The Tax Most Foundation Stewards Don't See Coming
When you inherit or take over a private foundation, most of the attention goes to the big compliance rules — self-dealing prohibitions, the 5% distribution requirement, and the annual 990-PF filing. Those are important. But there's another obligation that catches people off guard: the excise tax on net investment income under IRC §4940.
Unlike the excise taxes that only kick in when something goes wrong (self-dealing, excess business holdings, jeopardizing investments), the §4940 tax applies every year, regardless of how well you're running the foundation. If the foundation has investment income — and nearly every endowed foundation does — you owe this tax.
It's not a large tax. But if you don't know it exists, it creates problems: missed estimated payments, penalties, and the unsettling feeling that you're behind on something you should have caught months ago.
Here's everything you need to know about how it works, what counts, and how to keep the bill as low as legally possible.
How the Excise Tax Works
The excise tax on net investment income is straightforward in concept: the foundation pays a flat percentage of its net investment income each year. Since the Tax Cuts and Jobs Act of 2017 (effective for tax years beginning after December 20, 2019), the rate is a flat 1.39%.
Before that, foundations dealt with a two-tier system — a base rate of 2% that could drop to 1% if the foundation met certain distribution thresholds. That system was confusing and created perverse incentives. The flat 1.39% rate simplified things considerably, and it's what every private foundation uses today.
The tax is reported and paid on Part VI of Form 990-PF, and foundations are generally required to make quarterly estimated tax payments using Form 990-W if the expected tax is $500 or more.
The key formula:
Net investment income = Gross investment income + Net capital gains − Allowable expenses
Then: Excise tax = Net investment income × 1.39%
Let's break down each component.
What Counts as Gross Investment Income
Gross investment income includes all income the foundation receives from its investment assets. The most common categories are:
Interest income — Interest from bonds, CDs, money market accounts, savings accounts, and any debt instruments the foundation holds. This includes both taxable and tax-exempt interest (yes, even municipal bond interest counts for the §4940 excise tax, which surprises many people).
Dividend income — Dividends from stocks, mutual funds, and ETFs. Both ordinary dividends and qualified dividends are included. The distinction between qualified and ordinary dividends matters for regular income tax purposes, but for the §4940 excise tax, it's all investment income.
Rental income — If the foundation owns real property and collects rent, that's investment income. This gets more complicated if the property is used in the foundation's charitable activities, but for pure investment real estate, rental income goes on the investment income line.
Royalty income — Less common for family foundations, but royalties from intellectual property, mineral rights, or similar sources count.
Income from similar sources — The IRS uses this catch-all to include things like income from notional principal contracts, income from certain partnership interests, and other investment-type income.
What doesn't count: Contributions and gifts to the foundation are not investment income. Neither is income from activities that are substantially related to the foundation's charitable purpose (though this exception is narrow and rarely applies to investment holdings).
How Capital Gains Factor In
Capital gains are included in net investment income, but with some nuances worth understanding.
Net capital gains means gross capital gains minus capital losses, but only for gains and losses from the sale of assets used for investment purposes. If the foundation sells stock at a gain, that gain is included. If it sells another position at a loss, that loss offsets the gain.
Important limitation: Capital losses can offset capital gains, but they cannot create a net capital loss that reduces other investment income. If the foundation has $50,000 in interest and dividends but $30,000 in net capital losses, the excise tax base is $50,000 (minus allowable expenses), not $20,000. The capital loss doesn't reduce the interest and dividend income.
Basis matters: When calculating gains, the foundation uses its tax basis in the asset. For assets the foundation purchased, that's the purchase price plus transaction costs. For donated assets, the basis is generally the fair market value at the time of the donation (or the donor's basis, if lower and the asset would have produced a short-term gain if the donor had sold it). Getting the basis right, especially for assets that have been in the foundation for decades, is one of the more tedious but important parts of accurate 990-PF reporting.
