(a) Gross Investment Income

Only six specifically named types of income are included in gross investment income for a private foundation: interest, dividends, rents, payments with respect to securities loans,⁷ royalties, and income from sources similar to the five types specified.⁸ The Pension Protection Act of 2006 (PPA) expanded the type of income subject to the excise tax on investment income. The specified types of income produced by exempt function assets, such as student loan interest, continue to be taxed.⁹ Any such income subject to the unrelated business income tax (UBIT) of IRC §511 is not taxed twice and, therefore, is excluded from the excise tax.¹⁰ Income reported to a private foundation on Form K-1 for partnership investments often presents reporting issues. The distributions reported as interest, dividends, rents, security loans, and royalties are combined and reported with the foundation's other investment income of that character and subject to the excise tax. Other income reported on the K-1 (for example, that titled “Ordinary Income”) can be difficult to classify to reach the proper tax result.¹¹

The income and associated deductions are reportable using the method of accounting, either cash or accrual, normally used by the foundation for financial reporting purposes, with certain exceptions discussed subsequently.

(b) Interest

Interest income is taxed if it is earned on the following types of obligations and investments:

• Bank savings or money market accounts, certificates of deposit, commercial paper, and other temporary cash investment accounts.
• U.S. Treasury bills, notes, bonds and other interest-bearing government obligations, and corporate bonds.
• Interest on student loans receivable,¹² on mortgage loans to purchasers in low-income housing projects, and on loans to minority business owners as a program-related investment.
• Payments on collateral security loans.
• Municipal bond interest paid by state and local governments is excluded from tax, and any expenses allocable to the nontaxable interest are not allowable as deductions.¹³ However, municipal interest is included in “adjusted net income” for a private operating foundation.
• Series E bond interest, not previously reported by a decedent or by the estate, is taxed to the foundation.¹⁴
• Interest income need not be imputed on certain no- or low-interest-bearing loans made and held for exempt purposes described in §170(c)(2)(B)—essentially those loans classified as program-related investments.¹⁵

Distributions attributable to interest income earned by an estate do not retain their character as interest, but instead are treated as contributions to the foundation. Proceeds of a qualified employee plan, except for interest accrued after the date the gift is effective, are not among the specified types of income. Plan proceeds are deferred compensation, do not constitute investment income earned by the foundation, and are not taxable under IRC §4940.¹⁶ The IRS has privately ruled that the proceeds of a donated retirement account were not taxable because the excise tax is limited in its application to the specifically listed types of income: dividends, interest, rents, and royalties.¹⁷ Distribution amounts from qualified employee pension plans and individual retirement accounts are treated as deferred compensation for federal income tax purposes. The term “gross investment income” under §4940 includes interest, dividends, rents, payments with respect to securities, loans, and royalties, but does not include deferred compensation. Therefore, distributions to a trust from a decedent's plans will not constitute gross investment income for purposes of imposing the excise tax described in §4940.¹⁸

An unanswered question is whether income earned on an annuity contract is subject to the investment income tax.¹⁹ The increase in the annual value of an annuity contract is thought of as interest and calculated at an expressed rate. The annual increase, however, is not taxed as interest under certain income tax rules. The increase is taxable to holders other than natural persons as ordinary income from the annuity contract.²⁰ When a private foundation holds an annuity, several questions arise. The increase in value of an annuity should not be reportable for §4940 purposes because it is not interest, nor is it a dividend or rental or royalty income. Second, the unrelated business income tax rules specifically modify or exclude annuity income from that tax.²¹ Finally, the gain on the redemption of the annuity contract, effective August 17, 2006, would be a taxable gain.²²

(c) Dividends

Dividends that are taxable include:

• Dividends paid on all types of securities, whether listed and marketable or privately held and unmarketable.
• Mutual fund dividends (capital gain portion is also taxed, but as a capital gain).
• For-profit subsidiary dividends.
• Corporate liquidating distributions classified as dividends under IRC §302(b)(1), but not including payments on complete redemption of shares that are classified as capital gains.²³

The redemption of stock from a private foundation to the extent necessary to avoid the excess business holdings tax is a sale or exchange not equivalent to a dividend and previously was not taxed, but after the PPA, any gain is reported as taxable capital gain. Similarly, a conversion of the foundation's shares in a tax-free reorganization will produce taxable capital gain. Dividends earned on a paid-up life insurance policy that was donated to the foundation were found to be taxable.²⁴ Dividends and other distributions of income from a Subchapter S corporation are subject to the unrelated business income, rather than the investment excise tax.²⁵

Income from other types of peripheral security transactions do not produce dividends or interest and were not taxed before August 17, 2006. Similarly, an option to buy (a put) or sell (a call) a security produces gain or loss if it is sold or expires and therefore, after August 17, 2006, produces excise taxable income. Options to buy commodities, such as corn or wheat, or gold futures have similar characteristics. Other sophisticated types of investments, such as derivatives, were not anticipated when §4940 was written, but such revenues are now taxable.

