Governing private foundations using the tax law

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Journal of Accounting and Economics 41 (2006) 363–384 www.elsevier.com/locate/jae

Governing private foundations using the tax law$ Richard Sansinga,b,, Robert Yetmanc a

Tuck School of Business, Dartmouth College, Hanover, NH 03755, USA b Tilburg University, 5000 LE Tilburg, The Netherlands c Graduate School of Management, University of California at Davis, Davis, CA 95616, USA Available online 4 October 2005

Abstract This paper investigates two tax law provisions that act as governance instruments designed to regulate the behavior of private foundations. It examines tax return data from a sample of private foundations to determine the effects of the minimum distribution requirement and the dual tax rate regime. The minimum distribution requirement primarily affects the distribution behavior of foundations that are no longer receiving donations and are growing more slowly than the average foundation. The dual tax rate regime has countervailing effects on distributions by foundations, rewarding both higher levels of current distributions and lower levels of prior year distributions. r 2005 Elsevier B.V. All rights reserved. JEL classification: L31 Keywords: Private foundations; Governance; Non-profit organizations; Philanthropy

1. Introduction Non-profit organizations (other than churches) in the United States own financial assets worth about $1 trillion. Nearly half of these assets are owned by approximately 66,000 private foundations, with the remainder being held by public charities. A public charity is a section 501(c)(3) organization whose financial support is provided by the general public $

We thank Ken French, Jim Hines, Michal Matjeka, Sonja Rego, Michelle Yetman, workshop participants at Carnegie Mellon University, Tilburg University, participants at the 2003 University of North Carolina Tax Symposium and 2003 American Accounting Association convention, Doug Skinner (the editor), and Lillian Mills (the referee) for helpful comments. Corresponding author. Tel.: +1 603 646 0392; fax: +1 603 646 1308. E-mail address: [email protected] (R. Sansing). 0165-4101/$ - see front matter r 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.jacceco.2005.03.003

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(section 509(a)).1 In contrast, a private foundation is a section 501(c)(3) organization whose financial support is provided by a small group of people, usually members of the same family. Private foundations are similar to public charities in that a contribution to a foundation is tax deductible and endowment income is exempt from the federal income tax. But unlike public charities, most foundations simply make grants instead of engaging in charitable activities directly.2 In the aggregate, these private foundations represent a privately controlled endowment whose assets are held for the benefit of current and future public charities. They act as a conduit that transfers private wealth today to charitable beneficiaries in the future in a way that generates current charitable contribution deductions to donors and future virtually tax-exempt investment returns between the time the assets are transferred to the foundation and the time the assets are transferred from the foundation to a public charity. Although it is unusually large, the operations of the Bill and Melinda Gates Foundation are typical. In 2001, the foundation received one donation, consisting of 30 million shares of Microsoft stock from Bill and Melinda Gates with a value of $2.1 billion and a tax basis of $64,000. The foundation sold the stock, paying tax on the capital gain at a rate of 1%. In addition to the donation, the foundation also earned $1.5 billion of investment income. Of the foundation’s total assets of $21 billion, over 99.9% is held as investments, with the remainder consisting of foundation-fixed assets (offices, furniture, etc.). The investments form an endowment out of which the foundation makes grants. The foundation made about $1.15 billion in grants in 2001, or roughly 5.5% of the value of its portfolio. Grantees included the Global Alliance for Vaccines and Immunization, high schools, libraries, and homeless persons assistance organizations. Because foundations break the contemporaneous link between the charitable deduction to the donor and the eventual disbursement of funds to a public charity, Congress became concerned that some foundations would excessively accumulate funds instead of making distributions to charities. To address this concern, Congress adopted two governance mechanisms through the tax law. First, it imposed the minimum distribution requirement, which requires a foundation to spend at least 5% of its investment assets on charitable activities each year (section 4942). Second, it imposed a dual excise tax rate regime on a foundation’s net investment income. If a foundation’s charitable distributions (as a percentage of investment assets) during the year exceed the average distribution percentage over the past 5 years plus 1% of its net investment income, the foundation pays a 1% tax on its net investment income. If the current year’s charitable distributions are less than the five-year average benchmark plus 1% of its net investment income, the tax rate is doubled to 2% (section 4940(e)). The minimum distribution requirement and the dual tax rate regime are the two primary tax law provisions that Congress has enacted to regulate the distribution policies of private foundations. This paper examines the actual tax returns (IRS Form 990-PF) of approximately 3800 private foundations between 1994 and 2000 in order to determine the effects of these tax law provisions on the distribution policies of private foundations. By examining how foundations respond to the tax law provisions that govern them, we hope to shed light on how the sector 1

All statutory references are to the Internal Revenue Code of 1986, as amended. Private operating foundations engage in charitable activities directly instead of making grants. These foundations, which make up about seven percent of private foundations, face a different set of tax rule restrictions than grant-making foundations. We do not examine private operating foundations in this study. 2

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would be affected by changes in these provisions. This information is of value to policymakers and others concerned with the role of foundations in US philanthropy. We document substantial variation among foundations in the percentage of investment assets spent on charitable purposes, with a mean distribution percentage of 8.7%. About 4/7ths of our sample appear to adhere closely to the existing 5% minimum distribution requirement. The remaining 3/7ths of foundations in our sample distribute substantially more than the law requires. We find that foundations whose payouts are substantially more than the legally mandated 5% spend more on salaries and professional management fees as a percentage of investment assets. They are also more likely to receive new donations and are growing more rapidly than are foundations that adhere closely to the legal minimum. We conclude that the minimum distribution requirement is a binding constraint for foundations that are ‘‘passive’’ in terms of management expenditures and ‘‘cold’’ in the sense having no source of new donations and a relatively low rate of asset growth. This suggests that the governance effects of the minimum distribution requirement vary across foundations. We find that the dual tax rate regime rewards foundations that increase their distributions (to get the 1% tax rate), but also discourages additional distribution because it makes it harder to qualify for the 1% tax in future years. We find that some foundations (about 3% of our sample) appear to respond to the tax incentive by deliberately boosting their distributions in the current year just enough to qualify for the 1% tax. Most foundations appear to largely ignore the two-tier tax rate regime and instead focus on a particular payout strategy relative to the minimum distribution requirement. The foundation characteristic that is most highly correlated with the lower tax rate is size, so it is larger foundations that tend to take advantage of the dual tax rate regime. The lower tax rate appears to affect distributions of foundations that adhere closely to the minimum distribution requirement, but has no effect on the distributions of foundations that pay out substantially more. We conclude that the dual tax rate regime provides mixed incentives regarding foundation distribution policy, and so substituting a flat rate regime would have countervailing effects on foundation distributions. Overall, we conclude that the minimum distribution requirement and dual tax rate regime play important roles in the governance of private foundations, particularly with respect to foundations that spend little on professional management and are no longer receiving donations. Section 2 of the paper describes the minimum distribution requirement and the dual tax rate regime in more detail. Section 3 describes our data. In Section 4 we describe the sector in terms of private foundation characteristics such as size, administrative expenditures, and asset growth. In Section 5 we characterize the payout policies of private foundations in relation to the minimum distribution requirement, and explain cross-sectional variation in foundation behavior in terms of foundation characteristics. Section 6 examines which foundation characteristics are associated with the lower tax rate and the relation between tax rate reduction and the level of qualifying distributions. Section 7 concludes the paper. 2. Governance instruments 2.1. Minimum distribution requirement Because the deduction for a contribution to a private foundation occurs when the foundation receives the funds instead of when it distributes the funds to a public charity,

