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Technical Guide

TG 59: Taxes on Foundation Failure to

Distribute Income – IRC Section 4942

This document is not an official pronouncement of the law or the position of the IRS and cannot be used,

cited, or relied upon as such. This guide is current through the revision date. Changes after the revision

date may affect the contents of this document and users should consider any subsequent resources to

ensure technical accuracy. All references to “Section” in this document refer to the Internal Revenue

Code of 1986, as amended, unless specifically noted otherwise. The taxpayer names and addresses

shown in examples within this publication are fictitious.

Technical Guide Revision Date: 8/5/2024

Publication 5581 (Rev. 8-2024) Catalog Number 73364Z Department of the Treasury Internal Revenue Service www.irs.gov

Table of Contents

I. Overview................................................................................................ 6

Background / History ...................................................................... 6

Relevant Terms ............................................................................... 7

Law / Authority ................................................................................ 8

II. Requirements........................................................................................ 9

General Rules Governing Required Distributions ....................... 9

Taxes Imposed ................................................................................ 9

B.1. Taxes on Private Foundation ............................................... 9

Distributable Amount Defined ..................................................... 10

Computation of Minimum Investment Return ............................ 10

Illustrations of Exempt Purpose Assets ..................................... 12

Functionally Related Businesses ................................................ 13

Cash Held for Charitable Activities ............................................. 14

Valuation of Assets ....................................................................... 15

H.1. Securities with readily available market quotations, cash,

and common trust funds ........................................................ 15

H.2. Other assets, including real property ................................ 16

H.3. Valuation Date ..................................................................... 17

Qualifying Distributions ............................................................... 18

Distributions to Another Private Foundation or to a Controlled

IRC 501(c)(3) Organization ........................................................... 20

Payments to Certain Supporting Organizations ........................ 21

Accounting Principles Applicable to Qualifying Distributions . 22

Value of Property Distribution ..................................................... 22

Funds Borrowed for Exempt Purposes ...................................... 22

Changes in Use of an Asset ......................................................... 22

Certain Foreign Organizations..................................................... 22

Payment of Tax ............................................................................. 24

Examples of Qualifying Distributions ......................................... 24

Set-Asides ..................................................................................... 26

S.1. Suitability Test ..................................................................... 26

S.2. Revenue Rulings ................................................................. 27

S.3. Advance Approval ............................................................... 28

S.4. Cash Distribution ................................................................ 29

S.5. Minimum Distribution Required During Start-Up Period . 29

S.6. Minimum Distribution Required During Full-Payment

Period ....................................................................................... 30

S.7. Failure to Distribute Minimum Amounts ........................... 31

S.8. Cash Distribution Test ........................................................ 32

S.9. Evidence of Set-Asides....................................................... 33

S.10. Contingent Set-Asides ........................................................ 33

III. Other Considerations ......................................................................... 34

Twelve-Month Pass-Through ....................................................... 34

Applying Prior Corpus Distributions........................................... 35

Transfer by Donee to Secondary Recipient................................ 37

Set-Aside by Donee ...................................................................... 38

Treatment of Qualifying Distributions......................................... 38

Election as to Treatment of Certain Qualifying Distributions ... 38

Method of Making Election........................................................... 39

Carryover of Excess Qualifying Distributions............................ 39

Reduction of Distributable Amount............................................. 40

Excess Qualifying Distributions .................................................. 40

Adjustment Period ........................................................................ 40

IV. Examination Techniques ................................................................... 41

Introduction ................................................................................... 41

Chapter 42 First Tier Excise Taxes Table ................................... 41

Qualifying Distributions ............................................................... 43

One Act/Failure to Act, Multiple Violations................................. 44

Procedural Information Regarding Correction........................... 47

Correction Period .......................................................................... 50

Advance Approval of Proposed Correction ............................... 51

All Chapter 42 Second tier Excise Taxes .................................... 52

Termination Tax ............................................................................ 54

Revocation ..................................................................................... 57

Statute of Limitations ................................................................... 58

Applicable Penalties ..................................................................... 61

Domestic Taxable Private Foundations ...................................... 63

Abatement of Excise Taxes ......................................................... 64

Pre-Examination Considerations................................................. 66

Field/Office Correspondence Exam Information........................ 73

Exam Case Closing Information .................................................. 75

V. Issue Indicators and Examination Tips ............................................ 79

Issue Indicators ............................................................................. 79

Examination Tips .......................................................................... 79

VI. Examples Worksheets / Exhibits ...................................................... 81

Section 4942: First tier Example .................................................. 81

Section 4942: Second tier Tax Example ..................................... 88

Statute Extension Example .......................................................... 91

Section 4942 Taxes on Failure to Distribute Income Lead

Sheet .............................................................................................. 93

I. Overview

(1) Organizations that are exempt from taxation under Section 501(c)(3) of the

Internal Revenue Code (Code) and do not fall into any of the public charity

statuses under Section 509(a) are called private foundations. Private

foundations raise complex and interrelated issues regarding the application of

Chapter 42.

Background / History

(1) Under Chapter 42, excise taxes are imposed on a private foundation under

Section 4942 where the foundation fails to distribute a minimum amount of

income to charity in a timely manner.

(2) Before the Tax Reform Act of 1969 (TRA ‘69), there was little legal pressure on

private foundations to distribute income to charity. Prior law said that a private

foundation would lose its exemption if its aggregate accumulated income was

unreasonable in amount or duration for carrying out its exempt purposes.

(3) The unreasonable accumulation of income limitation proved largely ineffective.

Since reasonableness or unreasonableness is difficult to determine, and since

the only available sanction, loss of exempt status, was often viewed as unduly

harsh, the prior law was rarely enforced. As a result, while the creator of a

private foundation may have received immediate and substantial tax benefits

from his or her contribution, charity may have received no benefit whatever or

very belated benefits. Congress responded to this situation by establishing a

minimum distribution requirement for private foundations as part of the TRA ‘69,

specifically through enacting Section 4942, which imposes excise taxes on

private foundations for failure to distribute income for Section 170(c)(2)(B)

purposes.

(4) Section 4942 was changed significantly by the Pension Protection Act of 2006,

P.L. 109-280, 120 Stat. 780 (PPA 2006). The Section 4942(a) first tier excise

tax was doubled from 15% to 30% and Section 4942(g)(4) was amended to

provide that a nonoperating private foundation may not count as a qualifying

distribution any amount paid to (1) a non-functionally integrated Type III

supporting organization or (2) any other Section 509(a)(3) supporting

organization if a disqualified person with respect to the foundation directly or

indirectly controls the supporting organization or a supported organization of

such supporting organization.

(5) Regarding the filing requirements for private foundations, for tax years

beginning on or after July 2, 2019, Section 3101 of Public Law 116-25 requires

that returns by exempt organizations be filed electronically. If an organization is

filing Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Trust

Treated as Private Foundation, for a tax year beginning on or after July 2, 2019,

the organization must file the return electronically. Limited exceptions apply.

(6) Electronic filing requirements have not changed for Form 990-PF filers with tax

years beginning before July 2, 2019 (which includes calendar year 2019 Forms

990-PF). Required electronic filing for calendar year filers will apply for tax

years beginning in 2020 and later.

(7) There are new reporting standards for net assets, and Part II of Form 990-PF

was updated to reflect the Financial Accounting Standards Board’s (FASB’s)

reclassification of net assets into two classes, net assets without donor

restrictions and net assets with donor restrictions.

(8) 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.

(9) For tax years beginning in 2020, an individual liable for a Chapter 42 excise tax

will not have the option to file jointly with the organization with respect to which

the excise tax relates. Beginning with tax year 2020, Form 4720 has been

revised to identify whether the filer is the organization or an individual.

Accordingly, for tax years after 2019, an agent preparing Form 4720 to report

individual excise tax liability during an examination will no longer convert Form

4720 to “Form 4720-A.” The revenue agent will, instead, complete Form 4720

identifying the filer as an individual as described in the instructions for Form

4720. Please see the instructions to Form 4720 for further information.

Relevant Terms

(1) Taxable period: With respect to the undistributed income of a private

foundation for any taxable year, the period beginning with the first day of the

taxable year and ending on the earlier of the date of mailing of a notice of

deficiency under Section 6212(a) with respect to the initial excise tax imposed

under Section 4942(a) or the date on which the initial excise tax imposed under

Section 4942(a) is assessed. See Treas. Reg. 53.4942(a)-1(c)(1).

(2) Undistributed income: Defined in Section 4942(c) as the amount by which the

distributable amount (defined in Section 4942(d)) for that taxable year exceeds

the qualifying distributions (defined in Section 4942(g)) made before that time

out of such distributable amount. See Treas. Reg. 53.4942(a)-2(a).

(3) Distributable amount: Equals the foundation’s minimum investment return,

reduced by any income taxes and the tax on net investment income imposed by

Section 4940, increased by certain amounts listed in Section 4942(f)(2)(C). See

Section 4942(d) and Treas. Reg. 53.4942(a)-2(b). The amounts listed in

Section 4942(f)(2)(C) are: amounts received or accrued as repayments of

amounts which were considered as a qualifying distribution for any taxable

year, amounts received or accrued from the sale or other disposition of property

to the extent that the acquisition of such property was considered as a

qualifying distribution for any taxable year, and any amount set aside under

Section 4942(g)(2) to the extent it is determined that such amount is not

necessary for the purposes for which it was set aside.

(4) Minimum investment return: Defined in Treas. Reg. 53.4942(a)-2(c) as 5% of

the excess of the aggregate fair market value of all assets of the foundation

(other than those that are used or held for use directly in carrying out the

foundation’s exempt purpose as described in Treas. Reg. 53.4942(a)-2(c)(3); or

certain other assets which are excluded as described in Treas. Reg.

53.4942(a)-2(c)(2)) over the amount of the acquisition indebtedness for those

assets (determined under Section 514(c)(1), but without regard to the taxable

year in which the indebtedness was incurred). However, under Treas. Reg.

53.4942(a)-2(c)(5)(iii), for a taxable year shorter than 12 months, the minimum

investment return is calculated by using a percentage equal to five multiplied by

a fraction the numerator of which is the number of days in the short taxable year

and the denominator of which is 365. See Treas. Reg. 53.4942(a)-2(c)(5)(iii).

(5) Qualifying distribution: Defined as an amount paid to accomplish one or more

purposes described in Section 170(c)(2)(B), an amount paid to acquire an asset

used (or held for use) directly in carrying out one or more purposes described in

Section 170(c)(2)(B), or an amount set aside for a specific project that comes

within one or more purposes described in Section 170(c)(2)(B). See Section

4942(g).

Law / Authority

(1) Section 4942 is one of several private foundation excise tax provisions enacted

by the TRA ‘69. Section 4942 requires private foundations to distribute a current

minimum amount to charity for taxable years beginning after December 31,

1969. During the early years after the TRA ‘69, a foundation was required to

distribute the greater of its adjusted net income or minimum investment return

on its assets other than those which are used (or held for use) directly in the

carrying out of the foundation’s exempt purpose. However, Section 823 of

Economic Recovery Act of 1981, P.L. 97-34, 95 Stat. 172, 351 (1981), reduced

the required payout for private foundations so that they are only required to

distribute a “distributable amount,” which is based largely on an organization’s

minimum investment return, statutorily defined as 5% of the value of the noncharitable use assets, effective for taxable years beginning after December 31,

1981. Failure to make timely distributions at the required level will result in the

imposition of excise taxes, and, if the failure is willful or flagrant, additional

penalty taxes, including a possible termination tax.

II. Requirements

(1) Generally, Section 4942 imposes a tax on certain private foundations if they

have “undistributed income,” which is defined by Section 4942(c) as the

foundation’s “distributable amount” for the taxable year less “qualifying

distributions” attributable to that year. The “distributable amount” is equal to the

foundation’s “minimum investment return” reduced by the Section 4940 tax and

any unrelated business income tax imposed on the foundation. See Section

4942(d).

General Rules Governing Required Distributions

(1) Section 4942 and the applicable regulations contain an extensive set of rules

governing required distributions for private foundations. Generally, the rules

require the following:

a. A private foundation, other than an operating foundation, is required to

distribute its distributable amount for each taxable year beginning after

December 31, 1969. Distributable amount generally means a private

foundation’s minimum investment return (an imputed return on noncharitable use assets), reduced by any taxes imposed under subtitle A and

Section 4940. See Section 4942(d) and Treas. Reg. 53.4942(a)-2(b)(1)(ii).

b. The required distributions must be qualifying distributions. In general, a

qualifying distribution is any expenditure or grant, and certain set-asides, for

charitable, educational, religious, or similar purposes (Section 170(c)(2)(B)

purposes). Certain conditions and restrictions apply to payments to

nonoperating foundations, controlled organizations, and certain supporting

organizations. See Treas. Reg. 53.4942(a)-3(a)(2).

When the distributable amount for a taxable year exceeds the amount of

the qualifying distributions made for that distributable amount, the difference

constitutes undistributed income of the taxable year. See Treas. Reg.

53.4942(a)-2(a) and Section 4942(c).

Taxes Imposed

(1) A private foundation that fails to pay out the distributable amount in a timely

manner is subject to excise taxes. See Section 4942(a).

B.1. Taxes on Private Foundation

(1) Generally, Section 4942 requires a private foundation to distribute the

distributable amount for each taxable year by the end of the succeeding taxable

year. If a private foundation is considered to have undistributed income of a

taxable year at the end of the second or any succeeding taxable year, it’s

subject to an initial excise tax equal to 30% of the amount of that undistributed

income for each of such second and succeeding taxable years if it remains

undistributed. See Treas. Reg. 53.4942(a)-1(a)(1) and Section 4942(a).

(2) After imposition of the initial excise tax on undistributed income of a specific

taxable year, if any portion of such income remains undistributed at the close of

the taxable period, a tax equal to 100% of the amount remaining is imposed.

See Section 4942(b) and Treas. Reg. 53.4942(a)-1(a)(2).

(3) Payment of the excise taxes imposed by Section 4942(a) or (b) is in addition to,

and not in lieu of, making the distribution of such undistributed income required

by Section 4942. Treas. Reg. 53.4942(a)-1(a)(3).

Distributable Amount Defined

(1) The distributable amount equals the foundation’s minimum investment return,

reduced by any income taxes and the tax on net investment income imposed by

Section 4940, increased by certain amounts listed in Section 4942(f)(2)(C). See

Section 4942(d) and Treas. Reg. 53.4942(a)-2(b). The amounts listed in

Section 4942(f)(2)(C) are:

a. Amounts received or accrued as repayments of amounts which were

considered as a qualifying distribution for any taxable year;

b. Amounts received or accrued from the sale or other disposition of property

to the extent that the acquisition of such property was considered as a

qualifying distribution for any taxable year; and

Any amount set aside under Section 4942(g)(2) to the extent it is

determined that such amount is not necessary for the purposes for which it

was set aside.

(2) The distributable amount of a taxable year may be subject to adjustment for

excess distributions made during certain prior taxable years. See Treas. Reg.

53.4942(a)-3(b)(5)(iii).

(3) The regulations require the distributable amount to be increased by the income

portion of distributions from trusts described in Section 4947(a)(2) for amounts

placed in trust after May 26, 1969. See Treas. Reg. 53.4942(a)-2(b)(2)(i).

However, in Ann Jackson Family Foundation v. Commissioner, 97 T.C. 534

(1991), in which a private nonoperating foundation received distributions

totaling $350,000 per year from a split-interest trust as defined by Section

4947(a)(2), the court held that the distributions from the split-interest trust are

not included in the distributable amount as defined in Section 4942(d) and that

Treas. Reg. 53.4942(a)-2(b)(2) was invalid. The Ninth Circuit affirmed in its

opinion at 15 F.3d 917 (1994). Notice 2004-36, 2004-1 C.B. 889, states that the

Treasury Department and the IRS intend to propose regulations modifying the

regulations under Section 4942 in a manner consistent with the holdings of the

Tax Court and the Ninth Circuit in Ann Jackson Family Foundation. Until further

guidance is promulgated, private foundations should compute the distributable

amount under Section 4942(d) without regard to Treas. Reg. 53.4942(a)2(b)(2)(i).

