Recycling charitable dollars: IRS gives green light to more program-related investments

Private foundations lost more than 20% of their assets during the economic crisis, according to the Foundation Center (see Foundation Growth and Giving Estimates, available at tinyurl.com/2vhk93e). At the same time, the demand for charitable services—and foundation dollars to support those services—increased significantly. The combination of these dynamics prompted many private foundations to consider new strategies to do more with less. Even today, as endowments slowly recover, foundations are increasingly pursuing ways to address societal needs while protecting their balance sheets.

The IRS and Treasury Department issued proposed regulations in 2012 (REG-144267-11) to make it easier for private foundations to do just that. The new guidance is intended to reduce transaction costs associated with program-related investments (PRIs), a type of charitable disbursement that enables foundations to make a positive impact in a financially savvy way. Specifically, PRIs are investments made primarily to further the foundation’s mission; the potential for financial gain must not be a primary driver of the decision to make the PRI (see “Capital With a Conscience,” JofA, July 2008, page 54). Consequently, PRIs count toward foundations’ mandatory annual payout requirement, just as traditional grants do. (For more on required distributable amounts, see “Advising Private Foundations,” JofA, April 2008, page 36.) However, private foundations expect PRI recipients, unlike grant recipients, to repay the investment, possibly with interest. Once the money is repaid, foundations recycle the funds to other charitable projects, multiplying the impact of each philanthropic dollar.

The proposed regulations include nine new examples of permissible PRIs, doubling the number of examples that foundations can use to guide their PRI efforts. The new examples are more diverse in structure, location, and purpose. This issuance marks the first time in 40 years that the IRS has updated the PRI rules. While proposed regulations are generally not authoritative guidance, the IRS explicitly states that taxpayers may rely on these proposed regulations.

PRIs: A PRIMER

Under Sec. 4944(c) and associated existing regulations, a PRI must primarily further one of the charitable purposes of Sec. 170(c)(2)(B) (religious, charitable, scientific, literary, educational, etc.) and may not be used for a political activity prohibited for exempt organizations under Sec. 170(c)(2)(D) (attempting to influence legislation or participating or intervening in a political campaign). It must not have as a significant purpose the production of income or appreciation of property (Regs. Sec. 53.4944-3(a)(1)).

An investment is made primarily to accomplish a charitable purpose under Sec. 170(c)(2)(B) if it significantly furthers the accomplishment of the foundation’s exempt activities and would not have been made but for its relation to the foundation’s exempt activities (Regs. Sec. 53.4944-3(a)(2)(i)). Therefore, an investment that qualifies as a PRI for one private foundation may not qualify for another, depending on the mission of each. In determining whether a significant purpose of an investment is the production of income or the appreciation of property, a relevant consideration is whether a traditional investor would make the same investment on the same terms (Regs. Sec. 53.4944-3(a)(2)(iii)).

The structure of a PRI is a function of project needs, prevailing market conditions, and the recipient’s ability to generate sufficient cash flows with which to repay the foundation’s investment. Most commonly, PRIs are created as below-market-rate loans to public charities. However, the regulations specify that the PRI recipient does not have to be a not-for-profit organization; a PRI in a for-profit business enterprise is permissible as long as the foundation makes the investment primarily to further its own mission. For example, a foundation focused on economic empowerment may make a PRI in a commercial bank that was created to provide financial services in low-income communities.

PRIs are not intended to replace traditional grants but rather to further a societal mission in ways that grants cannot. They are most appropriate when the recipient is building capacity and the project will eventually generate a stream of revenue. Foundations have made PRIs, for example, to finance the acquisition and renovation of charter school facilities in areas with poorly performing public schools. The principal is repaid once students enroll. PRIs also serve as a form of interim financing, for example, when a charity is waiting to receive the proceeds from a government grant.

If the PRI generates any income during the investment period, such as interest on a PRI loan, the foundation reports it as investment income that is subject to the excise tax on net investment income. When the principal is ultimately returned, the foundation increases its required annual charitable disbursement by the repayment amount. Accordingly, the foundation then recycles the repaid dollars into other charitable disbursements, such as new grants or additional PRIs. If a PRI is not repaid, the foundation treats it as a grant. A 2007 study by FSG Social Impact Advisors of PRI loans found a default rate of approximately 4%.

