[Code of Federal Regulations]
[Title 26, Volume 17]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR53.4942(a)-2]

[Page 75-86]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 53_FOUNDATION AND SIMILAR EXCISE TAXES--Table of Contents
 
             Subpart C_Taxes on Failure To Distribute Income
 
Sec. 53.4942(a)-2  Computation of undistributed income.

    (a) Undistributed income. For purposes of section 4942, the term 
``undistributed income'' means, with respect to any private foundation 
for any taxable year as of any time, the amount by which:
    (1) The distributable amount (as defined in paragraph (b) of this 
section) for such taxable year, exceeds
    (2) The qualifying distributions (as defined in Sec. 53.4942(a)-3) 
made before such time out of such distributable amount.
    (b) Distributable amount--(1) In general. For purposes of paragraph 
(a) of this section, the term ``distributable amount'' means:
    (i) For taxable years beginning before January 1, 1982, an amount 
equal to the greater of the minimum investment return (as defined in 
paragraph (c) of this section) or the adjusted net income (as defined in 
paragraph (d) of this section); and
    (ii) For taxable years beginning after December 31, 1981, an amount 
equal to the minimum investment return (as defined in paragraph (c) of 
this section), reduced by the sum of the taxes imposed on such private 
foundation for such taxable year under subtitle A of the Code and 
section 4940, and increased by the amounts received from trusts 
described in subparagraph (2) of this paragraph.
    (2) Certain trust amounts--(i) In general. The distributable amount 
shall be increased by the income portion (as defined in subdivision (ii) 
of this subparagraph) of distributions from trusts described in section 
4947(a)(2) with respect to amounts placed in trust after May 26, 1969. 
If such distributions are made with respect to amounts placed in trust 
both on or before and after May 26, 1969, such distributions shall be 
allocated between such amounts to determine the extent to which such 
distributions shall be included in the foundation's distributable 
amount. For rules relating to the segregation of amounts placed in trust 
on or before May 26, 1969, from amounts placed in trust after such date 
and to the allocation of income derived from such amounts, see paragraph 
(c) (5) of Sec. 53.4947-1.
    (ii) Income portion of distributions to private foundations. For 
purposes of subdivision (i) of this subparagraph, the income portion of 
a distribution from a section 4947(a)(2) trust to a private foundation 
in a particular taxable year of such foundation shall be the greater of:
    (a) The amount of such distribution which is treated as income 
(within the meaning of section 643(b)) of the trust, or
    (b) The guaranteed annuity, or fixed percentage of the fair market 
value of the trust property (determined annually), which the private 
foundation is entitled to receive for such year, regardless of whether 
such amount is actually received in such year or in any prior or 
subsequent year.
    (iii) Limitation. Notwithstanding subdivisions (i) and (ii) of this 
subparagraph, a private foundation shall not be required to distribute a 
greater amount for any taxable year than would have been required 
(without regard to this subparagraph) for such year had the corpus of 
the section 4947(a) (2) trust to which the distribution described in 
subdivision (ii) of this subparagraph is attributable been taken into 
account by such foundation as an asset described in paragraph (c) (1) 
(i) of this section.

[[Page 76]]

    (c) Minimum investment return--(1) In general. For purposes of 
paragraph (b) of this section, the ``minimum investment return'' for any 
private foundation for any taxable year is the amount determined by 
multiplying:
    (i) The excess of the aggregate fair market value of all assets of 
the foundation, other than those described in subparagraph (2) or (3) of 
this paragraph, over the amount of the acquisition indebtedness with 
respect to such assets (determined under section 514(c)(1), but without 
regard to the taxable year in which the indebtedness was incurred), by
    (ii) The applicable percentage (as defined in subparagraph (5) of 
this paragraph) for such year.

For purposes of subdivision (i) of this subparagraph, the aggregate fair 
market value of all assets of the foundation shall include the average 
of the fair market values on a monthly basis of securities for which 
market quotations are readily available (within the meaning of 
subparagraph (4)(i)(a) of this paragraph), the average of the 
foundation's cash balances on a monthly basis (less the cash balances 
excluded from the computation of the minimum investment return by 
operation of subparagraph (3)(iv) of this paragraph), and the fair 
market value of all other assets (except those assets described in 
subparagraph (2) or (3) of this paragraph) for the period of time during 
the taxable year for which such assets are held by the foundation. Any 
determination of the fair market value of an asset required pursuant to 
the provisions of this subparagraph shall be made in accordance with the 
rules of subparagraph (4) of this paragraph.
    (2) Certain assets excluded. For purposes of this paragraph, the 
assets taken into account in determining minimum investment return shall 
not include the following:
    (i) Any future interest (such as a vested or contingent remainder, 
whether legal or equitable) of a foundation in the income or corpus of 
any real or personal property, other than a future interest created by 
the private foundation after December 31, 1969, until all intervening 
interests in, and rights to the actual possession or enjoyment of, such 
property have expired, or, although not actually reduced to the 
foundation's possession, until such future interest has been 
constructively received by the foundation, as where it has been credited 
to the foundation's account, set apart for the foundation, or otherwise 
made available so that the foundation may acquire it at any time or 
could have acquired it if notice of intention to acquire had been given;
    (ii) The assets of an estate until such time as such assets are 
distributed to the foundation or, due to a prolonged period of 
administration, such estate is considered terminated for Federal income 
tax purposes by operation of paragraph (a) of Sec. 1.641(b)-3 of this 
chapter (Income Tax Regulations);
    (iii) Any present interest of a foundation in any trust created and 
funded by another person (see, however, paragraph (b) (2) of this 
section with respect to amounts received from certain trusts described 
in section 4947(a) (2));
    (iv) Any pledge to the foundation of money or property (whether or 
not the pledge may be legally enforced); and
    (v) Any assets used (or held for use) directly in carrying out the 
foundation's exempt purpose.
    (3) Assets used (or held for use) in carrying out the exempt 
purpose--(i) In general. For purposes of subparagraph (2)(v) of this 
paragraph, an asset is ``used (or held for use) directly in carrying out 
the foundation's exempt purpose'' only if the asset is actually used by 
the foundation in the carrying out of the charitable, educational, or 
other similar purpose which gives rise to the exempt status of the 
foundation, or if the foundation owns the asset and establishes to the 
satisfaction of the Commissioner that its immediate use for such exempt 
purpose is not practical (based on the facts and circumstances of the 
particular case) and that definite plans exist to commence such use 
within a reasonable period of time. Consequently, assets which are held 
for the production of income or for investment (for example, stocks, 
bonds, interest-bearing notes, endowment funds, or, generally, leased 
real estate) are not being used (or held for use) directly in carrying 
out the foundation's exempt purpose, even though the income from such 
assets is used to carry out such exempt purpose. Whether an

