Charities should pay special attention to two recent events in the area known as “mission” or “impact investing”—terms used to describe the deployment of philanthropic investment capital to advance charitable ends. The first event is the announcement by The Kresge Foundation of its decision to allocate by 2020 up to 10% percent of its investment assets—some $350 million—to mission investing. This represents a real breakthrough for private foundations in the amount they are using to advance their charitable ends.
This announcement is amplified in the context of the other event—new IRS Notice 2015-62 that gives charitable organizations a modern standard to use in their investment decisions. The IRS notice also provides a signal for charitable organizations, particularly private foundations, in how they may use their investment capital in ways that not only elicit a reasonable investment return, but also advance charitable purposes.
Federal tax law compels private foundations to expend about five percent of their average annual asset value for charitable purposes. The approach roughly resembles that of an endowment fund, where the corpus is preserved while the income is expended to advance charitable mission. That means the other approximately 95% of the charity’s assets is dedicated to investment in order to provide for the five percent return for the following year. Various proposals have been made over the years to increase the five percent payout, but the amount has remained constant since the 1969 Tax Act.
But, today’s private foundations are not managed by the bankers of yore. Increasingly they are run by managers who consider themselves social entrepreneurs and impact investors. These new managers now seek to deploy both their five percent payout and other philanthropic assets in a more strategic manner. If they can do mission-related investing, this can strike a balance between the need for income to satisfy the five percent payout and advancing mission by deploying some investments that advance social ends. Housing and health care are two burgeoning areas of mission investing.
Of course, federal tax law generally does not dictate fiduciary duties in the investment of charitable assets; that is a function of state law. From a corporate perspective, the recent wide-spread adoption of the Uniform Prudent Management of Institutional Funds Act (“UPMIFA”) provides a basis for fiduciaries to consider impact investing within the context of their broader duties. But, despite its relative obscurity, the Tax Code’s prohibition of investments that “jeopardize” exempt functions in Section 4944 has had an out-sized effect on private foundations’, and even public charities’, decisions to deploy investment assets in a more focused fashion.
Code Section 4944(a) imposes penalty excise taxes on private foundations and their managers for investing “any amount in such a manner as to jeopardize the carrying out of any of its exempt purposes.” Regulation § 53.4944-1(a)(2)(i) borrows a state law fiduciary standard by providing that an investment jeopardizes the carrying out of exempt purposes if foundation managers, in making such investment, failed to exercise ordinary business care and prudence (under the circumstances prevailing at the time of making the investment) in providing for the long-term and short-term financial needs of the foundation to carry out its exempt purposes.
Program-related investments allowed in Code Section 4944(c) (or “PRIs”) have long been used as a form of mission-related investments. PRIs avoid the prohibition against jeopardy investments and do double duty by qualifying toward the private foundation’s required annual minimum distribution. However, while PRIs are a safe harbor for charitable investments, they have very specific requirements that are not always possible with broader mission-related investments.
Notice 2015-62 answers the question of whether an investment made by a private foundation that furthers its charitable purposes, but is not a PRI (because a significant purpose of the investment is the production of income or the appreciation of property), is subject to tax under Code Section 4944. The Notice does this by connecting the state-law fiduciary considerations of UPMIFA with the avoidance of jeopardy investments under Code Section 4944.
The Notice clarifies that, although the Regulations list some factors that managers generally consider when making investment decisions, they do not provide an exhaustive list of facts and circumstances that may properly be considered. In a nod to the state-law standards under UPMIFA, foundation managers may consider all relevant facts and circumstances when exercising ordinary business care and prudence in deciding whether to make an investment. That includes the relationship between a particular investment and the foundation’s charitable purposes. So foundation managers are not required to select only investments that offer the highest rates of return, the lowest risks or the greatest liquidity, so long as the managers exercise the requisite ordinary business care and prudence under the facts and circumstances prevailing at the time of the investment in making investment decisions that support, and do not jeopardize, the furtherance of the private foundation’s charitable purposes.
Importantly, the Notice states as a legal conclusion that this standard under Code Section 4944 is “consistent with investment standards under state laws, which generally provide for the consideration of the charitable purposes of an organization or certain factors, including an asset’s special relationship or special value, if any, to the charitable purposes of the organization, in properly managing and investing the organization’s investment assets.” That conclusion recognizes the congruence between the state law fiduciary standard for investing and federal tax law requirements, despite the fact that state law standards do indeed differ.
Of course, private foundations (and even public charities) wishing to pursue a more holistic investment approach through mission investing should carefully review their investment policy to assure that both state and federal legal standards are satisfied. But now, for mission investments that do not meet the legal requirements for PRIs, foundations can meet the new requirements by having documentation that relates their decision-making to both the relevant legal standards and the charitable mission of the institution.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.