Taxes on Failure to Distribute Income (IRC 4942)

Generally, §4942 of the Internal Revenue Code imposes an excise tax on any undistributed income of a private foundation. An additional excise tax will be imposed on any income remaining undistributed at the end of the taxable period. The taxable period begins on the first day of the tax year and ends on the earlier of either: 1) The date a notice of deficiency for the initial tax is mailed; or 2) The date the initial tax is assessed.

General requirement. The income of the foundation must be distributed as qualifying distributions. Private foundations must make qualifying distributions to the extent of their minimum investment return for the year. The minimum investment return for any private foundation is 5% of the excess of the combined fair market value of all assets of the foundation, other than those used or held for use for exempt purposes, over the amount of indebtedness incurred to buy these assets.

However, a foundation may set aside funds for periods up to 60 months for certain major projects. Excess qualifying distributions may be carried forward for a period of 5 tax years immediately following the tax year in which the excess was created. Special transitional rules apply to foundations created before May 27, 1969.

Exceptions. The tax does not apply to the undistributed income of a private operating foundation or of an exempt operating foundation. The tax also does not apply to the undistributed income of a private foundation that failed to distribute only because of an incorrect valuation of assets, if:

The incorrect valuation was not willful and was due to reasonable cause,
The undistributed income is distributed as qualifying distributions during the allowable distribution period,
The foundation notifies the Service that the income has been distributed to correct its earlier failure to distribute, and
The distribution is treated as a correction of deficient distributions for earlier tax years that would otherwise be subject to this tax
The foundation must be able to show it has made all reasonable efforts in good faith to value its assets according to applicable rules.

A qualifying distribution is:

Any amount (including program-related investments) paid to accomplish religious, charitable, scientific, literary, or other public purposes. Qualifying distributions do not include contributions to organizations controlled by the contributing foundation or by one or more disqualified persons with respect to the foundation or to private nonoperating foundations (with exceptions for certain contributions to exempt organizations, discussed below).
Any amount paid to buy an asset used (or held for use) directly to carry out a charitable or other public purpose. Depreciation on these assets, however, is not considered a qualifying distribution.
Any qualifying amount set aside.

In general, a distribution to a public charity described in §509(a)(1), (2), or (3) to accomplish a religious, charitable, scientific, literary, educational, or other permitted public purpose is a qualifying distribution. See Grants to Organizations, for rules on when a private foundation may rely on the public charity status of a grantee.

The amount of a qualifying distribution of property is the fair market value of the property on the date it is made. The amount of a qualifying distribution is determined only under the cash receipts and disbursements method.

A private foundation that bought an asset and claimed a qualifying distribution under item (2) will be allowed a second qualifying distribution for the same asset if the asset is later given to a publicly supported charitable organization that is not controlled by the foundation, and it is donated for a purpose described in item (1).

The amount of the second qualifying distribution will be the difference between the fair market value of the asset on the date of the contribution and the amount of the first qualifying distribution.

Borrowed funds. If a private foundation borrows money during a tax year to make a charitable expenditure, then a qualifying distribution is considered made only at the time the borrowed funds are actually distributed for a charitable purpose.

Control. An organization is controlled by a foundation or by one or more disqualified persons if any of these persons may, by combining their votes or positions of authority, require the organization to make an expenditure or prevent the organization from making an expenditure, regardless of the method by which control is exercised or exercisable. Control of a donee organization is determined without regard to any conditions imposed on the donee as part of the distribution or any other restrictions as to how the distribution may be used unless the conditions and restrictions are imposed on a distribution of net assets to terminate private foundation status.

In general, it is the donee, not the distribution, that must be controlled by the distributing private foundation to disqualify an otherwise qualifying distribution. If a foundation provides support to an organization and imposes budgetary procedures on that organization, this will not, of itself, constitute control of the donee. Budgetary procedures include expenditure responsibility to require reports from the donee organization on:

The use of the funds,
Compliance with the terms of the grant, and
The progress made by the donee toward achieving the purposes for which the grant was made.

The controlled organization does not have to be a private foundation. It may be any kind of exempt or nonexempt organization including a school, hospital, operating foundation, or social welfare organization.