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Congress became concerned that foundations were retaining their income in order to advance the private interests of the foundations’ donors. These concerns led to the enactment of several tax provisions in 1969 designed to ensure that private foundations fulfill a charitable purpose (Troyer, 2000). One of these provisions requires that foundations spend at least 5% of their investment assets (i.e., the distributable amount) on charitable grants or charitable administrative expenditures each year (section 4942). Charitable expenditures in excess of the minimum can be carried forward and used to satisfy the minimum distribution requirement in a future year. This ‘‘minimum distribution requirement,’’ the details of which have changed several times over the years, is designed to prevent excessive retention of assets within foundations. Steuerle (1977) examines the theoretical foundations of the minimum distribution requirement. The minimum distribution requirement is the subject of considerable controversy, with some advocating an increase in the percentage of assets that must be annually paid out while others defend the current rules. Supporters of the status quo argue that an increase would likely deplete the real value of foundation assets, which would in turn cause a decrease in the real level of payout over time (Cambridge Associates, 2000). By avoiding asset depletion, the current rules allow foundations to maintain the real value of their endowment in perpetuity (Craig, 1999). This in turn preserves an endowment for the benefit of the charitable sector, controlled by ostensibly prudent stewards who are not subject to pressures to meet immediate needs at the cost of future unmet needs. Those advocating an increase in the percentage of assets that must be paid out point to the rapid growth of the private foundation sector, and assert that the field has become ‘‘more concerned with investment banking than with grantmaking’’ (Mehrling, 1999). They reject the idea that perpetuity is a legitimate goal of a charitable foundation. Brody (1997) examines the broader questions of whether the non-profit sector should even have an endowment, whether this endowment should be controlled by private foundations instead of public charities, and whether private foundations should be allowed to exist in perpetuity. Hansmann (1990) criticizes the accumulation of wealth by universities on grounds of inter-generational equity. Current saving represents a transfer of wealth from the current generation to future generations, which seems inequitable in light of the general increase in economic prosperity over time. Deep and Frumkin (2001) summarize the arguments for and against changing the minimum distribution requirement. They also express a concern that the 5% rule has become a ceiling as well as a floor on distributions, leading to convergence in distribution strategies among foundations. As this convergence is unlikely to represent the most effective way to carry out the mission for all foundations, they regard the 5% payout requirement as a failure. 2.2. Excise tax on investment income Private foundations are subject to an excise tax on their net investment income. In general, a private foundation faces a 2% tax on its net investment income (section 4940(a)). However, this tax rate is halved to 1% for a foundation that makes a sufficiently large ‘‘qualifying distribution.’’ In general, a qualifying distribution is either a grant made to a public charity or an administrative expenditure related to the foundation’s charitable (as opposed to its investment) activities. A foundation’s qualifying distribution must generally be at least equal to 5% of its investment assets. Although there are some institutional complications to these general rules, such as exactly which assets comprise the base on

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which the 5% is calculated and the calculation of net investment income, we leave our discussion of these features until later in the analysis. To qualify for the reduced tax rate, the ratio of qualifying distributions to investment assets must be at least as large as the sum of the average ratio of qualifying distributions to investment assets over the preceding 5 years, plus 1% of the foundation’s net investment income. For example, suppose over the preceding 5 years the foundation spent on average 6% of its investment assets in qualifying distributions. This year the foundation has investment assets of $100 million and net investment income of $8 million. If this year’s qualifying distributions are less than $6,080,000, then its tax is $160,000; if qualifying distributions are $6,080,000 or more, then its tax is $80,000. This system features a severe ‘‘cliff effect’’ in that a $1 shortfall in qualifying distributions doubles the tax on investment income. For example, in the fiscal year ending August 31, 1999, The Eugene McDermott Foundation fell less than $5000 short of the distribution threshold, which increased its tax by over $150,000. A criticism of the system is that it may actually deter a foundation from increasing its current year distributions, because that makes it harder to achieve the 1% tax rate in subsequent years. Recent legislative proposals would replace this two-tiered tax rate with a single flat rate (Stokeld, 2000). We interpret this dual tax rate regime as another governance mechanism designed to increase the level of qualifying distributions that foundations make. 3. Data The data we use for our analysis consists of the foundations’ IRS Form 990-PF. Each private foundation files an annual Form 990-PF that discloses its current income statement, balance sheet, compliance with the minimum distribution requirement, and the calculation of its excise tax. These returns are publicly available from either the National Center for Charitable Statistics (NCCS) or directly from the IRS. Our sample of IRS Form 990-PFs is from the Internal Revenue Service Statistics of Income file for the years 1994 through 2000, which are all the years currently available. The 1994 database includes the entire population of 50,914 foundations that existed in 1994, while the 1995 to 2000 samples include approximately 8000 observations for each year. The sample observations for 1995 to 2000 were based on a stratified sampling method which over-weighted larger foundations. All foundations with total year-end assets of $10 million or more are included in the annual samples. These samples are available from the NCCS.3 This aggregated pooled sample contains 97,717 foundation-year observations. We exclude 6909 private operating foundation observations, which operate charitable programs rather than make grants and face a different set of tax rules. We also exclude 2654 foundation-year observations with zero assets. Zero asset foundations frequently act as little more than annual conduits where a donor provides funds to the foundation, which disburses those funds to a charity before the end of the year. These types of foundations are not affected by either of the two governance mechanisms we examine in this paper. We require that all observations be included in each of the 7 years (i.e., a balanced pooled sample), which reduces our sample to 3779 annual observations for each of the 7 years 3 The National Center for Charitable Statistics is a project of the Urban Institute and is given authority by the IRS to collect and distribute data on nonprofit organizations. Data can be requested at the Center’s website: http://www.nccs.urban.org.

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from 1994 to 2000. Although each year contains less than 10% of the total foundations by number, our sample represents over 66% of the total assets of all foundations in each year. For the most recent year in our sample (2000), our sample contains $310 billion in foundation assets and includes the 35 largest private non-operating foundations, each of which owned assets of over $1 billion at the end of 2000. Two data issues arise with our use of this sample. First, the foundation sector is diverse and our sample contains observations with extreme minimum and maximum values of many of our variables of interest. This is particularly true when ratios of some values are used. We attempt to mitigate the influence of extreme values on our analyses in several ways. We winsorize all of our data at the 1st and 99th percentiles. Our descriptive statistics as well as our regression analyses use these winsorized values. In addition, we conduct extensive outlier testing in each regression model including examining residual plots and screening our data based on Cook’s D statistics, leverage statistics, and standardized residual statistics (Belsley et al., 1980). Second, because we estimate our models using a pooled cross section, the issue of correlation over time is a serious concern. This is particularly true in the foundation setting where payout and/or tax planning strategies are stable over time. We attempt to mitigate the effects of intertemporal correlations using direct and indirect approaches. As a direct approach we use the panel data, but correct the standard errors by clustering techniques. Clustering has the effect of creating a ‘‘super observation’’ which reduces the effects of intertemporal correlations on estimated standard errors. All results present t-statistics based on clustered standard errors. As an indirect approach we estimate our models by year. Although this approach mitigates the effects of intertemporal correlations (as each firm only appears once), it also has the effect of ignoring economically genuine across time effects. We choose to present our panel results. Untabulated yearly analysis confirms these results with few modifications. In some years some of the variables were not statistically significant, although there was no pattern and in no case was there more than 2 years of statistically insignificant variables for any coefficient for any year. In no case were the signs of any of the coefficients in the annual regressions different than those obtained in the panel analysis. 4. Foundation characteristics We explain variations in how foundations respond to the two tax law governance instruments using six independent variables, on which we report in Table 1.4 SIZE is the natural logarithm of foundation assets (Form 990-PF, Part II, line 16(c)). Our sample includes 1392 foundations with less than $10 million of assets as of the end of 2000, 1964 foundations with between $10 million and $100 million of assets, 388 foundations with between $100 million and $1 billion of assets, and 35 foundations with over $1 billion of assets. Our median foundation has assets of about $14.3 million. We use two measures of whether a foundation is ‘‘active’’ or ‘‘passive’’ in terms of its expenditure behavior. PAYROLL is the ratio of a foundation’s employee compensation (including director’s and trustee’s fees) (Part I, lines 13–15) and professional fees (Part I, line 16) to its investment assets (Part II, lines 1,2, and 10–13). We interpret high 4 All correlations between our independent variables are less than .24 except for the correlation of .42 between PAYROLL and BRICKS. This suggests that each of these variables is capturing a distinctive foundation characteristic.

