Generally, under Section 4944(a), if a private foundation (PF) invests any amount in such a manner as to jeopardize the carrying out of any of its exempt purposes, there is an excise tax imposed equal to 10 percent of the amount so invested. There is an exception under Section 4944(c) for program-related investments (PRI). For purposes of Section 4944 investments, the primary purposes of which is to accomplish one or more of the purposes described in Section 170(c)(2)(B) and no significant purpose of which is the production of income or the appreciation of property, shall not be considered as investments which jeopardize the carrying out of exempt purposes. IRC Section and Treas. Regulation IRC Sections IRC Sections 4944(a) & (b) Initial Taxes and Additional Taxes IRC Section 4944(c) Exception for Program-Related Investments IRC Section 4944(d) Special Rules IRC Section 4944(e) Definitions Treas. Regulation Treas. Reg. Section 53.4944-3(a) Exception for Program-Related Investments Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources) Administrative materials Rev. Rul. 78-90, 1978-1 C.B. 380 considered low interest rate loans by a PF, established to aid the blind in securing employment, that are made to blind persons who desire to establish themselves in business but who are unable to obtain funds through commercial sources constitute PRI under Section 4944(c) and are also qualifying distributions under Section 4942(g). GCM 39720 (1988) discussed whether a community investment program that allows a portion of the assets to be invested outside of the target community can qualify as a PRI under Section 53.4944-3(a)(1). The GCM agreed that the proposed investment qualifies as a PRI despite the use of a portion of the assets outside of the target community. IRS website Program Related Investments Analysis If a PF invests any amounts in such a manner as to jeopardize the carrying out of any of its exempt purposes, Section 4944(a) imposes an excise tax on the making of such investment. Section 53.4944-1(a)(1). An investment shall be considered to jeopardize the carrying out of the exempt purposes of a PF if it is determined that the PF managers, in making such investment, have 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. Section 53.4944-1(a)(2) A PRI shall not be classified as an investment which jeopardizes the carrying out of the exempt purposes of a PF. Section 53.4944-3(a)(1). The investment must meet three requirements in order to constitute a PRI: The primary purpose of the investment is to accomplish one or more of the purposes described in Section 170(c)(2)(B); No significant purpose of the investment is the production of income or the appreciation of property, and No purpose of the investment is to accomplish one or more of the purposes described in Section 170(c)(2)(D). Primary exempt purpose An investment shall be considered as made primarily to accomplish one or more of the purposes described in Section 170(c)(2)(B) if it significantly furthers the accomplishment of the PF’s exempt activities and if the investment would not have been made but for such relationship between the investment and the accomplishment of the PF’s exempt activities. Section 53.4944-3(a)(2)(i). Section 170(c)(2)(B) purposes include the following: Religious Charitable Scientific Literary Educational purposes Prevention of cruelty to children or animals Fostering national or international amateur sports competition without providing athletic facilities or equipment. In addition, for purposes of Section 4944, investments described in Section 4942(j)(4)(B) (relating to functionally-related businesses) are to be considered as being made primarily to accomplish Section 170(c)(2)(B) purposes. Section 53.4944–3(a)(2)(ii). Production of income In determining whether a significant purpose of the investment is the production of income or the appreciation of property, it shall be relevant whether the investors solely engaged in the investment for profit would be likely to make the investment on the same terms as the PF. However, the fact that an investment produces significant income or capital appreciation shall not, in the absence of other factors, be conclusive evidence of a significant purpose involving the production of income or the appreciation of property. Section 53.4944-3(a)(2)(iii). Section 170(c)(2)(d) purposes An investment shall not be considered as made to accomplish one or more of the purposes described in Section 170(c)(2)(D) if the recipient of the investment appears before, or communicates to, any legislative body with respect to legislation or proposed legislation of direct interest to such recipient, provided that the expense of engaged in such activities would qualify as a deduction under Section162. Section 53.4944-3(a)(2)(iv). Section 170(c)(2)(D) purposes include the following: Attempting to influence legislation; Participating in or intervening in (including the publishing or distributing of statements) any political campaign on behalf of (or in opposition to) any candidate for public office. The regulations at Section 53.4944-3(b) sets forth examples that illustrated the above provisions. Four of the examples in the regulations are set forth below: 1. X is a small business enterprise located in a deteriorated urban area and owned by members of an economically disadvantaged minority group. Conventional sources of funds are unwilling or unable to provide funds to X on terms it considers economically feasible. PF makes a loan to X bearing interest below the market rate for commercial loans of comparable risk. The PF's primary purpose for making the loan is to encourage the economic development of such minority groups. The loan has no significant purpose involving the production of income or the appreciation of property. The loan significantly furthers the accomplishment of PF's exempt activities and would not have been made but for such relationship between the loan and PF's exempt activities. Accordingly, the loan is a PRI even though the PF may earn income from the investment in an amount comparable to or higher than earnings from conventional portfolio investments. Section 53.4944-3(b) Example 1. 