You are on page 1of 10

Proposal for Philanthropic Facilitation Act

Basic Explanation - November 9, 2010

The problems are many and the dollars available for solutions are few. We need to maximize the returns from the use of nonprofit dollars and reduce the transactional costs while insuring compliance with the law and not creating new costs for government.

The transactional costs of complex excise taxes and burdensome paperwork for PRIs (Program Related Investments) result in decreased dollars brought to bear on the important issues of the day.
Why Support the Philanthropic Facilitation Act
This proposal outlines the benefits of passage of the proposed act which is truly bipartisan and structured to help the charitable activities of all nonprofits and L3Cs.* The proposal was written for us by Elizabeth Carrott Minnigh of Buchanan Ingersoll & Rooney (202-452-6048) elizabeth.minnigh@bipc.com. Please feel free to contact her with any legal questions. Some of the material contained herein was taken from a previous proposal by the Council on Foundations which supports this legislation. Please feel free to contact Andrew Schultz of COF (703-879-0715) schua@cof.org with questions relevant to COFs position. For all other questions please contact Robert Lang of Americans for Community Development (914-248-8443) robert.lang@ americansforcommunitydevelopment.org. We look forward to your support.

*Low-profit Limited Liability Company - It is a for profit venture that under its state charter must have a primary goal of performing a socially beneficial purpose not maximizing income. For More Information Regarding the L3C Visit Our Website:americansforcommunitydevelopment.org

P.O. Box 236 Granite Springs, NY 10527 americansforcommunitydevelopment.org

914.248.8443

P ROPOSAL

FOR

P HILANTHROPIC F ACILITATION A CT

Proposal Summary: The current economic recession has resulted in the coincidence of fewer philanthropic dollars with greater philanthropic need. Accordingly, private foundations are looking for a way to protect their endowments and, where appropriate, generate a return, however modest, on their funds available for distribution.1 Section 4940 of the Internal Revenue Code of 1986, as amended (the "Code"), imposes a two-tiered tax on net investment income, which creates an impediment to increased giving. The proposed Philanthropic Facilitation Act would simplify the excise tax on net investment income under Section 4940 of the Code, by eliminating the two-tiered rate and replacing it with a single, flat revenue-neutral rate of 1.4%2 and, thereby, encourage foundations to maximize annual distributions. The exception for program-related investments under Section 4944 of the Code, allows a non-profit to make a return on an investment that also qualifies as a qualifying distribution under Section 4942 of the Code. The proposed Philanthropic Facilitation Act would improve the ability of private foundations to use the program-related investments exception more efficiently, by streamlining the approval process, and thereby open up additional capital for investment in economicallydistressed industries, creating jobs and improving economic conditions in local communities.3 I. OVERVIEW OF TAX ON NET INVESTMENT INCOME: THE DISINCENTIVE FOR INCREASED DISTRIBUTIONS FROM PRIVATE FOUNDATIONS

Section 4940 of the Code requires private foundations to pay an annual excise tax equal to 2% of their net investment income. In any year in which a foundation's distributions (measured as a percentage of assets) exceed the average payout rate of the foundation calculated over the preceding five years by at least 1%, this excise tax is reduced to 1%. The requirement under Section 4940(e) of the Code that a foundation's distributions exceed the average payout rate of the foundation calculated over the preceding five years by at least 1% was intended to ensure that the tax savings afforded to the foundation be used for additional charitable expenditures and not merely added to the endowment of the foundation.4 Regardless of whether a foundation qualifies for the 1% reduction under Section 4940 of the Code, the foundation is still required under Section 4942 of the Code to make annual minimum distributions equal to approximately 5% of the foundation's assets.

Shelly Banjo, Consider It an Investment, WALL ST. J., Nov. 9, 2009, available at http://online.wsj.com. The Staff Joint Committee on Taxation analyzed the Section 4940 excise tax in connection with S. 676 / H.R. 4090, 111th Cong. (2009), and indicated that a flat rate of 1.39% would be revenue neutral. Council on Foundations, Simplify the Excise Tax on Private Foundations (S. 676 / H.R.4090), Oct. 2010, available at http://www.cof.org/templates/311.cfm?ItemNumber=16095. 3 Private foundations give away an estimated $40 billion annually. See Pablo Eisenberg, What's Wrong With Charitable Givingand How to Fix It, WALL ST. J., Nov. 9, 2009, available at http://online.wsj.com. 4 STAFF OF JOINT COMM. ON TAX., 98th Cong. 2d, Gen. Explanation of H.R. 4170, at 672-3 (Dec. 31, 1984)
2

