributions must equal at least two-thirds of its minimum investment return (3 percent of investment assets). This test is designed to prevent a private foundation from seeking POF status to take advantage of the income test that requires distribution of income or MIR, whichever is lower. Assuming that a POF holds marketable securities that pay no dividends, the income test, taken alone, would require no current charitable spending. A POF with a portfolio of low-current-yield securities would have to distribute part of its principal or contributions received to meet this test.²⁰⁵

Support Test. Under this test, the POF's support (meaning donations and not including investment income) must be received from the general public and from five or more noncontrolled §501(c)(3) organizations, with none giving more than 25 percent of the POF's support. An organization wishing to meet this test must carefully study the regulations.²⁰⁶

(e) Adjusted Net Income

Before 1982, all private foundations were required to distribute their adjusted net income or their MIR, whichever was higher. For traditional foundations effective for years beginning in 1982, only MIR need be paid out, and adjusted net income is not relevant. Private operating foundations, however, distribute their MIR or the adjusted net income, whichever is lower. Adjusted gross income is calculated using the following formula for POFs:²⁰⁷

• A = Gross income of all types for the year (not limited to income subject to the investment income tax), plus
• B = Long-term capital gains, less
• C = Contributions received, less
• D = Ordinary and necessary expenses paid or incurred for the production or collection of gross income or for the management, conservation, or maintenance of property held for the production of such income.²⁰⁸

Over the years, a few rulings have been published to clarify the amounts includable in adjusted net income. A brief summary follows:

• Bond premium amortization is permitted, following the rules of IRC §171.²⁰⁹
• Annuity, IRA, and other employee benefit plan payments are includable to the extent that the amount exceeds the value of the right to receive the payment on the decedent's date of death.²¹⁰
• Capital gain dividends paid or credited for reinvestment by a mutual fund are not included, because they are considered long term by IRC §852(b)(3)(B).²¹¹

(f) Compliance Period

A private operating foundation is expected to make active program distributions beginning in its first year of qualification; it is not allowed the one-year delay²¹² for making qualifying distributions permitted for normal private foundations. The income test and the asset, endowment, or support tests are applied each year for a four-year period that includes the current and past three years. The POF has a choice of two methods to calculate its compliance with the tests, but it must use the same method for both tests:

1. All four years can be aggregated; that is, the distributions for four years are added together. The POF must use the same secondary test—the asset, endowment, or support test—for all four years.
2. For three of the four years, the POF meets the income test and any one of the asset, endowment, or support tests.

An operating foundation may calculate its required distributions using either a four-year aggregate method or a three-out-of-four test in any year (which can change from one year to the next). For an operating foundation applying the three-out-of-four test, the required distributions must be made in at least three years. There is no carryover resulting from excessive expenditures. Use of this method thereby eliminates the benefit of, or essentially does not count, the expenditures made in the failed year. Application of the aggregation (four-year average) method instead essentially allows the operating foundation to apply excess qualifying distributions from year to year, similar to the rules for normal foundations. A new operating foundation delayed in the commencement of its active programs might qualify by using the cash distribution test.²¹³

If the POF fails to qualify for a particular year, it is treated as an ordinary private foundation for that year. It can return to POF classification as soon as it again qualifies under both the income test and the assets, endowment, or support test. There is no requirement that a POF that applies the second method make up the deficient year.²¹⁴

(g) Advantages and Disadvantages of Private Operating Foundations

Private operating foundations have several special advantages and one disadvantage.

Contribution Deduction Limits Are Preferential. The percentage limits for charitable deductions are higher for POFs than for private foundations. They are the same as the deductions permitted for public charities. A full 60 percent of an individual's income can be sheltered by contributions to a POF, but only 30 percent of one's income can be deducted for gifts to a normal PF. The full fair market value of all property gifts, including marketable securities, real estate, artworks, and other appreciated property, is deductible for donations to a POF. Only marketable securities donated to a traditional private foundation are fully deductible, and the deduction for noncash gifts is limited to 20 percent of the donor's income.²¹⁵

Distributable Amount May Be Lower. The minimum distribution requirement for a POF may be lower than for normal private foundations. In some cases, given a sufficient return on investment, a POF can better build an endowment over the years. It must only distribute its actual net income when it is lower than MIR and only needs to pay out two-thirds of its MIR.

