How private foundations work: the 5% payout rule, the investment tax and the limits on self-dealing

A private foundation is a charity that usually gets its money from one main source, such as a family or a company, and mostly gives grants rather than running programs of its own. In return for tax exemption, federal law holds it to stricter rules than other charities. It must pay out a minimum amount each year, pay a small tax on its investment income, file a public return every year and stay out of financial dealings with its insiders. Breaking those rules triggers excise taxes on the foundation and, in some cases, on the people who run it.

Private foundation or public charity

The starting point surprises many people. Under the tax code, every organization that qualifies under section 501(c)(3) is a private foundation unless it falls into a category that section 509(a) excludes, the IRS explains. The excluded groups are public charities: institutions such as hospitals and universities, organizations with broad public support, and organizations that actively support them. A new charity that wants public-charity status generally has to tell the IRS within 27 months of the end of the month in which it was organized, usually on Form 1023, or it is presumed to be a private foundation.

The label matters to donors. Cash gifts to most private non-operating foundations are deductible up to 30% of a donor’s adjusted gross income, according to IRS Publication 526, while cash gifts to public charities can be deducted up to 60%, a ceiling the 2025 tax law made permanent.

The 5% payout rule

Section 4942 of the tax code requires a foundation to pay out a “distributable amount” each year. The statute builds it from a minimum investment return of 5% of the fair market value of the foundation’s assets that are not used directly for its charitable work, minus any debt used to buy them. The foundation then subtracts the income taxes and the investment excise tax imposed on it for the year.

Grants to other charities count toward the requirement, along with other qualifying distributions. A foundation has until the end of the following tax year to make the payout. If income is still undistributed after that, the foundation owes a 30% tax on the shortfall, and a further 100% tax if it does not make up the shortfall within 90 days of being notified by the IRS. A foundation may set money aside for up to 60 months for certain major projects, and it can carry extra distributions forward for five years. The 30% tax does not apply to private operating foundations, which run their own charitable programs and meet a separate spending test.

The tax on investment income

Section 4940 imposes an excise tax on the net investment income of most domestic private foundations, including private operating foundations. For tax years beginning after December 20, 2019, the rate is 1.39%, with no reduced rate, according to the IRS. An exempt operating foundation does not pay it. The tax is reported on Form 990-PF, and a foundation that owes $500 or more for the year pays it in quarterly estimated installments.

The July 2025 tax law, Public Law 119-21, left that rate alone. It changed a different levy, the excise tax on the investment income of large private colleges and universities, replacing its single rate with tiers of 1.4%, 4% and 8% depending on endowment per student.

The rules on insiders, holdings and spending

Four more sections of the tax code police how a foundation behaves. Each starts with an initial tax and adds a much larger one if the problem is not corrected in time.

The managers’ exposure is capped. For self-dealing, the initial and additional taxes on a manager are each limited to $20,000 per act, but there is no cap for the self-dealer. For a jeopardizing investment, the caps are $10,000 and $20,000. For taxable expenditures, a manager’s initial tax is capped at $10,000 and the additional tax at $20,000. The holdings limit also reaches beyond foundations: certain donor-advised funds and supporting organizations are treated as private foundations for that rule.

The annual return

Every private foundation must file Form 990-PF each year, whether or not it had income or activity. The return is due on the 15th day of the fifth month after the foundation’s year ends, which is May 15 for a calendar-year foundation, and a six-month extension is available on Form 8868. Under the instructions for 2025 returns, a late return costs $25 a day, or $130 a day for a large organization (one with gross receipts over $1,309,500), up to the lesser of $13,000 ($65,000 for a large organization) or 5% of gross receipts, unless the foundation shows reasonable cause.

The return is public. Exempt organizations must make their annual returns available for inspection for three years, and while most may withhold the names and addresses of their contributors, private foundations may not.

What this means for grantees and donors

For organizations seeking grants, the payout rule sets a floor, not a ceiling: a foundation can give more than its distributable amount in any year. Because the return is public, a grantseeker can check a foundation’s filings before applying. For donors weighing a foundation against a donor-advised fund, the differences include who legally controls the money, what becomes public and which excise taxes apply. Our explainer on how donor-advised funds work sets out the other side, and our guide to reading a Form 990 covers the return most public charities file.