PROPOSAL FOR PHILANTHROPIC FACILITATION ACT

PAGE 2

The current two-tier excise tax is a disincentive to increased giving, because a high distribution in a single year makes it more difficult for the foundation to qualify for the lower rate on net investment income over the following five-year period.5 This disincentive will be greater in coming years, then in the recent past, because asset values have declined sharply. This will reduce the denominator by which payout rates are calculated. Under these circumstances, a foundation will be subject to the higher 2% excise tax rate in future tax years, unless it reduces the dollar amount of its annual distributions. These reduced distributions, however, will occur at a time when they are most needed to support their mission driven purposes, in the current economic environment.

Because the calculation of distributions necessary to qualify for the reduced 1% excise tax depends on the 12-month average asset balance of the foundation, which cannot be known until the end of the tax year, and on the foundation's investment income, which may not be fully known until the following tax year, foundations are unable to accurately predict which excise tax rate will apply during a given tax year. Each year, foundations must spend time and money to ensure that the amount spent by the end of each tax year is neither too high (thereby making the foundation unlikely to qualify for the reduced rate under Section 4940 of the Code in future years) nor too low (thereby violating the qualifying distribution requirements under Section 4942 of the Code). A flat excise tax would reduce the administrative burdens on foundations, reduce administrative overhead and increase the amounts available for program related investments and other qualifying distributions.
TO

II.

OVERVIEW OF THE PROGRAM-RELATED INVESTMENT EXEMPTION: T HE K EY I NCREASED R ETURNS FOR F OUNDATIONS

Section 4944 of the Code imposes an excise tax on private foundations for engaging in high-risk (i.e., "jeopardy investments") investments, unless such investments further the foundation's exempt purposes. These investments are referred to as program related investments (PRIs). PRIs qualify as qualifying distributions under Section 4942 of the Code; however, unlike a grant the foundation has the potential to receive a return on its distribution, and then redistribute such funds in support of other charitable activities, in line with its mission. Traditionally, PRIs have been structured as interest-free or below-market loans, loan participations or guarantees, letters of credit and equity investments.

Richard Sansing & Robert Yetman, Governing Private Foundations Using the Tax Law, Vol. 41, Issue 3 J. of Acc'tg & Econ 363, 365 (Sept. 2006) (based upon review of review of 3800 actual IRS Form 990-PF filed between 1994-2000).

PROPOSAL FOR PHILANTHROPIC FACILITATION ACT

PAGE 3

Although the favorable tax treatment of, and potential investment return, on PRIs should make them attractive to private foundations, a survey of more than 75,000 private foundations showed that in 2006 those private foundations collectively made qualifying distributions in the aggregate amount of $39.0 billion; on an endowment base of $614.7 billion and in 2007 those private foundations collectively made qualifying distributions in the aggregate amount of $44.4 billion; on an endowment base of $682.2 billion;6 however, over that same two year period, PRIs accounted for less than 1% of these qualifying distributions, despite being a strong tool to advance their charitable purposes.7 Currently, there is no process to confirm that a private foundation's proposed PRI investments will comply, both initially and over time, with the PRI regulations under Reg. 53.4944-3(a). Additionally, there is no uniform standard for forming entities to serve as recipients of PRIs. Traditionally, many private foundations have refrained from investing in forprofit ventures due to the uncertainty of whether a specific investment would qualify as a PRI or because of the cost, time and resources to acquire a private letter ruling from the IRS to verify that the particular venture is a valid PRI8 or a legal opinion from counsel. Implementing an application process that would permit registration of the proposed recipient of a PRI, similar to the process that nonprofits under take in submitting Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, and a reporting requirement for the actual recipients of PRIs, similar to the Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation, would cut down on the transaction costs associated with making a PRI, thereby facilitating their use and providing greater protections to both the private foundation and the government that the PRI funds are being used properly.

