Program-related investments (“PRIs”) are closely tied to the topic of social enterprise and hybrid entities, the subject of past posts. This is because one particular type of entity, the low profit limited liability company (“L3C”), was designed largely around the key concept of a PRI in order to appeal to private foundation funders. This post will explore PRIs generally, including recent developments in the area, as well as explain the connection between the PRI and L3C.
Basic PRI Requirements
To backtrack a little, private foundations are a subset of 501(c)(3) tax-exempt entities, and are subject to certain rules and requirements that public charities (another subset of 501(c)(3) tax-exempt entities) are not. Among these are the rules under section 4944 of the Internal Revenue Code prohibiting jeopardizing investments, which specifically provide that a program-related investment is not a jeopardizing investment.
In order to qualify as a program-related investment, three requirements must be met:
- the investment must have as a primary purpose the accomplishment of one or more of the foundation’s charitable purposes;
- the investment cannot have as a significant purpose the production of income or appreciation of property; and
- the investment cannot have as any purpose the influencing of legislation or participation in a political campaign.
However, it is important to note that charities other than private foundations may look to the rules around program-related investments to help guide similar investments they make that are program- or mission-focused. In addition, the PRI is not a new tool, but has gotten a lot of attention during the economic downturn and as more people and organizations explore social enterprise and related concepts.
Uncertainty Has Impeded Use
The most common structures for PRIs are interest-free or below-market loans, though they can also take the form of loan guarantees, letters of credit, and equity investments. Because a PRI generally is intended to be repaid, unlike a grant, it allows a private foundation to recoup its initial charitable investment, as well as potentially obtain a return on its investment. This can allow a foundation to increase its own charitable expenditures by using the returned funds for other charitable activities.
However, despite the PRI’s flexibility and the opportunity it allows for advancing charitable purposes, it is still not widely used. This is likely due to an overall impression within the charitable sector that PRIs are complex, difficult to administer, and may run afoul of relevant law. Some mistakenly believe that a private letter ruling from the IRS (a process that can cost upward of $50,000) is required in order to undertake a PRI. Also adding to the uncertainty around PRIs is the fact that the PRI examples included in the regulations are fairly limited, and focus largely on community development of deteriorated urban areas.
New Regulations Bring More Clarity
However, the IRS recently proposed new regulations that contain nine new examples that help shed light on what qualifies as a PRI. The new examples provide an important update to the current regulations, and reflect 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 illustrate certain principals that will be of interest to private foundations, including:
- 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 (501c)3) as well as others) and for-profit businesses (including LLCs).
The examples are summarized below:
- Example 11: Purchase of common stock in a business enterprise in order to induce the enterprise 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.
The Connection Between L3Cs and PRIs
The L3C concept was developed with the PRI regulations in mind, and though state laws adopting the form vary somewhat, in essence the L3C requires that the entity significantly furthers the accomplishment of one or more charitable or educational purposes within the meaning of the relevant Internal Revenue Code provisions, and would not have been formed but for the accomplishment of those purposes; does not have as a significant purpose the production of income or appreciation of property; and has no purpose to accomplish political or legislative purposes. These requirements track the PRI regulations very closely.
Critics of the L3C form have pointed out that for-profit entities (including standard LLCs) currently can receive PRIs from private foundations if the regulatory requirements are met, and that there is nothing about the L3C form that inherently makes it a more suitable recipient of PRIs. Additionally, the fact that the L3C statutes apply PRI-type restrictions at the entity level does not free a private foundation from looking at the investment itself and determining that it qualifies as a PRI. Finally, the focus on tranched investment—with private foundations taking on the most risk and enabling more favorable investment terms for private parties—can implicate issues of private benefit and inurement.
However, the debate around this issue has certainly increased public awareness of PRIs themselves, and the benefits that can go along with using them. As larger organizations, such as the Bill and Melinda Gates Foundation, increasingly utilize PRIs as part of their charitable activities, it can be hoped that more organizations will be willing to give PRIs a try.