(d) Rentals

Amounts paid in return for the use of real or personal property, commonly called rent, are taxable—whether the reason for renting the property is an investment purpose or is related to the foundation's exempt activities.²⁶ The portion of the rental income attributable to that portion of the property that is debt-financed is taxed as unrelated income and therefore excluded from the investment income excise tax.²⁷

(e) Royalties

Payments received in return for assignments of mineral interests owned by the foundation, including overriding royalties, are taxed. Only cost, not percentage, depletion is permitted as an offsetting deduction for excise tax purposes. For unrelated business income tax purposes, percentage depletion is permitted as it is for normal taxpayers. Royalty payments received in return for use of a foundation's intangible property, such as the foundation's name or a publication containing a literary work commissioned by the foundation, are also taxable. Income from a working interest in a mineral property is excluded; instead, it is considered unrelated business income (and the property may be an excess business holding).

(f) Estate or Trust Distributions

Payments to the foundation from an estate or trust do not generally “retain their character in the hands” of the foundation. In other words, such payments do not pass through to the foundation as taxable income. Even if the estate income is recognized by the PF for financial purposes because the foundation follows the accrual method of accounting, income earned during administration of a trust estate is not treated as foundation investment income.²⁸ The estate assets, including accumulated income, are also not treated as foundation assets for the purpose of calculating grant payout requirements.²⁹ Part of the reason for this rule lies in the fact that the wholly charitable trust pays its own 2 percent excise tax, and its distributions are not taxed again to the foundation upon their receipt. Income earned during administration of an estate that is set aside or earmarked for payment to a foundation is deductible as a charitable contribution. Such income is not taxable to either the estate or the foundation (unless administration is unreasonably continued).³⁰

Distributions from trusts and estates are not included in a private foundation's net investment income. The tax court found that the regulation that excluded estate distributions and certain trust payments from income was inconsistent because it required inclusion of amounts paid by split-interest trusts.³¹ In the summer of 2004, the IRS announced its intention to recommend amendment of the regulations to allow exclusion of all trust distributions.³² As of 2010, the regulations still had not been changed to reflect this intent, although the instructions to Form 990-PF make the intent clear.

(g) Partnerships

When a private foundation buys, or is given, an interest in a partnership, its proportionate share of certain income earned by the partnership is reportable for excise or unrelated business income tax purposes. The partnership income retains the same character in the foundation's hands. Form K-1 is provided to the foundation each year, reflecting its share of the various types of income earned by the partnership. Detailed information to allow a tax-exempt partner, including a private foundation, to report its share of unrelated business income and calculate its tax liability must be provided. Rentals from indebted real estate are the most common type of unrelated income distributed from partnerships.³³ As mentioned previously, all income distributed to a foundation from a Subchapter S corporation and reported on Form K-1 is subject to the unrelated business income tax, rather than the excise tax, even if the character of the income in the hands of the corporation is interest, dividends, rent, or royalty.

Income earned on investments in foreign partnerships and corporations is subject to complex rules set out in subpart F of the tax code. The earnings of such entities generally retain their tax classification and character as they pass through to the PF. In limited circumstances, however, earnings of a controlled foreign corporation that are not distributed to the domestic PF may not currently be taxable.³⁴ See §18.2(g) for reporting requirements for offshore investments.

(h) Foreign Investments

An increased number of non-U.S. investments in recent years are held by PFs. In diversifying their portfolios, tax-exempt organizations have been advised to purchase international securities, through both U.S.-based mutual funds and hedge funds.³⁵ The tax reporting for such domestic funds and outright purchase of marketable securities of an international company through a U.S. financial institution do not bring any unique reporting requirements. The dividends, interest, and resulting capital gains from such passive security investments are reported on Form 990-PF and subject to the excise tax.³⁶

Some of these passive investments are made in the form of so-called offshore hedge funds organized in either partnership or corporate form. Income of a hedge fund organized as a partnership is treated as being earned proportionately by and reportable by each partner, including those that are tax-exempt.³⁷ Therefore, the exempt investor receives and must report on Forms 990 an allocated part of the dividends, interest, capital gains, and other income from derivatives, options, notional contracts, and the like. The partnership reports the income and must furnish the organization a Form K-1 that contains details necessary for correct tax reporting. When an investment is made in corporate form, the issues discussed later in this subsection influence the tax reporting.

Additional tax reporting obligations can arise from hedge fund investments. Most costly is normal income tax that may be due on part or all of the fund income that is classified as unrelated business taxable income (UBTI). The taxable income usually results when the fund uses margin or other borrowed funds, called acquisition indebtedness, to leverage the investments.³⁸ When UBTI is realized, the exempt must report it on Form 990-T and pay the normal income tax as if the entity were a nonexempt corporation or trust.³⁹ In order to offer protection to their investors, fund sponsors many times create a “blocker” structure to keep any taxable income from passing through the offshore hedge fund to the investor.

