# Exempt Organizations

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- **Document type:** Agency decision

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Exempt Organizations
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

2

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
3

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
4

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

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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

(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
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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.

8

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).
c.

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).
9

(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
c.

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
10

(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
c.

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),
c.

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
11

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.
c.

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:
12

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;
c.

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
f.

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:
13

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.
14

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
c.

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,
c.

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

15

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
c.

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
16

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
17

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).
c.

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
18

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.
f.

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
19

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
20

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.
21

b. Section 4 clarifies the date the Section 4958(c)(3) excise tax applies on
certain excess benefit transactions involving supporting organizations.
c.

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
22

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.
c.

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
23

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).
24

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.
25

(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:

26

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
c.

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

27

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;
c.

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.
28

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
c.

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,
c.

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.
29

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).
30

(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.

31

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;
c.

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.

32

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).

33

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
c.

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).
34

(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,
c.

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
35

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).
36

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
37

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
c.

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.
38

(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
39

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.

40

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

After

4940(a)

PF

up to 2%

up to 2%

None

None

1.39%**

4941(a)(1)

Self-dealer

5%

10%

None

None

No change

4941(a)(2)

FM

2.5%

5%

$10,000 per act

$20,000 per act

No change

4942(a)

PF

15%

30%

None

None

No change

4943(a)(1)

PF

5%

10%

None

None

No change

4944(a)(1)

PF

5%

10%

None

None

No change

4944(a)(2)

FM

5%

10%

$5,000 per act

$10,000 per act

No change

41

4945(a)(1)

PF

10%

20%

None

None

No change

4945(a)(2)

FM

2.5%

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
c.

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,
42

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,
c.

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
43

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.

45

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 amou

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Airs%3A1405f154524e895c. Public record. Not legal advice.