Q&A #24 – When must a newly-classified private foundation start complying with the 5% minimum distribution rule?

Question: I am on the Board of a 501(c)(3) organization that has not had success raising donations outside of the small group of founders. Consequently, we expect that we will soon fail to satisfy the public support test to remain a public charity and will be reclassified as a private foundation. We are particularly worried about the 5% minimum distribution rule applicable to private foundations and are starting to plan for this requirement. When do we have to start complying with the 5% minimum distribution rule?

Answer: This seemingly simple question is actually quite complicated. Private foundation status comes with numerous new rules, restrictions, and reporting requirements (the 5% minimum distribution rule is only one of many new requirements that you need to be aware of), so you are on the right track if you are starting the planning process for this transition as early as possible.

For background, the 5% minimum distribution rule (found in section 4942 of the Internal Revenue Code and Treas. Reg. §§ 53.4942(a)-1, 53.4942(a)-2, and 53.4942(a)-3) basically states that a private foundation must spend at least 5% of the average fair market value of its investment assets each year for charitable or administrative purposes. This is a very simplified summary of the rule, which has many nuances regarding issues such as distinguishing “investment assets” from “exempt function assets,” how assets are valued, what expenditures count as “qualifying distributions,” and how qualifying distributions may be allocated across different tax years.

As to your specific question, there are rules that should somewhat ease your transition into compliance with this rule. Generally, an organization will not be reclassified as a private foundation until it has failed the public support test for 2 years in a row (however, a new organization that fails the public support test in its 6th tax year of existence will be reclassified as a private foundation right away). Also, most of the private foundation requirements (including the 5% minimum distribution rule) will not apply until the tax year following the year in which the organization was reclassified as a private foundation (although the organization is required to file Form 990-PF and comply with certain other rules in the first year that it is reclassified).

Additionally, the minimum distribution requirement phases in gradually over a 4-year “start-up” period. In the first year that the minimum distribution requirement applies, the minimum distribution is 20% of the “distributable amount” that would otherwise apply. This percentage increases by 20% each year thereafter, so that by the fifth year that the minimum distribution rule applies, you will need to spend or pay out the full “distributable amount.”

Planning Tip – Throughout the transition process, it is very important to communicate regularly with a CPA who is well-versed in the Form 990-PF and the tax rules applicable to private foundations. You may need a new CPA, as some CPAs who are experts in handling Forms 990 for public charities do not have much experience with the Form 990-PF. Reclassification as a private foundation will likely require an overhaul of your organization’s compliance practices, recordkeeping, and perhaps investment strategy. Therefore, it is crucial to work with a CPA who can walk you through the numbers to get a sense of how these new requirements will impact the organization’s finances. 

This analysis assumes that your organization will not qualify as a “private operating foundation,” which generally refers to private foundations that directly carry out charitable programs (such as a museum or library) instead of making grants to other organizations. Private operating foundations are not subject to the 5% minimum distribution requirement but must comply with a different set of rules.

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