There are numerous variations on the theme of blocker structures, but the essence is that the investment activities potentially producing UBTI are held in a “blocker corporation.” The corporate form serves to block any UBTI from flowing through to the exempt investor. Most of these corporate offshore hedge funds are controlled taxwise by U.S. antideferral regimes for controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs).

Exempt organizations coming under CFC rules must report income currently even if the income is merely accumulated instead of being actually distributed. A CFC is a foreign corporation in which significant “U.S. shareholders” own more than 50 percent of the total combined voting power or value on any day during the corporation's tax year.⁴⁰ To be classified as a “U.S. shareholder,” the exempt must own at least 10 percent of the voting stock of the corporation. Of course, if the exempt has no UBTI from “debt-financing” its stock purchase, these antideferral rules merely affect the timing of reporting dividend income subject only to the 1 or 2 percent excise tax.

The foreign corporation tax rules under which an offshore hedge fund is most likely to qualify, assuming it accepts U.S. investors, is the PFIC. Like the CFC rules, the PFIC tax laws were established as an antideferral regime—or, at the least, a regime that would make income deferral an “expensive” proposition. A foreign corporation will be a PFIC if 75 percent or more of its gross income for the tax year consists of passive income, or 50 percent or more of the average fair market value of its assets consists of assets that produce, or are held for the production of, passive income.⁴¹

The general rule for a PFIC is that no taxes are due until there is an actual distribution of accumulated dividends or until the shareholder disposes of shares it owns. This allowable deferral of income is of little significance to exempts that have not debt-financed their purchase of PFIC stock, except to be concerned about proper reporting and timing of the dividend income subject to §4940 excise taxes. If an organization does have debt-financed stock, deferring the UBTI produced comes at a high price.

Whenever the deferred income is reported, all of the income is taxed as ordinary income even though some capital gains may have been included. In addition to the taxes due on the debt-financed income, an “interest penalty” must be paid.⁴² To avoid the ordinary income classification for all income and to avoid the interest penalty, the organization may wish to make a qualified electing fund (QEF) election. Exempt organizations are not permitted to make QEF elections unless the income from the PFIC is subject to UBIT, that is, the PFIC stock was purchased with acquisition indebtedness.⁴³ If such an election is made, the organization currently includes its pro rata share of the offshore hedge fund's ordinary and long-term gains in income for each tax year, and pays tax thereon even though such income and gains are not actually distributed.⁴⁴

In addition to the complexities already noted, there are other tax reporting forms to be filed in connection with foreign investments, particularly when the investment exceeds $100,000. If the investment entity is a foreign corporation, Form 926 and/or Form 5471 may be required. For PFIC corporate forms, Form 8621 may have to be filed. For a partnership investment entity, Form 8865 may be required. (See Exhibit 18.2 for a chart reflecting the complexities of the reporting requirements for such investments.) Prudent organizations will take the additional costs of meeting the filing requirements into account in evaluating the potential return on such foreign investment vehicles.

New IRC §965 was added to the tax code by the Tax Cuts and Jobs Act to tax the accumulated post-1986 deferred foreign income of a corporation, determined as of December 31, 2017. Regulations totaling 247 pages were proposed to explain the new tax. Referred to as a “toll tax,” the new code requires U.S. shareholders (generally U.S. persons who directly, indirectly, or constructively own 10 percent or more of the stock of a foreign corporation) to pay a transition tax on the untaxed foreign earnings of certain specified foreign corporations by treating those earnings as included in the income of the U.S. shareholder. A participation exemption allows deductions to impose lower effective rates depending on whether the foreign earnings are held in cash. Guidance with respect to private foundations that are U.S. shareholders of specified foreign corporations says:

• Any §965 inclusion is generally included in the calculation of gross investment income of a private foundation for purposes of determining the excise tax imposed under §4940.
• The §965(c) deduction is not treated as an ordinary and necessary expense paid or incurred for the production or collection of gross investment income for purposes of §4940(c)(3)(A) (and, accordingly, the full amount of any inclusion is generally subject to the excise tax on net investment income).
• Private foundations are not permitted to make an election—generally available to other taxpayers—to pay any §965 tax liability in eight annual installments with respect to any excise tax imposed under §4940. There is no mention of treating such income as unrelated business income.

(a) Basis

The tax basis for calculating gain or loss is equal to the amount paid by the PF for the assets it purchases or constructs, except for donated assets discussed below, less any allowable depreciation or depletion. Income tax rules apply to determine the tax basis of a private foundation's assets for purposes of calculating gain or loss upon disposition.⁵⁴ Many times a foundation will hold securities of the same class issued by the same company but acquired at different times, referred to as blocks of stock. The PF will have a different tax basis for each block because of the differing acquisition dates (whether acquired by the donor or the foundation directly). The general rule for income tax purposes requires use of the FIFO (first-in, first-out) method to track basis for such shares.⁵⁵ When shares are sold, they are considered to come from the lot purchased on the earliest date for purposes of determining basis and holding period. The foundation can, if the stock lots can be adequately identified as coming from a lot purchased at a later date, however, sell particular blocks of stock.

