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The Five and Five Exception plays a key role in how certain gifts to private foundations or trusts are handled for tax purposes. It sets clear limits on how much can be withdrawn each year without creating extra tax obligations. This rule helps donors support charitable causes while staying compliant with IRS regulations. Understanding how the Five and Five Exception works can prevent costly mistakes and protect the benefits of both giving and receiving through these arrangements.
The Purpose of the Five and Five Exception
The Internal Revenue Service (IRS) created this rule to stop donors from placing too much into a private foundation while keeping excessive rights over the gift. Without limits, a person could contribute a significant sum, claim a tax deduction, and still retain enough control to benefit from the assets.
The five and five exception sets clear limits on how much a donor can withdraw or control each year without triggering additional taxes. It also prevents foundations from being structured in ways that look charitable but operate mainly for the donor’s personal gain.
How the Five and Five Exception Works
The rule gets its name from the two limits it sets:
- Five Percent of the Trust Assets – The donor or beneficiary can withdraw no more than five percent of the trust’s fair market value each year.
- Five Thousand Dollars – Alternatively, the donor or beneficiary can withdraw up to $5,000 annually without penalty.
The IRS allows the higher of these two amounts in a given year. For example, if five percent of the trust’s value is greater than $5,000, the donor may withdraw that amount. If it is less, the donor can still take $5,000.
Where the Five and Five Exception Applies
This rule most often appears in:
- Private Foundations – When donors set up foundations for charitable purposes but want to maintain some rights over assets.
- Charitable Lead Trusts and Charitable Remainder Trusts – When trusts are designed to provide benefits to a charity and an individual.
- Estate Planning – To structure gifts that avoid excessive taxes while complying with IRS rules.
Why It Matters for Tax Purposes
The IRS treats certain gifts to private foundations differently than gifts to public charities. Public charities typically have broader community oversight, while private foundations are controlled by a small group of people, often the donor’s family. This can make it easier to misuse funds if limits are not in place.
The five and five exception provides a clear framework that prevents abuse while still letting donors participate in how funds are used. It also helps ensure that the charitable purpose of the foundation remains the primary focus.
Example of the Five and Five Exception in Action
Imagine a donor creates a charitable remainder trust with a fair market value of $300,000. Five percent of that value is $15,000. Under the five and five rule, the donor could withdraw up to $15,000 in that year without creating a taxable event. If the trust value was $80,000, five percent would be $4,000. In that case, the donor could still take $5,000 because the rule allows the higher of the two amounts.
Benefits of Following the Five and Five Rule
- Tax Compliance – Staying within the limits avoids unexpected taxes.
- Flexibility – Donors can still receive some benefit from their contributions.
- Clarity – The rule provides a clear, easy-to-calculate threshold each year.
Potential Issues if the Rule Is Ignored
Exceeding the allowed withdrawal amount can trigger taxes and penalties. It can also cause the IRS to reclassify the gift, reducing or removing tax deductions. For a foundation or trust, breaking the rule could lead to scrutiny or audits, which may damage credibility with donors and beneficiaries.
Planning Around the Five and Five Exception
Donors can work with financial advisors and tax professionals to plan contributions in ways that meet their charitable goals without exceeding limits. Some strategies include:
- Splitting gifts over several years to stay within annual thresholds.
- Using a mix of public charity and private foundation donations.
- Timing withdrawals to coincide with years when the trust value allows a larger percentage-based limit.
The Role of Legal Documentation
Trust agreements and foundation bylaws often include language that reflects the five and five limits. This ensures compliance and makes it easier for trustees to manage distributions. Clear documentation also protects the donor’s intentions and provides guidance for future administrators.
How It Differs from Other IRS Rules
While the five and five exception focuses on withdrawals from trusts and foundations, other IRS rules limit how much can be deducted for charitable contributions or how certain assets are valued. Donors should understand these distinctions to avoid confusion and make the most of their giving strategies.
Conclusion
The five and five exception helps balance a donor’s ability to benefit from assets placed in a private foundation or trust with the need to maintain genuine charitable purposes. By allowing the higher of $5,000 or five percent of the trust’s value each year, it offers flexibility without opening the door to abuse.
For anyone involved in charitable giving through private foundations or trusts, understanding and following the five and five exception is essential. It protects the donor’s tax advantages, supports compliance with IRS regulations, and keeps the charitable mission at the center of the arrangement.
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