SunTrust Foundations and Endowments team outlines strategies for minimum distributions, qualifying distributions and over distribution, including tax implications.
[Meghan Pietrantonio] Thank you to everyone who is joining our webinar today. The SunTrust Foundations and Endowments Specialty Practice provides comprehensive investment and administrative services to charitable organizations. In our work with private foundation clients, we often field questions regarding IRS rules and regulations relating to private foundation payouts. So we're very excited to share with you today some important information that we think will help you in your roles as trustees, directors and fiduciary.
Here is the agenda for today's call. First we will review how the IRS determines the required minimum distribution and the one-year in arrears methodology. We'll review excess distributions and the implications on grant making and perpetuity. Then we'll present several models to address utilizing carry forward. And then finally at the end, we'll have time for questions. So with that, I'd like to get into the topic of today. Today, we are discussing the private foundation minimum distribution requirements, which is commonly referred to as the five-percent payout. I'm sure most of you use this term or have heard it among your grantees. Understanding the private foundation minimum distribution requirements and the utilization of carry forward amounts can be difficult. However, gaining an understanding is especially important for foundations that find themselves in significant over-distribution positions because of the implications on investment, future grant-making capacity and ability to exist in perpetuity.
I'm pleased to introduce our two experts, who are presenting for us today. First is Allen Mast, who is an attorney and private foundation expert with over 15 years of foundation and grant-making experience. Allen leads our private foundation team for the SunTrust Foundations and Endowments Specialty Practice, which manages serves 150 private foundations across the country. Allen is a graduate of Davidson College and UNC School of Law. Allen will review for us the minimum distribution requirement, the importance of the one-year in arrears methodology, and over distribution carry forward position. Then we will hear from Michelle Michalowski. Shelley is the Director of PWC, a national exempt organizations tax services group. She has over 12 years of experience, providing specialized tax consulting and compliance services to tax-exempt clients.
Based in Washington DC, Shelley has experience serving various types of tax-exempt organizations, including private foundations, hospitals, museums, supporting organizations and educational institutions. Shelley is a specialist in compliance and planning services for private foundations and other tax-exempt organizations and has extensive experience with the redesigned form 990. At PWC, she is the go-to expert on private foundation excise taxes, executive compensation, alternative investment review and unrelated business and contacts. She's a frequent instructor and presenter on issues affecting private foundations and other exempt organizations. Shelley is a graduate of the College of William and Mary, and obtained her MS in Taxation from American University. Shelley will discuss for us today the implications of excess distribution, methods to address over-distribution and utilizing carry forward.
With that, I'd like to turn it over to my colleagues, Allen Mast. Allen.
[Allen Mast] Thanks, Meghan. And welcome to everyone participating in today's discussion. As Meghan said, I'll be reviewing three topics that are important to prudently managing private foundation distributions: those include the minimum distribution requirement, the importance of the one-year in arrears grace period for satisfying the minimum distribution requirement, and an overview of excess distributions and carry-overs. I’ll begin on slide four with the minimum distribution requirement. As you know, private foundations must distribute annually qualifying distributions of at least five percent of the average monthly fair-market value of their non-charitable use assets calculated during a tax year. This is the well-known five-percent payout rule that defines the minimum that foundations must distribute each year.
But as you probably know, there's a lot more to the rule than simply multiplying your foundation's year-end market value by five percent. Before beginning the minimum distribution requirement calculation, a foundation must value its assets by dividing them into categories usually into cash, marketable securities and real estate. For cash, you average the beginning and ending value each month, creating a rolling monthly average. For marketable securities, you use the traditional month-end value. And for real estate, you use evaluation conducted within at least the five years.
When you have your valuations, you're ready to begin the calculation itself, which is illustrated by the simple example at the bottom half of slide four. And this corresponds with part ten and part 11 of a private foundation's tax return, the form 990-PF. And looking at the calculation here on the page, you start with an average monthly fair-market value during the year of $10 million. Now the IRS permits private foundations to reduce this amount 1.5 percent because it assumes a private foundation holds that amount for charitable purposes. And in this case, that would equal $150,000. So you subtract that amount from the $10 million, which yields $9,850,000, which would be the value of this foundation's non-charitable use assets.
Now this the value that you multiply by five percent, which generates what the IRS calls the minimum investment return, which is really the base minimum distribution requirement. And in this case, five percent multiplied by $9,850,000 yields $492,500. And it's from this base minimum distribution requirement, what the IRS calls the minimum investment return, you add to that any grant recoveries that you've received during the year. And just as an aside, a grant recovery of course is where a previously distributed grant is returned by a grantee. And though rare, they do happen. And in this example, this foundation had a grant recovery of $10,000.
