Is It Time For A Flat Tax On Private Foundations?

Robert Lyons, CPA, MST
Published Date:
Apr 1, 2016

Under our current federal tax structure, private foundations pay a 2% excise tax on their net investment income when filing Form 990-PF.  In certain years, the 2% rate can be reduced to 1% when the foundation’s charitable distributions exceed the average distributions during a five-year averaging process. This is determined on Part V of Form 990-PF.

Each year, private foundations have to determine whether they should pay the 1% or 2% excise tax. Depending on the timing of distributions, this can be as simple as deciding to bring charitable grants planned for the subsequent year into the current year in cases where the calculation is close. Because of private foundations’ dependence on year-end balances in cash and investments, this requires speculative planning at best. If the foundation makes significantly higher grants than its historical average during the five-year base period, it might be difficult to meet the 1% test until the extraordinary year drops off the Part V schedule of Form 990-PF.

President Obama’s proposed budget for the 2017 fiscal year includes a change in how private foundations are taxed. The budget, released on Feb. 9, 2016, would again replace the current two-tier structure for taxing private foundations with a single 1.35% excise tax rate. In one form or another, this “flat tax” rate proposal has been introduced a number of times over the past several years, ranging from 1% to 1.39%. The rate is partially determined on a “zero” impact or “revenue-neutral” basis. 

Why is there an excise tax on private foundations to begin with?  Unlike public charities that were part of the original 1913 tax code, private foundations – first defined in the Tax Reform Act of 1969 - have had a sordid past. Prior to 1969, they were investigated by the Walsh Committee (Senate Industrial Relations Committee) for allegedly large stock holdings, by the Cox Committee (House Select committee to Investigate and Study Educational and Philanthropic Foundations) and

Rep. B. Carrol Reece (the House Special Committee to Investigate Tax-Exempt Foundations and Comparable Organizations) in 1954 for alleged support of subversive activity; and by Rep. Wright Patman extensively during the 1960s for furthering private interest rather than public benefit. Foundations were perceived as a way to “stash” money away and avoid taxes with no real intent to distribute.

The Tax Reform Act of 1969 was was considerably more far reaching than just its impact on private foundations. However, private foundations bore most of the financial brunt in the not-for-profit community. As a result of the Act, an excise tax, calculated on an annual basis, was imposed on the net investment income of private foundations. Simply put, the excise tax is based on gross investment income and capital gains, less investment expenses. In this case, investment expenses are defined as those expenses paid or incurred to produce or collect investment income from interest, dividends, rents, amounts received from payments on securities loans, royalties, income from notional principal contracts, annuities, substantially similar income from ordinary and routine investments, and income from similar sources. Some expenses, such as bank fees and brokerage fees, are easy to allocate to investment activities. Other expenses, such as salaries, benefits, occupancy, utilities, and so forth, are not – these have to be allocated on a reasonable and consistently applied methodology, not on the need to reduce excise taxes. There has to be a relationship between the expense and the investment.

At the time the Tax Reform Act of 1969 was passed, the Treasury Department realized that it would take a considerable amount of effort to police the new not-for-profit requirements, and Congress stated that private foundations should share the additional cost brought on by the Act.  In other words, the additional revenue brought in by the Act should fund IRS oversight of the not-for-profit sector. The excise tax originally started out at 4% and was eventually reduced to its current two-tier structure. There was a flaw in this plan, however, because excise tax revenue is allocated to the Department of Treasury’s general fund, and not reserved for the IRS Tax Exempt and Government Entities Division.

In one way or another, industry, members of Congress, and presidential candidates have all proposed at one time or another to reduce or abolish the excise tax altogether. As an alternative to abolishment of the tax, it is clearly time for Congress to reduce the tax to a flat tax – for example, to 1.35%, which is considered revenue-neutral. Hopefully, in an election year, Congress will listen.

lyonsRobert Lyons, CPA, MST, is the managing tax director within the nonprofit and government Group at Marks Paneth LLP.  Mr. Lyons brings to his role the skills he has developed during more than 30 years of providing tax and consulting services to his clients in the nonprofit, higher education, and public sector niches.  His experience includes handling substantial exempt organization tax issues.  Mr. Lyons has testified in front of the House and Ways Committee in Washington D.C. establishing the current treatment of affinity royalty arrangements.  He has also been involved in special projects related to unrelated business income for exempt organizations, including but not limited to state filing issues, including settlements, foreign filing requirements for off-shore activities and use of exempt bond proceeds. 

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