Finally. On September 15th, the Internal Revenue Service (the “IRS”) issued much anticipated guidance (the “IRS Notice”) that should help facilitate mission-related investing by private foundations organized as corporations. Mission-related investments (“MRIs”), also known as “impact investments,” provide an opportunity for charitable organizations to align their general investment activities – to varying degrees – with their mission. The IRS Notice clarifies that MRIs made by private foundations in a manner consistent with the prudence standards contained in the Uniform Prudent Management of Institutional Funds Act (“UPMIFA”), a version of which is in effect and applicable to nonprofit corporations in most states, should not be considered jeopardizing investments under Section 4944 of the Internal Revenue Code (the “Code”). By harmonizing the approach to prudence under the Code with the definitions found in most state nonprofit corporate law, the IRS has removed a degree of uncertainty that had an impact on the comfort level of some private foundations in making or deciding whether to make MRIs.
Under Code Section 4944 and the related Treasury Regulations, a foundation (and foundation managers) may be subject to excise taxes if the foundation makes an investment without exercising ordinary business care and prudence. The Code requires a foundation to analyze each investment based on the facts and circumstances prevailing at the time of the investment, in light of the portfolio as a whole, with an eye toward the long- and short-term financial needs of the foundation to carry out its exempt purposes. The Regulations provide that foundation managers may consider various factors, including expected return, the risks of rising and falling price levels, and the need for a diverse portfolio, and they subject certain investments perceived as high-risk to increased scrutiny. Program-related investments (“PRIs”) – which are investments made primarily for charitable purposes where the production of income or appreciation of property is not a significant purpose – are an exception to the jeopardizing investment rules. However, other types of MRIs are not similarly protected and it was previously unclear whether and to what extent a foundation could choose to accept a lesser return from an investment that had a strong mission component, but did not otherwise qualify as a PRI. Accordingly, a foundation wishing to make a non-PRI impact investment (theoretically) risked triggering a tax under Section 4944 if it could not justify such investment using a purely “economic” prudence analysis.
While the federal tax law requirements applicable to mission-related investing were often viewed as antiquated, state law has increasingly made room for such investments. The adoption by most states of prudence standards in line with UPMIFA allows foundation managers of nonprofit corporations to consider, among other factors, an asset’s “special relationship or special value, if any, to the charitable purposes of the institution.” Thus, under UPMIFA (including New York’s version of the statute) foundation managers may consider not only economic factors when creating an investment portfolio, but the degree to which individual investments align with the foundation’s mission.
The IRS Notice fixes this disconnect – noting that the list of “facts and circumstances” specified in the Regulations is not exhaustive – and helpfully clarifies that a foundation will not be subject to the jeopardizing investment tax for an investment made in consideration of an asset’s “special relationship or special value” if the investment was made through the exercise of ordinary business care and prudence under applicable state law, even if the investment is expected to yield a lower rate of return than more conventional investments.
The IRS Notice does not impact PRIs, nor does it provide any protection from liability for investments that would be considered imprudent under state or federal law generally. Thus, Section 4944 will still be available as an enforcement tool for the IRS to target egregious and imprudent investing practices.
Private foundations structured as charitable trusts should check applicable state law to determine whether UPMIFA-like standards are available. We note that while the Uniform Prudent Investor Act – the uniform law applicable to charitable trusts – has analogous language, individual states, including New York, may not have gone as far in their own statutes.
So what are the takeaways here? To put it simply, process matters (and is your friend if you want to make impact investments):
- Make sure that your investment policy/statement addresses MRIs in the context of your overall investment strategy and approach, including asset allocation.
- Articulate the general and/or specific aspects of mission alignment that you would like to see in an MRI or an MRI program and develop a process to ensure that such review is captured (and documented) as part of the investment process.
- Make sure the people responsible for sourcing and making MRIs coordinate with your regular investment team (if they are different).
- Lastly, periodically review your investment policy/statement to make sure it is current and reflects the needs (both mission-related and financial) of your foundation.