Calculating the Five Percent Payout

What is the five percent payout requirement?

Each year, every private foundation must make eligible charitable expenditures that equal or exceed approximately five percent of the value of its endowment. The purpose behind the minimum payout requirement contained in Internal Revenue Code Section 4942 is to prevent foundations from simply receiving gifts, investing the assets, and never spending any funds on charitable purposes. The basic rule can be stated simply, but its calculation is complex.

While the word "payout" is convenient, it is somewhat misleading. The Tax Code section that creates the rule does not contain the word. "Payout" suggests grants or contributions paid out to other charities. Although these grants normally comprise more than 93% of the expenditures of most foundations, many other expenses can also be used to meet the minimum payout requirement. In short, the five percent payout rule does not need to be satisfied solely with grants.

Within what time period must the five percent be paid out?

Private foundations have until the end of the following tax year in question to satisfy the minimum payout requirement. For example, a new foundation could pay out nothing during its initial tax year and then satisfy the first year's minimum by applying retroactively the first expenditures in the second year. Similarly, any foundation can satisfy last year's payout requirement retroactively with this year's qualifying payments.

Example: A new family foundation is incorporated on April 1, 2022, and opts to complete a shortened first tax year on December 31, 2022 (nine months). The foundation would have 12 extra months—until December 31, 2023—to complete its 2022 payout. Note also that its 2022 payout will be based on only nine months; average assets will be calculated by adding nine monthly asset totals and dividing by nine, and the percentage applied will be nine-twelfths of 5 percent (or 3.75 percent). 

Example: A seven-year-old family foundation whose tax year ends on June 30 reaches June 30, 2022, $50,000 short of meeting its payout requirement for 2022. This foundation has until June 30, 2023, to make up the $50,000 shortfall. Normally, a foundation in this condition would make up the $50,000 in the first few months after June 30, 2022, and then start making qualifying distributions that qualify for its tax year that begins July 1, 2022. 

How is asset size calculated for purposes of the five percent rule?

For purposes of calculating the payout, the size of the endowment is a 12-month average of the endowment’s fair market value for the tax year in question. The technical term for endowment or assets used by the IRS and the Form 990-PF tax return is "noncharitable use assets." Note that the endowment includes only noncharitable use assets (cash, stocks, bonds, and other investments). Charitable use assets (assets used in carrying out charitable purposes) do not count in calculating the payout. Examples of charitable use assets are a building that houses the foundation, fixtures, and other capital equipment such as furniture and computers. The measurement is not taken either at the beginning or the end of the year. The 12-month average allows for fluctuation that occurs in investment markets.

The foundation should decide (with its accountant and counsel) which method of calculating a monthly market value makes sense. The measurement can be taken on the first or the last day of the month, or the values can be measured on the first and last days and averaged. Any method can be chosen as long as it is reasonable and applied consistently. Once a fair market value is determined for each month, all 12 amounts are added together and then divided by 12 to obtain the value to which the five percent applies. If the foundation is new or changing accounting years so that the tax year in question is a partial tax year, appropriate adjustments should be made. For example, if the tax year is only seven months long, add up seven monthly averages and then divide by seven (the payout will be 7/12 of five percent).

How is the payout actually calculated?

As noted above, determining payout is complex. In fact, there is no clear definition of payout. There is a clear definition of the "distributable amount," which is the minimum a foundation must meet to avoid penalty. The five percent calculation is only one of many that bring you to the final calculation of the distributable amount; in most cases, the distributable amount will be quite close to five percent.

Once the foundation has calculated the 12-month average fair market value of its endowment, at least two other adjustments are permitted. First, the law presumes that any foundation needs to have cash on hand to conduct business; thus, the endowment value for the year may be reduced by 1.5% for "cash deemed held for charitable purposes." Second, after calculating the 5% figure the foundation may claim a credit against the payout amount for any taxes paid during the year, namely the 1.39 percent excise tax on investment income. The final figure is called the "distributable amount." Qualifying distributions equal to this distributable amount must be made to satisfy the payout requirement.

