Form 990-PF Qualifying Distributions and Excess Distribution Carryovers

The payout computation has two halves. One produces the distributable amount; the other identifies what the foundation actually paid that counts. Most section 4942 exposure comes from the second half, and specifically from distributions that were made but do not qualify, or qualify in a different year than the foundation assumed.

What qualifies

Section 4942(g) treats the following as qualifying distributions when paid to accomplish an exempt purpose described in section 170(c)(2)(B).

• Grants and other amounts paid for charitable purposes, including program-related investments
• Reasonable and necessary administrative expenses incurred in carrying out charitable activities
• Amounts paid to acquire assets used directly in carrying out exempt purposes
• Amounts set aside under section 4942(g)(2), where the suitability or cash distribution test is satisfied and, for the suitability test, IRS approval is obtained

What does not qualify, or qualifies only conditionally

• Investment management fees and other expenses allocable to producing investment income
• Contributions to a controlled organization, or to a private non-operating foundation, unless the recipient redistributes the amount out of corpus by the close of the following year and the grantor exercises expenditure responsibility under section 4945(h)
• Amounts paid to individuals as grants without advance approval of the selection procedures where section 4945(g) applies
• Grants pledged but not paid — the test is payment, on the cash basis, regardless of the foundation's accounting method

The order of application

Qualifying distributions are applied in a fixed order, and this ordering is where carryovers are quietly consumed. Amounts are applied first against undistributed income from the prior year, then against the current year's distributable amount, and only the remainder becomes an excess distribution available to carry forward.

A foundation carrying prior-year undistributed income and also making a large current-year grant may find that the grant satisfies the prior year first, leaving the current year short.

The five-year carryover

Excess qualifying distributions may be carried forward under section 4942(i) for the five tax years following the year of the excess, and are applied on a first-in, first-out basis. Unused amounts expire at the end of the fifth year; there is no extension and no election to defer their use.

Two consequences follow. A foundation approaching an expiring layer gains nothing by distributing more in that year, since additional excess only creates a new layer. And a foundation relying on carryover to meet the current year should confirm that the layer it is counting on has not aged out, because the schedule on the return is prepared year by year and errors in an early layer propagate forward indefinitely.

Consequences of a shortfall

Undistributed income remaining at the close of the following tax year is subject to an initial excise tax of 30% under section 4942(a). If the shortfall is not corrected within the taxable period, an additional tax of 100% of the remaining undistributed amount applies under section 4942(b). Correction means distributing the amount; the initial tax is not avoided by later distribution, but the additional tax is.