How Private Operating Foundations Use Program- Related Investments As Qualifying Distributions

PRIVATE FOUNDATIONS

HOW PRIVATE OPERATING FOUNDATIONS USE PROGRAM- RELATED INVESTMENTS AS QUALIFYING DISTRIBUTIONS

BRIGIT KAVANAGH, ESQ. AND JANE M. SEARING, CPA An exception to the jeopardizing investment rules Background and definitions under Section 4944(c) allows a private foundation Non-POF private foundations. By default, all domes - to make an investment that might otherwise jeop - tic or foreign organizations described in Section ardize the private foundation’s ability to achieve its 501(c)(3) are private foundations, and it is only by exempt purposes. Such program-related invest - satisfying one of several tests that the organization ments (PRIs), are allowed only if (1) the primary avoids private foundation status. 6 Non-operating purpose of the investment is to accomplish one or private foundations (non-POF) are subject to the more charitable purposes, (2) neither the produc - strict set of laws found in Chapter 42 of the Code. tion of income nor the appreciation of property is a These include the excise taxes on net investment significant purpose of the investment, and (3) nei - income, self-dealing, the failure to distribute in - ther influencing legislation nor participating or in - come, excess business holdings, jeopardizing in - tervening in a political campaign on behalf of or in vestments, and taxable expenditures. 7 In addition, opposition to any candidate for public office is a the income tax charitable contribution deduction purpose of the investment. PRIs are treated as limit for gifts to a non-POF foundation is less favor - grants, 1 and allowed as qualifying distributions of able than for gifts to public charities. 8 the investor private foundation 2 when the distribu - tion is made. 3 Non-POF qualifying distributions. Non-POF foun - Private operating foundations (POFs) must make dations must distribute a certain amount of their a certain amount of qualifying distributions directly assets each year on expenditures that constitute for the active conduct of activities constituting the qualifying distributions. Qualifying distributions POF’s charitable, educational, or other similar ex - are defined generally as amounts paid to accom - empt purposes. 4 Generally, the POF must use such plish charitable purposes, capital purchases to car - qualifying distributions itself rather than by or ry out the organization’s exempt purpose, and through one or more grantee organizations. 5 reasonable and necessary administrative expenses Because PRIs are used by the recipient organiza - to accomplish the private foundation’s charitable tion, akin to a grantee organization, a question arises purposes. 9 Non-POF qualifying distributions are regarding when, if ever, a POF’s PRI will be treated calculated on the cash method of accounting. as a qualifying distribution made directly for the ac - The amount the non-POF foundation must spend is tive conduct of activities, and countable toward the its “distributable amount,” which is roughly equal to 5% POF’s satisfaction of the private operating founda - of the foundation’s average non-charitable use asset bal - tion tests. ance of the prior year. 10 While non-POF foundations can engage in direct charitable activities, and many do, non-POF foundations generally spend the distributable BRIGIT KAVANAGH is a founding partner in the California law firm of Kavanagh Rhomberg LLP and an adjunct professor in the Golden amount on making grants to support the programs of Gate University School of Law LL.M. program. JANE M. SEARING is other organizations. All qualifying distributions are a tax shareholder at Clark Nuber PS in Bellevue, WA, where she leads the tax-exempt organization group. counted, whether the activities supported by the non-

