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Thursday, September 26, 2013

Investing the Other 95%


You’ve met the 5% Minimum Distribution Requirement. Now what?

Meeting the 5% Minimum Distribution Requirement (MDR)
To ensure that foundations use at least some of their funds for charitable purposes each year, Internal Revenue Code 4942 requires every private foundation to make “qualifying distributions” equal to or greater than 5% of the average market value of its non-charitable use assets. In addition to grants and other charitable expenditures, the term “qualifying distribution” also includes:

  • Reasonable and necessary administrative expenses paid to accomplish one or more tax-exempt purposes
  • Amounts paid to acquire assets used or held for use for direct charitable purposes
  • Qualified set-asides and program-related investments

If a foundation fails to make the qualifying distributions within 12 months of the end of the tax year, or hasn’t already made the distribution in a carry-over1, the foundation is subject to a 30% tax on the shortfall.

Plan Ahead to Avoid Tax Penalties
Through careful planning, foundation managers can ensure that the foundation is meeting the MDR each year.

  • Foundation Staff: They devote significant time and resources creating the annual list of grant recipients. Staff members may perform extensive research, hire consultants and review grant applications to create a list of potential grant recipients. When the list is complete and ready to present to the board, they should ensure they’ve already completed the calculation to prove they are meeting the 5% MDR.
  • Board of Directors (BOD): They focus their efforts on the foundation’s mission and the wishes of the initial benefactor(s), and at the end of the process, they approve the list of the organizations that will receive grants. As a secondary check on the staff, the BOD should ensure they keep MDR top of mind.

Once a foundation has met the MDR, what should it do with the remaining ~95% of assets? That’s a key question for their Chief Investment Officer (CIO).

Be Smart About Investing the Other 95%
A foundation’s CIO will often be found discussing the investment return on the foundation’s portfolio—the other ~95% of the foundation’s assets. These discussions also include a review of the foundation’s long-term investment strategy, risk tolerance, alternatives and emerging market opportunities and hedge fund fees. However, what isn’t included is a substantive review of where the money goes once it is invested in Fund A or Partnership X—and that substantive review is key. 

Know Where the Money is Going: Absent this review of the other 95% of assets, the foundation can’t be sure that it isn’t undermining its own efforts. For example, at the same moment that the foundation decides to contribute to the “Save the Rainforest” charity, the investment managers may have decided to invest a portion of the foundation’s portfolio in a fast-food chain that is destroying the rainforest. That’s a big waste of resources—and a potential public relations nightmare.

Know Smart Investing Doesn’t Have to Equal Low ROI: Some foundations may believe that they have to accept a lower ROI in order to invest prudently. However, the good news is that that assumption is false. Foundations don’t have to accept a lower ROI to invest in companies whose values are in alignment with their values—the CIO and the foundation’s investment advisors just need to do a little additional vetting before making investment decisions. Fortunately, some of the forward-looking investment advisors have already developed socially responsible and mission-aligned investment strategies (e.g., female equality strategies, environmental steward strategies, human rights strategies, etc.).

Shared Values
For any foundation, maintaining mission critical objectives is key. After meeting the 5% MDR, foundations can turn their attention to understanding where the rest of their investments are going—and make smart decisions about investing assets with organizations or funds that continue to enhance their objectives.


1 IRC Sec. 4942(a)

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