2. Assume the facts as above except that after the date of execution of the loan the PF extends the due date of the loan. The extension is granted in order to permit X to achieve greater financial stability before it is required to repay the loan. Since the change in the terms of the loan is made primarily for exempt purposes and not for any significant purpose involving the production of income or the appreciation of property, the loan shall continue to qualify as a PRI. Section 53.4944-3(b) Example 2. 3. X is a business enterprise which is owned by a nonprofit community development corporation. When fully operational, X will market agricultural products, thereby providing a marketing outlet for low-income farmers in a depressed rural area. The PF makes a loan to X bearing interest at a rate less than the rate charged by financial institutions which have agreed to lend funds to X if the PF makes the loan. The loan is made pursuant to a program run by the PF to encourage economic redevelopment of depressed areas, and no significant purpose involves the production of income or the appreciation of property. The loan significantly furthers the accomplishment of the PF's exempt activities and would not have been made but for such relationship between the loan and PF's exempt activities. Accordingly, the loan is a PRI. Section 53.4944-3(b) Example 6. 4. A PF invests $100,000 in the common stock of corporation M. The dividends received from such investment are later applied by the PF in furtherance of its exempt purposes. Although there is a relationship between the return on the investment and the accomplishment of the PF's exempt activities, there is no relationship between the investment per se and such accomplishment. Therefore, the investment cannot be considered as made primarily to accomplish one or more of the purposes described in Section 170(c)(2)(B) and cannot qualify as program-related. Section 53.4944-3(b) Example 7. Treasury Decision 9762 April 2016 On April 21, 2016, the Treasury Department issued final regulations for PRIs (T.D. 9762) which became effective on April 25, 2016. These regulations provide additional examples. Although not specifically stated in the preamble to the new regulations, the examples stand for the following principles: 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; the exempt purposes served by a PRI are not limited to situations involving economically disadvantaged individuals and deteriorated urban areas; 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; 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; and 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 new examples specifically permit foundations to use 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 use 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. The previous ten examples as contained in the regulations at Section 53.4944-3(b) of which we only set forth four above, focused on investment for the relief of the poor; however, the nine new examples, example numbers 11 through 19 in the regulations, 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. A few of the new examples are noted below: 1. The foundation’s purchase of the business’s common stock is a PRI. 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. 2. The foundation’s purchase of the business’ common stock is a PRI.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. 3. The foundation’s loan accompanied by the acceptance of common stock is a PRI the facts are the same as Example 2, 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. 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. Internal Revenue Bulletin, 2016-19, May 9, 2016 (T.D. 9762) Examples of Program Related Investments. Issue indicators or audit tips Issue indicators However, under certain conditions, a PRI may cease to be a PRI because of critical changes in circumstances such as serving illegal or private purposes. In such an event, the PF will become subject to the tax imposed by Section 4944(a)(1) no earlier than the 30th day after the date on which the PF (or any of its managers) have actual knowledge of such critical changes in circumstances. Section 53.4944–3(a)(3)(i). In addition, consider how the former PRI must be treated for Section 4942 purposes, including computation of the distributable amount, as well as compliance with the other provisions of chapter 42, Section 4941 self-dealing, Section 4943 excess business holdings and Section 4945 taxable expenditures. Some of The Challenges That Will Be Faced The investment must be examined under the facts and circumstances existing at the time the PF made the investment. A review on the basis of hindsight (whether the investment was an actual success or failure) is not relevant to this determination. Once it has been ascertained that a particular investment is not one that jeopardizes the exempt purposes of the foundation, subsequent losses that may result from the investment will not be considered for purposes of Section 4944. Section 53.4944–1(a)(2)(i). Be aware that just because an investment qualifies as a PRI, that other Chapter 42 provisions do not come into play, such as Section 4941 self-dealing. Audit tips Review the PF’s Articles of Incorporation or Certificate of Incorporation, along with any other restrictions that may have been placed on the PF’s assets to determine whether a PRI is consistent with the PF's purposes. Review minutes of board of director’s meetings or committee meetings on finance. Inquire if they have a policy regarding investment risks. If applicable, review contracts or documents with the organization’s financial brokers with regard to investment policies and risks. Review and inspect balance sheet items and identify the type of investments (margin accounts, futures market, securities which are not publicly traded, investing in companies owned by related parties). Review contracts and agreements surrounding the PRI. Were any DPs involved in the transactions in a personal capacity that could result in act(s) of self-dealing? Review regular reports the PF receives on the PRI. Review if the PF does not receive regular reports. Review files the PF has regarding its due diligence prior to the investment. Research the investment to learn of any public information, including related parties, misuse, fraud, etc.
