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Why Program-Related Investments Are Not Risky Business

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Nicole Motter, a member of the bar in the state of Georgia, unravels misperceptions about a powerful tool that can unlock additional financing for social enterprises: program-related investments.

Program-related investments (PRIs) hold incredible potential for the social enterprise arena. Rather than giving away money through grants, PRIs allow foundations to make investments as loans or equity stakes in the hopes of regaining their investments plus a reasonable rate of return. This arrangement allows foundations to increase the amount of money available to the social sector, while simultaneously building stronger and more sustainable socially minded entities. As part of a broader strategy involving impact investing and the market-based solutions of target recipients, PRIs stand to tackle tough social issues on a scale never before seen by moving beyond traditional notions of charity that, in many ways, continue to restrain large-scale progress.

PRIs also have attractive benefits for foundations. First, PRIs count towards a foundation’s qualifying distributions just as if they were grants, helping foundations meet their annual five percent payout requirement. In addition, PRIs are exempted from the excess business holdings tax, generally imposed for investments that comprise more than a 20 percent interest in for-profit ventures, as well as the jeopardizing investment tax, generally imposed for investments that financially endanger the charitable work of the foundation.

Yet, despite their value, PRIs have been underutilized. Several reasons for this exist. The first is that they have been dubbed by many in the legal community as too risky for the average foundation, largely due to lack of IRS guidance on what qualifies as a PRI. The second reason, stemming from the first, is the belief that foundations, in fear of this risk, avoid making PRIs. Although these two beliefs have long stifled PRI activity, both are inaccurate.

Risk Shmisk: Special Tax Rules for Foundations

As a background matter, foundations must follow a special set of tax rules in order to avoid certain penalties. PRIs are excepted from many of these restrictions in the form of the benefits for foundations mentioned above. These rules also set forth the definition of PRIs. Namely, a PRI is an investment not used for political campaigning or lobbying that 1) must be made primarily to further the foundation’s tax-exempt purposes, and 2) cannot be significantly motivated by the intent to make a profit. Despite the perks, many in the legal community refrain from championing PRIs due to perceived risk to the foundation if this definition isn’t clearly met.

So, you ask, what’s the risk? What happens if a foundation makes an investment intended as a PRI, and the IRS later decides it does not qualify? In most cases—and contrary to popular belief—nothing. A PRI that ultimately fails to qualify will simply be treated as a regular foundation investment (think endowment), subject again to the regular charitable distribution, excess business holdings, and jeopardizing investment rules (for which it would have received special treatment had it been deemed a PRI). And even if the IRS takes steps to evaluate the PRI and notifies the foundation it doesn’t qualify—which, in my knowledge, rarely, if ever, has happened—the foundation is only opened back up to the possibility of two, easily avoidable risks (assuming, of course, the investment doesn’t run afoul of the core foundation rules prohibiting the diversion of charitable assets toward private use).

Where PRI qualification is a concern, these two risks can be easily pre-empted:

  • Excess Business Holdings — This rule is only applicable to equity-type investments in for-profit ventures. To avoid any possibility of penalties if concerned the PRI designation might fall through, simply keep the foundation’s interest in the target social enterprise under 20 percent. For corporations, this means voting stock. For LLCs and other unincorporated entities, this means beneficial interest or profits interest. Note, however, if there is no concern about the PRI qualifying, invest away. A higher relative amount of investment in start-up social enterprises can be very helpful in jumpstarting an idea.
  • Jeopardizing Investments — While theoretically applicable to all foundation investments that don’t make the PRI cut (i.e., not just equity investments in for-profits), in practice this risk rarely presents a problem. The purpose of the jeopardizing investment tax is to penalize non-charitable imprudently-made investments that, if lost, would compromise the foundation’s ability to carry out its work. Without weeding through the complex regulations, then, it seems the easiest way to avoid the chance of penalties if a foundation is concerned its PRI may not qualify is to simply avoid making the PRI for a substantial portion of its assets. That way, if the investment is lost, the work of the foundation won’t be endangered. For example, a foundation worth $1 billion probably could make a $1 million investment without triggering the jeopardizing investment rules; however, a foundation worth $1 million likely could not, since if lost the foundation would have no money left over.

All the Cool Kids are Doing It

In further support of the fact that PRIs aren’t all that risky, some of the most well-known foundations in the country have been making PRIs safely for up to 40 years. And not only that—they’ve been doing it in ways that break the mold on what many have long considered the PRI safe zone.

While low-cost housing and community development projects have traditionally attracted PRIs, many foundations are branching out into other program areas. For example, in 2007 the Kellogg Foundation earmarked $75 million from its mission-driven investment program toward enterprises that directly provide nutritious food to at-risk children, their families, and their communities, and to ultimately aid access to healthcare (a far cry from traditional urban renewal projects). Nontraditional program areas such as education, arts and culture, social and health programs, and environmental sustainability continue to gain popularity; in fact, in 2007, education had risen to the number one PRI-attracting program area.

Other foundations have stepped outside the box with nontraditional financing structures beyond the standard below-market rate loan traditionally associated with PRI-making. In 2011, the Bill & Melinda Gates Foundation, for example, used a PRI to acquire a $10 million equity stake in a for-profit biotechnology company. Consistent with its mission to reduce health inequities in poor countries, the PRI is aimed at ensuring better delivery of vaccines to the poor. Equity investments such as these are gaining popularity across the board as financial vehicles for PRIs. In addition, foundations need not be concerned that making a PRI in a for-profit carries extra risk. As long as the foundation’s mission is furthered through the investment, the type of entity receiving it doesn’t matter. As David Chernoff, associate general counsel of the MacArthur Foundation, has noted, "What is crucial is that a charitable or other exempt purpose will be served—not who is the messenger."

Think foundations need private letter rulings from the IRS to ensure safe PRIs? Think again. I spoke with one of the country’s largest and most PRI-active foundations (that asked to remain anonymous) and it revealed it does not seek private letter rulings from the IRS before making PRIs due to the time, cost, and inability to apply the ruling to future investments. The foundation also revealed that it has never been penalized by nor attracted a single inquiry from the IRS in all its PRI activity over the years (nor has it heard of any other foundation being checked). Given that this foundation has been making PRIs for decades, this information is eye-opening for foundations looking to throw their hats in the PRI-making ring.

Nicole Motter's experience working in nonprofits for 10 years before receiving her J.D., and seeing little progress, convinced her that a different model is needed to make headway on some of the world’s toughest social problems. She can be reached at nicole.motter@gmail.com. 

The views expressed in this article are those of the author and are not meant to be construed as legal advice.

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