Minimum Investment Return for Private Foundations: The 5% Payout Rule

A non-operating private foundation must pay out at least 5 percent of the fair market value of its investment assets each year for charitable purposes. That figure, known as the minimum investment return for private foundations, comes from Internal Revenue Code Section 4942 and sets the floor for annual grantmaking. Falling short triggers an excise tax of 30 percent on the undistributed amount, and 100 percent if the shortfall is not corrected in time.¹

How the 5 Percent Is Calculated

Start with the fair market value of every asset the foundation holds that is not used directly in its charitable work. The statute calls these noncharitable-use assets: investment portfolios, rental real estate held for income, cash reserves above operating needs, and similar holdings. Subtract any acquisition indebtedness, meaning debt taken on to buy those assets. Multiply the result by 0.05. That is the minimum investment return.¹

A foundation that borrowed $2 million against a $5 million commercial building counts only $3 million of that property in the base. On a $10 million investment portfolio with no debt, the minimum investment return is roughly $500,000.

Different asset types get valued differently. Publicly traded securities and cash are averaged monthly across the tax year, which prevents a single bad week from distorting the number.² Real estate and other illiquid holdings are carried at appraised fair market value, and the Form 990-PF instructions let a foundation rely on a real estate appraisal for up to five years before commissioning a new one.³

What Stays Out of the Base

Assets used directly in the charitable mission are excluded. Program office space, equipment, and a building housing a foundation-run museum do not inflate the payout requirement.⁴

A cash operating reserve is also excluded automatically. Regulations presume 1.5 percent of the noncharitable-use asset value is needed for grant disbursements and administrative costs, and that slice is kept out of the calculation. A foundation that can show it genuinely needs more liquidity may request a higher exclusion from the IRS.⁵

From Minimum Investment Return to Distributable Amount

The 5 percent figure is not quite the amount the foundation must send out the door. Two adjustments bring it down to the distributable amount, which is the legally binding number. The Section 4940 excise tax on net investment income, currently 1.39 percent, gets subtracted, along with any unrelated business income tax the foundation paid during the year.⁶ Money already paid to the government does not also count against the charitable obligation.

The minimum investment return is reported on Part IX of Form 990-PF and the distributable amount on Part X. The two parts walk through the math line by line.³

What Spending Counts Toward the Payout

Only “qualifying distributions” reduce the obligation. Four categories cover most of what foundations do:

Grants and direct charitable expenditures for charitable, educational, scientific, religious, or literary purposes.
Reasonable administrative expenses tied to running charitable programs. Investment management costs do not qualify.
Program-related investments, meaning loans or equity investments made primarily to advance the mission rather than to earn a return. These count in the year the money goes out.
Assets purchased for direct use in exempt activities, such as a building bought to house a program, counted in the year of acquisition.

Everything is measured on a cash basis. A distribution counts when the foundation actually pays it, not when it is pledged or committed.⁷

Several kinds of spending are specifically excluded. Grants to another non-operating private foundation generally do not qualify, nor do grants to organizations controlled by the foundation or its disqualified persons. Chapter 42 excise taxes, including the Section 4940 tax, never count.⁷

Set-Asides for Multi-Year Projects

A foundation planning a large project that will take years to complete can earmark funds as a set-aside and count them now, as long as the money is actually spent within 60 months. Set-asides require either advance IRS approval on Form 8940 under the suitability test, or compliance with the separate cash distribution test that dictates minimum spending during start-up and full-payment periods. Set-aside amounts appear on Line 3 of Part XII of Form 990-PF.⁸

The Deadline and What Happens If You Miss It

A foundation has until the end of the tax year following the year of calculation to make qualifying distributions covering the obligation. A calendar-year foundation calculating its 2026 distributable amount has through December 31, 2027, to pay it out.¹

Miss it and the IRS imposes an initial excise tax of 30 percent on the undistributed amount. A $100,000 shortfall produces a $30,000 tax.¹

If the shortfall is still uncorrected at the end of the correction period, a second tax of 100 percent of the remaining undistributed amount applies. The foundation effectively forfeits every dollar it failed to distribute. The correction period runs from the first day of the tax year in which the failure occurred through 90 days after the IRS mails a notice of deficiency for the additional tax, with possible extensions.⁹

Fixing a Shortfall

The 100 percent tax disappears entirely if the foundation zeroes out its undistributed income during the correction period. If assessed, it is abated; if paid, it is refunded.

Foundations also get relief for honest valuation mistakes. When a shortfall results from an incorrect asset valuation that was not willful and had reasonable cause, the initial 30 percent tax does not apply, provided the foundation distributes the correct amount within the allowable distribution period and notifies the IRS.¹⁰

Banking Surplus Distributions

Distributing more than required in one year is not wasted. Excess qualifying distributions carry forward for up to five years and reduce the distributable amount in those later years.¹ A foundation that funds a big capital project one year can apply the excess against leaner years that follow. Carryovers must be used in order, oldest first, and a foundation cannot refresh an expiring carryover by relabeling current-year distributions as coming from corpus.¹¹

Operating Foundations Do Not Owe This Tax

All of the above applies to non-operating private foundations, the standard grantmaking type. Private operating foundations, which spend their money directly on their own charitable programs, are exempt from the Section 4942 undistributed income tax. To qualify, an organization must spend substantially all of its adjusted net income or minimum investment return, whichever is less, directly on active charitable work, and meet one of three additional tests related to asset use, distribution levels, or public support.¹ If your foundation runs its own programs rather than funding outside organizations, confirming operating status can take the payout rule off the table entirely.

1
Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income
2
Internal Revenue Service. Combined Fair Market Value of Foundation Assets – Private Foundation Minimum Investment Return
3
Internal Revenue Service. 2025 Instructions for Form 990-PF
4
Internal Revenue Service. Assets Used for Exempt Purposes – Private Foundation Minimum Investment Return
5
eCFR. 26 CFR 53.4942(a)-2 – Computation of Undistributed Income
6
Office of the Law Revision Counsel. 26 USC 4940 – Excise Tax Based on Investment Income
7
eCFR. 26 CFR 53.4942(a)-3 – Qualifying Distributions Defined
8
Internal Revenue Service. IRC Section 4942(g)(2) Certain Set-Asides
9
Internal Revenue Service. Correction Period – Failure to Distribute Income
10
eCFR. 26 CFR 53.4942(a)-1 – Taxes for Failure to Distribute Income
11
Internal Revenue Service. Private Foundations – Carryover of Excess Qualifying Distributions