ELITE ADVISOR BEST PRACTICES

Proposed Regulations Expand PRI Opportunities for Private Foundations - Part Three

Real-world examples (third in a series)

By Richard Fox

Key Takeaways:

  • PRIs may now accomplish a wide variety of tax-exempt purposes, including advancing science, providing relief to the poor, fighting environmental deterioration and promoting the arts.
  • Investments with potentially high rates of return are not necessarily disqualified from qualifying as PRIs.
  • A private foundation that holds an equity position in a loan, a provision of credit enhancement or a guarantee arrangement may still qualify as a PRI.
  • Nine examples contained in this article will help foundations, advisors and regulators clarify what constitutes a PRI.


Last time, we explored the background on PRIs, discussed expenditure responsibility requirements and provided an explanation of proposed regulations. Here it’s important to understand that the proposed regulations do not modify the existing regulations but, instead, provide nine detailed and instructive additional examples that illustrate that PRIs may be used to accomplish a wider variety of charitable purposes through a wider range of investment vehicles than those reflected under the existing regulations.

Explanation of Proposed Regulations

The new examples clarify that a PRI may accomplish a wide variety of tax-exempt purposes, such as advancing science, providing relief to the poor and distressed, combating environmental deterioration, and promoting the arts. Several examples demonstrate that an investment that funds activities in one or more foreign countries, including overseas investments that alleviate the impact of a natural disaster or that fund educational programs for poor individuals, may further the accomplishment of charitable purposes and qualify as a PRI.

Thus, unlike the existing regulations, the examples in the proposed regulations make it clear that investments outside the United States may qualify as PRIs. One example illustrates that the existence of a high potential rate of return on an investment does not, by itself, prevent the investment from qualifying as a PRI. Another example illustrates that 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, and two examples illustrate that a private foundation’s provision of credit enhancement can qualify as a PRI. The final example demonstrates that a guarantee arrangement may qualify as a PRI.

The following sets forth the fact patterns in the nine new examples in the proposed regulations in which the IRS concludes, in each case, that the investment constitutes a PRI:

Example 1. 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.

Example 2. Q, a developing country, produces a substantial amount of recyclable solid waste materials that are currently disposed of in landfills and by incineration, contributing significantly to environmental deterioration in Q. X is a new for-profit business located in Q. X’s only activity will be collecting recyclable solid waste materials in Q and delivering those materials to recycling centers that are inaccessible to a majority of the population. If successful, the recycling collection business would prevent pollution in Q caused by the usual disposition of solid waste materials. X has obtained funding from only a few commercial investors who are concerned about the environmental impact of solid waste disposal. Although X made substantial efforts to procure additional funding, X has not been able to obtain sufficient funding because the expected rate of return is significantly less than the acceptable rate of return on an investment of this type. Because X has been unable to attract additional investors on the same terms as the initial investors, Y, a private foundation, enters into an investment agreement with X to purchase shares of X’s common stock on the same terms as X’s initial investors. Although there is a high risk associated with the investment in X, there is also the potential for a high rate of return if X is successful in the recycling business in Q.

Example 3. Assume the facts as stated in Example 2, except that X offers Y shares of X’s common stock in order to induce Y to make a below-market rate loan to X. X previously made the same offer to a number of commercial investors. These investors were unwilling to provide loans to X on such terms, because the expected return on the combined package of stock and debt was below the expected market return for such an investment, based on the level of risk involved, and they were also unwilling to provide loans on other terms X considers economically feasible. Y accepts the stock and makes the loan on the same terms that X offered to the commercial investors.

Example 4. X is a for-profit business located in V, a rural area in State Z. X employs a large number of poor individuals in V. A natural disaster occurs in V, causing significant damage to the area. The business operations of X are harmed because of damage to X’s equipment and buildings. X has insufficient funds to continue its business operations, and conventional sources of funds are unwilling or unable to provide loans to X on terms it considers economically feasible. In order to enable X to continue its business operations, Y, a private foundation, makes a loan to X bearing interest below the market rate for commercial loans of comparable risk.

Example 5. A natural disaster occurs in W, a developing country, causing significant damage to W’s infrastructure. Y, a private foundation, makes loans bearing a below-market interest rate to H and K, poor individuals who live in W, to enable each of them to start a small business. H will open a roadside fruit stand. K will start a weaving business. Conventional sources of funds were unwilling or unable to provide loans to H or K on terms they considered economically feasible.

Example 6. X, a limited liability company, purchases coffee from poor farmers residing in a developing country, either directly or through farmer-owned cooperatives. To fund the provision of efficient water management, crop cultivation, pest management and farm management training to the poor farmers by X, Y, a private foundation, makes a below-market interest rate loan to X. The loan agreement requires X to use the proceeds from the loan to provide the training to the poor farmers. X would not provide such training to the poor farmers absent the loan.

Example 7. X is a social welfare organization that is recognized as an organization described in Section 501(c)(4). X was formed to develop and encourage interest in painting, sculpture and other art forms by, among other things, conducting weekly community art exhibits. X 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 X on terms it considers economically feasible. Y, a private foundation, makes a below-market interest rate loan to X to fund the purchase of the new space.

Example 8. X is a nonprofit corporation that provides child care services in a low-income neighborhood, enabling many residents of the neighborhood to be gainfully employed. X is recognized as an organization described in Section 501(c)(3). X’s current child care facility has reached capacity and has a long waiting list. X has determined that the demand for its services warrants the construction of a new child care facility in the same neighborhood. X is unable to obtain a loan from conventional sources of funds, including B, a commercial bank, because X lacks sufficient credit to support the financing of a new facility. Pursuant to a deposit agreement, Y, a private foundation, deposits funds in B and B lends an identical amount to X to construct the new child care facility. The deposit agreement requires Y to keep the funds on deposit with B during the term of X’s loan and provides that if X defaults on the loan, B may deduct the amount of the default from the deposit. To facilitate B’s access to the funds in the event of default, the agreement requires that the funds be invested in instruments that allow B to access them readily. The deposit agreement also provides that Y will earn interest on the deposit at a rate substantially less than Y could otherwise earn on this sum of money if Y invested it elsewhere. The loan agreement between B and X requires X to use the proceeds from the loan to construct the new child care facility.

Example 9. Assume the same facts as stated in Example 8, except that instead of making a deposit of funds into B, Y enters into a guarantee agreement with B. The guarantee agreement provides that if X defaults on the loan, Y will repay the balance due on the loan to B. B was unwilling to make the loan to X in the absence of Y’s guarantee. X must use the proceeds from the loan to construct the new child care facility. At the same time, X and Y enter into a reimbursement agreement whereby X agrees to reimburse Y for any and all amounts paid to B under the guarantee agreement. The signed guarantee and reimbursement agreements together constitute a “guarantee and reimbursement arrangement.”

Conclusion

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 nine new examples contained in the proposed regulations demonstrate that PRIs may be used to accomplish a wider variety of charitable purposes through a wider range of investment vehicles than those reflected under the existing regulations that were issued 40 years ago. 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. As a result, the proposed regulations may 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.


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).