Jeopardy Investments

Jeopardy Investments

Article posted in IRS Notices on 29 October 2015| comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 29 October 2015
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Summary

Richard Fox examines a recent IRS notice which favorably impacts the ability of Private Foundations to make mission related investments.

By: Richard L. Fox, Esquire

IRS Notice 2015-62 Provides New Guidance on Jeopardy Investments; Private Foundations Can Consider Charitable Purposes When Making Investments - Expands Opportunities for Mission-Related Investments

Notice 2015-62 confirms that foundation managers of private foundations may consider the relationship of a proposed investment to the foundation’s charitable purpose when determining whether a proposed investment is prudent. Under this guidance, private foundations may make investments that further their charitable mission, i.e., so called “mission-related investments” (“MRIs”), even if they provide a lower rate of return than might otherwise be achieved through other investments and they do not otherwise constitute program-related investments (“PRIs”). Notice 2015-16 now aligns the prudent-investor standard for jeopardy investments under IRC § 4944 with state standards applicable to charitable investments under the Uniform Prudent Management of Institutional Funds Act. The IRS notice came out just a few days before the Kresge Foundation’s announcement that it would put 10 percent of its endowment, or $350-million, into MRIs by 2020, one of the largest such commitments by a private foundation.

Background on Excise Tax on Jeopardy Investments Made by Private Foundations

As part of the Tax Reform Act of 1969, Congress enacted the jeopardy investment excise tax provisions under IRC § 4944 in order to deter private foundations from engaging in speculative investment practices that could jeopardize the carrying out of a private 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 § 4944 subjects private foundations and, under certain conditions, foundation managers, to a two-tier excise tax regime for investing any amount in such a manner as to jeopardize the carrying out of any of the foundation's exempt purposes.  IRC §§ 4944(a) and (b).  

Treas. Reg. Section 53.4944-1(a)(2)(i) provides specific guidance as to jeopardy investment rules.  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.  In the exercise of the requisite standard of care and prudence the foundation managers may take into account the expected return (including both income and appreciation of capital), the risks of rising and falling price levels, and the need for diversification within the investment portfolio (for example, with respect to type of security, type of industry, maturity of company, degree of risk and potential for return).

The determination of whether an investment jeopardizes the carrying out of the foundation's exempt purposes is made on an investment-by-investment basis, in each case taking into account the foundation's entire portfolio. Investments that are considered “high risk” may be closely scrutinized to determine whether the foundation managers have met the requisite standard of care. However, once an investment has been determined not to jeopardize the carrying out of the foundation's exempt purposes, the investment will not later be considered a jeopardy investment, even if the foundation subsequently realizes a loss as a result of the investment.

Exception for Program-Related Investments from Jeopardy Investment Tax Regime

Under an important exception under the jeopardy investment excise tax regime, program-related investments (“PRIs”) are not subject to the jeopardy investment excise tax rules otherwise applicable to investments made by private foundations. Instead, pursuant to IRC § 4944(c), PRIs “shall not be considered as investments which jeopardize the carrying out of exempt purposes.” Therefore, as long as an investment is 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.

PRIs are mission-driven investments that closely resemble grants because their primary purpose must be to further tax-exempt purposes. The idea behind a PRI is that the investment 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 purposes described in IRC § 170(c)(2)(B), which includes religious, charitable, scientific, literary, and educational purposes.
  • No significant purpose of which is the production of income or the appreciation of property.
  • No purpose of which is to attempt 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, the following question is relevant: Would investors whose sole motivation is the production of income likely make the investment on the same terms as the private foundation?  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. In addition to not being subject to the jeopardy investment excise tax rules, they are:

  1. Treated as qualifying distributions under IRC § 4942 for purposes of meeting a private foundation's 5% annual minimum distribution requirement.
  2. Excluded from the assets taken into account in calculating the 5% annual minimum distribution requirement under IRC § 4942.
  3. Not treated as excess business holdings under IRC § 4943.
  4. Not treated as taxable expenditures under IRC § 4945, as long as the private foundation exercises expenditure responsibility when it is required to do so.  

Notice 2015-62:  Do Mission-Related Investments That Are Not PRIs Constitute Jeopardy Investments?

Notice 2015-62 specifically notes that “Questions have arisen about whether an investment made by a private foundation that furthers its charitable purposes, but is not a PRI because a significant purpose of the investment is the production of income or the appreciation of property, is subject to tax under section 4944.”  

As indicated above, under the regulations, an investment made by a private foundation will not be considered to be a jeopardy investment if, in making the investment, the foundation managers exercise ordinary business care and prudence (under the circumstances prevailing at the time the investment is made) in providing for the long-term and short-term financial needs of the foundation to carry out its charitable purposes. Although the regulations list some factors that managers generally consider when making investment decisions, Notice 2015-62 states that “the regulations do not provide an exhaustive list of facts and circumstances that may properly be considered.”   In particular, the regulations do not address whether an investments that furthers a charitable purpose of a private foundation may be properly considered in determining whether a proposed investment is prudent for purposes of the jeopardy investment rule.

Notice 2015-62 now specifically provides that a private foundation may take into account the relationship between the investment and the foundation’s charitable purposes in determining whether foundation managers have exercised ordinary business care and prudence in making an investment, specifically stating as follows:

When exercising ordinary business care and prudence in deciding whether to make an investment, foundation managers may consider all relevant facts and circumstances, including the relationship between a particular investment and the foundation's charitable purposes. Foundation managers are not required to select only investments that offer the highest rates of return, the lowest risks, or the greatest liquidity so long as the foundation managers exercise the requisite ordinary business care and prudence under the facts and circumstances prevailing at the time of the investment in making investment decisions that support, and do not jeopardize, the furtherance of the private foundation's charitable purposes.

For example, a private foundation will not be subject to tax under section 4944 if foundation managers who have exercised ordinary business care and prudence make an investment that furthers the foundation's charitable purposes at an expected rate of return that is less than what the foundation might obtain from an investment that is unrelated to its charitable purposes.  (Emphasis added.)

Notice 2016-52 notes that this standard is consistent with investment standards under state laws, which generally provide for the consideration of the charitable purposes of an organization or certain factors, including an asset's special relationship or special value, if any, to the charitable purposes of the organization, in properly managing and investing the organization's investment assets. See, e.g., Unif. Prudent Mgmt. of Institutional Funds Act. §§ 3(a), 3(e)(1)(H) and accompanying comments, 7A pt. III U.L.A. 21-22 (Pocket Pt. 2015).

Conclusion

In a time of increasing popularity of MRIs, Notice 2015-62 is welcome news because it specifically provides that foundation managers of private foundations may consider the relationship between an investment and the foundation’s mission in determining whether an investment is prudent.  The Notice also provides that MRIs will not be considered imprudent because they provide an expected return that is less than what could be earned on other investments.  Notice 2015-62 opens the doors to a private foundation investing in mission-driven investments that it might have previously not have made because the investment would not be considered a PRI and its anticipated investment returns are less than what otherwise could be earned on non-mission-driven investments.
 

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