Computation of Minimum Investment Return

(1) The minimum investment return, as defined in Treas. Reg. 53.4942(a)-2(c), of a

private foundation for any taxable year is 5% of the excess of the aggregate fair

market value of all assets of the foundation (other than those that are used or

held for use directly in carrying out the foundation’s exempt purpose or

described in (3) below) over the amount of the acquisition indebtedness for

those assets (determined under Section 514(c)(1), but without regard to the

taxable year in which the indebtedness was incurred). However, for a taxable

year shorter than 12 months, the minimum investment return is calculated by

using a percentage equal to five multiplied by a fraction the numerator of which

is the number of days in the short taxable year and the denominator of which is

365. See Treas. Reg. 53.4942(a)-2(c)(5)(iii).

(2) The aggregate fair market value of all assets of the foundation includes:

a. The average of the fair market values on a monthly basis of securities for

which market quotations are readily available,

b. The average of the foundation’s cash balances on a monthly basis, and

The fair market value of all other assets except those described in (3) below

for the period during the taxable year for which such assets are held by the

foundation. See Treas. Reg. 53.4942(a)-2(c)(1).

(3) Certain Assets Excluded. Treas. Reg. 53.4942(a)-2(c)(2) specifically excludes

the following categories of assets from the determination of the minimum

investment return:

a. Any future interest (such as a vested or contingent remainder, whether legal

or equitable) of a foundation in the income or corpus of any real or personal

property until all intervening interests in, and rights to the actual possession

or enjoyment of such property have expired, or, although not actually

reduced to the foundation’s possession, has been constructively received

by the foundation,

b. The assets of an estate until the assets are distributed to the foundation or,

due to a prolonged period of administration, that estate is considered

terminated for income tax purposes by operation of Treas. Reg. 1.641(b)3(a),

Any present interest of a foundation in any trust created and funded by

another person,

d. Any pledge to the foundation of money or property, and

e. Any assets used, or held for use, directly in carrying out the foundation’s

exempt purpose.

(4) Treas. Reg. 53.4942(a)-2(c)(3)(i) lists the following guidance on assets used, or

held for use, in carrying out a foundation’s exempt purpose.

a. Used or held for use. An asset is used, or held for use, directly in carrying

out the foundation’s exempt purpose only if the asset is actually used by the

foundation in carrying out its charitable, educational, or other similar Section

170(c)(2)(B) purpose which gives rise to the exempt status of the

foundation, or if the foundation owns the asset and establishes to the

satisfaction of the IRS that its immediate use for such exempt purpose is

not practical, based on the facts and circumstances of the particular case,

and that definite plans exist to commence such use within a reasonable

period of time.

b. Whether a particular asset is used, or held for use, directly by the

foundation to carry out its exempt purpose is a question of fact. For

example, management of a foundation’s endowment fund isn’t a direct

implementation of its exempt function. Consequently, an office building

used for providing offices for employees managing the endowment fund is

not being used (or held for use) directly by the foundation to carry out its

exempt purpose. Similarly, assets held for production of income or for

investment aren’t held for carrying out the foundation’s exempt purpose

even though the income from such assets is used to carry out exempt

purpose.

Dual use assets. Where property is used both for exempt purposes and for

other purposes, if the exempt purposes use represents 95% or more of the

total use, the property is considered to be used exclusively for exempt

purposes. If the exempt use is less than 95%, a reasonable allocation

between exempt and non-exempt use must be made for purposes of

minimum investment return computation.

d. Temporary Lease of Property Acquired for Exempt Use. Property acquired

by the foundation to be used for exempt purposes may be considered as

used, or held for use, directly to carry out exempt purposes even though the

property is leased, in whole or in part, for a limited period during which

arrangements are made for its conversion to the use for which it was

acquired, provided such income-producing use does not exceed a

reasonable period of time. Generally, one year is deemed to be a

reasonable period for such purpose. Income derived under such lease is

includible in the foundation’s adjusted net income. If the income-producing

use exceeds a reasonable period, the property, thereafter, shall not be

deemed to be used for exempt purposes. Further, if acquisition of the

property had been treated as a qualifying distribution of a prior year, the

value of the property is added to the adjusted net income computation for

the taxable year in which the income-producing use becomes unreasonable

in length of time. If, subsequently, the property is used directly for exempt

purposes, a qualifying distribution of its then fair market value will be

deemed to have been made.

Illustrations of Exempt Purpose Assets

(1) Treas. Reg. 53.4942(a)-2(c)(3)(ii) illustrates when assets are used, or held for

use, in carrying out exempt purposes with the following examples:

a. Administrative assets, such as office equipment and supplies which are

used by employees or consultants of the foundation, to the extent such

assets are devoted to and used directly in the administration of the

foundation’s charitable, educational, or other similar exempt activities;

b. Real estate or the portion thereof used by the foundation directly in its

charitable, educational, or other similar activities;

Physical facilities used in exempt activities such as housing paintings

owned by the foundation which are on public display, fixtures and

equipment in classrooms, qualified research facilities and related equipment

which, under the facts and circumstances, serve a useful purpose in the

conduct of such activities;

d. Any interest in a functionally related business as defined in Treas. Reg.

53.4942(a)-2(c)(3)(iii) or in a program-related investment as defined in

Section 4944(c);

e. The reasonable cash balances necessary to cover current administrative

expenses and other normal and current disbursements directly connected

with exempt activity; and

Any property leased by a foundation in carrying out its charitable,

educational or other similar exempt purpose at no cost, or at a nominal rent,

to the lessee or for a program-related purpose within the meaning of

Section 4944(c), such as the leasing of renovated apartments to lowincome tenants at a low rental as part of the lessor-foundation’s program for

rehabilitating a blighted portion of a community.

(2) Two revenue rulings give additional examples of exempt purpose assets. Rev.

Rul. 74-498, 1974-2 C.B. 387, describes a collection of paintings loaned under

an active loan program for exhibition in museums, universities, and similar

institutions. Rev. Rul. 75-207, 1975-1 C.B. 361, describes an island preserved

in its natural state and to which access is limited to invited public and private

researchers.

Functionally Related Businesses

(1) A functionally related business is defined in Section 4942(j)(4) and Treas. Reg.

53.4942(a)-2(c)(3)(iii)(a) as:

a. A trade or business which is not an unrelated trade or business as defined

in Section 513, or

b. An activity which is carried on within a larger aggregate of similar activities

or within a larger complex of other endeavors which is related (aside from

the need of the organization for income or funds or the use it makes of the

profits derived) to the charitable, educational, or other similar exempt

purpose of the organization.

(2) Treas. Reg. 53.4942(a)-2(c)(3)(iii)(b) gives the following examples of

functionally related business:

Example 1: X, a private foundation, maintains a community of historic value

which is open to the public. For the convenience of the public, X, through a

wholly owned, separately incorporated, taxable entity, maintains a restaurant

and hotel in such community. Such facilities are within the larger aggregate of

activities which makes available for public enjoyment the various buildings of

historic interest and which is related to X’s exempt purpose. Thus, the operation

of the restaurant and hotel under such circumstances constitutes a functionally

related business.

Example 2: Y, a private foundation, as part of its medical research program

under Section 501(c)(3), publishes a medical journal in carrying out its exempt

purpose. Space in the journal is sold for commercial advertising.

Notwithstanding the fact that the advertising activity may be subject to the tax

imposed by Section 511, such activity is within a larger complex of endeavors

which makes available to the scientific community and the public developments

with respect to medical research and is therefore a functionally related

business.

(3) In Rev. Rul. 76-85, 1976-1 C.B. 357, the IRS ruled that because a trade or

business in which substantially all of the work is performed without

compensation is a functionally related business, a foundation may exclude its

interest in the business from the computation of its minimum investment return.

Cash Held for Charitable Activities

(1) To determine the amount of the exclusion from the minimum investment return

base for cash needed to cover current administrative expenses and other

normal and current disbursements directly connected with the foundation’s

charitable, educational, or other similar exempt activities, the necessary cash

amount is generally deemed to be 1.5% of the fair market value of the minimum

investment return base without regard to this exclusion. The amount is

computed on an annual basis. However, if the IRS is satisfied that under the

facts and circumstances that a greater amount is needed for current expenses

and disbursements, then an additional amount may be excluded from the fair

market value of the minimum investment return base. See Treas. Reg.

53.4942(a)-2(c)(3)(iv).

(2) All remaining cash balances, including amounts necessary to pay any tax

imposed by Section 511 or Chapter 42 of the Code, except Section 4940 tax,

are included in the minimum investment return base. See Treas. Reg.

53.4942(a)-2(c)(3)(iv).

(3) In Rev. Rul. 75-392, 1975-2 C.B. 447, the IRS concluded that a private

foundation whose average cash balance during the tax year represented 1% of

the fair market value of its minimum investment return base may exclude 1.5%

of the fair market value. Under the regulations, this amount is considered a

reasonable cash balance even though it exceeds the actual average cash

balance.

Valuation of Assets

(1) Treas. Reg. 53.4942(a)-2(c)(4) has specific rules for the valuation of publicly

traded securities, cash balances, common trust funds, real estate, and other

assets for purposes of calculating the private foundation’s minimum investment

return.

H.1. Securities with readily available market quotations, cash, and

common trust funds

(1) Fair Market Value Based on Readily Available Market Quotations. A private

foundation may use any reasonable method to determine the monthly fair

market value of securities for which market quotations are readily available if

such method is consistently used. The term “securities” includes but is not

limited to, common and preferred stocks, bonds, and mutual fund shares. See

Treas. Reg. 53.4942(a)-2(c)(4)(v).

(2) Market quotations are readily available if a security is:

a. Listed on NASDAQ, the New York Stock Exchange, NYSE American

(“American Stock Exchange” in the regulations), or any city or regional

exchange in which quotations appear daily, including foreign securities

listed on a recognized foreign national or regional exchange;

b. Regularly traded in a national or regional over-the-counter market, for which

published quotations are available; or

Locally traded, for which quotations can readily be obtained from

established brokerage firms.

(3) Examples of Reasonable Valuation Methods for Readily Marketable Securities.

Treas. Reg. 53.4942(a)-2(c)(4)(i)(e) gives various examples of reasonable

valuation methods for readily marketable securities. These include consistently

valuing a security:

a. On the last day of each trading month based upon the quoted closing price,

b. By taking the mean of the closing prices on the first and last trading days

and the trading day on or closest to the 15th day of each month,

By taking the mean of the highest and lowest quoted prices on the last

trading day of each month, or

d. By taking the mean of the bid and asked prices on the first trading day of

month.

(4) Under Treas. Reg. 53.4942(a)-2(c)(4)(i)(c), a reduction is available for listed

securities for blockage or similar factors under Section 4942(e)(2)(B). The

allowable reduction is limited to 10% of the value as determined above. The

value is reduced to the extent that the private foundation shows that the

securities couldn’t be liquidated within a reasonable period except at a price

less than fair market value because of:

a. The size of the block of securities,

b. The fact that the securities are in a closely held corporation, or

The fact that the sale of the securities would result in a forced or distress

sale.

(5) Computer Pricing System. Readily marketable securities which are held in trust

for, or on behalf of, a foundation by a bank or other financial institution which

values such securities periodically by use of a computer, may be valued using

the computer pricing system, provided the IRS has accepted such computer

pricing system as a valid method for valuing securities for federal estate tax

purposes. See Treas. Reg. 53.4942(a)-2(c)(4)(i)(d).

(6) Cash. The amount of a foundation’s cash balances for purposes of the

minimum investment return base is determined by valuing cash monthly taking

the average of the amount of cash on hand as of the first and last days of each

month. See Treas. Reg. 53.4942(a)-2(c)(4)(ii).

(7) Common Trust Funds. Valuation of a foundation’s participating interest in a

common trust fund, as defined in Section 584, on the basis of the average of

the valuations reported to the foundation during its taxable year will ordinarily

constitute an acceptable method of valuation where the common trust fund is

established and administered under a plan providing for the periodic valuation

of participating interests during the fund’s taxable year and the reporting of such

valuation to participants. See Treas. Reg. 53.4942(a)-2(c)(4)(iii).

(8) Unlisted securities of a controlled corporation. If a private foundation owns

voting stock of an issuer of unlisted securities and has, or together with

disqualified persons or another private foundation has, effective control of the

issuer (within the meaning of Treas. Reg. 53.4943-3(b)(3)(ii)), then, if the

issuer’s assets consist of shares of listed securities, the assets are valued as

described in (1) above, including any allowable reduction for blockage or similar

factors. See Treas. Reg. 53.4942(a)-2(c)(4)(iv).

H.2. Other assets, including real property

(1) Other Assets. The fair market value of assets other than those described above

is determined annually except that valuations of real property may be

determined on either an annual basis or on the five-year basis described below.

The determination of value of assets (except real property which must be

evaluated by an independent, non-disqualified person where the valuation is to

be used for five years) may be made by employees of the private foundation or

any other person, without regard to whether that person is a disqualified person

with respect to the foundation. Except as provided below, valuations of assets,

if accepted by the IRS, are valid only for the taxable year for which made. A

new valuation is required for succeeding taxable years. See Treas. Reg.

53.4942(a)-2(c)(4)(iv)(a).

(2) Five-year determinations. The value of any interest in real property may be

determined on a five-year basis, or in other words for the taxable year of the

valuation and four succeeding taxable years, provided the determination is

made by means of a certified, independent appraisal made in writing by a

qualified person who is neither a disqualified person with respect to, nor an

employee of, the private foundation and provided further that the valuation

made falls within the range of reasonable values for the appraised property.

See Treas. Reg. 53.4942(a)-2(c)(4)(iv)(b).

(3) Certified appraisal. An appraisal is certified only if it contains a statement at its

end that in the opinion of the appraiser the values placed on the assets

appraised were determined in accordance with valuation principles regularly

employed in making appraisals of such property using all reasonable valuation

methods. The foundation must keep a copy of the appraisal in its records.

(4) Replacement of five-year determinations. Any five-year determination of value

may be replaced during the five-year period by another five-year valuation

made according to the requirements for five-year valuations, or an annual

valuation made under the “Other Asset” requirements above. The most recent

valuation must be used in computing the foundation’s minimum investment

return.

(5) Five-year valuation. The five-year valuation must be made no later than the last

day of the first taxable year for which such new valuation is applicable.

(6) Presumptive validity of five-year valuation. A five-year valuation of a real

property interest, if properly made per the above-described rules, won’t be

disturbed by the IRS during the applicable five-year period even if the actual fair

market value of the property changes during that period. See Treas. Reg.

53.4942(a)-2(c)(4)(iv)(b).

(7) Methods of valuation. Commonly accepted methods of valuation must be used

in making an appraisal. Valuations made per the principles in the regulations

under Section 2031 constitute acceptable methods of valuation. “Appraisal”

means a determination of fair market value and is not to be construed in a

technical sense peculiar to property or any interests such as, for example,

mineral interests in real property. See Treas. Reg. 53.4942(a)-2(c)(4)(iv)(c).

H.3. Valuation Date

(1) Assets that are required to be valued on an annual basis may be valued as of

any day in the private foundation’s taxable year to which that valuation applies,

if the foundation follows a consistent practice of valuing those assets as of such

date in all taxable years. See Treas. Reg. 53.4942(a)-2(c)(4)(vi)(a).

(2) A valuation of an interest in real property pursuant to a certified, independent

appraisal made in writing by a qualified person may be made as of any day in

the first taxable year of the private foundation to which such valuation is to be

applied. See Treas. Reg. 53.4942(a)-2(c)(4)(vi)(b).

(3) Assets held for less than a taxable year. If an asset in the minimum investment

return base has been held for only part of a taxable year, it’s taken into account

in determining the minimum investment return by multiplying its fair market

value by a fraction, the numerator of which is the number of days in such

taxable year that the foundation held the asset and the denominator of which is

the number of days in that taxable year. See Treas. Reg. 53.4942(a)2(c)(4)(vii).

Qualifying Distributions

(1) “Qualifying distribution” is another crucial concept under Section 4942. It is the

amount subtracted from the distributable amount in computing the amount of

undistributed income taxable under Section 4942(a).