JULY/AUGUST 2017 taxation of exempts 39 from a non-POF foundation. As described below, EXHIBIT 1 the required distribution amount is calculated using Data for Hypo 1 POF (Example 1) the “income test” and one of three alternative tests. The penalty for failure to meet the distribution require- Non-charitable use assets $ 1,000,000 ments of a POF is reversion to non-POF status and Adjusted Net Income (Page 1, Part I, Line 27c) $ 30,000 the potential to fail the 5% minimum distribution Minimum Investment Return requirement under Section 4942(d). Like a non-POF (Page 8, Part X, Line 6) $ 50,000 foundation, POF qualifying distributions are calcu- Qualifying Distributions lated on the cash method of accounting. In addition, (Page 8, Part XII, Line 4) $ 40,000 the income tax charitable contribution deduction for gifts to a POF is the enhanced deduction limit POF’s grants are conducted by the non-POF founda- available for gifts to public charities.13 tion or by one or more grantees of the non-POF foundation. Failure to spend the entire distributable amount Qualifying as an operating foundation. As described results in an excise tax on the undistributed portion. above, to qualify as an operating foundation, a POF Non-POF foundations must spend the distrib- must meet one mandatory test, the “income test,” and utable amount by the close of the following tax year.11 one of three alternative tests—the “assets test,” the That is, the distributable amount for a given year is “endowment test,” or the “public support test.” based on the asset balance of the prior year. The income test requires a POF to spend substantially all (defined as 85%14) of the lesser of the POF’s Where to find this on Form 990-PF. POFs and Non- adjusted net income (ANI) or its minimum invest- POF foundations both use Form 990-PF (Return ment return (MIR) on direct charitable activity.15 of Private Foundation) to report that they are meet- Stated differently, first look at the POF’s ANI and its ing the distribution requirements under Section MIR. Then take the lesser of the two and multiply that 4942. There is some overlap in the way the two number by 85%. The POF must spend at least that types of foundations approach the form, but there much in qualifying distributions for direct charitable are also differences. The following sections on the activities to satisfy the income test.16 If the POF’s qual- Form 990-PF relate to calculating non-POF quali- ifing distributions are greater than its MIR, or if MIR fying distributions: is less than ANI, the rule is slightly different and often • Page 8, Part X (“Minimum Investment Return”). overlooked, as the difference is not highlighted in • Page 8, Part XI (“Distributable Amount”). Form 990-PF.17 All POFs must satisfy the income test. • Page 8, Part XII (“Qualifying Distributions”). Next, the POF must satisfy one of the three alter- • Page 9, Part XIII (“Undistributed Income”). native tests: 1. The assets test is satisfied if substantially more than Private operating foundations. In many ways, a POF half (defined as 65% or more18) of the POF’s assets works just like a non-POF foundation. A POF is are devoted directly to the foundation’s direct char- equally subject to the operating restrictions found itable activities, to functionally related businesses,19 in Chapter 42, with one significant exception: Section or to both.20 In other words, the POF will satisfy the 4942 qualifying distributions. A POF is not subject assets test if more than 65% of its assets are chari- to the excise tax for failure to distribute income under table use assets or functionally related businesses. Section 4942.12 Instead, a POF’s qualifying distribu- 2. The endowment test is satisfied if the POF normally tions must constitute direct charitable activity qual- makes qualifying distributions for direct charitable ifying distributions (discussed below) and the amount activity in an amount not less than two-thirds of the a POF must spend each year is calculated differently foundation’s MIR,21 or roughly 3.3% of the POF’s

1 12 Reg. 53.4945-4(a)(2). Section 4942(a)(1). 2 13 Reg. 53.4942(a)-3(a)(2). Section 170. 3 14 Reg. 53.4942(a)-3(a)(1). Reg. 53.4942(b)-1(c). 4 15 Reg. 53.4942(b)-1(a). Section 4942(j)(3)(A). 5 16 Reg. 53.4942(b)-1(b)(1). Id. 6 17 Section 509(a). Section 4942(j)(3)flush language and Reg. 53.4942(b)-1(a)(1)(ii). If 7 Sections 4940-4945, respectively. the POF’s qualifying distributions are greater than its MIR but less 8 Section 170(b), Section 170(e). than ANI, then at least 85% of the POF’s qualifying distributions 9 must constitute direct charitable activity. However, if the POF’s MIR Section 4942(g)(1)(A) and (B). 10 is less than its ANI and the POF’s qualifying distributions are equal Section 4942(d). to or greater than ANI, then only the portion of qualifying distribu- 11 Section 4942(a). tions equal to 85% of ANI must constitute direct charitable activity.