A foundation that receives a donation of shares with different acquisition dates and tax bases might establish a tax accounting system to track the correct basis for shares that it will sell if there are significant differences in the basis. If the foundation plans to dispose of all the gifted shares within one tax year, the identification by block is not necessary. If instead the foundation expects to sell the shares over a period of years, it may benefit from being able to orchestrate the reportable gain or loss by delivering particular blocks with varying bases. As discussed in §13.5(b), a foundation might be able to control, to some extent, the years in which it pays a 1 percent rather than a 2 percent tax. Selling higher-basis shares in a 2 percent year can be beneficial. Keeping in mind the fact that capital losses cannot be carried over or deducted against other income subject to excise tax, the foundation might also purposefully create gain to offset losses.

Donated Assets . Assets acquired by gift retain the donor's basis (so-called carryover basis) and holding period.⁵⁶ Accounting principles suggest that a foundation record donated property at its value on the date the gift is made. For tax purposes, however, it may not step up the tax basis to such value. In a parallel fashion, the holding period of donated assets includes the period such property was held by the donor.⁵⁷ Essentially, the PF pays the tax unpaid by the donor. A foundation holding low-basis securities may be able to reduce this tax burden if it can dispose of the shares in a year (other than its first year) in which its tax rate is reduced to 1 percent.⁵⁸

The basis of inherited property is usually equal to its Form 706 (estate tax return) value, which is ordinarily its value on the date of the decedent's death. For property held by a foundation on December 31, 1969—the date when the tax became effective—special rules apply. The tax basis for any property held on that date is equal to its December 31, 1969, valuation, unless a loss is realized on the sale using such a value.⁵⁹ Property held in a trust or in an estate created before 1969 may also use the 1969 basis.⁶⁰

Appreciation of assets held by a newly classified private foundation attributable to the time it was a supporting organization may not necessarily be subject to the §4940 excise tax on capital gains.⁶¹ A health-care conglomerate asked the IRS to consider the issue concerning its reorganization. It planned to convert itself into a grant-making private foundation and to sell its assets, including (c)(3) health centers, a publicly traded HMO, a for-profit physician practice management group, and an insurance subsidiary, over a period of years. Although IRC §4940 and its regulations contain no provision regarding the basis of assets of a converted public charity, the IRS privately allowed a generous position. It allowed a step-up of basis of fair market value on the date a public charity was converted to a private foundation (PF). Essentially, it treated the built-in gains as if they had been realized during the period the organization was a public charity (and therefore free of the PF excise tax). The ruling cited the transition rule allowing a step-up to value as of December 31, 1969, when the excise tax was first imposed, as rationale for not requiring recognition of gain realized while the now-private foundation was classified as a supporting organization.⁶²

It is sometimes difficult to establish the correct tax basis for a foundation's assets. When a foundation changes financial institutions or investment advisors, it may be difficult to verify historic cost basis. In some situations, the question is when, or if, a foundation can rely on the year-end gain/loss reports. A good-faith effort should be made to obtain correct information, but sometimes it is impossible. Another question that may arise is the method of assigning cost to a sale of one of several blocks of the same stock. Technically, a change of accounting method occurs if the foundation, for example, has been using the average cost of all shares and the new financial institution follows a FIFO method. The foundation needs to instruct new advisors as to the method it has used in the past.

The regulations that address basis issues for private foundations provide no answer for an important question: Must a foundation use the trade or the settlement date in accounting for gains and losses on sales of its marketable security investments? A foundation is to follow the tax rules in Subchapter O of the Internal Revenue Code for purposes of determining gain or loss on sale or other disposition of property.⁶³ This directive means that the carryover basis rules apply to donated property received by a PF. The answer to the question posed about trade date is not addressed, but rulings have found that the trade date is used to determine the holding period and also the sale date.⁶⁴ Further, the trade date is specifically required for recognizing a loss on a stock transaction.⁶⁵ Lastly, trade date, rather than settlement date, is used by a PF following either the cash or the accrual method of accounting.⁶⁶ Financial institutions that issue gain or loss statements for accounts they hold should use the trade date.

A PF that has used the settlement date may need to consider whether a change to use of the trade date is a change in its accounting method to be reported on Form 3115. It may be sufficient for the PF to simply disclose the change in an attachment to its Form 990-PF.⁶⁷

(b) Questionable Types of Gain

Gain from sale of property capable of producing the specified types of taxable income (interest, dividends, rents, security loans, and royalties) are taxed even if the property is disposed of immediately after the foundation receives it. Because the statute applies to “property used for the production” of the specified income, clever foundations in the early days were hopeful they could escape the tax on low-basis property gifts by selling them as soon as the property was given.⁶⁸ The foundations argued that they never held the property to produce the specified types of income, so the tax should not apply.