Unrealized gains don't count. The excise tax applies only when gains are realized — when the foundation actually sells or disposes of an asset. The foundation can hold appreciated assets indefinitely without triggering the excise tax on those unrealized gains.
Expenses That Reduce the Tax
This is where foundations leave money on the table. You're allowed to deduct expenses that are ordinary and necessary for the production or collection of investment income, or for the management, conservation, or maintenance of investment property. Common deductible expenses include:
Investment management fees — Fees paid to investment advisors, portfolio managers, or financial planners for managing the foundation's investment portfolio. This is typically the largest deduction and the most straightforward.
Custodial fees — Fees paid to brokerages or custodians for holding the foundation's investment assets.
Investment-related legal and accounting fees — Legal fees for reviewing investment documents, tax preparation costs attributable to investment income reporting, and accounting fees for investment record-keeping. Note that you need to allocate costs that serve both investment and charitable functions — you can only deduct the portion attributable to investment activities.
Other direct costs — Things like safe deposit box rental for investment-related documents, subscriptions to investment research services, and similar direct costs of managing the investment portfolio.
What you can't deduct: General foundation operating expenses — staff salaries for program work, office rent for charitable activities, grant administration costs — are not deductible against investment income. The deduction is specifically for investment-related expenses.
Here's the practical takeaway: if you're paying an investment advisor 0.5% to 1.0% on your foundation's assets, that fee is likely your largest deduction against the §4940 tax. Make sure it's being captured on the 990-PF. If your CPA isn't asking about investment management fees, bring it up.
Estimated Tax Payments: Don't Skip These
Foundations must make quarterly estimated tax payments if they expect to owe $500 or more in excise tax for the year. The due dates follow the same schedule as corporate estimated taxes:
- April 15
- June 15
- September 15
- December 15
The safe harbor is the same as for other entities: pay at least 100% of the prior year's tax liability across the four installments, or pay based on the current year's expected income. Underpayment penalties apply if you don't meet the requirements, and while the penalties aren't enormous, they're entirely avoidable with basic planning.
For most foundations with stable investment portfolios, the simplest approach is to base estimated payments on the prior year's tax. If the portfolio hasn't changed dramatically, you'll be close enough to avoid penalties.
Practical tip: If you're in the first year of managing a foundation — especially one you've inherited — ask the prior advisor or CPA for the most recent 990-PF. The excise tax amount from that return gives you a reasonable baseline for current-year estimates.
Strategies to Minimize the Excise Tax
The 1.39% rate is modest, so extreme tax planning around §4940 rarely makes sense. But there are sensible practices that reduce the tax without distorting your investment strategy:
1. Maximize Your Expense Deductions
This is the lowest-hanging fruit. Make sure every legitimate investment-related expense is captured and properly allocated on the 990-PF. Foundations that self-manage investments or use a family member as an informal advisor sometimes miss deductions because there's no formal fee to report. If the foundation is paying for any investment-related service, it should be tracked and deducted.
2. Be Thoughtful About Gain Realization
Since unrealized gains aren't taxed, there's no §4940 reason to sell appreciated positions unless the investment rationale supports it. When you do rebalance or liquidate positions, consider whether capital losses in other positions can offset gains. Tax-loss harvesting — selling losing positions to offset gains — works for the §4940 excise tax just as it does for regular income taxes.
That said, don't let the 1.39% tail wag the investment dog. Holding a position that should be sold purely to avoid a small excise tax is rarely good stewardship.
3. Consider the Timing of Asset Sales
If the foundation needs to sell significant appreciated assets, consider whether spreading the sales across two tax years would reduce the overall excise tax burden. This matters most when a large one-time gain (such as selling donated real estate or a concentrated stock position) would create a spike in the excise tax.
4. Coordinate With the Distribution Requirement
The 5% distribution requirement and the excise tax interact in a practical way: when the foundation distributes appreciated assets to grantees (rather than cash), the distribution satisfies the 5% requirement at fair market value without triggering a capital gain. This means no additional excise tax on the transferred appreciation.