[[Page 77]]

asset is held for the production of income or for investment rather than 
used (or held for use) directly by the foundation to carry out its 
exempt purpose is a question of fact. For example, an office building 
used for the purpose of providing offices for employees engaged in the 
management of endowment funds of the foundation is not being used (or 
held for use) directly by the foundation to carry out its charitable, 
educational, or other similar exempt purpose. However, where property is 
used both for charitable, educational, or other similar exempt purposes 
and for other purposes, if such exempt use represents 95 percent or more 
of the total use, such property shall be considered to be used 
exclusively for a charitable, educational, or other similar exempt 
purpose. If such exempt use of such property represents less than 95 
percent of the total use, reasonable allocation between such exempt and 
nonexempt use must be made for purposes of this paragraph. Property 
acquired by the foundation to be used in carrying out its charitable, 
educational, or other similar exempt purpose may be considered as used 
(or held for use) directly to carry out such exempt purpose even though 
the property, in whole or in part, is leased for a limited period of 
time during which arrangements are made for its conversion to the use 
for which it was acquired, provided such income-producing use of the 
property does not exceed a reasonable period of time. Generally, 1 year 
shall be deemed to be a reasonable period of time for purposes of the 
immediately preceding sentence. For treatment of the income derived from 
such income-producing use, see paragraph (d)(2)(viii) of this section. 
Where the income-producing use continues beyond a reasonable period of 
time, the property shall not be deemed to be used by the foundation to 
carry out its charitable, educational, or other similar exempt purpose, 
but, instead, as of the time the income-producing use becomes 
unreasonable, such property shall be treated as disposed of within the 
meaning of paragraph (d)(2)(iii)(b) of this section to the extent that 
the acquisition of the property was taken into account as a qualifying 
distribution (within the meaning of paragraph (a)(2) of Sec. 53.4942(a-
3) for any taxable year. If, subsequently, the property is used by the 
foundation directly in carrying out its charitable, educational, or 
other similar exempt purpose, a qualifying distribution in the amount of 
its then fair market value, determined in accordance with the rules 
contained in subparagraph (4) of this paragraph, shall be deemed to have 
been made as of the time such exempt use begins.
    (ii) Illustrations. Examples of assets which are ``used (or held for 
use) directly in carrying out the foundation's exempt purpose'' include, 
but are not limited to, the following:
    (a) Administrative assets, such as office equipment and supplies 
which are used by employees or consultants of the foundation, to the 
extent such assets are devoted to and used directly in the 
administration of the foundation's charitable, educational or other 
similar exempt activities;
    (b) Real estate or the portion of a building used by the foundation 
directly in its charitable, educational, or other similar exempt 
activities;
    (c) Physical facilities used in such activities, such as paintings 
or other works of art owned by the foundation which are on public 
display, fixtures and equipment in classrooms, research facilities and 
related equipment which under the facts and circumstances serve a useful 
purpose in the conduct of such activities;
    (d) Any interest in a functionally related business (as defined in 
subdivision (iii) of this subparagraph) or in a program-related 
investment (as defined in section 4944(c));
    (e) The reasonable cash balances (as described in subdivision (iv) 
of this subparagraph) necessary to cover current administrative expenses 
and other normal and current disbursements directly connected with the 
foundation's charitable, educational, or other similar exempt 
activities; and
    (f) Any property leased by a foundation in carrying out its 
charitable, educational, or other similar exempt purpose at no cost (or 
at a nominal rent) to the lessee or for a program-related purpose 
(within the meaning of section

[[Page 78]]

4944(c)), such as the leasing of renovated apartments to low-income 
tenants at a low rental as part of the lessor foundation's program for 
rehabilitating a blighted portion of a community. For treatment of the 
income derived from such use, see paragraph (d) (2) (viii) of this 
section.
    (iii) Functionally related business--(a) In general. The term 
``functionally related business'' means:
    (1) A trade or business which is not an unrelated trade or business 
(as defined in section 513), or
    (2) An activity which is carried on within a larger aggregate of 
similar activities or within a larger complex of other endeavors which 
is related (aside from the need of the organization for income or funds 
or the use it makes of the profits derived) to the charitable, 
educational, or other similar exempt purpose of the organization.
    (b) Examples. The provisions of this subdivision may be illustrated 
by the following examples:

    Example (1). X, a private foundation, maintains a community of 
historic value which is open to the general public. For the convenience 
of the public, X, through a wholly owned, separately incorporated, 
taxable entity, maintains a restaurant and hotel in such community. Such 
facilities are within the larger aggregate of activities which makes 
available for public enjoyment the various buildings of historic 
interest and which is related to X's exempt purpose. Thus, the operation 
of the restaurant and hotel under such circumstances constitutes a 
functionally related business.
    Example (2). Y, a private foundation, as part of its medical 
research program under section 501(c) (3), publishes a medical journal 
in carrying out its exempt purpose. Space in the journal is sold for 
commercial advertising. Notwithstanding the fact that the advertising 
activity may be subject to the tax imposed by section 511, such activity 
is within a larger complex of endeavors which makes available to the 
scientific community and the general public developments with respect to 
medical research and is therefore a functionally related business.