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Table 1 Full sample descriptive statistics Obs.

Mean

25th

Median

75th

Std. Dev.

Panel A: independent variables Total assets (in thousands) SIZE PAYROLL BRICKS DONATE GROWTH CAPGAIN STOCK PAYROLL$ BRICKS$

26,453 26,453 26,453 26,453 26,453 22,674 26,332 26,453 26,453 26,453

62,927 16.247 0.009 0.011 0.583 0.221 0.424 0.768 341,688 478,448

3950 15.189 0.002 0.000 0.000 0.075 0.107 0.687 10,300 0

14,331 16.478 0.006 0.000 1.000 0.155 0.496 0.904 57,406 0

33,680 17.332 0.009 0.002 1.000 0.241 0.712 1.000 191,109 51,816

402,659 1.843 0.020 0.053 0.493 0.385 0.355 0.316 2,099,695 3,912,702

Panel B: dependent variables QD/DA GRANTS/DA HIGHTAX SPTAX MINTAX MAXTAX

22,638 22,638 26,453 7,871 26,453 26,453

1.751 1.585 0.521 0.621 0.063 0.076

0.969 0.867 0.000 0.000 0.000 0.000

1.093 1.015 1.000 1.000 0.000 0.000

1.428 1.333 1.000 1.000 0.000 0.000

2.649 2.310 0.500 0.484 0.243 0.264

Notes: SIZE is the log of total assets, PAYROLL is the total payroll including officers’ compensation and outside consulting fees scaled by assets, BRICKS is the sum of depreciable assets and 8
occupancy expense (eight times occupancy expense is a rough approximation of the value of the rented property), DONATE is equal to 1 if the foundation received any additional donations in our sample period and 0 otherwise, GROWTH is the growth rate of the organization’s assets, CAPGAIN is the amount of realized capital gains as a percentage of investment income, STOCK is the ratio of stock investments to total stock plus bond investments, PAYROLL$ and BRICKS$ are the unscaled values, QD/DA is the ratio of qualified distributions for charitable or administrative purposes to the required distributable amount, GRANTS/DA is the ratio of qualified charitable distributions to the required distributable amount (i.e., administrative expenses are omitted), HIGHTAX is equal to 1 if the foundation paid the 2% tax on net investment income and 0 if it paid the 1% tax, SPTAX is equal to 1 if the foundation made sufficient distributions to just barely qualify for the 1% tax on net investment income and zero otherwise, MINTAX is equal to 1 if the foundation paid the 1% tax on net investment income for every year it is in our sample and zero otherwise, and MAXTAX is equal to 1 if the foundation paid the 2% tax on net investment income for every year it is in our sample and zero otherwise.

PAYROLL firms to be professionally managed, either via employees or paid outside experts. PAYROLL has a mean (median) value of .009 (.006), suggesting that the average foundation spends less than 1% of its assets per year on compensation expenses. The mean (median) unscaled value for compensation (PAYROLL$) is $341,688 ($57,406). We explore further the PAYROLL variable by using detailed compensation data for the year 2000 (available from the NCCS). We find that of our sample of 3779 foundations, 591 paid compensation in excess of $100,000 to at least one employee. Employees of less than 2% of our sample received compensation in excess of $1 million dollars, while employees of approximately 5% received compensation between $500,000 and $1 million. BRICKS is the ratio of a foundation’s tangible property (owned or leased) that is used in carrying out its charitable activities to its financial assets. The value of owned tangible

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property is from Part II, line 14(c); we estimate the value of leased tangible property by multiplying a foundation’s occupancy expense (Part I, line 20) by eight.5 A high BRICKS foundation likely owns or leases space in which it carries out its activities; a low BRICKS foundation does not own or lease office space. The mean (median) value of BRICKS is .011 (zero). The mean (median) unscaled value for tangible property (BRICKS$) is $478,448 ($0). We use four measures of a foundation’s financial activity. DONATE is a binary variable that takes a value of one if the foundation received any donations (Part I, line 1) during our sample period. A foundation that still receives donations has an external source of funds, and therefore may adopt a more generous distribution policy than an ‘‘old and cold’’ foundation that receives none. A foundation that does not receive any donations may be one for which the original donor has died and the heirs have no interest in donating more to the foundation. About 58% of our foundations received donations during our sample period. GROWTH reflects the annual increase in the fair market value of the foundation’s assets (Part II, line 16 minus line 23). This increase could be due to either new donations or investment returns in excess of expenditures. The mean (median) growth rate for our sample is 22.1% (15.5%).6 High GROWTH firms may adopt a more generous distribution policy. CAPGAIN is the percentage of a foundation’s gross investment income (Part I, line 12) from realized capital gains (Part IV, line 2). The mean (median) CAPGAIN for our sample is .424 (.496). High CAPGAIN firms are likely to be foundations with lower dividend and interest income that need to liquidate asset holdings to meet its distribution requirements. In addition, a high CAPGAIN firm has more discretion over the timing of its taxable income realizations. Therefore, it has a particularly strong incentive to coordinate its gain realization and charitable distribution strategies so as to have its realized capital gains taxed at a 1% rate under the dual tax rate regime. Finally, we include STOCK, which is equal to the value of stock investments scaled by the sum of the value of its stock and bond investments. We expect that a foundation with a high value of STOCK has a longer investment horizon and is thus less likely to make current distributions. The mean (median) value for STOCK is 77% (90%). The foundations in our sample have assets that range from less than $1 million to over $20 billion. In Table 2 we report the descriptive statistics for our independent variables for four size-based partitions of our sample—foundations with less than $10 million of assets, between $10 million and $100 million, between $100 million and $1 billion, and over $1 billion. A comparison of the mean and median values suggests that the values of our variables are comparable across size partitions.

5 This capitalization factor is used in The Uniform Division for Income Tax Purpose Act (UDITPA) for purposes of converting rented property to owned property when computing the property factor of the state income apportionment formula. Results are robust to various combinations of use and discount rates. 6 We expect that the GROWTH variable reflects in part year-to-year variations in stock market performance. The data that are currently available (1994–2000) does not reflect a sustained bear market period. Whether the GROWTH variable behaves differently during a sustained bear market is an empirical question, the answer to which we leave to future research.