Donating appreciated stock directly to a grantee — rather than selling the stock, paying the excise tax on the gain, and then granting the cash — can be more efficient for both the foundation and the recipient. Not every grantee can accept non-cash assets, but for those that can, it's worth considering.
5. Track Your Basis Carefully
Accurate basis records prevent you from overpaying the excise tax. Foundations that have held assets for years or decades sometimes lack good basis documentation, which can lead to overstated gains. Work with your CPA to reconstruct and document the basis for every investment position. This is especially important after a generational transition, when the original documentation may have been lost or was never properly maintained.
Common Mistakes With the §4940 Tax
Having worked with foundations navigating compliance for the first time, I see a few recurring errors:
Forgetting that tax-exempt interest counts. Municipal bond interest is exempt from regular income tax, but it's included in net investment income for §4940 purposes. Foundations with significant municipal bond holdings are sometimes surprised by this.
Missing estimated payment deadlines. New foundation stewards who don't realize estimated payments are required often get hit with underpayment penalties on their first 990-PF filing. It's an easy mistake to avoid if you know it's coming.
Not deducting investment management fees. If the foundation's 990-PF shows zero on the expense line of Part VI but the foundation is paying an investment advisor, someone isn't connecting the dots.
Overstating gains due to bad basis records. Especially common with inherited foundations where the original donor contributed appreciated property decades ago. Without accurate basis documentation, the default is often to use zero basis, which means the full sale price is treated as gain.
Confusing §4940 with other excise taxes. The §4940 tax is not a penalty — it's an annual cost of operating a private foundation. The penalty excise taxes (§4941 through §4945) are entirely different and apply only when specific rules are violated. Don't let someone tell you the foundation is "in trouble" because it owes excise tax on investment income. Every foundation with investments owes this tax.
What This Looks Like on the 990-PF
The excise tax calculation lives in Part VI of Form 990-PF (Excise Tax Based on Investment Income). Here's the simplified flow:
- Report gross investment income (Line 1 — interest, dividends, rents, royalties)
- Report net capital gains (Line 2, from Part IV)
- Report allowable expenses (Line 3)
- Calculate net investment income (Lines 1 + 2 − 3)
- Apply the 1.39% rate (Line 5)
- Subtract estimated tax payments already made (Line 8)
- Determine the balance due or overpayment (Line 9)
The form itself isn't complicated, but the inputs — accurate income reporting, proper basis calculations, and complete expense deductions — require careful record-keeping throughout the year. If you're preparing the 990-PF yourself or reviewing your CPA's work, Part VI is worth a close look.
When to Get Help
The §4940 excise tax is one of the more manageable aspects of foundation compliance. If you have a straightforward investment portfolio (publicly traded securities, a competent investment advisor, and good records), the calculation is routine.
It gets more complex when the foundation holds non-traditional assets — real estate, partnership interests, closely held business stock, or alternative investments. The income and gain calculations for these assets can be tricky, and the expense allocation rules get more involved. If your foundation holds anything beyond standard publicly traded investments, working with a CPA experienced in private foundation tax is worth the cost.
And if you've recently inherited a foundation and aren't sure whether estimated payments have been made, whether investment fees are being deducted, or whether the basis records are reliable — an advisory call can help you get your arms around the situation quickly. The goal isn't to create dependence on an advisor. It's to make sure you understand what's happening, what's being done correctly, and where the gaps are. From there, you can decide what to handle yourself and what needs professional attention.
The excise tax on investment income is a cost of doing business as a private foundation. It's modest, it's predictable, and with proper planning, it shouldn't cause any surprises. The foundations that get into trouble aren't the ones who owe the tax — they're the ones who didn't know it existed until their CPA filed the first 990-PF and asked where the estimated payments were.