Foundations make money mainly by investing a large pool of donated capital — the endowment — and living off the returns. Dividends, interest, and capital gains from that portfolio fund grants and operations year after year. Ongoing donor contributions add to the base, and public charities and community foundations layer in fundraising and government grants on top. Federal law then shapes almost every part of that financial picture: a 5% annual payout requirement, an excise tax on investment income, and strict limits on how the money can be earned and spent.
The Endowment and Donor Contributions
Most foundations begin with a large initial gift from a wealthy individual, a family, or a corporation. That starting capital becomes the endowment, the permanent investment base the foundation draws returns from rather than spending down. The original donor, their family, or outside supporters often add to the endowment over time.
Federal tax law pushes those gifts along. Cash donations to a private foundation are deductible up to 30% of the donor’s adjusted gross income, and gifts of appreciated property like stock or real estate are capped at 20% of AGI.1Office of the Law Revision Counsel. 26 USC 170 – Charitable Contributions and Gifts Contributions above those limits carry forward for up to five additional tax years. The deduction is the primary reason large donors choose to route wealth through a foundation rather than giving it away outright.
Investment Income Is the Main Engine
Once the endowment exists, it goes to work. Foundation managers spread the corpus across stocks, bonds, mutual funds, real estate, and sometimes private equity or hedge funds. Dividends come from stock holdings, interest from bonds and fixed-income securities, and capital gains when assets are sold at a profit. A diversified portfolio is built to generate returns that cover annual charitable spending, operating costs, and inflation combined.
Every private foundation pays a federal excise tax of 1.39% on its net investment income each year.2Office of the Law Revision Counsel. 26 USC 4940 – Excise Tax Based on Investment Income Net investment income means gross investment income plus capital gains, minus the ordinary expenses of earning it. The rate is modest next to what individuals or corporations pay on investment gains, but the dollar figure grows quickly for foundations managing hundreds of millions.
The math forces a real strategic choice. A foundation spending 5% of its portfolio each year while inflation runs 2% to 3% needs investment returns near 7% to 8% just to hold steady in real terms. That pushes many foundations toward heavier equity and alternative allocations than a conservative individual investor would carry. Preserving capital while generating enough return to fund the mission is the central financial tension in every foundation.
The 5% Payout Requirement
Federal law requires every private foundation to distribute a minimum amount for charitable purposes each year. The baseline is 5% of the fair market value of the foundation’s investment assets.3Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income The actual distributable amount comes out slightly below a flat 5% because the foundation subtracts the excise tax it already paid on investment income, but 5% is the working number driving nearly all foundation budgeting.
Qualifying distributions include grants to other charities, direct charitable expenditures, reasonable administrative costs of making those grants, and program-related investments.4Internal Revenue Service. Qualifying Distributions: In General The IRS is particular about what counts. General overhead unrelated to charitable activity will not qualify, and foundations that pad payout numbers with questionable administrative expenses invite scrutiny.
Missing the target is expensive. The initial excise tax on undistributed income is 30% of the shortfall.3Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income If the foundation still has not corrected the shortfall by the end of the taxable period, a second-tier tax of 100% of the remaining undistributed amount applies. The second penalty essentially confiscates every dollar the foundation should have distributed.
Fundraising and Government Grants for Public Charities
Public charities and community foundations run on a different revenue mix than private foundations do. Annual galas, charity auctions, online campaigns, and email drives convert community participation into operating funds. Digital fundraising through social media has become a standard tool for reaching donors who never attend an in-person event. These activities produce liquid money that goes straight to grantmaking or operations.
Government grants are another major stream, especially for organizations focused on community development, education, or public health. The federal grant process is competitive and requires detailed proposals aligned with the funding agency’s priorities.5Grants.gov. How to Apply for Grants Winning a grant comes with strict reporting obligations throughout the award period.
Diverse funding is not just strategic for a public charity; it is a legal requirement. To keep public charity status, the organization must pass one of two public support tests measured over a rolling five-year period. Generally, at least one-third of total support must come from public sources like individual donations, corporate gifts, government grants, and program revenue.6Internal Revenue Service. Exempt Organizations Annual Reporting Requirements – Form 990, Schedules A and B: Public Charity Support Test Investment income does not count as public support. A charity that leans too hard on endowment returns or a single large donor risks being reclassified as a private foundation, with tighter rules and the 1.39% excise tax attached.
