Section 4942 of the Tax Code: Minimum Payouts and Penalties

Under Section 4942 of the Internal Revenue Code, a non-operating private foundation must pay out roughly 5% of the value of its investment assets each year as qualifying distributions, and it has until the end of the following tax year to do it. Miss the target and the foundation owes an excise tax of 30% of the shortfall. Fail to fix the shortfall inside the correction window and a second tax of 100% of what’s still undistributed takes the rest. The Section 4942 private foundation distribution rules are built around one figure, called the distributable amount, and the rest of the statute is about how you calculate it, what spending satisfies it, and what happens when you fall short.¹

How Much You Have to Distribute

The distributable amount for any tax year beginning after 1981 equals the foundation’s minimum investment return, reduced by certain taxes the foundation already owes.² The pre-1982 rule that compared minimum investment return to adjusted net income and used the larger of the two no longer applies, though it still turns up in old guides.

The 5% Minimum Investment Return

Minimum investment return is 5% of the fair market value of the foundation’s non-charitable-use assets, less any acquisition indebtedness on those assets.¹ Non-charitable-use assets are the foundation’s investment holdings: stocks, bonds, cash, income-producing real estate, and similar property. Assets used directly for the exempt purpose, like a building where programs run or research equipment, stay out of the base.

Before applying the 5% rate, the foundation subtracts 1.5% of the non-charitable-use asset value as cash deemed held for charitable activities. A foundation with $10 million in investment assets subtracts the $150,000 cash allowance, leaving $9,850,000. Five percent of that is $492,500. Acquisition indebtedness on the assets would reduce the base further before the 5% is applied.

Valuing the Assets

Publicly traded securities have to be valued monthly using any reasonable method applied consistently, and the twelve monthly values are averaged for the year.³ You can use the first day of the month, the last day, or an average of both, so long as you pick one approach and use it consistently. Assets that aren’t publicly traded follow separate rules and often require a professional appraisal. A good-faith appraisal from a qualified appraiser is one of the strongest ways to show reasonable cause if the IRS later questions a valuation.⁴

Subtracting Taxes to Get the Final Figure

Once you have the minimum investment return, subtract the foundation’s Subtitle A income taxes and its Section 4940 excise tax on net investment income for the year.¹ The Section 4940 tax is a flat 1.39% of net investment income.⁵ The result is the distributable amount the foundation must satisfy through qualifying distributions.

What Spending Counts as a Qualifying Distribution

Not every dollar out the door counts. A qualifying distribution is an amount paid to accomplish a charitable, educational, scientific, religious, or other exempt purpose, and the statute is specific about what fits.¹

Grants to public charities under Section 509(a)(1), (2), or (3) count immediately in the year paid, and grants to private operating foundations count the same way. Grants to other non-operating private foundations count only if the granting foundation exercises expenditure responsibility: it must ensure the money is used for the intended charitable purpose, obtain reports from the grantee, and report to the IRS.⁶

Grants to individuals for scholarships, research, or similar purposes can qualify, but the foundation needs advance IRS approval of its grant-making procedures and must award the grants on an objective, nondiscriminatory basis. Without that prior approval, an individual grant is treated as a taxable expenditure, not a qualifying distribution.⁷

Reasonable administrative expenses tied to charitable work qualify: staff salaries, rent, professional fees, to the extent they relate to exempt activities rather than investment management. Expenses that serve both purposes must be allocated.

Buying an asset used directly for exempt purposes, such as a program building or research equipment, is a qualifying distribution for the full purchase price in the year of acquisition; you don’t spread it across the useful life.¹ Program-related investments, made primarily to advance the mission rather than to earn income, also count when the cash or property is transferred.

Set-asides are the exception to spending it now. A foundation can treat an amount set aside for a specific future project as a qualifying distribution if it can show the project is better accomplished by accumulating funds than by paying them out immediately.⁸ The project has to be specific and identifiable, the funds have to be paid out within five years, and IRS advance approval is required.¹

The Deadline and How Carryovers Work

The distributable amount calculated for one tax year isn’t due until the end of the following tax year. For a calendar-year foundation, the target set for 2025 must be met by December 31, 2026.⁹

Distribute more than the target and the excess carries forward for up to five years, where it can be applied against future distributable amounts.¹⁰ Earlier excesses have to be used before later ones, and an expiring carryover can’t be refreshed by electing to treat current-year distributions as coming out of corpus.¹¹ Use it inside five years or lose it. Foundations that lean on carryovers need to track each year’s excess separately and apply the layers in order.

