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Excise Tax on Net Investment Income of Private Foundations

January 06, 2017

The IRS imposes a 2% excise tax on the net investment income of private foundations—learn more about this not-so-highly favored tax.

Setting up a private foundation offers substantial benefits for those interested in creating a family legacy dedicated to charitable giving. However, a private foundation can be costly, and is highly regulated by the IRS. Under section 4940, the IRS imposes an excise tax equal to (generally) 2% of the net investment income of the majority of domestic tax-exempt private foundations. Learn more about the excise tax here.

More about the excise tax on Net Investment Income

There are special tax regulations which apply to private foundations. Even though foundations are tax exempt, a foundation’s net investment income may only be subject to an excise tax of 1% if qualified charitable distributions exceed a formula based calculation. Otherwise, the Foundation is taxed at 2% of its net investment income.

  • The tax is reported on Form 990-PF, Return of Private Foundation. Paying the tax depends on estimated tax requirements. Your estimated tax payments are determined by completing Form 990-W. This computes the timing and amounts of the estimated tax installment payments.
  • The amount may be reduced to 1% in specific situations in which the foundation makes a certain level of qualified distributions.
  • Foundations that fail to make qualified distributions of at least 5% of their net assets each year, must pay a 15% excise tax on the shortfall.

What is the purpose of the tax?

It is intended to help offset the government’s cost of regulating private foundations.

Calculating the tax

Net investment income = Gross income from investments (including capital gain net income) – Allowable deductions.

Net investment income is multiplied by the 1% or 2% rate to get the Excise tax rate.

Problems with the tax

  • The private foundation excise tax is difficult to administer and because of its overly complex, two-tier structure, it frequently deters foundations from increasing giving for unanticipated grants, like post natural disaster assistance.
  • Foundations can actually be penalized with higher taxes under the two-tiered rate when they give more during times of extraordinary need.
  • Calculating the tax rate requires foundation staff to constantly monitor and adjust their investments and spending (time and money that would obviously be better spent serving their community)

Can you avoid the tax at all?

For many years lawmakers have been trying to simplify the tax to a single flat rate. As of 2016, the tax is still being imposed on all private foundations.

Questions on your foundation’s obligations? Contact me or any member of the Not-for-Profit Services team today.

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