    (iv) Cash held for charitable, etc. activities. For purposes of 
subdivision (ii) (e) of this subparagraph, the reasonable cash balances 
which a private foundation needs to have on hand to cover expenses and 
disbursements described in such subdivision will generally be deemed to 
be an amount, computed on an annual basis, equal to one and one-half 
percent of the fair market value of all assets described in subparagraph 
(1) (i) of this paragraph, without regard to subdivision (ii) (e) of 
this subparagraph. However, if the Commissioner is satisfied that under 
the facts and circumstances an amount in addition to such one and one-
half percent is necessary for payment of such expenses and 
disbursements, then such additional amount may also be excluded from the 
amount of assets described in subparagraph (1) (i) of this paragraph. 
All remaining cash balances, including amounts necessary to pay any tax 
imposed by section 511 or any section of chapter 42 of the Code except 
section 4940, are to be included in the assets described in subparagraph 
(1) (i) of this paragraph.
    (4) Valuation of assets--(i) Certain securities. (a) For purposes of 
subparagraph (1) (i) of this paragraph, a private foundation may use any 
reasonable method to determine the fair market value on a monthly basis 
of securities for which market quotations are readily available, as long 
as such method is consistently used. For purposes of this subparagraph, 
market quotations are readily available if a security is:
    (1) Listed on the New York Stock Exchange, the American Stock 
Exchange, or any city or regional exchange in which quotations appear on 
a daily basis, including foreign securities listed on a recognized 
foreign national or regional exchange;
    (2) Regularly traded in the national or regional over-the-counter 
market, for which published quotations are available; or
    (3) Locally traded, for which quotations can readily be obtained 
from established brokerage firms.
    (b) For purposes of this subdivision, commonly accepted methods of 
valuation must be used in making an appraisal. Valuations made in 
accordance with the principles stated in the regulations under section 
2031 constitute acceptable methods of valuation. This paragraph 
(c)(4)(i)(b) applies only for taxable years beginning before January 1, 
1976. See section 4942(e)(2)(B) and paragraph (c)(4)(i)(c) of this 
section for special valuation rules that apply for subsequent taxable 
years.

[[Page 79]]

    (c) For purposes of this subdivision (i) and with respect to taxable 
years beginning after December 31, 1975, if the private foundation can 
show that the value of securities determined on the basis of market 
quotations as provided by subdivision (i)(a) does not reflect the fair 
market value thereof because:
    (1) The securities constitute a block of securities so large in 
relation to the volume of actual sales on the existing market that it 
could not be liquidated in a reasonable time without depressing the 
market.
    (2) The securities are securities in a closely held corporation and 
sales are few or of a sporadic nature, and, or
    (3) The sale of the securities would result in a forced or distress 
sale because the securities could not be offered to the public for sale 
without first being registered under the Securities Act of 1933 or 
because of other factors,

then the price at which the securities could be sold as such outside the 
usual market, as through an underwriter, may be a more accurate 
indication of value than market quotations. On the other hand, if the 
securities to be valued represents a controlling interest, either actual 
or effective, in a going business, the price at which other lots change 
hands may have little relation to the true value of the securities. No 
decrease in the fair market value of any given class of securities 
determined on the basis of market quotations as provided by subdivision 
(i)(a) shall be allowed except as authorized by this subdivision, and no 
such decrease shall in the aggregate exceed 10 percent of the fair 
market value of such class of securities so determined on the basis of 
market quotations and without regard to this subdivision.
    (d) In the case of securities described in subdivision (i)(a) of 
this subparagraph, which are held in trust for, or on behalf of, a 
foundation by a bank or other financial institution which values such 
securities periodically by use of a computer, a foundation may determine 
the correct value of such securities by use of such computer pricing 
system, provided the Commissioner has accepted such computer pricing 
system as a valid method for valuing securities for Federal estate tax 
purposes.
    (e) This subdivision may be illustrated by the following examples:

