There is much talk in philanthropy about the “five percent rule,” the legal requirement that each year, a private foundation is required to spend at least five percent of its endowment on grants and expenses related to charitable activity. Clients are often asking me for more specifics regarding the “five percent,” and I’ve put together an overview that I’m hoping will be helpful. Please keep in mind that this is a blog, and therefore does not constitute official legal or accounting advice. If you have any additional questions, please don’t hesitate to email me: ccasey@pfs-llc.net, and certainly consult a qualified accountant or attorney to ensure compliance.

#### WHY 5%

As a very general rule, 5% of a foundation’s corpus (endowment) should be spent each year on grants and certain expenses related to charitable activity in order to remain compliant with federal and state tax codes as they relate to foundations and charitable trusts.

The 5% payout rule is designed to allow foundations to grow their assets so they can maintain their purchasing power (giving ability) in perpetuity. With historic market returns of approximately 8% in a balanced portfolio and 3% historic inflation, a foundation should be able to spend 5% of its corpus each year and maintain relevance.

But what does that 5% number really mean, and how is it applied? How is the 5% properly calculated? And, what are the consequences of missing the payout requirement? The answers are fairly complex, but the important lesson is that foundation directors and administrators should simply try their best to budget well and then not worry too much about “hitting” the payout number on an annual basis.

#### WHAT IS PAYOUT?

The first important definition is “payout”: the total amount of grants approved and paid to qualifying 501(c)(3) organizations during a fiscal year, plus the total amount of “eligible” expenses incurred by the foundation during that same year. The inclusion of eligible expenses in the payout requirement is designed to reflect the fact that there are costs associated with making good grants (due diligence, record keeping, learning best practices, etc.). Some foundations set up an office, hire staff and/or engage consultants to administer their foundations.

The eligible amount of charitable administrative expense is based on a prudent and consistently applied estimate of the relative amount of board and staff work that is dedicated to grantmaking versus investments in a particular foundation. In most cases, a majority of the associated expense (i.e. 75% to 85%) is considered “eligible” towards the 5% payout. Generally, a third (33%) to half (50%) of accounting and audit expenses can be applied towards the five percent, as well as a majority (i.e. 95%) of legal fees, dues, subscriptions and conference fees. These are considered by the government as the necessary expenses of running a foundation, and a foundation’s accountant can recommend exact percentages for the various expenses, based on the kind of work the foundation does. Any taxes paid (estimated or prior year amounts due) during the year are credited back towards the payout requirement. Any investment expenses, such as fees paid for investment advice or investment management fees, are not eligible.

#### BASIS FOR CALCULATION

The next important question is: 5% of what amount? The answer is somewhat complicated. Rather than taking the assets at the beginning or end of the fiscal year, a foundation must calculate its payout based on a 13-month average of investable assets. The average is calculated by adding up the market values of investable assets (cash, equities, fixed income, and private, or “alternative,” investments) each month of the year, plus the same assets of the prior December, and dividing by thirteen.

One of the inherent problems in this formula is that most foundations budget early in the year. And even if budgeting and all of the grantmaking happens in December, it is still impossible to know what the 13-month average will be until the books are closed sometime in the first quarter of the following year, or (in many cases) until after the audit is completed. To further confuse the calculation, the IRS allows a 1.5% set-aside for the cash needs of the foundation. So, essentially, the foundation must pay out 5% of 98.5% of the average assets of the foundation over the preceding thirteen months. As a result, the best anyone can be expected to do is to make thoughtful estimates, because the net asset base on which the 5% is calculated is an inherently fuzzy number.

#### MISSING THE PAYOUT TARGET

We now have an understanding of how to calculate the 5%, as well as a realization that actually hitting the 5% in a given year is more closely related to luck than to skill. But what is the consequence of “missing” the 5%? The short answer is that there is no consequence. The only legal requirement is that the entirety of any unpaid amount from the prior year (the “carryover”) be spent during the current fiscal year. In addition, it is prudent to budget 5% for the current year. Over time, it looks bad if a foundation fails to pay something close to 5% over several years, but in any given year, there is no penalty associated with underpayment. In a growing foundation, carryovers can get very big, very fast, so it is recommended that a foundation make every effort to give approximately 5% each year. It is prudent for a foundation to revise its spending plan later in the year to reflect the activity in the markets.