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Table 2 Size partitioned descriptive statistics Mean

25th

Median

75th

Std. Dev.

0.012 0.011 0.530 0.231 0.358 0.711

0.002 0.000 0.000 0.070 0.004 0.549

0.006 0.000 1.000 0.148 0.391 0.900

0.011 0.000 1.000 0.239 0.667 1.000

0.026 0.058 0.499 0.419 0.370 0.370

Assets X$10 million and o$100 million PAYROLL 13,430 0.008 BRICKS 13,430 0.012 DONATE 13,430 0.620 GROWTH 11,736 0.212 CAPGAIN 13,424 0.453 STOCK 13,430 0.801

0.002 0.000 0.000 0.078 0.187 0.739

0.005 0.000 1.000 0.157 0.524 0.906

0.009 0.004 1.000 0.242 0.724 1.000

0.015 0.051 0.485 0.351 0.340 0.277

Assets X$100 million and o$1 billion PAYROLL 2189 0.007 BRICKS 2189 0.010 DONATE 2189 0.609 GROWTH 1991 0.224 CAPGAIN 2189 0.543 STOCK 2189 0.834

0.003 0.000 0.000 0.077 0.371 0.775

0.005 0.002 1.000 0.161 0.631 0.897

0.008 0.006 1.000 0.240 0.776 0.994

0.012 0.039 0.488 0.410 0.307 0.214

Assets X$1 billion PAYROLL BRICKS DONATE GROWTH CAPGAIN STOCK

0.002 0.001 0.000 0.100 0.526 0.822

0.004 0.003 1.000 0.173 0.671 0.909

0.006 0.006 1.000 0.273 0.755 0.969

0.003 0.005 0.483 0.461 0.267 0.176

Obs. Assets o$10 million PAYROLL 10,630 BRICKS 10,630 DONATE 10,630 GROWTH 8761 CAPGAIN 10,515 STOCK 10,630

204 204 204 186 204 204

0.004 0.004 0.632 0.269 0.596 0.863

Notes: Variable descriptions are contained in Table 1.

5. Payout policy 5.1. Distributions by the sample We first examine the payout behavior of foundations and the relation between a foundation’s qualifying distributions and the legally mandated minimum amounts. We use two measures of a foundation’s level of charitable distributions relative to the required amount. We define QD/DA as the ratio of the current year’s qualifying distributions (Part XII, line 4) to the prior year’s distributable amount (Part XI, line 7). For example, the distributable amount from 1998 must be distributed by the end of 1999 to avoid violating the minimum distribution requirement. Descriptive statistics in Table 1 show substantial variation within our sample regarding the payout percentage. The mean of QD/DA is over 1.75, so the average payout percentage for our sample is over 8.7% of assets as compared to the legally mandated minimum of 5%. Foundations at the 75th,

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|___________________________| _________________________| 12/31/96 Date on which 1996 DA is calculated

12/31/97 Date by which 1996 DA must be distributed Date on which 1997 DA is calculated

12/31/98 Date by which 1997 DA must be distributed

Fig. 1. Timeline illustrating the minimum distribution requirement. Example: A calendar year foundation with no distribution carryovers from 1995 or 1996 computes a distributable amount (DA) of $9 million on 12/31/96. This amount must be distributed by 12/31/97 to avoid violating the minimum distribution requirement. In 1997, it makes qualifying distributions of $11 million and computes a DA of $14 million. It must make qualifying distributions of at least $12 million by 12/31/98 to avoid violating the minimum distribution requirement; the $12 million is the difference between the $14 million distributable amount and the $2 million excess distribution it made in 1997. If the foundation distributed less than $12 million in 1998, it would violate the minimum distribution requirement and be classified as a SUBMIN foundation for 1998. If it distributed between $12 million and $13.2 million, we classify it as a MINIMUM foundation. If it distributed between $13.2 million and $15.4 million, we classify it as a TIMELYMIN foundation. If it distributed more than $15.4 million in 1998, we classify it as a SPENDER foundation. A SUBMIN foundation would have a ratio of qualified distributions to the legal minimum distribution of less than 1.0 (left of the ‘‘spike’’ in Fig. 2). If the foundation made distributions of between $12 million and $14 million, it would be right of the ‘‘spike’’ in Fig. 2 but left of the ‘‘spike’’ in Fig. 3. The excise tax rate that applies to 1997 depends on the 1997 level of qualifying distributions, which is compared to the qualifying distributions (as a percentage of assets) in the years 1992–1996.

50th, and 25th percentiles have payout percentages of 7.1%, 5.5% and 4.8%, respectively. We emphasize that because excess prior year distributions can be carried forward, a foundation that currently distributes less than 5% of its assets (QD/DA less than 1.0) is not necessarily violating the minimum distribution requirement. Fig. 1 contains a timeline illustrating these distribution requirements. Both administrative expenditures and charitable grants qualify as charitable distributions, leading some to wonder whether foundation assets are being transferred to charitable beneficiaries or being spent on foundation administration, perhaps as ‘‘excessive’’ perquisites. Our second measure of distributions, GRANTS/DA, replaces qualifying distributions with grants (Part I(d), line 25). This measure excludes administrative expenses and other qualifying distributions other than grants from the numerator. As with QD/DA, this measure varies substantially within our sample. The mean (1.59) implies that on average, 8.0% of foundation assets are distributed as grants, suggesting that a substantial majority of charitable disbursements are in the form of grants rather than administrative expenditures. Foundations at the 75th , 50th, and 25th percentiles have grant percentages of 6.6%, 5.1% and 4.3%, respectively. Table 3 aggregates the foundation-level data to show how our entire sample behaved from 1995 to 2000. The value of foundation assets more than doubled from about $146.5 billion to over $309.7 billion, an annualized growth rate of over 13%, reflecting in part the bull market during that period. About 74% of the gross asset growth was from asset returns (income plus unrealized appreciation) and about 21% was from new donations. Of the $102 billion in expenditures, about $86 billion was in the form of grants and about $9 billion in employee compensation and professional fees. Average annual grants divided by average annual assets is about 6.3%; average annual compensation and fees is less than 0.7% of assets.

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Table 3 Analysis of growth for a balanced pooled sample of 3,779 private non-operating foundations from 1994 to 2000 (amounts in $ millions) Market value of total assets at the end of fiscal year 1994

146,538

Changes to market value from 1995 to 2000 Contributions Investment income Other revenue Grants paid to charities Employee compensation and fees Other expenses Change in liabilities Unrealized asset appreciation Market value of total assets at the end of fiscal year 2000

56,177 149,676 4949 (85,845) (9039) (7435) 6844 47; 857 309; 722

Notes: All variables are from the Form 990-PF. Unrealized asset appreciation is asset appreciation over time that has not yet been recognized in the foundations’ income statements.