No Penalty Tax. The penalty tax on the failure to make qualifying distributions does not apply to private operating foundations, and the deficiency of distributions need not be corrected. Failure of the income or asset test, however, can be most costly due to loss of POF status.

Disadvantage. The primary disadvantage is that the one-year delay afforded to PFs to meet the minimum distribution requirement is lost. An operating foundation is expected to make active program distributions beginning in its first year of qualification; it is not allowed the one-year delay²¹⁶ for making qualifying distributions permitted for normal private foundations.

(h) Conversion to or from Private Operating Foundation Status

An IRS ruling is not technically required for a private foundation to convert itself into an operating foundation, or conversely for an operating foundation to become a normal private foundation, because the qualification is based on numerical tests.²¹⁷ Any foundation is qualified if it meets the tests by changing its method of operation or mix of assets. A POF can fail the test in one year and again qualify the next year.²¹⁸ Interestingly, both active program expenditures and grants to other organizations count as qualifying distributions for a normal PF, though only amounts spent on the POF's own programs count toward meeting the POF tests. Careful tracking of qualifying distributions is necessary for a foundation that switches from one type to the other (and/or back).

The impact of the conversion on the cumulative qualifying distribution tests must be evaluated prior to making the change (one hopes it will not be inadvertent). An operating foundation must meet its minimum distribution requirements within the year; a normal PF must make distributions one year later, as illustrated in Exhibit 15.1. An operating foundation converting to a normal private foundation may therefore gain a one-year grace period. Converting to an operating foundation instead accelerates the time for required distributions. Funders of an operating foundation can be adversely affected by conversion to a private foundation. An operating foundation is treated like a public charity for charitable donation percentage limitations, making donations to operating foundations more favorable.²¹⁹ The effective date for conversion to operating classification is not clearly set out in the tax code or in the regulations.

An IRS advance ruling is not technically required for a PF to convert to operation as a POF. The foundation is qualified if it meets the tests by changing its method of operation or mix of assets. Most foundation officials, however, seek the comfort of an IRS determination to sanction a conversion. The conversion decision is also complicated because the transition takes four years and the one-year time lag for making charitable distributions is lost. For a converting traditional foundation, distributions are accelerated with the payment of both the prior-year distributable amount and active program distributions before year-end.

A private foundation seeks IRS approval for its conversion to a POF by submitting Form 8940 to the IRS Service Center in Cincinnati, Ohio, informing them of the change of operation and requesting a revision of the determination letter. Detailed descriptions of the programs to be conducted, along with brochures, class schedules, architectural drawings, or other written and visual (a video or photos) information that illustrates the programs the foundation conducts (or plans to conduct), should be sent. Financial information from Form 990-PF, Part XIV, reflecting detailed expenditure categories and assets to be used to accomplish the programs, should be included.

An existing foundation does not get the fresh start permitted for new foundations mentioned at the beginning of this section. The IRS has concluded that “a private foundation that has been in existence for at least four years and not heretofore qualified for operating foundation status may satisfy the operating foundation requirements by showing that it has met the Income Test and one of the three alternative tests over a four-year period.” Unfortunately, such a foundation is “considered an operating foundation effective the final year of the four-year period.”²²⁰ Because a converting PF is not a new organization, this conclusion is logical. One foundation was able to qualify in the year of its conversion by receiving approval for a single, but substantial, set-aside to operate a facility to assist persons with limited employability due to temporary or permanent disabilities.²²¹ Despite the fact that it could not meet the tests during its first through third years, it did meet the test on an aggregate basis of all four years.

(a) Timing of Distributions

To identify a deficiency of distributions and to correct the condition, one must understand how payments are applied. A foundation's charitable expenditures that are considered qualifying distributions are totaled for each year in which they are paid, but they are not necessarily applied in that year. The terminology can be confusing here because the current-year distributable amount is based on the prior year's minimum investment return.²²⁶ Nevertheless, qualifying distributions are applied as follows:²²⁷

• First, the qualifying distributions are applied to the current year's DA (essentially, the prior year's adjusted minimum investment return).²²⁸
• Next, the remaining qualifying distributions can be applied (election required) to make up any prior year's deficiency of distributable amount (for a year in which the PF has undistributed income subject to the excise tax).
• Any remaining distributions are then applied to the next year's DA.
• Finally, any remaining distributions are taken out of corpus to meet a redistribution requirement or become an excess which is carried forward.²²⁹

Importantly, a payment in the current tax year is first allocated to the mandatory payout requirement for that year, as stated in the first bullet. When a PF needs to make additional distributions to correct a prior-year underdistribution, it is important not to include the correction amount in its tallies to evaluate satisfaction of the current year amounts paid out. In other words, not only the currently required amount, but also the additional correction amount must be paid out to correct the prior-year deficiency.

