Family Office Corner: Family Foundations, Impact Investing and the Tax Laws

While family foundations commonly advance their charitable missions through their grant-making, many are exploring how to make a similar impact through their investments. Harvard Business School’s Project on Impact Investing notes that “impact investing has become a central, rapidly expanding part of the investment landscape in the United States and across the world.” Family foundations are embracing this new landscape, and the federal tax laws provide quite a bit of flexibility for them to engage, particularly with respect to so-called program-related investments, which are treated similarly to grants. The following explores the tools available to family foundations that are contemplating impact investments and the associated tax law considerations.

What Are Impact Investments?

The Global Impact Investing Network, a network of organizations dedicated to increasing the scale and effectiveness of impact investing around the world, defines impact investments as those “made with the intention to generate positive, measurable social and environmental impact alongside a financial return.” Foundation impact investing can take a variety of forms, including socially responsible investing through the use of investment screens, mission-related investments and program-related investments. 

Socially Responsible Investing and Screens

Screens are essentially filters that help identify acceptable investments based on established parameters. Foundations can invest for impact by using mission-aligned screens to determine which companies or sectors should or should not be included in their investment portfolios. For example, a foundation focused on combating climate change could use a negative screen to construct an investment portfolio that prevents the foundation from investing in the oil and gas industry. Alternatively, a foundation may work with an investment advisor to implement positive screens that enable the foundation to build an investment portfolio with companies that have strong reputations for their governance, environmental and/or labor practices.

Mission-Related Investments and Program-Related Investments

In addition to screens, a family foundation may identify specific impact investment opportunities and then structure them as mission-related investments or program-related investments. 

Mission-Related Investments. Mission-related investments are subject to all the same tax law considerations as a foundation’s traditional investments, including the rules on prudent investing and the unrelated business income tax. The mission focus, however, enables a foundation to still meet prudent investing standards even if the financial returns are slightly lower than those of traditional investments in the portfolio. As a mission-related investment, a foundation may decide to invest, for example, in a fund exclusively supporting early-stage companies focused on clean technology, renewable energy and sustainable living. Although for-profit investors are also investing in the fund and there is a strong potential for financial upside, there is investment risk associated with startup companies. Accordingly, a foundation may decide to characterize this investment as mission-related to clarify that the mission tie provides the basis for investment prudence despite the associated risk. 

Program-Related Investments. Unlike mission-aligned screening programs and mission-related investments, program-related investments fall outside the prudent investing standards, allowing a foundation to take on even greater risk. They can be made in a variety of forms—including loans, equity and convertible debt—and to various types of entities, including other 501(c)(3) organizations and startup companies. To qualify under the tax rules, the investment must satisfy the requirements of Internal Revenue Code (IRC) Section 4944(c), which defines “program-related investment” as an investment that (1) has as its primary objective the accomplishing of one or more charitable purposes, (2) does not have as a significant purpose the production of income or the appreciation of property and (3) does not participate in or seek to accomplish lobbying or campaign activities. Foundations also must impose obligations on a program-related investment recipient to ensure compliance with these requirements.

So, for example, if a foundation supports higher education access for low-income communities, it could make an equity investment in a startup company providing tutoring software to community colleges. However, to ensure that this investment advances the foundation’s charitable purposes, the foundation would need to enter into a side letter with the company requiring that the tutoring platform be made available for free to community colleges located in low-income communities. 

Tax Law Considerations 

The primary tax law consideration in impact investing is avoiding “jeopardizing investments”—investments that jeopardize the carrying out of the foundation’s tax-exempt purposes, which are subject to a 10% excise tax on the invested amount. The Treasury regulations provide that an investment jeopardizes the carrying out of a foundation’s tax-exempt purposes if the foundation managers, “in making such investment, have failed to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long- and short-term financial needs of the foundation to carry out its exempt purposes.” IRS guidance relies on state law for evaluating prudence, so foundations should ensure that their impact investments meet applicable state standards. 

In this regard, program-related investments receive more favorable tax treatment in certain aspects compared with mission-related investments and those involving mission-aligned screens. For example:

• Program-related investments fall under an exception to the excise tax on jeopardizing investments and also are often eligible for a similar exception to prudent investing standards under state laws.
• Program-related investments are treated like grants, and the amount of a program-related investment is excluded from the definition of “net investment income” that is subject to tax under IRC Section 4940. 
• With the exception of recaptures, program-related investments are not counted in the calculation of a foundation’s payout requirement under IRC Section 4942 and are treated as qualifying distributions for these purposes. 
• Program-related investments are not subject to the tax on excess business holdings under IRC Section 4943. 

Foundations, however, must exercise “expenditure responsibility” over program-related investments made to recipients that are not Section 501(c)(3) public charities. Expenditure responsibility generally requires the foundation to (1) see that the grant is spent solely for the purpose for which it is made, (2) obtain full and complete reports from the recipient on how the funds are spent and (3) make full and detailed reports on the program-related investment to the IRS. The expenditure responsibility rules also require foundations to enter into an agreement with the recipient of a program-related investment that must include specific obligations regarding the use, recordkeeping and reporting of the foundation’s funds. 

Developing an Impact Investing Program

Family foundations seeking to develop an impact investing program should consult with outside advisers, including investment advisers and legal counsel, to ensure that impact investments are evaluated and made in the context of the foundation’s overall investment portfolio. Additional steps for creating and implementing an impact investment approach also should include the following:

• The foundation’s board of directors (or board of trustees) and its investment committee, as applicable, should make the decision to engage in impact investing and ensure the decision is addressed in the foundation’s investment policy. 
• The foundation should develop a process and document its procedures for evaluating opportunities, tracking the impact investments and ensuring compliance with the tax laws and any applicable state law prudent investing standards. 
• The foundation should follow the same due diligence procedures for impact investments that it uses for traditional investments, while incorporating additional measures to address mission ties and/or the advancement of charitable purposes. For program-related investments, the foundation should coordinate its consideration of these investments with the determination that, as program-related investments, they fall outside the foundation’s traditional investment standards. This determination helps demonstrate that, as required by the tax laws, no significant purpose of the program-related investment is the production of income or the appreciation of property. 
• The foundation may want to develop template documents, such as loan agreements or side letters, to ensure that it appropriately addresses the various tax law considerations. 
• The foundation may consider obtaining a tax opinion that an investment qualifies as a program-related investment. Reliance on such an opinion can provide a basis for the foundation to avoid excise taxes under IRC Section 4944(a) if the IRS subsequently determines on audit that the investment did not qualify as a program-related investment.

Finally, as family foundations embrace impact investing, the sponsoring organizations of donor-advised funds are also increasingly supportive of impact investing and should be consulted regarding any interest in employing impact investing strategies through a donor-advised fund.