EXECUTIVE SUMMARY
Private foundations must
distinguish between what are
sometimes called mission–related investments
and program–related investments (PRIs). PRIs
enable private foundations to make venture
capital–type investments that might otherwise
be penalized under the IRC as “jeopardizing,”
that is, risky.
Mission–related
investments, although not technically
defined, nonetheless have their
distinct purposes, too, mainly growing the
foundation’s assets in a socially responsible
manner.
PRIs also help private
foundations meet requirements for
qualified distributions, similar to its
grants, and are recorded as charitable–use
assets. As such, they are excluded from assets
considered when calculating a minimum
investment return of 5% that underlies the
foundation’s minimum distribution
requirements.
Private foundations must
observe expenditure responsibility
(ER) rules governing PRIs or grants
made to an entity that is not a qualified
public charity under IRC § 501(c)(3). Two
states, North Carolina and Vermont, have
introduced legislation authorizing a hybrid
entity known as a low–profit limited liability
company (L3C), and others are considering
doing so. Advocates are urging Congress to
exempt foundations from ER requirements in
making PRIs to L3Cs.
Jane M. Searing, CPA, M.S.
Taxation, is a shareholder and head of the
exempt organization tax practice at Clark
Nuber PS in Bellevue, Wash. She is the
chairman of the AICPA’s Exempt Organization
Technical Resource Panel. Her e–mail address
is
jsearing@clarknuber.com.
While skittish
investors chase elusive returns amid the risks of
the credit market meltdown, a calmer class of
investors has been steadily growing in number and
influence. They regard an investment’s performance
only after giving careful consideration to its
greater purpose. Socially responsible investing
(SRI)—sometimes also known as mission–related
investing—is centuries old but came to the fore in
the latter half of the last century, in the
struggles of South African apartheid and other
causes. Now its growth has accelerated.
Between 1995 and 2007, the value of SRI assets
grew 324% in the United States, compared with the
260% growth of assets under professional
management generally, reports the Social
Investment Forum. And between 2005 and 2007, SRI
increased 18%, far outstripping overall assets’ 3%
growth (2007 Report on Socially Responsible
Investing Trends in the United States).
While much of that growth has been in mutual funds
that screen their investments according to social
and environmental values, a major force has been
“mission–driven institutions such as foundations,”
the Social Investment Forum report says. And
that’s not surprising, given that private
foundations are becoming more prominent,
especially in charitable giving by families (“Advising
Private Foundations,” JofA, April
08, page 36). CPAs advising charitable
organizations must reckon with the rules that come
into play when investing seeks both a return to
the investor and the higher good. Although a
private foundation usually seeks to make its
income–producing investments in a socially
responsible manner, only program–related
investments (PRIs) are defined in the Internal
Revenue Code (IRC § 4944(c) and related Treas.
Reg. § 53.4944–3).
A DISTINCTION WITH A DIFFERENCE
PRIs and mission–related investments may
sound similar. But they serve crucially different
purposes within a private foundation, which may
well rely upon a CPA adviser to help it
distinguish between them. Most notably, PRIs allow
the foundation to make venture–capital and other
beneficial investments without running afoul of
rules prohibiting high–risk, or “jeopardizing,”
investments. Jeopardizing investments include
selling short and similarly risky strategies or
asset classes. See Treas. Reg. § 53.4944-1(a)(2)
for specific prohibitions. Generally, a PRI:
Has as its primary purpose the
charitable purposes described in IRC §
170(c)(2)(B) (religious, charitable, scientific,
literary or educational, fostering amateur sports
competition or preventing cruelty to children or
animals);
Does not have as a significant
purpose income production or property
appreciation; and
Does not have as its purpose any of
the disqualifying purposes described in IRC §
170(c)(2)(D) (attempting to influence legislation;
participating in, opposing or intervening in a
political campaign of a candidate for public
office). A PRI is often in a risk category
that could otherwise result in a jeopardizing
investment excise tax penalty. Those penalties are
10% of the amount so invested for each year of a
“taxable period,” assessed against the private
foundation. In addition, 10% can be assessed
against any foundation manager who knowingly,
willfully and without reasonable cause
participates in such an investment. A taxable
period begins with the making of the jeopardizing
investment and ends on the mailing date of a
notice of deficiency for the initial tax, the date
the initial tax is assessed, or the date the
investment is removed from jeopardy, whichever is
earliest. An additional 25% penalty is imposed on
the foundation and 5% on the manager if such
investments are not removed from jeopardy within
the taxable period. Mission–related
investments, on the other hand, can be subject to
jeopardizing investment penalties. They are part
of a private foundation’s overall investment
portfolio that fits with its values and
principles. These investments are aimed primarily
at property appreciation and income production.
Perhaps the difference can be best
illustrated by examples (10 are given in Treas.
Reg. § 53.4944–3(b)). Consider a hypothetical
foundation with an exempt purpose of improving the
lives of and developing the infrastructure
supporting the citizens of Big City, USA. This
foundation might invest a portion of its
investment portfolio (noncharitable–use assets) in
a private equity fund composed primarily of real
estate investments. Such an investment would be
consistent with the foundation’s mission and
values. However, the same foundation might also
make a PRI in an organization building a new
community center in downtown Big City. Both
investments are in real estate and are in line
with the mission and values of the foundation.