The courts agreed with the IRS that the fact that the assets were sold immediately upon receipt did not remove their character as being held to produce interest, dividends, rents, royalties, or capital gain through appreciation. However, the last phrase in that sentence, “capital gain through appreciation,”⁶⁹ is not in the statute.

A case involving a sale of timberland further clarified the application of the tax to such properties. Even though it was conceivable that the real estate in question could have been used to produce rental income, it was not. The court in the Zemurray case held that property that produces “capital gain through appreciation” is not an independent category of income taxable under §4940 and that the regulations were invalid. Instead, it was “economically prudent and reasonable” for the Zemurray Foundation to grow and cut the timber. As the foundation did not use the land to produce a type of income specified in the statute, gain on its sale was not subject to the tax. The court held that only property that can reasonably be expected to generate one or more of the five types of income is subject to the tax.⁷⁰ Other assets that fell into this nontaxable category before August 2006 included collectibles such as art works, gold, antiques, cattle, and undeveloped raw land.

Deferred Foreign Earnings . The Tax Cuts and Jobs Act requires that certain types of deferred income under IRC §965(a) be treated as unrelated business income. This new tax code does not refer to private foundations; at this time (January 2020) it is not technically considered to be investment income. The available FAQs for this new code section do not address the question, but some expect that Congress may impose that tax in the future.

(c) Nontaxed Gains

The following types of capital gains are still not subject to the excise tax:

• Distribution of property for charitable purposes is not considered a sale or other disposition for purposes of this tax. Thus, the gain inherent in appreciated property distributed as a grant to another charity is not taxed. Gains on donated property are similarly not taxed for income tax purposes.
• Gain from disposition of “excess business holdings” held on December 31, 1969 (or received as a bequest under a trust irrevocable on May 26, 1969), and sold to or redeemed by a disqualified person to reduce the holdings, is not taxed.
• Gain realized in a merger or corporate reorganization ruled to be tax free under IRC §368 or other section of IRC Subchapter C is not taxed.
• Capital gains distributed by a split-interest trust are not taxed.
• Conversion of a nongrantor trust, treated as a private foundation, to grantor status did not produce gain or entail self-dealing because the parties involved, being siblings, were not disqualified persons.⁷¹
• Reorganization and consequential transactions involved in administration of a closely owned business are explored for impact on IRC §§ 4940, 4941, 4943, 4944, and 4945.⁷²

(a) Ordinary, Not Capital Losses

In reaching a conclusion that Ponzi scheme losses are ordinary, rather than capital, losses, the IRS said: “The character of an investor's loss related to fraudulent activity depends, in part, on the nature of the investment.”⁷⁴ A loss sustained from the worthlessness or other disposition of stock acquired on the open market for investment results in a capital loss, even if the decline is attributable to fraudulent activities of the corporation's officers. The distinction between a capital and an ordinary loss in the circumstance rests on the intention of the company officials. Did they have the specific intent to deprive the shareholder of money or property?⁷⁵ When officials intended to, and did, deprive the investors of money by criminal acts, the loss results from a theft treated as a casualty, and thereby is ordinary loss. How a private foundation reports theft loss is considered in §13.4(c), since it is not treated as a capital loss.

(b) Phantom Income

Ponzi schemes and other investment frauds⁷⁶ generally create “phantom” income in past years and the current year. The IRS, as of December 2009, in a report submitted to the government by the New York State Bar Association (NYSBA),⁷⁷ addressed the various issues that arise in this context pertaining to calculation of the tax on private foundations' investment income. Guidance from the IRS is needed, the report concludes, on the following points:

• May a private foundation file amended annual information returns (Form 990-PF) for open years to claim refunds of excise tax(es) on phantom investment income?
• May a foundation exclude any purported “income” from the scheme in the year of its discovery?
• May a foundation claim a theft-loss deduction in the year of discovery as a deduction against current-year gross investment income and capital gain net income? How is this theft loss calculated?
• Are these issues affected (or resolved) by filing amended returns?

The NYSBA report posed more questions in this context:

• If there was a prospect of recovery and, in a later year, less was recovered than expected, may a foundation take the balance as a theft loss deduction against its gross investment income or capital gain net income in that succeeding year?
• If more was recovered in a succeeding year than expected, would the foundation have to report net investment income in that succeeding year under tax benefit principles?
• Is there any impact if different tax rates (1 or 2 percent)⁷⁸ applied to the different years?
• If a private foundation paid this tax at a 1 percent rate, but, absent the fictitious (inflated) values reported for the foundation's investment in a Ponzi scheme, the percentage payouts in prior years would have been such that the foundation would not have qualified for the 1 percent rate, will the IRS seek to adjust the values and assert tax deficiencies based on application of the 2 percent rate?

