December 18, 2015
Private foundations, community foundations, and other public charities and nonprofit organizations are seeking different, and sometimes innovative, ways to further their charitable purposes. One area receiving increasing attention is “mission investing,” which is a catchall term often used to refer to a variety of investment options or strategies. These options and strategies include a continuum whose range includes socially responsible investments, impact investments, mission-related investments, and program-related investments. Recent IRS guidance about private foundations’ mission-related investments has heightened the focus and attention on mission investing generally. Many organizations are interested in whether mission investing might be an appropriate tool to further their mission, but questions remain. What is the difference between a “program-related investment” and a “mission-related investment?” How does a board ensure that the use of these strategies is consistent with the board’s fiduciary duties to the organization?
Table of Contents
A Brief History of Mission Investing
Traditionally, many public charities have carried out their exempt purposes through the direct conduct of a charitable program, such as the operation of a soup kitchen or homeless shelter. Other organizations, typically private foundations and community foundations, have traditionally carried out their charitable purposes by making grants to support another organization’s charitable programs. To support their activities, most grant-making organizations, as well as endowed organizations that conduct charitable programs directly, maintain an investment portfolio to provide some or all of their financial support. Operational management of an organization’s charitable programs and grant-making activities is typically conducted separately from the management of the organization’s investment portfolio.
Mission investing consists of strategies connecting an organization’s investment practices to its charitable mission. Depending upon the type of mission investing strategy implemented, an organization may be able to achieve greater public benefits in furtherance of its mission without sacrificing financial returns.
This is an old concept that has seen a recent resurgence in interest. Housing projects in New York were built in the early 1900s with loans provided by wealthy philanthropists. Over 50 years ago, several private foundations implemented program-related investments in the form of loans to support minority business development and housing projects in struggling communities. Socially responsible investing, a form of mission investing, captured headlines in the 1980s when significant anti-apartheid demonstrations led a number of colleges and universities to divest their portfolios from companies engaged in business in South Africa. In the last decade, new forms of legal entities (such as the benefit corporation and the low-profit limited liability corporation, or “L3C”) have been created for the purpose of combining for-profit motives with a broader social benefit.
Today, the concept of mission investing has expanded to include a wide range of activities, such as “socially responsible investing” strategies like screening or shareholder advocacy, program-related investments (PRIs), and mission-related investments (MRIs).
Screening and Shareholder Advocacy
Some organizations have adopted “socially responsible investing” (SRI) principles in an effort to use their financial assets to influence the broader market and support their mission. The most common approaches involve screening investment portfolios and shareholder advocacy.
Screening. Screening is the practice of eliminating or including the stock of certain companies in an organization’s investment portfolio, depending on the relationship between the companies’ activities and the organization’s mission. For example, environmental conservation organizations may decline to invest in companies that produce fossil fuels or engage in logging operations (a “negative screen”) and may choose to specifically include investments in alternative-energy companies or waste-reduction companies (a “positive screen”).
Due to increasing interest in SRI, some investment managers have created investment funds that incorporate SRI principles. Positive and negative screens are often used to select investments in accordance with a fund’s particular goals (which may include a social benefit in addition to traditional investment goals). Because SRI principles have not yet been standardized, it can be difficult to evaluate the performance of an SRI fund (especially in comparison to a more traditional approach).
When considering whether to screen an organization’s portfolio, the directors and officers of the organization must make a decision that is consistent with their duty of care to the organization. The implementation of a screen is an investment decision subject to the standard of care that is required under the Uniform Prudent Management of Institutional Fund (discussed in greater detail below in connection with mission-related investments).
Shareholder Advocacy. In addition to screening, some organizations may use their positions as shareholders of a for-profit company to apply pressure on that company to achieve certain objectives. For example, the organizations may propose corporate resolutions or exercise their voting power in ways that are aligned with their charitable mission. They may also build coalitions with other shareholders to force changes in a corporation’s business model.
The term “program-related investment” (PRI) is a federal tax term arising under the special federal tax rules that apply to private foundations. PRIs are investments used by private foundations to achieve their philanthropic goals. Because PRIs are expected to generate some return or a return of the original investment, they are an alternative or complementary strategy to traditional grants. While PRIs can come in many forms, the typical PRI is a loan or equity investment in an organization that is pursuing a program or activity that furthers the private foundation’s charitable mission. PRIs have been used to fund capital projects, provide loans for economic development, and support the development of new products that provide a public benefit (such as medications or vaccines).