So you add that back into the minimum investment return. You also subtract from the minimum investment return any amounts paid as excise tax on that investment income. And in this example, this foundation paid excise taxes during the year of $20,000. So you subtract the minimum, the excise tax from the minimum investment return, and that generates a value of $482,500, which would be this foundation's payout amount or minimum distribution requirement for the year. Turning to slide five. The minimum distribution requirement that we just calculated must be satisfied by making qualifying distributions, which can include charitable grants.
And of course, this is the way most of us satisfy the minimum distribution requirement. Amounts used to acquire charitable use assets, such as a foundation's office building or used for direct charitable activities, such as operating a museum, also count as qualifying distributions, as do qualified set-asides, which are assets that foundation's set aside today for a specific future project that count as a current grant in the current year. Now these must be approved, pre-approved by the IRS before you can embark on a qualified set-aside. Program-related investments, number four there, also count as qualifying distributions. So do certain reasonable and necessary administrative costs used to accomplish a foundation's exempt purpose, such as costs associated with grant administration, publishing an annual report, or preparing a foundation tax return.
And most importantly, for our discussion today, is that you can use excess distributions from prior years as qualifying distributions to reduce your current year minimum distribution requirement. And we'll talk about that in more detail in a just a minute. In terms of penalties, a foundation's failure to meet its minimum distribution requirement by making qualifying distributions results in an initial penalty of 30 percent of the shortfall. And if that isn't corrected in a timely manner, an additional penalty of 100 percent of the shortfall can be imposed.
On slide six, we talk about the one-year in arrears methodology. And this is really one of the most important features of the minimum distribution requirement. And that is that the minimum distribution requirement must be met, as we discussed, by making qualifying distributions but by the end of the following tax year. So for example, assume that based on your foundation's 2013 tax return, your foundation's minimum distribution requirement was $482,500, the amount that we generated in the example on slide four. This amount must be distributed no later than December 31, 2014, a year later, assuming now that your foundation is utilizing a calendar fiscal year. You’ll often hear this grace period referred to as the one-year in arrears method for calculating a foundation's minimum distribution requirement.
And most foundations, though not all, utilize this approach in calculating the minimum distribution requirement because of the advantages it affords. In slide seven, it lists some of those advantages. And they include that private foundation federal tax requirements are predicated on the one-year in arrears methods. So if you follow that method, you follow the federal tax requirements. Second, it generates a sum certain distribution amount. You know exactly what you must distribute and when, and that provides a great deal of certainty.
You also avoid having to estimate the distribution amount in the current year and the inherent uncertainty that it creates. So, you know, if you're a foundation and you use a current year method, you're trying to determine what the value of your assets are before you've actually occurred. So for example, if you were using a current year method this year, you still don't know what your month-end market values are for the rest of the year. And so you would have to estimate them or guess them to try to determine what your payout requirement would be in the current year. And that creates a great deal of uncertainty. Four, the method provides time to plan and be more strategic with your grant-making because you have this one-year grace period. And five, and this is in my view probably the most important point, is that it ensures that distributions are made when they're due, rather than before they're required.
And this keeps your foundation's assets invested longer, generating potential additional returns. And in a falling market, it avoids selling assets to pay grants not yet technically due. And finally, the one-year in arrears method can simplify your cash flow planning, which can be important for budgeting and raising cash to pay grants and expenses in a prudent manner. Slide eight talks about some of the drawbacks of the one-year in arrears method. And there are a few. Number one, even though you obtain a certain distribution amount and you have a one-year grace period in which to distribute it, the actual payout amount is really not available until the foundation’s tax return is completed.
And that's usually on or about May 15th of the following tax year for foundations on utilizing a calendar tax year or a fiscal year. And so even though theoretically, you have a one-year grace period, it's actually a little bit shorter because you have to wait on your tax return to find out what the actual distribution amount is. Number two, another potential disadvantage is that a minimum distribution requirement in one year must be paid by the end of the next year, using that year's assets to pay those distributions. So this can lead to a mismatch between the market value used to calculate the distribution requirement, and that used to pay the actual grants a year later.