Remember, the redistribution of a grant received by one PF from another PF must be charged against corpus and cannot reduce the donee PF's own distribution requirement.²³⁰ Also, a gift from a contributor who wishes to receive a higher percentage contribution deduction limitation must be paid from corpus.²³¹

Distributions more than the DA applied to corpus are carried forward for five years, a period of time called the adjustment period. Exhibit 15.1 provides an illustration of the way in which excess distributions are applied. The IRS Chief Counsel issued “Adjustments of Excess Distribution Carryovers from Closed Years,” taking the position that adjustments to years closed by the statute of limitations are permissible.²³² The memorandum recognizes the fact that in any one year a nonoperating PF has excessive or deficient distributions and, therefore, a carryover of excess distributions is an accumulation of all post-1969 years. It is an unusual foundation that pays out the exact minimum distribution amount.

A single error in calculating the amount required to be distributed or qualifying distributions in any one year causes all years to be wrong. Thus, the IRS takes the position, as yet unchallenged in court, that the years from 1970 forward are open years for this purpose. As shown in Exhibit 15.1, the excesses (designated as out of corpus) are available for carryforward over a five-year period in the order in which they occur.

A private foundation is required to meet its distribution requirements in the year in which it makes a distribution of its assets to another private foundation. Such a transfer “shall itself be counted towards satisfaction of such requirements to the extent the amount transferred meets the requirements of §4942(g), or is redistributed.”²³³ The grant to another private foundation counts as a qualifying distribution only if the recipient foundation re-grants, or pays out, the amount to be counted as qualifying. Thus, either the terminating or the transferee foundation must make qualifying disbursements to the extent the transferor foundation has undistributed income and the same persons control the transfer foundation.

Should a foundation find itself in a situation where it has undistributed income from a prior year (which was subject to a penalty on the prior year's return), it must correct the underdistribution in the current year (to avoid additional penalties) by distributing a sufficient amount in the current year to cover the current year's payout requirement plus the prior year's deficiency. Additionally, the foundation must make an election under §4942(h) to apply the excess amount from the current year to cover the prior year's deficiency. The election is made by entering the amount to be applied to the prior year's deficiency on Form 990-PF, Part XIII, Line 4b, column b and attaching a statement to the foundation's Form 990-PF. See the sample attachment following.

(b) Planning for Excess Distributions

Some foundations spend more money than required in supporting charitable programs and, as a result, have excessive distribution carryovers. A foundation might be created by a philanthropist who wishes to distribute much more than the required 5 percent payout amount. Another foundation's charter might stipulate that it is to dispose of all of its assets within 10 to 20 years. A careful foundation might also time its distributions from one year to the next to take advantage of the 1 percent tax rate.²³⁴ In such situations, the excess may serve a useful purpose.

(c) Cushion Against Decline in Income

A foundation can use accumulated excess distributions to meet its current-year requirements during years in which its investment yields are low or negative. Within the five-year limit and the tolerance of the organizations it normally funds, the foundation can reduce or eliminate spending until it uses up the carryover.

Allow Deduction to Funder. Excess distributions can be treated as qualifying distributions to satisfy the §170(e) requirement to remove the donation limit for appreciated property gifts for its funders.²³⁵ A full fair-market-value charitable deduction is not allowed for gifts of appreciated property, other than marketable securities, to a normal private foundation. This limitation is lifted if the foundation essentially distributes the gift. Retroactive treatment has been allowed.²³⁶

Substantial Contraction. Excess distributions might require enhanced reporting on the foundation's Form 990-PF and might cause an eventual dissolution of the foundation. There is no particular negative tax consequence for such a situation, except enhanced IRS reporting. Form 990-PF asks a foundation each year whether it has had a partial or complete liquidation, dissolution, termination, or substantial contraction. The definition of a substantial contraction is a distribution of more than 25 percent of a foundation's assets in one year. Details of such distributions, plus explanation of any organizational changes, are reported on the annual tax form. When a foundation distributes all of its assets, its tax attributes may be transferred to the grantee under the so-called termination rules outlined in §12.4.

