ELITE ADVISOR BEST PRACTICES
Proposed Regulations Expand PRI Opportunities for Private Foundations - Part One
Welcome news for private foundations as they clarify that program-related investments may be made to accomplish a variety of charitable purposes through a wide range of investment vehicles (first in a series)
By Richard Fox
- PRIs are mission-driven investments that closely resemble grants, because their primary purpose is to further tax-exempt purposes.
- PRIs allow foundations to use their resources to further their charitable mission through investment activities, including investments with for-profit businesses and individuals.
- The regulations send a clear signal by the IRS that PRIs can serve as valid and important tools for furthering a foundation’s charitable purposes.
If you advise affluent individuals, families or not-for-profit organizations, you might want to get up to speed on program-related investments. PRIs have become an increasingly popular tool for advancing the philanthropy of private foundations. Indeed, in 2011, the Bill and Melinda Gates Foundation created a $400 million fund dedicated exclusively to making PRIs. And now many states have enacted legislation to create a new type of legal entity known as a low-profit limited liability company, or L3C, specifically in an effort to encourage private foundation funding of business ventures that improve public welfare.
Although private foundations have traditionally focused principally on grant-making activities, PRIs allow foundations to use their resources to further their charitable mission through investment activities, including by making investments with for-profit business enterprises and individuals.
Definition of PRI
PRIs are mission-driven investments that closely resemble grants, because their primary purpose is to further tax-exempt purposes. The idea behind a PRI is that it is an investment that would not have been made but for the fact that it will further the foundation’s charitable mission. Specifically, a PRI is defined as an investment:
- Whose primary purpose is to accomplish one or more of the objectives described in Section 170(c)(2)(B), which includes for religious, charitable, scientific, literary and educational purposes
- That has no significant intention of producing income or appreciating property
- That has no intention of attempting to influence legislation or participate in or intervene in any political campaign
An investment is made primarily to accomplish tax-exempt purposes if it significantly furthers the accomplishment of the private foundation’s exempt activities and would not have been made but for the relationship between the investment and the accomplishment of those exempt activities. In determining whether a significant purpose of an investment is the production of income or the appreciation of property, a relevant question is whether investors who are engaged in the investment solely for the production of income would be likely to make the investment on the same terms as the private foundation. However, the fact that an investment subsequently produces significant income or capital appreciation is not, in the absence of other factors, conclusive evidence that income or appreciation was a significant purpose of the investment and therefore does not preclude the investment from being a valid PRI.
PRIs can play an important role in a private foundation’s philanthropy as, in addition to not being subject to the jeopardy investment excise tax rules, they are:
- Treated as qualifying distributions under Section 4942 for purposes of meeting a private foundation’s 5 percent annual minimum distribution requirement
- Excluded from the assets taken into account in calculating the 5 percent annual minimum distribution requirement under Section 4942
- Not treated as excess business holdings under Section 4943
- Not treated as taxable expenditures under Section 4945, as long as the private foundation exercises expenditure responsibility when it is required to do so
The IRS became aware that many private foundations were hesitant to make potential program-related investments because the existing regulations that were issued in 1972—which focus on domestic situations principally involving economically disadvantaged individuals and deteriorated urban areas—did not provide the necessary degree of comfort to ensure private foundations that their investments would constitute PRIs. The IRS also determined that the private foundation community sought regulations that would include examples reflecting modern-day investment practices and illustrating certain principles clarifying the nature of permissible PRIs.
In response to the call from the private foundation community, the Treasury and the IRS have now issued proposed regulations providing new guidance in the form of nine additional examples describing permissible PRIs. We’ll get to an example shortly. The issuance of these regulations, which update the existing regulations issued 40 years ago, is welcome news for private foundations, as the examples in the proposed regulations clarify that PRIs may be used to accomplish a wider variety of charitable purposes through a wider range of investment vehicles than those described under the existing regulations.
X is a for-profit business that researches and develops new drugs. X’s research demonstrates that a vaccine can be developed within ten years to prevent a disease that predominantly affects poor individuals in developing countries. However, neither X nor other commercial enterprises like X will devote their resources to develop the vaccine, because the potential return on investment is significantly less than required by X or other commercial enterprises to undertake a project to develop new drugs. Y, a private foundation, enters into an investment agreement with X in order to induce X to develop the vaccine. Pursuant to the investment agreement, Y purchases shares of the common stock of S, a subsidiary corporation that X establishes to research and develop the vaccine. The agreement requires S to distribute the vaccine to poor individuals in developing countries at a price that is affordable to the affected population. The agreement also requires S to publish the research results, disclosing substantially all information about the results that would be useful to the interested public.
The examples contained in the proposed regulations are very detailed and instructive and reflect the types of investments that the IRS has previously determined qualify as PRIs in private letter rulings issued to specific foundations. However, having these examples in the form of regulations, as opposed to nonprecedential private rulings, provides more comfort to private foundations that these types of investments are viewed by the IRS as permissible PRIs. The proposed regulations do not alter the existing regulations or the general rules applicable to PRIs but demonstrate that a wide range of investments may qualify as PRIs and send a clear signal that PRIs can serve as a valid and important tool in furthering the charitable purposes of a private foundation. As a result, the proposed regulations should serve to broaden the interest of private foundations in making PRIs and may offer potential recipients an increased opportunity to seek investments from private foundations. Although they will not become effective until they are published as final regulations, private foundations may immediately rely upon the proposed regulations before they are finalized.
In my next installment, we’ll look into the background of PRIs, expenditure responsibility requirements, IRS guidelines and real-world examples of PRIs in action.
The issuance of the proposed regulations is welcome news, as they go a long way toward adding clarity to the types of PRIs that may be made by private foundations. The regulations also send a clear signal from the IRS that PRIs can serve as a valid and important tool in furthering their charitable purposes.