5.2. Distribution policy and foundation characteristics To explore further the relation between payout decisions and foundation characteristics, we use a multiple regression model to explain variations in QD/DA and GRANTS/DA as a function of our six independent variables, which we report in Table 4. We find that both QD/DA and GRANTS/DA are decreasing in SIZE, suggesting that smaller foundations choose higher payout rates. Both payout variables are also increasing in both DONATE and GROWTH, so a foundation that receives donations during the sample period or has higher than average growth in assets also chooses a higher payout rate. Both variables are also decreasing in STOCK, so foundations with a higher fraction of investment assets in stock instead of bonds distribute less in both grants and total qualifying distributions. GRANTS/DA is negatively associated with BRICKS but has an insignificant positive association with PAYROLL, so foundations that spend more on facilities make fewer grants but foundations that are professionally managed do not make fewer grants. Because most of the expenditures contained in PAYROLL and BRICKS are qualifying distributions, the coefficients on both variables are higher in the QD/DA regression than in the GRANTS/DA regression, with PAYROLL being positive and significant and BRICKS being positive but not significant in the QD/DA regression. 5.3. Payout policy relative to the minimum distribution requirement We next examine the payout policy of foundations in relation to the minimum distribution requirement. We partition the sample into four mutually exclusive and collectively exhaustive groups based upon how a foundation complies with the requirement. A foundation must distribute 5% of its assets (the distributable amount from Part XI, line 7). This distribution must occur no later than the end of the following year, but may occur during the current year. Failure to distribute by the end of the following year will subject the foundation to a 15% penalty on the undistributed amount. Our sample partition is based on two criteria. The first is how a foundation’s distributions compare to the amount needed to avoid violating the minimum distribution

0.057 0.046 0.860 0.066 0.022 0.027 0.193 0.259 0.357 0.345

BRICKS

(3.98) 15.130 (5.11) 0.623 (0.93) (3.56) 1.773 (0.74) 2.232 (4.05) (15.01) 47.060 (2.60) 7.749 (0.62) (2.94) 86.166 (8.69) 11.899 (2.11) (1.73) 1.874 (1.26) 0.394 (0.87) (1.84) 25.007 (8.09) 1.332 (2.63) (16.10) 7.059 (5.38) 0.610 (1.41) (13.78) 2.459 (1.06) 0.021 (0.03) (8.97) 12.455 (5.89) 0.058 (0.06) (11.27) 9.257 (1.85) 2.685 (1.44)

PAYROLL

0.462 0.410 4.533 0.376 0.469 0.658 0.228 0.120 0.243 0.440

(15.83) (14.87) (4.57) (4.58) (10.38) (13.30) (5.48) (1.90) (1.55) (3.19)

DONATE

2.486 2.247 0.885 0.978 1.850 2.455 0.676 0.172 0.236 0.116

(15.34) (14.31) (2.14) (9.27) (9.88) (24.01) (10.49) (1.55) (1.50) (1.00)

GROWTH

0.021 0.003 0.646 0.057 0.171 0.250 0.154 0.341 0.357 0.453

(0.40) (0.05) (1.84) (0.65) (3.20) (4.16) (2.93) (3.63) (2.08) (3.51)

CAPGAIN

0.479 0.419 0.479 1.338 0.007 0.444 0.253 0.301 0.820 0.308

(5.95) (5.87) (1.83) (8.71) (0.10) (5.94) (3.85) (2.77) (4.19) (1.80)

STOCK

Notes: Variable descriptions are contained in Table 1. Z-statistics (clustered t-statistics) are in parentheses. All models include year fixed effects.

QD/DA GRANTS/DA SUBMIN MINIMIZE TIMELYMIN SPENDER HIGHTAX SPTAX MINTAX MAXTAX

Dependent variable: SIZE

Table 4 Regression analyses of the effects of organizational characteristics on private foundation payout, spending, and tax management activities

22,398 22,405 22,445 22,475 22,453 20,751 22,156 6,800 22,430 22,417

Obs

0.30 0.27 0.36 0.04 0.05 0.12 0.11 0.08 0.07 0.10

Pseudo R2

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requirement. The second is how a foundation’s distributions compare to the prior year’s distributable amount. Based on these criteria we arrive at four subsamples, which we name SUBMIN, MINIMIZE, TIMELYMIN, and SPENDER. SUBMIN contains those foundations that violate the minimum distribution requirement by failing to distribute the legally obligated amount. MINIMIZE contains those foundations that distribute between 100% and 110% of the legal minimum, thereby barely satisfying the minimum distribution requirement. TIMELYMIN contains those foundations that distribute more than 110% of the legal minimum but less than 110% of the prior year distributable amount. Foundations in this category appear to use the distributable amount from the prior year as a guideline for its distribution policy; therefore, their distributions barely satisfy the minimum distribution requirement, but do so in a timely fashion instead of delaying the distribution until the following year. SPENDER contains those foundations whose current distributions exceed both 110% of the legal minimum and 110% of the prior year’s distributable amount. To illustrate our partition, consider a foundation that in 1997 has a distributable amount of $10 million. Its distributions in 1997 exceed its minimum legal requirement (which is based on its 1996 distributable amount) by $2 million, so its minimum permitted distribution in 1998 is $8 million. If the foundation makes qualifying distributions of less than $8 million in 1998, it violates the minimum distribution requirement (SUBMIN); if it distributes between $8 and $8.8 million, we classify it as a MINIMIZE foundation; if it distributes between $8.8 million and $11 million, it is a TIMELYMIN foundation; and if it distributes more than $11 million, it is a SPENDER foundation. Figs. 2 and 3 illustrate foundation distributions relative to these two criteria. Fig. 2 illustrates the distribution of a foundation’s ratio of qualified distributions to the legal minimum distribution. Fig. 2 excludes any foundation that satisfied its legal obligation via a distribution in the prior year. For the subset of foundations that are required to make a distribution in the current year to avoid the 15% penalty, there is a noticeable ‘‘spike’’ just to the right of the value of 1.0. Foundations in this spike are those that pay little more than the legally required minimum amount. Fig. 3 shows the ratio of current distributions to the prior year distributable amount, without regard to how much of the distributable amount was distributed in a prior year. As was the case in Fig. 2, there is a clear clustering of distributions around 1.0. This is consistent with a foundation using the minimum distribution requirement as a benchmark for choosing its level of qualifying distributions. Based on this partition, our sample contains 417 SUBMIN observations, 3397 MINIMIZE observations, 11,560 TIMELYMIN observations, and 11,079 SPENDER observations. Although it is certainly true that this is not the only way one could partition the foundation sector, we believe that our partitions reasonably capture the different ways in which foundations react to the minimum distribution requirement. First we examine the category SUBMIN, which includes those foundations that violate the minimum distribution requirement.7 Violating the requirement triggers a 15% excise tax on the undistributed amount, followed by a 100% tax if the failure is not corrected within the next year. While violations are uncommon, they did occur in 1.6% of our observations. Foundations violating the minimum distribution requirement (SUBMIN ¼ 1) tend to be small, with 2.93% of foundations with assets less than $10 million 7

It also includes foundations that are in the process of converting from a private foundation to a public charity pursuant to section 507(b)(1)(B).