40 taxation of exempts JULY/AUGUST 2017 PRIVATE FOUNDATIONS EXHIBIT 2 Form 990-PF Extract for Hypo 1 POF (Example 1)

average asset balance for the year. The endowment planning challenges as it is impossible to know the test is the test POFs tend to meet most frequently. ANI and the MIR for a year prior to the end of that 3. The support test is satisfied if the POF is receiving year. There is some relief, however, in that a POF may a specified level of public support from the general meet the tests either on a three-out-of-four-years public and other exempt organizations. 22 It is very basis, or on a four-year aggregation basis. 24 A new or - unusual for a POF to meet this test. It is comprised ganization generally must satisfy the tests in its first of three sub-tests, all of which must be met. year, and must use the aggregation basis to satisfy the tests in its second and third tax years of existence. 25 Practice tip. While all foundations’ assets are irrevoca - bly dedicated to charitable purposes, the assets test Qualifying distributions for direct charitable activity. looks at the value of foundation’s assets actually being To qualify as a POF, the foundation must make qual - used in the foundation’s charitable programs. The ifying distributions “directly for the active conduct of foundation’s assets held purely for investment are not the activities constituting the purpose or function for included. To calculate whether a POF satisfies the as - which it is organized and operated.” 26 This frequently sets test, divide the value of the foundation’s charita - 18 ble use assets by the foundation’s total assets. Examples Reg. 53.4942(b)-2(a)(5). 19 of the kinds of assets allowed as charitable use assets in Reg. 53.4942(a)-2(c)(3)(iii). A functionally related business is one that is not an unrelated trade or business, or an activity that is the assets test are a museum building and its collection, not carried on either within a larger aggregate of similar activi - a scientific laboratory, a library, and intangible assets ties or within a larger complex of other endeavors related to the charitable, educational, or other similar exempt purpose of the such as patents, copyrights, and trademarks. foundation. 20 Section 4942(j)(3)(B)(i). 21 Section 4942(j)(3)(B)(ii). Timing. In contrast to a non-POF foundation, a POF 22 Section 4942(j)(3)(B)(iii). must make its qualifying distributions by the close of 23 23 Section 4942. 24 the current tax year. That is, the amount a POF must Reg. 53.4942(b)-3(a). 25 distribute in a given year is based on the assets and in - Reg. 53.4942(b)-3(b)(1). 26 come of the POF for that current year. This can pose Section 4942(j)(3).

PRIVATE FOUNDATIONS JULY/AUGUST 2017 taxation of exempts 41 EXHIBIT 3 Form 990-PF Extract #1 for Hypo 2 POF (Example 2)

is referred to as direct charitable activity. The regula - • Page 1, column (c) (“Adjusted Net Income”). tions define direct charitable activity as follows: • Page 8, Part XII (“Qualifying Distributions”). [Q]ualifying distributions are not made by a founda - tion “directly for the active conduct of activities con - stituting its charitable, educational, or other similar ex - Putting it together so far empt purpose”‘ unless such qualifying distributions The challenge, therefore, is understanding which of are used by the foundation itself, rather than by or through the POF’s activities constitute direct charitable activ - one or more grantee organizations which receive such qual - ifying distributions directly or indirectly from such foun - ity, and then tracking them accordingly. dation. us, grants made to other organizations to as - sist them in conducting activities which help to accom - Example 1. Hypothetical Foundation (“Hypo 1 plish their charitable, educational, or other similar ex - POF”) was formed on 1/1/16 and is a POF. Hypo empt purpose are considered an indirect, rather than 1 POF does not hold significant charitable use as - direct, means of carrying out activities constituting the charitable, educational, or other similar exempt pur - sets and does not receive support from the general pose of the grantor foundation, regardless of the fact public. In 2016, Hypo 1 POF made grants totaling that the exempt activities of the grantee organization $6,000. Hypo 1 POF’s finances for the 2016 tax may assist the grantor foundation in in carrying out its 27 year are as shown in Exhibit 1. own exempt activities. (Emphasis added.) The extract from Hypo 1 POF’s Form 990-PF, Stated plainly, to count as a distribution for direct shown in Exhibit 2, illustrates how Hypo 1 POF sat - charitable activity, a POF must use the distribution isfies the POF tests. for its own programs and not merely to support the First, because Hypo 1 POF is a private operating programs of another organization. Support for the foundation, it must satisfy the income test. Second, be - programs of another organization typically involves cause Hypo 1 POF does not have significant charitable a grant to the beneficiary organization. Grants, with - use assets, it will not satisfy the assets test. Similarly, be - out the significant involvement described below, do cause Hypo 1 POF does not have public support, it will not count as direct charitable activity. Similarly, PRIs, not satisfy the support test. Hypo 1 POF must there - described more fully below, are debt or equity invest - fore satisfy the endowment test. As a new foundation, ments used by the investee organization, not directly it is required to meet the tests by the close of year one. by the POF. As with grants, a PRI will not ordinarily Exhibit 2 shows that to satisfy the income test, constitute direct charitable activity. Hypo 1 POF needed to spend at least $25,500 on di - rect charitable activity qualifying distributions (Line Where to find this on Form 990-PF. As stated above, 2b). To satisfy the endowment test, Hypo 1 POF POFs and non-POF foundations both use the Form needed to spend at least $33,500 on direct charitable 990-PF to report that they are meeting the distribu - activity qualifying distributions (Line 3b). tion requirements under Section 4942. POFs report Exhibit 2 also shows Hypo 1 POF’s total qualifying their direct charitable activity qualifying distributions distributions for the year of $40,000 (Line 2c). How - on Form 990-PF, Page 10, Part XIV. The following ever, the $6,000 of grants, which do not constitute di - sections on the Form 990-PF relate to calculating the rect charitable activity, must be subtracted from total POF qualifying distributions: qualifying distributions (Line 2d). This results in di - • Page 8, Part X (“Minimum Investment Return”). rect charitable activity qualifying distributions of