And this can be especially challenging in a falling market, like we saw in the Great Recession where foundations were having to pay grants based on a distribution requirement that was calculated based on an asset value that was much larger than the foundation had to pay its grants the next year. Number three, you know, foundations are often advised to closely follow the minimum distribution requirement, and I think that's pretty good advice. But doing so can make a grant recovery more difficult because you really don't have a cushion to absorb the recovered amounts. So they’re rare. Grant recoveries are rare, but some foundations still decide to distribute a little bit more than the minimum distribution requirement just in case they encounter a grant recovery during the year.
So there are some advantages and disadvantages to the one-year in arrears method. But on balance, most foundations find that the advantages clearly out weigh the disadvantages, and that's why a significant majority of foundations utilize the one-year in arrears method in calculating their minimum distribution requirement. Now on slide nine, we examine the situation where foundations distribute more than minimum distribution requirement. And there are a number of reasons why a foundation may make excess distributions, including it may wish to address an important one-time or short-term charitable need, for example, a once-in-a-decade capital campaign of a key charitable partner. It may also decide that a long-term commitment to an issue program or organization is more important than the impact of exceeding the minimum distribution requirement.
Now I’ve worked for a foundation that actually considered such a commitment, but we ultimately decided not to. But I can tell you that a decision like this really requires careful deliberation because of the implications to the foundation's ability to carry out its mission over the long term. And Shelley is going to discuss that in more detail in a couple of minutes. Third, the foundation's donor may have instructed the board to spend down the foundation's assets over a period of time. Now historically, this is a rare approach for a donor to undertake. Although you do, in recent years, have seen that a little bit more. The classic example recently is the Atlantic Philanthropies in New York, which is in the process of currently spending down its very large endowment by the end of 2016.
Number four, the foundation may have chosen to use a current year distribution method, rather than a one-year in arrears method -- this is just what we were talking about a minute ago -- which can lead to excess distributions because the foundation is essentially paying its grants a year in advance, year after year, which can lead to excess distributions. And five, the board, there have been circumstances where a board just simply wasn't paying close enough attention to the relationship between the distribution requirement and the amount of grants actually going out the door. And we have advised foundations who found themselves in those types of circumstances. On slide ten, we talk about what happens when a foundation actually makes excess distributions.
How is that handled? And it's interesting because the IRS actually anticipates that some foundations will make excess distributions from time to time. And it's created a process to help manage them. And it operates like this with the three bullets on slide ten. If a foundation distributes more than the minimum distribution requirement in a give year, the excess amount is accumulated and can be carried over for a period of five years. That excess distribution can be used to reduce the foundation’s minimum distribution requirement during that five-year period. And importantly, in each tax year of the amount of the oldest year of over-distribution, that fifth year of over-distribution expires and reduces the total corpus of the foundation if not utilized.
So essentially, the Internal Revenue Service has set up a system that encourages foundations that make excess distribution in one year to hold back making some distributions in a future year to make up for it. Now slide 11 illustrates how this works in practice on the 990-PF through a simple hypothetical example. Now there's a lot going on here on the page, but I'm going to focus on just three items or three questions. Number one, where do you find the excess distributions on your 990-PF? Number two, what are the opportunities for this foundation to utilize them?
And three, what's the impact to the foundation if it doesn't utilize them? To number one, you find the excess distributions for the current year for this foundation on line three, which is indicated by the top red circle on the page. The excess distributions that will go into the next tax year are at the bottom on lines nine and ten with the bottom red circle. Now turning to the top red circle on line three, this shows that the foundation came into the year with total excess distributions of $1,041,934. And those were carried over from the prior five years, as you can see on line three and the total on line 3F.
Now remember that excess distributions expire after five years. So in this instance, the $453,565 from 2007 on line 3A will expire unless it is utilized on this return. To the second question, what opportunities does this foundation have to use its excess distribution carry-overs? Well, line one up on the top right corner of the page, the very top, shows the foundation's minimum distribution requirement is $742,124.
That's the amount that the foundation must distribute this year. But remember, the foundation has over $1 million, $1,041,934 in excess distributions just sitting there on like 3F. And it can do one of three things with that $1 million. It can use some of it to satisfy the entire distribution requirement for the year for this foundation. This foundation wouldn't have to pay a penny in grants. And still it would have almost $300,000 in excess distributions left to carry over into the next year. Second, it could use some of the excess distributions to satisfy just a portion of the total distribution requirement. It wouldn't have to use all of it to pay all of the $742,000 of the minimum distribution requirement.
It could just pay some of it, and the foundation could still make some grants. Or three, it could none of the excess distribution carry-overs to satisfy the distribution requirement. And that's what this foundation chose to do. It chose to use none of its excess distributions towards this minimum distribution requirement. So instead, this foundation was required to meet the minimum distribution requirement of $724,124 with qualifying distributions, which it did on line four, which you can see shows that the foundation made $889,860 in new grants for the year.
