Action Item: Foundations must understand the final Program Related Investment regulations and ensure that their planned and ongoing investments comply with the most recent IRS guidance to ensure their investments do not jeopardize their tax-exempt status or subject foundation managers to intermediate sanctions.
Overview
Four years ago, the U.S. Department of the Treasury (“Treasury Department”) proposed regulations adding nine new examples of program-related investments (“PRIs”) to Treasury Regulation § 53.4944-3(b). On April 21, 2016, the Treasury Department issued final new regulations for PRIs (T.D. 9762), which became effective on April 25, 2016. The final regulations provide important guidance to foundation investing, which became an important source of financing when many traditional sources of funding dried up in the wake of the 2008 financial crisis.
There are four requirements for PRIs. First, the primary purpose of making the investment is to accomplish one or more of the private foundation’s charitable purposes. Second, there is no significant purpose to generate income or appreciate property. Third, the investment would not have been made but for the relationship between the investment and the accomplishment of the foundation’s charitable purpose. Fourth, no purpose of the investment is an attempt to influence legislation or participate or intervene in a political campaign.
Since the PRI regulations were first written in 1972, foundations have utilized PRIs to support economic development, scientific and technological advancement, educational and artistic programs, and the environment. The new examples specifically permit foundations to utilize PRIs to invest in for-profit entities, either through a purchase of common stock or through a below market interest rate loan, so long as such investments further the foundation’s exempt purpose. The new examples also specifically permit private foundations to utilize PRIs to guarantee the commercial loans of another nonprofit corporation, so long as there is a reimbursement agreement between the private foundation and nonprofit corporation.
Although not specifically stated in the preamble to the new regulations, the examples stand for the following principles: (1) an activity conducted in a foreign country furthers an exempt purpose if the same activity would further an exempt purpose if conducted in the United States; (2) the exempt purposes served by a PRI are not limited to situations involving economically disadvantaged individuals and deteriorated urban areas; (3) the recipients of PRIs are not required to be within a charitable class so long as they are the instruments for furthering an exempt purpose; (4) a potentially high rate of return does not automatically prevent an investment from qualifying as a PRI; (5) PRIs can be achieved through a variety of investments, including loans to individuals, tax-exempt organizations, and for profit-organizations, and equity investments in for-profit organizations; (6) a credit enhancement arrangement may qualify as a PRI; and (7) a private foundation’s acceptance of an equity position in conjunction with making a loan does not necessarily prevent the investment from qualifying as a PRI. The IRS has stated that it intends to post these principles on
its website.
The previous ten examples focused on investment for the relief of the poor; however the nine new examples stand for the position that a foundation may make PRIs to for-profits, nonprofits, or individuals so long as the investment furthers the foundation’s exempt purpose and a significant purpose for making the investment is not to make a profit.
Examples
Example 11: A private foundation enters into an investment agreement with a business that researches and develops new drugs. The business has demonstrated that a vaccine can be developed within 10 years to prevent a disease that predominately affects poor individuals in developing countries. The investment agreement requires the private foundation to purchase the business’s stock and the business to distribute the vaccine to poor individuals in developing countries at a price those individuals can afford, but does not prohibit the business from selling the drug to others at a market rate. The agreement also requires the business to publish its research results and disclose substantial information about the results as promptly as possible without jeopardizing the business’s right to secure patents necessary to protect its ownership of the vaccine and control the results of the research. But for the foundation’s investment, the vaccine may not have been developed because the business and other commercial enterprises like the business would not have devoted their resources to the vaccine’s development because the potential return on investment on the vaccine is significantly less than what is typically required by the business or other commercial enterprises.
The private foundation expects that its rate of return in the business will be less than the expected market rate of return for an investment of similar risk. Its primary purpose for making the investment is to fund scientific research in the public interest. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the foundation’s exempt activities and would not have been made but for the relationship between the investment and the foundation’s exempt activities.
The foundation’s purchase of the business’s common stock is a PRI.
Example 12: A recycling business will be formed in a developing country that produces a substantial amount of recyclable solid waste that is currently disposed of in landfills or incinerated, which contributes to environmental deterioration in that country. The business will collect recyclable solid wastes and deliver those materials to recycling centers that are inaccessible to the majority of the population. The business, if successful, would lessen the environmental deterioration in the country. The business has attracted a few commercial investors, but has been unable to obtain sufficient funding because the expected return on investment is significantly less than the acceptable rate of return on an investment of this type. A private foundation enters into an agreement to purchase shares of the business’s common stock on the same terms as the commercial investors.
Although there is a high risk associated with the investment, there is also the potential for a high rate of return if the recycling business is successful. The private foundation’s primary purpose for making the investment is to combat environmental deterioration. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the foundation’s exempt activities and would not have been made but for the relationship between the investment and the foundation’s exempt activities.
The foundation’s purchase of the business’s common stock is a PRI.
Example 13: The facts are the same as Example 12, except that the recycling business offers the private foundation shares of its common stock in order to induce the private foundation to make a below-market rate loan to it. The recycling business previously made the same offer to a number of commercial investors, but they were unwilling to provide the loans because the expected return on the combined package of stock and debt was below the expected market return for such a package based on the level of the risk involved. The commercial investors were also unwilling to provide loans on other terms that the recycling business considered economically feasible. The private foundation accepts the stock and makes the loan on the same terms that were offered to the commercial investors.
The private foundation’s primary purpose for making the investment is to combat environmental deterioration. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the foundation’s exempt activities and would not have been made but for the relationship between the investment and the foundation’s exempt activities.
The foundation’s loan accompanied by the acceptance of common stock is a PRI.