(a) Deductions Allowed

The following deductions are permitted:

• Depreciation on property the income of which is taxed using a straight-line method (calculated over the estimated useful life of the property), but no accelerated system is allowed.⁸⁴ The basis for calculating depreciation for purchased or constructed assets is equal to their cost. Donated property retains the donor's, or a carryover, basis. The normal income tax rules are used to measure basis.⁸⁵
• Cost, but not percentage, depletion on mineral interests.⁸⁶
• Investment management and counseling fees, except for that portion attributable to tax-exempt interest or unrelated business income.
• Legal, accounting, and other professional fees allocable to investment income activity. A private foundation can ask its advisors to render billings specifically identifying such an allocation based on time actually spent.⁸⁷
• Taxes, insurance, maintenance, and other direct and specifically identifiable costs paid for property producing rental income, and an allocable part of such costs for administrative offices used for investment management purposes. Space rental would be similarly deductible to the extent the space is occupied by persons responsible for managing the properties that produce income subject to the excise tax.
• A proportionate part of operating expenses, including director, trustee, officer, and staff salaries and associated costs, meetings, dues, office and clerical costs, and bank trustee fees.
• An allocable portion of expenses paid or incurred incident to a charitable program that produces taxable investment income is deductible to the extent of the income earned.⁸⁸
• Bond premium amortization.⁸⁹
• An allocable portion of the costs of setting up the foundation, if the cost was associated with planning for investments and their tax consequences.

(b) Deductions Not Allowed

No deduction is permitted for costs associated with a foundation's grant-making and other charitable or exempt function projects. When a project or asset produces or is operated to produce some income, the deductions for the activity are allocated between the exempt and the investment uses.⁹⁰ With such joint-purpose activities, the primary motivation for undertaking the project (investment or gratuitous) must be determined. When the expenses are incurred in connection with an exempt function project, allocable expenses are deductible only to the extent of the gross investment income from the project.⁹¹ An investment project conceivably could result in a deductible loss. The typical historic restoration project is not expected to produce net income. Because admission charges for visiting such buildings are normally incidental to the overall cost of the project, it would be hard to prove that the building loss is deductible against other investment income. The following items are examples of nondeductible expenses for investment income purposes:

• Charitable distributions and administrative expenses associated with grant-making program costs are not deductible.⁹² Similarly, expenses of programs directly conducted by the foundation are not deductible. These expenses are treated as qualifying charitable disbursements.
• For exempt function assets, depreciation of their cost, and cost of their maintenance, repair, or conservation, are not deductible, except to the extent of income generated by the property.⁹³
• Capital losses in excess of capital gains are not deductible, nor is a carryover permitted to the succeeding year.⁹⁴ This is a potentially costly rule for a foundation that does not properly time its asset dispositions.
• Operating losses incurred in a preceding year do not carry forward from year to year.⁹⁵
• The allocable portion of expenses of exempt function income-producing property or activity in excess of the income produced therefrom and reportable as investment income are not deductible.⁹⁶
• Expenses allocable to taxable unrelated business income are not deductible. (The income is also not includable.)⁹⁷
• Interest paid on borrowing to acquire exempt function assets is not deductible. For example, interest paid on a bond issue floated to finance the building of a retirement community is not paid on behalf of an investment.⁹⁸ If the building is rental property, however, the interest and other property maintenance and operational expenses should be deductible,⁹⁹ but subject to possible limits on loss deductions.
• Interest paid to borrow funds that a foundation relends to another charitable organization (presumably at low interest or interest-free) has been ruled not deductible. Such interest expense is deductible only to the extent of any interest income collected from the relending or temporary income earned on the funds.¹⁰⁰
• A trust termination fee paid by the sole beneficiary private foundation was not paid for the production of income, nor were the unused deductions from the final trust return deductible to the PF.¹⁰¹
• The special corporation deductions, including the dividends received deduction, are not allowed.¹⁰²

(c) Deducting Theft Losses

IRC §4940 and the applicable regulations describing expenses that offset investment income for a private foundation did not anticipate theft losses from investment schemes. There is no specific guidance about how a private foundation would treat such losses, but for some matters income and expense reporting rules applicable to income taxpayers apply. The general rule for deductions against investment income do not refer to IRC §§62, 162, or 165, though certain portions of the regulations refer to income tax sections.¹⁰³ The proper method of reporting the theft may be to file amended returns.