Without clarification of the rules surrounding PRIs, the philanthropic community may continue to be unwilling to undertake PRIs, and, thereby, continue to diminish the resources available for philanthropy at a faster than necessary rate, while at the same time endowments in private foundations will likely increase significantly over the near term, due to the current income and estate tax structure. III. U TILIZING C OMPANY
THE

PRI E XEMPTION : T HE L OW -P ROFIT , L IMITED L IABILITY

The Foundation Center, Foundation Growth and Giving Estimates: Current Outlook (2009 Ed.), available at http://foundationcenter.org/gainknowledge/research/pdf/fgge09.pdf. 7 The Foundation Center, Doing Good with Foundation Assets, excerpted from THE PRI DIRECTORY (3d Ed.), available at http://foundationcenter.org/gainknowledge/research/pdf/pri_directory_excerpt.pdf. 8 The current user fee for a private letter ruling for exempt organizations is $ $10,000. Rev. Proc. 2010-8, 2010-1 I.R.B., 6.06.

PROPOSAL FOR PHILANTHROPIC FACILITATION ACT

PAGE 4

The low-profit, limited liability company (L3C) format evolved from a desire to relieve economic distress caused by high unemployment occurring in areas such as the automobile manufacturing (see industry summary attached as Exhibit A hereto) and news dissemination (see Proposal for Community News Facilitation Act attached as Exhibit B hereto). However, L3Cs are not limited to the foregoing industries; rather proposed L3Cs also include food banks, health clinics, affordable housing, museums and many other entities with a charitable purpose. The L3C is a new form of LLC formed specifically to further one or more religious, charitable, scientific, literary or educational purposes within the meaning of Section 170(c)(2)(B) of the Code (an "exempt purpose"). Although the entity is expected to be a profitable entity, profit-making is a secondary and insubstantial part of its mission. While the primary purpose of the L3C itself must be an exempt purposes, there is not requirement that each activity undertaken must be an exempt activity.9 For example, an L3C may be structured to undertake a specific activity to produce sufficient revenue so as to pay the costs associated with achieving its overall exempt purpose.

Pursuant to state statutes, an L3C must be organized and operated at all times in a manner that investments therein satisfy the requirements under Reg. 53.4944-3(a), namely the L3C must possess the following characteristics: The primary purpose significantly furthers the accomplishment accomplish one or more of exempt purposes, and the L3C would not have been formed but for its relationship to the accomplishment of such purpose(s). No significant purpose is the production of income or the appreciation of capital; and No purpose is to influence legislation or to "participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office."10

The L3C was first introduced in the United States in April 2008 when Vermont adopted the L3C as an official legal structure. Subsequently, the following jurisdictions have followed suit: Illinois,11 Louisiana,12 Maine,13 Michigan,14 North

Public charities and private foundations may undertake a minor amount of activities that are trade and business unrelated to directly furthering their exempt purposes, although these activities will generate unrelated business taxable income under Section 512 of the Code. Since the L3C is a fully taxable, the L3C is taxable on all of its revenue, whether or not it directly furthers an exempt purpose. 10 Code 170(c)(2)(D). 11 805 ILCS 180/1-5, 805 ILCS 180/1-10, 805 ILCS 180/5-5. 12 La. R.S. 12:1301(A)(21), 1302(C), 1305(B)(3), 12:1306(A)(1), 1309(A). 13 Me. Rev. Stat. Ch. 21, 1502, 1508, 1559, 1611 (effective as of July 1, 2011). 14 Mich. Comp. Laws 450.4102.

PROPOSAL FOR PHILANTHROPIC FACILITATION ACT

PAGE 5

Carolina,15 Utah16 and Wyoming.17 Additionally, the Oglala Sioux Tribe and the Crow Indian Nation of Montana have adopted L3C legislation. Additionally, North Dakota18 has enacted legislation authorizing feasibility studies of the L3C. Similarly, the Arkansas Interim Study Proposal 2009-171 was adopted this summer.19 Bills have also been introduced in the state legislatures in the following 11 jurisdictions: Colorado,20 Kentucky,21 Maryland,22 Massachusetts,23 Missouri,24 Montana,25 New York,26 North Dakota,27 Oregon28, Tennessee29 and Virginia.30

As a type of LLC, the L3C's flexible structure allows tranched investments by members, which have varying levels of risk. If private foundations or public charities make the first loss investments thereby absorbing the highest risk tranche at a very low return, then the balance of the investments in the L3C will be at a much lower risk and the L3C will be able to attract non-charitable investors, who may earn market returns at acceptable levels of risk. Accordingly, the L3C can use the PRI funds to leverage commercial sources of funds to bring them to bear on social problems traditionally addressed exclusively by non-governmental organization (NGOs) or government programs. Thus effective use of an L3C can free up charitable and governmental dollars to use in other areas.