(2) Section 4942(g) defines “qualifying distributions.” In general, and without regard

to the specific limitations discussed below, a qualifying distribution pursuant to

Treas. Reg. 53.4942(a)-3(a)(2) means:

a. An amount paid to accomplish one or more purposes described in Section

170(c)(2)(B),

b. An amount paid to acquire an asset used (or held for use) directly in

carrying out one or more purposes described in Section 170(c)(2)(B), or

c. An amount set aside for a specific project that comes within one or more

purposes described in Section 170(c)(2)(B).

(3) Distributions or expenditures that are creditable against a private foundation’s

obligation to distribute its distributable amount are referred to as qualifying

distributions. Treas. Reg. 53.4942(a)-3(a)(2) defines the term qualifying

distribution as:

a. Any amount paid by a private foundation to accomplish one or more

purposes described in Section 170(c)(2)(B), or Section 170(c)(1) (amounts

paid to accomplish charitable, religious, and educational purposes or

amounts contributed to a governmental unit for exclusively public

purposes).

b. Any amount paid to acquire an asset used (or held for use) directly in

carrying out one or more purposes described in Section 170(c)(2)(B) or

Section 170(c)(1).

Any amount set aside which meets the criteria for set-asides.

d. Included in amounts paid for one or more purposes described in Section

170(c)(2)(B), or Section 170(c)(1), are amounts paid for program-related

investments, as defined in Section 4944(c). Also included is that portion of

reasonable and necessary expenses, direct and indirect, that a foundation

incurs in implementing these purposes. See Treas. Regs. 53.4942(a)3(a)(2)(i) and 53.4942(a)-3(a)(8).

e. For purposes of determining whether an organization is an operating

foundation under Section 4942(j)(3): If a foundation awards scholarships,

grants or other payments to individuals as a part of an active program in

which the foundation maintains some significant involvement, then such

scholarships, grants or other payments and related administrative expenses

are considered direct charitable activities. Examples of active programs and

a definition of the term "significant involvement" are contained in Treas.

Reg. 53.4942(b)-1(b)(2). Additional examples are in Treas. Reg.

53.4942(b)-1(d). Merely reviewing grant applications, interviewing, or

testing applicants, selecting grantees, and performing other related

administrative actions doesn’t constitute a significant involvement in an

individual grant program.

To determine whether an organization is an operating foundation under

Section 4942(j)(3): In determining whether any expenditure is for the direct

active conduct of a charitable activity, the definitions and special rules of

Section 4942(j)(3) and the related regulations (which define an operating

foundation) generally apply. However, except for expenses related to

"significant involvement" grants, grant administrative expenses don’t

constitute expenditures directly for the active conduct of charitable activities

even though they’re treated that way under Section 4942(j)(3). If a

foundation maintains some significant involvement in an individual grant

program, both the grants and the related grant administrative expenses

(and qualified set-asides for those purposes) are expenses of a direct

charitable activity. Direct charitable activities also include all qualifying

distributions that consist of amounts paid or set aside to acquire assets

used in the conduct of the foundation’s charitable activities, including its

grant programs whether or not the foundation maintained a significant

involvement in those programs. See Treas. Reg. 53.4942(b)-1(b)(1).

g. Examples of expenditures for direct charitable activities include, among

others, amounts paid or set aside to acquire or maintain the operating

assets of a museum, library, or historic site or to operate any such facility;

to provide goods, shelter, or clothing to indigents or disaster victims if the

foundation maintains some significant involvement in the activity rather than

merely making grants to the recipients; to conduct educational conferences

and seminars; to operate a home for the aged or disabled; to conduct

scientific, historic, public policy, or other research with significance beyond

the foundation’s grant program and which doesn’t constitute a proscribed

attempt to influence legislation; to publish and disseminate the results of

such research, reports of educational conferences, or similar educational

material; to support the service of foundation staff on boards or advisory

committees of other charitable organizations or on public commissions or

task forces; to provide technical advice or assistance to a governmental

body, a governmental committee or subdivision of either in response to a

written request by the governmental body, committee or subdivision; and to

conduct performance in the performing arts.

h. Expenses paid in connection with providing direct technical assistance to

grantees are also considered direct charitable activities. This assistance

must have significance beyond the purposes of the grants made to those

grantees and must not consist merely of monitoring or advising the

grantees in their use of the grant funds. Technical assistance involves

furnishing of expert advice and related assistance such as compliance with

governmental regulations; reducing operating costs or increasing program

accomplishments; fundraising methods; and maintaining complete and

accurate financial records. See Treas. Reg. 53.4942(b)-1(d).

Distributions to Another Private Foundation or to a Controlled IRC

501(c)(3) Organization

(1) General. Private foundations other than operating foundations primarily carry on

their charitable activity in an indirect manner by making grants to individuals or

to other organizations directly engaged in charitable activities. If, therefore, one

private foundation, A, makes a qualifying distribution to another foundation, B,

the stream of funds currently expended for active and direct charity will not, in

the ordinary case, be increased. In a related but different vein, if private

foundation A makes a distribution to an organization which A or its disqualified

persons (Section 4946) control, the common control may serve to unduly delay

use of the income in active charity. To ensure that distributions by private

foundation flow promptly into the stream of funds sustaining current direct

charitable activity, Section 4942 imposes strict requirements on distributions to

another private foundation or to a controlled organization. A distribution to

another private foundation or to a controlled organization may be counted as a

qualifying distribution of the contributor only if the recipient places an equivalent

amount in the active charitable stream within 12 months after the taxable year

in which the contribution is received. This and other conditions of the "12-month

pass-through" are discussed below.

(2) Meaning of Controlled Organization. Controlled organization, for purposes of

Section 4942, means an organization controlled, directly or indirectly, by the

contributing private foundation or one or more disqualified persons, as defined

in Section 4946, with respect to the contributing foundation. An organization is

controlled by a foundation or one or more disqualified persons with respect to

the foundation if any of such persons may, by aggregating their votes or

positions of authority, require the donee organization to make an expenditure or

prevent the donee organization from making an expenditure, regardless of the

method by which the control is exercised or exercisable. “Control" is determined

without regard to any conditions imposed upon the donee such as a restriction

on the way the distribution is to be used unless the restriction is described in

Treas. Reg. 1.507-2(a)(7). In general, it is the donee, not the distribution, which

must be controlled for the limitation to apply. Thus, the imposition of budgetary

control isn’t control within the meaning of this paragraph. The controlled

organization may be any type of exempt or nonexempt organization. See Treas.

Reg. 53.4942(a)-3(a)(3).

(3) When a private foundation with a carryover of excess qualifying distributions,

transfers all its assets to a private foundation controlled by the same persons

who controlled the transferor pursuant to Section 507(b)(2) the transferee may

reduce its distributable amount by the transferor’s carryover. Rev. Rul. 78-387,

1978-2 C.B. 270. See also Rev. Rul. 2002-28, 2002-1 C.B. 941, in which the

IRS issued a ruling addressing a private foundation’s responsibilities relating to

Section 507 and Sections 4940-4945 when it transferred all its assets to one or

more effectively controlled private foundations. The IRS concluded for the

Section 4942 issue that the transfers don’t constitute qualifying distributions for

the transferor foundation under Section 4942. A transferee foundation assumes

its proportionate share of the transferor foundation's undistributed income under

Section 4942 and reduces its own distributable amount for purposes of Section

4942 by its proportionate share of the transferor’s excess qualifying distributions

under Section 4942(i).

Payments to Certain Supporting Organizations

(1) A nonoperating private foundation may not count as a qualifying distribution

under Section 4942 any amount paid to (1) a non-functionally integrated Type

III supporting organization, or (2) any other Section 509(a)(3) supporting

organization if a disqualified person with respect to the foundation directly or

indirectly controls the supporting organization or a supported organization of

such supporting organization. See Section 4942(g)(4). The grant will also

constitute a taxable expenditure under Section 4945 if the private foundation

does not exercise expenditure responsibility with respect to the grant.

(2) Notice 2006-109, 2006-2 C.B. 1121. This notice offers guidance on four aspects

of applying these newer provisions of the Code:

a. Section 3 lists criteria for private foundations that might make distributions

to supporting organizations that can be used to determine for purposes of

Sections 4942(g)(4) and 4945(d)(4) whether an organization is a Type I,

Type II, or functionally integrated Type III supporting organization. Section 3

also provides criteria for determining whether a supporting organization, or

any of its supported organizations, are controlled by disqualified persons.

This Notice may continue to be relied upon as modified by Notice 2014-4,

2014-2 I.R.B. 274 (Jan. 6, 2014) and Revenue Procedure (Rev. Proc.)

2018-32, 2018-23 I.R.B. 739, which states that private foundations, for

grant making purposes under Sections 4942 and 4945, may rely on an

organization's supporting organization type to the extent set forth in Tax

Exempt Organization Search (Pub. 78 data) or the EO BMF Extract.

Section 3 of Notice 2006-109 also gives similar guidance for Section 4966

for donor advised funds that make grants to supporting organizations.

b. Section 4 clarifies the date the Section 4958(c)(3) excise tax applies on

certain excess benefit transactions involving supporting organizations.

Pursuant to the authority under Section 4966(d)(2)(C), Section 5.01

excludes certain employer-sponsored disaster relief funds from the

definition of donor-advised fund.

d. Section 5.02 clarifies how the IRS will apply Section 4966(a) excise taxes

for payments made per educational grants awarded before the PPA 2006

enactment date.

Accounting Principles Applicable to Qualifying Distributions

(1) An organization’s qualifying distributions will be determined solely on the cash

receipts and disbursements method of accounting. See Treas. Reg. 53.4942(a)3(a)(1).

Value of Property Distribution

(1) The amount of a qualifying distribution of property is the fair market value of the

property on the date the qualifying distribution is made. See Treas. Reg.

53.4942(a)-3(a)(1).

Funds Borrowed for Exempt Purposes

(1) Treas. Reg. 53.4942(a)-3(a)(4) describes the treatment of a private foundation’s

repayment of funds borrowed to make charitable expenditures. This type of

payment ordinarily isn’t a qualifying distribution; only the distribution or

expenditure of the borrowed funds for specific charitable, educational, or similar

purposes is treated as a qualifying distribution.

(2) Interest paid for borrowed funds is treated as a deduction from gross income in

the taxable year in which it is paid. See Treas. Reg. 53.4942(a)-3(a)(4)(iii).

Changes in Use of an Asset

(1) If an asset not used, or held for use, for exempt purposes is subsequently

converted to such a use, the foundation may treat the conversion as a

qualifying distribution. The amount of the qualifying distribution is the fair market

value of the asset as of the date of its conversion. Fair market value is

determined by making a valuation of the asset as of the conversion date in

accordance with the valuation rules discussed above. See Treas. Reg.

53.4942(a)-3(a)(5).

(2) The correct conversion date of real property converted from nonexempt to

exempt uses is the date the foundation adopts and immediately proceeds to

implement a plan for the exempt use, even though the actual conversion isn’t

completed until the following year. Rev. Rul. 78-102, 1978-1 C.B. 379.

Certain Foreign Organizations

(1) A private foundation may wish to treat grants to foreign grantees as qualifying

distributions that satisfy the distribution requirements imposed by Section 4942

and not as expenditures requiring expenditure responsibility in order to not be

subject to the excise tax on taxable expenditures imposed by Section 4945. If a

private foundation makes a good faith determination that a foreign grantee

qualifies as a qualifying public charity, the grant will generally be a qualifying

distribution that doesn’t require expenditure responsibility to not be a taxable

expenditure. A distribution for Section 170(c)(2)(B) purposes to a foreign

organization which has not received a ruling or determination letter that it is an

organization described in Section 509(a)(1), (2), or (3) or in Section 4942(j)(3)

will be treated as a distribution to an organization described in Section

509(a)(1), (2), or (3) (other than an organization described in Section

4942(g)(4)(A)(i) or (ii)) or in Section 4942(j)(3) if the distributing foundation has

made a good faith determination that the donee organization is an organization

described in Section 509(a)(1), (2), or (3) (other than an organization described

in Section 4942(g)(4)(A)(i) or (ii)) or in Section 4942(j)(3). See Treas. Reg.

53.4942(a)-3(a)(6)(i).

(2) A good faith determination that a foreign donee organization is described in

Section 509(a)(1), (2), or (3) (other than an organization described in Section

4942(g)(4)(A)(i) or (ii)) or in Section 4942(j)(3) ordinarily will be considered

made if both of the following are true:

a. It’s based on current written advice received from a qualified tax practitioner

concluding that the donee is an organization described in Section 509(a)(1),

(2), or (3) (other than an organization described in Section 4942(g)(4)(A)(i)

or (ii)) or in Section 4942(j)(3), and

b. The foundation reasonably relied in good faith on the written advice per the

requirements of Treas. Reg. 1.6664-4(c)(1). The written advice must give

sufficient facts on the operations and support of the donee organization for

the IRS to determine that the donee organization would be likely to qualify

as an organization described in Section 509(a)(1), (2), or (3) (other than an

organization described in Section 4942(g)(4)(A)(i) or (ii)) or in Section

4942(j)(3) as of the date of the written advice. See Treas. Reg. 53.4942(a)3(a)(6)(i).

(3) Rev. Proc. 2017-53, 2017-40 I.R.B. 263. This revenue procedure:

a. Modifies and supersedes Rev. Proc. 92-94, 1992-2 C.B. 507, which

provided a simplified requirement process that private foundations could

follow in making good faith determinations (also known as equivalency

determinations).

b. Reflects the changes to the equivalency determination final regulations

published in 2015 (Treasury Decision 9740), including the elimination of the

ability of a private foundation to rely on a grantee affidavit for purposes of

the special rule.

Reflects the changes to the public support tests for Section 170(b)(1)(A)(vi)

and Section 509(a)(2) organizations set forth in final regulations published

in 2011 (Treasury Decision 9549) and applies these changes in the context

of equivalency determinations.

d. Includes other updates and changes in response to comments from the

public.

Payment of Tax

(1) Payment of any tax imposed under Chapter 42 of the Code shall not be treated

as a qualifying distribution. See Treas. Reg. 53.4942(a)-3(a)(7).

Examples of Qualifying Distributions

(1) Treas. Reg. 53.4942(a)-3(a)(8) illustrates qualifying distributions with the

following examples:

Example 1: M, a private foundation which uses the calendar year as the

taxable year, makes the following payments in 1970: (i) a payment of $44,000

to five employees for conducting a foundation program of educational grants for

research and study; (ii) $20,000 for various items of overhead, 10% of which is

attributable to the activities of the employees mentioned in payment (i) of this

example and the other 90% of which is attributable to administrative expenses

which were not paid to accomplish any Section 170(c)(1) or (2)(B) purpose; and

(iii) a $100,000 general purpose grant paid to an educational institution

described in Section 170(b)(1)(A)(ii) which is not controlled by M or any

disqualified persons with respect to M. Payments (i) and (ii) of this example are

qualifying distributions to the extent of $46,000 ($44,000 of salaries and 10% of

the overhead, both of which are reasonable administrative expenses paid to

accomplish Section 170(c)(1) or (2)(B) purposes). Payment (iii) of this example

is also a qualifying distribution, since it is a contribution for Section 170(c)(2)(B)

purposes to an organization which isn’t described in Treas. Reg. 53.4942(a)3(a)(2)(i)(a) or (b). The other 90% of payment (ii) of this example may constitute

items of deduction under Treas. Reg. 53.4942(a)-2(d)(1)(ii) if such items

otherwise qualify.

Example 2: On February 21, 1972, N, a private foundation which uses the

calendar year as the taxable year, pays $500,000 for real property on which it

plans to build hospital facilities to be used for medical care and education. The

real property produces no income and the hospital facilities will not be

constructed until 1974 according to the set-aside plan submitted to and

approved by the IRS pursuant to Treas. Reg. 53.4942(a)-3(b). The purchase of

the land is a qualifying distribution under Treas. Reg. 53.4942(a)-3(a)(2)(ii). If,

however, the property were used to produce rental income for more than a

reasonable period of time before construction of the hospital is begun, then as

of the time such rental use becomes unreasonable (i) such purchase would no

longer be deemed to constitute a qualifying distribution under Treas. Reg.

53.4942(a)-3(a)(2)(ii) and (ii) the amount of the qualifying distribution would be

included in N’s gross income. See Treas. Regs. 53.4942(a)-2(c)(3)(i) and

53.4942(a)-2(d)(2)(iii)(b).

