Impact Investing and Program-Related Investments:  The Impact on Private Foundation Excise Taxes

Posted on Tue, Nov 20, 2018 ©2021 Drucker & Scaccetti

Kieser2By: Rachel M. Kieser, CPA, MT

 

Over the past few years, you may have heard the term “impact investing” used more frequently in financial- and tax-planning circles.  Impact investors provide funding to for-profit ventures that support social or environmental causes but also produce financial returns.  Individual investors and private foundations alike have been increasingly turning to impact investing to further their missions and make a difference in their communities and beyond.  But, how does this effect private foundations looking to invest?

 

When private foundations are looking to make impact  investments, it is important to consider both the possible excise tax consequences of the investment, as well as the resulting tax  benefit, such as helping the foundation to avoid the excise tax on undistributed income.

 

The Internal Revenue Code imposes several excise taxes on private foundations for engaging in prohibited activities.  For instance, private foundations are prohibited from “self-dealing,” or entering into transactions with disqualified persons, such as substantial contributors and foundation managers.  Foundations are also not allowed to enter into transactions that inure to the benefit of interested persons, make investments that could jeopardize their ability to carry out their exempt purposes, or hold more than 2% of the voting stock and value of another corporation.  When reviewing any prospective investment, it is essential that the foundation managers determine that the investment will not subject the foundation to excise taxes.

 

With respect to income-producing investments, remember that any income from the investment will be subject to the 1% or 2% excise tax on net investment income each year.  Additionally, if the investment produces unrelated business income, it will be subject to the “Unrelated Business Income Tax” or “UBIT” and taxed at either the corporate tax or trust tax rate, depending upon how the foundation was organized.

 

Now we’ll discuss the potential tax-related benefits of impact investing to private foundations. Each year, foundations must distribute 5% of their noncharitable assets to charities or be subject to an excise tax on its undistributed income.  If an impact investment can be treated as a “program-related investment,” any amounts invested in the venture during the year are treated as a distribution towards the 5% required minimum distribution.  Additionally, the value of the impact investment asset is not included in the calculation of the required minimum distribution amount.  As a result, in addition to furthering the foundation’s mission through making the investment, the organization is also able to retain additional funds to invest and use for future grants or other impact investments.

 

Program-related investments are defined by the Treasury Regulations as investments that possess the following characteristics:

  1. The primary purpose of the investment is to accomplish one or more of the foundation’s exempt purposes;
  2. The production of income or the appreciation of property is not a significant purpose of the investment; and
  3. The investment’s purpose is not related to influencing legislation or participating in political campaigns on behalf of candidates.

 

The IRS  has provided several examples of the types of investments that may qualify as program-related investments including:

  1. Low-interest or interest-free loans to needy students;
  2. High-risk investments in nonprofit low-income housing projects;
  3. Low-interest loans to small businesses owned by members of economically disadvantaged groups, where commercial funds at reasonable interest rates are not readily available;
  4. Investments in businesses in low-income areas (both domestic and foreign) under a plan to improve the economy of the area by providing employment or training for unemployed residents; and
  5. Investments in nonprofit organizations combating community deterioration.

 

If your family foundation is considering making a new impact investment and you need assistance with determining the potential excise tax consequences, call on The Tax Warriors® at Drucker & Scaccetti.  With expertise in private foundation tax compliance and planning, we can help you grow your family foundation in the most tax-efficient manner.

 

Topics: UBIT, Private Foundation, Excise tax, impact investing, program related investment, impact investment

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