Changes in asset use. If an asset not used or held for use for public or charitable, educational, etc. purposes is later converted to exempt use, the foundation may treat the conversion as a qualifying distribution. The amount of the qualifying distribution is the fair market value of the converted assets on the conversion date. For determining fair market value of the assets, see Valuation of Assets.

The date a foundation adopts and immediately begins to implement a plan to convert property from nonexempt to exempt uses is the conversion date even if the actual conversion occurs later.

Payment of any Chapter 42 excise tax imposed on the foundation is not considered a qualifying distribution.

The characterization of qualifying distributions made during the tax year (that is, whether out of the prior or current year's undistributed income, or corpus) is made as of the close of the tax year in question, except when the donee organization chooses to treat all or part of the distribution as made out of a distribution from corpus made in a designated prior tax year (see Treatment of qualifying distributions, below. Once it is determined that a qualifying distribution is from corpus, that distribution will first be charged to distributions that are required to be redistributed as described earlier.

All amounts contributed to a specific charitable, educational, religious, etc., exempt organization in anyone tax year of that organization will be treated as a single contribution by the contributing private foundation.

If the requirements for establishing the contribution as a qualifying distribution to certain exempt organizations are not completely satisfied, then only that part of the contribution that was redistributed will be treated as a qualifying distribution.

To satisfy distribution requirements, a donee organization may choose to treat as a qualifying distribution from corpus for the current year any amount distributed in a prior tax year that was treated as a distribution out of corpus if:

That amount has not been used for any other purpose (such as a carryover of excess qualifying distributions, or a prior year redistribution),
The corpus distribution occurred within the preceding 5 years, and
The amount distributed is not later used for another purpose.

The choice must be made by attaching a statement to the Form 990-PF filed for the tax year for which the choice is to apply. The statement must contain a declaration by the appropriate foundation manager that the foundation is making a choice under these provisions, and must specify that the distribution is to be treated as having been made out of a distribution from corpus in a designated prior tax year or years.

Example. In 2002, the Miller Foundation, a private foundation, made a contribution out of 2001 income to the James Foundation, a private nonoperating foundation. The contribution was the only one received by the James Foundation in 2002. In 2003 the James Foundation made a qualifying distribution to an art museum maintained by an operating foundation in an amount equal to the contribution received from the Miller Foundation. The James Foundation also distributed all of its undistributed 2002 and 2003 income for other charitable, educational, religious, etc. purposes. The distribution to the art museum is treated as made out of corpus.

The Miller Foundation's contribution to the James Foundation is a qualifying distribution out of the Miller Foundation's 2001 income. This is a qualifying distribution if it obtains adequate records or enough other evidence from the James Foundation showing the nature and amount of the distribution, the recipient's identity, and the fact that the distribution is treated as made out of corpus. If the James Foundation's qualifying distributions during 2003 had been equal only to the contribution received from the Miller Foundation and its 2003 undistributed income, the James Foundation could have chosen to treat the amount distributed in excess of its 2003 undistributed income as a qualifying distribution made out of corpus (see Special choice, later) and thus satisfy the qualifying distribution requirements.

Limit. A contribution by a private foundation to a recipient organization, which the recipient uses to make payments to a secondary recipient, is not a contribution by the private foundation to the secondary recipient if the foundation does not earmark the use of the contribution for any named secondary recipient, and does not keep the power to control the selection of the secondary recipient by the organization to which the foundation has contributed.

Treatment of qualifying distributions. Any qualifying distribution made during the tax year will be treated as being made:

First, out of undistributed income of the immediately preceding tax year (if the private foundation was subject to the initial excise tax for the prior tax year) to the extent thereof,
Second, out of undistributed income for the current tax year to the extent thereof, and
Then, out of corpus.

Distributions are taken into account in the order of time in which made.

Special choice. If any qualifying distribution is not treated as being made out of undistributed income of the immediately preceding tax year, the foundation may choose to treat any part of the distribution as made out of the undistributed income of a designated prior tax year or out of corpus.

This choice is made by filing a statement with the IRS during the tax year in which the qualifying distribution is made or by attaching a statement to the foundation's annual return, for the tax year in which it made the qualifying distribution. The statement must contain a declaration by an appropriate foundation manager that the foundation is making the choice, under Regulations §53.4942(a)-3(d)(2) and must specify whether the distribution is made out of undistributed income for a designated prior tax year (or years) or is made out of corpus.