Example 3: In 1971, X, a private foundation engaged in holding paintings and

exhibiting them to the public, purchases an additional building to be used to

exhibit the paintings. Such expenditure is a qualifying distribution under Treas.

Reg. 53.4942(a)-3(a)(2)(ii). In 1975, X sells the building. Under Treas. Reg.

53.4942(a)-2(d)(2)(iii)(b), all the proceeds of the sale (less direct costs of the

sale) are included in X’s gross income for 1975.

Example 4: In January 1969, M, a private foundation which uses the calendar

year as the taxable year, borrows $10 million to give to N, a private college, for

the construction of a science center. M borrowed the money from X, a

commercial bank. M is to repay X at the rate of $1.1 million per year ($1 million

principal plus $0.1 million interest) for 10 years beginning in January 1973. M

distributed $5 million of the borrowed funds to N in February 1969, and the

other $5 million in March 1970. M files a statement with the form it is required to

file under Section 6033 for 1973 which contains the information required by

Treas. Reg. 53.4942(a)-3(a)(4)(ii)(b). Pursuant to M’s election, each repayment

of loan principal constitutes a qualifying distribution in the year of repayment.

Accordingly, the distribution of $5 million to N in March 1970 will not be treated

as a qualifying distribution. Each payment of interest ($0.1 million annually) with

respect to M’s loan from X is treated as a deduction under Treas. Reg.

53.4942(a)-2(d)(1)(ii) in the taxable year in which it’s made.

Example 5: Private foundation Y engages in providing care for the aged. Y

makes a distribution of cash to H, a hospital described in Section

170(b)(1)(A)(iii) which is not controlled by Y or any disqualified person with

respect to Y. The distribution is made subject to the conditions that H will invest

the money as a separate fund which will bear a name commemorating the

creator of Y and will use the income from such fund only for H’s exempt hospital

purposes which relate to care for the aged. Under these circumstances, the

distribution from Y to H is a qualifying distribution pursuant to Treas. Reg.

53.4942(a)-3(a)(2)(i).

(2) In addition, several revenue rulings illustrate IRS determinations on

classification of payments as qualifying distributions.

(3) In Rev. Rul. 74-560, 1974-2 C.B. 389, the IRS ruled that a private foundation

may not treat as a qualifying distribution an amount equal to straight-line

depreciation on a building it constructed for charitable purposes.

(4) In Rev. Rul. 75-495, 1975-2 C.B. 449, the IRS considered legal fees paid in a

suit brought to determine the proper beneficiary of a portion of a private

foundation’s net income. Because the payment was a reasonable and

necessary administrative expense, it met the requirements for classification as

a qualifying distribution.

(5) In Rev. Rul. 78-90, 1978-1 C.B. 380, the IRS ruled that low-interest loans made

to blind persons to enable them to establish themselves in business serve

charitable purposes and constitute program-related investments within the

meaning of Section 4944(c) and, accordingly, are qualifying distributions.

(6) In H. Fort Flowers Foundation, Inc. v. Commissioner, 72 T.C. 399 (1979), the

court agreed with the IRS that a private foundation’s use of its income to restore

to corpus an amount earlier contributed to a university wasn’t a qualifying

distribution. See also, GCM 39808 (Jan. 16, 1990), which states the IRS can

adjust the excess distribution carryover applicable for years not barred by the

statute of limitations by recalculating the distributable amount or the amount of

qualifying distributions for years that are closed.

Set-Asides

(1) Certain amounts set aside, rather than currently distributed, for one or more

purposes described in Section 170(c)(2)(B) or Section 170(c)(1), may be

treated as qualifying distributions.

(2) Under Section 4942(g)(2) and Treas. Reg. 53.4942(a)-3(b), as they existed

before the Tax Reform Act of 1976, a set-aside was treated as a qualifying

distribution only if it was approved in advance by IRS. To obtain this approval,

Section 4942(g)(2) required a private foundation to establish both that (i) the

set-aside would be paid for the specific project within five years and (ii) the

suitability of the set-aside would achieve the goals of the specific project

(suitability test).

(3) While the rules for advance approval remain unchanged, Section 4942(g)(2), as

amended by the Tax Reform Act of 1976, effective for set-asides made in

taxable years beginning after December 31, 1974, provides another way to treat

a set-aside as a qualifying distribution under which a private foundation must

distribute minimum amounts of cash during specific test years (cash distribution

test).

(4) The legislative history of the Tax Reform Act of 1976 states that the cashdistribution test was intended to alleviate a situation which was unforeseen at

the time of the 1969 Act that is, the case of new foundations or certain existing

foundations whose assets are suddenly multiplied many times over, which find

it impossible to meet the Section 4942 payout requirements in their early years

if their set-aside programs under the suitability test did not receive timely

advance IRS approval. There are two major advantages to the cash distribution

test:

a. The set-aside doesn’t need advance approval from IRS.

b. The private foundation doesn’t need to establish that the project for which

the amount is set-aside can be better accomplished by the set-aside than

by the immediate payment of funds.

S.1. Suitability Test

(1) Under Treas. Reg. 53.4942(a)-3(b)(1) and (2), a set-aside may be treated as a

qualifying distribution only if, at the time of the set-aside, the private foundation

shows the IRS that:

a. The set-aside amount will be paid for the specific project within 60 months

from the date of the first set-aside, and

b. The project is one which can be better accomplished by such set-aside than

by the immediate payment of funds.

(2) Specific Project defined. Under Treas. Reg. 53.4942(a)-3(b)(2), the term

"specific project" includes, but is not limited to, situations where relatively longterm grants or expenditures must be made to assure the continuity of particular

charitable projects or program-related investments or where grants are made as

part of a matching-grant program. "Specific project" may include, for example, a

plan:

a. To erect a building to house a direct charitable, educational, or other similar

exempt activity of the 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;

b. To purchase an additional group of paintings offered for sale only as a unit

which requires an expenditure of more than one year’s income; or

To fund a specific research program which is of sufficient magnitude to

require an accumulation prior to commencement of the research, even

though not all the details of the program have been finalized.

S.2. Revenue Rulings

(1) In Rev. Rul. 75-511, 1975-2 C.B. 450, a foundation whose primary activity was

making renewable scholarships and fixed sum research grants was unable to

show that its grant-making program could be better accomplished by using setasides than by the immediate payments of funds.

(2) Rev. Rul. 75-511, in quoting the applicable regulations, further states that

specific projects of the kind that might qualify for a set-aside are those involving

relatively long-term grants or expenditures that must be made in order to assure

the continuity of particular charitable projects; for example, a plan to fund a

specific research program which is of such magnitude as to require an

accumulation of funds prior to commencement of the research. The ruling also

states that the foundation’s grant-making program is regularly carried on as part

of its normal ongoing charitable activities. In most instances, the foundation had

been able to fund these activities out of current income, and it had given no

compelling reasons why it couldn’t continue to fund its grant-making program in

this manner. Under these circumstances, the ruling concluded that the

foundation hadn’t shown that its grant-making program could be better

accomplished using set-asides than by the immediate payment of funds.

However, while this conclusion is still correct under the suitability test, this

factual situation could now qualify under the cash distribution test, assuming the

other parts of that test are satisfied, because the foundation need not show that

its grant-making program could be better accomplished using set-asides than

by the immediate payment of funds.

(3) In Rev. Rul. 77-7, 1977-1 C.B. 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.

(4) In Rev. Rul. 74-450, 1974-2 C.B. 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".

(5) Rev. Rul. 74-450 further states that entering into the above contract would

commit the organization to a major project costing substantially more than the

foundation’s total available income on an annual basis, notwithstanding the fact

that a major part of the required disbursement wouldn’t fall due until after the

entire project was well along towards completion. Therefore, the project is one

which can be better accomplished by a set-aside than by the immediate

payment of funds.

S.3. Advance Approval

(1) According to Treas. Reg. 53.4942(a)-3(b)(7)(i), 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. The regulations state that the request for

advance approval of a set-aside under the suitability test must include:

a. A statement describing the nature and purposes of the specific project and

the amount of the set-aside for which approval is requested;

b. 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;

d. 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(s) (general or specific) of any physical facilities to be acquired or

constructed as part of the project; and

e. A statement by an appropriate foundation manager (as defined in Section

4946(b)) 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.

S.4. Cash Distribution

(1) In general, the cash distribution test under Treas. Reg. 53.4942(a)-3(b)(3) is

satisfied if:

a. 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;

b. The private foundation actually distributes in cash or its equivalent for a

Section 170(c)(1) or (2)(B) purpose (a charitable purpose) the "start-up

period minimum amount" during the foundation’s "start-up period" (see

below definitions for both phrases); and

The private foundation distributes in cash or its equivalent for a charitable

purpose, the "full-payment period minimum amount" in each taxable year of

the foundation’s "full-payment period" (both phrases are described below).

(2) For these tests, 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.

S.5. Minimum Distribution Required During Start-Up Period

(1) For foundations created after December 31, 1971 (or for organizations that first

become foundations after that date), the "start-up period" is the four taxable

years following the taxable year in which the foundation was created or became

a foundation. For these purposes, a foundation will be considered created in the

taxable year in which its distributable amount (Section 4942(d)) first exceeds

$500. See Treas. Reg. 53.4942(a)-3(b)(4).

(2) Under Treas. Reg. 53.4942(a)-3(b)(4)(ii), the start-up period minimum amount

is the amount a foundation must distribute in its start-up period and can’t be

less than the sum of:

a. 20% of its distributable amount for the first taxable year of the start-up

period,

b. 40% of its distributable amount for the second taxable year of the start-up

period,

60% of its distributable amount for the third taxable year of the start-up

period, and

d. 80% of its distributable amount for the fourth taxable year of the start-up

period.

(3) The above requirement means that the total amount must be distributed before

the end of 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. See Treas.

Reg. 53.4942(a)-3(b)(4)(iii).

(4) Examples. Treas. Reg. 53.4942(a)-3(b)(4)(v) provides the following examples to

illustrate this principle.

Example 1: F, a private foundation created on January 1, 1975, uses the

calendar year as its taxable year. The start-up period for F is January 1, 1976,

through December 31, 1979. F has distributable amounts under Section

4942(d) for taxable years 1976 through 1979 in the following amounts: 1976,

$100,000; 1977, $120,000; 1978, $150,000; 1979, $200,000. F’s start-up period

minimum amount is the sum of the following amounts: 20% of $100,000

($20,000); 40% of $120,000 ($48,000); 60% of $150,000 ($90,000); and 80% of

$200,000 ($160,000); which equals $318,000. Thus, F is required to distribute

at least $318,000 in cash or its equivalent during the start-up period.

Example 2: F, a private foundation created in 1969, uses the calendar year as

its taxable year. F’s start-up period is the calendar years 1972 through 1975. F

makes two cash distributions in 1972. The first distribution is made because of

a set-aside made in 1969. Under Section 4942(g), that distribution is treated as

a qualifying distribution made in 1969. The second distribution is treated under

Section 4942(h) as made from F’s undistributed income for 1971. In addition, F

makes a cash distribution in 1976 that is treated under Section 4942(h) as

made from F’s undistributed income for 1975. In determining whether F had

distributed its start-up period minimum amount within the start-up period, the

1972 distributions are both considered because they were made during F’s

start-up period. The 1976 distribution is not considered, however, because that

distribution was not actually made during F’s start-up period.

(5) Exception. Generally, only a distribution made during the start-up period is

considered in determining whether a foundation has distributed the start-up

period minimum amount. However, in the case of a foundation created after

December 31, 1971 (or which first became a foundation after that date), a

distribution made during the taxable year in which it was created (the year

preceding the first taxable year of its start-up period) may be treated as a

distribution made during the start-up period. In addition, a distribution made

within 5 1/2 months after the end of the start-up period will be treated as a

distribution made during the start-up period if (see Treas. Reg. 53.4942(a)3(b)(4)(iv):

a. The foundation was unable to determine its distributable amount for the

fourth taxable year of the start-up period until after it ended, and

b. The foundation made distributions before the end of the start-up period

based on a reasonable estimate of its distributable amount for the fourth

taxable year of the start-up period.

S.6. Minimum Distribution Required During Full-Payment Period

(1) A private foundation’s full-payment period is each taxable year that begins after

the end of the start-up period. During this period, it must distribute in cash or

equivalent 100% of its distributable amount (Section 4942(d)) with respect to

the taxable year (without regard to Section 4942(i)). See Treas. Reg.

53.4942(a)-3(b)(5)(ii).

(2) For taxable years beginning after December 31, 1975, if a foundation distributes

more than the full-payment period minimum amount for a taxable year, the

excess can be carried forward to reduce the full-payment period minimum

amount for the next 5 taxable years (referred to as an "adjustment period"). An

excess distribution made in one taxable year must be completely applied to

future years before a subsequent excess distribution can be considered. See

Treas. Reg. 53.4942(a)-3(b)(5)(iii).

(3) Generally, pursuant to Treas. Reg. 53.4942(a)-3(b)(5)(iv), only a distribution

made during a taxable year of the full-payment period may be considered in

determining whether a foundation has distributed the full payment period

minimum amount for a taxable year. Treas. Reg. 53.4942(a)-3(b)(5)(v) provides

the following examples to show this rule.

Example 1: F, a private foundation created on January 1, 1973, uses the

calendar year as its taxable year. F has a start-up period of January 1, 1974,

through December 31, 1977, and a full-payment period that includes every

taxable year beginning after December 31, 1977. F’s distributable amount (as

determined under Section 4942(d)) for 1978 is $500,000. Thus, F’s full-payment

minimum amount for 1978 is $500,000. During 1978 F distributes $100,000 in

cash to Charity X and $400,000 in cash to Charity Y because of a set-aside

made in 1973. F has distributed its full-payment period minimum amount for

1978 because it has made actual cash distributions during that year which total

$500,000. However, F has made qualifying distributions (as determined under

Section 4942(g)) with respect to 1978 of only $100,000. To avoid liability for the

tax on undistributed income under Section 4942(a), F must distribute or setaside an additional $400,000 before January 1, 1980.

Example 2: Assume the facts as stated in Example 1 except that in 1978 F

makes cash distributions totaling $600,000. Since the total cash distributions

made in 1978 ($600,000) exceed the full-payment period minimum amount for

1978 ($500,000), there exists a $100,000 excess which must be used by F to

reduce its full-payment period minimum amounts for the years 1979-1983 (the

taxable years in the adjustment period with respect to the 1978 excess).

Therefore, if F’s distributable amount (as determined under Section 4942(d)) for

1979 is $500,000, F’s full-payment period minimum amount for 1979 is

$400,000 ($500,000 – $100,000). See Treas. Reg. § 53.4942(a)-3(b)(5)(v).

S.7. Failure to Distribute Minimum Amounts

(1) Under Treas. Reg. 53.4942(a)-3(b)(6)(i), if a foundation fails to distribute the

start-up period minimum amount during the start-up period or the full-payment

period minimum amount during the full-payment period:

a. Any set-aside made during either period that wasn’t approved in advance

under the suitability test will not be treated as a qualifying distribution.

b. Any set-aside made after the taxable year in which the failure to distribute

took place won’t be treated as a qualifying distribution unless it is approved

under the suitability test.

(2) So, in this situation a deficiency may be assessed under Section 4942(a). In

addition, Section 6501(l)(3) has a special rule for the period within which a

deficiency may be assessed.

(3) However, Treas. Reg. 53.4942(a)-3(b)(6)(ii) notes that if the failure to distribute

the full-payment period minimum amount was not willful and was due to

reasonable cause, the foundation is allowed to correct the failure to distribute.

Correction by distribution of cash must occur during the correction period as

defined in Section 4963(e), determined for the earliest taxable event (Section

4963(e)(2)(A)) that would result if the failure to distribute were not corrected.

This distribution to correct is treated as made during the taxable year in which

the failure to distribute occurred. If the failure to distribute is because the fullpayment period minimum amount could only be determined after the end of the

taxable year, no "willful failure to distribute" will occur if the foundation makes an

additional distribution within 5 1/2 months after the end of the taxable year.