42 taxation of exempts JULY/AUGUST 2017 PRIVATE FOUNDATIONS EXHIBIT 4 Form 990-PF Extract #2 for Hypo 2 POF (Example 2).

$34,000 (Line 2e). This is greater than the amounts grantee (or investee) organization. Thus, PRIs ordi - needed to satisfy the income and endowment tests. Ac - narily do not constitute direct charitable activity and cordingly, Hypo 1 POF will qualify as a POF in 2016. will not be included in the POF’s expenditures made directly for the active conduct of exempt activities, Practice tip. Many POFs make grants in addition to unless the POF retains “significant involvement,” actively conducting programs. It is important to sub - described below. Disbursements for a PRI appear on tract any grantmaking or other expenditures that do Page 7, Part IX-B of the Form 990-PF in the year the not constitute direct charitable activity from the investment is made. The total for all PRIs made dur - amount shown on Line 2c, as illustrated in Exhibit 2. ing the year is carried forward to Page 8, Part XII, Line 1b for Qualifying Distributions. Unless the require - Program-related investments ordinarily do not con - ments for significant involvement are met, a POF stitute direct charitable activity. As described above, must subtract the PRI amount from its qualifying dis - private foundations, including POFs, are subject tributions for the active conduct of exempt activities to an excise tax on investments that jeopardize the on Part XIV, line 2d. This is illustrated in Exhibits 3 foundation’s ability to conduct its charitable pro - and 4 . grams. 28 An exception is made for an investment satisfying the requirements of a program-related Example 2. The facts surrounding Hypothetical 2 investment. 29 Among other requirements, the pri - Foundation (“Hypo 2 POF”) are the same as those mary purpose of the investment must be to accom - for Hypo 1 POF, except that Hypo 2 POF makes plish one or more charitable purposes. 30 27 Reg. 53.4942(b)-1(b)(1). 28 The intersection of PRIs and grants. Under the Reg - Section 4944(a). 29 Section 4944(c). ulations, program-related investments count toward 30 31 Id. qualifying distributions and they are treated as 31 32 Reg. 53.4942(a)-3(a)(2)(i). 32 grants under Section 4945. As also noted above, Reg. 53.4945-4(a)(2). 33 expenditures for direct charitable activity generally Reg. 53.4942(b)-1(b)(2). 34 mean those used by the POF and not by or through a Reg. 53.4942(b)-1(b)(2)(ii).