(d) Calculating the Tax

A foundation that fails to make the required charitable expenditures in a timely manner is subject to an excise tax of 30 percent on the undistributed amount. The tax is charged for each year or partial year that the deficiency remains uncorrected. Essentially, the tax calculation starts on the first late day and continues until a notice of the deficiency is issued by the IRS (but in whole-year increments). This taxable period also closes on the date of voluntary payment of the tax.²³⁷ Note that there is no tax on the foundation managers.

Assume that a calendar-year PF fails to distribute $50,000 of its 2020 DA by December 31, 2021. If the amount is distributed within the first year after the deadline (by December 31, 2022), a 30 percent tax is due. If the correction takes two years or is not fixed until the second year after it was due (on or before January 1, 20123), another 30 percent is due, or a total of 60 percent. The additional 30 percent would be due even if the payment is made on January 2, 2023.

An additional 100 percent tax is triggered if the PF fails to make up the deficient distributions within 90 days of receiving IRS notification of the problem. The allowable correction period is 90 days after the date of mailing of the deficiency notice.²³⁸ The notice date is critical to calculating the tax. If the deficiency is self-admitted on the face of Form 990-PF, Part XIII or XIV, an accompanying Form 4720 is due to be filed to calculate the tax due. If the deficiency is not self-admitted, the IRS computers may (but have not in the past) recognize the problem and generate a notice.

In the more common situation, the underdistribution is found by the foundation itself and less often by the IRS upon examination. When the IRS mails a notice when the examination is completed, the PF has 90 days from the date of the notice to correct the problem by making grants. If it does not, the 100 percent additional penalty tax is imposed.

(e) Abatement of Penalty

Valuation Mistakes. When a PF fails to make the required annual charitable distributions due solely to an incorrect valuation of assets, the statutory sanction may be excused. In the interest of being fair, the underdistribution can essentially be corrected if four conditions for abatement listed in the code are satisfied:²³⁹

1. The failure to value the assets properly was not willful and was due to reasonable cause.
2. The deficiency is distributed as a qualifying distribution by the PF within 90 days after receipt of the IRS notice of deficiency.
3. The PF notifies the IRS of the mistake by submitting information on its Form 990-PF and recalculating its qualifying distributions.
4. The extra distribution made to correct the deficiency is treated as being distributed in the deficiency year.

To prove that the undervaluation was not willful and was due to reasonable cause, the PF must show that it made all reasonable efforts in good faith to value the assets correctly.²⁴⁰ A system regularly maintained for collecting the information, such as saving a month-end copy of stock quotes, evidencing good faith, satisfies this requirement. In seeking abatement for mistakes in valuing real estate or a partnership, the foundation must prove that it acted in good faith to request the values from property managers. Reliance on an invalid appraisal received from an unrelated, but accredited, appraiser, based on fully disclosed information pertaining to the property to be valued, should be considered reasonable.

Underdistribution Mistakes. The IRS has discretion to abate the first-tier, or 30 percent (annual rate), penalty applicable to distribution mistakes.²⁴¹ A private foundation that fails to meet the minimum distribution requirement may be excused from penalty in certain cases. The second-tier taxes may also be abated.²⁴² The exception applies if:

• The taxable event was due to reasonable cause and not to willful neglect.
• The event was corrected within the correction period for such events.

The standards for evaluating reasonable cause are discussed in §16.4(c). A foundation seeks abatement of the penalty by filing Form 4720 along with an explanation of the reasons why the penalty should be forgiven. Exhibit 15.2 illustrates a request for abatement. In the author's experience, the IRS has been fair in permitting abatement where reasonable cause can be shown. Reliance in good faith on incorrect legal advice may or may not be a good cause.²⁴³

Penalties were not imposed against a trustee who was elderly and not familiar with tax matters because the failures were due to reasonable cause and not willful neglect. She had sought the advice of a local tax preparer who advertised that he was an enrolled agent authorized to practice before the IRS. The IRS had examined and accepted fiduciary returns filed for a nonexempt charitable trust. The trust had made charitable disbursements that fell short of the mandatory payout requirements that applied because it was a private foundation. The trust had also failed to pay tax on net investment income. The violations were corrected, but the IRS found no evidence that the taxable events occurred due to a voluntary, conscious, and intentional failure on the part of the trust and trustee.²⁴⁴