S.8. Cash Distribution Test

(1) Approval and Information Requirements. Prior approval of a set-aside under the

cash distribution test isn’t required. Instead, for taxable years ending after April

2, 1984, Treas. Reg. 53.4942(a)-3(b)(7)(ii) provides that the foundation must

attach the following information to its annual information return for the taxable

year in which the set aside is made:

a. A statement describing the nature and purposes of the specific project for

which amounts are to be set aside;

b. A statement that the amount set aside will be paid for the specific project

within a specified period not to exceed 60 months;

A statement that the project will not be completed before the end of the

taxable year in which the set-aside is made;

d. A statement showing the distributable amounts determined under Section

4942(d) for any past taxable years in the private foundation’s start-up and

full-payment periods; and

e. A statement showing the aggregate amount of actual payments made in

cash for charitable purposes during each taxable year in the foundation’s

start-up and full-payment period. This statement should include a detailed

description of any payments that are to be treated as distributed during a

taxable year before the taxable year in which those payments were actually

made (under Treas. Reg. 53.4942(a)-3(b)(4)(iv) and (6)(ii)) and, in addition,

should explain the circumstances that justify the application of those rules.

Note: For the five taxable years following the year in which the amount is

set-aside, this attachment must include the statements required in (d) and

(e).

S.9. Evidence of Set-Asides

(1) A set-aside that is approved under the suitability test or which satisfies the cash

distribution test need only be noted as a bookkeeping entry on the foundation’s

books of account signifying a pledge or obligation to be paid at a future date(s).

See Treas. Reg. 53.4942(a)-3(b)(8). Rev. Rul. 78-148, 1978-1 C.B. 380, held

that a foundation, that otherwise meets the requirements for a set-aside under

the suitability test, may make a set-aside by means of a bookkeeping entry,

consisting of the amount by which its minimum investment return for its

immediately preceding taxable year exceeds its adjusted net income for that

year.

(2) If the suitability test is otherwise satisfied, the 60-month period for paying the

amount set-aside may, for good cause shown, be extended.

S.10. Contingent Set-Asides

(1) If a foundation is involved in litigation and can’t distribute assets or income

because of a court order, the foundation may seek and obtain a contingent setaside. The amount of the set-aside will be limited 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, would have been distributed. If the litigation

encompasses more than one taxable year, the foundation may seek additional

contingent set-asides. These amounts must be distributed by the last day of the

taxable year following the taxable year in which the litigation is terminated. See

Treas. Reg. 53.4942(a)-3(b)(9).

III. Other Considerations

(1) There are other considerations to analyze when examining a transaction that

may fall within the definition of Section 4942.

Twelve-Month Pass-Through

(1) Under Treas. Reg. 53.4942(a)-3(c)(1), a contribution to a controlled Section

501(c)(3) organization or to a private foundation which is not an operating

foundation will be treated as a qualifying distribution in the year in which it is

made, if:

a. The donee organization, in turn, makes a distribution equal to the full

amount of such contribution not later than the close of the first taxable year

after the taxable year in which it received the contribution,

b. The donee organization’s distribution of the contribution is a qualifying

distribution which is treated under Section 4942(h) as a distribution out of

the donee’s corpus (or would be so treated if the donee were a private

foundation which is not an operating foundation) and

The private foundation making the contribution obtains adequate records or

other sufficient evidence from the donee organization which: shows that the

donee organization has made a qualifying distribution of the contribution;

shows the names and addresses of the recipients thereof; and shows that

as to the donee the distribution is treated as made out of corpus under

Section 4942(h) or would be so treated if the donee were a private

foundation which is not an operating foundation. This condition in effect

generally requires that the donee organization have no undistributed

income with respect to the taxable year preceding its compensatory

qualifying distribution since, under Section 4942(h), distributions may be

allocated to corpus only after undistributed income of the preceding taxable

year has been distributed. See Section 4942(h)(2) and Treas. Reg.

53.4942(a)-3(d)(2).

(2) Use of pass-through for administrative expense. "Qualifying distributions"

include expenditures for reasonable administrative expenses. If the donee

expends the contribution for an administrative expense which is part of a

Section 170(c)(1) or 170(c)(2)(B) expenditure and can’t reasonably account

separately for the contribution, the donee’s statement setting forth the purpose

for which the expenditure was made and that the amount was distributed as a

corpus distribution will satisfy the requirements of (1)(c) above.

(3) Distribution requirements. Not later than the close of the first taxable year after

the taxable year of receipt of any contribution described in this section, the

donee organization must distribute an amount equivalent in value to such

contribution. The compensating distribution must be attributable to the donee’s

corpus; so, the donee must first distribute any undistributed income for the prior

taxable year. See Treas. Reg. 53.4942(a)-3(c)(2)(i).

(4) Failed pass-through. If a donee organization fails to entirely redistribute passthroughs of a prior taxable year by the close of the succeeding taxable year,

any redistributions are deemed made pro rata out of all pass-throughs received

in the prior taxable year regardless of any earmarking by the donee. A failed

pass-through is taken back into gross income of the donor foundation in the first

taxable year succeeding the donee’s first taxable year following donee’s taxable

year of receipt. See Treas. Reg. 53.4942(a)-3(c)(2)(i).

(5) Value of contribution. The fair market value of contributed property is

determined as of the date of the contribution. Such fair market value must be

used in determining whether an amount equal in value to the contribution has

been redistributed. See Treas. Reg. 53.4942(a)-3(c)(2)(i).

(6) Characterizing donee’s qualifying distribution. In determining whether the donee

of a pass-through has made compensating distributions out of its corpus in the

taxable year succeeding the contribution, characterization of the origin of the

donee’s qualifying distributions in those succeeding taxable years is made at

the end thereof. Unless the donee organization has made an election under

either Treas. Reg. 53.4942(a)-3(d)(2) or Treas. Reg. 53.4942(a)-3(c)(2)(iv) to

vary the normal treatment of qualifying distributions, amounts distributed in the

succeeding taxable year are allocated first to undistributed income of the

donee’s prior taxable year, then to undistributed income of its current taxable

year, and then to corpus. When a qualifying distribution is determined to be

attributable to corpus, that distribution is charged to pass-through contributions

received in the donee’s immediately preceding taxable year. See Treas. Reg.

53.4942(a)-3(c)(2)(ii).

Applying Prior Corpus Distributions

(1) The pass-through distribution requirement may be satisfied under an election to

treat distributions out of corpus in certain prior taxable years as a current

distribution out of corpus. See Treas. Reg. 53.4942(a)-3(c)(2)(iv). This

treatment of prior distributions from corpus may be applied, at the election of

the foundation, in satisfaction of pass-through requirements both for a

contribution from another foundation and a contribution from an individual made

under the provisions of Section 170(b)(1)(F)(ii). To be available for treatment as

a current distribution out of corpus, the prior distribution out of corpus:

a. Must have been distributed as a distribution out of corpus under the

provisions of Section 4942(h),

b. Must not have been availed of for any other purpose, for example, in

satisfaction of redistribution requirements on some other contribution,

Must have occurred within the preceding five years, and

d. May not be later availed of for any other purpose.

(2) The election to treat a prior distribution out of corpus as a current distribution

out of corpus is made by attaching a statement to the return the foundation is

required to file under Section 6033 with respect to the taxable year for which the

election is to apply. The statement must contain a statement by an appropriate

foundation manager, within the meaning of Section 4946(b)(1), that the

foundation is making an election under the provisions of Treas. Reg.

53.4942(a)-3(c)(2)(iv), and that the distribution is made out of the undistributed

income of a prior taxable year(s) which was treated under Treas. Reg.

53.4942(a)-3(d)(1)(iii) as a distribution out of corpus. See Treas. Reg.

301.9100-1 regarding an extension of time for making certain elections.

(3) Treas. Reg. 53.4942(a)-3(c)(3) illustrates the pass-through requirements with

the following examples.

Example 1: In 1972 M, a private foundation, contributes out of 1971 income to

X, a private non-operating foundation. The contribution is the only one received

by X in 1972. In 1973, X makes a qualifying distribution to an art museum

maintained by an operating foundation in an amount equal to the amount of the

contribution received from M. X also distributes all its undistributed income for

1972 and 1973 for other purposes described in Section 170(c)(2)(B). Under

Treas. Reg. 53.4942(a)-3(d), the distribution to the museum is treated as a

distribution out of corpus. Thus, M’s contribution to X is a qualifying distribution

out of M’s 1971 income provided M obtains adequate records or other sufficient

evidence from X showing the nature and amount of the distribution made by X,

the identity of the recipient, and the fact that the distribution is treated as made

from corpus. If X’s qualifying distributions during 1973 had been equal only to

M’s contribution to X and X’s undistributed income for 1972, X could have made

an election under Treas. Reg. 53.4942(a)-3(d)(2) to treat the amount distributed

in excess of its 1972 undistributed income as a distribution out of corpus and in

that manner satisfied the pass-through distribution requirements.

Example 2: Assume the facts stated in example 1, except that X is a private

college described in Section 170(b)(1)(A)(ii) which is controlled by disqualified

persons with respect to M and that the records which X furnishes to M show

that the distribution would have been treated as made out of corpus if X were a

private non-operating foundation. Under these circumstances, the result is the

same as in example 1.

Example 3: Assume the facts stated in example 1, except that X makes a

distribution to the museum equal only to one-half of the contribution from M,

that the remainder of such contribution is added to X’s funds and used to pay

charitable administrative expenses, and that the records obtained by M from X

are not sufficient to show the amounts distributed or the identities of the

recipients of the distributions. The contribution by M to X will be a qualifying

distribution only to the extent that M can obtain (i) other sufficient evidence

(such as statements from officers or employees of X or from the museum)

showing the facts required by Treas. Reg. 53.4942(a)-3(c)(1) and (ii) a

statement from X setting forth that the remainder of the contribution was used

for charitable administrative expenses which constituted qualifying distributions

described in Treas. Reg. 53.4942(a)-3(a)(2)(i).

Example 4: X and Y are private non-operating foundations. A is an exempt

organization which is not described in Section 501(c)(3) but which supervises

and conducts a program described in Section 170(c)(2)(B). Y, but not X,

controls A within the meaning of Treas. Reg. 53.4942(a)-3(a)(3). In 1972, X and

Y each makes a grant to A of $100, specifically designated for use in the

operation of A’s Section 170(c)(2)(B) program. X has made a qualifying

distribution to A because the distribution is one described in Treas. Reg.

53.4942(a)-3(a)(2)(i). However, because A is controlled by Y, Y’s grant of $100

to A does not constitute a qualifying distribution. Furthermore, because A is not

an exempt organization described in Section 501(c)(3), Y’s grant to A does not

constitute a qualifying distribution.

Example 5: N, a private non-operating foundation, had distributable amounts of

$100 in 1970 and $125 in 1971. In 1970 N received total contributions of $540:

$150 from Y, a public charity; $70 from Z, a private foundation; $140 from Q, a

private foundation, subject to the requirement that N earmark the amount and

distribute it before distributing Z’s contribution; and, $180 from R, also a private

foundation. However, R specifically instructed N that such contribution did not

have to be redistributed because R already had made enough qualifying

distributions to avoid all Section 4942 taxes. N is not controlled by Y, Z, Q, or R

and N made no qualifying distributions in 1970. By the close of 1971, N had

made qualifying distributions of $420, earmarking $140 as having been a

distribution of Q’s contribution, but had made no election under Treas. Reg.

53.4942(a)-3(d)(2) to have any amount distributed which was in excess of N’s

1970 undistributed income treated as distributed out of corpus. Therefore, the

first $225 of qualifying distributions made in 1971 (the sum of $100 and $125,

N’s distributable amounts for 1970 and 1971, respectively) are treated as

amounts described in Treas. Reg. 53.4942(a)-3(d)(1)(i) and (ii). Since Y’s

contribution is a contribution from a public charity and does not have to be

"redistributed" and since R specifically instructed N that its contribution need not

be "redistributed", the remaining $195 of qualifying distributions will be treated

as distributed pro rata from Z’s and Q’s contributions, regardless of N’s

earmarking. Accordingly, of Z’s original qualifying distribution of $70 only $65

($195 multiplied by $70, Z’s contribution, over $210, the total ($70 plus $140) of

Z’s and Q’s contributions) will be treated as redistributed by N. Similarly, of Q’s

original qualifying distribution of $140 only $130 ($195 multiplied by $140 over

$210) will be treated as redistributed by N. Thus, Z’s gross income for 1972 will

be increased by $5 ($70 less the $65 redistributed), and Q’s gross income for

1972 will be increased by $10 ($140 less the $130 redistributed).

Transfer by Donee to Secondary Recipient

(1) Treas. Reg. 53.4942(a)-3(c)(4) states that where a private foundation makes a

distribution to organization X which in turn uses that distribution to make a

distribution to organization Y, the latter distribution is not considered a

contribution by the private foundation to organization Y if the private foundation

doesn’t earmark the use of the contribution for any named secondary recipient

and doesn’t retain power to cause the selection of the secondary recipient by

organization X. This rule of non-attribution applies even though the contributing

foundation has reason to believe that certain organizations will benefit from its

contribution so long as the original donee organization exercises control in fact

over the selection process and makes the selection completely independently of

the contributing foundation.

Set-Aside by Donee

(1) An amount contributed by a private foundation to another private foundation

that, in the taxable year following the 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. Rev.

Rul. 78-45, 1978-1 C.B. 378.

Treatment of Qualifying Distributions

(1) 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) and Treas. Reg.

53.4942(a)-3(d)(1) state that the amount of any qualifying distribution is treated

as made of:

a. First, any undistributed income of the immediately preceding taxable year (if

the private foundation was subject to the initial excise tax of Section

4942(a) for such year) to the extent thereof;

b. Second, out of the undistributed income for the taxable year to the extent

thereof; and

Then, out of corpus.

(2) Treas. Reg. 53.4942(a)-3(d)(3) illustrates the treatment of qualifying

distributions.

Election as to Treatment of Certain Qualifying Distributions

(1) If a private foundation has no undistributed income for the immediately

preceding taxable year, a qualifying distribution made in its current taxable year

would normally be treated as made from the undistributed income of the current

taxable year, and then out of corpus. If no undistributed income remains for the

preceding taxable year, a private foundation may elect to vary the normal

crediting sequence to credit a qualifying distribution in the current taxable year

to a taxable year or years prior to the immediately preceding taxable year, or to

corpus. See Treas. Reg. 53.4942(a)-3(d)(2).

(2) This election’s availability is significant where an under-distribution has

occurred for a prior taxable year and the taxable period remains open for that

year.

(3) Treas. Reg. 53.4942(a)-3(d)(3) illustrates the effect of an election with the

following example: 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 makes an approved set-aside of $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) regarding M’s undistributed income

for 1981 is mailed to M under Section 6212(a). M notifies the IRS in writing on

March 24, 1983, that it is making an election under Treas. Reg. 53.4942(a)3(d)(2), and that its distribution of January 14th (to the extent it exceeds

undistributed income for 1982) is to be applied first against undistributed

income for 1981. Thus, under these facts and circumstances, an initial excise

tax of $45 (15% of $300) is imposed by Section 4942(a). Since M made the

election described above, the $300 of undistributed income for 1981 is treated

as distributed during the correction period (as defined in Treas. Reg.

53.4942(a)-1(c)(3)), and therefore no additional excise tax will be imposed. In

addition, $200 ($700 minus $500) of the $700 qualifying distribution is treated

as made of undistributed income for 1983.

Note: The above example uses the outdated 15% tax rate for the initial excise

tax. The current initial excise tax rate is 30%.

Method of Making Election

(1) Treas. Reg. 53.4942(a)-3(d)(2) notes that an election to vary the normal

sequence for treatment of qualifying distributions is made by filing a statement

with the IRS during the taxable year in which such qualifying distribution is

made or by attaching a statement to the return required to be filed by the

foundation with respect to the taxable year in which the qualifying distribution

was made. See also Rev. Proc. 74-41, 1974-2 C.B. 495. The statement must

contain a foundation manager’s declaration that the foundation is making a

Section 4942(h) election and must specify whether the distribution is made of

the undistributed income of a designated prior taxable year (or years) or is

made from corpus. An election made during the taxable year in which the

qualifying distribution is made may be revoked in whole or in part by the filing of

a revocation statement with the foundation’s annual return for the taxable year

in which the qualifying distribution was made.

Carryover of Excess Qualifying Distributions

(1) Under Section 4942(i) 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 which is the

five taxable years immediately following the taxable year in which the excess

distribution occurred.

