Private foundations are required to spend annually a certain amount of money for charitable purposes, including grants to other charitable organizations. The amount that must be distributed annually is determined by computing the foundation's distributable amount. The distributable amount is equal to the foundation's minimum investment return with certain adjustments. This distributable amount must be distributed by the foundation as a qualifying distribution. This Issue Snapshot explains how to determine the treatment and ordering of such qualifying distributions under Section 4942(h). IRC sections and Treas. regulations IRC Section 4942 Taxes on failure to distribute income IRC Section 4942(a) Initial tax on failure to distribute income IRC Section 4942(b) Additional tax on failure to distribute income IRC Section 4942(g) Definition of qualifying distributions IRC Section 4942(h) Treatment of qualifying distributions Treas. Reg. Section 53.4942(a)-2 Computation of undistributed income Treas. Reg. Section 53.4942(a)-3 Qualifying distributions defined Treas. Reg. Section 53.4942(a)-3(a)(8) Examples of qualifying distributions Treas. Reg. Section 53.4942(a)-3(d)(1) Treatment of qualifying distributions - In general Treas. Reg. Section 53.4942(a)-3(d)(2) Treatment of qualifying distributions - Election Treas. Reg. Section 53.4942(a)-3(d)(3) Treatment of qualifying distributions - Examples Resources (court cases, Chief Counsel advice, revenue rulings, internal resources) Rev. Rul. 78-45, 1978-1 C.B. 380. An amount contributed by a private foundation to another private foundation that, in the taxable year following the taxable year in which it received the contribution, established an approved set-aside in the amount of the contribution and made a valid election to treat the entire amount of the set-aside as a distribution out of corpus may be treated by the donor foundation as a qualifying distribution under Section 4942. In this revenue ruling, the donee foundation made distributions equal to the distributable amount for its prior year, plus x dollars. Section 4942(h) treats qualifying distributions as made first out of the undistributed income of the immediately preceding taxable year. Since the donee foundation had no undistributed income for its prior year at the time it set aside x dollars, no amount of the x dollars is treated as a distribution out of undistributed income of the prior year. Section 4942(h) next treats qualifying distributions as made out of the undistributed income of the current taxable year. However, such amount may be treated as a distribution out of the undistributed income of a designated prior taxable year or out of corpus if a timely election is made. Issue snapshot: IRC Section 4942, Taxes on Failure to Distribute Income - Carryover of Excess Distributions or Undistributed Income Issue snapshot: IRC Section 4942(g)(2), Certain Set-Asides Issue snapshot: IRC Section 4946 - Definition of Disqualified Person Analysis A private foundation is required to distribute its distributable amount for each taxable year. The distributable amount must be distributed as qualifying distributions. Section 4942(g)(1) defines qualifying distributions as: Any amount (including that portion of reasonable and necessary administrative expenses) paid to accomplish religious, charitable, scientific, literary, or other public purposes as described in Section 170(c)(2)(B). Qualifying distributions do not include (i) contributions to organizations controlled directly or indirectly by the contributing foundation or by one or more disqualified persons with respect to the foundation, or (ii) contributions to private nonoperating foundations (except for certain contributions to exempt organizations). See Issue Snapshot on IRC Section 4946 Definition of Disqualified Person. Any amount paid to buy an asset used (or held for use) directly to carry out a charitable or other public purpose. In addition, Section 4942(g)(2) provides that any qualifying amount set aside for a specific project that comes within one or more purposes described in Section 170(c)(2)(B) may be treated as a qualifying distribution if certain requirements are met. See Issue Snapshot on IRC Section 4942(g)(2) Certain Set Asides. Treatment of qualifying distributions Whenever a qualifying distribution is made, it becomes necessary to determine the taxable year against which the amount involved is to be credited, since a private foundation may have undistributed income from one or more years or may have no undistributed income. Section 4942(h)(1) and Treas. Reg. 53.4942(a)-3(d)(1) state that the amount of any qualifying distribution is treated as having been made out of: First, out of the undistributed income for the prior tax year; Second, out of undistributed income for the current tax year; and Third, out of corpus. Note: Where a qualifying distribution is not treated as made out of the undistributed income of the immediately preceding taxable year, the foundation may elect to treat any portion of such distribution as made out of the undistributed income of a designated prior taxable year or out of corpus. See Section 4942(h)(2) and Treas. Reg. 53.4942(a)-3(d)(2). Thus, if a foundation has no undistributed income for the prior tax year, it may elect to treat all of its qualifying distributions as made out of corpus. A foundation may make an election to treat qualifying distributions as made out of corpus for several reasons. The foundation may have undistributed income for one or more tax years preceding the prior tax year and thus need to correct deficient distributions for such year(s). The foundation may want to be treated as a foundation described in Section 170(b)(1)(F)(ii) (sometimes referred to as either a pass-through or "conduit" foundation), or may want a donor foundation to receive credit for a qualifying distribution to it, as set forth in Section 4942(g)(1)(A)(i) or (ii) and (g)(3) (contributions to private non-operating foundations or to certain controlled organizations). Treas. Reg. 53.4942(a)-3(d)(3) provides examples of the treatment and ordering