However, the private equity fund is part of the
foundation’s investment portfolio, while the PRI
to develop the community center is treated as a
qualified distribution and a charitable–use asset
for the duration of the investment. The
development of a community center is likely not an
economically viable investment when evaluated on
the likely return on investment the foundation
will receive. Another reason for
distinguishing program–related from
mission–related investments is the different
purpose they play in the often complex
administrative requirements for private
foundations.
ACTS OF KINDNESS NOT RANDOM
A private foundation must also distribute a
minimum amount of its assets each year. The
minimum distribution amount is based upon a
minimum investment return of 5% on the average
fair market value of noncharitable–use
assets—generally those that are not currently used
for a charitable purpose. Charitable–use assets
include all assets purchased for exempt purposes,
program–related investments and 1.5% of the
average value of cash and marketable securities
that are not program–related investments.
Modifications and exclusions apply, but at the
gross level, non–operating private foundations
must distribute 5% of the average value of
non–charitable–use assets by the close of the
following tax year through qualified
distributions. PRIs are qualified distributions
that can be used to satisfy this requirement. See
Treas. Reg. § 53.4942(a)–3(a)(2). PRIs can
be either equity or debt investments and share
similarities with recoverable grants. A grant is
recoverable when it can be fully or partially
recovered by the grantor if its terms are not met.
This is different from a unilateral grant, which
is not generally recoverable so long as the
organization keeps its exempt status and doesn’t
use the grant for a prohibited purpose. Both PRIs
and recoverable grants are usually managed by the
foundation’s grant managers. Both are treated as
qualified distributions when the cash leaves the
foundation, and both are added to the required
distributable amount if they are recovered in a
subsequent tax period. In contrast to PRIs,
recoverable grants—as with unilateral grants—are
an expense on the foundation’s income statement. A
PRI appears on the foundation’s balance sheet, not
the income statement. When a PRI is made,
cash is transferred to the investee organization
either in the form of a debt or equity investment,
and a corresponding receivable or charitable–use
investment is recorded on the foundation’s balance
sheet. When the PRI returns some portion of the
principal investment, the foundation has until the
close of the following year to redistribute these
funds. When it makes a recoverable grant,
a private foundation records an expense. If the
grant is recovered, it is treated the same as
repayment of principal on a PRI. Both are included
in the current year’s distribution requirement to
be satisfied by the close of the following tax
year. The amount that is counted as the qualified
distribution with respect to a grant or PRI is the
amount of cash or assets transferred out of the
foundation. Each year, private foundations
must determine the amount of asset distributions
required. In making this calculation, a foundation
must determine which assets are charitable–use
assets and which are non–charitable–use or
investment assets. Only the investment assets are
included in the 5% minimum investment return
calculation. Although this calculation is the
topic of many pages of the IRC and Treasury
Regulations, it can be briefly summarized: First,
different assets are valued, based upon different
averaging periods. Some asset values may be
discounted, while others are excluded altogether
from the non–charitable–use asset base. Second,
PRIs are treated as charitable–use assets and
therefore excluded from the 5% minimum investment
return calculation. Third, mission–related
investments are not treated as charitable–use
assets and are included in the non–charitable
asset base for purposes of calculating the minimum
investment return.
INCOME TREATMENT THE SAME
The treatment of income generated by a PRI
and mission–related investment is the same. To the
extent the investment generates interest,
dividends, rents, capital gains or other types of
income listed in IRC § 4940, the foundation pays
tax at a rate of either 1% or 2% on the net income
after expenses. Similarly, total capital losses
are limited to capital gains in calculating net
investment income for the year. In other words, a
private foundation may not dispose of either a
program– or mission–related investment and use the
capital loss to offset other types of investment
income, such as interest or dividend income.
Another peculiarity of net investment income
calculation for private foundations is that any
net capital losses generated in one tax year may
not be carried to either prior or later tax
periods to offset capital gains in these other tax
periods. Foundation investment advisers should
monitor the overall net investment income
recognized in any tax period and consider
recognizing gains on investments to offset any
anticipated losses, which will be lost once the
tax year closes. See Exhibit 1 for a
comparison of characteristics of PRIs and
mission–related investments.
EXERCISING EXPENDITURE RESPONSIBILITY
Under current law, private foundations can
make a grant or PRI to any type of entity, so long
as it is made exclusively for charitable purposes.
If the grant or PRI is to a qualified 501(c)(3)
public charity, the foundation must verify that
the receiving organization has a current public
charity status and that the funds will be used
exclusively for a qualified charitable purpose. A
grant or PRI to a non–501(c)(3) organization or
private foundation, however, requires the grantor
foundation to exercise expenditure responsibility
(ER) oversight, which requires it to make an
inquiry before the grant or PRI. See Treas. Reg. §
53.4945–5. The grantor or investor foundation must
also:
Execute a written agreement,
Require the grantee or investee to
keep a separate accounting for funds from the
foundation,
Require regular reports from the
grantee or PRI organization, and
Attach an expenditure responsibility
report to the foundation’s annual excise tax
return. Mission–related investments do not
require ER oversight because they are not
qualified distributions. As part of the
foundation’s overall investment portfolio,
however, they are subject to the prudent investor
acts of the states where these investment
management standards have been adopted. These acts
are: Uniform Prudent Investor Act (UPIA), Uniform
Management of Institutional Funds Act (UMIFA) and
Uniform Prudent Management of Institutional Funds
Act (UPMIFA).