    Example (1). U, a private foundation, owns 1,000 shares of the stock 
of M Corporation. M stock is regularly traded on the New York Stock 
Exchange. U consistently follows a practice of valuing its 1,000 shares 
of M stock on the last trading day of each month based upon the quoted 
closing price for M stock. U's method of valuing its M Corporation stock 
is permissible under the rules contained in subdivision (i) (a) of this 
subparagraph.
    Example (2). Assume the facts as stated in example (1), except that 
U consistently follows a practice of valuing its 1,000 shares of M stock 
by taking the mean of the closing prices for M stock on the first and 
last trading days of each month and the trading day nearest the 15th day 
of each month. U's method of valuing its M stock is permissible under 
the rules contained in subdivision (i) (a) of this subparagraph.
    Example (3). Assume the facts as stated in example (1), except that 
U consistently follows a practice of valuing its M stock by taking the 
mean of the highest and lowest quoted prices for the stock on the last 
trading day of each month. U's method of valuing its M stock is 
permissible under the rules contained in subdivision (1) (a) of this 
subparagraph.
    Example (4). V, a private foundation, owns 1,000 shares of the stock 
of N Corporation. N stock is regularly traded in the national over-the-
counter market and published quotations of the bid and asked prices for 
the stock are available. V consistently follows a practice of valuing 
its 1,000 shares of N stock on the first trading day of each month by 
taking the mean of the bid and asked prices on that day. V's method of 
valuing its N Corporation stock is permissible under the rules contained 
in subdivision (i) (a) of this subparagraph.
    Example (5). W, a private foundation, owns 1,000 shares of the stock 
of O Corporation. O stock is locally traded and quotations can readily 
be obtained from established brokerage firms. W consistently follows a 
practice of valuing its O stock on the 15th day of each month by 
obtaining a bona fide quotation of bid and asked prices for the stock 
from an established brokerage firm and taking the mean of such prices on 
that day. If a quotation is unavailable on the regular valuation date, W 
values its O stock based upon a bona fide quotation on the first day 
thereafter on which such a quotation is available. W's method of valuing 
its O Corporation stock is permissible under the rules contained in 
subdivision (i) (a) of this subparagraph.


[[Page 80]]


    (ii) Cash. In order to determine the amount of a foundation's cash 
balances, the foundation shall value its cash on a monthly basis by 
averaging the amount of cash on hand as of the first day of each month 
and as of the last day of each month.
    (iii) Common trust funds. If a private foundation owns a 
participating interest in a common trust fund (as defined in section 
584) established and administered under a plan providing for the 
periodic valuation of participating interests during the fund's taxable 
year and the reporting of such valuations to participants, the value of 
the foundation's interest in the common trust fund based upon the 
average of the valuations reported to the foundation during its taxable 
year will ordinarily constitute an acceptable method of valuation.
    (iv) Other assets. (a) Except as otherwise provided in subdivision 
(iv) (b) of this subparagraph, the fair market value of assets other 
than those described in subdivisions (i) through (iii) of this 
subparagraph shall be determined annually. Thus, the fair market value 
of securities other than those described in subdivision (i) of this 
subparagraph shall be determined in accordance with this subdivision 
(a). If, however, a private foundation owns voting stock of an issuer of 
unlisted securities and has, or together with disqualified persons or 
another private foundation has, effective control of the issuer (within 
the meaning of Sec. 53.4943-3(b)(3)(ii), then to the extent that the 
issuer's assets consist of shares of listed securities issues, such 
assets shall be valued monthly on the basis of market quotations or in 
accordance with section 4942(e)(2)(B), if applicable. Thus, for example, 
if a private foundation and a disqualified person together own all of 
the unlisted voting stock of a holding company which in turn holds a 
portfolio of securities of issues which are listed on the New York Stock 
Exchange, in determining the net worth of the holding company, the 
underlying portfolio securities are to be valued monthly by reference to 
market quotations for their issues unless a decrease in such value is 
authorized in accordance with section 4942(e)(2)(b). Such determination 
may be made by employees of the private foundation or by any other 
person, without regard to whether such person is a disqualified person 
with respect to the foundation. A valuation made pursuant to the 
provisions of this subdivision, if accepted by the Commissioner, shall 
be valid only for the taxable year for which it is made. A new valuation 
made in accordance with these provisions is required for the succeeding 
taxable year.
    (b) If the requirements of this subdivision are met, the fair market 
value of any interest in real property, including any improvements 
thereon, may be determined on a 5-year basis. Such value must be 
determined by means of a certified, independent appraisal made in 
writing by a qualified person who is neither a disqualified person with 
respect to, nor an employee of, the private foundation. The appraisal is 
certified only if it contains a statement at the end thereof to the 
effect that, in the opinion of the appraiser, the values placed on the 
assets appraised were determined in accordance with valuation principles 
regularly employed in making appraisals of such property using all 
reasonable valuation methods. The foundation shall retain a copy of the 
independent appraisal for its records. If a valuation made pursuant to 
the provisions of this subdivision in fact falls within the range of 
reasonable values for the appraised property, such valuation may be used 
by the foundation for the taxable year for which the valuation is made 
and for each of the succeeding 4 taxable years. Any valuation made 
pursuant to the provisions of this subdivision may be replaced during 
the 5-year period by a subsequent 5-year valuation made in accordance 
with the rules set forth in this subdivision, or with an annual 
valuation made in accordance with subdivision (iv)(a) of this 
subparagraph, and the most recent such valuation of such assets shall be 
used in computing the foundation's minimum investment return. In the 
case of a foundation organized before May 27, 1969, a valuation made in 
accordance with this subdivision applicable to the foundation's first 
taxable year beginning after December 31, 1972, and the 4 succeeding 
taxable years must be made no later than the last day of such first 
taxable year. In the

