Do Foundations Pay Taxes? Investment, UBIT, and Penalty Taxes

Yes, private foundations do pay taxes. They are exempt from regular federal income tax under Section 501(c)(3), but in exchange for that exemption they owe a flat 1.39% excise tax on their net investment income every year, corporate-rate tax on any unrelated business income, and potentially heavy penalty taxes if they run afoul of the rules on self-dealing, minimum distributions, business holdings, risky investments, or prohibited spending. Every private foundation also has to file Form 990-PF annually, no matter how little it earned or gave away.

The 1.39% Tax on Investment Income

The tax nearly every private foundation actually pays is the Section 4940 excise tax: 1.39% of net investment income for the year. That income covers interest, dividends, rents, royalties, and net capital gains from selling assets such as stocks or real estate. The tax is due even if the foundation gave away far more than it earned.¹

Expenses directly connected to producing investment income are deductible, including investment management fees and custodial costs. Capital losses offset capital gains for the year, but a net capital loss cannot reduce other categories of investment income. Gains and losses on assets already subject to unrelated business income tax are left out of the calculation to avoid double taxation.²

One category of foundation owes nothing under Section 4940: exempt operating foundations. To qualify, a foundation must operate as an operating foundation (spending most of its income directly on charitable activities rather than making grants), have been publicly supported for at least 10 years, have a board where at least 75% of members are not disqualified persons such as substantial contributors or their families, and have no officers who are disqualified persons.¹

Legislation enacted in 2025 introduced a tiered rate structure that can replace the flat 1.39% with higher rates for foundations holding more than $50 million in assets. These provisions apply to tax years beginning after December 31, 2025, so foundations filing for 2026 should check current IRS guidance at IRS.gov/Form990PF for the applicable rate.

Tax on Unrelated Business Income

When a foundation earns money from a commercial activity unrelated to its charitable mission, that income is taxed at the regular corporate rate of 21% under Sections 511 through 513. A foundation that runs a retail store or a consulting practice on the side is the standard example. Even if every dollar of profit ends up in charitable grants, the tax still applies, because the point is to prevent tax-exempt organizations from undercutting for-profit competitors.³

Unrelated business income is reported on Form 990-T, separate from the 990-PF. Not every revenue-generating activity counts. Donated merchandise sold in a thrift shop is specifically excluded. The general test is whether the activity is regularly carried on and lacks a substantial connection to the foundation’s exempt purpose.⁴

Debt-financed property is a common trap. If a foundation holds mortgaged property that produces income, a proportional share of that income is treated as unrelated business income even when the property is being held as an investment. The taxable percentage matches the ratio of outstanding debt to the property’s adjusted basis. Property received by bequest gets a 10-year grace period on the mortgage, and so does gifted property where the mortgage was placed more than five years before the gift and the donor held the property for at least five years.⁵

Penalty Taxes on Prohibited Activities

The largest tax exposure most foundations face is not the routine 1.39%. It is the set of penalty excise taxes under Sections 4941 through 4945. Each violation category carries an initial tax, and if the foundation does not correct the problem in time, a much larger second-tier tax applies.⁶

Self-Dealing

Section 4941 covers almost any financial transaction between a foundation and a “disqualified person,” a category that includes substantial contributors, foundation managers, their family members, and entities they control. Selling property to the foundation, leasing office space from a board member, and lending money in either direction all count. The initial tax is 10% of the amount involved, charged to the disqualified person for each year the transaction remains uncorrected. A foundation manager who knowingly approves the deal owes an additional 5%, capped at $20,000 per act.⁷

Reasonable compensation to a disqualified person for personal services necessary to the foundation’s charitable purpose is allowed. Paying a founder a fair salary to run the grantmaking program is not self-dealing. Paying that founder an inflated salary for vaguely defined consulting is where problems typically begin.⁸

Failure to Distribute Income

Every non-operating private foundation must distribute at least 5% of the fair market value of its non-charitable-use assets each year as qualifying distributions. Qualifying distributions include grants to public charities, direct charitable expenditures, and certain administrative costs tied to charitable activities. If the foundation falls short, Section 4942 imposes an initial tax of 30% of the undistributed amount.⁷

Excess Business Holdings

Under Section 4943, a foundation and its disqualified persons together generally may not hold more than 20% of the voting stock of any business enterprise. That limit rises to 35% if unrelated third parties effectively control the company. Holdings above the limit trigger an initial tax of 10% of the excess value for each year they remain.⁷

Jeopardizing Investments

An investment that risks the foundation’s ability to carry out its charitable mission (highly speculative trading, for instance) triggers Section 4944. The initial tax is 10% of the amount invested, plus another 10% on the manager who approved it, capped at $10,000 per investment.⁷

Taxable Expenditures

Section 4945 flatly prohibits certain spending: lobbying, political campaign activity, grants to individuals without advance IRS approval, and grants to non-public-charity organizations unless the foundation exercises “expenditure responsibility” to confirm proper use of the funds. The initial tax is 20% of the improper expenditure on the foundation, plus 5% on any manager who approved it (up to $10,000).

