Although private foundations are not subject to an income tax, each private foundation must pay an annual excise tax on its net investment income. Congress imposed this tax in 1969 to pay for the costs of auditing and monitoring private foundations. The tax is usually 2% of investment income minus certain expenses. If the annual estimated tax is expected to be $500 or more, the excise tax must be paid quarterly, on dates set by the Internal Revenue Code (IRC) corresponding to your fiscal year.
If a foundation’s qualifying distributions meet certain requirements, it may be able to reduce the excise tax from two percent to one percent. To obtain this reduction, a foundation must show that the qualifying distributions that it paid out before the end of the tax year (as opposed to within the 12 month grace period) equal or exceed the sum of (1) the average percentage of assets distributed by the foundation for the previous five years multiplied by the current year’s net investment assets and (2) one percent of net investment income.
The following types of investment income are subject to the excise tax:
- All items of income that arise from ordinary and routine investments, including interest, dividends, rent or royalties and any capital gains associated with the assets that produce that type of income. Other items to note include income from notional principal contracts, annuities, and other substantially similar income from ordinary and routine investments.
- Capital gains from appreciation on all types of property. This includes gains recognized from options, straddles, and hedging transactions, as well as gains made upon the sale of tangible personal property, such as art collections.
- Capital gains from the sale of assets used to further a tax-exempt purpose. For example, a foundation will be taxed on the capital gain earned on the sale of a building which had been used free of cost by local public charities.
- Even gains recognized on the sale of furniture or equipment used by a foundation generally will be subject to tax unless otherwise excluded as described below.
Certain gains are excluded, such as a gain from any portion of property used for at least one year for the foundation’s tax-exempt purpose, if the entire property is immediately exchanged following such period solely for property of “like kind,” which is also used primarily for the foundation’s tax-exempt purpose.
Also, foundations may not carry back losses from the sale or other disposition of property to offset gains in prior years.