Fixing a Problem of Foundation Payout

The topic of private, non-operating foundations’ payout has not been popular as of late. This is not surprising as we are still in the aftermath of one of the worst financial crises to hit the U.S. Arguably, however, this topic shouldn’t be tied to how well or how poorly foundations’ investments are faring; rather, payout should be an ongoing discussion as it represents a timeless question of what we want foundations to achieve. Hence, I’m bringing this topic up again, but with a different approach to this conversation. Rather than advocate for a solution based on a personal ideology of what I think foundations should be doing, I’d like to revisit a technical benefit of tying foundation payout to investment performance, a long-forgotten part of the original tax code that was jettisoned with too little deliberation. To get to my point, it’s worth pausing on (1) the genesis story of payout to contextualize why this topic has been so controversial and (2) the ideologies underlying the payout rate before moving on to (3) my own suggestion of how foundations can maximize charitable spending while retaining donors’ privilege of grantmaking.

If you’ve been in the foundation sector long enough, you’ve read countless articles and listened to innumerable speeches of the pros and cons of either maintaining the 5% minimum distribution rate or raising it to increase charitable spending. The notion of the payout requirement is rooted in the Tax Reform Act of 1969 (TRA 1969), which is what first recognized and regulated private foundations. One way to think of payout then is that it is a defining characteristic of foundations and is what distinguishes private foundations from any other type of charitable entity.

TRA 1969 was an outcome of years of distrust of endowed philanthropies. Before the Act was passed, endowed charitable organizations, such as the Ford Foundation, were being roundly criticized for protecting wealth and not distributing it for taxpayer benefit. Beginning in 1961, Congressman Wright Patman of Texas made it his personal mission to go after what he considered to be tax shelters for the elite, and his efforts were rewarded with the signing of TRA 1969 by President Nixon who declared, “Tax-free foundations were brought under much closer Federal scrutiny. . . . [as] congressional consideration of this matter reflected a deep and wholly legitimate concern about the role of foundations in our national life.” Patman’s suspicion of foundations was not unfounded. Private foundation expert Troyer (2000) recalled that when he entered law practice in the late 1950s, tax lawyers and estate planners used to advise clients to establish endowed nonprofits as a way to avoid estate taxes and as an instrument to maintain control of wealth.

What TRA 1969 effectively did was distinguish between private foundations and public charities (the former fails the public support test) and required that foundations must distribute a minimum amount of their wealth annually. (I should mention that all this pertains only to non-operating foundations; operating foundations’ direct charitable activities exempt them from payout.) At the time, there was very little consideration given to determining an appropriate minimum rate: Hence, the rate was set without “any systematic data about the consequences it would have on the operations of foundations” (Salamon, 1992, p. 119). When TRA 1969 passed, the minimum distribution requirement was set at an annual rate of 6% adjusted based on investment rates and market yields. In other words, legislators favored a distribution rate that was on par with investment yields so that money gained would be spent. Put more bluntly, the winning sentiment was that foundations should not last into perpetuity and wealth should be given away for the good of all. But this sentiment did not last, and under much pressure from foundation executives, the law was changed to a flat 5% rate in 1981 (TRA 1981).

What are we to make of this history? My own view is that the 5% rate should be seen as a compromise between those arguing for preserving wealthy elite’s privilege to practice philanthropy (i.e., the ‘private interest’ position) and those who see foundations’ tax-subsidized assets as accountable to the public good (i.e., the ‘public interest’ argument). Although there was strong opinions from both sides, there is nothing clear-cut in the historical documents or in the legal codes that definitively answers which viewpoint is more correct. In actuality, TRA 1969 and TRA 1981, taken together, reflect a great deal of ambiguity by making private foundations beholden to both public and private interests: TRA 1969 mandated spending for the public good while TRA 1981 protected foundations’ ability to exist into the future. Given the lack of clarity in policy, it’s no wonder that the payout rate has remained a source of contention over the years.

