2023 Tax Planning Guide for Private Foundations
The CPA KPA 2023 Tax Planning Guide for Private Foundations provides valuable information and planning tips to help navigate complex tax and compliance issues. This discussion specifically focuses on private non-operating foundations, also known as grantmaking or family foundations. Here are some important considerations for year-end compliance and annual assessments:
Form 990-PF
Form 990-PF is an annual tax return that private foundations need to file with the IRS. This form calculates the excise tax on their net investment income and provides a comprehensive snapshot of the foundation's financial status, including details on grants and other operational activities.
Foundations operating on a calendar year, from January 1 to December 31, must submit this form by May 15th of the subsequent year. Those on non-calendar fiscal years have until the 15th day of the fifth month after their year ends.
Due to the Taxpayer First Act of July 1, 2019, all private foundations are now required to electronically submit their returns, including Form 990-PF and related forms like Form 990-T (Exempt Organization Business Income Tax Return) and Form 4720 (Return of Certain Excise Taxes). This means the traditional hard-copy submissions via postal mail are no longer accepted.
Consider Donating to the Foundation
Considering a charitable contribution to the foundation offers numerous advantages. Not only does it bolster the foundation's charitable mission, but it also presents potential tax benefits for the donor. Individuals contributing to a private foundation generally qualify for a tax deduction on their individual income tax returns, within the guidelines and limitations set by the IRS. Furthermore, these contributions directly enhance the foundation's capacity to advance its charitable efforts
Meeting the 5% Minimum Distribution Requirement
Private foundations must distribute around 5% of their assets annually for charitable purposes, known colloquially as the 5% rule. The minimum distribution amount is calculated on Form 990-PF, the annual tax return for private foundations. To verify the distribution amount for 2023, refer to Line 6f, Column d in Part XII (Undistributed Income) of the foundation's 2022 Form 990-PF.
The minimum distribution requirement is fulfilled through "qualifying distributions". These primarily consist of grants given to public charities but also include any expense incurred to carry out the foundation's charitable mission. Operating expenses, such as payroll and office expenses, generally contribute towards meeting this requirement. Other qualifying distributions include expenditures on directly operated charitable programs, the purchase of assets as charitable use assets, and the acquisition of program-related investments. Private foundations that fail to meet the annual distribution requirement are subject to a punitive excise tax for each year the distribution fails to occur. Excess qualifying distributions, beyond the 5% minimum requirement in a given year, can be carried forward for use in future years.
All qualifying distributions are governed by the cash basis method of accounting even if the foundation typically uses the accrual method. This is especially important for grant checks issued near the end of the year. If a grant check is mailed in time to be collected and postmarked by December 31, it counts as a charitable disbursement for that year, regardless of when the recipient deposits the check. It's important to note that backdating a check doesn't make it count for the previous year; the date of mailing determines its eligibility.
Private foundations can also fulfill the minimum distribution requirement by issuing grants in the form of publicly traded securities. By donating highly appreciated public securities, foundations can avoid paying the excise tax on investment income on a security’s appreciation and still receive credit for a qualifying distribution based on its fair market value. Many large public charities readily accept donations of publicly traded securities. This strategy is particularly useful when the foundation has received a highly appreciated public security as a donation (remember that private foundations assume the donor's cost basis for donated property). The foundation can simply grant the appreciated security to a public charity, bypassing the unfavorable tax consequences of selling the security.
Verification of Estimated Tax Payments
Private foundations generally need to make estimated tax payments on their net investment income in equal installments every quarter. For calendar year foundations, the due dates for these payments are May 15, June 15, September 15, and December 15. It's important to pay attention to these deadlines because underpayment of any installment can result in penalties, even if the total estimated tax payments for the year are sufficient. However, if a foundation's total tax liability for the year is less than $500, no estimated tax payments are required.
Private foundations have several methods available to ensure they pay enough estimated tax throughout the year to avoid penalties. The most common approach is the safe-harbor method, which provides a reliable way to calculate estimated tax payments. Under to the safe harbor rule, foundations can escape penalties by making estimated tax payments equivalent to 100% of their previous year's net investment income tax. However, there are some exceptions to using the safe-harbor method. If the foundation's prior tax year was less than 12 months long or if no tax was owed on the previous year's return, they cannot use this method. In such cases, the foundation should explore other methods, such as ratably paying 100% of the current year's net investment income tax, to ensure accurate and timely estimated tax payments.