Because PRIs are derived from the special rules that apply to private foundations, PRIs are a tool used almost exclusively by private foundations. PRIs provide certain tax benefits to private foundations for purposes of the strict rules applicable to private foundations. In order to gain those advantages, private foundations must ensure that their PRIs satisfy certain requirements in the Internal Revenue Code. Public charities, including community foundations, are not subject to these private foundation rules and are not required to comply with the private foundation rules.
Definition of “Program-Related Investment.” The term “program-related investment” is defined under the provisions of the Internal Revenue Code (the “Code”) that prohibit a private foundation from making a “jeopardy investment.” The jeopardy investment rules, found in section 4944 of the Code, impose an excise tax if a private foundation invests its assets in a manner that jeopardizes the accomplishment of the foundation’s exempt purposes. Any foundation making a jeopardy investment is subject to an excise tax of 10 percent of the amount invested. Any foundation manager who participated in making the investment knowing that it jeopardized the foundation’s exempt purposes may also be subject to an excise tax, unless the manager’s participation was not willful and was due to reasonable cause.
An investment that meets the definition of a PRI will not be a jeopardy investment. An investment must meet three requirements to qualify as a PRI:
An investment will be made primarily to accomplish one or more exempt purposes if it satisfies two requirements. First, the investment must significantly further the accomplishment of the private foundation’s exempt activities. Second, the investment would not have been made but for the relationship between the investment and the accomplishment of the private foundation’s exempt purposes. It is not necessary for the entity that receives the investment to be a charitable organization. In addition, an investment in a “functionally related business” is considered to be made to accomplish exempt purposes.
In determining whether a significant purpose of an investment is the production of income or the appreciation from property, a relevant consideration is whether for-profit investors would be likely to make the same investment on the same terms as the private foundation. As a result of this requirement, most PRIs are structured with below-market rates of return. The fact that an investment actually produced significant income or appreciation is not, by itself, conclusive evidence of a significant purpose to produce income or appreciation.
The IRS released proposed regulations in 2012 that broadened the examples of PRIs for purposes of the jeopardy investment rules. These new examples of PRIs include the following:
Because PRIs are often made to new or emerging organizations, it is not uncommon for the recipient of a PRI to undergo substantial changes as it grows. A PRI will not cease to be a PRI if such future changes, either to the form of the underlying activity or to the terms of the investment, are made primarily for exempt purposes and not for a significant purpose involving the production of income or appreciation of property. If there is a critical change in circumstances that causes a PRI to lose its status as a PRI, the foundation will not be subject to the jeopardy investment tax before the 30th day after the date on which the foundation (or any of its directors or officers) has actual knowledge of such critical change. If there is a critical change that causes an investment to lose its PRI status, the determination of whether the investment is a jeopardy investment is made under the normal jeopardy investment rules.
Private Foundation Rules and PRIs. PRIs provide private foundations with certain tax advantages in connection with the strict rules applicable to private foundations. As described above, a PRI will not be treated as a jeopardy investment for purposes of the excise tax on jeopardizing investments. In addition, PRIs are (1) counted as “qualifying distributions” for the purposes of the private foundation minimum distribution requirements, (2) excluded from the assets used to determine a private foundation’s distributable amount under the minimum distribution rules, (3) not treated as business holdings for purposes of the private foundation excess business holdings rules, and (4) not taxable expenditures, as long as the private foundation exercises expenditure responsibility where it is required to do so.
Minimum Distribution Requirements. Private foundations must distribute a certain minimum amount each year for exempt purposes to avoid an excise tax on undistributed income under section 4942 of the Code. A private foundation must distribute at least 5 percent of the average fair market value of its noncharitable assets (cash, securities, other investment assets, etc.) each year. The distributions that count toward the minimum distribution requirement (“qualifying distributions”) include any amounts paid to accomplish an exempt purpose and any amount paid to acquire an asset used or held for use directly in carrying out an exempt purpose.
Amounts paid to acquire or make a PRI are treated as qualifying distributions. Additionally, PRIs are not taken into account when determining a foundation’s required minimum distribution because they are not counted as noncharitable assets.
Excess Business Holdings. Private foundations may own a limited percentage of interests in “business enterprises.” If a foundation’s business holdings exceed the limits permitted under section 4943 of the Code, the foundation will be subject to a 10 percent excise tax on the excess holdings. PRIs are not subject to these rules, because PRIs are not considered “business enterprises.”