L3C: DESIGNED TO RECEIVE PRIs?
A new hybrid organization is intended to
ease the administrative burden for both
foundations and the recipient of a PRI. The
low–profit limited liability company, or “ L3C,” is a type of LLC
organized under state law to engage in socially
beneficial activities (see sidebar “L3Cs on the
Rise”). A number of states are considering this
new entity, but as of late 2007, only two, North
Carolina and Vermont, had introduced legislation
to establish them. Although an L3C would
not be exempt from federal tax, its organizational
structure mirrors the language in the Treasury
Regulations describing PRIs, namely:
It is formed primarily for charitable
or educational purposes,
No significant purpose of the entity
is the production of income or the appreciation of
property, and
No purpose of the entity is to
conduct legislative or political activities.
Although one or more states may allow the
creation of the L3C as a new entity type, what
regulatory body will ensure that the three
required principles are adhered to and revoke L3C
status if the principles are violated? Since the
current Tax Code and Regulations allow private
foundations to make a PRI for any charitable
purpose, the Council on Foundations (COF)
announced in its 2007 legislative agenda that it
would encourage Congress to allow foundations to
make PRIs in L3C organizations without requiring
expenditure responsibility oversight. Such a
measure would seem to require a determination
whether an L3C qualifies as a charitable
organization under IRC § 501(c)(3) and either the
IRS or the states to oversee it. If the
private foundations are required to determine the
charitable status of an L3C, they most likely
would handle it the same way as an equivalency
determination a private foundation makes when
making a grant to a foreign charitable
organization. However, since this option puts the
burden on the private foundation, most private
foundations would simply elect to perform ER
reporting to eliminate the significant penalties
potentially incurred if it turns out their
original determination was incorrect.
EFFICIENT AND PENALTY– FREE
Appreciating the differences between PRIs
and mission–related investments and the need for
both is essential for private foundations and
their managers to avoid significant penalties and
to manage the foundation’s assets efficiently.
CPAs advising private foundations can play a
crucial role in making sure these two forms of
investments are properly distinguished from one
another. And those in public practice who may have
dealings only in passing with foundations and
exempt organizations generally are increasingly
likely to be called upon to explicate their often
labyrinthine governing rules.
L3Cs on the Rise On
April 30, Vermont’s governor signed the first
legislation (H 775) creating low–profit
limited liability companies (L3Cs). North
Carolina introduced similar legislation in the
summer of 2007. As of this spring, the North
Carolina legislation was with the Senate
Committee on Finance, where it had been for
nearly a year. A Vermont L3C will be
subject to federal income taxes under
subchapter K unless it elects tax treatment as
a corporation by filing the check–the–box
election on Form 8832, Entity
Classification Election. Members of the
L3C are not required to be Vermont residents.
What’s more, currently an LLC, and almost
certainly soon an L3C, can be created over the
Internet. Therefore, anyone can create an L3C,
no matter where they reside. The legislation
contains several specific classification
requirements: 1. The company: a.
Significantly furthers the accomplishment of
one or more charitable or educational purposes
within the meaning of IRC § 170(c)(2)(B), and
b. Would not have been formed but for
the company’s relationship to the
accomplishment of charitable or educational
purposes. 2. No significant purpose of
the company is the production of income or the
appreciation of property; provided, however,
that the fact that a person produces
significant income or capital appreciation
shall not, in the absence of the other
factors, be conclusive evidence of a
significant purpose involving the production
of income or the appreciation of property.
3. No purpose of the company is to
accomplish one or more political or
legislative purposes within the meaning of IRC
§ 170(c)(2)(D). Failure to meet these L3C
requirements but continuing to meet the LLC
requirements will result in classification as
a Vermont LLC. The name of the organization
must be changed from L3C to LLC at the time of
conversion. The primary reason for
enacting this legislation was to stimulate
foundation and institutional investment in
these charitable, member–owned organizations.
However, until the IRS changes the rules
regarding expenditure responsibility reporting
for program–related investments in
non–public–charity organizations, significant
private foundation investment in these
organizations is unlikely. If Congress makes
this change, the use of L3C organizations will
likely grow dramatically across the nation.
AICPA RESOURCES
Articles
“Advising
Private Foundations,” JofA,
April 08, page 36
“Private
Foundations: Achieving Maximum Use of
Excess Qualifying Distributions,”
The Tax Adviser, April 02, page
225
OTHER RESOURCES
Publication
Private Foundations: Tax Law and
Compliance (3rd ed.), by Bruce R.
Hopkins and Jody Blazek, Wiley, 2008
Web site
Social Investment Forum, www.socialinvest.org
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