The Failure of Private Foundations to Anticipate Distribution Shortfalls, Causing Effective Tax Rates Greater than 100%

Abstract

We survey private foundations for governance factors and internal processes that help explain why they barely miss (or not) the benchmark for qualifying distributions that would save them taxes on net investment income. Private foundations are subject to a 2% tax rate on their net investment income. If qualifying distributions are above a benchmark, the foundation qualifies for a 50% reduction in the tax rate to a 1% tax rate. This tax rate structure provides a “cliff effect” where the additional distributions required to qualify for the lower tax rate may actually be less than the potential tax savings (Sansing & Yetman, 2006). For example, one foundation in our sample could have saved $15,613 in tax by paying an additional $318 in distributions. We view this situation as a clear governance failure. Our first contribution to the literature is that board interest and information system strength affect the likelihood of avoiding such a governance failure, even after controlling for the general quality of management with management compensation and professional fees. Our second contribution is that foundations without sufficient financial savvy and sophistication appear to pay higher taxes. Given the large number of small, relatively unsophisticated foundations in America, differential tax rates based on sophistication is an interesting policy debate.

Citation

Addy, N. and Yoder, T. (2012), "The Failure of Private Foundations to Anticipate Distribution Shortfalls, Causing Effective Tax Rates Greater than 100%", Stock, T. (Ed.) Advances in Taxation (Advances in Taxation, Vol. 20), Emerald Group Publishing Limited, Leeds, pp. 29-67. https://doi.org/10.1108/S1058-7497(2012)0000020005