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Jan 22, 2016

New IRS rule may improve access by for-profit social enterprises to foundation capital

Anyone who has considered foundation investment in social enterprises has heard the term PRI (program related investments).  It  applies to private foundations but it seems to be used by all foundations.  It is a term intended to ease foundations’ worries that they might be penalized for investing in a social enterprise rather than in a high-growth, high-return conventional company.  The issue is what constitutes an appropriate investment of a foundation’s capital.

The IRS has just issued a notice that should make foundations more comfortable in placing more of their investment portfolio into social enterprises.  First, a warning:  I am not a lawyer, so take this information as suggestive and seek professional legal counsel before acting on this blog.  Second, I will try to minimize legal jargon, which makes the first warning especially important.

Foundation investments are governed by state law, which largely follows UPMIFA, a recommended set of statutes drafted by the National Conference of Commissioners on Uniform State Laws.  This statute defines the “prudent person” standard for trustees of foundations to oversee the investments of their foundation.  Their mandate is broadly expressed as “providing for the long-term and short-term financial needs of the foundation to carry out its exempt purposes.”  Many foundations interpret this as a requirement that all investments be at market rates of return.  This specifically discourages low-return, high-risk investments, which describes most investments in start-up social enterprises.

So is there any way for foundations to invest in a social enterprise, whether for-profit or non-profit, that may not yield the financial returns of more conventional investments?

Enter the PRI:  the IRS allows an exemption if the investment addresses the charitable purpose of the foundation but “no significant purpose [of the company invested in] is the production of income or the appreciation of property.”  Nuts.  The business has to be buried in a nonprofit’s financials or, if it is a for-profit, have a weak financial model, otherwise the foundation will be penalized!

One response has been to create a business structure called the low-profit limited liability company (L3C) to avoid the “significant purpose” prohibition on profit-making.  That concept has not taken off.  So qualifying as a PRI has remained the safe haven for philanthropic investment.  Not very helpful for the sizable number of for-profit social enterprises who plan for  growth or  financial sustainability by building a strong balance sheet through accumulation of profits.

As social enterprise has become more popular and widespread, the PRI restriction has limited the availability of capital to start-up, for-profit social enterprises.  Until now — hopefully.

The IRS released Notice 2015-62 “Investments Made for Charitable Purposes” which I hope will make foundations more comfortable with investing in these types of social enterprises.  My reading of this notice is that an investment does not have to meet the PRI standard of insignificant profit potential if it has below-market rate of return potential but the social impact of the social enterprise is related to the charitable purpose of the foundation.  Here is the language that does this:  “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 foundation managers exercise the requisite ordinary business care and prudence...”  In particular, an investment is okay if it “furthers the foundation’s charitable purpose at an expected rate of return that is less than what the foundation might obtain from an investment that is unrelated to its charitable purpose.

In other words, if the social enterprise’s social impact is relevant to the foundation’s charitable purpose, the foundation can invest in the company even if the social enterprise is a for-profit but is not likely to generate high returns for the foundation.

I hope that the hesitation of foundations to shift a material portion of their investment portfolio to social enterprises will be mitigated by this IRS ruling.  Social enterprise and the profits it can generate are the best hope of our communities to produce sustainable social impact that can keep apace of the growing social needs of our communities.  Access to the balance sheets of our foundations is essential if our emerging social enterprises are to become a significant component of our social sector.

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Allen Proctor, President & CEO

Center for Social Enterprise Development