Case:

Lucky Lucy 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 AI startup with the name Northern Long Shot, Inc. This company has been building creative new AI applications. 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 to continue with creative application development. The new company was called Northern Long Shot II. Lucy exchanged $5 million in stock for 60% of the stock in Northern Long Shot II, Inc. After the exchange, Lucy decided to give the Northern Long Shot II stock to her private charitable foundation to help those in need.

Lucy’s attorney had previously advised her that private foundations are subject to various rules regarding self-dealing, minimum distributions, excess business holdings and taxable distributions. Lucy asked her attorney whether her private foundation would be required to pay any tax. Her attorney responded that private foundations must pay an excise tax on net investment 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 1.39% tax that must be paid in quarterly installments.

Sec. 4940(c) of the Internal Revenue Code provides the rules 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 included in computing the tax imposed by Sec. 511 (UBTI)." Sec. 4940(c)(3).

Lucy was unhappy with the private foundation tax. However, as she thought about her goals, she decided that this would just be “a cost of doing business.” In addition, she wanted full control and was willing to pay the excise tax for that reason. As a result, she funded her private foundation. She is now able to make generous grants to charities that focus on helping the needy.