Navigating IRS rules can feel overwhelming, but understanding the excise taxes that apply to private foundations is essential for staying compliant and protecting your charitable resources. These taxes exist to prevent misuse of assets, ensure funds serve the public good, and discourage activities that could compromise your mission. Whether you’re new to foundation management or need a refresher, the six excise taxes below, ranging from self-dealing to jeopardizing investments, highlight what every leanly staffed foundation should know to avoid penalties and stay focused on impact.
1. Tax on Net Investment Income
In 2020, Congress passed the Further Consolidated Appropriations Act of 2021, which set a flat 1.39% excise tax on the net investment income of private foundations for taxable years beginning after December 20, 2019. Certain gains are excluded, such as those from property used for at least one year for the foundation’s exempt purpose if the entire property is exchanged solely for “like-kind” property that will also be used primarily for exempt purposes.
Foundations typically must pay this excise tax through quarterly estimated payments. Keep in mind that some alternative investments may generate unrelated business income, which can trigger additional taxes or require specialized U.S. filings for foreign transactions.
For more, see Exponent Philanthropy’s Legal Essentials for Small Foundations.
2. Self-Dealing Restrictions
Self-dealing rules prohibit a wide range of transactions between a private foundation and its insiders, known as “disqualified persons.” These rules are both broad and absolute; there are no exceptions for small transactions or those conducted at arm’s length, and even arrangements that seem logical or beneficial to the foundation (such as leasing office space from a trustee at below-market rates) are not allowed.
Violations carry significant penalties. A disqualified person faces an initial 10% tax, and foundation managers who knowingly participate face a 5% tax, up to $20,000. If the issue is not corrected, the disqualified person may owe an additional 200% tax, and managers may face an additional 50% tax, also capped at $20,000.
For more, see Exponent Philanthropy’s How to Avoid Self-Dealing.
3. Failure to Make Required Distributions
Private foundations must make annual charitable expenditures, called qualifying distributions, equal to at least 5% of the fair market value of their prior year’s endowment. For example, a foundation with average assets of $5 million in fiscal year 2022 would need to distribute roughly $250,000 in qualifying expenditures by the end of its next fiscal year (or by December 31, 2023, for calendar-year filers).
If a foundation fails to meet this minimum, it faces a 30% tax on the undistributed amount. If the shortfall is not corrected, an additional tax of up to 100% may be imposed.
For more, see Exponent Philanthropy’s Meeting Your Minimum Distribution Requirement.
4. Excess Business Holdings Rules
To prevent abuses that could arise when a nonprofit controls a for-profit enterprise, such as influencing stock prices, private foundations are generally prohibited from owning more than a small share of any business. The IRS limits a foundation, together with its disqualified persons, to no more than a 20% interest in a business enterprise.
Foundations typically have five years to dispose of any excess holdings to reach the 20% (or, in some cases, 35%) limit. They may request an additional five-year extension by demonstrating serious efforts to divest and showing that the size or complexity of the holdings makes timely divestiture impractical.
The initial penalty for excess business holdings is a 10% tax on the foundation, with an additional 200% tax imposed if the issue is not corrected.
For more, see Exponent Philanthropy’s Excess Business Holdings.
5. Jeopardizing Investments
Foundation boards have a legal duty to manage assets prudently and avoid investments that could jeopardize the foundation’s ability to carry out its charitable purposes. The IRS may impose penalties if a foundation engages in investments that “jeopardize the carrying out of [its] exempt purposes.”
Although certain types of investments are subject to heightened scrutiny, the IRS typically assesses penalties only when a foundation has clearly mismanaged its assets, especially when self-dealing is involved. Historically, closely scrutinized investments have included trading securities on margin, trading commodity futures, investing in working interests in oil and gas wells, purchasing puts, calls, straddles, or warrants, and selling short.
The initial penalty for a jeopardizing investment is a 10% tax on the amount of the investment, paid by the foundation, plus a 10% tax (up to $10,000 per investment) on foundation managers who knowingly participated. If the issue is not corrected, the foundation may face an additional 25% tax, and managers may face an additional 5% tax (up to $20,000).
For more, see Exponent Philanthropy’s Legal Requirements for Foundation Investments.
6. Taxable Expenditure Prohibitions
Taxable expenditures are grants or payments made by a private foundation that are either prohibited outright or fall within IRS-regulated areas without following the required procedures. These include activities such as influencing public elections, funding noncharitable purposes, or lobbying to influence legislation.
The initial tax on a taxable expenditure is 20% of the amount involved, paid by the foundation, plus a 5% tax on any foundation manager who knowingly and willfully approved the expenditure, typically meaning they acted without relying on a reasoned, written legal opinion. If the expenditure is not corrected, the foundation may face an additional tax of up to 100% of the amount, and managers may face an additional 50% tax.
For more, see Exponent Philanthropy’s Taxable Expenditures.
Legal Expertise at Your Fingertips
Understanding these excise taxes is key to stewarding your foundation’s resources wisely and keeping your philanthropy on course. When questions get complex, our SignaturePLUS Membership can help. It includes up to 10 hours of legal Q&A each year, giving your board and staff timely, expert guidance whenever you need it. Upgrading your membership ensures you have trusted support just a phone call or email away.
About the Author
Brendan McCormick is the director of research and publications at Exponent Philanthropy. He works with members, partners, and staff to develop resources and research on our funder community.
Disclaimer
While we pride ourselves on our advice, please realize Exponent Philanthropy is not a law or accounting firm. The information contained in this post is for informational purposes only and not as part of an attorney-client relationship. The information is not a substitute for expert legal, tax or other professional advice tailored to your specific circumstances, and may not be relied upon for the purposes of avoiding any penalties that may be imposed under the Internal Revenue Code. It is our advice that you seek independent counsel, for any tax, accounting or legal issues you may have, related to matters that are of a material concern to you or your organization.