It is important to note that private foundations must make all estimated tax payments electronically using the Electronic Federal Tax Payment System (EFTPS). EFTPS, a secure payment service provided by the U.S. Treasury that allows for online transactions with the federal government. It's worth noting that the IRS does not accept physical checks from private foundations for estimated tax payments; instead, they must be made online through EFTPS.
Excise Tax on Net Investment Income
Private foundations pay a flat rate excise tax of 1.39% on their net investment income. Net investment income includes interest, dividends, net capital gains (if positive), rents, and royalties, minus any allowable investment expenses. All types of investment income are taxed at this same flat rate, except for income subject to unrelated business income tax (UBIT) provisions, which is generally taxed at the standard corporate rate rate (21% for 2023).
Allowable Deductions Against Investment Income
Private foundations can deduct all ordinary and necessary expenses related to their investments, such as advisory fees paid to portfolio managers and other direct investment costs. However, if an expense is deducted against investment income, it cannot also be used as an exempt charitable expense to meet the 5% minimum distribution requirement.
Sometimes, certain expenses serve both investment and exempt charitable purposes. In such cases, the foundation should use a reasonable method to allocate these expenses between the two activities. Common expenses that may require allocation include accounting fees and compensation for foundation officers. The portion of expenses allocated to investment activities can be claimed as an investment expense deduction, while the portion allocated to exempt charitable purposes helps fulfill the annual 5% distribution requirement. It's crucial for private foundations to maintain well-organized accounting procedures to track expenses related to investment income and exempt charitable activities, as well as those that require allocation.
Capital Gains and Losses
Net capital gains for private foundations are taxed at the regular net investment income tax rate of 1.39%, without any special tax rate. Capital losses can be used to offset capital gains, but they cannot be deducted against other net investment income like dividends and interest, nor carried forward to future years. To optimize their tax position, foundations should aim to time the realization of capital losses with the realization of capital gains, allowing the losses to offset the gains effectively.
Before the year-end, private foundations should review their investment portfolios to decide if any capital sales should be made. If the foundation has excess realized capital losses, it may be beneficial to sell a security with a gain to absorb the losses. The cash from the sale can then be used to repurchase the same security, resetting the tax basis at a higher level (this reduces potential future gains). On the other hand, if the foundation has excess capital gains, capital loss harvesting can be done to offset the gains.
It is worthwhile to note that private foundations are subject to the wash sale rules. A wash sale occurs when a security is sold at a loss and a substantially identical security is acquired within 30 days before or 30 days after the sale date. With wash sales, the loss recognized from the security sale is disallowed and cannot be used to offset other capital gains. Instead, the wash sale loss will be added to the basis of the repurchased securities. Wash sales can be avoided by purchasing a replacement security that is not substantially identical or by simply waiting out the 30-day time period to buy back the security.
Unrelated Business Income Tax
Private foundations are subject to the unrelated business income tax (UBIT). For private foundations, unrelated business income refers to the income earned by the organization from commercial activities that are unrelated to its main charitable mission or investment activities. Such income often comes from alternative investments like hedge funds, private equity, privately-held businesses, and publicly traded partnerships. Additionally, if the foundation engages in revenue-generating activities, such as selling advertising space on its website, the income generated from those activities can also be considered unrelated business income.
Depending on the regulations of the state where the income is generated and where the foundation is located, unrelated business income may also incur state income tax liabilities or necessitate additional filing requirements.
For tax purposes, unrelated business income is subject to the general corporate tax rate, which stands at a flat rate of 21% for the year 2023. This means that any income derived from these unrelated activities will be taxed at this specified rate, and the foundation will need to report and pay taxes on this portion of its income separately from its charitable and investment income.
Understanding Self-dealing
One pivotal aspect private foundations should be keenly aware of is self-dealing. This encompasses both direct and indirect financial transactions involving the foundation and certain disqualified individuals — foundation managers, major donors, their families, and affiliated businesses. Surprisingly, even transactions that appear wholly favorable to the foundation can be deemed as self-dealing. Common instances include property sales or rentals with an insider, facilitating services or goods, extending loans, or permitting an insider to take advantage of foundation assets. Notably, while there are exceptions, such as reasonable compensation for foundation leaders and management, the repercussions of self-dealing violations can be substantial for both the individual and the foundation. Given the complexities and potential penalties, foundations must exercise caution and diligence when navigating transactions that could be construed as self-dealing.