PRIVATE FOUNDATIONS JULY/AUGUST 2017 taxation of exempts 43 $60,000 in qualifying distributions (Part XII, Line such as a partnership or limited liability company, can 4); of that, $20,000 is for a PRI (Part XII, Line 1b) qualify for significant involvement. However, Ltr. Rul. and $6,000 is for a grant (Part I, Line 25, not shown ). 9834033 and Ltr. Rul. 200431018, discussed below, Illustrated in Exhibit 3. involve a POF that made grants and investments to a Unless Hypo POF retains “significant involve - limited liability company. The Service concluded that ment” in the PRI (described below), the $20,000 PRI the POF had maintained significant involvement in is pulled out of Hypo POF’s direct charitable activity both instances. qualifying distributions (Part XIV, Line 2d). Illus - Reg. 53.4942(b)-1(b)(2)(i) continues by explain - trated in Exhibit 4. ing determination as to whether significant involve - ment is present depends upon the facts and circumstances of each instance. Significant involvement In limited situations, a POF’s grants to individuals Whether the making or awarding of grants, scholar - ships, or other payments constitutes qualifying dis - and PRIs will count toward its direct charitable ac - tributions made directly for the active conduct of the tivity qualifying distributions if the POF retains a foundation’s exempt activities is to be determined on “significant involvement” in the grant or PRI. 33 Such the basis of the facts and circumstances of each par - grants and investments will be treated as qualifying ticular case. e test applied is a qualitative, rather than distributions made directly for the active conduct of a strictly quantitative one. erefore, if the founda - tion maintains a significant involvement … it will not exempt activities. As the phrase suggests, “significant fail to meet the general rule … solely because more of its funds are devoted to the making or awarding of grants, scholarships, or other payments than to the PRIs are treated as grants, and allowed as active programs which such grants, scholarships, or qualifying distributions of the investor private other payments support. [emphasis added]. foundation when the distribution is made. Reg. 53.4942(b)-1(b)(2)(i) goes on to state that if the foundation does nothing more than “select, involvement” requires that the POF be more than a screen, and investigate” applicants for grants or passive grantmaker or investor; instead, the POF scholarships, and if the recipients will simply work or must be so involved in the grant or investment that study either alone or exclusively under the direction the grant or investment is considered a direct char - of some other organization, said grants or scholar - itable activity of the POF. Reg. 53.4942(b)-1(b)(2)(i) ships will not be treated as qualifying distributions provides: made directly for the active conduct of the founda - tion’s exempt activities. The one exception is for the If a foundation makes or awards grants, scholarships, administrative expenses of the screening and investi - or other payments to individual beneficiaries ( in - cluding program-related investments within the gation. Such administrative expenses may be treated meaning of section 4944(c) made to individuals or cor - as qualifying distributions made directly for the ac - porate enterprises ) to support active programs con - tive conduct of the foundation’s exempt activities. ducted to carry out the foundation’s charitable, ed - The regulations describe two methods of satisfy - ucational, or other similar exempt purpose, such ing the significant involvement requirement, each grants, scholarships, or other payments will be 34 treated as qualifying distributions made directly for with three elements. the active conduct of exempt activities … only if the The first method involves an operating founda - foundation, apart from the making or awarding of tion that has as an exempt purpose the relief of the the grants, scholarships, or other payments, other - poor or distressed. To qualify as significant involve - wise maintains some significant involvement … in ment, all of the following three criteria must be met: the active programs in support of which such grants, scholarships, or other payments were made • An exempt purpose of the POF is the relief of or awarded [emphasis added]. poverty or human distress and its exempt activi - ties are designed to ameliorate conditions among First, note that Reg. 53.4942(b)-1(b)(2)(i) discusses a poor or distressed class of persons or in an area program-related investments made to “individuals” subject to poverty or national disaster. or to “corporate enterprises.” It is silent on whether a • e private operating foundation makes grants program-related investment in a pass-through entity, directly to poor or distressed persons without an intervening organization.