(2) GCM 39808 (Jan. 16, 1990). The IRS can adjust the excess distribution

carryover applicable for years not barred by the statute of limitations by

recalculating the distributable amount or the amount of qualifying distributions

for years that are closed.

Reduction of Distributable Amount

(1) Under Section 4942 (g)(2)(D) and Treas. Reg. 53.4942(a)-3(e)(1), the

distributable amount for a taxable year in the adjustment period is reduced to

the extent of the lesser of:

a. the excess of qualifying distributions made in prior taxable years to which

such adjustment period applies, or

b. the remaining undistributed income at the close of such taxable year after

applying any qualifying distributions made in such taxable year to the

distributable amount for such taxable year (determined without regard to

this paragraph).

(2) If during any taxable year of the adjustment period there is created another

excess of qualifying distributions, such excess isn’t considered until any earlier

excess of qualifying distributions has been completely applied against

distributable amounts during its adjustment period.

Excess Qualifying Distributions

(1) An excess qualifying distribution is a distribution of either undistributed income

or corpus with respect to a taxable year beginning after December 31, 1969,

that exceeds the distributable amount for that taxable year. See Treas. Reg.

53.4942(a)-3(e)(2).

Adjustment Period

(1) The taxable years in the adjustment period are the five taxable years

immediately following the taxable year in which an excess of qualifying

distributions is created. Section 4942(g)(2)(E) and Treas. Reg. 53.4942(a)3(e)(3). So, an excess can’t be carried over beyond five succeeding taxable

years. If at the time when it is carrying an excess of qualifying distributions, a

foundation ceases to be subject to the Section 4942(a) excise tax, for example,

by qualifying as an operating foundation, the excesses are extinguished for

purposes of this section even if the organization again becomes subject to

Section 4942(a) tax. See Treas. Reg. 53.4942(a)-3(e)(4) which gives examples

on applying the carryover provisions.

(2) Rev. Rul. 78-387, 1978-2 C.B. 270 describes a private foundation that

transferred all its assets to another private foundation controlled by the same

persons who controlled the transferor foundation. The transferor had a

carryover of excess qualifying distributions. Under Treas. Reg. 1.507-3(a)(9)(i)

the controlled transferee is treated as if it were the transferor. Accordingly, it

may reduce its distributable amount by the transferor’s carryover.

IV. Examination Techniques

(1) This section focuses on how to calculate and assert the excise tax once it has

been determined that the foundation has failed to meet its distribution

requirements. It also contains information relevant to examinations of private

foundations in general.

Introduction

(1) Section 4942 taxes don’t pyramid like continuing acts of self-dealing, but a

failure to distribute in a given year may give rise to tax in multiple years in the

taxable period similar to discrete acts of self-dealing. Also, if there is a failure to

distribute in one year, there may be a failure to distribute in subsequent years.

Section 4942 may be triggered when an otherwise “qualifying distribution” is

disqualified.

Chapter 42 First Tier Excise Taxes Table

(1) The table below identifies the parties subject to the Chapter 42 excise taxes

(initial/first tier taxes generally applicable to private foundations under

subchapter A), the applicable tax rates before and after the implementation of

PPA 2006, and what limit, if any, applies to the tax, and if so, how much.

(2) The Taxpayer Certainty and Disaster Tax Relief Act (TCA) 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 (former Section 4940(e)). The changes

are effective for taxable years beginning after December 20, 2019.

Code Section

Liable Party

Tax Rate

(PPA 2006*)

Limit (PPA 2006*)

TCA

Before

After

Before

After

4940(a)

up to 2%

None

1.39%**

4941(a)(1)

Self-dealer

10%

None

No change

4941(a)(2)

2.5%

$10,000 per act

$20,000 per act

No change

4942(a)

15%

30%

None

No change

4943(a)(1)

10%

None

No change

4944(a)(1)

10%

None

No change

4944(a)(2)

10%

$5,000 per act

$10,000 per act

No change

4945(a)(1)

10%

20%

None

No change

4945(a)(2)

2.5%

$5,000 per act

$10,000 per act

No change

*The tax rate changes are effective for full tax years that begin after August 17, 2006.

**The tax rate changes are effective for full tax years after December 20, 2019.

(3) If an organization or individual incurs an excise tax under Sections 4941, 4942,

4943, or 4944 in a given year, then the first tier tax is imposed that year and

each subsequent tax year or partial year in the taxable period (but under

Section 4943, only for tax years that end within the taxable period).

Note: If a foundation has undistributed income under Section 4942 for its first

taxable year that remains undistributed as of the end of its second taxable year,

then the Form 4720 instructions treat the Section 4942 tax on the undistributed

income as imposed as of the end of its second taxable year and reportable on

Form 4720 for its second taxable year (normally due May 15 of its third taxable

year for a calendar year filer).

(4) For Sections 4941, 4943, and 4944, the taxable period doesn’t end until the

earliest of:

a. Full correction (in the case of Section 4943 when the excess business

holding is eliminated, or in the case of Section 4944, when the amount

invested is removed from jeopardy),

b. Assessment, or

Issuance of a notice of deficiency.

(5) For Sections 4942 and 4945, the taxable period ends on the earliest of:

a. Issuance of a notice of deficiency, or

b. Assessment.

Note: The notice of deficiency should reflect taxes owed for all years and partial

years up to the date of notice, as a second notice of deficiency might not be

allowed for taxes on the same act or failure to act (See Section 6212(c)).

(6) Under Section 4945, there is only one first tier tax in the taxable period (unlike

Sections 4941-4944).

(7) Use the tax year of the disqualified person for Section 4941 (Rev. Rul. 75-391,

1975-2 C.B. 446). Similarly, use the tax year of the private foundation for tax

paid by the private foundation under Section 4940 or 4942-4945, and the tax

year of the foundation manager for foundation manager taxes under Sections

4941, 4944 and 4945.

(8) Except for Section 4940, excise taxes are reported on Form 4720, Return of

Certain Excise Taxes Under Chapters 41 and 42 of the Code. Previously, for

years prior to 2020, if the taxpayer was a self-dealer, disqualified person,

organization or foundation manager, donor or donor adviser, or related person,

the taxpayer completed Part II of the Form 4720 to report the tax. When Part II

was processed, the Form 4720 was designated as Form 4720-A. Alternatively,

such taxpayer (described above) had the option to report liability for excise tax

on the return filed by the organization, assuming that both had the same taxable

year. For tax years beginning in 2020, each taxpayer must file a separate Form

4720. Form 4720 has been revised to identify whether the filer is the

organization or another taxpayer subject to the Chapter 42 excise taxes.

Accordingly, for tax years after 2019, an agent preparing the Form 4720 under

substitute for return (SFR) procedures to report a taxpayer’s excise tax liability

during an examination will no longer convert the Form 4720 to “Form 4720-A.”

The revenue agent will, instead, complete a Form 4720 identifying the filer as

described in the instructions for Form 4720. Please see the instructions for

Form 4720 and Notice 2021-01, 2021-2 I.R.B. 315, for further information.

Note: Electronic filing of the Form 4720 is required for private foundations for

Form 4720 returns due on or after July 15, 2021. A limited exception applies for

2020 Form 4720 returns with a due date on or after July 15, 2021, that are

submitted on paper and bear a postmark date on or before June 16, 2021.

(9) To calculate Section 4940 and Section 4942 taxes, complete the Form 990-PF,

Return of Private Foundation or Section 4947(a)(1) Trust Treated as Private

Foundation. Reclassify expenditures as necessary to determine the qualifying

distributions.

(10)The applicable report forms are:

a. Form 4621, Exempt Organizations - Report of Examination,

b. Form 4883, Exempt Organizations Excise Tax Audit Changes,

Form 886-A, Explanation of Items, and

d. Form 870-E, Waiver of Restrictions on Assessment and Collection of

Deficiency and Acceptance of Overassessment.

Qualifying Distributions

(1) Qualifying distributions are made to achieve Section 170(c)(2)(B) purposes.

(2) If it’s determined that a distribution doesn’t serve a Section 170(c)(2)(B)

purpose and doesn’t meet an exception in Section 4942 or in Treas. Reg.

53.4942(a)-3, then redo 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, redo the form for each year under audit.

Note: Some transactions that constitute self-dealing transactions and/or taxable

expenditures aren’t qualifying distributions. Look at each

transaction/expenditure on a case by case basis.

(3) A taxpayer generally can’t make any elections with respect to qualifying

distributions during the examination. Taxpayers must make the elections before

filing the Form 990-PF. If the taxpayer properly made a pre-filing election, verify

it. If there is a valid election, consider that when revising Part XIII. (The election

might be in another part of the form.)

(4) Refer to the Correction section for a discussion of acceptable correction.

(5) Complete Forms 4883, 4621, 886-A and 870-E. See Exhibits below showing

how to compute and propose the tax.

Note: To incur the Section 4942 excise 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.

Note: Form 870-E is used with respect to the taxes that a taxpayer agrees to

pay in full, suspends interest from continuing to accrue, and facilitates closure.

See IRM 8.6.4, Reaching Settlement and Securing an Appeals Agreement

Form, and IRM 4.70.14, Resolving the Examination. List separately the tax for

each act/failure to act or taxable event (and for each year within the taxable

period) and prepare a separate Form 870-E for each taxpayer as applicable.

(6) The Section 4942 tax is reported on Form 4720 and assessed against the

private foundation. See IRM 4.70.13, Executing the Examination, to set up a

substitute for return or secure a delinquent return.

One Act/Failure to Act, Multiple Violations

(1) The structure of Chapter 42 permits the assessment of excise taxes under

different statutes for the same transaction. For instance, a self-dealing

transaction (Section 4941) is frequently also a taxable expenditure (Section

4945), that may also affect the net investment income (Section 4940) and the

qualifying distributions (Section 4942). See Treas. Reg. 53.4944-1(a)(2)(iv);

Rev. Rul. 77-161, 1977-1 C.B. 358; Kermit Fisher Foundation v. Commissioner,

T.C. Memo. 1990-300.

(2) Section 4940 and Section 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); Rev. Rul. 75-410, 1975-2 C.B.

446; Julia R. & Estelle L. Foundation, Inc. v. Commissioner, 598 F.2d 755 (2d

Cir. 1979); Kermit Fisher Foundation v. Commissioner, supra. 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. See Treas. Reg. 53.4940-1(e)(2)(iv).

However, deductions with respect to property used for an exempt purpose more

than the income derived from the property may be treated as a qualifying

distribution. See Treas. Reg. 53.4942(a)-2(d)(4)(i).

(3) For taxable years beginning before December 21, 2019, Section 4940(e) and

Section 4942 were especially inseparable. Adjustments to the net value of non44

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; Section 4942 applies them

against undistributed income to compute the tax liability. The following

examples illustrate several outcomes when changes are made to the first page

of the Form 990-PF.

(4) Note that the examples below regarding Section 4940, which imposes an

excise tax on the net investment income of most domestic tax-exempt private

foundations, including private operating foundations, are for tax years beginning

on or before December 20, 2019. For those tax years, the excise tax is 2% of

net investment income, but is reduced to 1% in certain cases. For tax years

beginning after December 20, 2019, the excise tax is 1.39% of net investment

income, and there is no reduced 1% tax rate.

Example 1: The foundation engages in self-dealing expenditures. The

foundation reported these amounts in Part I Column d as charitable

disbursements. The IRS later disallows these amounts and the Part XII Line 1a

amount is reduced. This in turn reduces the qualifying distributions. When the

qualifying distributions for the year are less than: the sum of 1% of the net

investment income and the product of 1) the 5-year average distribution ratio

and 2) the net value of the non-charitable use assets, the foundation can’t use

the Section 4940(e) 1% tax rate. For Section 4942 purposes, undistributed

income is offset by qualifying distributions. When the qualifying distributions are

reduced or disallowed, the potential for tax on undistributed income arises. This

flow of actions is demonstrated as follows:

Form 990-PF Line Adjustment

Increase or Decrease

Part I Line 26 Column (d)

Decrease

Part XII Line 1(a)

Decrease

Part XII Line 4

Decrease

Part V Line 8

Decrease

Part XIII Line 4

Decrease

Note: Part V of the Form 990-PF will no longer be used for taxable years

beginning after December 20, 2019, because the Taxpayer Certainty and

Disaster Tax Relief Act passed on December 20, 2019, included legislation that

reduced the 2% excise tax on the net investment income of a private foundation

to 1.39%. The legislation also repealed the 1% special rate that applied if the

private foundation met certain distribution requirements.

If Part V Line 8 is less than Part V Line 7, use the 2% tax rate for Section 4940.

A decrease in qualifying distributions results in Section 4942 tax if Part XIII Line

6(e) is greater than zero.

Example 2: The foundation understates the net investment income (either

understating investment revenues or over-allocating/overstating investment

expenses or both). This directly increases the Section 4940 tax. Also, this

decreases the distributable amount (Part XI). This decreases the amount of

undistributed income to be offset by qualifying distributions in Part XIII. This flow

of actions is demonstrated as follows:

Form 990-PF Line Adjustment

Increase or Decrease

Part I Line 27(b)

Increase

Part VI Line 5

Increase

Part XI Line 2(a)

Increase

Part XI Line 7

Decrease

Part XIII Line 1

Decrease

If the amount on Part XIII Line 1 is greater than the sum of Part XIII Lines 4(d)

and 5, there will be an amount in Part XIII Line 6f. This amount is then reported

on the subsequent year’s Form 990-PF Part XIII Line 2a.

Example 3: The foundation overstates the net investment income. The Section

4940 tax is reduced, and the distributable amount in turn is increased,

increasing any possible Section 4942 tax.

Example 4: The foundation understates the non-charitable use assets. (This

frequently occurs when the return preparer averages the beginning and end of

year bank/brokerage balances in lieu of the month end balances.) The noncharitable use assets net value and the minimum investment return (Part X

Lines 5 and 6) increases. In addition to affecting the subsequent year’s

distribution ratio, it raises the threshold for meeting the Section 4940(e) reduced

tax rate. For Section 4942 purposes, the distributable amount increases, thus

increasing the chance for tax two years down the road.

Example 5: The foundation overstates the non-charitable use assets. The net

value of non-charitable use assets decreases, as do the minimum investment

return and distributable amount. This lowers the Section 4940(e) threshold, and

the chance for a possible Section 4942 tax is reduced.

(5) Section 4941 and Section 4945 excise tax liability can commonly occur for the

same transaction. Many self-dealing transactions aren’t considered to be for

Section 170(c)(2)(B) purposes, thus becoming taxable expenditures. On the

other hand, a taxable expenditure isn’t necessarily a self-dealing transaction

and vice-versa. See Rev. Rul. 77-161, 1977-1 C.B. 358. Remember to apply

the appropriate Code section and Regulations when analyzing each

transaction.

Example 1: A foundation manager uses foundation funds to go on a vacation in

the Bahamas. This transaction is both a self-dealing transaction and a taxable

expenditure.

Example 2: The same foundation manager is a member of Church X

congregation. The manager uses the funds to pay for a “recuperation retreat”

for the church’s pastor and the pastor’s family in the Bahamas. The manager

isn’t related to the pastor by blood or marriage, and the pastor and family aren’t

otherwise disqualified persons with respect to the foundation. The foundation

doesn’t have advance approval under Section 4945(g) to make grants to

individuals. Due to lack of advance approval of the grant procedures under

Section 4945(g), the transaction constitutes a taxable expenditure but not a

self-dealing expenditure.

(6) An act subject to Section 4943 may also trigger other taxes in certain situations.

Example: A foundation purchases stock of a disqualified person’s wholly

owned corporation directly from the disqualified person. The purchase of the

stock constitutes a self-dealing transaction. If the foundation owns more than

2% of the total stock of the corporation, the purchase may trigger Section 4943.

A donation of the stock won’t constitute a self-dealing transaction but may

trigger Section 4943.

(7) As with Section 4943, an act subject to Section 4944 may also trigger other

taxes in certain situations.

Example: The foundation bought stock of a disqualified person’s wholly owned

corporation from the disqualified person. The corporation is a corporate sole

entity used to shelter the disqualified person’s income and assets. The

disqualified person isn’t a minister of a church and thus the entity constitutes a

sham corporation. The purchase constitutes a jeopardizing investment and a

self-dealing transaction. As with the previous example, if the foundation owns

more than 2% of the total stock of the corporation, the transaction may also

trigger Section 4943.