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2,500

2,000

1,500

1,000

500

0 0.25

0.50

0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 Ratio of Qualified Distributions to legal minimum distribution

2.75

Fig. 2. Distribution of foundations relative to the legal minimum. Notes: Foundations are required to make minimum ‘‘qualified distributions’’ (which include payments to charities and also includes the administrative expenses of the foundation) equal to 5% of their investment assets. This requirement can be satisfied by making these necessary payments in the current year, the following year, or a combination of the two. This graph shows the ratio of current qualified distributions to the minimum amount needed to avoid violating the minimum distribution requirement. A value on the horizontal axis of 1.0 means that the foundation made the minimum distribution allowed. Values greater than 1.0 mean that the foundation met its prior years obligation plus it paid out additional funds which are creditable against the current year’s payout requirements. Values less than 1.0 suggest that the foundation did not meet its obligation to fully payout its prior year’s obligation. Foundations in this group likely owe penalties for failure to meet their payout obligations. The ‘‘spike’’ shown in the graph (the largest number of observations are in the x-axis value of 1.0) illustrates the frequency with which foundations distribute the minimum amount.

being SUBMIN firms. While it is rare for large foundations to violate the requirement, it does occur. For example, the William G. McGowan Charitable Fund, a private foundation with over $140 million in assets, was required to make qualifying distributions of about $7.3 million in the year ending June 30, 2001, but only distributed about $6.9 million. The $400,000 shortfall triggered a $60,000 penalty under section 4942. Our logit regression results in Table 4 indicate that SIZE is negative and significant, so SUBMIN firms tend to be small. This implies that the 1.6% frequency with which the minimum distribution constraint is violated overstates its economic significance. PAYROLL is negative and significant, so SUBMIN foundations tend to be passive in that their level of internal salaries and professional fees relative to financial assets are low. DONATE and GROWTH are negative and significant, so SUBMIN firms tend to be cold in that they are no longer receiving donations and the rate of asset growth is low. Overall, what emerges is a picture of small and inert foundations that violate the minimum distribution constraint. We next examine the MINIMIZE foundations, those that distribute just enough to avoid violating the minimum distribution requirement. We set MINIMIZE to one if a

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3,000 2,500 2,000 1,500 1,000 500 0 0.25

0.50

0.75 1.00 1.25 1.50 1.75 2.00 2.25 Ratio of Qualified Distributions to the Distributable Amount

2.50

2.75

Fig. 3. Distribution of foundation payouts relative to the distributable amount. Notes: Fig. 3 illustrates the ratio of qualified distributions in one year to the distributable amount from the previous year. A value on the horizontal axis of less than 1.0 does not imply that the foundation is violating the minimum distribution requirement because the requirement may have been satisfied (in whole or in part) with qualifying distributions in the prior year. The cluster of observations around 1.0 suggests that many foundations adhere closely to the minimum distribution requirement when choosing its qualifying distributions. The many observations well in excess of 1.0 shows that a considerable number of foundations spend well in excess of the minimum distribution requirement.

foundation’s qualifying distributions exceeds the legal minimum by 10% or less, and zero otherwise. For example, observations in Fig. 2 with values on the horizontal axis of between 1.0 and 1.1 would be coded as a ‘‘1’’ and all other observations would be coded as a ‘‘0’’.8 As a result, organizations categorized as MINIMIZE distribute little more than the legally required amount. About 13% of the foundations in our sample are MINIMIZE foundations. Our logit regression results in Table 4 indicate that these foundations tend to be large (the coefficient on SIZE is positive and significant), so the 13% rate understates the economic significance of the minimum distribution requirement. They also tend to be passive (negative coefficients on both PAYROLL and BRICKS) and cold (negative coefficients on DONATE and GROWTH). Finally, they tend to own more stocks than do other foundations (positive coefficient on STOCK). Overall, these foundations are large but inert both in terms of professional management and inflow of assets (either via new donations or accumulated income.) These foundations appear to be trying to preserve their assets by distributing as little as possible because there is little prospect of getting new donations and the value of the foundation’s portfolio is not growing. TIMELYMIN foundations are those that distribute more than 110% of the prior year’s undistributed income but less than 110% of the prior year’s distributable amount. For TIMELYMIN foundations, the minimum distribution requirement does not literally appear to be a binding constraint in the sense that they do not delay their payments as long as possible, but TIMELYMIN foundations do appear to adhere closely to the 5% level as 8

Our results are not sensitive to altering this cutoff over a wide range of alternatives.

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a guideline for making their qualifying distributions. Therefore, the difference between MINIMIZE and TIMELYMIN foundations is one of timing, not levels, of distributions. In our sample, 44% of the foundations are in the TIMELYMIN partition. Our logit regression indicates that TIMELYMIN foundations are cold in that they have negative and significant coefficients on DONATE and GROWTH. CAPGAIN is negative and significant, which suggests that TIMELYMIN foundations have little need to liquidate appreciated assets to make current cash expenditures. As in the case of the MINIMIZE foundations, TIMELYMIN foundations appear to be striving to preserve their assets as a response to a situation in which no new donations are being made to the foundation and foundation assets are shrinking or growing slowly. Finally, we examine the partition of our sample that pays out more than 110% of the prior year’s distributable amount. These SPENDER foundations do not appear to use the minimum distribution requirement as a guideline when choosing the level of their qualifying distributions. SPENDER foundations make up about 42% of our sample. SPENDER foundations are active, with positive coefficients on PAYROLL and BRICKS, so they spend relatively high amounts (relative to financial assets) on both professional management and physical facilities. SPENDER foundations are also hot, with positive coefficients on DONATE and GROWTH. This indicates that SPENDER foundations are experiencing relatively high asset growth and are still receiving new donations. CAPGAIN is positive and significant. This is consistent with donors contributing stock that has appreciated in value, which the foundation sells at a 1% or 2% tax rate to both diversify its portfolio and obtain cash to make charitable distributions. STOCK is negative and significant, suggesting that SPENDER foundations invest more in bonds than do other foundations.9 Table 5 shows the percentage of the MINIMIZE, TIMELYMIN, and SPENDER foundations in each of eight cells that are defined by whether a foundation is big or small (as defined by whether a foundation is above or below the median value of SIZE), cold or hot (above or below median GROWTH) and passive or active (above or below median PAYROLL). While each type of foundation can be found in each cell, MINIMIZE foundations are much more likely to be big and passive (37.8%) than active and hot (15.7%). TIMELYMIN foundations are more likely to be cold than hot. SPENDER foundations are more evenly distributed across the cells, but are more likely to be big and hot (30.2%) than small and cold (21.7%). Each of the differences noted above are statistically different at the 1% level using a w2-test, as are the joint differences of each variable across all the cells. 5.4. Governance implications of the minimum distribution requirement The analysis in the preceding sections shows that the minimum distribution requirement affects foundations in two ways. For about 1/7th of our sample, the rule constrains how foundations behave by penalizing foundations that violate the rule (SUBMIN) or induces 9

We repeated each of our regressions for the subset of foundations with over $100 million in assets. Our regression results are quite similar with exception of the SIZE variable, which is now no longer significant in the QD/DA, GRANTS/DA, and MINIMIZE regressions, but is positive and significant in the TIMELYMIN regression and negative and significant in the SPENDER regression. Therefore, our descriptions of how foundation characteristics (other than size) are associated with foundation behavior hold for both large and small foundations.