Hence, much of the debate over payout pivots on the fundamental differences in opinions of what and whom foundations should serve. Consequently, such an outsized ideological cage match has diverted attention from smaller details of payout regulation that merit attention. For instance, under current regulations, there is no answer to the question of what happens to foundations that realize greater yields on investments that surpass charitable spending. In other words, what should happen to foundations that grow wealth at a greater rate than they redistribute it? The answer, I would argue, lies in the original TRA 1969 notion of tying spending to investment returns.

I suggest that a foundation’s payout rate be determined by comparing its charitable spending rate and its yield on investments, minus rate of inflation, over a 25-year time horizon. (A variable payout rate is not a new idea [cf. Frumkin, 1998] but what I propose is a much longer time horizon to support intergenerational equity.) So, let’s say that a foundation averaged distributions of 5% over a 25-year period and over that same period the average rate of inflation was 5.17% (this is actually the averaged inflation rate between 1975-2000), the foundation would then need to distribute at a rate of .17% more over the next 25 years. The calculation begins with a foundation’s first tax return and if the averaged inflation rate is below the mandatory minimum, the 5% still applies. In actuality, most foundations distribute more than 5% of non-charitable use assets so, given the rate of inflation, this proposal will not likely result in public charities experiencing a huge windfall. What this proposal does do, however, is ensure that wealth does not growing disproportionate to charitable obligations. In sum, by basing adjustments in payout rate over the long term, this would protect foundations’ financial ability to work toward perpetuity while ensuring that any investment gains beyond rates of inflation are spent for the greater social good.

What this proposal does not do is resolve the debate about whom foundations should primarily serve—foundation owners or the public good. Hence, I'm not going to touch the question of how payout should affect perpetuity, which would require greater clarity in policy about a foundations' social role. Short of that, however, an adjusted payout rate minus inflation over nearly a generation timespan ensures that foundation wealth does not grow at the expense of taxpayers’ expectations for social benefits. Although there has been criticism of even having a payout requirement (Deep &Frumkin, 2001), we now know empirically that mandating distributions has been effective. Desai and Yetman (2005) discovered empirically that foundations behaved more charitably in response to government regulations and oversight. Furthermore, Worthy (1975) found that foundations paid out less before the mandatory distribution requirement than after its implementation. Therefore, the payout requirement is working and merits continued refinement, particularly in calibrating the balance between competing desires for wealth accumulation and charitable spending.

Works Cited

Deep, A., & Frumkin, P. (2001). The foundation payout puzzle (Working paper no. 9). Cambridge, MA: Hauser Center for Nonprofit Organizations, Harvard University.

Desai, M. A., & Yetman, R. J. (2005). Constraining managers without owners: Governance of the not-for-profit enterprise (No. w11140). National Bureau of Economic Research. Retrieved from http://www.nber.org/papers/w11140

Frumkin, P. (1998). The long recoil from regulation: Private philanthropic foundations and the Tax Reform Act of 1969. The American Review of Public Administration, 28(3), 266–286. doi:10.1177/027507409802800303

McGlaughon, K. (2013). Foundation Source annual report on private foundations (No. 2). Fairfield, CT: Foundation Source. Retrieved from http://www.foundationsource.com/resources/FS_2013_Annual_Report.pdf

Renz, L. (2012). Understanding and benchmarking foundation payout. New York, NY: Foundation Center. Retrieved from http://foundationcenter.org/gainknowledge/research/pdf/payout2012.pdf

Salamon, L. M. (1992). Foundations as investment managers, part 1: The process. Nonprofit Management and Leadership, 3(2), 117–137. doi:10.1002/nml.4130030203

Troyer, T. A. (2000). The 1969 private foundation law: Historical perspective on its origins and underpinnings. The Exempt Organization Tax Review, 27(1), 52–65.

Worthy, K. M. (1975). The Tax Reform Act of 1969: Consequences for private foundations. Law and Contemporary Problems, 39(4), 232–254.