Procedural Information Regarding Correction

(1) Each Chapter 42 excise tax (except for Section 4940) requires correction of the

taxable event that triggers the excise tax. (Sections 4942, 4943, and 4944

generally don’t refer to “correction” but effectively require correcting the violation

to avoid multiple taxes and second tier taxes.) Failure to make correction can

result in the imposition of second tier taxes. When one transaction triggers

multiple excise taxes, the correction for one tax may possibly also satisfy

correction for the other taxes. Refer to the specific Technical Guides and

Regulations for directions on the appropriate correction methods for each Code

subsection.

(2) The immediately following table identifies the Code subsection requiring

correction and the actions required to make it. There is no correction for Section

4940, as it has no second tier excise tax. Section 4940 is an excise tax that is

computed like an income tax, except that certain deductions aren’t allowed,

such as the net operating loss deduction under Section 172. See Treas. Reg.

53.4940-1(e).

Code Section

4941(e)(3)

4942(h)(2)

and

4963(d)(2)

4943(c)

4944(e)(2)

4945(i)(1)

Correction

Undo the transaction to the extent possible. Restore the

foundation to the same or better financial position than it

would have been had the transaction not occurred. See

Treas. Reg. 53.4941(e)-1(c)

Reduce the amount of undistributed income to zero. Can

elect to treat qualifying distributions as made from a prior

year’s undistributed income. Treas. Reg. 53.4942(a)3(b)(6), relating to failure to distribute minimum amounts

under the cash distribution test for set-asides, allows for

correction (by distribution of cash or cash equivalent

only) within the correction period if the failure to

distribute was not willful and was due to reasonable

cause.

Depending on when and how the business holding was

received, the organization may have a transition period

in which to dispose of the excess holding. Correction is

made when no excess holdings remain. Treas. Reg.

53.4943-9(c)

Remove the investment from jeopardy by either selling it

or disposing of it (other than exchanging it for another

jeopardizing investment). Treas. Reg. 53.4944-5(b)

Recover as much of the expenditure as possible, and

any other correction the IRS may prescribe if unable to

recover the whole expenditure. In certain situations,

obtain or make a report on the use of a grant, or obtain

approval of grantmaking procedures. Treas. Reg.

53.4945-1(d)

(3) The correction amount isn’t necessarily the same as the amount involved in a

particular transaction. Compute the correction amount and the taxable amount

involved separately. Refer to the specific Exempt Organizations Technical

Guides and regulations for directions on the appropriate correction methods.

Note: When two or more excise taxes are involved, verify that correction has

been made for each tax code section under which liability arises. What may

constitute correction for one section may not be sufficient correction under

another code section.

(4) When correction is made, obtain verification. See the following list (not allinclusive) for acceptable proof of correction. Discuss with the manager and

Area Counsel as to appropriate methods of correction and proof, if desired:

a. Copies of cancelled check(s) to the foundation and bank statement(s)

showing the deposit(s).

b. New title documents for returned real property.

Copies of cancelled check(s) and bank statement(s) showing appropriate

distributions.

d. Brokerage/financial institution statement(s) showing that a foundation no

longer owns an asset or stock.

e. Copies of reports secured concerning the uses of grants made.

(5) Be alert for attempts to circumvent the correction requirement. At a minimum,

ensure that the parties don’t:

a. Deposit the correction amount and then issue a new check back to the

party making correction.

b. Obtain new title documents for returned property and then change title back

to the party that returned the property.

Redeposit amounts distributed to satisfy Section 4942 (such as voided

checks, circular transactions).

d. Transfer assets or stocks to other financial institutions or to disqualified

parties for which statements aren’t provided.

e. Engage in an act of self-dealing when attempting to make correction.

(6) If revoking or involuntarily terminating the foundation, request and verify that

correction is made to a governmental agency or other Section 501(c)(3)

organization that isn’t itself at risk of revocation.

(7) In the event that requests to extend the correction period (See Section

4963(e)(1)(B)) are received, under Delegation Order 7-4 (IRM 1.2.2.8.4,

Delegation Order 7-4), Area Managers may authorize extensions of the

correction period, or delegate the authority to the group manager. Consult the

group manager if considering granting an extension of time to make correction.

It is recommended that the appropriate TE/GE Division Counsel also be

consulted per the group manager’s authorization.

(8) Extensions of the correction period aren’t ordinarily granted unless these factors

are present:

a. The taxpayer is actively seeking in good faith to correct the taxable event.

b. Adequate correction is unavailable or can’t reasonably be expected to occur

during the original correction period.

(9) The taxable event appears to be an isolated occurrence, and it appears unlikely

that similar taxable events will occur in the future. See Treas. Reg. 53.49631(e)(3).

Note: An extension of the correction period also extends the period in which the

taxpayer may petition the Tax Court for the deficiency. See Treas. Reg.

301.6213-1(e).

(10)A taxpayer paying the full amount of the first tier tax during the original

correction period extends the correction period to the later of:

a. 90 days after paying the first tier tax

b. The last day of the original correction period.

Note: If the taxpayer pays the first tier tax after IRS mails a statutory notice of

deficiency and before the 90-day period of the notice has expired, the taxpayer

has 90 days from the payment date to make correction. Treas. Reg. 53.49631(e)(4). If the taxpayer petitions the Tax Court regarding the second tier taxes,

before the correction period (including extensions) expires, the correction period

runs until the decision is final. See Treas. Reg. 53.4963-1(e)(2).

(11)See Treas. Reg. 53.4963-1(e)(5) for extensions of the correction period where a

claim for refund is filed with respect to payment of the full amount of the first tier

tax imposed with respect to the taxable event or when a suit or proceeding with

respect to the claim is filed.

(12)If there has been a waiver of the restrictions on assessment and collection of

the deficiency or if the deficiency is paid, and therefore no notice of deficiency is

mailed, the correction period will end with the end of the collection prohibition

period described in Treas. Reg. 53.4961-2(e)(5). See Treas. Reg. 53.49631(e)(6).

Correction Period

(1) Section 4942(g)(2)(C) provides that if, for any taxable year to which clause

(ii)(II) of subparagraph (B) applies, the private foundation fails to distribute in

cash or its equivalent amounts not less than those required by such clause

and–

a. The failure to distribute such amounts was not willful and was due to

reasonable cause, and

b. The foundation distributes an amount in cash or its equivalent which is less

than the difference between the amounts required to be distributed under

clause (ii)(II) of subparagraph(B) and the amounts actually distributed in

cash or its equivalent during that taxable year within the correction period

(as defined in Section 4963(e)), such distribution in cash or its equivalent

shall be treated for the purposes of this subparagraph as made during such

year.

(2) Under Section 4963(e), the correction period is the period beginning on the first

day on which there is undistributed income and ending 90 days after the date of

mailing under Section 6212 of a notice of deficiency with respect to the

additional tax, extended by:

a. any period in which a deficiency cannot be assessed under Section 6213(a)

(determined without regard to the supplemental proceeding provided for

under Section 4961(b), and

b. any other period which the IRS determines is reasonable and necessary to

bring about correction.

(3) Section 4942(h)(2) provides that in the case of any qualifying distribution which

(under paragraph (h)(1)) isn’t 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. The election shall be made by

the foundation at such time and in such manner as the IRS shall by regulations

prescribe.

Advance Approval of Proposed Correction

(1) Taxpayers may request advance approval of a proposed correction. If granted,

the advance approval provides assurance to taxpayers and organizations that

IRS will view an intended remedial action favorably as correction.

(2) Advance approval is only available when:

a. The only barrier is the reluctance to correct because the taxpayer is

uncertain of final IRS approval, and

b. The other aspects of the issue aren’t disputed.

(3) For all other cases, treat the case as unagreed if the taxpayer is unwilling to

make correction.

(4) To grant advance approval, all the following conditions must be met:

a. The taxpayer indicates acceptance of initial tax liability (Sections 4941

through 4945).

b. Correction will be very difficult or costly, requiring the exercise of sound

judgment on a broad scale.

The taxpayer should be able to complete the proposed correction within 90

days from the date of approval.

d. The taxpayer submits a written request for advance approval, attention of

the Area Manager.

(5) The written request must:

a. Fully describe the surrounding circumstances giving rise to the initial tax

liability.

b. Outline in detail the nature and method of the proposed correction.

Accept an initial tax liability for the act or failure to act in question.

d. Include the date by which the taxpayer will complete the correction.

(6) When such a written request is received, suspend further action on the issue,

and continue all other aspects of the examination. Send a copy of the request to

the Area Manager (scanned and secured e-mail if possible). Consult with Area

Counsel if complex correction situations arise from the written request.

Schedule and hold a conference call with the Group and Area Managers.

(7) If the Area Manager approves the request, prepare, and issue a draft correction

approval letter. See Letter 5305, Private Foundation Correction Approval Letter.

The letter must:

a. Explain in detail the proposed corrective action.

b. Specify the due date for correction completion.

Require the taxpayer to notify the area manager upon completion.

d. Clarify that the taxpayer’s reliance on the letter is conditioned on the

taxpayer meeting the conditions specified for correction.

Reminder: Monitor the time remaining on the statute of limitations.

Consider requesting a statute extension as needed.

(8) If the Area Manager denies the request, prepare, and issue a draft correction

rejection letter. See Letter 5306, Private Foundation Correction Rejection Letter.

In the letter:

a. Outline the taxpayer’s proposal.

b. Explain why it doesn’t constitute correction.

Clarify that other methods of correction are still available.

d. Suggest a correction action (or actions) that would be acceptable.

(9) If the Area Manager accepts the request, keep the case in the group, and

continue to work other issues on the case. When the Area Manager provides

notification that the taxpayer corrected, secure proof. Secure the taxpayer’s

agreement to the first tier tax on Form 870-E. Collect the first tier tax or secure

an installment agreement request (Form 9465, Installment Agreement

Request).

(10)If notification or proof isn’t received by the due date for correction, contact the

taxpayer to confirm correction. Ask the taxpayer to send proof right away (via

express mail, or fax).

(11)If proof of correction isn’t promptly received after contacting the taxpayer, close

the case as unagreed. See IRM 4.70.14, Resolving the Examination.

All Chapter 42 Second tier Excise Taxes

(1) See the following table for the additional/second tier taxes generally applicable

to private foundations under subchapter A for each code section.

Code Section

Liable Party

Tax Rate

4941(b)(1)

Self-dealer

4941(b)(2)

Limit? (PPA 2006*)

Before

After

200%

None

50%

$10,000 per act

$20,000 per act

4942(b)

100%

None

4943(b)

200%

None

4944(b)(1)

25%

None

4944(b)(2)

$10,000 per act

$20,000 per act

4945(b)(1)

100%

None

4945(b)(2)

50%

$10,000 per act

$20,000 per act

*The limit changes are effective for the first full tax years that begin after August 17, 2006.

(2) Second tier taxes are:

a. Triggered by the failure to make correction,

b. Imposed at the same time as first tier taxes for assessment or when a

notice of deficiency is issued, and

Abated if correction is made within the correction period.

d. Indicate in the report of examination (Forms 4883, 4621, 886-A) the amount

of potential second tier taxes if the taxpayer doesn’t make correction. With

Area Manager approval, the closing of an agreed first tier tax case can be

delayed for a reasonable period to permit correction, depending on the facts

and circumstances.

(3) Before granting the above extension, ensure that the taxpayer has:

a. Signed the Form 870-E.

b. Paid the first tier tax.

Granted a statute extension, if necessary.

Note: Obtain the Area Manager’s approval due to the additional case cycle

time.

(4) All second tier taxes are imposed once per act/failure to act or taxable event.

Refer to the specific Code section and the regulations for how to determine the

amount of the second tier tax calculation. Under Sections 4942 and 4943, if the

taxpayer partially corrects (reduces but does not eliminate undistributed income

or excess business holdings), the second tier tax is on the uncorrected

remaining amount.

Example: M, a private foundation which uses the calendar year as its taxable

year, has at the end of 1981, $50,000 of undistributed income for 1981. As of

January 1, 1983, $40,000 is still undistributed. On August 15, 1983, a notice of

deficiency with respect to the excise taxes imposed by Section 4942(a) and (b)

is mailed to M under Section 6212(a) and the taxable period ends. Thus, under

these facts, an initial excise tax of $12,000 (30% of $40,000) is imposed upon

M. An additional excise tax of $40,000 (100% of $40,000) is imposed by

Section 4942(b). Under Section 4961(a), however, if the undistributed income is

reduced to zero during the correction period, this latter tax will not be assessed,

and if assessed, it will be abated, and if collected, it will be credited or refunded

as an overpayment.

(5) See IRM 4.70.14, Resolving the Examination, for additional information for the

necessary letters and forms to complete. For a proposed second tier tax

liability, show the second tier tax on the last year which shows an adjustment

for the first tier tax, noting in the examination report that the additional tax will

be imposed at the end of the taxable period if the act/failure to act or taxable

event is not corrected.

(6) If the taxpayer doesn’t agree to the tax or fails to make correction, the case is

unagreed. See IRM 4.70.14, Resolving the Examination, for case closing

procedures.

Termination Tax

(1) This section focuses on those situations when tax is due under Section 507 for

termination of private foundation status. The termination tax acts like a third tier

excise tax. The phrase “termination” has several different meanings in the

context of private foundations. The term is ordinarily used when an entity

dissolves or goes out of business. For a private foundation, however,

termination of foundation status doesn’t necessarily mean dissolution has

occurred. Termination for Section 507 purposes means any of the following:

a. The foundation notifies the IRS and pays the Section 507(c) tax (if any).

(See Section 507(a)(1).)

b. The IRS involuntarily terminates the foundation and imposes Section 507(c)

tax. (See Section 507(a)(2).)

The foundation transfers all of its net assets to certain public charities. (See

Section 507(b)(1)(A).)

d. The foundation becomes a public charity. (See Section 507(b)(1)(B).)

Note: Transfer under Section 507(b)(2) of all a foundation’s net assets to

one or more other foundations doesn’t, by itself, terminate private

foundation status. The foundation must separately terminate, whether

voluntarily (Sections 507(a)(1), 507(b)(1)(A), or 507(b)(1)(B)) or involuntarily

(507(a)(2)).

(2) If the foundation hasn’t engaged in repeated willful acts or one flagrant, willful

act triggering Chapter 42 taxes, the foundation may opt for termination under

Section 507(b)(1)(A) or (b)(1)(B). If terminated under Section 507(b)(1), the

foundation pays $0 in termination taxes.

(3) If the foundation voluntarily terminates under Section 507(a)(1), the foundation

submits its final Form 990-PF and pays a termination tax ($0 tax if the

foundation distributes all its net assets before providing notice of termination).

The foundation follows the instructions to the Form 990-PF as to the method of

notification.

(4) Consider a Section 507(a)(2) involuntary termination when there have been

multiple willful repeated acts committed under Chapter 42. Also consider

Section 507(a)(2) if there has been one willful flagrant act committed triggering

Chapter 42 treatment. If proposing involuntary termination, you can propose

revocation at the same time.

Note: If a private foundation’s Section 501(c)(3) status is revoked but its private

foundation status isn’t terminated under Section 507, then the foundation

becomes a taxable private foundation; it’s no longer tax-exempt but still subject

to Chapter 42 taxes as a private foundation. See Section 509(b) and Treas.

Reg. 1.509(b)-1(b).

Note: As a practical matter, termination tax assessments are more likely to

occur during a subsequent examination. Once Chapter 42 taxes have been

assessed, any new violations identified in a later examination will provide proof

of willfulness.

(5) Computing the termination tax requires multiple smaller computations normally

provided by the foundation:

The Termination Tax is the Smaller of:

A) The aggregate tax benefit - the sum of:

B) The value of the net assets as of

the date the foundation first committed

The increase in income, estate, and

gift taxes** on substantial

contributors that would result from

the disallowance of their

contributions. The taxes are

computed from the later of the

foundation inception date or March

1, 1913. Section 507(d)(1)(A))

The income taxes of the foundation,

had the foundation filed Forms 1120,

U.S. Corporation Income Tax Return,

or Forms 1041, U.S. Income Tax

Return for Estates and Trusts, in lieu

of Forms 990-PF. The taxes are

computed from the later of the

foundation inception date or January

1, 1913.* (Section 507(d)(1)(B))

The aggregate tax benefit from

other private foundations in Section

507(b)(2) transfers. (Treas. Regs.