For individual income tax purposes, the IRS ruled that such theft losses are an itemized deduction rather than a reduction in adjusted gross income.¹⁰⁴ Such a loss, less any reasonably expected recovery, is recognized in the year the theft is discovered.¹⁰⁵ A net operating loss, available for carryback to three prior tax years and forward for 20 years, results when the theft loss exceeds the taxpayer's income. The §1341 claim-of-right calculation may be applied when income was included in a prior year because it appeared that the taxpayer had an unrestricted right to the item. That calculation allows the taxpayer a refund if the tax reduction achieved by deducting the theft loss in the current year is less than the tax differentiation due to inclusion of the amount in a prior year. The ruling does not specifically mention private foundations, though most normal income tax rules do apply in measuring reportable income and expense.

(d) Changing Accounting Method or Tax Year

Many private foundations follow the cash method of accounting, as qualifying distributions must be reported on a cash basis. The 990-PF instructions under “Accounting Methods” say that except for Part I, Column D, the financial information should be reported “on the basis of the accounting method the foundation regularly uses to keep its books and records.” There is no instruction regarding a change in accounting method. Absent an instruction, the question is whether Form 3115 should be filed for 990-PF purposes when the foundation changes its accounting method for financial reporting purposes. The rules for normal taxpayers provide for an automatic accounting method change from accrual to cash for an entity with average annual gross receipts of $10 million or less. Thus, a PF would file Form 3115 for 990-T filing purposes to change its method for reporting its taxable unrelated business income. An unanswered question is whether such a filing affects the accounting method used for 990-PF purposes. It is arguable that the net investment income reported on 990-PF pursuant to §4940 is not taxable income within the meaning of the 3115 filing instructions. Due to the modest 1 to 2 percent tax rate imposed on investment income, in many cases the net increase or decrease in reportable income resulting from a change can reasonably be reported in the year of change on Form 990-PF. When the 1 percent difference in the tax rate is significant, recalculation of the past year might be desirable. The author found no guidance on the question and would welcome comments.

A change in tax reporting year, when the foundation has not previously changed its year within the past 10 years, is accomplished simply by filing a short-period return. Say a June 30 fiscal-year reporting PF wishes to change to a calendar-year reporting cycle. A six-month return reporting activity from July 1 through December 31 would be filed to achieve a new December 31 year-end. Three consequences must be considered in deciding to make the change:

1. Acceleration of qualifying distribution deadline. The entire annual payout requirement calculated for the full year that would have ended the following June must be paid out within six months.¹⁰⁶
2. Potential impact on 1–2 percent tax. The higher level of expenditures to meet the qualifying distributions requirement during the six-month period in comparison to the average value of the assets could cause a higher-than-usual payout percentage for the short period that would affect the calculation for several years (if this method of calculating the tax still applies).¹⁰⁷
3. Forms 1099 and K-1 provided to the PF by financial institutions and partnerships and used in preparing Form 990-PF are issued on a calendar-year basis, so reporting on a calendar-year basis may ease the compliance effort.

(a) Distributing, Rather than Selling, Property

For several very different—but interacting—reasons, a foundation might sell assets that result in recognized capital gains subject to tax. The typical foundation invests its assets for total return.¹⁰⁸ Under this investment philosophy, more than 50 percent of the average security portfolio is invested in common stocks. The aim is a combined income from current dividends, interest, and capital appreciation. It is expected that capital gains will be regularly earned as portfolio holdings are sold in response to market changes. When the desired result—capital gain—occurs, tax is due.

The dividends and interest, sometimes referred to as the current return, from a total-return security portfolio often equal less than the foundation's 5 percent payout requirement.¹⁰⁹ A foundation with such a portfolio essentially distributes its capital gains to meet the requirement. Thus, tax occurs for the second reason: Securities are sold to raise the cash to make qualifying distributions that provide an opportunity for tax savings. If the securities (or other property), rather than cash from their sale, are distributed to grantees, the capital gain earned on the property is not taxed. Such a distribution is not treated as a sale or other distribution for excise tax purposes.¹¹⁰

For example, suppose that one-half, or $500,000, of a PF's $1 million of income is capital gains on appreciated securities. Assume also that the PF plans to make grants of $100,000 each to five charitable grantees. As much as $10,000 in tax is saved if the grants are paid with the securities themselves ($500,000 × 1.39% tax). The higher the untaxed gain in a PF's portfolio, the greater the possibility for savings. The tax basis for calculating the gain for donated securities is equal to the donor's basis, meaning that many PFs have a good chance to realize the savings. Readily marketable securities are most suitable for delivery to grantees, because of the ease with which they can be converted to cash. However, any investment property producing dividends, interest, rents, or royalties is subject to this special tax exception; such property might include a bond or a rental building.

Implementing the savings requires some advance planning and cooperative grantees. Grants are normally pledged and paid in round numbers (e.g., $5,000 or $50,000). Securities do not normally sell for round numbers, and the price changes constantly. The grantee rather than the granting PF may have to pay the sales commission. The PF may want to gross up the number of shares to be delivered to ensure that the grantee receives the intended funding. The potential savings can be compared to the costs before such noncash grants are made. The size of the grant and the likelihood that the grantee will retain the securities in its own portfolio can enhance the attractiveness of this medium for grant funding.