THE BENEFITS OF PRIs

PRIs are a potentially valuable tool for private foundations, recipient organizations, and society at large. The primary advantage of PRIs over grants from the foundation’s perspective is the ability to conserve limited philanthropic capital while still fulfilling the foundation’s exempt purpose, reducing the trade-off between current and future distributions. PRIs are classified as charitable-use assets, which means they are excluded from the asset base on which foundations compute their minimum mandatory payout. As noted previously, PRIs also count toward this distribution requirement.

PRIs can provide recipient organizations with access to capital under more favorable terms than traditional commercial financing. They can also provide capital to recipients that are undertaking risky projects or projects with low returns that typical profit-seeking investors will not finance. Beyond direct monetary assistance, successful participation in a PRI can improve a recipient organization’s credit history and attract additional capital from other foundations, government grantors, and commercial sources. Private foundations often build long-term relationships with the recipient organizations, helping them develop the management expertise necessary to establish financially sustainable programs.

PRIs allow foundations to make investments that tax regulations otherwise prohibit. For instance, PRIs are an exception to the prohibition against jeopardizing investments—those that could endanger the foundation’s ability to execute its tax-exempt mission (Sec. 4944(c)). PRIs are also excluded from the limitation on excess levels of business holdings (Regs. Sec. 53.4943-10(b)). These exemptions allow foundations to take larger, riskier positions with PRIs than they could otherwise have in their investment portfolios. They let foundations fill a void that traditional investors are unwilling to fill, helping move a large range of societal missions forward in new ways and encouraging the development of market-based approaches to combat social problems.

NEW GUIDANCE ON ACCEPTABLE PRIs

The IRS has provided little guidance historically as to what it deems an acceptable PRI, assuming the investment falls within the foundation’s mission. Regs. Sec. 53.4944-3(b), issued in 1972, provides nine narrow examples of acceptable PRIs and one example of an investment that does not qualify as a PRI. These original examples pertain to domestic investments in deteriorated urban areas and/or related to economically disadvantaged individuals. (In the example that does not qualify as a PRI, a private foundation invests in common stock of a corporation and later applies dividends it receives from the stock in furtherance of its exempt purpose. Although there is a relationship between the organization’s exempt purpose and the return on the investment, there is no such relationship with the investment itself.)

The new proposed regulations (see Exhibit 1, “New PRI Examples”) contain nine additional examples of permissible PRIs that are more diverse than the original set. These examples incorporate contemporary social concerns and business practices and highlight the following points:

• PRIs may address a variety of charitable purposes, including advancing scientific discovery, preserving the environment, fostering education, and promoting the arts;
• PRIs may fund activities in a foreign country;
• PRI recipients do not need to be not-for-profit entities if a for-profit recipient is an instrument for accomplishing the foundation’s exempt purpose;
• An investment with a potentially high rate of return is not automatically precluded from qualifying as a PRI; and
• PRIs may take many forms, including loans, equity investments, and credit enhancements (e.g., linked deposits and loan guarantees).

In each of the new examples, the investment furthers the issuing private foundation’s mission and would not have been made except for the relation between the investment and the foundation’s mission.

The proposed regulations are expected to increase foundations’ confidence in making a variety of PRIs. “It is our belief that the finalization of the proposed regulations will contribute to a substantial increase in PRI activity among foundations, particularly those just entering the field,” said Peter Berliner, managing director of Mission Investors Exchange, in a comment letter to the IRS. “More dollars will be invested in ways that will generate very significant and desirable social change.” Mission Investors Exchange’s members have made more than $4 billion in PRIs.

Private foundations may have been reluctant to use PRIs in the past because of the risk that the IRS would disagree with the classification of the investment as a PRI, subjecting the foundation to excise taxes on multiple fronts: jeopardizing investments, excess business holdings, and failure to meet the minimum payout requirement. Obtaining legal preapproval for any particular PRI to mitigate this risk is costly and time-consuming. The new guidance provides formal regulatory approval of many types of PRIs, guidance that is particularly useful for smaller and newer foundations that lack the resources to obtain legal opinions and private letter rulings.