That's $147,736, which you can see, more than it was actually required to distribute. So on this page, this foundation really did two things. It chose not to use the excess distributions towards its minimum distribution requirement. And it also continued the trend of making more grants than was required. And this really impacts the foundation in two important ways. First, the 2007 carry-over on line 3A of $453,000 went unused and will now expire because it's in its fifth year so it's rolling off. And as a result, the foundation has lost the opportunity to offset its excess distributions that it made in 2007.
And this leads to a direct reduction in the foundation's corpus. And second, the foundation continued the trend of adding to its excess distribution. And on line 10E, you can see that it added $147,736 to the excess distributions, which now total for the prior five years of $736,105, which will carry over to the next tax year, and the foundation will again have the opportunity to utilize that towards its minimum distribution requirement. So let me close my section by suggesting that, as a private foundation fiduciary or staff member, it's important to know what method of calculating the minimum distribution requirement your foundation uses and why.
And as Shelley is now going to discuss, it's also important to understand the implications of excess distributions and what can be done to address them. Shelley.
[Michelle Michalowski] Thanks a lot, Allen. Now we've gone through all the details. We've reminded you of how part 13 works on 990-PF, the requirements for your minimum distribution calc, what it is to be in a position of over-distribution, what excess distribution carry-overs are. And we're going to move on to the next slide here and talk a little bit about why you should care, why we're really here talking about this topic today. And Allen touched on this a little bit. But just to highlight it, especially for perpetual foundations where you're tasked as a fiduciary or a manager in making sure that the foundation you work with last forever.
In doing that, by distributing more than the minimum amount, you could be putting that at risk. And we want to focus here on the slide at the exhibit one chart. This chart comes from a white paper, which was written by the Foundation and Endowment Specialty Practice at SunTrust, authored by Quanda Allen. And it's called "The Long-Term Impact of Over-Distribution of Private Foundations." I highly suggest you seek that out. It's a very great white paper, and it includes this exhibit. And what this helped us see is that, if you have three different foundations, and they start with a $10 million corpus and one foundation consistently distributes at five percent, so the minimum, the other foundation distributes at six percent, that's the red line here, and the third distributes at seven percent. After a 30-year period, you can see that this makes a significant difference on the overall corpus of the foundation. So after 30 years, the organization distributing at five percent has increased their overall corpus because they have -- and there are certainly assumptions here about your minimum investment return and things like that.
But you see what the assumed return being the same across the board, your five-percent payout has managed to increase its corpus through its investments. Your six-percent payout is hovering around $10 million, slightly below. And your seven-percent payout organization is all the way down to $7 million in corpus. So there's over a $5 million spread in corpus, starting from a $10 million point for organizations just between a five-percent and seven-percent payout. So over time, it really does make a difference in the assets that the foundation has to work with going forward. So it's important to keep in mind and to be mindful of the decisions that you're making regarding distributions.
So when Allen went through a list of reasons why you might choose to over-distribute and that's fine, but the choice should be made mindfully. And it shouldn't be just because you didn't notice that the grants you were giving away were, you know, well above and maybe you lost out on some excess distribution to carry forward. So we're going to move here and look at some hypotheticals and some common responses. So let's say you work at a foundation or you're a board member of a foundation, and you find yourself in an over-distribution situation. And this happens sometimes because you get new management that comes in or because all of a sudden you have a new board member and they say, "Well, why does the return show these excess distributions carry forward? What are we doing with those?" Oftentimes, we work with clients who really, you know, one question has suddenly sent them on this quest to figure out, you know, how they ended up in over-distribution scenario and what they should do about it.
So you have some common responses. You find yourself in an over-distribution situation, you could do nothing. You can continue to award new grants at the same rate. And you could say, you know, "We like our current mode of business and we're not going to change it." The result there is similar to the example of part 13 that Allen walked through. You're going to allow your carry-overs to expire unused. You're not going to get the benefit of any of your excess distributions carry forward. And you risk potentially in the future lowering your overall endowment of the foundation. Your second course of action: you could postpone awarding some or all of your new grants. So you could say, "I see where we're at. We’re not going to take drastic changes. But, you know, let's look at the giving that we're doing going forward and maybe dial it back a little bit."
