The Five Percent Fig Leaf

Abstract

What do we ask of private foundations? What should we?

The current answer to this first question, provided by Tax Reform Act of 1969, and continuing to this day, is the annual payout requirement which requires private foundations to spend 5% of their assets each year. The purpose of the payout requirement rule was to address the concern that donors to private foundations get significant up-front tax benefits for their creation of a private foundation, but that, absent a payout rule, there could be a near unlimited delay between the time of tax benefits and the time the public benefited from the charitable activities of the private foundation.

Judging by appearances, the 5% rule is stronger than ever. For at least fifteen years there have been no Congressional proposals or lobbying efforts to change the 5% payout rule. Moreover, the 5% payout rule has become widely accepted and widely touted (by the foundation world, among others) as a reasonable compromise that allows private foundations to exist in perpetuity while ensuring that a portion of their funds be put to current charitable use.

However, despite the apparently robust nature of the 5% payout rule, this Article argues that the 5% payout rule operates more as a fig leaf than as a meaningful control on private foundation spending. Analyzing how the rule operates fifty years after its enactment, it has become increasingly evident that the meaning of the term “payout” is so elastic that the rule cannot be relied upon to fulfill its stated purpose of ensuring the current flow of dollars to charitable activities.

This Article proceeds in three parts. Part I outlines the law and history of private foundation regulation. It begins with a brief description of the tax benefits of creating private foundations, and then turns to the particular rules and restrictions applicable to private foundations, including the 5% payout requirement. Part II then turns to consider whether under the current rules the payout rule actually works to accomplish its intended goals. Finally, Part III considers policy proposals designed to refine the rules so that they can more closely fulfill the larger purpose of the rules providing tax benefits for charitable giving.