1.507-5(a)(3) and 1.507-3(a)(2))

a Chapter 42 violation that culminates

in its Section 507 termination, or the

effective termination date, whichever

amount is higher. See Section

507(e)(1). Default to this amount

unless the “aggregate tax benefit” is

calculated.

The accumulated interest on the

above amounts as computed via

4. Report Generation System NT (RGS

NT) or Integrated Data Retrieval

System (IDRS) command code

INTST. (See Section 507(d)(1)(C))

*For purposes of this calculation, the charitable contribution deduction allowed a

trust is deemed to have been limited to 20% of taxable income. See Section

507(d)(1)(B)(ii).

** For any year in which a gift tax would be due if a charitable deduction were not

available, refer to the Instructions to Form 709, United States Gift (and Generation Skipping Transfer) Tax Return, for that particular year for assistance in calculating

the appropriate amount of deemed gift tax.

(6) Aggregate tax benefit is used as the amount of the termination tax only if the

foundation substantiates the amount by adequate records or other

corroborating evidence. See Section 507(c)(1). As the IRS retains records for a

limited period, it may not be feasible to compute the tax from the date of

inception. Obtain what information is available via IDRS, return requests, and

Online Statistics of Income EO Image Net (SEIN). Establish Audit Information

Management System (AIMS) controls via the Reporting Compliance and Case

Management System (RCCMS) using source code 45 to retrieve the returns of

the substantial contributors.

(7) See IRM 4.70.14, Resolving the Examination, for guidance on converting the

Form 990-PF to Forms 1120 or 1041. Use the RGS NT to determine the

increase in income tax from the disallowance of charitable contributions

deductions.

(8) Propose the tax using Forms 4883 and 4621. Use Form 990-PF to assess the

tax in lieu of Form 4720.

(9) Imposition of the termination tax doesn’t eliminate liability for the underlying

Chapter 42 taxes that initiated the termination process. See Treas. Reg. 1.5071(b)(2).

(10)When you close the case as a termination, prepare Form 2363-A, Request for

IDRS Input for BMF/EO Entity Change, to update the status code, indicating the

effective date in YYYYMM format:

a. Status 23: 507(a)

b. Status 24: 507(b)(1)(A) (No termination tax applies)

Status 25: 507(b)(1)(B) (No termination tax applies)

(11)Termination of private foundation status under Section 507 results in the

foundation being treated as an organization created on the day after

termination. See Section 509(c).

Revocation

(1) Propose to revoke exemption if the foundation ceases to be operated

exclusively for exempt purposes but the circumstances don’t warrant

involuntary termination of private foundation status under Section 507(a)(2). A

Section 501(c)(3) foundation must engage primarily in activities that accomplish

Section 501(c)(3) purposes. If more than an insubstantial part of its activities

doesn’t further an exempt purpose, propose revocation. A private foundation is

subject to the auto-revocation process of Section 6033(j). (See IRM 4.70.14,

Resolving the Examination.)

(2) Foundations are subject to similar restrictions as other Section 501(c)(3)

organizations:

a. Absolute prohibition for political campaigning.

b. Limitation on lobbying (subject to Section 4945(d) which functions as a

virtual ban on lobbying).

Prohibition on inurement.

d. Prohibition on operating for the benefit of private interests.

e. Limitation on UBI activities (less than primary purpose).

Limitation on commercial-type insurance (See Section 501(m)).

g. Prohibition on illegal activities/purposes that violate public policy.

(3) If the foundation violates any of the prohibitions and/or restrictions listed above,

propose revocation. Private foundations are subject to declaratory judgement

under Section 7428 when proposing revocation. An administrative record and

administrative record index are required for all proposed revocations and should

be prepared in accordance with IRM 4.70.14, Resolving the Examination.

Additionally, when proposing revocation, follow the information in IRM 4.70.14,

Resolving the Examination.

(4) In many revocations, the foundation, disqualified persons, and foundation

managers may also be subject to Chapter 42 excise taxes. If there are willful

repeated acts or a single willful and flagrant act triggering Chapter 42 taxes,

propose the termination tax in addition to revocation. You may include the basic

report forms (Forms 4883 and 4621) with Letter 3614, 30-day letter package for

Chapter 42 excise taxes. Form 870-E shows all tax deficiencies of the

foundation.

(5) In revocations of private foundations, the foundation becomes a taxable

foundation and must file an income tax return as well as Form 990-PF. See

Section 509(b) and Treas. Reg. 1.509(b)-1(b). Use status codes 18 (for trusts)

and 19 (for corporations) in lieu of status code 22. Status codes 18 and 19 set

the Form 990-PF and Form 1041 or Form 1120 filing requirements. Prepare

Form 2363-A with status code change and indicate the effective date of

revocation in YYYYMM format. Leave the Form 2363-A in the case file for

processing following review.

(6) All revocations are subject to Mandatory Review.

Statute of Limitations

(1) The Form 990-PF initially controls all statutory limitations periods for

assessment and collection of taxes (or “statutes”) with respect to the excise

taxes. (See Section 6501(l)(1) and Treas. Reg. 301.6501(n)-1(a).) The following

table identifies the Code section, the taxable party, the return used to report the

tax, and the year in which the tax is imposed.

Code Section Liable Party Tax Form

4940(a)

4941(a)(1)

Self-dealer

990-PF

*4720

Tax Year

On the same form, same year.

If individual: Year of Form 1040,

U.S. Individual Income Tax

Return, in which transaction

occurs.

All others: Year of Form 1041

(trust), 1065 (partnership), or

1120 (corporation) in which

transaction falls. *

4941(a)(2)

*4720

Form 1040 year in which

transaction occurs.

4942(a)

4720

Same year of Form 990-PF

4943(a)(1)

4720

Same year of Form 990-PF

4944(a)(1)

4720

Same year of Form 990-PF

4944(a)(2)

*4720

Form 1040 year in which

transaction occurs.

4945(a)(1)

4720

Same year of Form 990-PF

Form 1040 year in which

transaction occurs.

*Contact Area Counsel if considering asserting tax on indirect self-dealing

against a disqualified person partner or other owner of the disqualified

person entity (in addition to asserting tax on self-dealing against the entity).

4945(a)(2)

*4720

(2) The rules for the length of statutory period for assessing Chapter 42 taxes are:

Length of

Statute

Requirements

Code Section

3 years

Form 990-PF filed disclosing the

transaction (must adequately

identify existence and nature of

transaction). See Cline v.

Commissioner, T.C. Memo. 1988144.

6501(a) and (e)(3)

Section 4940, 4948: Exceeds 25%

of amount reported on return.

6 years

Section 4941 – 4945:

Transaction not disclosed on the

return.

6501(e)(3)

Requires Area Counsel memo.

False or fraudulent return with

intent to evade tax.

Open ended Form 990-PF not filed (SFR).

6501(c)(1) and (c)(3),

6020(b)

Requires Area Counsel memo for

false or fraudulent returns.

(3) See table below for Section 4942 statute modifications:

4942

Subsection

Additional Time

Code Section

Reference

+1 year to statute date

6501(l)(2)

+2 years to statute date

6501(l)(3)

4942(g)(3)

Failure to distribute

deficiency

4942(g)(2)(B)(ii)

Failure to set aside

deficiency

(4) Prepare and obtain statute extensions for all parties to an excise tax. This

entails extensions on the foundation, disqualified persons, and foundation

managers, if applicable. Use Form 872, Consent to Extend the Time to Assess

Tax, to secure the extension.

Note: A statute extension for the foundation’s return doesn’t extend the statute

for a disqualified person or foundation manager. Separate statute extensions

must be secured for all parties. Refer to IRM 25.6.22, Extension of Assessment

Statute of Limitations by Consent, for further information regarding statute

extensions.

Caution: You may use Form 872-A, Special Consent to Extend the Time to

Assess Tax, as an alternative to allow an open-ended extension, until

terminated by the submission of Form 872-T, Notice of Termination of Special

Consent to Extend the Time to Assess Tax. Use Form 872-A only for cases with

valid formal protests to Appeals.

(5) The statutory limitations period for Chapter 42 taxes reportable on Form 4720

ordinarily begins with the filing of Form 990-PF, whether or not Form 4720 is

filed. If there are multiple acts/failures to act or taxable events over a period of

years, the Forms 4720 will have separate statutes for each transaction. When

extending the statute for the Form 4720, extend the statute for all the

transactions.

Note: The filing of Form 990-PF for the year of the initial taxable act ordinarily

starts the limitations period (or periods, if multiple acts during the tax year) for

second tier tax as well as first tier tax, even though second tier tax doesn’t arise

until the end of the taxable period. See the example in Treas. Reg.

301.6501(n)-1(c) regarding an act of self-dealing. Similarly, the second tier tax

payable by a foundation manager is essentially on refusal to agree to correct,

which does not arise until after a Thorne letter is sent.

(6) For discrete acts, if the statute expired for the year the act occurred, no

assessment can be made for any subsequent year. However, for continuing

transactions under Section 4941, even if the statute expired for the year in

which the original transaction occurred, tax for each open year may be asserted

(because a new act is deemed to occur every year within the taxable period).

Similarly, an excess business holding acquired in a closed year of the

foundation that is still held by the foundation in one or more open years is

subject to Section 4943 tax for an open year, assuming the holding is still an

excess business holding.

(7) When preparing the extensions, reference the specific Code section in the type

of tax. Use “excise (Section 494X)”. If extending multiple excise tax code

sections, state “excise (Sections 494X and 494Y)”. If extending both income

and excise taxes, state “income and/or excise (Section 494X)”. It is

recommended that a consent for both income and excise tax be used only

when a private foundation may be liable for both excise tax under Section 4940

on its investment income and income tax (such as unrelated business income

tax). This is because a regular Form 872 is used to extend the statute for these

taxes, based on the foundation’s taxable year and not taxable periods arising

from taxable events (which require using a modified Form 872).

(8) Extensions for Section 4941 through Section 4945 taxes require a modification

of the Form 872. Replace the phrase “on any returns made by or for the above

taxpayer(s) for the period(s) ended” with “from the above taxpayer(s) for the

years that are fully or partially within the taxable period(s) that began”. Use the

date of the first act or failure to act (or taxable event) for the start of the taxable

period.

(9) If there are multiple acts in a single tax year that trigger Chapter 42 taxes, you

may list them on the modified Form 872.

(10)For each year in which acts or failures to act occur which give rise to Chapter

42 taxes, including for deemed or continuing transactions (such as loan

transactions in which each year the loan is outstanding, a new or separate

transaction is created), secure a modified Form 872. Separate consents for

each year in which new or continuing transactions occurred should be obtained.

(11)As the Section 4940 tax is assessed on the Form 990-PF, prepare any statute

extensions for Section 4940 taxes using the regular Form 872. Associate the

statute extension with the appropriate Form 990-PF.

Applicable Penalties

(1) For a complete overview of the penalties that apply to private foundations, see

IRM 20.1.8, Employee Plans and Exempt Organizations Miscellaneous Civil

Penalties.

(2) As the Form 990-PF is both an information return and an excise tax return for

purposes of Section 4940, foundations are subject to several sets of penalties:

a. Section 6652(c) - daily delinquencies (Section 6652(c)(1)(A) - failure to file

return or show correct information), public inspections (Section

6652(c)(1)(C) and (D)) and prohibited tax shelters (Section 6652(c)(3)).

b. Section 6651(a), Section 6655, and Section 6662(c) - failure to file, failure

to pay, estimated tax (Section 6655(g)(3)(B)), and accuracy-related due to

negligence penalties. See IRM 20.1.2, Failure To File/Failure To Pay

Penalties, IRM 20.1.3, Estimated Tax Penalties and IRM 20.1.5, Return

Related Penalties.

Note: The daily delinquency penalty of Section 6652(c)(1)(A) is computed

on the number of days late. The failure to file penalty of Section 6651(a) is

computed as a percentage of the Section 4940 tax due. A late filed Form

990-PF can be subject to both penalties. Both are normally automatically

computed and assessed when the return is posted to BMF.

(3) Foundations can also be subject to the criminal penalties of Section 7203,

Section 7206, and Section 7207, as well as the civil fraud penalty of Section

6663. See IRM 9.1.3, Criminal Statutory Provisions and Common Law, and IRM

20.1.5, Return Related Penalties.

(4) Foundations, individuals, and taxable entities who file (or are required to file but

do not file) Form 4720 may be subject to failure to file, failure to pay,

negligence, and civil fraud penalties.

(5) Any entity or individual previously liable for a Chapter 42 tax may be subject to

a 100% penalty. See Section 6684. This penalty may also be imposed where

the act or failure to act is both willful and flagrant. In both circumstances, the act

or failure to act must not be due to reasonable cause. Under Section 6684 if a

person becomes liable for tax under any section of Chapter 42 and meets the

criteria, then such person is liable for a penalty equal to the amount of such tax.

Thus, this penalty can be imposed with respect to both first tier and second tier

taxes.

Note: The IRS bears the burden of proof on whether an act or failure to act was

willful and flagrant. See Thorne v. Commissioner, 99 T.C. 67 (1992); Moody v.

Commissioner, 69 T.C.M. (CCH) 2517 (1995).

(6) Foundations that file Form 990-T, Exempt Organization Business Income Tax

Return, may be subject to failure to file, failure to pay, estimated tax, accuracy,

and civil fraud penalties.

(7) The officers, directors, trustees, and employees of a foundation may be subject

to the public inspection compliance penalty of Section 6685 on the responsible

party. See IRM 20.1.8, Employee Plans and Exempt Organizations

Miscellaneous Civil Penalties.

(8) When computing penalties under Section 6651(a)(1) and (2), 6651(f), 6662, or

6663, use the first tier tax amounts for the computations. Because the second

tier taxes are not taxes that are reported (or required to be reported) on any tax

return, they aren’t subject to those penalties. Imposition of the penalties under

Sections 6662 and 6663 requires that the taxpayer file a return. If the taxpayer

did not file a return, those penalties don’t apply. An SFR doesn’t constitute a

return for the purpose of applying penalties under Section 6662 and 6663.

Example: In a report of examination issued to a disqualified person for selfdealing transactions, the agent proposes $15,000 in tax on a $150,000

payment. The agent prepared a substitute for return package (IRM 4.70.13,

Executing the Examination), because the taxpayer didn’t file the late Form

4720. The agent proposes the failure to file and pay penalties. The 201312

return was due on May 15, 2014. The agent issued the report October 15,

2016. The failure to file penalty is at a 22.5% rate (4.5% x 5 months), for

$3,375. The failure to pay penalty rate is at 14.5% (.5% x 29 months late), for

$2,175. See Section 6651(a)(1), (a)(2), and (c)(1) (which reduces the penalty

amount under Section 6651(a)(1) when both the failure to file and failure to pay

penalties apply).

Note: The examination report should explain that the failure to pay computation

is merely an estimate because the penalty will continue to accrue, until the

initial tax is fully paid, up to a maximum rate of 25%.

(9) If proposing or recommending a failure to pay penalty for a non-filer under a

substitute for return package, the failure to pay determination must be included

in the examination report. See IRM 4.70.13, Executing the Examination. In

addition, the failure to pay penalty may only be asserted on a certified substitute

for return. Examiners should follow the instructions on Form 13496.

(10)Be aware that with some exceptions, Section 6751(b)(1) requires written

supervisory approval for penalty assessment which must be obtained prior to

issuing any written communication of penalties to a taxpayer that offers the

taxpayer an opportunity to sign an agreement or consent to assessment or

proposal of the penalty. See IRM 20.1.5, Return Related Penalties, which

outlines the requirements for securing written supervisory approval and

describes the documentation required for the case file. Section 6751(b)(2)

provides exceptions to this requirement for additions to tax and penalties under

6651, 6654, 6655, or 6662 (but only with respect to an addition to tax by reason

of subsection (b)(9)) and any penalties automatically calculated through

electronic means. See IRM 20.1.1, Introduction and Penalty Relie

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