A supporting organization (SO) can provide flexible options for investing charitable dollars in private equity, real estate, and other nontraditional assets. And some people have begun to use them for impact investing. Here’s what you should know about your philanthropic alternatives when looking to invest charitable dollars beyond stocks, bonds, and cash.
Historically, the vast majority of charitable assets are invested in cash and publicly traded securities (traditional asset classes). However, from a stewardship perspective, and in an effort to maximize investment return, often the people who desire to give would prefer to have their charitable dollars invested in a broader spectrum of asset classes. This is particularly true for those who built their personal wealth through nontraditional assets, such as a closely held business or real estate investments. Sometimes, the assets that initially funded the charitable donation consisted of these types of nontraditional assets.
Despite this, relatively few donors ever consider making charitable gifts of the more nontraditional assets. Yet, these types of assets represent some of the most attractive assets to give because they can often provide multiple tax benefits and higher potential investment returns.
Relatively few donors ever consider making charitable gifts of the more nontraditional assets. Yet, these types of assets represent some of the most attractive assets to give.
Also, for many who give to charity, a nontraditional asset represents the majority of their total wealth, and donating a nontraditional asset can enable them to give far more away than they could have if they were limited exclusively to giving cash or public securities.
The emergence and growth of impact investing has also begun to fuel an increasing desire among those who give to charitable causes to invest their charitable dollars in private businesses, real estate, and other investments that not only have a profit motive, but also have a social and/or spiritual impact.
Impact investing encompasses a broad spectrum of situations and scenarios, for example investing in a for-profit film, such as last year’s hit movie I Can Only Imagine. This was a faith-based film that had a significant charitable purpose, so even if the film did not turn a profit, it shared the gospel message, had other important messages and accomplished its exempt purpose. Nonetheless, the film grossed more than $80 million at the box office with a production budget of only $7 million and the charitable dollars invested reaped a strong financial return. The return could then be reinvested in another impact investment or faith-based film, or granted directly to various charities.
Three alternative giving vehicles
Investing in nontraditional assets in a charitable environment can be challenging due to various issues and obstacles that arise under current tax laws. The most common charitable vehicles used to facilitate charitable giving include the following three alternatives:
Although the supporting organization is the least known and least used of these three charitable vehicles, it can be the most effective and the most flexible charitable entity for investing in private equity, real estate, and other nontraditional investments.
The effectiveness and flexibility of nontraditional assets are partially attributed to the fact that supporting organizations:
- Provide a fair market value charitable deduction for gifts of such assets. Private foundations, by contrast, provide a deduction limited only to the assets’ income tax basis.
- Are not subject to the self-dealing rules that apply to private foundations. These rules can dramatically restrict various transactions between the donor and the private foundation and its assets. (Note: See key issue #1, below.)
- Are not subject to the excess business holdings rules. These rules apply to both private foundations and donor-advised funds and could restrict the charitable entity from holding and investing in such assets long-term. (Note: See key issue #2, below.)
Of course, even in the context of supporting organizations, investing charitable dollars in private businesses, real estate, impact investments, and other types of nontraditional investments must be done with great care and consideration of the various tax rules and issues.
Two key issues
- Supporting organizations must be aware of the “excess benefit rules” under the tax code. These rules effectively prohibit certain transactions between the donor (and other “disqualified persons”) and the supporting organization, including its underlying assets. These prohibited transactions include any “grant, loan, compensation, or other similar payment” provided by the supporting organization to the donor or other disqualified persons. All economic transactions that may occur between the supporting organization and disqualified persons should be examined to ensure compliance with these rules.
- In order to qualify as a supporting organization under the tax code, the donor and other disqualified persons can’t “control” the supporting organization. This prohibition precludes the disqualified persons from having majority appointments on the board of the supporting organization. The IRS has taken the position that this rule also prohibits disqualified persons from controlling the underlying assets of a supporting organization, even when they do not control the board of directors of the supporting organization.
Furthermore, the IRS takes the position that a business entity that is controlled by a disqualified person, but is partially owned by the supporting organization, could violate this rule and cause the supporting organization to fail to qualify as such. In this case, the supporting organization would terminate and default to private foundation status. The extent of this position is illustrated by the following examples:
Assume a privately owned business entity is capitalized with both voting and nonvoting interests. The voting interest represents one percent of the equity of the business, and the nonvoting interests represent 99 percent of the equity of the business. Assume that some portion of the non-voting interest is gifted to a supporting organization, but that the donor (“disqualified person”) retains the one percent voting interest. If the supporting organization’s sole asset is the nonvoting interest in the business, then the IRS takes the position that the donor essentially controls the nonvoting interests and, therefore, the supporting organization itself. Thus, the IRS takes the position that the supporting organization would not qualify as such, and instead would be treated as a private foundation.
“Control” is an issue that needs to be appropriately addressed and navigated to ensure that investments in privately owned businesses, real estate, and certain other assets are permissible.
In most cases, these issues can, in fact, be effectively navigated. The following examples illustrate permissible structures that will generally satisfy or avoid any control issues. These examples are in the context of investments in private businesses. However, these examples would apply similarly to real estate in which the donor (“disqualified person”) continues to own a controlling interest – whether directly or through a business entity such as a partnership, limited liability company or S corporation.
Example 1. The control issue, in the context of a business entity, arises when the donor owns a voting interest in the entity that exceeds 50 percent of the total voting interests, even if the voting interests represent only one percent of the equity of the business. If there are multiple owners of the entity, and the donor’s (and any other disqualified persons’) interest in the voting interests is 50 percent or less, then no adverse control issues arise.
Example 2. If a donor gifts interests in a business entity to a supporting organization and retains a majority interest in the voting interests of the entity so that the control issue would otherwise be violated—but the supporting organization owns additional assets that are not controlled by the donor and that are equal in value to or exceed the value of the business entity – then no adverse control issues arise. This is because the donor’s deemed control is 50 percent or less of the entire assets of the supporting organization. Of course, a situation like this would require careful monitoring to ensure that the value of all donor controlled assets never exceeds the 50 percent threshold.
In both of the above examples, the specific facts and circumstances might satisfy the control requirements easily, while in other situations it might be difficult or even impossible. Therefore, a careful examination of the facts, circumstances, goals and objectives of each donor is required.
Finally, the Uniform Prudent Management of Institutional Funds Act, which provides guidance and authority to charitable organizations concerning the management and investment of charitable assets, must be considered and carefully reviewed. A supporting organization and its board of directors must ensure that the supporting organization’s Investment Policy addresses risk and fiduciary responsibility.
The ability to invest charitable dollars in nontraditional investments, such as private businesses, real estate, and impact investments may be very appealing to those who want to see their charitable dollars grow. This can be more difficult to achieve through a private foundation or a donor-advised fund. However, a supporting organization may provide the needed investment flexibility and, as a result, may expand and enhance the investment options, alternatives, and performance with respect to charitable dollars that are not immediately deployed for charitable purposes.
- Affluent philanthropists often desire for their contributions to charities to be invested in assets beyond cash, bonds and publicly traded stock.
- An SO is generally the most effective charitable vehicle for investing in nontraditional asset classes, such as private businesses and real estate.
- Expanding the breadth of permissible investments for charitable dollars provides enhanced investment flexibility and the potential for greater investment returns and more funds available for charitable purposes.