Section 4942 imposes an excise tax of 30 percent on the undistributed income of most domestic private foundations, excluding private operating foundations. A private foundation can avoid the excise tax on certain undistributed income if an amount set aside for a specific project is treated as a qualifying distribution. IRC Section and Treas. Regulation IRC Section 4942(g)(2)(A) In general IRC Section 4942(g)(2)(B) Requirements IRC Section 4942(g)(2)(C) Certain failures to distribute IRC Section 4942(g)(2)(D) Reduction in distribution amount IRC Section 4942(g)(2)(E) Adjustment period Treas. Reg. Section 53.4942(a)-3(b)(1) In general Treas. Reg. Section 53.4942(a)-3(b)(2) Suitability test Treas. Reg. Section 53.4942(a)-3(b)(3) Cash distribution test; in general Treas. Reg. Section 53.4942(a)-3(b)(7) Approval and information requirements Treas. Reg. Section 53.4942(a)-3(b)(9) Contingent set-aside Resources (court cases, Chief Counsel Advice, Revenue Rulings, internal resources) Revenue Ruling 75-511, 1975-2 CB 450 – A foundation, whose primary activity consisted of making renewable scholarships and fixed sum research grants, was unable to show that its grant-making program could be better accomplished by the use of set-asides than by the immediate payment of funds. Revenue Ruling 77-7, 1977-1 CB 354 – The term "specific project" was held to include a building project to be undertaken by a public charity unrelated to the foundation making the set-aside. Revenue Ruling 74-450, 1974-2 CB 388 – An operating foundation's conversion of a portion of newly acquired land into an extension of an existing wildlife sanctuary and the remainder into a public park under a four-year construction contract, under which payments were made mainly during the last two years, was held to constitute a specific project. Technical Guide 59 Taxes on Foundation Failure to Distribute Income IRC 4942 PDF Set-Asides webpage Analysis How does a private foundation establish that certain set-asides meet the definition of qualified distributions to avoid the excise tax on undistributed income under Section 4942(a)? An excise tax is imposed on private foundations for failure to distribute income for charitable purposes. To avoid liability for this tax, a foundation must make qualifying distributions each year at least equal to the foundation's distributable amount (as defined in Section 4942(d)). However, an amount set aside in one year for a specific project, but paid out in future years, may be treated as a qualifying distribution if the requirements in Section 4942(g)(2) are met. These requirements are satisfied if the foundation establishes that the amount set aside will be paid for the specific project within 60 months after it is set aside, and either by meeting a suitability test or a cash distribution test, as further described below. If the suitability test or cash distribution test is otherwise satisfied, the 60-month period for paying the amount set aside may, for good cause shown, be extended by the Commissioner. Set-asides qualifying under the suitability test Treas. Reg. Section 53.4942(a)–3(b)(2) provides that the suitability test is satisfied if the foundation establishes to the satisfaction of the Commissioner that the specific project for which the amount is set aside is one that can be better accomplished by the set-aside than by the immediate payment of funds. Specific projects that can be better accomplished by the use of a set-aside include, but are not limited to, projects in which relatively long-term grants or expenditures must be made in order to assure the continuity of particular charitable projects or program-related investments or where grants are made as part of a matching-grant program. Such projects include: A plan to erect a building to house the direct charitable, educational, or other similar exempt activity of the private foundation (such as a museum building in which paintings are to be hung), even though the exact location and architectural plans have not been finalized; A plan to purchase an additional group of paintings offered for sale only as a unit that requires an expenditure of more than one year's income; or A plan to fund a specific research program that is of such magnitude as to require an accumulation of funds before beginning the research, even though not all of the details of the program have been finalized. Set-asides qualifying under the cash distribution test Treas. Reg. Section 53.4942(a)–3(b)(3) provides that the cash distribution test is satisfied if: The specific project for which the amount is set aside will not be completed before the end of the taxable year in which the set-aside is made, The private foundation actually distributes, in cash or its equivalent and for one or more of the purposes described in Section 170(c) (1) or (2)(B), the "start-up period minimum amount" described in subparagraph (4) of this paragraph during the private foundation's start-up period, and The private foundation actually distributes, in cash or its equivalent and for one or more of the purposes described in Section 170(c) (1) or (2)(B), the "full-payment period minimum amount" described in subparagraph (5) of this paragraph in each taxable year of the private foundation's full-payment period. For purposes of the cash distribution test, an amount set aside will be treated as distributed in the year in which actually paid and not in the year in which set aside. Start-up period A foundation's start-up period is generally four years following the year in which it was created. Treas. Reg. Section 