ELITE ADVISOR BEST PRACTICES

Proposed Regulations Expand PRI Opportunities for Private Foundations - Part Two

Program-related investments may be made to accomplish a variety of charitable purposes through a wide range of investment vehicles and the Treasury and IRS are clearly listening (second in a series)

By Richard Fox

Key Takeaways:

  • The Treasury and the IRS are clearly listening to the concerns of private foundations when it comes to PRIs.
  • Generally, the jeopardy investment prohibition is violated if foundation managers neglect to exercise ordinary business care and prudence when making investments.
  • If a private foundation makes a PRI with a non-501(c)(3) organization that is classified as a public charity, then the foundation must exercise expenditure responsibility pursuant to Section 4945. It’s not always easy.
  • The expenditure responsibility rules that apply to grants also generally apply to PRIs, although certain rules are tailored specifically for PRIs.


In my last installment, we introduced advisors to PRIs, including definitions, a quick history and how this increasingly popular tool can be used to advance the philanthropic goals of private foundations. Here we’ll explore the background on PRIs, discuss expenditure responsibility requirements and provide an explanation of proposed regulations.

Exception to Jeopardy Investment Rules

As part of the Tax Reform Act of 1969, Congress enacted the jeopardy investment excise tax provisions under IRC Section 4944 in order to deter private foundations from engaging in speculative investment practices that could jeopardize the foundation’s tax-exempt purposes. Under these rules, a private foundation is prohibited from making investments that jeopardize its ability to accomplish its exempt purposes. To enforce this prohibition, IRC Section 4944 subjects private foundations and, under certain conditions, foundation managers to a two-tier tax regime for investing any amount of money in a manner that could jeopardize the foundation’s exempt purposes.

Generally, the jeopardy investment prohibition is violated if it is determined that the foundation managers, in making an investment, failed to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long- and short-term financial needs of the foundation to carry out its exempt purposes. Under an important exception, PRIs are not subject to the jeopardy investment excise tax rules otherwise applicable to investments made by private foundations, as, pursuant to Section 4944(c), PRIs “shall not be considered as investments which jeopardize the carrying out of exempt purposes.” Therefore, as long as an investment constitutes a PRI, there is no exposure to the jeopardy investment excise tax rules, notwithstanding that the investment may otherwise be considered imprudent purely from an investment standpoint.

Expenditure Responsibility Requirements

If a private foundation makes a PRI with an organization other than a Section 501(c)(3) organization that is classified as a public charity, then the foundation must exercise expenditure responsibility pursuant to Section 4945. This is no simple task, and a private foundation must understand that in making PRIs, it must take on this burden. And if it fails to exercise expenditure responsibility properly over the PRI, the PRI will be considered to constitute a taxable expenditure, subjecting the foundation to substantial excise tax under Section 4945.

The expenditure responsibility rules that apply to grants also generally apply to PRIs, although certain rules are tailored specifically for PRIs. Generally, the expenditure responsibility rules require that a foundation:

  • Conducts a pre-grant due diligence of the grantee
  • Enters into a written agreement that specifies the purposes of the investment
  • Obtains full and complete periodic reports from the recipient indicating how the funds were spent
  • Makes full and detailed reports to the IRS on Form 990-PF regarding the use of the funds

In the case of a PRI, the expenditure responsibility rules specifically require that the written agreement between the foundation and the PRI recipient specify the purpose of the investment and include a commitment by the recipient:

  1. To use all the funds received from the private foundation only for the purposes of the investment and to repay any portion not used for such purposes, provided that, with respect to equity investments, such repayment shall be made only to the extent permitted by applicable law concerning distributions to holders of equity interests
  2. At least once a year during the existence of the program-related investment, to submit full and complete financial reports of the type ordinarily required by commercial investors under similar circumstances and a statement that it has complied with the terms of the investment
  3. To maintain books and records adequate to provide information ordinarily required by commercial investors under similar circumstances and to make such books and records available to the private foundation at reasonable times

Many private foundations make grants that are subject to the expenditure responsibility rules or otherwise generally follow the expenditure responsibility rules as part of their internal grant-making procedures. For these foundations, the exercise of expenditure responsibility over PRIs should not be overly burdensome. Other private foundations, however, and particularly smaller foundations that restrict their activities to making grants to public charities, may not be inclined to take on the expenditure responsibility requirements and, therefore, may consider engaging in PRIs overly burdensome.

Recognition by IRS of Need for Additional Guidance for PRIs

The IRS became aware that private foundations were hesitant to make PRIs because the examples in the existing regulations that were originally issued back in 1972 often did not make them comfortable that a proposed investment would constitute a permissible PRI. These regulations are limited to containing examples focusing only on domestic situations principally involving economically disadvantaged individuals and deteriorated urban areas, and the investments in the examples are generally in the form of interest-free or below-market-rate loans. The IRS further found that the private foundation community would find it helpful if the regulations “could include additional PRI examples that reflect current investment practices and illustrate certain principles,” including confirming the following:

  • An activity conducted in a foreign country furthers a charitable purpose if the same activity would further a charitable purpose if conducted in the United States.
  • The charitable purposes served by a PRI are not limited to situations involving economically disadvantaged individuals and deteriorated urban areas.
  • The PRI recipients need not be within a charitable class if they are the instruments for furthering a charitable purpose.
  • A potentially high rate of return does not automatically prevent an investment from qualifying as a PRI.
  • 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.
  • A credit enhancement arrangement may qualify as a PRI.
  • A private foundation’s acceptance of an equity position in conjunction with making a loan doesn’t necessarily prevent the investment from qualifying as a PRI.
Conclusion

The Treasury and the IRS clearly took the request by the private foundation community to heart, as the examples contained in the proposed regulations adopt the foregoing principles for purposes of determining whether an investment by a private foundation constitutes a PRI.


About the Author

Richard L. Fox is an attorney and partner in the Philadelphia office of the law firm of Dilworth Paxson LLP (www.dilworthlaw.com) where he heads the Philanthropic and Nonprofit practice. Mr. Fox is the author of the treatise “Charitable Giving: Taxation, Planning and Strategies,” a Thomson Reuters/Warren, Gorham and Lamont publication. He is also a member of the editorial board of Estate Planning and a member of the Board of Advisors of the American College Chartered Advisor in Philanthropy program (www.theamericancollege.edu).