In that situation, you're probably still going to allow some carry-overs to expire unused. But you're likely going to start, you know, making long-term changes to lower your over-distribution position to potentially use some of your excess distribution carry forward. And there's a slightly more dramatic approach, which is you can really try to maximize using your carry-overs by renegotiating your grant commitments and by altering potential future giving plans in a more dramatic fashion. And we're going to look at real scenarios with some numbers for all of these. And by doing that you can reduce or potentially eliminate the foundation being in a carry-over position, which means that you're maximizing the use of your assets. Now there are some other planning opportunities that can get fancy.
You can call your representatives. You can talk about out of corpus selections. But for most organizations that we work with, these first three items are really the first planning points. So let's get into an actual scenario and we'll talk about the assumptions here. So your hypothetical here is that your board members come to you and they've said, "Why are we in this over-distribution position? What can we do about it? Please show up at the next board meeting with some planning choices and opportunities that would allow us to make decisions about what to do with this over-distribution and these excess distribution carry forwards." And in this case, we have to make some assumptions to simplify this example and they're on this page. First, your PF was created in 2009 with an initial contribution of $10 million. Annually, your PF earns $1 million in net investment income and grants out $1 million.
Notice, we're keeping it clean. Your corpus will stay the same at $10 million. You've got $1 million coming in. You pay out $1 million in grants. That resulted in annual minimum distribution requirement if you dial back to the calculation that Allen walked you through right at the beginning of this presentation. It'll come out to $472,500. So that's what you have to pay each year to avoid an excise tax. With current grant commitments that means by paying out $1 million every year that you're paying out $527,500 more than you have to. And you can see that down here in the excerpt from part 13 from the form 990-PF. You see that each year you have an excess of the $527,500, and, as a result, after a five-year period, you have total excess distributions carry over of $2.6 million.
This is the position for the hypothetical that we find ourselves in. So what do we do about it? What does our planning look like going forward? On the next slide here, we looked at your grant commitments or pledges. In this scenario, we're going to say that your PF has existing grant commitments with 20 different grantees. You can think of these as pledges. You can think about these as budgeted grants. It's not important for this particular scenario. We're going to talk about them as grant commitments, but it could just as easily be your budget. We have grant commitments with 20 grantees, and each commitment calls for $50,000. As a result, you are projected to pay out $1 million each year for the next three years. So this is the scenario going forward. What are your planning options? We're going to look at three options here.
One is that you honor these $3 million of grant commitments but you choose to make no other new grants. Option two is that you break your grant commitments, which would be applicable to a scenario where you have just budgeted that amount and now you've chosen to just wipe your budget clean, and you make no new grants. That's an extreme position, but it's a good baseline for discussion here. So option two is really that you have zero expenditures. And then option three is the middle ground, which has a lot of different room for different variables. And that's where you renegotiate your current agreements, but you're making no other new grants. And we'll talk about the details when we get to that option. So let's look at option one. Option one, the scenario is that you honor your existing commitments. So if you remember, it was $1 million in each of the next three years, but you're making no new grants. In this chart here, we're going to see it three different times for three options.
The first column shows you the tax return year. The second column is the grants paying so this is where you see your $1 million each of three years for the total $3 million grant. The third column is your expired carry-over summary. So it lets you know how much of that original $2.6 million carry over that you're losing. It also factors in that when you're paying $1 million, you're generating more carry over so you may actually be losing more than the original $2.6 million. And the third column shows you when you finally flip into a position of undistributed income, when you've finally used all of your carry-overs or they've expired and now you're in a position where you need to make payments again. So walking through those different pieces of this, you can see that by simply moving forward with your existing commitments and not really changing any behavior, other than not making new grants, you're really losing quite a bit of your carry-overs.
You're not getting to take advantage of them. So out of a total $2.6 million, you're losing $1.8 million, $1.9 million of carry over. And it's going to take all the way to 2017. So when you get to the -- oh, I’m sorry. 2022. At the 2022 tax return year is when you're finally make it back to the one-year in arrears position. So the making no new grants is helping you out in the long term, but continuing to spend at the current rate for the next three years is hurting you in the short time. But this scenario is the least painful. You're not making dramatic changes necessarily to your existing behavior. But you're really helping yourself out in the very long term.
So if you're not making any other new grants here when you get to 2023 that's when you would have an exposure to the excise tax. You would want to make sure that you had new expenditures at that point. So keep this one in mind. Option one scenario, you didn’t change your behavior a lot, and you lost about $1.8 million, $1.9 million of your carry over. . We'll move on to option two. Option two is your excess, your extreme scenario, which is not likely to occur but useful to discuss. And you can see that it's extreme when you look at the grants paid column. Your foundation has said we will spend zero dollars. And you'll notice that this hypothetical is very simple because it does not take into account administrative expenses. So every foundation has some administrative expenses to factor into a qualifying distributions. For the purposes of this example, we're really just looking at the grants paid number.