35 • e private operating foundation maintains a staﬀ Reg. 53.4942(b)-1(b)(2)(ii)(A). 36 Reg. 53.4942(b)-1(b)(2)(ii)(B). (salaried or volunteer) of qualified individuals 37 Id. who supervise and direct the activity on a contin - 38 Leckie Scholarship Fund, 87 TC 251 (1986), acq. 1987-2 CB 1. uing basis. 35

44 taxation of exempts JULY/AUGUST 2017 PRIVATE FOUNDATIONS The second method of retaining significant in - tours, and compiled data and statistics to promote volvement requires that all of the following three cri - the county as a desirable place to live and work. teria be met: The Tax Court found that this level of involve - • e private operating foundation has some spe - ment far exceeded the “mere selection, screening, cialized skill or expertise in a particular area (e.g. and investigation” of applicants to the Fund, and medical research, social work, etc.). held that the Fund maintained significant involve - • e private operating foundation maintains a ment in the grants. 38 salaried staﬀ who supervise or conduct programs If the facts of the case had differed in a single re - or activities that support the private operating gard—the Fund making PRI loans to the students foundation’s work in this area. • As part of that program, the private operating foundation makes payments to encourage the re - Private operating foundations (POFs) cipient’s involvement in the POF’s particular area must make a certain amount of qualifying of interest and programs. 36 distributions directly for the active In both methods, the POF is directly carrying out conduct of activities constituting some portion of the charitable programs. For in - the POF’s exempt purposes. stance, a POF’s program to make grants to individu - als qualifies as direct charitable activity where “the rather than grants—it is reasonable to conclude that recipients, in addition to independent study, attend the PRIs would also have been considered direct classes, seminars, or conferences sponsored or con - charitable activity because the Fund retained signifi - ducted by the [private operating] foundation.” 37 cant involvement in them.

Practice tip. While in some situations a POF’s in - Ltr. Rul. 9826048. The POF in Ltr. Rul. 9826048 volvement in a functionally related business (dis - sought a ruling that its proposed economic devel - cussed above in connection with the assets test) could opment program would qualify as a PRI, and that give rise to direct charitable activity, this is not always the PRI distributions made pursuant to the pro - true. Whether PRIs made to a functionally related gram would constitute distributions for the active business constitute direct charitable activity turns on conduct of a charitable program because the POF whether the POF has retained significant involve - maintains significant involvement in the invest - ment in the investment. ments. The POF planned to make investments (such as loan guarantees, loans, and equity invest - ments) and to offer financial assistance (such as Relevant rulings and holdings deposit insurance to financial institutions and busi - The following rulings deal with significant involve - nesses). The POF’s investment activity was focused ment generally. Only Ltr. Rul. 9826048, Ltr. Rul. in economically depressed areas to create jobs and 9834033, and Ltr. Rul. 199947038 specifically ad - stimulate the local economies. Along with the in - dress program-related investments and significant vestments and deposit insurance, the POF would involvement. However, all of the rulings cited pro - “hire, train, and/or finance technical assistance vide examples of the involvement needed to consti - groups,” to work with financial institutions that tute significant involvement. qualified for the POF’s investments. The Service ruled that the POF met the require - Leckie Scholarship Fund. The “Miss Elizabeth” D. ments under the second method, set out above, for Leckie Scholarship Fund made scholarship grants determining significant involvement in the PRI ac - to high school graduates in an economically de - tivities. In so ruling, the Service noted that the POF: pressed county to enable them to attend college. The Fund was a private operating foundation the … has salaried staff of administrators with special - purpose of which was to raise the standard of liv - ized skills, expertise, or involvement in interna - tional economic development conducting and super - ing in the specific county by aiding students with vising the economic development program. As part college tuition and encouraging them to return to of the program, [the POF] will make program-relat - the county to live and work. The Fund’s volunteer ed investments to businesses and financial institutions board of trustees not only selected recipients, but to promote jobs and economic growth in the target - also maintained contact with the students through - ed geographic areas. ese program-related invest - ments will be under [the POF]’s general direction and out the year, assisted them in finding summer jobs supervision. As another part of the economic devel - in the county, introduced them to business and opment program, [the POF]’s staff will approve de - other leaders in the county, conducted county velopment schemes, based on the advice of affiliat -

