The Internal Revenue Service (IRS) on October 9 released a denial letter issued to an organization seeking exemption under Section 501(c)(3) to operate a program to “to deploy capital into projects that promote a social good and that otherwise struggle to find financing in normal capital markets.” This denial letter has garnered much attention from organizations and practitioners in the impact investing space, and many 501(c)(3) organizations are asking if their own impact investing activities are at risk.
For the reasons discussed here, this denial is neither surprising nor concerning. It does serve as a reminder, however, that “charitable” means more than merely promoting social good, and that focusing primarily on a financial return to investors (even if below market) does not suffice. In order for an investment to be charitable, the primary purpose of the investment must be the charitable purpose it serves.
ORGANIZATION DENIED EXEMPT STATUS
The organization at issue was formed by a “parent” 501(c)(3) organization and applied for its own exemption under Section 501(c)(3). In its application for exemption, the organization stated that its purpose was to deploy capital into projects that promote a social good and that otherwise struggle to find financing in normal capital markets. Its articles of incorporation stated that it was organized exclusively for charitable purposes, including “increasing the capital available to organizations that develop and/or operate (i) long term affordable housing for the economically and physically disadvantaged, (ii) community facilities such as schools and community health centers, (iii) businesses providing access to healthy foods, (iv) sustainable energy projects, (v) commercial real estate, and (vi) other projects that may increase social welfare.”
The organization planned to raise capital from “individuals and institutions who want to see that their funds accomplish positive social and environmental objectives and as a concomitant objective to earn financial returns and utilize that capital to finance projects and organizations in line with the investors' dual objectives.” The organization would be funded primarily through below-market investment management fees from managing private investment funds formed to accomplish these purposes. In order to provide a near market return for investors, the organization planned to share space and services, including employees, with its “parent” 501(c)(3) organization. The organization would also be required to register with the US Securities and Exchange Commission as an investment advisor.
Funds the organization had created included, for example:
- Funds to make loans to finance preventive health and social service investment in order to reduce costly acute care interventions and thereby create cost savings that could potentially be used to repay investors a modest return. An example provided in the ruling of a loan this fund originated was to finance the provision of social services for individuals exiting incarceration to help prevent recidivism and reduce the prison population. According to the organization, the loan was not a market investment due to the absence of collateral and the experimental nature of the program. It was administered by a separate Section 501(c)(3) public charity.
- Funds to finance small scale energy efficiency and clean energy project finance, for instance, a nursing home, small industrial facility, or health center might seek to make capital improvements to its heating and cooling and lighting systems that would drive down its utility costs. A portion of the savings could be used to pay for the costs of the improvements over time. The investment examples of this fund provided in the ruling were of loans originated by a third party and managed by the organization. Similar to the first fund above, the organization asserted the loans were not marketable due to the lack of collateral but also in this instance the small size of the borrower.
In its exemption application, the organization stated that these kinds of activities are not well supported by traditional capital markets because they are too niche, too small scale, or too low-return to draw the attention and resources of banks, venture capital and private equity funds, and public stock and bond markets. The organization’s objective was to raise and manage capital to serve these underserved parts of the economy that are unlikely to have ready access to capital from a wide array of other sources. The organization also stated that these types of borrowers would be likely to use alterative lending platforms with high interest rates. The interest rates of the loans offered by the organization in the funds were redacted in the ruling but the IRS asserted they were standard market rates.
The organization stated that its officers and employees would be allowed to invest for their own accounts in the investment funds the organization created, and the organization projected earning substantial profit after only the first three years of operations. The organization’s method for selecting investments was to screen potential investment opportunities to determine the merits of each potential portfolio company. It would then conduct a comprehensive due diligence process to identify and address any potential risks; this process may include assessments of organizational competence, analysis of cash flow projections, analysis of financial statements, assessments of available collateral to determine its value and marketability, a review of business plans, and market analysis.
BASIS FOR IRS DENIAL
The IRS determined that the organization was not operated exclusively for Section 501(c)(3) purposes because a substantial portion of its activities was managing funds for a fee to provide market or near-market returns for investors. The IRS stated that the organization was in direct competition with other commercial players in the market and its activities resembled the conduct of a trade or business that is ordinarily carried on by commercial ventures organized for profit. The organization was “like any other investor” in the marketplace in trying to secure the highest returns possible for its clients. Thus, the IRS determined that the charitable purposes were only incidental to the trade or business activities the organization was otherwise conducting.
In support of its determination, the IRS identified several factors:
- The funds were offered to any interested investors who sought investment with a public purpose but who also expected a market or near-market return
- Only some of the projects financed by the funds the organization managed were in furtherance of Section 501(c)(3) purposes
- The organization offered competitive rates for private investors
- The organization was funded solely by management fees
- The organization projected a high financial reserve over the first few years of operations
- The organization had no plans to receive charitable donations from the public
- The loans originated or managed by the organization were market rate
Perhaps most importantly, the IRS noted that the investment screening process prioritized financial return over charitable impact. Portfolio investments were first vetted to determine that they were suitable from a risk/reward perspective before any consideration of social and environmental factors. This led the IRS to conclude that the organization’s primary concern was the rate of return for its investors, and the charitable impact of the investment funds was only incidental to its overall non-exempt purposes.
As a threshold matter, it is important to remember that some activities are inherently charitable and others are only charitable if they are carried out in a charitable manner. Providing investment management services is not an inherently charitable activity, even when provided by or to a charitable organization and even if provided at below-market rates. Similarly, investing in projects that promote a social good or in projects that lack access to normal capital markets because they are too niche or too small scale is not inherently a charitable activity, and such an investment would not become charitable merely because the investment is made at below-market rates. A loan to an organization for the purpose of earning a return is also generally not a charitable activity, even if the loan is made to a charitable organization.
The organization at issue in the denial letter focused on investments that it believed would promote a social good, but it did so for the purpose of providing market or near-market returns for its investors. The investment process prioritized the financial return of a potential investment rather than the charitable purpose for the investment.
This is consistent with the distinction between program-related and mission-related investments. A mission-related investment may have some social good, it may even further a charitable purpose, but a significant reason for the investment is still earning a return. The return may be less than an investor may otherwise make if the investor were focused exclusively on the return without consideration as to the positive social impact, but the investment is still treated as an investment and not a charitable expenditure. In contrast, the primary purpose of a program-related investment is furthering a charitable purpose, and no significant purpose may be to earn a return (even if it does, in fact, earn a significant return). Thus, a program-related investment is considered an expenditure for charitable purposes and is treated as a charitable grant under federal tax law.
The proposed activities of the organization in the denial letter are distinguishable from, for example, a charitable organization that provides investment management services to an investment fund that it controls and that is making program-related investments that further the organization’s charitable purposes. This case is also distinguishable from an organization that is engaged in substantial charitable activities while also providing an insubstantial amount of investment management services that may not further its charitable purposes.
Organizations engaged in impact investing should remain mindful of the distinction between a program-related investment and a mission-related investment and how they are treated for tax purposes. Organizations making program-related investments must make sure not only to focus primarily on the charitable purpose of the investment, but also to document that purpose and how the investment furthers that purpose. Once the return on the investment becomes a key consideration in making the investment, the investment is unlikely to qualify as a program-related investment and would not be a charitable expenditure.