[[Page 81]]

case of a foundation organized after May 26, 1969, a valuation made in 
accordance with this subdivision applicable to the foundation's first 
taxable year beginning after February 5, 1973 and the succeeding 4 
taxable years must be made no later than the last day of such first 
taxable year. Any subsequent valuation made in accordance with this 
subdivision must be made no later than the last day of the first taxable 
year for which such new valuation is applicable. A valuation, if 
properly made in accordance with the rules set forth in this 
subdivision, will not be disturbed by the Commissioner during the 5-year 
period for which it applies even if the actual fair market value of such 
property changes during such period.
    (c) For purposes of this subdivision, commonly accepted methods of 
valuation must be used in making an appraisal. Valuations made in 
accordance with the principles stated in the regulations under section 
2031 constitute acceptable methods of valuation. The term appraisal, as 
used in this subdivision, means a determination of fair market value and 
is not to be construed in a technical sense peculiar to particular 
property or interests therein, such as, for example, mineral interests 
in real property.
    (v) Definition of ``securities''. For purposes of this subparagraph, 
the term ``securities'' includes, but is not limited to, common and 
preferred stocks, bonds, and mutual fund shares.
    (vi) Valuation date. (a) In the case of an asset which is required 
to be valued on an annual basis as provided in subdivision (iv)(a) of 
this subparagraph, such asset may be valued as of any day in the private 
foundation's taxable year to which such valuation applies, provided the 
foundation follows a consistent practice of valuing such asset as of 
such date in all taxable years.
    (b) A valuation described in subdivision (iv)(b) of this 
subparagraph may be made as of any day in the first taxable year of the 
private foundation to which such valuation is to be applied.
    (vii) Assets held for less than a taxable year. For purposes of this 
paragraph, any asset described in subparagraph (1)(i) of this paragraph 
which is held by a foundation for only part of a taxable year shall be 
taken into account for purposes of determining the foundation's minimum 
investment return for such taxable year by multiplying the fair market 
value of such asset (as determined pursuant to this subparagraph) by a 
fraction, the numerator of which is the number of days in such taxable 
year that the foundation held such asset and the denominator of which is 
the number of days in such taxable year.
    (5) Applicable percentage--(i) In general. For purposes of paragraph 
(c)(1)(ii) of this section, except as provided in paragraph (c)(5)(ii) 
or (iii) of this section, the applicable percentage is:
    (a) Six percent for a taxable year beginning in 1970 or 1971;
    (b) Five and a half percent for a taxable year beginning in 1972;
    (c) Five and one-quarter percent for a taxable year beginning in 
1973;
    (d) Six percent for a taxable year beginning in 1974 or 1975; and
    (e) Five percent for taxable years beginning after Dec. 31, 1975.
    (ii) Transitional rule. In the case of organizations organized 
before May 27, 1969 (including organizations deemed to be so organized 
by virtue of the provisions of paragraph (e)(2) of this section), 
section 4942 shall, for all purposes other than the determination of the 
minimum investment return under section 4942(j)(3)(B)(ii), for taxable 
years:
    (a) Beginning before January 1, 1972, apply without regard to 
section 4942(e).
    (b) Beginning in 1972, apply with an applicable percentage of 4\1/8\ 
percent,
    (c) Beginning in 1973, apply with an applicable percentage of 4\3/8\ 
percent and
    (d) Beginning in 1974, apply with an applicable percentage of 5\1/2\ 
percent.
    (iii) Short taxable periods. In any case in which a taxable year 
referred to in this subparagraph is a period less than 12 months, the 
applicable percentage to be applied to the amount determined under the 
provisions of subparagraph (1) of this paragraph shall be equal to the 
applicable percentage for the calendar year in which the short taxable 
period began multiplied by a fraction, the numerator of which is the 
number of days in such short taxable period and the denominator of which 
is 365.

[[Page 82]]

    (d) Adjusted net income--(1) Definition. For purposes of paragraph 
(b) of this section, the term ``adjusted net income'' means the excess 
(if any) of:
    (i) The gross income for the taxable year (including gross income 
from any unrelated trade or business) determined with the income 
modifications provided by subparagraph (2) of this paragraph, over
    (ii) The sum of the deductions (including deductions directly 
connected with the carrying on of any unrelated trade or business), 
determined with the deduction modifications provided by subparagraph (4) 
of this paragraph, which would be allowed to a corporation subject to 
the tax imposed by section 11 for the taxable year.

In computing the income includible under this paragraph as gross income 
and the deductions allowable under this paragraph from such income, the 
principles of subtitle A of the Code shall apply except to the extent 
such principles conflict with section 4942 and the regulations 
thereunder (without regard to this sentence). Except as otherwise 
provided in this paragraph, no exclusions or deductions from gross 
income or credits against tax are allowable under this paragraph. For 
purposes of subdivision (i) of this subparagraph, the term ``gross 
income'' does not include gifts, grants, or contributions received by 
the private foundation but does include income from a functionally 
related business (as defined in paragraph (c)(3)(iii) of this section).
    (2) Income modifications. The income modifications referred to in 
subparagraph (1)(i) of this paragraph are as follows:
    (i) Section 103 (relating to interest on certain governmental 
obligations) shall not apply. Hence, interest which would have been 
excluded from gross income by section 103 shall be included in gross 
income.
    (ii) Capital gains and losses from the sale or other disposition of 
property shall be taken into account only in an amount equal to any net 
short-term capital gain (as defined in section 1222(5)) for the taxable 
year. Long-term capital gain or loss is not included in the computation 
of adjusted net income. Similarly, net section 1231 gains shall be 
excluded from the computation of adjusted net income. However, net 
section 1231 losses shall be included in the computation of adjusted net 
income, if such losses are otherwise described in subparagraph (1)(ii) 
of this paragraph. Any net short-term capital loss for a given taxable 
year shall not be taken into account in computing adjusted net income 
for such year or in computing net short-term capital gain for purposes 
of determining adjusted net income for prior or future taxable years 
regardless of whether the foundation is a corporation or a trust.
    (iii) The following amounts shall be included in gross income for 
the taxable year:
    (a) Amounts received or accrued as repayments of amounts which were 
taken into account as a qualifying distribution within the meaning of 
paragraph (a)(2)(i) of Sec. 53.4942(a)-3 for any taxable year;
    (b) Notwithstanding subdivision (ii) of this subparagraph, gross 
amounts received or accrued from the sale or other disposition of 
property to the extent that the acquisition of such property was taken 
into account as a qualifying distribution (within the meaning of 
paragraph (a)(2)(ii) of Sec. 53.4942(a)-3) for any taxable year; and
    (c) Any amount set aside under paragraph (b) of Sec. 53.4942(a)-3 
to the extent it is determined that such amount is not necessary for the 
purposes for which it was set aside.
    (iv) Any distribution received by a private foundation from a 
disqualified person in redemption of stock held by such private 
foundation in a business enterprise shall be treated as not essentially 
equivalent to a dividend under section 302(b)(1) if all of the following 
conditions are satisfied:
    (a) Such redemption is of stock which was owned by a private 
foundation on May 26, 1969 (or which is acquired by a private foundation 
under the terms of a trust which was irrevocable on May 26, 1969, or 
under the terms of a will executed on or before such date which are in 
effect on such date and at all times thereafter);
    (b) Such foundation is required to dispose of such property in order 
not to