53.4942(a)-3(b)(4)(i). For these purposes, a foundation will be considered created in the taxable year in which its distributable amount first exceeds $500. The start-up period minimum amount is that amount that a foundation must distribute in its start-up period and cannot be less than the sum of: 20 percent of its distributable amount for the first taxable year of the start-up period; 40 percent of its distributable amount for the second taxable year of the start-up period; 60 percent of its distributable amount for the third taxable year of the start-up period, and 80 percent of its distributable amount for the fourth taxable year of the start-up period. The above requirement means that the total amounts above must be distributed by the end the start-up period and is not a requirement that any portion of this amount be distributed in any particular year of the start-up period. Example: A foundation was created on January 1, 2000 and uses the calendar year as its taxable year. The start-up period is January 1, 2000, through December 31, 2003. Foundation has distributable amounts for taxable years 2000 through 2003 in the following amounts: Taxable Year Distributable Amount 2000 $100,000 2001 $120,000 2002 $150,000 2003 $200,000 The foundation's start-up period minimum amount is the sum of the following amounts: 20 percent of $100,000 ($20,000); 40 percent of $120,000 ($48,000); 60 percent of $150,000 ($90,000); and 80 percent of $200,000 ($160,000), which totals $318,000. Thus, the foundation is required to actually distribute at least $318,000 in cash or its equivalent during the start-up period. Contingent set-asides Treas. Reg. Section 53.4942(a)-3(b)(9) provides that, generally, when a foundation is involved in litigation and may not distribute assets or income because of a court order, it may request a set-aside. The amount to be set aside shall be equal to that portion of the foundation's distributable amount which is attributable to the assets or income that are held pursuant to court order and which, but for the court order precluding the distribution of such assets or income, would have been distributed. If the litigation encompasses more than one taxable year, the foundation may seek additional contingent set-asides. Such amounts must actually be distributed by the last day of the taxable year following the taxable year in which the litigation is terminated. Requesting advance approval of a set-aside under the suitability test Treas. Reg. Section 53.4942(a)–3(b)(7) provides that a private foundation must apply for approval of a set-aside under the suitability test before the end of the taxable year in which the amount is set aside. To request the determination letter, the foundation must submit a completed Form 8940, Request for Miscellaneous Determination, and pay the required user fee. The current user fee amount can be found in Appendix A (schedule of user fees) of Revenue Procedure 2020-5 (updated annually). The regulations provide that the request for advance approval of a set-aside under the suitability test must include: A statement describing the nature and purposes of the specific project and the amount of the set-aside for which approval is requested; A statement describing the amounts and approximate dates of any planned additions to the set-aside after its initial establishment; A statement of the reasons why the project can be better accomplished by a set-aside than by the immediate payment of funds; A detailed description of the project including estimated costs, sources of any future funds expected to be used for completion of the project, and the location of any physical facilities to be acquired or constructed as part of the project; and A statement by a foundation manager that the amounts to be set aside will actually be paid for the specific project within a specified period of time that ends not more than 60 months after the date of the first set-aside, or a statement showing good cause why the period for paying the amount set aside should be extended (including a showing that the proposed project could not be divided into two or more projects covering periods of no more than 60 months each) and setting forth the extension of time required. Additional information regarding this type of request can be found in Revenue Procedure 2020-5 (updated annually). Establishing a qualifying set-aside under the cash distribution test The foundation must attach a schedule to its Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Trust Treated as Private Foundation, showing how the requirements are met. A schedule is required for the year of the set-aside and for each subsequent year until the set-aside amount has been distributed. See Treas. Reg. Section 53.4942(a)-3(b)(7)(ii) for specific requirements. Claiming amounts set aside as qualifying distributions on Form 990-PF The foundation should enter amounts set-aside on Line 3 of Part XII of Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Trust Treated as Private Foundation. Issue indicators or audit tips Set-asides claimed as qualifying distributions under the suitability test in Form 990-PF, Part XII, should be substantiated by proof of advance IRS approval. Set-asides claimed as qualifying distributions under the cash distribution test in Form 990-PF, Part XII, should be substantiated by detailed return information. 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. 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, examine whether the Section 4942 excise taxes should be imposed for failure to distribute income.
