More and more wealthy families are interested in using their family assets, their private family foundations, and their donor-advised funds to do more than traditional grant making. They are looking instead to make loans to charities, and loans to‑‑and even equity investments in‑‑for-profit entities that are furthering charitable purposes. By adopting the program-related investments (“PRIs”) approach, a foundation and other investors have an opportunity to recycle the funds as they are repaid, for additional charitable purposes, thereby potentially increasing the long-term impact of their charitable assets.
This article provides information about the mechanics of PRIs, especially from a compliance context for foundations. Even so, there is much that can be adapted from PRIs that can be useful to other investors wanting to advance charitable purposes and outcomes while also preserving, even growing, and eventually recycling their investment.
Who is the PRI investor?
From an IRS compliance standpoint, we generally are talking about private foundations – that is, nonprofit corporations (or trusts) that are tax-exempt under Section 501(c)(3) of the Internal Revenue Code (the “Code”) and that are classified under Section 509(a) as private foundations. To be clear, though, Section 501(c)(3) public charities, including their donor-advised funds, could also take advantage of these investments, as can others.
What is a PRI? What are its advantages for a foundation?
A PRI is an investment that a foundation makes from its charitable pool of assets, not from the assets it intends to invest for purposes of growing the endowment. Therefore, a PRI is not subject to traditional investment policies and prudent investor standards. Nor is a foundation required to limit its levels of ownership as required by the “excess business holdings” rules, although they still must comply with the self-dealing and co-investment rules.
A PRI counts towards satisfying a foundation’s required five percent minimum distribution requirement. Unlike a grant that a foundation does not expect to see any money from, a foundation must understand how to treat money returned to it pursuant to a PRI. That money is of two types: (1) return of the principal or invested amount; and (2) distributions or payments of interest, dividends, or appreciation over and above the first category. Category one returns increase the annual payout obligation of the foundation for the given time period such that the foundation must payout at least 5% for that period plus amounts returned as category one payments. Category two payments are treated as investment income to the foundation, just like any other investment income. Losses — that is returns and payments that do not equal the category one principal or invested amount — are not available to reduce endowment or gains from unrelated business taxable income on which taxes must be paid.
A PRI must satisfy all three of the following tests:
- The investment must further one or more charitable purposes of the foundation such that “but for” the investment’s connections to the foundation’s charitable purpose it would not be made. This is a determination specific to each foundation, its mission, and the proposed PRI;
- The production of income or the appreciation of property may not be a significant purpose of the investment; and
- As is true of any foundation grant, the PRI cannot be used to fund electioneering or lobbying activities.
In addition, when the investment is made in a for-profit entity, the foundation must exercise “expenditure responsibility” over the investment, which involves careful due diligence before making the investment, correct provisions in the investment documents, reporting back to the foundation on the use of funds, proper reporting on the tax return, and follow-up with the investee if it is not properly spending the invested funds.
For additional information on expenditure responsibility, please see the following publications by Adler & Colvin:
- Legal Explanation of Program Related Investments (“PRI Primer”)
- Expenditure Responsibility – A Primer and Ten Puzzling Problems
Certainly, as the preceding makes clear, foundations have regulatory reasons for complying with these requirements. Other 501(c)(3) organizations can also benefit from adopting these requirements as aids in fulfilling their own legal obligations to ensure charitable use of their assets and to protect against impermissible private benefit. For other than 501(c)(3) investors, adaptations of the above approach can contribute to their objectives, especially approaches to due diligence, reporting, and accountability.
How does a PRI satisfy the charitability requirement?
First, the investment must be intended to further a recognized charitable purpose under Section 501(c)(3). Note that the activity being funded does not have to qualify under Section 501(c)(3). Classic PRI examples include funding a for-profit bank or grocery store in a poor or deteriorating neighborhood that does not have access to these services. Running a grocery store or bank is not charitable, but relieving poverty, giving underserved people easier access to healthy food, combatting community deterioration, and helping communities without access to safe banking, are charitable purposes.
Second, the purpose must be one that is within the foundation’s mission. A foundation whose purposes are limited to supporting public television would not want to make a PRI to put a grocery store in an underserved community.
The Kauffman Foundation has developed a charitability term sheet as an example of how a foundation structured a particular investment to further its charitable mission and ensure accountability thereto. The example involves investing in a private equity fund(s) targeting activities to provide capital to under-represented and underserved entrepreneurs. That is, those who are of color or are women unable to attract capital from traditional sources because of those characteristics and to entrepreneurs whose companies operate in economically disadvantaged areas.
How does a foundation demonstrate that no significant purpose of the investment is profit-oriented?
There is no requirement that the investment fail or that it does not generate a profit – potentially even at market. The test, rather, is one of intent or purpose. Is this the type of investment that the foundation would make under its own investment policy and investment standards? Will other market participants likely participate on the same terms and conditions? If so, then it is not likely going to satisfy the ‘no significant purpose’ test. Some of the factors that foundations should consider in favor of satisfying this test include:
For PRI Loans and Guarantees:
- a lower than market interest rate;
- no security or weak security;
- subordinate positioning relative to others;
- banks and other commercial lenders are not willing to loan on these terms; or
- the loan is needed as a catalyst for equity investors.
For PRI Equity Investments:
- insufficient commercial investors are willing to invest generally or on these terms;
- high risk investment, with limited liquidity or risky exit; and
- the investment is needed as a catalyst for obtaining loans or other investments.
Complying with this second prong of the PRI elements must be balanced with protecting against others unduly benefiting from the foundation’s positioning. Impermissible private benefits must still be avoided.
Robert A. Wexler; Principal; Adler & Colvin
John E. Tyler III; General Counsel, Secretary, and Chief Ethics Officer; Ewing Marion Kauffman Foundation