#### TAXES & THE 5%

The final confusing factor in the whole 5% payout discussion is the tax implication. It is a common misconception that private foundations are tax-exempt organizations like standard 501(c)(3) nonprofit organizations. As you probably know, the excise tax rate on foundation income (realized gains, interest, dividends, and contributions into the foundation by donors) is either 1% or 2%, depending on payout. The excise tax rate is 2% by default, but a foundation may qualify for the lower tax rate. The rate is determined by taking the average payout for a foundation over the prior five years and comparing it to the current year payout rate. If the payout rate in the current year exceeds the average of the prior five years, the foundation pays 1%. If it falls under the five-year average, the foundation pays 2%.

While this tax policy appears to encourage higher and higher payout over time, the unintended consequence of the policy is that it allows some gamesmanship and encourages foundations to underpay in years when income is low, so the “hurdle rate” is lower in years when a major gift or taxable income is coming into the foundation. If a foundation always tries to achieve the lower 1% tax rate, it must constantly exceed its prior years’ payout, which makes it harder and harder to achieve the lower taxable rate in a year with high income. However, in general, given the very low excise tax rates (1% or 2%), it almost never makes sense to allow taxes to influence grant decisions.

#### AN EXAMPLE: THE ABC FOUNDATION

After so much narrative, let’s take a very basic example. The ABC Foundation is established with a $1 million gift on December 31, 2015, and no grants are made. Let’s assume the donor family pays for all of the associated expenses of establishing the foundation, rather than having the foundation do so. During 2016, the assets grow 10% to a little over $1,100,000, with asset growth compounding and spread equally over the course of the twelve months (0.8% per month). The foundation has no expenses and all grants are approved and paid in December of 2016. Given this highly unlikely scenario, the 5% payout target would be calculated as follows:

13-month Average Investable Assets: $1,051,560

Less: 1.5% cash allowance ($15,733)

Net Asset Base to Calculate 5% $1,035,787

5% Payout on net assets $51,789

Less: Estimated excise tax payments* ($20,000)

Plus: Carryover from 2015 $3,789

5% payout target in 2016: $35,578

*Because there were no grants in 2015, there is a 2% tax on the initial gift of $1 million. With only one month of assets in the foundation in 2015, the 13-month average net value of assets at the end of 2015 is $75,769, which requires a payout of $3,789, which carries into 2016. Technically, the only requirement in 2016 is to pay the $3,789.

Despite the steady growth and respectable year-end return, the thirteen-month average of the foundation’s assets is $1,051,560, which is $53,153 less than the value of the assets at December 31, 2016. However, the directors of The ABC Foundation would have had no idea what the final 13-month average for 2016 would be until sometime in early 2017. As a result, they most likely would have set their payout budget at $50,000, which would have been a good (and prudent) estimate and would have led to a 2016 payout of 4.83% and a small carryover into 2017.

So what is the payout requirement in 2017? Ideally, the directors of the foundation would go through the same budgeting process with smart assumptions and come up with a reasonable 5% target, and then add the carryover from the prior year. But remember that the only requirement is that The ABC Foundation pay its 2016 carryover in grants and eligible expenses in 2017. The following year, the payout requirement would be whatever was unpaid in 2017, based on the calculation as described above. The problem, of course, is that carryovers can get big fairly quickly, as explained above.

#### CONCLUSION

The 5% payout rule is one of the most confusing and least understood aspects of managing a foundation. Certainly, the intent of every foundation board should be to pay out at least 5% of the foundation’s endowment on an annual basis – that is the spirit of the law. And, after all, foundations are set as a vehicle to make charitable contributions. However, paying exactly 5% in any given year is very difficult, and trying to do so is can be an exercise in futility. However, consistently falling short of the 5% payout will not only earn the scrutiny of the Attorney General, but also flouts the charitable intentions of the various laws that allow for the existence of private foundations.