So we have said zero expenditures. What does that do? And one of the things that surprises people is that even if you chose to spend zero money, you're still going to lose some carry-overs. So once you've gotten yourself in a position of extreme excess distribution carry forward, you can't always correct it in a manner that allows you to use all of you carry over. This is the most extreme situation, and you're still losing $270,000 of carryover. So this is as good as it could possibly get as far as utilizing your carry-over. You're still going to lose some, but you'll notice that this extreme scenario puts all the pain up front. And what it does it that you reach the one-year in arrears position in 2019 so relatively soon. It only takes you a five-year period to get to, back to we need to make minimum payouts and we need to have expenditures again and our carry-over balance is down to zero.
So this is the other end of your spectrum here as to how quickly, despite the pain, that you could get yourself into a zero carry-over position. Moving on to option three. So option three is really the planning period, the planning ground. You can play around quite dramatically with when you pay your grants, how you spread it out, how much carry-over you'd like to use. For the purposes of this scenario to keep it somewhat simple, we've looked at a scenario where you renegotiate your existing grant commitments to instead of paying these grants over the next three years, you're going to pay them over a ten-year period. So you see that the total of the grants paid column is still $3 million. But instead of doing it in three years, you're doing it in ten. This is a realistic possibility. Sometimes in order to renegotiate with grantees, you pay them more money.
So you might say, "Well, we're going to pay you $4 million instead of $3 million, but we're going to do it over a ten-year period." And the way that this is scheduled is that you're paying less up front, which means that you're utilizing more of your expiring carry-overs up front. And that allows you to maximize your use of expired carry-overs without, you know, going to the extreme of spending zero money. So in this case, we've spread out our grants over the ten-year period. And you'll see that we lose some carry-overs. We're still losing $775,000 of carry-overs. But it's pretty good. It's not, you know, you had $2.6 million to start. You lost a little bit. But it's not the scenario as scenario one where you lost $1.8 million, $1.9 million. So this is a pretty good middle ground. You're still making all the commitments that you promised; you're just doing it over a different timeframe. You're losing some carry-overs, but you're really in a position where you're using quite a bit of them.
And then more importantly, we actually chose these numbers as far as when you pay out the grants so that they would be in a position where all throughout this ten-year period, you've gotten yourself to a position where you’re paying pretty close to your minimum amount. So you're not perfect, but you're much closer to your out-closer, closer to your minimum, and you're not creating that much more of an excess carry-over. And that's really where you want to get to in the long point. You want your expenditures to be matching up with that one-year in arrears position so that you're not generating these excess carry-forwards that you have to do extreme planning to try to figure out how to use. You want to find a balance point. So those are the three options. If anyone has any questions about any of the options, feel free to ask Allen. Meghan, if you guys have any questions or I've missed something that you want to bring up, please let me know.
And otherwise, I'm going to take a minute to step away from talking just about over-distribution so that we can mention the interplay between excess distribution carry-forwards and the targeting of the one-percent reduced tax rate, which is our next slide here. So for any of the organizations out there that regularly target the one-percent reduced tax rate or who have discussed potentially targeting it, it's important to remember that both the minimum payout calculation, so this five-percent payout, and the test to qualify for the one-percent rate -- and I've included part five here from a 990-PF to allow you to see, to remind you because this is the simplest of tests and not many of the tests on the 990-PF are particularly simple, certainly not this one.
But this, so this test is based on a rolling five-year average of your qualifying distributions to your non-charitable assets. Because the way the test is set up and because it looks at qualifying distributions, it really requires you to continue to meet year-after-year the one percent rate. You have to have qualifying distributions that increase each and every year. And you can see that that is diametrically opposed to the goals we've been talking about throughout the rest of this presentation of keeping your qualifying distributions at a minimum payout level. As a result, if you target a one percent rate on a consistent basis, you're likely going to find yourself in a position of over-distribution. So keep that in mind that there's a give and take between these two items.