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Table 5 Categorization of spending strategies based on foundation characteristics Passive

Active

Big and cold

18.3% MINIMIZE 12.8% TIMELYMIN 11.0% SPENDER

10.1% MINIMIZE 14.3% TIMELYMIN 12.6% SPENDER

Big and hot

19.5% MINIMIZE 12.5% TIMELYMIN 16.5% SPENDER

7.9% MINIMIZE 10.6% TIMELYMIN 13.7% SPENDER

Small and cold

12.8% MINIMIZE 10.8% TIMELYMIN 9.3% SPENDER

11.3% MINIMIZE 16.9% TIMELYMIN 12.4% SPENDER

Small and hot

7.8% MINIMIZE 10.1% TIMELYMIN 13.1% SPENDER

7.8% MINIMIZE 12.0% TIMELYMIN 11.4% SPENDER

Notes: A passive (active) foundation has a value of PAYROLL below (above) the median value for the sample. A big (small) foundation has a value of SIZE above (below) the median value for the sample. A cold (hot) foundation has a value of GROWTH below (above) the median value for the sample. The percentages in each cell are jointly statistically different from each other at the 0.001 level (w2 value of 489).

foundations to make sufficiently high distributions (MINIMIZE) so that the rule is not violated. For these foundations, which tend to be large and cold (low rate of asset growth and no new donations), the minimum distribution requirement increases the level of charitable distributions. For about 3/7ths of our sample (TIMELYMIN), the minimum distribution requirement acts as a guideline that defines the level of charitable distributions. As was the case for the SUBMIN and MINIMIZE foundations, the minimum distribution requirement affects the level of charitable distributions that these foundations, which also tend to be cold, choose. For the last 3/7ths of our sample (SPENDER), the minimum distribution requirement does not appear to affect foundation behavior. It is this group of foundations that increases the mean level of distributions to 8.7% of assets as opposed to the 5% minimum. These foundations tend to be active (high PAYROLL and high BRICKS) and hot (high GROWTH and DONATIONS ¼ 1). 6. Excise tax on net investment income 6.1. Tax rate and foundation characteristics This section examines how our sample of foundations responds to the dual excise tax rate on net investment income. We first examine the entire sample to see how firms paying the 2% tax rate differ from those paying the 1% rate. We set HIGHTAX equal to one for a firm paying the higher tax rate and zero otherwise. Regression results in Table 4 show that HIGHTAX foundations tend to be small (SIZE is negative), so larger foundations tend to face a lower tax rate than small foundations. HIGHTAX foundations tend not to be professionally managed (PAYROLL is negative), so more spending on salaries and

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3,500 3,000 2,500 2,000 1,500 1,000 500 0 0.25

0.50

0.75 1.00 1.25 1.50 1.75 Ratio of Foundation Payouts to 1% Rate Qualifying Amount

2.00

Fig. 4. Distribution of foundation payouts relative to the amounts necessary to qualify for the reduced tax on net investment income. Notes: Foundations pay either a 1% or a 2% tax on their net investment income. If a foundation’s qualifying distributions exceeds a qualifying threshold, the foundation qualifies for the 1% tax; otherwise it must pay the 2% tax. The threshold is based on the average amount of qualified disbursements as a percentage of assets over the past 5 years. This graph shows the distribution of foundation qualifying distributions relative to this threshold. A value of 1.0 means that the foundation paid out just enough to qualify for the 1% tax. Values greater than 1.0 mean that the foundation paid out more than was legally required to qualify for the 1% tax. Values less than 1.0 mean that the foundation did not qualify for the 1% tax and thus paid the 2% tax on net investment income. The noticeable ‘‘spike’’ in the distribution (the largest number of observations are in the x-axis value of 1.0) is consistent with a subset of foundations carefully planning their payout strategy so as to qualify for the reduced tax rate of 1%.

professional fees is associated with a lower tax rate. DONATE is negative, suggesting that foundations that are still receiving donations are more willing to make the higher level of distributions needed to qualify for the lower tax rate. GROWTH is positive, suggesting that foundations experiencing rapid growth do not increase their qualifying distributions by enough to qualify for the lower tax rate. CAPGAIN is negative and significant, suggesting that foundations with unusually high levels of income that can be timed (such as capital gain realizations) time those realizations in years in which they face the 1% tax rate. We next examine foundations with a level of qualifying distributions that is close to the threshold to qualify for 1% tax rate. Fig. 4 documents the peculiar ‘‘cliff effect’’ that the section 4940 investment tax regime induces: a cluster of firms just over the threshold value of 1.0. We investigate how foundations that just barely qualify for the lower tax rate differ from those that just fell short. We set SPTAX equal to one if the foundation’s qualifying distributions exceed the threshold to qualify for the 1% tax rate by less than 10% of that threshold and equal to zero if the foundation’s qualifying distributions miss the threshold to qualify for the 1% tax rate by less than 10% of that threshold.10 In this way our 10

We recognize that additional partitions are available. Additional partitions that we considered are those observations that are to the left or right of SPTAX observations. Untablulated analysis reveals that observations on either side of the SPTAX firms behave similarly with respect to our chosen independent variables. Thus we choose to combine these two groups in our analysis.

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dependent variable surrounds the value of 1.0 in Fig. 2 by plus and minus 10% (i.e., only observations with values of 0.9 and 1.1 on the horizontal axis of Fig. 2 are included in our analysis). We use a logit regression to compare the foundations on either side of 1.0 to each other. In our sample, about 19% of the foundations are in the SPTAX group (i.e., SPTAX ¼ 1) and about 11% fall just short (i.e., SPTAX ¼ 0). Given a foundation is within 10% of the threshold, the results in Table 4 show that the probability that it is a SPTAX foundation is increasing in SIZE, so large foundations appear to pay more attention to the dual tax rate regime or are more willing to increase qualifying distributions in order to qualify for the lower rate than are small foundations. SPTAX is also increasing in CAPGAIN, which suggests that foundations plan so as to time capital gain realizations in low tax rate years (or, equivalently, they time their qualifying distributions to be high in years with high realized capital gains). We next examine those foundations that pay the same tax rate during every year of our sample period. We define a MINTAX (MAXTAX) foundation to be one if it qualifies for the 1 (2)% tax rate in every year of our sample, and zero otherwise. Table 1 indicates that about 6.3% of foundations in our sample pay the 1% tax rate every year while about 7.6% of foundations pay the 2% tax every year. Consistent with our HIGHTAX results, the results in Table 4 show that MINTAX foundations are large and professionally managed (coefficients on SIZE and PAYROLL are positive and significant). MAXTAX foundations are small (SIZE is negative) and tend not to be receiving new contributions (DONATIONS is negative). The latter result suggests that foundations that are no longer receiving donations are not willing to increase charitable distributions in order to qualify for the lower tax rate.11 6.2. Governance implications of the dual tax rate regime The dual tax rate regime is controversial because it is thought to have countervailing effects on foundation behavior. First, it induces a foundation to increase its qualifying distributions so as to qualify for the lower tax rate. Second, it deters a foundation from making high current distributions because a high distribution this year makes it more difficult to qualify for the lower tax rate during the next 5 years. This creates a tax-induced incentive to smooth distributions over time, thereby increasing the tax on foundations that increase contributions in difficult economic times and reduce them in times of prosperity. This occurs because to qualify for the lower tax rate, a foundation’s current distributions (as a fraction of current assets) are compared to the average of its ratio of distribution to assets over the previous 5 years (the base period ratio).12 In Table 6 we compare the ratio of current year qualifying distributions to current year investment assets for foundations qualifying for the 1% tax rate to those of foundations 11 We repeated the analysis for foundations with assets in excess of $100 million. The results were generally similar in the HIGHTAX and SPTAX regressions, with GROWTH (CAPGAIN) being positive (negative) and significant in both HIGHTAX regressions, and DONATE and CAPGAIN being positive and significant in both SPTAX regressions. The MINTAX and MAXTAX regression results were not similar, as SIZE was the most important factor in the full sample regression. 12 Before 1990, the credit for increasing research activities under section 41 had a similar feature that provided countervailing incentives for research expenditures.