Because an L3C can tap into both private foundation and for-profit investors, an L3C offers a more economically sustainable format than a non-profit, alone. Additionally, because an L3C must have an exempt purpose as its primary purpose, the L3C format aligns the L3C with the foundation while expanding the resources available for social enterprise investing within its community.

15 16

N.C. Gen. Stat. 57C-2-01, 57C-2-21, 55D-20(a). Utah Code 48-02c-412 and 48-02c-1411. 17 Wyo. Stat. 17-15-102(a)(ix), et seq. 18 H.B. 1545. 19 H.B. 2102. 20 H.B. 10-1111. 21 H.B. 371. 22 H.B 5 / S.B. 430. 23 H 4589. 24 H.B. 817. 25 H.B. 235. 26 A 10414 / S 6726. 27 H.B. 1545. 28 H.B. 2886. 29 S.B. 0472/H.B. 0664. 30 H.B. 261.

PROPOSAL FOR PHILANTHROPIC FACILITATION ACT IV. NECESSARY AMENDMENTS REGULATIONS


TO THE

PAGE 6

INTERNAL REVENUE CODE AND TREASURY

In order to implement the foregoing objectives, we respectfully request that Congress make the following amendments to the Internal Revenue Code of 1986, as amended (the "Code") and Treasury regulation thereunder: Amend Section 4940(a) of the Code to strike "2 percent" and insert "1.4 percent." Delete Section 4940(e) of the Code. Amend Section 4944(c) of the Code to clarify that a PRI: (i) is not an investment which jeopardizes the carrying out of exempt purposes; (ii) qualifies as a qualifying distribution under Section 4942 of the Code; and (iii) is not a business holding within the meaning of section 4943 of the Code. Amend Section 4944(c) of the Code to clarify that the primary purpose of the PRI is to accomplish one or more of the purposes described in Section 170(c)(2)(B) of the Code and no significant purpose of the PRI is the production of income or the appreciation of property. Amend Section 4944(c) of the Code to provide a voluntary procedure for entities wishing to be the recipients of PRIs to receive a determination by the IRS that an investment in said entity qualifies as a PRI, for private foundations with a common purpose and, if an investment is deemed to qualify, all private foundations may rely on this determination, unless and until the Secretary publishes a notice of revocation of the determination. The time and cost of said determination should be equivalent to the average time and cost for the determination of 501(c)(3) tax-exempt status, for a non-profit. Add a new section to Chapter 60 of the Code to require information returns for forprofit entities receiving PRIs requiring disclosure of: Its gross income for the year; Its expenses attributable to such income, incurred within the year; A narrative statement describing the disbursements for and the results obtained from the use of assets for the exempt purposes of the entity; A balance sheet showing its assets, liabilities and net worth as of the beginning of such year; The names and addresses of all private foundations investing PRIs in the forprofit entity. A statement of the portion of its liabilities and net worth that represent capitalization from PRIs as of the beginning of such year;

PROPOSAL FOR PHILANTHROPIC FACILITATION ACT

PAGE 7

A statement of any interest, dividends or other distributions paid with respect to any PRIs during the year; and Such other information as the Secretary may by forms or regulations prescribe.

Add a new section to Chapter 61 of the Code to require publication of aforementioned information returns for for-profit entities receiving PRIs.31 Amend Section 7428(a)(1) of the Code to include determinations of whether an investment in an entity qualifies as a PRI. Direct amendments to the Treasury regulations as follows: Amend Reg. Sec. 53.4942(a)-3 to clarify that a PRI qualifies as a qualifying distribution. Amend Reg. Sec. 53.4943-3 to exclude a PRI from the definition of a business holding. Amend Reg. Sec. 53.4944-3 to reflect all of the changes to Section 4944 of the Code outlined above, including (without limitation) inclusion of: Examples of the following: (i) an investment in a L3C that would qualify as a PRI; (ii) an investment in a L3C that would not qualify as a PRI at the outset; and (iii) an investment that initially qualified as a PRI but due to a change in circumstance no longer so qualifies.32 Procedures for a private foundation to divest itself of a PRI that no longer so qualifies, within a specified time period, without incurring excise tax.


362369.10

Such conforming changes as may be necessary to implement the foregoing provisions.

