Exempt organizations can still end up paying some tax. A private foundation pays an excise tax on its net investment income at a rate of two percent. If certain distribution requirements are met, the excise tax can be reduced to one percent. This difference in rate can be quite significant in absolute dollars when a large gain is realized by the foundation.
What is Net Investment Income?
Net investment income includes interest, dividends, capital gains and partnership income with deductions allowed for expenses directly related to the income. Expenses include investment management fees and foreign taxes. Some expenses are allocated between investment income and charitable purposes, such as director’s fees, accounting fees, etc, generally based on the amount of time spent on each area.
How does the Foundation decide what estimates to pay in during the year?
If net investment income has been less than $1M over the previous three years, a private foundation can use the prior year tax amount as the basis of its estimated tax payments for the current year. If the net investment income has been over $1M in any of the prior three years, the private foundation must calculate and pay estimated taxes based on actual investment income during the year using an annualized income installment method.
How does the annualized method work?
The annualized method uses the actual results for a period of time during the year and assumes that the remaining months will have a similar rate of income. There are two different methods available to exempt organizations for the number of months’ income to include at each period. Using the standard option, the first quarter estimate is based on two months of income, the second quarter is based on three months, the third quarter is based on six months and the fourth quarter is based on nine months.
For the third quarter estimate due for 2015, a private foundation using the standard option would calculate its net investment income for the first six months of the year and then multiply it by two to get an annualized amount.
When are payments due?
For a calendar year foundation, the first quarter payment should be 25% of the total tax anticipated for the year and is due May 15th; by the second quarter, 50% of the tax should be paid by June 15th; the third quarter payment should be 75% of the total tax and is due by September 15th. The fourth quarter estimate is due December 15th and should cover 100% of the anticipated tax.
What is the tax rate?
The tax rate applied to net investment income is either 1% or 2%, depending on whether the foundation has made sufficient charitable disbursements to qualify for the reduced rate.
How does a private foundation qualify for the reduced tax rate?
To qualify for the 1% excise tax, the Foundation looks at the amounts distributed and the average fair market value (FMV) of assets over the previous five years. The qualifying distributions are divided by the average FMV each year to come up with a percentage or ratio. The percentages for the previous five years are then averaged.
Here is an example:
Year Qualifying Distributions Avg FMV of Assets Percentage/Ratio
2014 $1,000,000 $23,500,000 4.2553%
2013 $ 975,000 $21,200,000 4.5991%
2012 $1,100,000 $19,500,000 5.6410%
2011 $ 950,000 $18,900,000 5.0265%
2010 $1,400,000 $18,100,000 7.7348%
5 Year Avg 5.4513%
If the average FMV of the assets in 2015 is $25M, the distribution amount required to pay the reduced 1% tax would be $1,362,825, or the five year average multiplied by fair market value of the investments this year. The 1% test is calculated each year. A foundation either meets the test (having distributed enough during the year) and pays the 1% tax, or it does not meet the test and instead pays a 2% tax.
In reality, the average FMV fluctuates during the course of the year. Since both investment income and the average FMV is not certain until after year end, calculations during the year of the distribution amount required for the 1% test are an estimate.
In the first year, a foundation cannot qualify for the reduced excise tax since it does not have a base period.
If the foundation had unrelated business income (which most foundations do not incur), then such income will be taxed at the normal corporate tax rates in lieu of the net investment income excise tax. The payment schedule and timing are the same for unrelated business income tax as it is for excise tax.
Please contact us if your private foundation would like assistance on how to calculate the threshold for the reduced tax, or estimated tax payments during the year.