Understanding the Excise Tax on Net Investment Income for Private Foundations under IRC Section 4940
Private foundations play a crucial role in philanthropy, providing essential funding for various charitable activities. However, they operate under stringent regulations, including the imposition of an excise tax under IRS Section 4940 on their net investment income. Understanding this tax is vital for foundation managers to ensure compliance and optimize their financial strategies.
What is the Excise Tax on Net Investment Income?
The excise tax on net investment income, often referred to as the Section 4940 tax by tax professionals, is a federal tax imposed on private foundations' net investment income. This tax was introduced to ensure that private foundations contribute to public revenues and help fund regulatory oversight.
Tax Rate and Calculation
The excise tax rate on net investment income for private foundations is 1.39%. Previously, the rate varied between 1% and 2%, depending on the foundation’s charitable disbursements in relation to its income. However, the Taxpayer Certainty and Disaster Tax Relief Act of 2019 simplified this by establishing a flat rate. It is worth noting that private foundations do not have a special capital gains tax rate like individual taxpayers do.
To calculate the excise tax, private foundations must determine their net investment income, which includes:
• Gross investment income: Interest, dividends, rents, royalties, and most capital gains.
• Deductions: Ordinary and necessary expenses incurred in earning investment income, such as investment advisory fees, custodial fees and foreign taxes paid on dividends.
The net investment income is then multiplied by the excise tax rate to determine the tax liability.
Compliance Requirements
1. Form 990-PF Filing: Private foundations must file Form 990-PF annually, reporting their income, expenses, and activities – this is where the excise tax on net investment income is officially calculated.
2. Payment of Tax: The excise tax should be paid using quarterly estimated tax payment system (although some foundations pay the entire amount upfront in the first quarter). Recent regulatory changes require private foundations to use electronic payment methods, primarily the Electronic Federal Tax Payment System (EFTPS), for estimated tax payments. Mailing in payments via check is no longer permitted. Any remaining balance is settled with the annual Form 990-PF filing.
Strategies to Minimize Excise Tax Liability
1. Investment Portfolio Management: Efficient management of the foundation’s investment portfolio can help minimize taxable income. This includes strategic asset allocation and tax-efficient investment strategies.
2. Charitable Disbursements - Using In-Kind Securities to Meet the 5% Requirement: A significant portion of the tax liability often arises from capital gains generated by selling investments to raise cash to meet the 5% requirement for annual charitable distributions. This tax burden can be mitigated by providing grants in the form of appreciated securities directly to public charities. By doing so, foundations can avoid the step of liquidating investments, thereby sidestepping the recognition of a capital gain. The public charity that receives the securities will then sell them and, as a completely tax-exempt entity, will not incur any tax liability on the sale. To implement this strategy, the recipient charity must be able to accept the securities, which typically means having a brokerage account set up. Most large public charities are equipped to handle in-kind donations of securities.
Understanding UBIT: A Separate Tax from the Excise Tax on Net Investment Income
Private foundations are also subject to Unrelated Business Income Tax (UBIT) under IRS Code Section 511, which is a completely separate tax from the excise tax on net investment income. UBIT applies to income generated from commercial activities that are not substantially related to the foundation's charitable purpose. The IRS defines unrelated business income (UBI) as income from a trade or business, regularly carried on, that is not substantially related to the organization's exempt purpose.
Common causes of UBI for private foundations include income from alternative investments like hedge funds, private equity funds, and venture capital funds, as well as direct ownership in for-profit businesses and commercial activities such as advertising income from websites and publications. Passive income, such as interest, dividends, capital gains, and royalties, is generally excluded from UBI.
UBI is taxed at a higher rate of 21%, compared to the 1.39% excise tax rate on net investment income. Additionally, substantial UBI can jeopardize a foundation’s tax-exempt status if it constitutes a significant portion of the foundation’s income, as the IRS may view it as contradictory to the nonprofit status. Foundations should be vigilant during due diligence on alternative investments to avoid potential UBI exposure or to be fully aware of the consequences if they do incur UBI.
Conclusion
The excise tax on net investment income is a key consideration for private foundation operations, impacting their financial planning and compliance. Foundation managers must be diligent in understanding the calculation and compliance requirements of this tax, as well as exploring strategies to minimize their tax liability. Proper management of investment portfolios, strategic charitable disbursements, and awareness of unrelated business income (UBI) can help foundations optimize their financial outcomes. By staying informed and seeking professional guidance when needed, private foundations can efficiently manage their tax obligations while continuing to fulfill their charitable missions.
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