If you’re targeting distribution, which for many organizations is more important to honest, you have to be quite large to really make a difference between paying the one and two percent tax rates, and for that difference to be big enough that it's worth over-distributing. But if, so, for example, you might also be sitting in a board meeting and have members ask you, "Well, why can't we target the one percent rate?" And the answer is that you can target it, but it will create or exacerbate an over-distribution period, position if you choose to target it for a period of time. And very sophisticated organizations that do target this one-percent rate, the way that they'll do it to try to protect their over-distribution position is that they will target it for maybe four years. And then on that fifth year, they will plan to take a dive, meaning that they will have dramatically reduced qualifying distributions in the fifth year.
As a result of that "dive", they'll help themselves by using ups[?] and excess distribution to carry forward. And they'll reset this average, which allows them to, you know, get their qualifying distributions required for one-percent targeting down to a more manageable position. So I just wanted to mention that because there really is some interplay there, and you can't necessarily have everything that you want in the world meeting your minimum distribution without over-distributing and also qualifying for the one percent rate. So that's the end of our slides here. But we really do encourage, if any one has questions to ask. Or Allen, if there's anything you want to add here now that hopefully everyone is still awake after walking through all these models.
[Allen Mast] Thanks, Shelley. This is Allen. No, I think you covered it very, very well.
What I will mention is that we, at SunTrust, have worked with a number of foundations in the last, say, 12 to 18 months, who have found themselves in over-distribution situations and, as a result of new leadership or changes in staffing, wanted to address that and went through planning and scenarios very similar to what you just demonstrated to help them do that. And, of course, we did that with the assistance of PWC, and that was very helpful to us and to the foundation. It can be a complex challenge to address, but one that is certainly do-able.
[Meghan Pietrantonio] And with that, Rachel, if you will please open the line for questions. I think Allen and Shelley probably definitely have a couple of questions on the line with this complex issue.
[Host] Okay. No problem. And thank you. And right now, we will begin our question and answer session. And if you would like to ask a question, please press tare and then one. And please record your name clearly when prompted. Your name is required to introduce your question. To withdraw a request, you may press tare and then two. Once again, to ask a question, please press tare and then one. Please record your name clearly. Your name is required to introduce your question. To withdraw a request, you may press tare and then two.
[Meghan Pietrantonio] And while we're waiting for questions on the line, I received a question over the live meeting. And I think, Allen, this is probably for you, but Shelley please jump in. The question is: how do grantees respond when you apply either the option two or you break all of your commitments, or option three where you negotiate your commitments as you try to really reduce that carry-forward position?
[Allen Mast] Yeah, that's a good question. We have dealt with that very specific issue in two instances just in the last year or so. The short answer is that option two does not go over very well. If you can imagine, the foundation has relationships with grantees. It's made commitments. And a conversation where foundation basically says that we are not going to be in a position to honor our commitments is often a non-starter. What is sort of the basis of a more interesting conversation is renegotiating grant commitments to create a situation where you can address your excess distribution carry-overs.
And that has occurred, as I said, on two occasions where there were many grantees involved and that conversation, those conversations went well. Grantees are very understanding about that circumstance. And they were very willing to essentially create a work out situation where grants payments were extended over a period of years and that went well. But the option one where you're essentially saying that we're not going to ho nor our grant commitments is really not a workable solution.
[Meghan Pietrantonio] Thank you, Allen. Rachel, are there any questions on the phone?
[Host] At this time, ma'am, no questions on phone.
[Meghan Pietrantonio] Okay. I have one more question on live meetings. Shelley, this one is for you. Okay.
The question is: how come when calculating the reduced tax on net investment income, we add the one-percent net investment income tax? But when calculating the qualifying distributions in part 13, we have to subtract it, re-qualify until we get to that calculation?
[Michelle Michalowski] Well, there's some pretty complicated policy decisions behind those, why that's the case. When you're looking at your qualifying distributions, you're being allowed the benefit or you're making sure that you're not getting counted as a qualifying distribution year[?] tax. Hence, why you need to take it back out. When you're looking at the calculation for the one percent rate, I believe that the way the math works is that you're being -- it's made sure that you're not being penalized for having only paid one percent.
And by adding that one percent back in -- I wish I had the 990-PF in front of me. But I do know that the way that the math works when you have to add that extra one percent back in, it's actually a benefit to the taxpayer. It puts you on equal footing with someone who might have paid the two percent rate. And I think that the law behind that is back in the way when this test came into play, you know, someone raised their hand and pointed that it put them in the wrong position. And so that line was added to alleviate that.
[Allen Mast] That's a good question.
[Meghan Pietrantonio] All right. Thank you so much, Shelley.
