Nonprofit organizations are either public charities or private foundations. Typically, public charities receive broad public support in the form of donations, grants, or funds from the government. Unlike public charities, private foundations are funded by a limited number of private sources. To prevent them from improperly advancing private interests while taking advantage of the tax exemptions for nonprofits, the IRS imposes additional regulations on private foundations.
Section 4943(a) of the Internal Revenue Code prevents private foundations from investing in joint ventures by imposing an initial 10 percent excise tax on the value of excess business holdings. In addition, Section 4942 requires a private foundation to disburse a certain amount of its assets annually and imposes penalty taxes for a failure to do so. Most importantly, Section 4944 imposes penalty taxes on jeopardy investments.
Jeopardy investments are defined as investments that risk a private foundation's ability to carry out its charitable purpose. In general, this means that the investment risks the foundation's resources in an imprudent way. To determine whether an investment is a jeopardy investment, the IRS engages in a case-by-case fact-intensive examination of the information available to foundation managers at the time the decision to invest was made. As a result, it is difficult for a private foundation to know with certainty whether or not it is making a jeopardy investment at the time of the investment. Since an L3C's tiered capital structure requires that private foundations assume a high risk at low rates of return, private foundation investments in L3Cs are likely to be considered jeopardy investments, unless they qualify for an exception as Program Related Investments.
A determination that an investment is a jeopardy investment has severe consequences for the investor. Private foundations must pay an initial tax of 5 percent of the value of such investments for every taxable year from the point when the investment was made up until the tax is assessed or the investment is corrected. If the investment is not removed from jeopardy within the taxable period following the assessment of the initial tax, the foundation must pay an additional tax of 25 percent. Furthermore, a foundation manager who made a jeopardy investment knowingly and willfully must pay a 5 percent penalty tax, unless her behavior was due to reasonable cause. If the manager refuses to remove the investment from jeopardy after the initial tax is assessed, she must pay an additional 5 percent. The manager is personally liable for these taxes and may not pass them on to the foundation.
Exception for Program-Related Investments
The Internal Revenue Code provides a narrow exemption from jeopardy investment penalty taxes for a private foundation's Program-Related Investments (PRIs). PRIs may involve high risk and low returns, but the IRS does not treat them as jeopardy investments because they further the investing foundation's charitable goals. PRIs may take the form of below-market-rate loans, loan guarantees, linked deposits, or equity investments.
The test to qualify as a PRI set out in Regs. Sec. 53.4944-3(a) requires that:
(1) the primary purpose of the investment must be to accomplish a charitable purpose;
(2) producing income cannot be a significant purpose of the investment; and
(3) the investment cannot be made for political or lobbying purposes.
An investment in an L3C does not automatically qualify for the PRI exception. The IRS may retroactively declare the investment was not a PRI, and the foundation would have to pay the relevant penalty taxes for jeopardy investments.
As a consequence, a private foundation's investment in an L3C exposes it to the risk of incurring penalty taxes. To reduce the uncertainty, the foundation may seek a written opinion from legal counsel that clearly explains why an investment qualifies as a PRI. Such an opinion may protect the foundation and its managers from incurring the initial penalty tax for jeopardy investments even if the IRS declares it to be incorrect. However, a lawyer's opinion may be costly to obtain and would only protect the foundation until the IRS makes an official determination of the nature of the investment. If the IRS declares the investment does not qualify as a PRI and the investment is not removed from jeopardy within the tax period following that determination, penalty taxes will be imposed on the foundation as well as its manager.
A private foundation may also request that the IRS pre-approve its investment though a private letter ruling. Such requests may take up to eighteen months to process. In the mean time, the foundation may incur tens of thousands of dollars in filing and legal fees without any guarantee of positive results. Even if the investment is pre-approved as a PRI, the foundation would have obligations to monitor the recipient L3C's use of PRI funds and ensure that the foundation's charitable goals are attained, or it may still be liable for penalties.
To determine whether it is making a PRI prior to investing in an L3C, a foundation would consider each of the following factors:
(1) the investing foundation's own charitable mission;
(2) the social goals of the recipient L3C;
(3) whether the social goals the L3C seeks to accomplish further the foundation's charitable mission;
(4) whether the governance and financial structure of the recipient L3C insure that the PRI requirements of Regs. Sec. 53.4944-3(a) will be met; and
(5) the cost of obtaining a written opinion from legal counsel or a private letter ruling from the IRS.
Tax Treatment of Program Related Investments
Private foundations benefit when their investments in ventures like L3Cs are officially determined to be PRIs. Such investments qualify as a disbursement under Section 4942 of the Internal Revenue Code, which required private foundations to distribute a certain amount of their assets annually. The foundation may earn income from the PRI, for which it will have to pay no tax. Finally, if the private foundation receives its investment back, it will have more funds to distribute via PRIs and grants. A foundation must reinvest a PRI and any income from it within a year of receipt.