PRIVATE FOUNDATIONS JULY/AUGUST 2017 taxation of exempts 45 ed nonprofit organizations; will develop and over - ing and a number of services to help prepare the see a standardized small business lending training pro - foster youth to live independently. The POF pro - gram; will establish standardized credit policies and procedures for participating financial institutions; will vided training and assistance to help the public hire, train, and/or finance [technical assistance charity develop its programs and also provided di - groups] in the designated countries; and will provide rect assistance to the individuals that the public ongoing training and guidance to foreign financial charity serves. In addition, the POF provided fund - institutions. us, [the POF] will do more than ing to the public charity in the form of a PRI. merely select, screen, and investigate applicants for investments, and will be significantly involved in its The Service concluded that the funding consti - economic development program.” tutes a PRI, that the POF is “actively involved” in the management of the public charity, and that it is “as - Ltr. Rul. 9834033. In Ltr. Rul. 9834033, the Serv - sisting it to accomplish its exempt purposes through ice ruled that a POF’s capital contributions to a the provision of both personnel and technical assis - controlled limited liability company were a pro - tance.” The ruling states that the POF is “maintain - gram-related investment and, because of the POF’s ing a “significant involvement” in the activities significant involvement, the capital contributions carried on by [the public charity], both through [the POF’s] direct involvement in various aspects of [the public charity’s] program and through [the POF’s] Whether PRIs made to a functionally related role in directing [the public charity’s] activities.” business constitute direct charitable activity The Service therefore held that the POF’s “initial turns on whether the POF has retained investment in [the public charity] and subsequent ex - significant involvement in the investment. penditures to assist [it] in carrying on its program are considered qualifying distributions made ‘directly for were disbursements that constituted direct chari - the active conduct of activities constituting [the table activity. POF’s] exempt purpose’ within the meaning of” Reg. The POF provided long-term care to children 53.4942(b)-1(b)(1). through foster homes and had a large staff that in - cluded 135 social workers. The POF and a public TAM 9203004. While only grants are involved, charity that provided family support formed a lim - and not a program-related investment, TAM ited liability company to operate a family services 9203004 provides a useful analysis of when a POF’s support center. The POF and the public charity each significant involvement in a grant program is suf - owned 50% of the capital and profits interest in the ficient to establish that the grants qualify as direct LLC, which was treated as a partnership for tax pur - charitable activity. poses. The LLC was actively engaged in providing The exempt purpose of the POF involved was to family services, both through its own employees and assist families and individuals involved in a particular through contracts with specialized organizations that industry. Individuals in need applied to the POF for conducted various treatment services for families or services. The POF, through an intake process, took on family members. The facts in the ruling state that qualified applicants as “clients.” The POF made grants even when the LLC was working with an outside directly to its clients, and also to public charities that service provider, it would “remain involved in the assisted clients whom the POF referred for outside treatment through participation in the design of the services. The POF had four “staff.” One was a volun - program and monitoring.” teer who had experience interviewing indigent indi - Thus, the POF’s 50% investment in establishing viduals at a clinic. The other three were paid staff who the LLC, as well as the POF’s ongoing portion of the were licensed social workers. The POF typically LLC’s activities and expenditures, were ruled to be helped the same families “year after year.” As a result, qualifying distributions directly for the active con - the POF’s staff come to “know these families, and aid duct of the POF’s exempt activities. recommendations are based upon the [staff’s] under - standing of the psychological needs of clients.” Ltr. Rul. 199947038. This letter ruling may involve In technical advice, the Service ruled that the POF the same POF as the one described in Ltr. Rul. maintained significant involvement in grants directly 9834033, above. The facts of Ltr. Rul. 199947038 to needy individuals as well as in grants to interven - again describe a POF that provides long-term care ing organizations. The Service said that “the qualita - to children through foster homes in several cities tive facts and circumstances [lead] to a conclusion that and that has a large staff again employing 135 so - [the POF] maintains a significant involvement with cial workers. A public charity in one of the cities its clients who receive assistance through counselling where the POF also had an office provided hous - and referral to other agencies.” The Service also noted