Consider an example. A foundation is funded with zero-basis shares donated by a now publicly traded company's founding family. The PF keeps a supply of stock certificates in a variety of share numbers. When a grant is due to be paid, one or more certificates for the number of shares approximating the amount pledged are delivered to the grantee. If the shares are selling for $60 and a $100,000 grant is due, approximately 1,670 shares would be delivered (the few extra shares cover the commission). The full fair market value of the shares on the delivery date is treated as a qualifying distribution. Thus, the difference between the value and the foundation's basis ($100,000 of capital gain in this example) is not taxed, saving the PF $1,390.

(b) Qualification for 1 Percent Tax Rate Applicable before 2020

Until fiscal years beginning in 2020, a foundation's excise tax rate on investment income is reduced to 1 percent for each year, not including its first year, during which the foundation's qualifying distributions equal a hypothetical distribution amount plus 1 percent of net investment income.¹¹¹ The average of the foundation's annual qualifying distributions as a portion of its average investment assets each year is calculated. For example, a foundation has $1 million of assets and makes grants of around $60,000 each year. Its distribution payout ratio is 6 percent of its assets. Taking into account the payout percentage for the five-year period preceding the current year, an average payout ratio is determined. If the current year's distributions equal the average plus 1 percent of the current-year investment income, only a 1 percent excise tax is due.

Some say that a PF can essentially choose to distribute 1 percent of its investment income to charitable recipients rather than the U.S. Treasury. The qualifying formula, as illustrated here, basically calculates a historic minimum distribution ratio by applying the past-five-year average percentage of distributions to the current endowment value and adding half of the normal tax. If the foundation makes distributions equal to and $1 more than its past percentage (times the current fair market value, or FMV), it can qualify for a reduced tax of 1 percent rather than 2 percent. The calculation briefly compares:

Because the qualifying distributions made by this hypothetical foundation during a year equal or exceed the $101,000, the PF's tax rate is 1 percent rather than 2 percent. Essentially, some say a foundation may be able to pay half of the tax to grantees. Note, though, that the calculation is based on the average monthly value of the foundation's investment assets, including the last day of its year; hence, planning for the savings is not easy. Since this tax reduction opportunity came into effect in 1985, foundations that realize the reduction often do so by accident rather than by specific planning. Unless the value of the PF's assets fluctuates widely, it is possible to deliberately time grant payments to reduce the tax to 1 percent in alternate years. For a foundation paying $20,000 to $30,000 in tax, a $10,000 biannual savings may be worth the trouble. To illustrate, Exhibit 13.1 contains a six-year projection for XYZ Foundation, which potentially redirects $48,000 in tax.

(c) Redistributing Donated Property

A donation to a nonoperating private foundation is not necessarily fully deductible, under a number of §170 constraints. The fair market value of noncash gifts, other than readily marketable securities to nonoperating private foundations, is not fully deductible. For a donor to receive a deduction for full fair market value of long-term capital gain property (such as real estate or a partnership interest), the foundation essentially must give away the full value of the gift, or the gift itself, within two months after the end of its year in which the donation was received.¹¹² A noncash donation retained by the foundation and essentially added to its endowment is limited in its deductibility to the donor's tax basis for calculating gain or loss for federal income tax purposes.¹¹³

During the years 1984 to 1994, and again since July 1, 1996 (the rule is now permanent),¹¹⁴ the redistribution issue did not apply to gifts of certain securities. A special exception for marketable securities applies to encourage inter vivos gifts that would build endowments for private foundations. A full fair market value deduction is permitted for the donation of qualified appreciated stock or shares of a corporation for which “market quotations are readily available on an established securities market.”

For gifts of property other than securities, foundations must make distributions equal to the FMV of the appreciated property to afford their donors an income tax deduction for the full value of the property. Such a foundation must choose whether to redistribute the property itself or cash. Choosing redistribution of the property rather than selling it or other property may present an opportunity for the foundation to avoid paying the excise tax on the capital gain.

For the redistribution “not [to] be treated as a sale or other distribution of property,” so as to qualify the gain for exclusion from excise tax, the foundation must grant property in a manner that is considered a qualifying distribution.¹¹⁵ The grant must be made for purposes described in §170(c)(1) or (b)(2) and must basically be made payable to an unrelated and uncontrolled public charity.¹¹⁶ Additionally, the gift must be treated as a distribution out of corpus.¹¹⁷ The fact that the distribution is charged to corpus (to meet the §170 requirement), rather than applied as a current distribution, does not cause the redistribution to fail as a qualifying distribution. Thus, a literal reading of the two applicable tax code sections and referenced regulation seems to allow the gain inherent in the redistributed property to be excluded from the excise tax.