[Michelle Michalowski] No problem. And I will say one of the other things when you're talking about grant commitments and agreements with organizations, that one of the challenges that organizations really face in hard times, so especially recently with the recession and you saw organizations that really saw their dollars decrease dramatically, that's the time that private foundations, as a grant-makers, really feel the pressure to increase their distributions.
Organizations that they work with regularly are saying, "Hey, we're in a really hard time. Can you give us anything extra? Can you increase your distribution?" And it's a tug at the heartstrings sort of playing. You say, "Well, you’re right. I'm supposed to be helping these organizations. Can we give them more money?" But it's important to take a step back, the fiduciary at that time, and say, "Your investments in the foundation are also, you know, they've been reduced as well. Your return on investment is lower." And so you need to be careful not really be excessively distributing at times like that. And we saw a lot of organizations really put themselves in an over-distribution scenario because of that particular fact matter.
[Meghan Pietrantonio] Thank you, Shelley. Rachel, I just wanted to see if there was, one last time, if there were any questions.
[Host] All right. So if you still have any questions, feel free to press tare one and record you name clearly. Your name is required to introduce your question. To withdraw a request, you can press tare and then two.
[Meghan Pietrantonio] Okay.
[Host] Okay. Ma'am, we don't have any questions on the queue.
[Meghan Pietrantonio] Okay. Well, with that we are just at or just before 4:00. And so I wanted to take this opportunity to thank Allen and thank Shelley for their participation on this call. This is a really complex issue and having their expertise really provides a lot of value to all of you on the webinar and to all of our clients here SunTrust.
Should you like or need additional information, or if you'd like to reach us, I've provided our contact information here on the PowerPoint. And we will also be sending a link to this recorded webinar to you following the webinar. And we hope that you will share it with your colleagues and fellow directors and trustees. Thank you so much for your time today. And with that, we will end this webinar.
[Host] And that concludes today's conference. Thank you for participating. You may now disconnect.
SunTrust Foundations and Endowments team outlines strategies for minimum distributions, qualifying distributions and over distribution, including tax implications.
This content does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.
Investment and Insurance Products:
Are Not FDIC or any other Government Agency Insured Are Not Bank Guaranteed May Lose Value
© 2018 SunTrust Banks, Inc.
Equal Housing Lender. SunTrust Bank - NMLS #93471. Member FDIC.
SunTrust, SunTrust PortfolioView, SunTrust Robinson Humphrey, SunTrust Premier Program, AMC Pinnacle, AMC Premier, Access 3, Signature Advantage Brokerage, Custom Choice Loan and SunTrust SummitView are trademarks of SunTrust Banks, Inc. All rights reserved. All other trademarks are the property of their respective owners.
Services provided by the following affiliates of SunTrust Banks, Inc.: Banking products and services are provided by SunTrust Bank, Member FDIC. Trust and investment management services are provided by SunTrust Bank, SunTrust Delaware Trust Company and SunTrust Banks Trust Company (Cayman) Limited. Securities, brokerage accounts and insurance (including annuities) are offered by SunTrust Investment Services, Inc., a SEC registered broker-dealer, member FINRA, SIPC, and a licensed insurance agency. Investment advisory services are offered by SunTrust Advisory Services, Inc., a SEC registered adviser. GFO Advisory Services, LLC is a SEC registered investment adviser that provides investment advisory services to a group of private investment funds and other non-investment advisory services to affiliates. Mortgage products and services are offered through SunTrust Mortgage, a tradename for SunTrust Bank, and loans are made by SunTrust Bank.
"SunTrust Advisors" may be officers and/or associated persons of the following affiliates of SunTrust Banks, Inc.: SunTrust Bank, our commercial bank, which provides banking, trust and asset management services; SunTrust Investment Services, Inc., a registered broker-dealer, which is a member of FINRA and SIPC, and a licensed insurance agency, and which provides securities, annuities and life insurance products; SunTrust Advisory Services, Inc., a SEC registered investment adviser which provides Investment Advisory services.
SunTrust Private Wealth Management, International Wealth Management, Business Owner Specialty Group, Sports and Entertainment Group, and Legal and Medical Specialty Groups and GenSpring are marketing names used by SunTrust Bank, SunTrust Banks Trust Company (Cayman) Limited, SunTrust Delaware Trust Company, SunTrust Investment Services, Inc., and SunTrust Advisory Services, Inc.
SunTrust Robinson Humphrey is the trade name for the corporate and investment banking services of SunTrust Banks, Inc. and its subsidiaries, including SunTrust Robinson Humphrey, Inc., member FINRA and SIPC.