OTHER CONSIDERATIONS

As interest in PRIs gains momentum, practitioners should be aware of the limitations of the proposed regulations. The new examples do not cover all potential investments of interest to foundations. Notably, the IRS did not include an example in which the recipient organization is a low-profit limited liability company (L3C), a relatively new business entity designed to attract foundation investment. Additionally, the IRS did not simplify the process by which foundations can obtain guidance from the IRS on whether an investment outside the given examples qualifies as a PRI. The not-for-profit sector prefers a process in which multiple foundations could rely on a single PRI determination. Finally, even though many of the new examples include equity investments, foundations making PRIs to organizations that are not public charities must still exercise expenditure responsibility to ensure that all money is used for the intended purpose.

PROVIDING GREATER ASSURANCE

Overall, the new guidance allows financial, tax, and legal advisers to provide greater assurance to constituencies of the philanthropic community who wish to engage in a range of charitable activities and financial arrangements. As PRIs become more popular, CPAs should familiarize themselves with the new examples of permissible PRIs and the variety of investment structures that qualify. This new guidance is important for CPAs that advise private foundations, but also for CPAs that work with organizations (not-for-profit or for-profit) that could benefit from receiving a PRI.

Exhibit 1: New PRI Examples

A private foundation makes:

• An equity investment in a subsidiary of a for-profit drug company to aid in the development and distribution of a vaccine to prevent a disease that primarily affects the poor in developing countries. 
• An equity investment with the possibility of a high rate of return in a new recycling company in a developing country where the investment is on the same terms as for commercial investors.
• Under the same facts as in the preceding example, a below-market loan to the recycling company, where the company issues the foundation shares of stock as an inducement to make the loan.
• A below-market loan to a rural company employing a high number of poor individuals after damage from a natural disaster would prevent the company from staying in business without additional capital.
• Below-market loans to poor individuals to start small businesses in a developing country affected by a natural disaster.
• A below-market loan to a limited liability company (LLC) to train poor farmers (the LLC’s suppliers) in a developing country in advanced agricultural methods and management. 
• A below-market loan to a Sec. 501(c)(4) social welfare organization formed to develop and encourage interest in the fine arts to purchase an art exhibition space.
• A linked deposit earning below-market interest to induce a commercial bank to lend the same amount of money to a nonprofit charitable organization to build a child care facility in a low-income neighborhood. The organization’s charitable purpose is providing child care services in the low-income neighborhood to enable its residents to be gainfully employed.
• Under the same facts as in the preceding example, a guarantee agreement with the bank. 

EXECUTIVE SUMMARY

The IRS and Treasury Department have issued proposed regulations addressing program-related investments (PRIs) by private foundations, the first new guidance on PRIs in 40 years. The proposed regulations are expected to reduce transaction costs and increase the use of PRIs; the proposed regulations state that taxpayers may rely on them before they are finalized.

The proposed regulations contain nine additional examples of acceptable PRIs that are broad in charitable purpose, including to recipients in foreign countries, and contain a variety of financial structures such as equity investments and credit enhancements.

Generating a high rate of return does not automatically disqualify an investment from being classified as a PRI.

CPAs advising private foundations, public charities, and socially conscious businesses will want to familiarize themselves with new types of PRIs as well as the limitations of this new guidance.

Allison L. Evans (evansall@uncw.edu) is an assistant professor of accounting at the University of North Carolina–Wilmington. Christine M. Petrovits (christine.petrovits@mason.wm.edu) is an associate professor of business at the College of William and Mary in Williamsburg, Va.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

AICPA RESOURCES

JofA articles

“Capital With a Conscience,” July 2008, page 54

“Advising Private Foundations,” April 2008, page 36

The Tax Adviser and Tax Section

The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies, and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at aicpa.org/tax. The current issue of The Tax Adviser is available at thetaxadviser.com.

OTHER RESOURCES

Publication

The PRI Directory (3rd edition), by Foundation Center and PRI Makers Network, 2010

Website

Mission Investors Exchange, missioninvestors.org