Private Foundations: The Five Excise Taxes
What a family foundation must do each year to avoid the excise taxes on investment income, self-dealing, under-distribution, business holdings, risky investments, and improper grants.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A private foundation — typically funded by one family or company — operates under rules stricter than a public charity's, enforced by excise taxes. It pays 1.39 percent on net investment income every year, must distribute about 5 percent of its investment assets annually, and cannot transact with its insiders except in narrow cases.
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What are the five regimes?
| Section | Rule | Tax for violation |
|---|---|---|
| 4940 | Annual tax on net investment income | 1.39 percent (P.L. 119-21 left the rate unchanged), paid with Form 990-PF |
| 4941 | Self-dealing: no sales, leases, loans, compensation beyond reasonable amounts, or use of foundation assets by disqualified persons (substantial contributors, managers, their families, and related entities) — even at fair value | 10 percent on the self-dealer (200 percent if uncorrected); 5 percent on managers who knowingly approve (50 percent if they refuse to agree to correction), each manager tax capped at $20,000 per act |
| 4942 | Minimum distribution: qualifying distributions of roughly 5 percent of the average fair value of non-charitable assets, by the end of the following year | 30 percent of the shortfall (100 percent if uncorrected) |
| 4943 | Excess business holdings: foundation plus disqualified persons may hold no more than 20 percent of a business (35 percent if others control it); five years to dispose of gifted holdings | 10 percent of the excess (200 percent if uncorrected) |
| 4944 | Jeopardizing investments that risk the foundation's ability to carry out its purposes | 10 percent on the foundation and on knowing managers (managers capped at $10,000); 25 percent on the foundation (5 percent on managers) if not removed from jeopardy |
| 4945 | Taxable expenditures: lobbying, political activity, grants to individuals without an approved program, grants to non-charities without expenditure responsibility | 20 percent on the foundation; 5 percent on knowing managers (capped at $10,000); 100 percent on the foundation (50 percent on managers) if uncorrected |
Why does self-dealing surprise families?
Because it is absolute. A foundation cannot buy a painting from its founder at appraised value, rent office space from the family company at market rent, or lend to a director at a fair interest rate. The main exceptions are reasonable compensation for personal services necessary to the foundation's charitable purposes and arrangements that cost the foundation nothing, such as an interest-free loan or rent-free space from the family. A founder who made a legally binding personal pledge and then has the foundation satisfy it has engaged in self-dealing.
How does the distribution requirement work?
Each year the foundation computes its distributable amount — 5 percent of the average fair market value of its investment assets (net of acquisition debt), minus the investment income tax and any unrelated business income tax — and must pay it out in qualifying distributions (grants, direct charitable expenses, reasonable administrative costs) by the end of the next year. Set-asides for specific projects can qualify with approval.
When is a donor-advised fund the better tool?
For families giving less than several million dollars, a donor-advised fund at a community foundation or sponsor avoids the private foundation excise taxes, the annual return, and the self-dealing traps, while still allowing the family to recommend grants and claim the higher public-charity deduction limits. A private foundation suits families who want control, want to employ family members, or want to make grants to individuals and run programs directly.
Frequently asked questions
Can the foundation pay a family member a salary?
Yes, for personal services that are reasonable and necessary — investment management, administration, program work — at a reasonable rate.
Does the foundation have to file even with no activity?
Yes. Form 990-PF is required every year regardless of size.
Can the foundation own the family business?
Generally only within the 20 percent voting-stock limit (35 percent if unrelated persons control the company), counting the family's own holdings, with a five-year window to reduce gifted or bequeathed shares.
Are grants to foreign charities permitted?
Yes, with equivalency determination or expenditure responsibility.
Official sources
The IRS explains: “In addition, the Internal Revenue Code contains five provisions that impose excise taxes on private foundations, foundation managers, or other disqualified persons that engage in certain prohibited acts.” — Internal Revenue Service, Private foundation excise taxes, https://www.irs.gov/charities-non-profits/private-foundations/private-foundation-excise-taxes
The IRS explains: “Form 990-PF is used to figure the tax based on investment income and to report charitable distributions and activities.” — Internal Revenue Service, About Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Trust Treated as a Private Foundation, https://www.irs.gov/forms-pubs/about-form-990-pf
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk runs the distribution calculation and the self-dealing review for family foundations each year. See pricing or book a free fit call.
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