The IRS recently issued final regulations on program-related investments (or PRIs), which bring guidance on these type of investments into the modern era through several examples that illustrate appropriate PRI activity and structure.
As a refresher, the IRS issued proposed regulations back in 2012 that initially laid out nine new PRI examples. In an important update to the 1960s-era regulations, the proposed examples reflected a variety of arrangements (equity investment, below-market loan, deposit and loan guarantee) and charitable endeavors (advancing science, combating environmental deterioration, promoting the arts and poverty relief). They also illustrated certain key principals for PRI activity:
- Foreign activities are charitable if they would be considered to further a charitable purpose if conducted in the United States;
- PRIs are not limited to situations involving economically disadvantaged individuals and deteriorated urban areas;
- PRI recipients need not be within a charitable class if they are the instruments for furthering a charitable purpose;
- A potentially high rate of return does not automatically prevent PRI status for investments; and
- PRIs can be made to a variety of recipients, including individuals, exempt organizations (Section 501(c)(3) as well as others) and for-profit businesses (including LLCs).
The examples are summarized below:
- Example 11: Purchase of common stock in a subsidiary of a drug company in order to induce the company to produce a vaccine, which must be distributed to poor individuals in developing countries at an affordable price.
- Example 12: Purchase of common stock in a business enterprise that collects recyclable waste in developing country (which would otherwise be burned and contribute to pollution and environmental degradation). Business enterprise was able to get a few investors who were concerned about environment, but was unable to get more due to expected low return. Private foundation purchases shares on the same terms as initial investors, and the example indicates there is a potential for a high rate of return if the business is successful.
- Example 13: Same facts as in Example 12, except that the foundation accepts shares of common stock offered as an inducement to make a below market rate loan to the business. The private foundation plans to liquidate stock as soon as business is profitable or it is established it will never become profitable.
- Example 14: Making a below market rate loan to a business that employs low-income individuals in a particular region, after a natural disaster causes extensive damage to the business’ equipment and buildings. The loan is intended to help the business rebuild and continue to employ these individuals.
- Example 15: Making a below market rate loan to two low-income individuals in a developing country, to allow them to start small businesses.
- Example 16: Making a below market rate loan to an LLC that purchases coffee from low-income farmers in a developing country. The loan is to fund the provision of efficient water management, crop cultivation, pest management and farm management training to the low-income farmers by the LLC, which would not otherwise provide this training.
- Example 17: Making a below market rate loan to a 501(c)(4) organization that works to promote the arts, to aid the organization in purchasing an exhibition space within the community.
- Example 18: Making a deposit in a commercial bank in order to induce the bank to lend to a 501(c)(3) child care organization that wants to expand due to demand. The deposit needs to remain at the bank throughout the loan term, and can be accessed by the bank if the child care organization defaults. The private foundation will earn modest return on the deposit.
- Example 19: Same facts as in Example 18, except the private foundation enters into a guarantee arrangement with the bank rather than making a deposit, and will pay the balance due if the child care organization defaults on the loan. The private foundation and the child care organization also enter into an agreement where the child care organization will reimburse the foundation for any amounts paid to the bank under the guarantee agreement.
After receiving comments regarding the proposed regulations, the IRS has finalized the regulations in largely the same format. However, it did make some important clarifications to the examples:
- In Example 11, the IRS has added language making it clear that the subsidiary can also sell the vaccine to those who can afford it at fair market value. The comments to the regulations make clear that this is appropriate since the primary purpose of the PRI is funding scientific research, and no significant purpose is the production of income. This is an important concept for those in the PRI field, who struggle with whether it is permissible to incorporate any fair market value activity into a larger PRI activity.
- In Example 13, involving an equity investment, the IRS removed original language stating that the private foundation investor planned to liquidate stock as soon as the business is profitable or it is established that it will never become profitable. However, the comments do note that an exit condition tied to a foundation’s exempt purpose in making the investment can be an important indicatation that the primary purpose of the investment is furthering exempt prposes. As such, while this is not a required condition, it may still be a recommended one in many circumstances.
- Example 15, involving below-market loans to low-income individuals in a developing country, originally had been framed in the context of a natural disaster. One commenter requested removing that fact, arguing that the loans should be permissible PRIs regardless. The IRS agreed, and removed that language. This is an important clarification, because as practitioners know, this type of PRI loan activity can be applied on a much larger scale than in areas affected by natural disasters, and removing that potentially confusing factor from the regulations is helpful. However, the IRS declined to change “developing country” to “foreign country,” stating in the comments that PRIs are more common in the developing world.
The IRS also declined to make certain requested changes:
- The IRS declined to modify Example 16, involving a PRI loan to an LLC, to make it an equity investment in the LLC. The IRS noted in the comments that when a foundation makes equity investments in LLCs or other entities treated as partnerships for tax purposes, the activities of the entity are attributed to the foundation—this raises a host of issues that the IRS thinks would be better handled through a revenue ruling.
- The IRS declined to add new examples illustrating different types of requested exempt activity (including news media and mixed-income housing), as the regulations aren’t meant to illustrate every type of permissible exempt activity.
- Finally, the IRS declined to modify or add examples expressly addressing PRIs to L3Cs or benefit corporations. The IRS notes that it is already clear that PRIs can be made to for-profits like LLCs and C corporations, and that having an entity elect a form like an L3C or benefit corporation would not be a determinative factor in any example’s conclusion. The IRS also declined to provide a mechanism for requesting approval of a PRI through the Form 8940 or using a process similar to that under Section 4945 (requesting approval of scholarship procedures)—noting that both were outside the scope of the regulations.
Overall, the final regulations continue to move in the direction of providing clarity and updated guidance to those interested in making PRIs. Combined with the guidance on mission-related investments provided late last year, here’s hoping that IRS efforts make more organizations comfortable with venturing into this area.