As year-end approaches, it is a good time to evaluate your Foundation’s position with regard to the Section 4940 excise tax on investment income. The Section 4940 tax is typically applied at a rate of 2 percent of investment income. Investment income includes dividends, interest, capital gains and capital losses along with other types including rents and royalties.
Foundations should evaluate their portfolio to better understand the tax impact of having realized gains (including year-end mutual fund distributions) and losses.
Foundations with Net Capital Losses
Organizations with significant realized capital losses should assess whether there are appreciated assets in their portfolio. Capital losses do not reduce other investment income such as dividends and interest. Capital losses can only be offset by capital gains. Unused capital losses do not carry over to future years. Consequently, capital losses need to be offset by gains in the same year, if possible. Wash sale rules do not apply to gains. Therefore, appreciated assets can be sold and then re-purchased immediately without adverse tax effect. This strategy effectively uses offsets capital losses and reduces future excise taxes by increasing the cost basis of portfolio holdings.
If the foundation does not currently have any appreciated positions, now may be a good time to solicit a contribution of appreciated assets. The Foundation takes (inherits) the donor’s cost basis in the appreciated property. As such, the same sell/repurchase strategy as noted above can be utilized.
Foundations with Net Capital Gains
Foundations with significant realized capital gains should consider liquidating loss positions. However, this strategy has limitations since the wash sale rules operate to disallow losses if the same securities are repurchased within 30 days. This means that the sell/repurchase strategy suggested above for harvesting gains is not effective for harvesting losses. A purchase of another security in the same industry or the purchase of a mutual fund with a similar investment strategy will not be treated as a wash sale.
Many Foundations with unrealized gains sell appreciated property in order to satisfy liquidity needed to make required charitable grant distributions. These Foundations can avoid realizing gains by distributing their appreciated assets to charitable organizations to fund required distributions. These transfers of appreciated securities qualify as distributions for purposes of meeting the required minimum distribution requirement. In addition, an unrealized gain is removed from the portfolio.
Finally, Foundations with significant potential tax exposure should evaluate their ability to qualify for a special 1 percent excise tax rate by making distributions in excess of their five-year average distribution percentage. Foundations need to be certain that they have met their minimum distribution requirements in the prior five years in order to be eligible for the reduced tax rate.