46 taxation of exempts JULY/AUGUST 2017 PRIVATE FOUNDATIONS versity. It operated the school and administered the U IRS Notice 2015-62 and program through a management agreement with the university. The Service ruled that in spite of the man - Mission-Related Investments agement agreement, the school and U program were a program of the POF and expenditures made in con - As a companion to making PRIs, many foundations engage in mission-related nection with the school and the program constituted investing as another way to further their charitable purposes. A mission-related investment is one for which alignment with the foundation’s mission is a factor direct charitable activity. The Service cited several in determining whether or not to make a particular investment. In other words, factors in drawing this conclusion: while the investment is motivated by profit and does not qualify as a PRI, a foun - • e management agreement with the university dation might nevertheless forego some economic profit in favor of pursuing a made clear that the university was acting under goal that is related to or consistent with the foundation’s mission. the authority and direction of the POF (through Prior to 2015, this practice called into question whether some of these invest - the LLC, a disregarded entity). ments might be considered jeopardizing investments under Section 4944. In No - • e POF had the authority to review all expendi - tice 2015-62, 2015-39 IRB 411, the Service clarified that “foundation managers tures and programmatic aspects of the school and may consider all relevant facts and circumstances [surrounding an investment], including the relationship between a particular investment and the foundation’s the program. charitable purposes.” The Notice went on to state that “[f]oundation managers • e name of the school and the program were are not required to select only investments that offer the highest rates of return, changed to reflect the POF’s involvement. the lowest risks, or the greatest liquidity so long as the foundation managers ex - • e academic program was supervised by a board ercise the requisite ordinary business care and prudence under the facts and cir - of overseers and the POF appointed a majority of cumstances prevailing at the time of the investment in making investment decisions that support, and do not jeopardize, the furtherance of the private foun - the members of that board. dation’s charitable purposes.” The Notice appears to bless an investing standard aligned with the standard set forth in the Uniform Prudent Management of Insti - tutional Funds Act, adopted in all states except Pennsylvania. Conclusion Few rulings specifically address the circumstances under which a POF’s involvement in a PRI satisfies the significant involvement test, allowing treatment that “the fact that [the POF] does reimburse other of the PRI expense as a direct charitable activity, and agencies for assistance provided to its clients does not thus countable toward satisfaction of the POF tests. It detract from the significant involvement maintained is important to note that a POF can make PRIs and by [the POF] in the welfare of such clients. [The POF] not retain significant involvement. While doing so maintains ongoing oversight over the aid provided to will not count toward satisfaction of the POF tests, its clients through a system of follow-up reports, re - there may nevertheless be a benefit to making a non- cently upgraded, and through its total approach to significant involvement PRI. For instance, a PRI is client welfare. In other words, the referrals are merely not treated as a business enterprise and is excluded a part of a total program of providing assistance to a from treatment as an excess business holding. 39 Ac - particularly distressed population.” cordingly, even if the POF holds more than 20% of a business enterprise, if the investment qualifies as a Ltr. Rul. 200431018. Ltr. Rul. 200431018 also does PRI, it will not be treated as an excess business hold - not involve a PRI. It is, however, an example of ing. In addition, the value of a PRI is excluded from when distributions made by a private operating the calculation of the spending amount required foundation through its single member limited lia - under the income and endowments tests because bility company constitute qualifying distributions PRIs are treated as charitable use assets instead of in - directly for active conduct of activities constituting vestment assets. 40 Finally, a POF can also determine its exempt purpose, and includes a number of fac - the investment is not a PRI but a mission related in - tors that the Service identified as important in con - vestment as discussed in Notice 2015-62 (discussed cluding the POF had maintained significant in the sidebar). These investments are generally mo - involvement. tivated by both profit as well as alignment with the The facts in the ruling state that a POF formed a foundation’s mission. single member limited liability company (“the LLC’) Knowing and understanding the facts of a POF’s that was disregarded for federal income tax purposes. investment—whether it is a mission-related invest - The LLC then purchased a school and what the rul - ment, a PRI, or a significant involvement PRI—is es - ing referred to only as “the U program” from a uni - sential, not only for reporting the investment correctly on the Form 990-PF, but in understanding the invest - 39 Reg. 53.4943-10(b). ment’s treatment for purposes of calculating mini - 40 Reg. 53.4942(a)-2(c)(3)(ii)(d). mum investment return and adjusted net income. I

48 taxation of exempts JULY/AUGUST 2017 PRIVATE FOUNDATIONS