Note: The foundation does not need to sell its stock in a business that becomes profitable for the investment in that stock to constitute a PRI; however, the establishment, at the outset of an investment, of an investment condition that is tied to the foundation’s exempt purpose in making the investment can be an important indication that a foundation’s primary purpose in making the investment is the accomplishment of the exempt purpose.
Example 14: A business in a rural part of a state employs a large number of poor individuals in that area. A natural disaster occurs in the area and the business’s operations are harmed because of damage to its equipment and buildings. The business has insufficient funds to continue its operations and conventional sources of funds are unwilling or unable to provide the business loans on terms that it considers economically feasible. In order to enable the business to continue operating a private foundation makes a loan to the business that is below the market rate for commercial loans of comparable risk.
The private foundation’s primary purpose for making the loan is to provide relief to the poor and distressed. No significant purpose of the investment involves the production of income or the appreciation of property. The loan significantly furthers the foundation’s exempt activities and would not have been made but for the relationship between the loan and the foundation’s exempt activities.
The foundation’s loan is a PRI.
Example 15: A private foundation makes loans to poor individuals in a developing country that bear interest below the market rate for commercial loans of comparable risk. The loans are made to enable the poor individuals to start small businesses, such as a roadside fruit stand. Conventional sources of funds are unwilling or unable to provide such loans on terms they consider economically feasible.
The private foundation’s primary purpose for making the loans is to provide relief to the poor and distressed. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the foundation’s exempt activities and would not have been made but for the relationship between the investment and the foundation’s exempt activities.
The foundation’s loans are PRIs.
Note: When providing microloans to individuals it is still important for the foundation to conduct due diligence on the individual and the business before entering an investment.
Example 16: A limited liability company (the “LLC”), which is treated as a partnership for federal income tax purposes, purchases coffee from poor farmers residing in developing countries, either directly or through farmer-owned cooperatives. A private foundation makes a loan to the LLC bearing interest below the market rate for commercial loans of comparable risk. The loan agreement requires the LLC to use the loan to fund the provision of efficient water management, crop cultivation, pest management, and farm management training for the poor farmers. The LLC would not provide such training to the poor farmers absent the loan.
The private foundation’s primary purpose for making the loan is to educate poor farmers about advanced agricultural methods. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the foundation’s exempt activities and would not have been made but for the relationship between the loan and the foundation’s exempt activities.
The foundation’s loan is a PRI.
Example 17: A social welfare organization recognized as an organization described in section 501(c)(4) was formed to develop and encourage interest in painting, sculpture, and other art forms by, among other things, conducting weekly community art exhibits. The organization needs to purchase a large exhibition space to accommodate the demand for exhibition space within the community. Conventional sources of funds are unwilling or unable to provide funds to the organization on terms it considers economically feasible. A private foundation makes a loan to the organization at an interest rate below the market rate for commercial loans of comparable risk to fund the purchase of the new space.
The private foundation’s primary purpose for making the loan is to promote the arts. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the foundation’s exempt activities and would not have been made but for the relationship between the loan and the foundation’s exempt activities.
The foundation’s loan is a PRI.
Example 18: A nonprofit corporation (the “nonprofit”) that provides child care services in a low-income neighborhood, which enables many of the neighborhood’s residents to be gainfully employed, meets the requirements of section 501(k) and is recognized as an organization described in section 501(c)(3). The nonprofit’s child care facility has reached capacity and has a long waiting list. The nonprofit has determined that the demand for its services warrants the construction of a new child care facility in the same neighborhood. The nonprofit is unable to obtain a loan from a conventional source of funds, including a commercial bank, because of the nonprofit’s credit record. Pursuant to a deposit agreement, a private foundation deposits money in the commercial bank during the term of the nonprofit’s loan and provides that if the nonprofit defaults on the loan, then the commercial bank may deduct the amount of the default from the private foundation’s deposit. The deposit agreement requires that the funds be invested in instruments that allow the commercial bank to access the funds readily in case of a default. The deposit agreement further provides that the private foundation will earn interest at a rate that is substantially lower than it could otherwise earn on the deposit if it had invested the money elsewhere. The loan agreement between the nonprofit and the commercial bank requires the nonprofit to use the proceeds from the loan to construct the new child care facility.
The private foundation’s primary purpose for making the deposit is to further its educational purposes by enabling the nonprofit to provide child care services within the meaning of section 501(k). No significant purpose of the deposit involves the production of income or the appreciation of property. The deposit significantly furthers the foundation’s exempt activities and would not have been made but for the relationship between the deposit and the foundation’s exempt activities.
The foundation’s deposit is a PRI.
Example 19: The facts are the same as Example 18, except that instead of making a deposit in the commercial bank, the foundation enters into a guarantee agreement with the commercial bank whereby the foundation agrees to repay the balance due on the loan if the nonprofit defaults on the loan. The commercial bank is unwilling to make the loan to the nonprofit absent the guarantee from the foundation. At the same time, the nonprofit and the foundation enter into a reimbursement agreement whereby the nonprofit agrees to reimburse the foundation for any and all amounts paid to the commercial bank under the guarantee agreement. The signed guarantee and reimbursement agreements together constitute a “guarantee and reimbursement agreement.”
The private foundation’s primary purpose for entering into the guarantee and reimbursement agreement is to further the foundation’s educational purposes. No significant purpose of the guarantee and reimbursement agreement involves the production of income or the appreciation of property. The guarantee and reimbursement agreement significantly furthers the foundation’s exempt activities and would not have been made but for the relationship between the guarantee and reimbursement agreement and the foundation’s exempt activities.
The guarantee and reimbursement arrangement is a PRI.
