The 5% Rule Explained

If you’re involved in any way with a private foundation, you will no doubt be familiar with the “5% payout rule.” As advocates for effective philanthropy, all of us at Pacific Foundation Services want to add ease and joy to giving back, and as Controller, it’s my hope to demystify this confusing if well-intentioned regulation.

In short, the U.S. government expects foundations to use their assets to benefit society and it enforces this through section 4942 of the Internal Revenue Code, which requires private foundations to distribute 5% of the fair market value of their endowment each year for charitable purposes. The complexity comes in understanding how that 5% is calculated, and which expenses qualify.

A Brief History

Fifty years ago, there was no rule regarding grant payments from private foundations. In 1969, lawmakers sought to close this perceived loophole by passing the Tax Reform Act, which imposed the first-ever minimum distribution rule for private foundations. The first iteration was imperfect and difficult to calculate, so in 1976, lawmakers created the “five percent rule” that exists to this day.

Why 5%

The 5% figure was agreed upon to ensure that private foundations would, in theory, be able to exist in perpetuity whilst also ensuring that communities and society benefit. The calculation was based on historic market returns of approximately 8% which, after accounting for 3% average historic inflation, leaves 5%. This 5% is merely a minimum, and it’s important to note that private foundations can and often do choose to pay much more.

As a general rule, a private foundation should make a charitable “payout”—in grants and qualifying operating expenses (explained further below)—totaling at least 5% of total assets annually to remain in compliance with federal and state tax codes. The total assets calculation is based on a thirteen-month average, not simply the value of the endowment at the end of the fiscal year.

Defining the “Payout”

The “payout” is defined as the total dollar amount of grants approved and paid to qualifying 501(c)(3) organizations during a fiscal year, plus the total amount of eligible expenses incurred by the foundation during that same year.

“Eligible expenses” refers to the portion of the foundation’s operating expenses that are deemed necessary for it to carry out its charitable activities. The inclusion of eligible expenses in the payout requirement is designed to reflect the costs associated with effective grantmaking—everything from due diligence and record keeping, to costs for setting up an office, and hiring staff or consultants to administer a foundation.

The eligible portion of a foundation’s operating expenses is based on a prudent estimate of the relative amount of board and staff work that is dedicated to grantmaking. There is no hard and fast rule, but there should be a logic to the formula. Once those percentages have been agreed upon, they should be applied consistently through the years, so it’s important to give this serious consideration as it will have a lasting impact on the payout.

Expenses that have an obvious link to grantmaking, such as due diligence, have close to 100% eligibility, whereas accounting and audit expenses are typically 33% to 50% eligible, and investment fees are not eligible at all because they relate exclusively to asset management and do not affect grantmaking. It is best to consult an accountant to determine the exact eligibility of different expenses, as this is based on the specific work of each foundation. It’s important to note, however, that the IRS does not provide guidance on this topic and there are no published acceptable ranges.

Overpaying or Underpaying the 5%

Now that we have a general understanding of how to calculate the payout, let’s explore the possibilities of either paying more or less than the 5%. Even foundations with highly sophisticated accounting systems must make assumptions, and there is typically an overpayment or an underpayment each year, which is fine. The over- or underpayments accumulate over time, and these carry-over amounts are taken into consideration the following year.

Whilst there are no punitive consequences for underpaying, it is against best practice for a foundation to fail to meet the 5% minimum over several years. In addition, accumulated underpayments can grow substantially, so it is recommended that foundations make every effort to the meet the 5% annually.

Tax Implications of the 5% Payout – updated!

The final confusing factor in the 5% payout discussion is the tax implication. It is a common misconception that private foundations are tax-exempt like standard 501(c)(3) nonprofit organizations. However, private foundations do have to pay excise tax on investment income (realized gains, capital gains, interest and dividends, etc.), albeit at a massively reduced rate.

In late 2019, the federal government agreed to a new, simplified tax rate for private foundations with the passage of the “Further Consolidated Appropriations Act, 2020.

Prior to passage of this new law, the tax system was confusing in that the default tax rate was 2% but a foundation could qualify for a 1% rate if their payout percentage in a given year was higher than the average payout percentage from the previous five years. This system created considerable complexity and uncertainty, and tempted foundations to make potentially unreliable projections in pursuit of the lower rate.

The new flat tax rate of 1.39% replaces the old system and should reduce the complexity and administrative burden, empowering foundations to plan their grantmaking without altering the tax ramifications. It is expected that the 2020 Form 990-PF—the tax return for private foundations—will be revised to reflect these changes.

To add another confusing wrinkle, the taxes due on investment income can also be deducted from the payout calculation.

So, What Does This Really Look Like?

Let’s look at a basic, fictional example. The “Do-Good Foundation” is established with a $1 million gift on December 31, 2019, and no grants are made during 2019. Let’s assume the donor family pays for all expenses associated with establishing the foundation, rather than having the foundation do so. During 2020, the foundation’s assets grow 10% to a little over $1,100,000, with asset growth compounding and spread equally over the course of the twelve months (0.8% per month). The foundation has no expenses and all grants are approved and paid in December of 2020. In this (improbable) scenario, the 5% payout target for 2020 would be calculated as follows:

• 13-month Average Asset Values: $1,049,437
  Less: 1.5% Cash Allowance ($15,742)
• Net Asset Base to Calculate 5%: $1,033,695
  5% Payout on Net Assets: $51,685
  Less: Estimated Excise Tax Due (1) ($695)
  Plus: Carryover from 2019 (2) $135
• 5% payout target in 2020: $51,125

Notes:
(1) In the example, I’ve assumed that there was investment income of $50,000, on which tax is due at a rate of 1.39%. I have not included the initial donation, because donations aren’t taxable – the only thing that is taxable is investment income.
(2) This was calculated using the formula that the IRS put together for calculating average asset values for foundations in their first year: multiply the average monthly values by the number of days the foundation held the assets and divide that figure by 365.

Despite the steady growth and respectable year-end return, the 13-month average of the foundation’s assets is $1,049,437, which is $50,902 less than the value of the assets at December 31, 2020.

As noted, it is extremely difficult to hit 5% exactly, and the reason is simple: the payout stems from the 13-month average of asset values, and the value for the final month of the year won’t be known until early in the following year. As a result, this foundation would have set their payout budget at around $50,000, which would have been a good (and prudent) estimate and amounted to a payout of 4.83%; a small underpayment, which would be carried over into 2021.

So, what would the payout requirement be for 2021? Ideally, the Board of Directors of the “Do-Good Foundation” would go through the same budgeting process, make smart assumptions and set a reasonable 5% target; they would then add the underpayment from 2020 and deduct the estimated tax due.

Conclusion

The 5% payout rule is one of the most confusing and least understood aspects of managing a foundation. Certainly, the intent of every foundation board should be to invest at least 5% towards charitable purposes on an annual basis, while recognizing that projecting that amount precisely in advance is not a perfect science. A foundation should also avoid repeatedly falling short of the 5% payout, which will not only invite scrutiny, but also flouts the philanthropic intentions of the various laws that govern private foundations.

I hope this summary has been useful. Please keep in mind that this is an informational article and does not constitute official legal or accounting advice. If you have additional questions on the subject, please don’t hesitate to email me and certainly consult a qualified accountant or attorney to ensure compliance.