of qualifying distributions: Example 1: M, a private foundation which was created in 1968 and which uses the calendar year as the taxable year, has distributable amounts and qualifying distributions for 1970 through 1976 as follows: Characteristics 1970 1971 1972 1973 1974 1975 1976 Distributable amount $100 $100 $100 $100 $100 $100 $100 Qualifying distribution 0 100 250 100 100 100 100 In 1971 the qualifying distribution of $100 is treated under Treas. Reg. 53.4942(a)-3(d)(1)(i) as made out of the $100 of undistributed income for 1970. The qualifying distribution of $250 in 1972 is treated as made: (1) $100 out of the undistributed income for 1971 under Treas. Reg. 53.4942(a)-3(d)(1)(i); (2) $100 out of the undistributed income for 1972 under Treas. Reg. 53.4942(a)-3(d)(1)(ii); and (3) $50 out of corpus in 1972 under Treas. Reg. 53.4942(a)-3(d)(1)(iii). The qualifying distribution of $100 in each of the years 1973 through 1976 is treated as made out of the undistributed income for each of those respective years under Treas. Reg. 53.4942(a)-3(d)(1)(ii). See Treas. Reg. 53.4942(a)-3(e) for rules relating to the carryover of qualifying distributions out of corpus. Example 2: M, a private foundation which uses the calendar year as the taxable year, has undistributed income of $300 for 1981, $200 for 1982, and $400 for 1983. On January 14, 1983, M makes its first qualifying distribution in 1983 when it sets aside (within the meaning of Treas. Reg. 53.4942(a)-3(b)) $700 for construction of a hospital. On February 24, 1983 a notice of deficiency with respect to the excise taxes imposed by Section 4942 (a) and (b) in regard to M's undistributed income for 1981 is mailed to M under Section 6212(a). M notifies the Commissioner in writing on March 24, 1983, that it is making an election under Treas. Reg. 53.4942(a)-3(d)(2) to have its distribution of January 14th applied first against its undistributed income for 1982, next against its undistributed income for 1981, and last against its undistributed income for 1983. Thus, $200 of the $700 qualifying distribution is treated as made out of the undistributed income for 1982; $300, out of undistributed income for 1981; and $200 ($700 less the sum of $200 and $300), out of the undistributed income for 1983. Thus, an initial excise tax of $45 (15% of $300) is imposed under Section 4942(a). Since M made the election described above, the $300 (treated as distributed out of undistributed income for 1981) corrects (within the meaning of Section 4963(d)(2)) the taxable act because the undistributed income for 1981 is reduced to zero. Furthermore, correction is made within the correction period (as defined in Section 4963(e)(1) and Treas. Reg. 53.4963–1(e)). Therefore, under the provisions of Section 4961(a), the additional tax imposed by Section 4942(b) will not be assessed. Note: The tax imposed under Section 4942(a) was increased from 15% to 30% for tax years beginning after August 17, 2006. Timing of qualifying distributions: Rules for elections If any qualifying distribution is not treated as being made out of undistributed income of the immediately preceding tax year, the foundation may choose to treat any part of the distribution as made out of the undistributed income of a designated prior tax year or out of corpus. In order to do this, the foundation must make an election. This election's availability is significant where an under-distribution has occurred for prior taxable year and the taxable period remains open for that year. This election must be made by filing a statement with the Service during the taxable year in which the qualifying distribution is made. The foundation can also make the election by attaching a statement to the return it is required to file under Section 6033 for the taxable year in which such qualifying distribution was made. The statement must contain a declaration by an appropriate foundation manager (within the meaning of Section 4946(b)(1)) that the foundation is making an election under Section 4942(h), and it must specify whether the distribution is made out of the undistributed income of a designated prior taxable year (or years) or is made out of corpus. When the election is made during the tax year in which the qualifying distribution is made, the election may be revoked in whole or in part by filing a statement with the Service during the same tax year or by attaching a statement to the foundation's annual return filed for the tax year during which the qualifying distribution was made. The revocation statement must contain a declaration by the appropriate foundation manager that the foundation is revoking the election described above in whole or in part and must specify the election or part thereof being revoked. See Treas. Reg. 53.4942(a)-3(d)(2). Carryover of excess qualifying distributions For any tax year during which the organization is a private nonoperating foundation, any excess qualifying distributions may be used to reduce distributable amounts in any tax year of the adjustment period. Under Section 4942(i)(1) and Treas. Reg. 53.4942(a)-3(e), if a private foundation makes excess qualifying distributions in any taxable year in which it is subject to Section 4942(a) initial tax, the excess distribution may be used to reduce distributable amounts in any taxable year of the adjustment period. Pursuant to Section 4942(i)(2), the adjustment period consists of the five taxable years immediately following the taxable year in which the excess distribution occurred. Example 1: X Foundation has an unused excess qualifying distribution carryover of $100,000 from a prior tax year (5 years ago) that will expire if it is not used in its current tax year. For its current tax year, X Foundation has a distributable amount of $100,000 and qualifying distributions also of $100,000. X Foundation has no undistributed income from prior tax years and does not elect to distribute any part of its qualifying distributions in satisfaction of sections 170(b)(1)(F)(ii) or 4942(g)(3). Because its qualifying distributions for the current tax year do not exceed its