[fishman]

The key word in the IRS code's 5% requirement is "distribute", which includes both contributions and administrative expenses, such as salaries to officers and directors.  Of course they could question whether the expenses are out of proportion to the contributions being made.  Also, as others have pointed out, there is a carry-over provision that allows a foundation to later make up for a year when its distributions fall below 5% of its endowment.  As a practical matter, the IRS doesn't seem to scrutinize those requirements very closely, but this situation certainly does have a foul odor coming from it.   

[fishman]

The key word in the IRS code's 5% requirement is "distribute", which includes both contributions and administrative expenses, such as salaries to officers and directors.  Of course they could question whether the expenses are out of proportion to the contributions being made.  Also, as others have pointed out, there is a carry-over provision that allows a foundation to later make up for a year when its distributions fall below 5% of its endowment.  As a practical matter, the IRS doesn't seem to scrutinize those requirements very closely, but this situation certainly does have a foul odor coming from it.