Private foundations contribute a staggering $105.21 billion to public charities annually, representing $1 out of every $5 donated.i By law, private nonoperating foundations must make “qualifying distributions” equal to 5% of their non-charitable assets annually, though studies show many exceed this requirement.ii But today’s generosity can have consequences for tomorrow. So, how can foundation managers maximize the impact of their qualifying distributions? The first step is to understand the rules—and there’s a lot more to the calculation than you might think.
What counts as a qualifying distribution?
Grants to qualified public charities typically comprise the bulk—but not all—of qualifying distributions. They also include:
- Reasonable and necessary administrative expenses incurred in the conduct of the foundation’s charitable activities
- Costs of direct charitable activities
- Amounts paid to acquire assets used in carrying out charitable purposes
- Set-asides for future charitable purposes, with direct IRS approval
- Program-related investments (PRIs)
Administrative expenses—including salaries, professional fees, and supplies that are incurred for grant-making—qualify. But investment management fees do not (unfortunately), and neither do the portion of salaries or foundation expenses allocated to investment oversight. If a foundation runs its own direct charitable programs or maintains a charitable facility, these costs count, too.
PRIs, which allow a foundation to recycle distributed dollars and use assets in creative ways to achieve its mission, are often structured as below-market interest rate loans. They count, but be careful. Any principal repayments from a borrower will constitute a refund of a previously issued grant and increase the 5% distribution requirement in the year principal is repaid.
How is the 5% minimum calculated?
First, the foundation must calculate the average value of its assets for the year. This excludes any debt incurred in acquiring investments, as well as any charitable-use assets such as a building that houses the foundation, furnishings, and equipment. Other assets are treated as follows:
- Cash is valued by averaging the amount on hand on the first and last days of each month.
- Marketable securities are based on a monthly average using any reasonable method.
- Alternative assets may be valued annually, and real estate appraised every five years.
The average asset value is then reduced by 1.5% (as an allowance for operating cash) and the resulting 98.5% is multiplied by 5%. This figure is then further reduced by any excise or income taxes the foundation paid during the year. It’s also adjusted to account for any outflows or inflows from PRIs to reach the final required distribution amount, called the “distributable amount.”
How long is the payout period?
Private foundations have 12 months after the end of their tax year to satisfy the payout requirement. While this may seem straightforward, it often trips people up.
Why the confusion? Some foundations do their grantmaking concurrently with their average asset calculations, essentially “working ahead” in terms of their IRS required distributions. Of course, it’s impossible to match the payout precisely since the average asset value, including the final month, won’t be known until next year. Sometimes this leads to suboptimal practices—such as spending time estimating the moving average asset value or delaying grants until late in the year when visibility is higher. These can be easily avoided by grantmaking in the subsequent year.
If a foundation makes sufficient qualifying distributions to satisfy the current year’s requirement (based on the prior year’s assets), additional qualifying distributions may be applied to reduce next year’s distributable amount or carried forward for a total of five years. In other words, if grants are large enough in one year, there may be no required distributions the following year.
On the other hand, if a foundation is making grants at the subsequent year-end to meet its true required distribution (based on the prior year’s asst values), there is great urgency. If a foundation fails to make the required distribution within the 12-month grace period, the IRS imposes a 30% penalty on the shortfall.
As an aside, there is no minimum distribution requirement in the year a foundation is established. Plus, in the founding year, the initial distribution is prorated for the partial year. For example, if a foundation is founded on November 1 of this year, the 5% rate is applied to 2/12ths of this year’s average assets, and the deadline for making the required distribution isn’t until December 31 of next year.
Can exceeding the minimum increase your impact?
Foundations often wonder if they could have a greater impact by granting more than the required 5% each year. The answer is yes—but only initially. For example, a $30 million foundation granting 7% would distribute $2.1 million in Year 1, eclipsing the $1.5 million if the foundation were withdrawing 5% (Display). But by Year 20, the 5% distribution has overtaken the 7%, and it will remain higher thereafter.
To measure a foundation's financial impact over time, we use a metric called Total Philanthropic Value (TPV), which is the sum of cumulative distributions in a given period plus the ending remainder value. Consider two $30 million foundations with 70% stock/30% bond portfolios sizing up their efforts 30 years hence. The one distributing 7% of its value each year has a TPV of $86 million, while its counterpart distributing only 5% produces surprisingly greater TPV, at $106.4 million worth of good, according to our projections (Display). While adhering to the minimum distribution may not be the right approach for every foundation, it’s worth contemplating for those looking to maximize their financial impact in perpetuity.
Are there other ways to increase impact?
Here are a few more creative strategies for foundations to consider:
- Run scholarship programs or provide emergency assistance directly to individuals who have experienced hardships like natural disasters.iii
- Reduce your 1.39% excise tax on net investment income by harvesting capital losses to offset net realized gains,iv and by making in-kind grants of appreciated securities to charity to avoid realizing the capital gain.
- Make grants to donor-advised funds (DAFs) as part of your qualifying distributions. This comes in handy when receiving a sizable contribution that triggers a much higher payout the following year. If the foundation doesn’t want to overwhelm current grantees, and may not have time to identify new recipients, a grant into a DAF may be a solution.
- Activate “the other 95%” of the portfolio by incorporating impact investments, PRIs, or environmental, social, and governance factors into your investment approach.
Foundation distributions are not one-size-fits-all. Some foundations distribute more to solve near-term problems, support nonprofits with declining funding sources, or spend down assets over a given time frame. However, for foundations seeking to maximize their long-term monetary impact, adhering to the minimum 5% distribution may be advantageous. One thing is certain: understanding the rules governing qualified distributions and evaluating the long-term financial implications can help foundation managers maximize their impact.
- Christopher Clarkson
- National Director, Planning | Foundation & Institutional Advisory
i Giving USA 2023 Infographic. Giving USA Foundation,™ The Giving Institute, and the Indiana University Lilly Family School of Philanthropy.
ii IRC Section 4942. The distributable amount for private nonoperating foundations equal to 5% of their non-charitable assets each year (the “minimum investment return” or “MIR”), subject to adjustments. In contrast, a private operating foundation must utilize 85% or more of lesser of adjusted net income or minimum investment return for charitable purposes (i.e., direct exempt activity). 2024 Foundation Operations and Management Report. Exponent Philanthropy. Appendix F4, Page 120. According to Exponent, the average foundation makes qualifying distributions equal to 6% of its assets.
iii A private foundation can donate to a school’s scholarship program or administer its own program and select the recipients. The foundation’s scholarship program procedures must be approved in advance by the IRS. Grants from donor-advised funds that support school scholarships cannot benefit a specific individual selected at the sole or majority discretion of the donor. Foundations can make hardship and emergency relief grants to individuals without obtaining prior IRS approval, while DAFs cannot make grants to individuals.
iv Note that foundations cannot carry forward capital losses to use in future years.
The Bernstein Wealth Forecasting SystemSM uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts: (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings, and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability. Moreover, actual future results may not meet Bernstein’s estimates of the range of market returns, as these results are subject to a variety of economic, market, and other variables. Accordingly, the analysis should not be construed as a promise of actual future results, the actual range of future results, or the actual probability that these results will be realized.