[[Page 83]]

be liable for tax under section 4943 (relating to taxes on excess 
business holdings) applied, in the case of a disposition before January 
1, 1975, without taking section 4943(c)(4) into account; and
    (c) Such foundation receives in return an amount which equals or 
exceeds the fair market value of such property at the time of such 
disposition or at the time a contract for such disposition was 
previously executed in a transaction which would not constitute a 
prohibited transaction (within the meaning of section 503(b) or the 
corresponding provisions of prior law).
    (v) If, as of the date of distribution of property for purposes 
described in section 170(c) (1) or (2)(B), the fair market value of such 
property exceeds its adjusted basis, such excess shall not be deemed an 
amount includible in gross income.
    (vi) The income received by a private foundation from an estate 
during the period of administration of such estate shall not be included 
in such foundation's gross income, unless, due to a prolonged period of 
administration, such estate is considered terminated for Federal income 
tax purposes by operation of paragraph (a) of Sec. 1.641(b)-3 of this 
chapter (Income Tax Regulations).
    (vii) Distributions received by a private foundation from a trust 
created and funded by another person shall not be included in the 
foundation's gross income. However, with respect to distributions from 
certain trusts described in section 4947(a)(2), see paragraph (b)(2) of 
this section.
    (viii) Gross income shall include all amounts derived from, or in 
connection with, property held by the foundation, even though the fair 
market value of such property may not be included in such foundation's 
assets for purposes of determining minimum investment return by 
operation of paragraph (c)(3) of this section.
    (ix) Gross income shall include amounts treated in a preceding 
taxable year as a ``qualifying distribution'' by operation of paragraph 
(c) of Sec. 53.4942(a)-3 where such amounts are not redistributed by 
the close of the donee organization's succeeding taxable year in 
accordance with the rules prescribed in such paragraph (c). In such 
cases, such amounts shall be included in the donor foundation's gross 
income for such foundation's first taxable year beginning after the 
close of the donee organization's first taxable year following the donee 
organization's taxable year of receipt.
    (x) For taxable years ending after October 4, 1976, section 
4942(f)(2)(D) states that section 483 (relating to imputed interest on 
deferred payments) does not apply to payments made pursuant to a binding 
contract entered into in a taxable year beginning before January 1, 
1970. Amounts that are not treated as imputed interest because of 
section 4942(f)(2)(D) and this subdivision will represent gain or loss 
from the sale of property. If the gain or loss is long term capital gain 
or loss, section 4942(f)(2)(B) excludes the gain or loss from the 
computation of the foundation's gross income. If, in a taxable year 
beginning after December 31, 1969, there is a substantial change in the 
terms of a contract entered into in a taxable year beginning before 
January 1, 1970, then any payment made pursuant to the changed contract 
is not considered a payment made pursuant to a contract entered into in 
a taxable year beginning before January 1, 1970. Whether or not a change 
in the terms of a contract (for example, a change relating to time of 
payment, sales price, or obligations under the contract) is a 
substantial change is determined by applying the rules under section 483 
and Sec. 1.483-1(b)(4). As used in this subdivision, a binding contract 
includes an irrevocable written option.
    (3) Adjusted basis--(i) In general. For purposes of subparagraph 
(2)(ii) of this paragraph, the adjusted basis for purposes of 
determining gain from the sale or other disposition of property shall be 
determined in accordance with the rules set forth in subdivision (ii) of 
this subparagraph and the adjusted basis for purposes of determining 
loss from such disposition shall be determined in accordance with the 
rules set forth in subdivision (iii) of this subparagraph. Further, the 
provisions of this subparagraph do not apply for any purpose other than 
for purposes of subparagraph (2)(ii) of this paragraph. For example, the 
determination of gain pursuant to the provisions of section 341 is

[[Page 84]]

determined without regard to this subparagraph.
    (ii) Gain from sale or other disposition. The adjusted basis for 
purposes of determining gain from the sale or other disposition of 
property shall be the greater of:
    (a) The fair market value of such property on December 31, 1969, 
plus or minus all adjustments after December 31, 1969, and before the 
date of sale or other disposition under the rules of Part II, Subchapter 
O, Chapter 1 of the Code, provided that the property was held by the 
private foundation on December 31, 1969, and continuously thereafter to 
such date of sale or other disposition; or
    (b) The adjusted basis as determined under the rules of Part II, 
Subchapter O, Chapter 1 of the Code, subject to the provisions of 
section 4940(c)(3)(B) and the regulations thereunder (and without regard 
to section 362(c)). With respect to assets acquired prior to December 
31, 1969, which were subject to depreciation or depletion, for purposes 
of determining the adjustments to be made to basis between the date of 
acquisition and December 31, 1969, and amount equal to straight-line 
depreciation or cost depletion shall be taken into account. In addition, 
in determining such adjustments to basis, if any other adjustments would 
have been made during such period (such as a change in useful life based 
upon additional data or a change in facts), such adjustments shall also 
be taken into account.
    (iii) Loss from sale or other disposition. For purposes of 
determining loss from the sale or other disposition of property, 
adjusted basis as determined in subdivision (ii)(b) of this subparagraph 
shall apply.
    (iv) Examples. The provisions of this subparagraph may be 
illustrated by the following examples:

