United States: IRS Issues New Guidance To Private Foundations On Program Related Investments

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Article by David C. Ulich and Danica Dodds
of sheppard mullin

The IRS recently issued proposed regulations that provide new examples that
illustrate what types of investments qualify as "program-related
investments" (PRIs). These new examples are based on published guidance and
on financial structures that had previously been approved in private letter
rulings.

Program Related Investments-In General

Excise taxes are imposed on private foundations, as well as their managers,
for making investments that jeopardize the carrying out of the private
foundation's exempt purposes. Generally, such "jeopardizing investments"
occur when foundation managers fail to exercise ordinary business care and
prudence in providing for the long- and short-term financial needs of the
private foundation.

PRIs are exempt from being treated as jeopardizing investments. In general,
PRIs are defined as investments that (1) have the primary purpose to
accomplish one or more "charitable" purposes, (2) do not have the
significant purpose of producing income or appreciating property, and (3) do
not support legislation or political campaigns.

Using PRIs can be a great way for a private foundation to stimulate and
advance charitable objectives. High-profile private foundations using PRIs
include the Bill and Melinda Gates Foundation.

The Proposed Regulations

The proposed regulations do not modify the existing regulations-instead,
they provide new examples of investments that qualify as PRIs by
illustrating certain principles and current investment practices. While the
examples in the existing regulations focus on domestic situations
principally involving economically disadvantaged individuals in deteriorated
urban areas, the new examples illustrate a broader range of situations more
likely to be encountered in practice:

PRIs can be achieved through a variety of investments, such as loans to
individuals, tax-exempt organizations, and for-profit organizations, as well
as equity investments in for-profit organizations.
A private foundation's acceptance of an equity position in conjunction with
making a loan does not necessarily prevent such investment from qualifying
as a PRI.
A credit enhancement arrangement (such as a deposit agreement or a guarantee
agreement) may qualify as a PRI.
A potentially high rate of return does not automatically prevent an
investment from qualifying as a PRI.
The charitable purposes that a PRI may serve are broad, and include
advancing science, combating environmental deterioration, and promoting the
arts.
Activities conducted in foreign countries are considered to further a
charitable purpose so long as the same activities would further a charitable
purpose in the U.S.
The recipients of PRIs do not need to be within a charitable class if they
are the instruments for furthering a charitable purpose. For example, an
investment in a for-profit that develops new drugs may qualify as a PRI if
the for-profit business agrees to use the investment to develop a vaccine
that will be distributed to poor individuals at an affordable cost.
Private foundations are permitted to rely on the new examples, even though
the proposed regulations will not be effective until the Treasury publishes
them as final regulations.

Benefits of Program Related Investments

PRIs receive special tax treatment, such as:

PRIs are excluded from the assets that a private foundation takes into
account when determining its "distributable amount" for the taxable year.
PRIs are excluded from being treated as "business holdings" subject to
excise tax.
PRIs are generally treated as "qualifying distributions" for purposes of
private foundation distribution requirements.
PRIs do not constitute "taxable expenditures" provided that "expenditure
responsibility" is exercised by the private foundation when required.
The new examples will be helpful to private foundations in determining if
their investments may qualify as a PRI and receive such beneficial tax
treatment.