Q: What is the 5% payout rule?

A: The “payout rule” refers to the fact that, by law, private nonoperating foundations must distribute five percent of the value of their net investment assets annually in the form of grants or eligible administrative expenses, with certain exceptions. The rule was created to prevent foundations from receiving assets but never actually making charitable distributions with them.

This familiar, if complex, rule is getting additional attention from family foundations looking at the fourth quarter of the year amid an economic downturn. What do the rules require? And what will that mean next year for foundations and the nonprofits they support?

As National Center President Virginia Esposito told Financial Times in mid-October 2008, giving in 2009 may not be seriously affected because distributions will be based on an endowment’s monthly averages throughout 2008, but diminished value at the end of the year and into 2009 could affect giving beyond 2009. Because of the way complex distribution rules are structured, the next two years could be very tough for foundations and the nonprofits depending on their support.

So what exactly are the rules?

The figure below from Splendid Legacy: The Guide to Creating Your Family Foundation illustrates some of the complexities of payout with a sample payout calculation for the Sanders Foundation.

 

The law actually doesn’t define payout but something called the distributable amount. As the figure above demonstrates, the foundation calculates the 12-month average fair market value of its endowment and subtracts the value of any charitable use assets. Five percent of that number minus, for instance, an excise tax credit yields the distributable amount. This is the amount that the foundation must “pay out” in qualifying distributions (grants and certain administrative expenses) by the end of the year following the year on which the calculation is based. Essentially, a foundation must make charitable distributions amounting to approximately five percent of the average value of its endowment at the end of 2007 by the end of 2008.

There’s definitely more to it, e.g., “set-asides,” “carryover,” and significant penalties for failure to make the required distributions. For more resources on the calculation of payout, visit the Council on Foundations and the Internal Revenue Service.

Consider these calculations as you contemplate your end-of-year grantmaking and look ahead to next year’s grants and expenses. Perhaps above all, keep your philanthropy’s mission in mind.

“A knee-jerk reaction of limiting pay-out to keep capital intact” may be antithetical to the intent most donors have to help others, says Esposito, encouraging families to ask themselves whether this is the right time to “worry about preserving the corpus of the foundation or about preserving the causes and institutions [they] really care about.”

Consult your advisors for more on how recent events might affect your foundation and its spending given payout requirements.