This week the Internal Revenue Service (IRS) issued new guidance to tax-exempt foundations on “mission-related investments” (MRIs), which seek a risk-adjusted financial return alongside social or environmental goals that are consistent with the foundation’s charitable purpose. MRIs are a growing source of impact investments in the U.S, and the new guidance could encourage more foundations to align their investment strategies with their charitable missions.
As a bit of background, U.S.-based private foundations combine for roughly $650 billion in endowments. In order to maintain their tax-exempt status, each year a foundation must allocate at least 5 percent of their total assets toward their charitable purpose. This can be done either in the form of grants or “program-related investments” (PRIs), defined by the IRS as below-market-rate investments for which the primary purpose is to accomplish a charitable purpose, not to generate a financial return.
In recent years, a growing number of foundations have sought to devote a portion of their investment portfolios—in addition to their grant-making and PRI activities—to impact investments that do not technically qualify as PRIs. But many foundation managers have hesitated to pursue these investments—known as MRIs—in part because they have been uncertain of the legal and tax consequences. Specifically, under Section 4944 of the Internal Revenue Code, a foundation faces a significant tax penalty if it pursues investments that “jeopardize the carrying out of any of its exempt purposes.” PRIs are explicitly exempt from this rule, but until this week, the IRS had not clarified whether MRIs could be deemed a “jeopardizing investment.”
The new guidance makes clear that foundations are free to pursue MRIs without facing a tax penalty, so long as the foundation’s managers “exercise ordinary business care and prudence…in providing for the long-term and short-term financial needs of the foundation.” Specifically, foundation managers are not required to select only investments that offer the highest rates of return, the lowest risks, or the greatest liquidity. MRIs—even those that produce slightly below-market returns—are consistent with the manager’s fiduciary duty, so long as they “support, and do not jeopardize, the furtherance of the private foundation’s charitable purposes.” Even if the foundation realizes a loss on a MRI at a later date, it cannot retroactively be deemed a “jeopardizing investment” if the foundation manager fulfilled their fiduciary duty at the time the investment was made.
It’s unclear what immediate impact the new guidance will have on foundation investment practices, but it is certainly a step in the right direction. According to a recent survey, only 41 percent of U.S.-based foundations engage in impact investing today (including both MRIs and PRIs). By clarifying the fiduciary rules surrounding MRIs, the IRS has opened the door for more foundations to use their endowments to tackle the most pressing issues facing low-income communities—from poor health and education outcomes to a lack of quality, affordable housing.
In 2013, our organizations co-founded the Accelerating Impact Investing Initiative (AI3)—along with our partners at the Initiative for Responsible Investment at Harvard University—to spark a national conversation about the federal government’s role in improving and expanding the market for impact investments. Enterprise and PCV strongly support the new IRS guidance, and we look forward to working with foundations and other stakeholders to expand the use of MRIs.
At the same time, we acknowledge that this is just one of many policy changes necessary to responsibly grow the impact investing market. As immediate next steps, we urge Congress and the Obama administration to expand federal support to Social Impact Bonds (SIBs) and other pay-for-success initiatives, and to clarify fiduciary rules governing private pension funds to encourage more economically targeted investments.