Case of the Week

Case:

Lucky Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor (RIA) and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucy was so successful in these markets that she now only manages her own large personal portfolio.

Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market.

Lucy had invested $1,000,000 in stock in a Canadian oil "wildcatter" with the name Northern Long Shot, Inc. This company has been drilling new exploratory wells in the far north. Recently, the stock rose from the $1 per share that she paid to over $5 per share. After this success, Northern Long Shot decided to "spin off" a smaller company with a portion of the successful wells. Lucy exchanged her $5 million in stock for 60% of the stock in the Northern Long Shot, Inc. spin-off. After the exchange, Lucy decided to give the Northern Long Shot spin-off stock to a private charitable foundation to help those in need.

Lucy discussed options with her attorney. She also asked her attorney whether Northern Long Shot Foundation would pay any tax.

Her attorney noted that private foundations are subject to various rules on self-dealing, minimum distributions, excess business holdings and taxable distributions. In addition, private foundations must pay an excise tax on income.

Question:

Lucy exclaimed, "What! Pay tax? This is a charitable foundation! Why should a charitable foundation have to pay tax? And how much tax will be paid?"

Solution:

Her attorney explained that while private foundations are generally exempt from income tax, the net investment income of a private foundation, including dividends, interest, royalties and net capital gains, is subject to a 2% tax that must be paid in quarterly installments. Under certain circumstances, a foundation may be eligible for a 1% reduction on the tax.

Section 4940(c) provides guidelines for calculating net investment income. Gross investment income plus net capital gains, minus ordinary and necessary expenses, equals net investment income. "Gross investment income" is defined as "the gross amount of income from interest, dividends, rents, payments with respect to securities loans, and royalties, but not including any such income to the extent in computing the tax imposed by Sec. 511 (UBTI)." Sec. 4940(c)(3).

Under Sec. 4940(e), some private foundations will be eligible for a 1% excise tax reduction if they meet certain distribution requirements. To be eligible, the private foundation must meet two requirements. First, the amount of the qualifying distributions made must meet or exceed the sum of an amount equal to the assets of the foundation for the particular taxable year, multiplied by the average percentage payout for the base period, plus 1% of the net investment income of the foundation. Second, the foundation must not have been liable for tax imposed for failure to distribute income for any year in the base period.

Lucy was not happy about the taxes that private foundations must pay. However, as she thought about her goals, she decided that this would just be "a cost of doing business." In addition, she did want full control and was willing to pay this excise tax to do so. As a result, she funded the Northern Long Shot Foundation. Now, she is able to make generous grants to charities that focus on helping those in need.