    Example (1). A private foundation, which uses the cash receipts and 
disbursements method of accounting, purchased certain depreciable real 
property on December 1, 1969. On December 31, 1969, the fair market 
value of such property was $100,000 and its adjusted basis (determined 
under the provisions of this subparagraph) was $102,000. The property 
was sold on January 2, 1970, for $105,000. Because fair market value on 
December 31, 1969, $100,000, is less than the adjusted basis as 
determined by Part II, Subchapter O, Chapter 1 of the Code, $102,000, a 
short-term gain of $3,000 is recognized (i.e., sale price of $105,000 
less the greater of the two possible bases) for purposes of subparagraph 
(2)(ii) of this paragraph.
    Example (2). Assume the facts as stated in example (1), except that 
the sale price was $95,000. Because the sale price was $7,000 less than 
the adjusted basis for loss ($102,000 as determined by the application 
of subdivision (iii) of this subparagraph), there is a capital loss of 
$7,000 which may be deducted against short-term capital gains for 1970 
(if any) in determining net short-term capital gain.
    Example (3). A private foundation, which uses the cash receipts and 
disbursements method of accounting, purchased unimproved land on 
December 1, 1969. On December 31, 1969, the fair market value of such 
property was $110,000 and its adjusted basis (determined under the 
provisions of this subparagraph) was $102,000. The property was sold on 
January 2, 1970, for $105,000. Since the fair market value on December 
31, 1969, $110,000, exceeds the adjusted basis as determined by Part II, 
Subchapter O, Chapter 1 of the Code, $102,000, such fair market value 
will be used for purposes of determining gain. However, because the 
adjusted basis for purposes of determining gain exceeds the sale price, 
there is no gain. Furthermore, because the adjusted basis for purposes 
of determining loss, $102,000, is less than sale price, there is no 
loss.

    (4) Deduction modifications--(i) In general. For purposes of 
computing adjusted net income under subparagraph (1) of this paragraph, 
no deduction shall be allowed other than all the ordinary and necessary 
expenses paid or incurred for the production or collection of gross 
income or for the management, conservation, or maintenance of property 
held for the production of such income, except as provided in 
subdivision (ii) of this subparagraph. Such expenses include that 
portion of a private foundation's operating expenses which is paid or 
incurred for the production or collection of gross income. Operating 
expenses include compensation of officers, other salaries and wages of 
employees, interest, rent, and taxes. Where only a portion of the 
property produces (or is held for the production of) income subject to 
the provisions of section 4942, and the remainder of the property is 
used for

[[Page 85]]

charitable, educational, or other similar exempt purposes, the 
deductions allowed by this subparagraph shall be apportioned between the 
exempt and nonexempt uses. Similarly, where the deductions with respect 
to property used for a charitable, educational, or other similar exempt 
purpose exceed the income derived from such property, such excess shall 
not be allowed as a deduction, but may be treated as a qualifying 
distribution described in paragraph (a)(2)(ii) of Sec. 53.4942(a)-3. 
Furthermore, this subdivision does not allow deductions which are not 
paid or incurred for the purposes herein prescribed. Thus, for example, 
the deductions prescribed by the following sections are not allowable: 
(a) The charitable contributions deduction prescribed under sections 170 
and 642(c); (b) the net operating loss deduction prescribed under 
section 172; and (c) the special deductions prescribed under Part VIII, 
Subchapter B, Chapter 1 of the Code.
    (ii) Special rules. For purposes of computing adjusted net income 
under subparagraph (1) of this paragraph: (a) The allowances for 
depreciation and depletion as determined under section 4940(c)(3)(B) and 
the regulations thereunder shall be taken into account, and (b) section 
265 (relating to expenses and interest relating to tax-exempt interest) 
shall not apply.
    (e) Certain transitional rules--(1) In general. In the case of 
organizations organized before May 27, 1969, section 4942 shall:
    (i) Not apply to an organization to the extent its income is 
required to be accumulated pursuant to the mandatory terms (as in effect 
on May 26, 1969, and at all times thereafter) of an instrument executed 
before May 27, 1969, with respect to the transfer of income producing 
property to such organization, except that section 4942 shall apply to 
such organization if the organization would have been denied exemption 
had section 504(a) not been repealed, or would have had its deductions 
under section 642(c) limited had section 681(c) not been repealed. In 
applying the preceding sentence, in addition to the limitations 
contained in section 504(a) or 681(c) before its repeal, section 
504(a)(1) or 681(c)(1) shall be treated as not applying to an 
organization to the extent its income is required to be accumulated 
pursuant to the mandatory terms (as in effect on January 1, 1951, and at 
all times thereafter) of an instrument executed before January 1, 1951, 
with respect to the transfer of income producing property to such 
organization before such date, if such transfer was irrevocable on such 
date; and
    (ii) Not apply to an organization which is prohibited by its 
governing instrument or other instrument from distributing capital or 
corpus to the extent the requirements of section 4942 are inconsistent 
with such prohibitions.
    (2) Certain existing organizations. For purposes of this section, an 
organization will be deemed to be organized prior to May 26, 1969, if it 
is either a testamentary trust created under the will of an individual 
who died prior to such date or an inter visos trust which was in 
existence and irrevocable prior to such date, even though it is not 
funded until after May 26, 1969. Similarly, a split-interest trust, as 
described in section 4947(a)(2) (without regard to section 
4947(a)(2)(C)), which became irrevocable prior to May 27, 1969, and 
which is treated as a private foundation under section 4947(a)(1) 
subsequent to such date, likewise shall be treated as an organization 
organized prior to such date. See section 507(b)(2) and the regulations 
thereunder with respect to the applicability of transitional rules where 
there has been a merger of two or more private foundations or a 
reorganization of a private foundation.
    (3) Limitation. With respect to taxable years beginning after 
December 31, 1971, subparagraph (1) (i) and (ii) of this paragraph shall 
apply only for taxable years during which there is pending any judicial 
proceeding by the private foundation which is necessary to reform, or to 
excuse such foundation from compliance with, its governing instrument or 
any other instrument (as in effect on May 26, 1969) in order to comply 
with the provisions of section 4942, and in the case of subparagraph 
(1)(i) of this paragraph for all taxable years following the taxable 
year in

