Optimal Spending In A Private Foundation Given Known Parameters

Abstract

Private foundations are subject to an income tax of either 1% or 2% on their net investment income.  The choice of whether to apply the 1% or 2% is based on a percentage derived by taking the funds expended divided by the asset base.  If the percentage expended in the current year was greater than the average percentage for the last five years the foundation qualifies for the reduced percentage.  Optimal spending is defined as the amount necessary to be expended in the current year to qualify for the reduced tax rate.  The only accurate way to calculate the percentage is after the year is over (this can be somewhat modified if the foundation opts to use first-of-month values for their assets, instead of the more common end-of-month values).  While accurate, this is not helpful for the private foundation that wishes to proactively try to qualify for the reduced percentage.  Therefore, a number of assumptions must be made in performance of the calculation.  This paper treats the assumptions as constants, based on the best estimate by an organization.  Future research will lift this constraint, but as a first step in developing the literature on optimal spending, using known parameters is justified, and perhaps required.