Taxable Expenditures. Private foundations are prohibited under section 4945 of the Code from making “taxable expenditures.” Taxable expenditures include lobbying-related expenditures, certain grants to individuals, grants to organizations other than public charities, and expenditures for any purpose other than a charitable, religious, scientific, literary, or educational purpose. However, a private foundation may make certain grants, which would otherwise be a taxable expenditure, if the foundation exercises “expenditure responsibility” with respect to the grant.
Most PRIs require the exercise of expenditure responsibility for as long as the foundation holds the investment. Expenditure responsibility is not required if the investment is made through a qualifying public charity or governmental entity, or if the recipient is a foreign organization that provides a sufficient affidavit indicating that the recipient is equivalent to a public charity or private operating foundation.
The IRS rules for expenditure responsibility require a foundation to assure that the PRI is used only for the purpose for which it is made. The foundation is required to obtain full and complete reports on how the PRI funds are spent. The foundation must fully disclose those expenditures to the IRS. The foundation should conduct a pre-investment inquiry into the grantee organization and require a pre-payment written commitment, signed by an officer or director of the grantee organization, which clearly specifies the purpose of the PRI and the reporting and accounting requirements. The commitment should also stipulate that the PRI funds may not be used for any noncharitable purpose.
Other Tax Issues. In addition to these rules, any gain or income generated by a PRI will need to be evaluated for purposes of the net investment income tax, the unrelated business income tax, and the other private foundation rules. For example, the return of principal on a PRI loan may be characterized as a return of capital which may not constitute investment income or unrelated business taxable income but which increases the amount of the foundation’s assets and minimum distributable amount for the year. Depending on the nature of a PRI, payments of interest, dividends, or the receipt of capital gains, may be treated as investment income or unrelated business taxable income. Typically, income generated by a PRI will not be unrelated business taxable income because a PRI will be “substantially related” to the foundation’s exempt purposes.
Finally, private foundations should be mindful of the strict self-dealing rules under section 4941 of the Code. PRIs in entities owned or controlled by a foundation’s disqualified persons could result in significant penalties.
In contrast to PRIs, which are used almost exclusively by private foundations, “mission-related investments” (MRIs) are investment strategies used by a wide range of organizations, including public charities and private foundations. Both MRIs and PRIs may provide an investment return while also providing a social benefit. Like PRIs, MRIs come in many forms including loans and equity investments. However, MRIs may be structured to generate a higher rate of return than PRIs because MRIs, unlike PRIs, are not subject to the requirement that “no significant purpose of the investment may be the production of income or the appreciation of property.”
MRIs and Private Foundations. The IRS recently clarified how private foundations can make MRIs without running afoul of the jeopardy investment rules of section 4944 of the Code. Because MRIs are treated as investments, rather than PRIs, they could potentially be a jeopardy investment. In the past, organizations have questioned whether it is permissible for a private foundation to invest in MRIs that carry lower returns than traditional investments in the same asset class. The concern was that the IRS would view an MRI’s lower return as jeopardizing the long-term financial needs of the investing foundation.
In Notice 2015-62, the IRS clarified that a foundation’s MRI will not be considered a jeopardizing investment if, in making the investment, the foundation’s managers exercised ordinary business care and prudence. The IRS specifically noted that the managers may include in their evaluation of an MRI “all relevant facts and circumstances, including the relationship between a particular investment and the foundation’s charitable purposes.” The Notice makes it clear that “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.”
The other private foundation rules also apply differently to MRIs. While a PRI will count toward a foundation’s minimum distribution requirement, an MRI will not be a qualifying distribution. PRIs are not included when calculating the value of a foundation’s assets for purposes of determining the foundation’s minimum distribution requirement, but MRIs are noncharitable use assets and are included in the asset base for calculating the foundation’s required minimum distribution. An MRI could result in an excess business holding, whereas PRIs are excluded from these rules by definition. MRIs are not subject to the taxable expenditure rules and do not require expenditure responsibility. Finally, MRIs can result in unrelated business taxable income, whereas PRIs typically do not.
MRIs and Unrelated Business Income Tax. The unrelated business income of private foundations and public charities is subject to the federal unrelated business income tax (UBIT). This tax is imposed on certain types of income derived from an unrelated trade or business regularly carried on by a tax-exempt organization. Because PRIs must have an exempt purpose as their primary purpose, they are often substantially related to the exempt purposes of the investing private foundation. For this reason, PRIs do not usually trigger UBIT.