Program-Related Investments
Program-related investments give foundations a way to put money to work advancing the mission while also getting the money back. A foundation might offer a below-market-rate loan to an affordable housing developer or take an equity stake in a social enterprise in a low-income neighborhood. The defining feature is that the investment’s primary purpose must be charitable, not financial. If a profit-motivated investor would make the same deal on the same terms, it probably does not qualify.7Internal Revenue Service. Program-Related Investments
The financial appeal is that the principal amount counts toward the 5% payout requirement when the investment is made.4Internal Revenue Service. Qualifying Distributions: In General When the borrower repays, the money re-enters the foundation’s investment pool and can be recycled into future grants or investments. A $1 million loan satisfies the payout requirement the year it is made, and five years later the foundation has the same $1 million available to deploy again. Incidental income like modest loan interest does not disqualify the investment, as long as producing income is not a significant purpose of the deal.7Internal Revenue Service. Program-Related Investments
Unrelated Business Income
Foundations can earn money from business activities unconnected to their charitable mission, but that income is taxed differently. A commercial parking lot, a gift shop selling non-donated merchandise, or a stake in a for-profit company all produce unrelated business income. The tax code defines it as income from any regularly conducted trade or business not substantially related to the organization’s exempt purpose.8Office of the Law Revision Counsel. 26 USC 513 – Unrelated Trade or Business
This income is taxed at corporate rates, currently 21%, and reported on Form 990-T.9Office of the Law Revision Counsel. 26 USC 511 – Imposition of Tax on Unrelated Business Income Foundations organized as trusts pay at graduated trust income tax rates instead, which can run higher. The tax exists so that a tax-exempt organization does not gain an unfair edge over regular businesses in the same market.
Two exceptions matter for many charities. A business staffed almost entirely by unpaid volunteers is not treated as unrelated business income, and neither is the sale of donated merchandise.8Office of the Law Revision Counsel. 26 USC 513 – Unrelated Trade or Business The donated-goods carve-out is why charity-run thrift stores avoid the tax even though a retail store would normally be an unrelated activity.
Rules That Shape How the Money Gets Made
Foundations do not have a free hand with the portfolio. Three separate provisions of federal law constrain how a foundation can invest, who it can transact with, and how much of any business it can own. Each carries its own escalating penalty.
Self-Dealing
Private foundations are broadly prohibited from financial transactions with “disqualified persons,” a category that includes substantial contributors, managers, their family members, and entities those people control.10Office of the Law Revision Counsel. 26 USC 4946 – Definitions and Special Rules Prohibited transactions include selling or leasing property to or from the foundation, lending money in either direction, paying unreasonable compensation, and transferring foundation assets for an insider’s benefit.11Internal Revenue Service. Acts of Self-Dealing by Private Foundation Even fair market value transactions can be prohibited if they fall in one of these categories.
The excise tax is 10% of the amount involved per year, paid by the disqualified person who participated. A foundation manager who knowingly approved the deal faces a separate 5% tax per year.12Office of the Law Revision Counsel. 26 USC 4941 – Taxes on Self-Dealing If the transaction is not unwound during the correction period, second-tier penalties escalate sharply.
Jeopardizing Investments
A jeopardizing investment is one that puts the foundation’s ability to carry out its charitable mission at risk. The tax code does not list prohibited asset types. Instead, it asks whether the foundation managers exercised ordinary business care and prudence.13Office of the Law Revision Counsel. 26 USC 4944 – Taxes on Investments Which Jeopardize Charitable Purpose A speculative bet no reasonable fiduciary would make with charitable funds is the kind of decision that triggers the provision.
The initial excise tax is 10% of the amount involved for each year the investment stays in jeopardy, imposed on both the foundation and any manager who knowingly participated. If the investment is not removed from jeopardy during the correction period, a 25% second-tier tax hits the foundation.14Internal Revenue Service. Taxes on Jeopardizing Investments Program-related investments are explicitly excluded from these rules because their primary purpose is charitable.
Excess Business Holdings
Private foundations face strict caps on how much of any business they can own. The general rule limits the combined holdings of the foundation and its disqualified persons to 20% of the voting stock in a corporation. If an independent third party has effective control, the ceiling rises to 35%.15Office of the Law Revision Counsel. 26 USC 4943 – Taxes on Excess Business Holdings Similar rules cover partnerships and other business structures.
The initial excise tax is 10% of the value of the excess holdings. Failure to divest within the taxable period brings a second-tier tax of 200% of the excess holdings.15Office of the Law Revision Counsel. 26 USC 4943 – Taxes on Excess Business Holdings Foundations that inherit large blocks of business stock through bequests have a limited window to sell down to compliant levels.
Put together, the finances of a foundation are a balancing act. Investment income has to outpace the mandatory 5% payout, the 1.39% excise tax, inflation, and operating costs. Donor gifts replenish the base. Program-related investments let the foundation recycle capital while satisfying its distribution requirement. Public charities add fundraising and grants but must keep the funding mix broad enough to pass the public support test. And every revenue stream sits inside a regulatory framework that punishes casual compliance quickly.