Example:

For the 2020 tax year, Foundation X’s 12-month average fair market value of its net total endowment equals $1 million. In 2020, it paid excise tax payments on its investment income of $1,000. Thus, the distributable amount for Foundation X is calculated as follows:

In this example, the actual distributable amount for which qualifying distributions are required is 4.825% of the foundation’s average assets (4.825% of $1 million = $48,250).

In short, the "five percent payout rule" is only a rough approximation. A foundation does not need to meet its payout solely through grants. In most years, the actual payout percentage needed to meet the distributable amount is likely to be slightly less than five percent because of additional adjustments written into the law.

What is carryover?

If, in any tax year, a foundation exceeds its minimum payout requirement (i.e., its qualifying distributions exceed its distributable amount), the excess may be "carried over" to help satisfy future year payouts (up to five years). Thus, it is possible that the payout—or qualifying distributions—in one year may be so great that no expenditures at all are necessary in the following year (or years) to meet the payout requirement. The carryover amount is calculated every year as part of the process for completing the Form 990-PF. There is no need to apply for a ruling or any other complicated procedure.

What is the penalty for failure to satisfy the rule? 

The penalty for failure to meet the 5% minimum is 30% of the shortfall or the remaining amount that the foundation should have spent to meet the required minimum level. The penalty is on the foundation only and cannot be applied to a foundation manager; however, a state attorney general might charge a manager for the amount of the penalty to replenish the foundation on the theory that the manager failed to exercise his fiduciary duty. 

What counts as a qualifying distribution? 

A foundation can meet the minimum-payout requirement with any expenditure that meets the definition of a “qualifying distribution.” In short, the law states a foundation must have qualifying distributions equal to approximately 5%, not a “payout” of 5 percent. Qualifying distributions are: (1) grants to public charities (two exceptions listed below); (2) grants to private foundations; (3) grants to noncharities or international organizations; (4) grants to individuals; (5) all reasonable administrative expenses necessary for the conduct of the charitable activities of the foundation; (6) costs of direct charitable activities; (7) amounts paid to acquire assets used directly in carrying out the charitable purpose of the foundation; (8) set-asides; and (9) program-related investments. 

Exception One: Grants to Certain Supporting Organizations: A supporting organization is a type of public charity, rather than a private foundation, because of its relationship with another tax-exempt organization. Grants to a narrow group of these supporting organizations will not count toward a private foundation’s minimum distribution requirement. Specifically, grants to the following supporting organizations do not count toward the payout requirement: (1) Type III supporting organizations that are not functionally integrated or (2) any supporting organization in which a disqualified person of the private foundation controls either the grantee-supporting organization or a tax-exempt organization the supporting organization was formed to support. 

Exception Two: To a Controlled Public Charity: To avoid private foundations fulfilling their payout by granting funds to a controlled organization that does not use those funds promptly for charitable activity, a grant to a public charity that is controlled by the private foundation or one or more of the private foundation’s disqualified persons will not count as a qualifying distribution unless certain distribution rules are followed. For these purposes, control is defined as the ability to require the grantee to make or refrain from making an expenditure. Specifically, if a private foundation wants to count a grant to a controlled public charity as a qualifying distribution, the grantee must expend the grant funds by the end of the first taxable year after the year in which the contribution is received. In other words, if the grant was received in 2022, a calendar-year grantee would be required to expend the funds by the end of 2023. The private foundation would have to obtain documentation to ensure the rules were met. 

Note that these rules also apply to grants to any other type of organization that is controlled by the private foundation or one or more disqualified persons of the private foundation.

For more information, see our page on What Counts as a Qualifying Distribution?

Are private operating foundations required to meet the minimum distribution requirements? 

Private operating foundations are exempt from the minimum distribution requirement. However, they must meet the “income test.” This test generally requires that the foundation make qualifying distributions of substantially all of its adjusted net income or minimum investment return. 

The IRS defines “substantially all” as 85% or more. Adjusted net income includes all income the private operating foundation received, less gifts, grants, or contributions, with some limited modifications. Minimum investment return is 5% of the combined fair-market value of all noncharitable assets, subject to certain adjustments.