MRIs, on the other hand, are less likely to be treated as substantially related to the exempt purpose of an investing exempt organization. Because MRIs are designed to generate market-rate returns, their exempt purpose is often secondary to the primary purpose of generating return on investment. Income from MRIs will be subject to UBIT unless it falls within one of the exclusions provided by the Code. For example, dividends, interest, or gains generated by an MRI generally would not be subject to tax, whereas operating income from a partnership carrying on a trade or business generally would be subject to tax.
Despite these exceptions, the UBIT rules contain several significant concerns for organizations investing in MRIs. First, income generated by “debt-financed property” will trigger UBIT, even if the income otherwise would be excluded. Second, some income generated by a “controlled organization” will trigger UBIT for the “controlling organization” even if the income otherwise would be excluded. Generally, an organization is controlled if more than 50 percent of its voting stock, value, profits interest, or beneficial interests are owned by a tax-exempt organization (after taking into account the constructive ownership rules). Finally, equity investments in partnerships or limited liability companies may trigger the debt-financed property rule if the recipient organization generates revenue using leverage or borrowings.
MRIs and Fiduciary Duties. While public charities are not subject to the private foundation rules, both public charities and private foundations must consider other applicable laws when considering an MRI. Board members of charitable organizations have fiduciary duties of care, loyalty, and obedience in all aspects of their work on the organization’s behalf. Although the duty of care originated at common law, it is codified with respect to management and investment of an organization’s investment assets in the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which has been adopted in 49 states and the District of Columbia.
Fiduciary Duties. A director has three primary duties to the organization.
Standard of Care in Management and Investment of Institutional Funds. UPMIFA provides detailed rules related to the standard of care for investment management, including delegation of management and investment decisions. The duty of care prescribed by UPMIFA generally requires that each person responsible for the management and investment of a charitable organization’s investment assets:
The responsible persons also must consider the organization’s exempt purposes as well as the particular purposes of a fund and must make management and investment decisions about each asset based on an overall diversified portfolio strategy, with risk and return objectives reasonably suited to the fund and to the institution.
UPMIFA generally prescribes eight factors the directors or officers must consider when making investment decisions:
Thus, in making decisions about whether to acquire or retain an asset, the organization can consider its mission, its current programs, and the desire to cultivate additional donations from a donor, in addition to factors related more directly to the asset’s potential as an investment.
Mission Investing and UPMIFA. Mission investing, described throughout this article, involves a charity using some of its investment assets in ways that specifically advance the charity’s nonprofit purposes while considering all of the factors required by the prudent investor standards of UPMIFA and other applicable law. The investment is chosen both for mission and financial return.
Mission investing may yield returns comparable to a traditional investment approach. But, if a mission investment ultimately produces a financial return lower than what another investment might have produced, the decision to make the investment is still considered prudent if the decision was made in good faith and prudently at the time it was made. This is the approach recently confirmed by the IRS in Notice 2015-62.
Donor Response. As noted above, UPMIFA allows fiduciaries to consider the “impact on donor contributions” of a particular investment decision. The national news regularly has examples of donor reactions to real or perceived failings on the part of a charity. Donors are not likely to react adversely in response to a charity’s failure to invest in a particular asset as long as overall investment performance is satisfactory and the charity maintains a properly diversified portfolio, but donors can quickly reduce or eliminate their support if they learn that the charity is investing in an asset or program that donors perceive as undermining the charity’s mission. In appropriate circumstances, divesting itself of offending investments may be advisable for an organization to maintain its reputation and ability to obtain charitable donations and grants.
Cost Considerations. UPMIFA also requires a charity to minimize costs when managing and investing its institutional funds, stating that the charity “may incur only costs that are appropriate and reasonable in relation to the assets, the purposes of the institution, and the skills available to the institution.” These costs may include those associated with hiring an investment advisor, as long as the costs are appropriate under the circumstances. Board members should pay close attention to fees associated with SRI funds and MRIs.
Mission investing is receiving greater attention in the nonprofit sector. Both private foundations and public charities continue to approach novel investment strategies to leverage their financial assets to achieve charitable objectives. The recent guidance from the IRS affirms that private foundations can make MRIs in addition to traditional PRIs. Additionally, the recent IRS notice indicates the willingness of the IRS to accept that mission investing has a place in investment strategies of charitable organizations. Organizations and their leaders can continue to approach mission investing with enthusiasm as long as they are careful to exercise their fiduciary duties and comply with any applicable federal tax laws.
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