Rebalancing Investment Portfolio
Private foundations should regularly rebalance their investment portfolios to maintain their desired mix of assets. Since the tax on investment income is just 1.39%, the cost of rebalancing is generally low. However, it's important not to make hasty decisions. A good opportunity for rebalancing often arises when foundations sell assets to meet their annual minimum distribution requirements. During this process, it's beneficial to sell holdings that have exceeded the desired asset allocation, bringing the portfolio back in line with the foundation's goals.
Portfolio reviews also provide an opportunity to ensure compliance with rules related to excess business holdings and jeopardizing investments. The excess business holding rules prevent foundations and their insiders from owning significant stakes in operating businesses, while the jeopardizing investment rules discourage reckless speculation with the foundation's investments. For more detailed information on these rules, you can refer to our articles regarding excess business holding rules and the jeopardizing investment rules.
Ensure Books and Records are Current
Private foundations are required to maintain accurate and up-to-date books and records. However, some foundations without a dedicated bookkeeper may struggle to keep their records current. In such cases, outsourcing accounting to a third-party service provider is a common and straightforward solution.
For foundations managing their own accounting, it's important to regularly reconcile the cash balance in their books with the monthly bank statements. Additionally, before the end of the year, the person responsible for the books should review if any checks, expenses, or other transactions were missed or haven't been cleared.
When recording expenses, the foundation's accounting system should clearly indicate which are related to investment income and which are for charitable activities. Moreover, expenses should be distinguished between general grantmaking purposes and those associated with running specific charitable programs. In cases where expenses pertain to both grantmaking and directly operated charitable programs, a reasonable method should be used to allocate the expenses appropriately.
Donation Acknowledgement Letters
When a private foundation receives a donation of $250 or more, it must send a written acknowledgement to the donor. As a good year-end practice, the foundation should check and confirm that all the necessary donation acknowledgment letters have been correctly issued. For a more in-depth discussion of the required procedures, please see our article on private foundation donation acknowledgment requirements.
Substantial Contributor Tracking
Private foundations must track substantial contributors, who are generally individuals contributing more than $5,000 to the foundation, with the contribution amount exceeding 2% of the foundation's total lifetime contributions received. When new substantial contributors emerge, the foundation should report them on its annual tax return (Form 990-PF). To manage this, the foundation needs a system to monitor all contributions received over its lifetime and specifically track potential substantial contributors separately.
Payroll Compliance
Private foundations with paid staff must follow all payroll laws and regulations, just like other for-profit and non-profit employers. Payroll processing companies can be very helpful in ensuring compliance, offering end-to-end assistance. However, private foundations remain responsible for ensuring proper adherence to the rules. They should verify that the following items are handled correctly:
• FICA taxes (Social Security and Medicare)
• Federal, state and local income tax withholding
• Unemployment insurance (FUTA + state unemployment insurance)
• Worker’s compensation insurance
Independent Contractor Payment Compliance
Private foundations need to report payments of $600 or more to non-corporate consultants and independent contractors, such as law firms, accounting firms, directors, or trustees. These payments should be reported on form 1099-NEC by January 31 of the following year. It's important to remember that payments made to incorporated businesses do not require reporting (with the exception of payments for legal services, which require a 1099-NEC even if the law firm is incorporated).
Figuring out when to file form 1099-NEC can be complex, but there are many online resources available to help. The rules that apply to other for-profit and non-profit entities generally apply to private foundations as well.
If a foundation issues only a few forms 1099-NEC, the easiest way to file is through postal mail using the IRS-provided PDF form with instructions. When filing Form 1099-NEC, the foundation must also file Form 1096, Annual Summary and Transmittal of US Information Returns. Alternatively, the foundation has the option to file electronically through the Filing Information Returns Electronically (FIRE) system, provided by the IRS. However, this approach requires setting up a special account, which can be somewhat cumbersome. Another convenient option for the foundation is to engage a company specializing in tax filings to handle the submission of these forms on their behalf. This outsourcing can save time and effort for the foundation, leaving the task in the hands of professionals experienced in tax compliance matters.
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