Qualifying for the reduced rate on NII.

• Author: Gonzales, Mario A.
• Position: Net investment income

Sec. 501(c)(3) tax-exempt private foundations are subject to a 2% excise tax on net investment income (NII), under Sec. 4940. This tax is truly an excise tax, as it is one of the few taxes imposed on private foundations not meant to discourage or punish the entity for a tax law violation. The tax was designed to fund exempt organizations' oversight; there has been (and continues to be) discussion on whether the funds file tax raises are used only to offset the cost of enforcing the sanctions.

Over the past 10 years, the funds raised by the tax have increased, while the number of related IRS audits has decreased. In 1984, Congress noticed that, historically, the excise tax collected exceeded the total costs of administering the exempt organization program and provided a way for foundations to pay a reduced rate (1%). With careful planning, a private foundation can take advantage of the reduced rate.

Definition

In general, Sec. 4940(c) defines NII as gross investment income plus net capital gain, less expenses directly attributable to producing, managing and collecting such income. Gross investment income includes, under Sec. 4940(c)(2), dividends, interest, rents, royalties and payments on securities loans.

Reduced Rate

To qualify for the reduced rate, the foundation's current-year distributions must exceed a minimum. Under Sec. 4940(e)(2), the minimum equals the average fair market value (FMV) of current-year noncharitable assets, multiplied by the average payout (as a percentage of asset value) for the past five base years, plus 1% of current-year NII.

Example: Y Foundation has a 5% average distribution ratio for the past five years, $1 million of current-year NII and $25 million average FMV of current-year assets. It would need to distribute at least $1.26 million (($25 million x .05) + ($1 million x .01)) to be eligible for the 1% rate.

Problems

Foundations encounter several problems in planning to meet the reduced-rate requirements. First, the calculation of the average FMV of assets is a monthly average that includes assets held through the last day of the year. Also, a foundation does not always know how much NII it will have for the year, nor does it know the degree to which the FMV of its assets will change.

Additionally, the foundation must also have complied with the Sec. 4942 minimum-distribution requirements for all base-period years, which require a minimum annual distribution of 5% of the average FMV of investment...