When the choice is made during the tax year in which the qualifying distribution is made, the choice may be revoked in whole or in part by filing a statement with the Service during the same tax year or by attaching a statement to the foundation's annual return filed for the tax year during which the qualifying distribution was made. The revocation statement must contain a declaration by the appropriate foundation manager that the foundation is revoking the choice described above in whole or in part, and must specify the choice or part thereof being revoked.

Example. The Oak Foundation, a private foundation, has undistributed income of $300 for 2001 and $200 for 2002. On January 14, 2003, the Oak Foundation made its first qualifying distribution in 2003 when it set aside $700 for hospital construction.

On February 22, 2003, a notice of deficiency for the initial and additional excise tax on failure to distribute income with regard to the 2001 undistributed income was mailed to the Oak Foundation. The Oak Foundation notified the Service in writing on March 20, 2003, that it was making a choice to apply the January 14, 2003, distribution (to the extent that it exceeded 2002 undistributed income) against the 2001 undistributed income. The Oak Foundation is liable for an initial excise tax of $45 (15% of $300).

Because the Oak Foundation made the choice described, the $300 of undistributed income for 2001 is treated as distributed during the correction period, and no additional excise tax is imposed. Under these circumstances the $700 distribution is treated as made first out of the undistributed income of 2002 ($200), then out of the remaining undistributed income of 2001 ($300). The $200 remaining may be applied against the distributable amount for 2003 or may be treated as a distribution out of corpus.

Carryover of excess qualifying distributions. For any tax year during which the organization is a private nonoperating foundation, any excess qualifying distributions (described later) may be used to reduce distributable amounts in any tax year of the adjustment period.

If a private foundation that had a carryover of excess qualifying distributions makes a §507(b)(2) transfer of all its assets to an effectively controlled foundation, the transferee foundation may reduce its distributable amount by the carryover.

The distributable amount for a tax year in an adjustment period will be reduced by the lesser of:

The excess of qualifying distributions made in prior tax years to which the adjustment period applies, or
The remaining undistributed income at the close of the tax year after applying any qualifying distributions made in that year to the distributable amount for the year.

Example. Maple Foundation, a private nonoperating foundation, has distributable amounts for 1998, 1999, and 2000 of $100 each. It made a qualifying distribution in 1999 of $250 and in 2000 of $70. The qualifying distribution made in 1999 will be treated as $100 made out of the undistributed income for 1998, then as $100 made out of undistributed income of 1999, and finally as $50 out of corpus in 1999. Since the total qualifying distributions with respect to 1999 ($150) exceed the distributable amount for 1999 ($100), a $50 excess of qualifying distributions exists which the Maple Foundation may use to reduce its distributable amounts for the years 2000 through 2004 (the tax years in the adjustment period with respect to the 1999 excess).

Therefore, the $100 distributable amount for 2000 is reduced by $30 (the lesser of the 1999 excess ($50) and the remaining undistributed income at the close of 2000 ($30), after the qualifying distributions of $70 for 2000 were applied to the original distributable amount for 2000 of $100), Maple Foundation then has a $20 excess of qualifying distributions to use for tax years in the adjustment period. If during any tax year of the adjustment period another excess of qualifying distributions is created, that excess will not be taken into account until the earlier excess has been completely applied against distributable amounts during its adjustment period.

An excess qualifying distribution is the amount by which the total qualifying distributions treated as made out of undistributed income for any tax year beginning after 1969, or as made out of corpus for the tax year (other than distributions by donee organizations described in Certain contributions to exempt organizations, earlier, or the amount applied to a prior tax year by the choices with respect to qualifying distributions) exceed the distributable amount for that tax year.

The adjustment period is the 5 tax years immediately following the tax year in which the excess of qualifying distributions is created. Thus, an excess qualifying distribution for anyone tax year may not be carried over for more than 5 tax years, However, if during any tax year of the adjustment period, the organization ceases to be subject to the initial tax (such as by becoming a private operating foundation), any portion of the excess qualifying distributions, that, before that tax year, has not been applied against distributable amounts may not be carried over to that tax year or later tax years in the adjustment period. This rule applies even though during any of those tax years the organization again becomes subject to the initial tax.

[Source: Internal Revenue Service, U.S. Dept. Of Treasury (IRS), http://www.irs.gov/]