The Penalty for Falling Short

The excise tax comes in two tiers, both imposed on the foundation itself.

The 30% First-Tier Tax

The initial tax is 30% of the undistributed income, meaning the gap between the distributable amount and actual qualifying distributions.¹ The rate rose from 15% in 2006, so older references understate it.

The tax attaches to any undistributed income still outstanding on the first day of the second taxable year after the year the distributable amount was calculated. For a calendar-year foundation, the 2025 distributable amount has to be out the door by the end of 2026. Anything left on January 1, 2027, triggers the 30% tax for periods within the taxable period, which runs from the first day of the taxable year until the earlier of the IRS mailing a notice of deficiency or the tax being assessed.¹

The Correction Window

There’s a chance to fix the shortfall before the second tier hits. The correction period runs from the date of the taxable event through 90 days after the IRS mails a notice of deficiency for the second-tier tax, and the IRS can extend it if additional time is reasonable and necessary.¹²

Correction means actually paying the missing amount out as qualifying distributions. Paying the 30% tax alone doesn’t cure the failure; the foundation still owes the charitable distributions on top of the penalty.¹³

The IRS can abate the first-tier tax if the foundation shows the failure was due to reasonable cause and not willful neglect. Good-faith reliance on a bona fide appraisal from a qualified professional is one of the cleanest ways to make that case when a valuation error caused the shortfall.⁴

The 100% Second-Tier Tax

If the correction period ends with the shortfall still undistributed, the second-tier tax is 100% of what’s left.¹ Combined with the 30% already owed, the total cost far exceeds what should have gone to charity to begin with. Foundations reaching this stage face a financial hit that can be existential.

If Your Foundation Is an Operating Foundation

Private operating foundations are largely outside the Section 4942 distribution rules because they spend directly on programs rather than making grants. To qualify, a foundation has to pass the income test, requiring qualifying distributions made directly for the active conduct of exempt activities equal to at least 85% of the lesser of adjusted net income or minimum investment return.¹⁴ The foundation also has to meet one of three supplemental tests, such as the endowment test requiring it to normally spend at least two-thirds of its minimum investment return directly on active exempt activities.¹⁵ Meet both and you skip the distributable amount calculation on Form 990-PF entirely. Grants out to third parties generally don’t count for the income test; the foundation itself has to be running the programs.

Where It All Lands on the Return

The calculation and compliance reporting run through Form 990-PF, with four parts doing the work in sequence.

Part IX computes the minimum investment return: fair market value of non-charitable-use assets, less acquisition indebtedness and the 1.5% cash allowance, times 5%.
Part X takes that figure and subtracts applicable taxes to reach the distributable amount for the year.
Part XI lists every grant, administrative expense, asset purchase, and program-related investment claimed as a qualifying distribution, and totals them against the Part X target.
Part XII tracks cumulative compliance across years, handling carryovers and any leftover shortfalls from prior years.

When first-tier or second-tier tax is owed, the foundation reports it on Form 4720, which is generally due on the same date as the Form 990-PF.¹⁶ Foundation managers or disqualified persons who file Form 4720 on their own tax year use the 15th day of the fifth month after the close of their taxable year.

1
Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income
2
eCFR. 26 CFR 53.4942(a)-2 – Computation of Undistributed Income
3
Internal Revenue Service. Valuation of Assets – Private Foundation Minimum Investment Return: General Rules for Valuing Securities and Additional Information
4
eCFR. 26 CFR Part 53 – Foundation and Similar Excise Taxes
5
Office of the Law Revision Counsel. 26 USC 4940 – Excise Tax Based on Investment Income
6
Internal Revenue Service. Grants by Private Foundations: Expenditure Responsibility
7
Internal Revenue Service. Grants to Individuals
8
Internal Revenue Service. Suitability Test: Private Foundation Set-Aside
9
Internal Revenue Service. Instructions for Form 990-PF (2025)
10
Internal Revenue Service. Refreshing Expiring Distribution Carryovers of Private Foundations
11
Internal Revenue Service. Private Foundations: Carryover of Excess Qualifying Distributions
12
Office of the Law Revision Counsel. 26 USC Chapter 42 – Private Foundations and Certain Other Tax-Exempt Organizations
13
eCFR. 26 CFR 53.4942(a)-1 – Taxes for Failure to Distribute Income
14
Internal Revenue Service. Private Operating Foundation – Income Test
15
Internal Revenue Service. Private Operating Foundation: Endowment Test
16
Internal Revenue Service. Form 4720: When to File