What Happens if a Violation Isn’t Corrected

The initial penalty taxes are meant to get a foundation’s attention. The second-tier taxes are meant to end the problem. If the prohibited transaction is not corrected within the “taxable period,” which generally runs from the date of the violation through 90 days after the IRS mails a deficiency notice, much larger taxes kick in:⁹

Self-dealing: 200% of the amount involved, paid by the disqualified person.⁸
Undistributed income: 100% of the amount that remains undistributed.¹⁰
Excess business holdings: 200% of the value of holdings that still exceed the limit.¹¹
Jeopardizing investments: 25% of the amount invested, on the foundation; 5% on any manager who refused to agree to remove the investment from jeopardy.¹²
Taxable expenditures: 100% of the expenditure amount on the foundation; 50% on the responsible manager.

These penalties are reported on Form 4720, which is due on the same date as Form 990-PF. Managers and disqualified persons who owe second-tier taxes each file their own separate Form 4720.¹³

Filing Form 990-PF and Paying the Tax

Every private foundation files Form 990-PF each year, regardless of how much it earned or gave away. The return is due on the 15th day of the 5th month after the end of the foundation’s tax year (May 15 for calendar-year filers). Paper filing is no longer accepted for tax years ending July 2020 or later; returns must be submitted electronically through an IRS-authorized e-file provider.¹⁴¹⁵

The 990-PF is unusually detailed. It requires a complete accounting of investment income, officer compensation, grants made (with recipient names and the charitable purpose of each grant), and any transactions with disqualified persons. The foundation must also report the fair market value of all assets at year-end, because that figure drives next year’s minimum distribution calculation. Once filed, the return is a public document that anyone can request, and the IRS makes filed returns searchable through its Tax Exempt Organization Search tool.¹⁶

Extensions and Estimated Payments

A foundation that needs more time can file Form 8868 for an automatic six-month extension of the filing deadline. The extension does not extend the deadline for paying tax. To avoid interest and penalties, the foundation should estimate and pay its full tax liability when it files the extension request.¹⁷

A foundation expecting to owe $500 or more in Section 4940 tax for the year must make quarterly estimated payments through the Electronic Federal Tax Payment System. For calendar-year filers, those installments are due April 15, June 15, September 15, and December 15.⁶

Late Filing Penalties

Missing the deadline without reasonable cause is expensive. For foundations with annual gross receipts of $1,208,500 or less, the penalty is $20 per day the return is late, up to the lesser of $12,000 or 5% of gross receipts. Foundations with gross receipts above $1,208,500 face $120 per day, up to $60,000. These penalties fall on the organization itself. The IRS can also send a written demand to responsible managers, and ignoring that demand adds a separate $10 per day penalty, up to $5,000, on the individual.¹⁸

A Note on Classification

All of the taxes above apply because the organization is classified as a private foundation. The IRS presumes every 501(c)(3) organization is a private foundation unless it affirmatively demonstrates otherwise. Under Section 508(b), a newly formed charity that does not notify the IRS it qualifies as a public charity is treated as a private foundation by default, which brings every excise tax and distribution requirement on this page with it. Public charities operate under a different set of rules and largely avoid these excise taxes, so getting the initial classification right is worth real attention.¹⁹

1
Office of the Law Revision Counsel. 26 USC 4940 – Excise Tax Based on Investment Income
2
Internal Revenue Service. Tax on Net Investment Income: Capital Gains and Losses
3
Office of the Law Revision Counsel. 26 USC 511 – Imposition of Tax on Unrelated Business Income of Charitable, Etc., Organizations
4
Office of the Law Revision Counsel. 26 USC 513 – Unrelated Trade or Business
5
Office of the Law Revision Counsel. 26 U.S. Code 514 – Unrelated Debt-Financed Income
6
Internal Revenue Service. Private Foundation Excise Taxes
7
Office of the Law Revision Counsel. 26 USC Ch. 42 – Private Foundations; and Certain Other Tax-Exempt Organizations
8
Office of the Law Revision Counsel. 26 U.S. Code 4941 – Taxes on Self-Dealing
9
Internal Revenue Service. Private Foundation Excise Tax: Correction Period – Overview
10
Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income
11
Office of the Law Revision Counsel. 26 U.S. Code 4943 – Taxes on Excess Business Holdings
12
Office of the Law Revision Counsel. 26 U.S. Code 4944 – Taxes on Investments Which Jeopardize Charitable Purpose
13
Internal Revenue Service. 2025 Instructions for Form 4720
14
Internal Revenue Service. Annual Exempt Organization Return: Due Date
15
Internal Revenue Service. E-file for Charities and Nonprofits
16
Internal Revenue Service. Instructions for Form 990-PF (2025)
17
Internal Revenue Service. Extension of Time to File Exempt Organization Returns
18
Internal Revenue Service. Filing Procedures: Late Filing of Annual Returns
19
Office of the Law Revision Counsel. 26 U.S. Code 508 – Special Rules With Respect to Section 501(c)(3) Organizations