distributable amount for the current tax year, X Foundation has no excess distribution carryover for its current tax year, and its $100,000 carryover from 5 years ago must expire. X Foundation cannot generate an excess distribution carryover for its current tax year by electing to treat the $100,000 qualifying distribution for the current year (or any part of it) as made out of corpus and applying the $100,000 carryover from the prior year (or any part of it) in satisfaction of its distributable amount for the current year. Example 2: Using the same facts from Example 1, except that instead of a $100,000 carryover from 5 years ago, X Foundation has unused excess qualifying distribution carryovers of $20,000 for each of the five prior years. Again, X Foundation has no excess distribution carryover for its current tax year, so in this case its $20,000 carryover from 5 years ago must expire. X Foundation cannot generate an excess distribution carryover for its current tax year by electing to treat the $100,000 qualifying distribution for the current year (or any part of it) as made out of corpus and applying the $20,000 carryovers from each of the five prior years (or any part of them) in satisfaction of its distributable amount for the current year. Although the $20,000 carryover from 5 years ago must expire, the other 4 carryovers of $20,000 per year accumulated during the past 4 years do not expire at this time. This is because the 5-year adjustment period has not elapsed with respect to any of the carryovers accumulated during the past 4 years. Issue indicators or audit tips If the foundation has undistributed income, verify whether the undistributed income was properly reported and tax paid on Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code. Prior and subsequent year returns should be reconciled to amounts in Part XIII of the Form 990-PF to ensure undistributed amounts and excess contributions are properly carried forward. Confirm the treatment of qualifying distributions is in accordance with Section 4942(h) and Treas. Reg. 53.4942(a)-3(d)(1). If a private foundation fails to establish that amounts set aside are qualifying distributions, consider whether it has distributed sufficient amounts as qualifying distributions. If not, determine whether Section 4942 excise taxes should be imposed for failure to distribute income. If a distribution does not meet the definition of a qualifying distribution as defined in Section 4942(g) and Treas. Reg. 53.4942(a)-3(a)(2), then recalculate the Form 990-PF Parts X, XI, XII, and XIII for the year(s) under audit. If operating under a six-year statute memo from Area Counsel, recalculate the form for each year under audit. A taxpayer generally can't make any elections with respect to qualifying distributions during an audit. If the taxpayer properly made an election, verify it. If there is a valid election, consider that when revising Part XIII. (The election might be found in another part of the form.) If proposing Section 4942 excise taxes, complete Forms 4883, 4621, 886-A and 870-E. Note that to incur the tax requires two years of failing to distribute; in other words, a foundation has until the end of Year 2 to make qualifying distributions of its distributable amount for Year 1. Consider opening all periods with open statutes when dealing with possible disqualified distributions. Chapter 42 excise tax liability can commonly arise under different Code provisions for the same transaction. For instance, a self-dealing transaction as defined in Section 4941 is frequently also a taxable expenditure as defined in Section 4945, that may also affect the Section 4940 net investment income and the Section 4942 qualifying distributions. Sections 4940 and 4942 are closely related. Expenses must be allocated between Section 4940 (investment activities) and Section 4942 (charitable activities). See Treas. Reg. 53.4940-1(e)(1). Also, a deduction for expenses paid or incurred in any taxable year for the production of gross investment income earned as an incident to a charitable function may not be greater than the income earned from such charitable function which is includible in gross investment income for such year. Treas. Reg. 53.4940-1(e)(2)(iv). However, deductions with respect to property used for an exempt purpose in excess of the income derived from the property may be treated as a qualifying distribution. Treas. Reg. 53.4942(a)-2(d)(4)(i). For taxable years beginning before December 21, 2019 (prior to the effective date of the Taxpayer Certainty and Disaster Tax Relief Act which repealed Section 4940(e)), Section 4940(e) and Section 4942 were especially inseparable. Adjustments to the net value of non-charitable use assets impact the investment tax calculations (under former Section 4940(e)) and the minimum investment return (Section 4942). Both taxes rely on determining qualifying distributions; former Section 4940(e) uses the distribution ratio to determine eligibility for the 1% tax rate, and Section 4942 applies them against undistributed income to compute the tax liability. Note that the Taxpayer Certainty and Disaster Tax Relief Act passed on December 20, 2019, included legislation that reduced the 2% excise tax on net investment income of private foundations to 1.39%. At the same time, the legislation repealed the 1% special rate that applied if the private foundation met certain distribution requirements. The changes are effective for taxable years beginning after December 20, 2019. Incorporate the items noted from analyzing the application and the tax returns. When asking for financial information, the supporting source documents (such as bank statements and cancelled checks) for up to five prior years may be requested. For private operating foundations, Part XIV of Form 990-PF supports the request of records for the three prior years. Note: When asking for the records, indicate the basis for the request, (for example, "Please provide the bank statements and cancelled checks for the years XXXX through YYYY to support the amounts reported on Part XIII of the Form 990-PF.")