31

Robert Ottenhoff, CEO of Guidestar, has stated that Guidestar would be willing to include such statements on its database. Telephone call between Robert Ottenhoff, CEO of Guidestar, and Robert Lang, CEO of Americans for Community Development LLC. 31 The regulations under 4944 were finalized in 1972 and are in great need of updated examples to reflect changes in both law and practices. In a letter from Stuart M. Lewis, Chair, Section of Taxation, American Bar Association, to Hon. Douglas Shulman, Commissioner, Internal Revenue Service, dated March 3, 2010, the ABA Section on Taxation proposed 19 proposed new program related investment examples. A copy of this letter is available at http://www.abanet.org/tax/pubpolicy/2010/Comments_Concerning_Proposed_Additional_Examples_on_Program_ Related_Investments.pdf.

PROPOSAL FOR PHILANTHROPIC FACILITATION ACT

PAGE 8
Exhibit A

AN INDUSTRY IN NEED: AUTO MANUFACTURERS Michigan, Ohio, and Indiana combined account for almost half of all jobs in the auto industry.33 These states, particularly Michigan, have built an infrastructure and an economic base oriented around that industry for more than a century. However, the auto industry is seeing decreased demand for its products, increased unemployment amongst autoworkers and excess capacity at facilities: The U.S. Bureau of Labor Statistics estimates that the already ailing industry will see a decrease in employment of 16.3% by 2018, compared to an estimated 11% percent growth for employment in all industries combined.34 For the past four years, Michigan has held the nation's highest unemployment rate, at approximately 15%.35 Auto sales for U.S. automakers began falling in the spring of 2008 as gas prices rose, and, in October 2008 when the current recession worsened, sales dropped to the lowest level recorded in 25 years.36 As sales by automakers have declined this has had ripple effect on suppliers, increasing the economic recession in this region.37 Despite approximately 100,000 workforce reductions since 2006 and closing factories nationwide, the automakers have been unable to cut their costs at a rate sufficient to keep up with the steadily declining market for new vehicles.38 The auto industry currently has the capacity to produce approximately 90 million cars and light trucks a year; however, only approximately 60 million were actually sold worldwide in 2009. 39 Accordingly, the worldwide auto industry has a third more capacity than is necessary to meet worldwide demand.40

Despite the decline of the auto industry, the region still possesses two important resourcesa large network of skilled laborers and existing manufacturing facilities. Many of the same people and factories that have made automobiles and automobile components can be adapted to manufacture wind turbines, batteries, electric transport vehicles, unique hydro power systems, solar energy systems and more. Moreover, with its extensive waterfront exposure there are numerous possible sites to implement these green energy concepts.
Bureau of Labor Statistics, Motor Vehicle and Parts Manufacturing in Career Guide to Industries (2010-2011 Ed.), available at http://www.bls.gov/oco/cg/cgs012.htm. Other states that account for significant numbers of jobs in the auto industry include Kentucky, Tennessee, and California. Id. 34 Id. 35 Associated Press, Pelosi, LaHood Laud US Investment, N.Y. Times (Jan. 11, 2010), available at http://www.ny times.com/aponline/2010/01/11/business/AP-US-Auto-Show-Lawmakers.html. 36 Times Topics, Automotive Industry Crisis, N.Y. Times (updated Jan. 12, 2010), available at http://topics.nytimes. com/top/reference/timestopics/subjects/c/credit_crisis/auto_industry/index.html. 37 Id. 38 Id. 39 Marketplace, Automakers Need to Face New Reality (NPR broadcast on Jan. 13, 2010), transcript available at http://marketplace.publicradio.org/display/web/2010/01/13/pm-reich-commentary/. 40 Id.
33

PROPOSAL FOR PHILANTHROPIC FACILITATION ACT

PAGE 9

However, due to the crippling economic recession in this region there is currently not sufficient capital available to purchase and retool the facilities and retrain workers. The substantial start-up costs and period of irregular income at the start of operations makes such retooling too risky for many for-profit investors. By utilizing the L3C format to access private foundation support, whether from large national foundations or small community foundations, the credit rating of the ventures can be substantially improved and attract greater interest from private investors. Additionally, once the facilities have been retooled and workers have begun to create the components necessary for green energy sources, new L3CS can be formed to set up and operate cites to implement these green energy businesses. As a result of these transactions, automakers and suppliers of auto parts would sell off their excess capacity and, thereby, resize their businesses to meet consumer demand and improve their balance sheets without additional governmental resources. Additionally, unemployed skilled workers would be reemployed in a growth industry, which will stimulate the economies in these regions. However, as noted above, the PRI rules must be clarified before a substantial number of entities will be willing to invest in L3CS.