IRC 4940: Net Investment Income Tax for Private Foundations

Under Internal Revenue Code section 4940, the IRC 4940 net investment income tax is a flat 1.39% excise tax that most domestic private foundations owe each year on their net investment income, reported and paid on Form 990-PF. The tax applies whether the foundation is tax-exempt or not, and the rate has been a single 1.39% for tax years beginning after December 20, 2019.¹

Which Foundations Owe the Tax

Three categories of organizations fall within section 4940. The largest is domestic private foundations that are tax-exempt under section 501(a). If an organization is described in section 501(c)(3) and doesn’t qualify for one of the public-charity exclusions in section 509(a), it is a private foundation and owes the tax.²

The second category is nonexempt charitable trusts under section 4947(a)(1): trusts where all interests are devoted to charitable purposes and for which a charitable deduction was allowed, but which have not obtained formal exempt status. The code treats them as 501(c)(3) organizations for Chapter 42 purposes, including this excise tax.³

The third category is taxable private foundations. Their tax equals the amount by which the hypothetical 4940(a) tax, plus what the foundation would owe as unrelated business income tax if it were exempt, exceeds the regular income tax it already pays. That structure prevents double taxation while still reaching investment income that would otherwise escape.⁴

One narrow exemption exists. Exempt operating foundations pay zero excise tax under section 4940(d), but qualifying is demanding: the foundation must be an operating foundation under section 4942(j)(3), have been publicly supported for at least 10 tax years, keep at least 75% of its governing body free of disqualified persons and broadly representative of the public, and have no disqualified individual as an officer at any time during the year. The status also requires a determination letter from the IRS, requested on Form 8940 with a user fee.⁵

How Net Investment Income Is Calculated

The calculation is: gross investment income plus capital gain net income, minus allowable deductions. The 1.39% rate then applies to that figure.⁴

Gross Investment Income

Gross investment income is the total received from interest, dividends, rents, royalties, and payments from securities loans. The statute also includes income from “similar sources,” so creative recharacterizations don’t avoid the tax. Income already subject to the unrelated business income tax under section 511 is excluded, so a foundation never pays both UBIT and the section 4940 tax on the same dollar.⁴

Interest from state and local government bonds is excluded under section 4940(c)(5), which applies the same tax-exempt bond treatment as section 103. Section 265 also applies, so expenses allocable to producing that tax-exempt interest cannot be deducted.⁶

Capital Gains and Losses

Capital gain net income is added to gross investment income before deductions and includes gains from selling stocks, bonds, real estate, and other investment assets. Gains on property used directly for charitable purposes, such as a building housing the foundation’s programs, are excluded entirely.⁷

Two rules catch foundations off guard. Capital losses can offset gains but cannot exceed them, and there are no carryovers: $100,000 of losses against $60,000 of gains uses only $60,000 of the losses, and the remaining $40,000 is lost. For property held continuously since December 31, 1969, basis for calculating gain can never be less than fair market value on that date. That grandfathering rule still matters for foundations sitting on legacy real estate or other long-held assets.⁴

Allowable Deductions

Foundations subtract ordinary and necessary expenses incurred to produce investment income or maintain investment property: advisory fees, custodial charges, portfolio-related legal costs, and the portion of staff salaries and office rent attributable to investment management. The link between the expense and the investment activity must be documented; grant-making and program costs don’t count.⁸

Several restrictions apply. Depreciation on investment assets is limited to straight-line; accelerated methods aren’t allowed. Depletion is limited to the cost method, with no percentage depletion. And when investment income comes incidentally from property used for charitable purposes, deductions tied to that income cannot exceed the income itself.⁸

The 1.39% Flat Rate

Before 2020, the tax operated on a two-tier system: a 2% default rate that could be reduced to 1% by meeting a five-year distribution benchmark. Tracking the ratio was a compliance burden, and some foundations accelerated year-end grants only to hit the lower tier. The Taxpayer Certainty and Disaster Tax Relief Act of 2019 replaced both tiers with the single 1.39% rate for tax years beginning after December 20, 2019, regardless of payout level.⁹

Filing Form 990-PF and Paying the Tax

Every private foundation and every nonexempt charitable trust treated as one files Form 990-PF each year. It is due by the 15th day of the 5th month after the close of the tax year, which is May 15 for calendar-year foundations. The form calculates the excise tax, reports charitable activity, and serves as the public disclosure document.¹⁰

A foundation expecting to owe $500 or more in excise tax for the year must pay quarterly estimated tax. The IRS treats private foundations as corporations for estimated tax purposes under IRC 6655, so the corporate installment framework applies. Form 990-W is the worksheet used to compute each installment.¹⁰

Electronic filing is mandatory. Under the Taxpayer First Act, e-filing has been required for Form 990-PF for all tax years ending July 31, 2020, or later. Paper filing is no longer available.¹¹

Penalties for Late Filing and Underpayment

Missing the Form 990-PF filing deadline triggers a penalty of $20 per day, capped at the lesser of $10,500 or 5% of the organization’s gross receipts for the year. If the IRS demands the return by a specified date and the foundation still doesn’t file, the responsible officer, director, or trustee can be personally charged $10 per day, up to $5,000.¹²

Underpayment of estimated tax carries a separate penalty under IRC 6655. The penalty applies the IRS underpayment interest rate to each missed or short installment, running from the installment due date to either the date of payment or the 15th day of the 5th month after year-end, whichever comes first. The statute treats private foundations as corporations and the section 4940 excise tax as a corporate income tax, so standard corporate estimated-tax safe harbors apply.¹³

Interest also accrues on any unpaid balance from the original due date. Every dollar spent on penalties and interest is a dollar unavailable for charitable purposes, which is why most practitioners treat quarterly estimated compliance as non-negotiable.

Foreign Foundations Follow a Different Rule

Section 4940 does not govern foreign private foundations. Under IRC 4948, a foreign organization classified as a private foundation owes a 4% excise tax on gross investment income derived from U.S. sources, with no deduction for expenses before the tax is applied. A U.S. tax treaty with the foundation’s home country may override that tax, and foreign foundations that receive at least 85% of their support (excluding gross investment income) from non-U.S. sources are carved out from most other Chapter 42 excise taxes as well.¹⁴

1
Congress.gov. Taxpayer Certainty and Disaster Tax Relief Act of 2019
2
Internal Revenue Service. Private Foundations
3
Office of the Law Revision Counsel. 26 U.S. Code 4947 – Application of Taxes to Certain Nonexempt Trusts
4
Office of the Law Revision Counsel. 26 USC 4940 – Excise Tax Based on Investment Income
5
Internal Revenue Service. Definition of Exempt Operating Foundation
6
Office of the Law Revision Counsel. 26 U.S. Code 4940 – Excise Tax Based on Investment Income
7
eCFR. 26 CFR 53.4940-1 – Excise Tax on Net Investment Income
8
Internal Revenue Service. Deductions – Net Investment Income of Private Foundations
9
Internal Revenue Service. Tax on Net Investment Income
10
Internal Revenue Service. Instructions for Form 990-PF
11
Internal Revenue Service. E-File for Charities and Nonprofits
12
Internal Revenue Service. Annual Exempt Organization Return: Penalties for Failure to File
13
Office of the Law Revision Counsel. 26 U.S. Code 6655 – Failure by Corporation to Pay Estimated Income Tax
14
Office of the Law Revision Counsel. 26 USC 4948 – Application of Taxes and Denial of Exemption With Respect to Certain Foreign Organizations