[[Page 86]]

which such judicial proceeding is terminated during which the governing 
instrument or any other instrument does not permit compliance with such 
provisions. Thus, the exception described in subparagraph (1)(ii) of 
this paragraph applies after 1971 only for taxable years during which 
such judicial proceeding is pending. Accordingly, beginning with the 
first taxable year following the taxable year in which such judicial 
proceeding is terminated, such foundation will be required to meet the 
requirements of section 4942 and the regulations thereunder (and be 
subject to the taxes provided upon failure to do so) except to the 
extent such foundation is required to accumulate income as described in 
subparagraph (1)(i) of this paragraph, even if the governing instrument 
continues to prohibit invasion of capital or corpus. In any case where a 
foundation's governing instrument or any other instrument requires 
accumulation of income as described in subparagraph (1)(i) of this 
paragraph beginning with the first taxable year following the taxable 
year in which such judicial proceeding is terminated, the distributable 
amount (as defined in paragraph (b) of this section) for such foundation 
shall be reduced by the amount of the income required to be accumulated. 
Therefore, if the foundation's adjusted net income for any taxable year 
equals or exceeds its minimum investment return for such year, the 
accumulation provisions will be given full effect. However, if the 
minimum investment return exceeds the adjusted net income for any 
taxable year, the foundation will be required to distribute such excess 
for such year. For purposes of this paragraph, a judicial proceeding 
will be treated as pending only if the foundation is diligently pursuing 
its judicial remedies and there is no unreasonable delay in such 
proceeding for which the private foundation is responsible.
    (4) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example (1). X, a private foundation organized in 1930, is required 
by the mandatory terms of its governing instrument to accumulated 25 
percent of its adjusted net income and to add such accumulations to 
corpus. The instrument also prohibits distribution of corpus for any 
purpose. On July 13, 1971, X instituted an action in the appropriate 
State court to reform the instrument by deleting the accumulation and 
corpus provisions described above. If the court's final order reforms 
the accumulation provisions to allow distributions of income sufficient 
to avoid the imposition of a tax under section 4942, then section 4942 
applies to X, regardless of the court's action with respect to the 
corpus provisions. However, if the court rules that the accumulation 
provision may not be reformed, section 4942 applies to X only to the 
extent provided for in subparagraph (3) of this paragraph, regardless of 
the court's action with respect to the corpus provision.
    Example (2). Private foundation Y was created by the will of A who 
died in 1940. Y's governing instrument requires that 40 percent of Y's 
adjusted net income be added to corpus each year. In an action commenced 
prior to December 31, 1971, a court of competent jurisdiction rules that 
this accumulation provisions must be complied with. In Y's succeeding 
taxable year its adjusted net income is $120,000, and its minimum 
investment return is $140,000. Thus, Y is required to accumulated 
$48,000 (40 percent of $120,000) and shall be allowed to do so. 
Therefore, Y's distributable amount for such taxable year shall be the 
greater of its adjusted net income ($120,000) or its minimum investment 
return ($140,000), reduced by the amount of the income required to be 
accumulated ($48,000) and the taxes imposed by Subtitle A of the Code 
and section 4940 and increased by any trust distributions described in 
paragraph (b)(2) of this section. Accordingly, Y's distributable amount 
for such taxable year is $92,000 ($140,000 reduced by $48,000), before 
other adjustments. If Y's minimum investment return had been $120,000 
instead of $140,000, its distributable amount for such taxable year 
would have been $72,000 ($120,000 reduced by $48,000), before other 
adjustments. Similarly, if Y's minimum investment return had been 
$100,000 instead of $140,000, its distributable amount for such taxable 
year would also have been $72,000, before other adjustments.

[T.D. 7256, 38 FR 3317, Feb. 5, 1973; 38 FR 4577, Feb. 16, 1973, as 
amended by T.D. 7486, 42 FR 24265, May 13, 1977; TD 7594, 44 FR 7138, 
Feb. 6, 1979; T.D. 7610, 44 FR 21644, Apr. 11, 1979; T.D. 7715, 45 FR 
56803, Aug. 26, 1980; T.D. 7849, 47 FR 50857, Nov. 10, 1982; T.D. 7878, 
48 FR 11943, Mar. 22, 1983]