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Administrative expenses treated as qualifying distributions for the purposes of IRC Section 4942 - Taxes on Failure to Distribute Income

Issue Title:

Administrative expenses treated as qualifying distributions for the purposes of IRC Section 4942 - Taxes on Failure to Distribute Income

Description:

Qualifying distributions under IRC Section 4942 include that portion of reasonable and necessary administrative expenses paid to accomplish one or more exempt purposes under IRC Sections 170(c)(1) and 170(c)(2)(B).

Neither the Internal Revenue Code nor the Treasury Regulations set any limits on the amount of administrative expenses that may be used as qualifying distributions provided that the administrative expenses are reasonable and necessary for the accomplishment of the private foundation’s exempt purposes.

Limitation amounts for administrative expenses under former Section 4942(g)(4) no longer apply to tax years beginning after 1990. See Pension Protection Act of 2006, Pub. L. No. 109-280, Section 1244(a), Section 1244(c).

IRC Section and Treas. Regulation:

  • Pension Protection Act of 2006, Pub. L. No. 109-280, Section 1244(a), Section 1244(c)
  • IRC Section 4942 – Taxes on failure to distribute income
  • Treas. Reg. Section 53.4942(a)-3 – Qualifying distributions defined

Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources): 

Revenue Rulings:

  • Rev. Rul. 75-495, 1975-2 C.B. 449 provides that legal fees not excessive in amount, paid by an exempt charitable trust in a suit to determine the proper beneficiary of a portion of its net income, are qualifying distributions under IRC Section 4942(g)(1).

  • Rev. Rul. 74-560, 1974-2 C.B. 389 provides that depreciation expense, for a building constructed for use directly in furtherance of the exempt purposes of a private foundation, is not a qualifying distribution under IRC Section 4942(g)(1)(B).

Analysis:

Issue:

Are there limits on the amount of administrative expenses that can be treated as qualifying distributions to meet the minimum distribution requirements of IRC Section 4942?

Administrative Expenses as Qualifying Distributions:

In general:

IRC Section 4942 requires private nonoperating foundations to make qualifying distributions, by the end of the following year, at least equal to five percent of the fair market value of all assets of the foundation other than those which are used (or held for use) directly in carrying out the foundation's exempt purpose  (its minimum investment return), reduced by acquisition indebtedness, certain carryovers and taxes paid by the foundation.

Qualifying distributions under Section 4942(g) include:

  • direct expenditures to accomplish a religious, charitable, scientific, literary, educational, or other permitted public purpose under IRC Section 170(c)(1) or (2)(B), including amounts paid to acquire assets used or held for use directly in carrying out such purposes,
  • certain set asides, and
  • grants to public charities or private operating foundations. Treas. Reg. Section 53.4942(a)-3(a)(2)(i).

Reasonable and necessary administrative expenses incurred to accomplish or support charitable activities count, without limitation, as qualifying distributions. IRC Section 4942(g)(1); Treas. Reg. Section 53.4942(a)-3(a)(2)(i).

Reg. Section 53.4942(a)-3(a)(8) Example 1 discusses instances of direct and indirect administrative expenses. Direct expenses are those which can be specifically identified with a particular activity.  Indirect (overhead) expenses are not specifically identifiable with a particular activity. See Issue Indicators or Audit Tips below for more information.

Certain contributions are not qualifying distributions. IRC Section 4942(g)(1)(A); Treas. Reg. Section 53.4942(a)-3(a)(2)(i).

Expenses not attributable to the accomplishment of charitable purposes are not qualifying distributions. For example, neither  depreciation on a building used directly in furtherance of an exempt purpose is a qualifying distribution; nor is the payment of private foundation excise taxes imposed under Chapter 42 of the Code.  See Rev. Rul. 74-560, 1974-2 C.B. 389; Treas. Reg. Section 53.4942(a)-3(a)(7).

Administrative expenses not attributable to exempt activities, such as expenses for the production of investment income, are not treated as qualifying distributions (Treas. Reg. § 53.4942(b)-1(b)(1)).

Neither the Internal Revenue Code nor the Treasury Regulations currently set any limits on the amount of administrative expenses that may be included as qualifying distributions provided that the administrative expenses are reasonable and necessary for the accomplishment of the private foundation’s exempt purposes. In Rev. Rul. 75-495, the legal fees of a private foundation (in a suit to determine the proper distributee of a charitable trust) were determined to be reasonable and necessary to exempt purposes and therefore, were qualifying distributions.

Limitation amounts for administrative expenses under former Section 4942(g)(4) no longer apply to tax years beginning after 1990.  See Pension Protection Act of 2006, Pub. L. No. 109-280, Section 1244(a), Section 1244(c).

The Pension Protection Act of 2006 modified the tax treatment of amounts paid to supporting organizations by private foundations. Limitations were imposed on distributions by nonoperating foundations to supporting organizations. In certain instances, distributions to supporting organizations will not be considered qualifying. See IRC Section 4942(g)(4).

Issue Indicators or Audit Tips: 

Determination/Audit Tips:

IRM 7.27.16.5 states that qualifying distributions also include that portion of reasonable and necessary expenses, direct and indirect, that a foundation incurs in implementing exempt purposes.

Direct expenses are those which can be specifically identified with a particular activity and include compensation and travel expenses of employees and officers; the cost of materials and supplies; and fees paid to outside firms and individuals.

Indirect (overhead) expenses are not specifically identifiable with a particular activity. They relate to the direct costs incurred in conducting the activity. Examples of indirect expenses are occupying expenses (except depreciation), supervisory and clerical compensation, repair, rental and maintenance of equipment, expenses of other departments, such as accounting, personnel, and payroll that serve the department or function that incurs the direct expenses of conducting an exempt activity.

Administrative expenses are allocated from total foundation expenses stated in Form 990-PF, Part I, Column (a), Lines 13 -24, and listed on the same lines in Column (d).

Although there are no current limits on the amount of administrative expenses that can be treated as qualifying distributions, expenses must be reasonable and necessary for the accomplishment of the private foundation’s exempt purposes. If the payment is not reasonable and necessary, it will be a taxable expenditure under IRC Section 4945.

Even reasonable and necessary expenses may be improperly allocated between Revenue and Expenses (Part I, (a)), Net Investment Income (Part I, (b)), and Disbursements for Charitable Purposes (Part I, (d)).  Allocations may be used to improperly minimize net investment income or maximize qualifying distributions.

Set-asides claimed as qualifying distributions in Form 990-PF, Part XII, should be substantiated from either detailed return information or proof of prior IRS approval.

Prior and subsequent year returns should be reconciled to amounts in Part XIII to ensure undistributed amounts and excess contributions are properly carried forward.

Many foundations distribute well in excess of the minimum 5% required each year in direct contributions, grant and gifts. Therefore, they may not need to allocate administrative expenses in Form 990-PF, Part I, Column (d), Lines 13 - 23, to maximize qualifying distributions.

Page Last Reviewed or Updated: 11-Jan-2017