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Table 6 Analysis of the 1% or 2% tax on foundation net investment income Panel A: Differences across 1% and 2% tax rate on net investment income Full sample: Base amount/assets Qualifying distributions/assets MINIMIZER sub-sample Base amount/assets Qualifying distributions/assets TIMELYMIN sub-sample Base amount/assets Qualifying distributions/assets SPENDER sub-sample Base amount/assets Qualifying distributions/assets Panel B: Differences across SPTAX ¼ 1 and SPTAX ¼ 0 Base amount/assets Qualifying distributions/assets Panel B: Differences across MAXTAX and MINTAX Base amount/assets Qualifying distributions/assets

T-test for difference in Means

Mean for 1% tax rate

Mean for 2% tax rate

0.067 0.087

0.111 0.067

8.70 5.12

0.041 0.049

0.049 0.038

4.74 12.43

0.051 0.051

0.064 0.039

3.00 8.47

0.085 0.118

0.202 0.120

11.38 0.18

Mean for SPTAX ¼ 1 observations 0.054 0.057

Mean for SPTAX ¼ 0 observations 0.062 0.058

T-test for difference in Means

Mean for MINTAX ¼ 1 observations 0.073 0.085

Mean for MAXTAX ¼ 1 observations 0.072 0.053

T-test for difference in Means

3.76 0.89

0.08 5.52

Notes: The base amount is the current year’s non-charitable use assets multiplied by the average distribution ratio for the past 5 years. Current year qualifying distributions in excess of this base amount qualify the foundation for the reduced 1% tax on net investment income. Failure to make qualifying distributions at least equal to the base amount will cause the foundation’s net investment income to be taxed at the 2% rate. SPTAX equals one if the observation’s qualifying distributions were just sufficient to meet the 1% tax on net investment income, while SPTAX equals 0 if the observations barely missed this payment threshold. MINTAX equals 1 if the observation paid the 1% tax on net investment income for each of the 6 years it is in our sample and MAXTAX is equal to 1 if it paid the 2% tax for each of the 6 years. We calculate the T-statistics using a single year of data (results for the year 2000 are shown) to mitigate concerns over non-independence across time. Inferences are identical across each of the years in our sample.

paying the 2% tax rate. We also compare the ratio of the base amount (base period fraction of qualifying distributions multiplied by current assets, plus 1% of current net investment income) to current year investment assets. A foundation qualifies for the 1% tax rate if the first ratio exceeds the second, and must pay the 2% tax rate otherwise. The purpose of these comparisons is to see whether foundations that qualify for the 1% tax rate do so by making higher current year distributions, lower prior year distributions, or a combination of the two. We find that both of the effects of the dual tax rate regime are reflected in the data for the full sample. First, 1% tax rate foundations distribute a higher fraction of their current assets than do their 2% tax rate counterparts. Second, 1% tax rate foundations have a lower base period distribution ratio than do 2% tax rate foundations.

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We repeat the comparison for the MINIMIZER, TIMELYMIN, and SPENDER foundations.13 The differences between the 1% tax rate and 2% tax rate MINIMIZER and TIMELYMIN foundations were similar to the full sample, with the 1% tax rate foundations having both higher current distributions and a lower base amount. The 1% and 2% SPENDER foundations, in contrast, had statistically indistinguishable current qualifying distributions but very different base amounts. Therefore, the evidence suggests that the dual tax rate regime does reward foundations that make higher distributions for the subset of foundations that appear to follow a minimal distribution strategy (MINIMZER and TIMELYMIN). For SPENDER foundations, however, the dual tax rate regime simply reduces the tax rate on foundations with lower base period distributions. We next compare foundations that barely qualify for the 1% tax rate by currently distributing between 100% and 110% of the base amount (SPTAX ¼ 1) with foundations that barely failed to qualify by currently distributing between 90% and 100% of the base amount (SPTAX ¼ 0). These foundations had statistically indistinguishable levels of current distributions. The lower tax rate foundations were different in that they had lower base amounts than their higher tax rate counterparts. This suggests that the dual tax rate regime had little effect on the distributions of foundations close to the threshold. Finally, we compare the current distribution ratios and base amounts of MINTAX and MAXTAX foundations, those foundations that paid the same tax rate during each year of our sample. These two groups of foundations had very similar base amounts, but the MINTAX foundations had significantly higher distributions. We conclude that the twotier tax rate structure has countervailing effects on foundation payout. 7. Conclusion We examine the effect of two tax law provisions, the minimum distribution requirement and the dual tax rate on investment income, which act as governance instruments regulating the behavior of private foundations. The minimum distribution requirement compels foundations to make a minimum level of qualifying distributions, which include both grants to section 501(c)(3) public charities and administrative expenses of the foundation. The dual tax rate regime lowers the tax rate on investment income from 2% to 1% for foundations that increase their distributions relative to their historical average. This system increases the tax on foundations that increase contributions in difficult economic times and reduce them in times of prosperity. We document substantial variation among foundations with respect to their behavior with respect to the minimum distribution requirement, with an average payout percentage of about 8.7% of assets as opposed to the legal minimum of 5%. Roughly 1/7th of our foundation-year observations distribute the legal minimum on charitable purposes. Another 3/7ths appears to treat the minimum distribution requirement as the benchmark for choosing how much to distribute. Foundations paying higher amounts tend to be more actively managed and faster growing than foundations that pay out less. They are also more likely to receive donations during our sample period. 13

Foundations that violate the minimum distribution requirement during the five-year base period are not eligible for the 2% tax rate. We omit these firms from the analysis in Section 6.

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R. Sansing, R. Yetman / Journal of Accounting and Economics 41 (2006) 363–384

The dual tax rate regime has countervailing effects on qualifying distributions in that 1% tax rate foundations make higher current year distributions (as a percentage of current assets) but also have made lower distributions in prior years. It is large foundations that tend to take advantage of the lower tax rate. The reduced tax rate appears to increase the distributions of foundations that adhere closely to the minimum distribution requirement, but has no effect on foundations that distribute higher amounts. The private foundation sector is diverse in terms of both revenue sources and expenditure activities. We conclude that the minimum distribution requirement and dual tax rate regime play an important governance role regarding the behavior of private foundations, particularly those that spend little on professional management, are not growing and are no longer receiving donations. References Belsley, D., Kuh, E., Welsch, R., 1980. Regression Diagnostics: Identifying Influential Data and Sources of Collinearity. Wiley, New York. Brody, E., 1997. Charitable endowments and the democratization of dynasty. Arizona Law Review 39 (Fall), 873–948. Cambridge Associates, 2000. Sustainable Payout for Foundations. Cambridge Associates, Inc., Cambridge, MA. Craig, J., 1999. In favor of five percent. Foundation News and Commentary 40 (May/June), 23–25. Deep, A., Frumkin, P., 2001. The foundation payout puzzle. Harvard University working paper. Hansmann, H., 1990. Why do universities have endowments? Journal of Legal Studies 19 (January), 3–42. Mehrling, P., 1999. Spending Policies for Foundations: The Case for Increased Grants Payout. National Network of Grantmakers, San Diego, CA. Steuerle, G., 1977. Pay-out Requirements for Foundations. US Department of the Treasury, Washington, D.C. Stokeld, F., 2000. EO proposals target charitable giving, higher education. Exempt Organization Tax Review 27 (March), 390–394. Troyer, T., 2000. The 1969 private foundation law: historical perspective on its origins and underpinnings. The Exempt Organization Tax Review 27 (January), 52–65.