What Counts as a Qualifying Distribution?

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%. Qualifying distributions are:

1. Grants 
   • Grants to public charities. Grants to public charities count toward minimum distribution requirements, with two exceptions:
     • 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 two types of supporting organizations do not count toward the payout requirement. First, Type III supporting organizations that are not functionally integrated, and second, 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.
     • Grants 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.
   • Grants to Private Foundations. Additional rules must be followed for grants to nonoperating private foundations to count as qualifying distributions. These are called “out-of-corpus” rules. These rules require that when a private nonoperating foundation receives a grant from another private foundation, the private foundation grantee must first meet its normal 5% payout requirement for the previous year and the year of the grant. Next, it must pass through the total value of the grant as payout no later than twelve months after the end of the tax year in which the grant was received—technically as qualifying distributions “out of corpus.” In short, a grant from one private foundation to another private foundation for the purpose of building up the grantee’s endowment will not be a qualifying distribution and so may not be counted toward the first foundation’s payout requirement. These rules were written into the law in 1969 to prevent the obvious loophole of having one private foundation satisfy its minimum-payout rule by making a grant to another private foundation, which then satisfies its payout with a grant back to the first foundation.
     • Example: Private foundation A grants private foundation B $50,000 in 2021. B must spend the entire $50,000 by the close of 2022. In 2021, B must meet its minimum-distribution requirement, in addition to expending the grant funds. If B carries part of the grant into 2022, it must again meet its minimum distribution requirements, in addition to expending any remaining grant funds.
     • A grant to a private operating foundation counts as a qualifying distribution without following the out-of-corpus rules.
   • Grants to Noncharities or International Organizations. Grants can be made to units of government and international organizations designated by executive order relatively easily and are qualifying distributions if made for public purposes.
     • On the other hand, grants to for-profit companies, new public charities, international organizations not recognized by executive order, or tax-exempt organizations that are not 501(c)(3) public charities require the private foundation to follow a process called expenditure responsibility. Private foundations also may choose a process called equivalency determination when making grants to non-U.S. organizations. If the appropriate rules are followed, all of these grants will be qualifying distributions.
     • Grants to Individuals. Grants for scholarships, emergency hardship, or disaster-relief grants to individuals (or to an entity for the benefit of a specified individual) are qualifying distributions.
2. All Reasonable Administrative Expenses Necessary for the Conduct of the Charitable Activities of the Foundation
   • Almost all administrative expenses count toward the payout as long as they are necessary and reasonable. Thus, after subtracting any portions that should be allocated to investment costs, the following expenses count: salaries, benefits, trustee fees, professional fees, consulting fees, travel expenses, general overhead, training, publications, office supplies (pencils, paper, and similar items that are not major assets), telephone, and rent.
   • The exception is that investment expenses incurred in managing the endowment do not count toward meeting the minimum payout requirement. Examples of investment expenses are investment management fees, brokerage fees, custodial fees, salaries, or board meeting expenses to oversee investments. However, investment expenses do count in reducing gross investment income to net investment income to which the 2% (or 1%) investment tax applies.
     • Example: The board of foundation X has a meeting during which 50% of the time is devoted to grantmaking and 50% to overseeing investments; if the costs of the meeting are $3,000 (travel, meals, materials, refreshments), then $1,500 would count as a charitable expense toward meeting the payout, and $1,500 would count as an investment expense to reduce gross investment income in calculating the 2% (or 1%) excise tax.
   • Also, the costs of complying with legal requirements count toward the payout; such compliance costs include preparing tax returns, defending legal matters, obtaining rulings from the IRS, and fulfilling state and federal filing requirements. The costs of publishing an annual report and obtaining a year-end audit also count toward the payout.
3. Costs of Direct Charitable Activities
   • All expenditures for carrying out a charitable activity of a family foundation in-house—rather than making a grant to another charity to perform the same activity—count toward the payout as qualifying distributions. Direct charitable activities include running a library or art gallery, performing in-house research and publishing the results, providing technical assistance to grantees and potential grantees, serving on the board or committee of another charity, maintaining a historic site, or conducting a conference. Legally, there is no limit to the amount of a foundation’s budget that can be spent on direct charitable activities. Any direct charitable activities should be described on the foundation’s Form 990-PF so a reader understands why the organization’s administrative expenses may appear higher than average for a private foundation.
4. Amounts Paid to Acquire Assets Used Directly in Carrying Out the Charitable Purpose of the Foundation
   • These amounts include amounts paid to acquire assets used directly in carrying out charitable purposes (computers, office furniture, a building to house the foundation). Although purchases of this type are normally amortized, the Form 990-PF tax return permits them to be fully utilized as qualifying distributions in the year paid. Only assets used for the production of income can be depreciated.
5. Set-Asides 

• Many foundations give multiyear grants. Typically, a foundation will commit to simply pay out for those years, with no need for IRS intervention, and count each grant against the distributable amount in the year it is granted. If a private foundation wishes to treat the entire grant as a qualifying distribution in the first distribution year, the foundation would be required to obtain IRS approval of a “set-aside.”
• Set-asides are rarely used because they require advance approval by the IRS, but they do count toward the payout. The foundation must convince the IRS that the specific project to be funded is better funded over multiple years (not more than five) rather than by immediate payment. A typical example is the construction of a building that may take several years from design to final completion. If the foundation receives approval of a set-aside from the IRS, the full amount of the multiyear grant may count toward the payout in the first year. Because of the technical requirements of set-asides, legal consultation is strongly advised.

1. Program-Related Investments

• Foundations may make investments in ventures that further the foundation’s charitable interest and have such expenditures count as qualifying distributions Generally, the investment must meet two requirements. First, it must have a charitable purpose as its primary objective, and second, the purpose of the investment cannot be to produce income or appreciation of property. Program- related investments often include loans at very low interest rates to grantees or other charitable organizations. Program-related investments count as qualifying distributions in the year the investment is made; however, when loans are repaid, the funds previously taken as qualifying distributions will increase the distribution amount in the year they are received.