Below-market arts loan is a program-related investment and qualifying distribution

Plain-English summary

A private foundation proposed an unsecured, below-market line of credit to a foreign alternative investment fund. The fund would use the money for below-market loans to museums, galleries, and other arts organizations in the foreign country, subject to contractual charitable-use, reporting, lobbying, and political-campaign restrictions. The foundation would participate in an advisory investment committee but could not approve, reject, or earmark funding for any secondary recipient. Its repayment rights would be subordinate to at least one other lender, and the borrower could retire debt it could not repay after using all available funds for exempt purposes. The IRS ruled that the loan primarily advanced the foundation's arts and arts-education mission, had no significant income or appreciation purpose, and was therefore a program-related investment under Section 4944. Because the borrower was not controlled by the foundation and retained actual selection authority, amounts transferred under the loan also counted as qualifying distributions under Section 4942.

Ruling snapshot

• Question: Does the foundation's below-market loan to a foreign fund qualify as both a program-related investment and a qualifying distribution?
• Outcome: Approved under Sections 4944 and 4942.
• Key authorities: IRC §§ 170(c)(2)(B), 4942(g), 4944(c), 4946; Treas. Reg. §§ 53.4942(a)-3, 53.4942(b)-1, 53.4944-3

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202123004 Third Party Communication: None
Release Date: 6/11/2021 Date of Communication: Not Applicable
Index Number: 4944.00-00, 4942.00-00
Person To Contact:
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Refer Reply To:
CC:EEE:EOET:EO2
PLR-120396-20
Date:
March 12, 2021

LEGEND

Foundation = [redacted]
Grantee = [redacted]
Foreign Country = [redacted]
Loan Amount = [redacted]
State = [redacted]

Dear -----------------------------:

We are responding to a letter submitted on your behalf by your authorized
representative dated September 3, 2020, as supplemented with additional supporting
documentation on October 30, 2020. Your letter requests rulings regarding the
application of §§ 4944 and 4942 of the Internal Revenue Code of 1986, as amended
(hereafter “IRC,” or the “Code”) to your loan to Grantee.

FACTS

This ruling is based only on the representations and documents submitted on
Foundation’s behalf by Foundation’s authorized representative in support of
Foundation’s letter request. The relevant facts, as provided and relied upon, are as
follows.

Foundation is a State non-stock corporation recognized by the IRS as a tax-exempt
organization described in IRC § 501(c)(3) and classified as a private foundation under
IRC § 509(a). Foundation represents that its mission is to advance the arts and art
education by empowering local artists and cultural institutions to expand public access
to a broader range of art and widen engagement with art by a cross section of the
public. In furtherance of its mission, Foundation represents that it engages in a wide
range of activities including grant-making to promote access to capital for local art and
cultural institutions.

Foundation represents that Grantee is a limited liability partnership established under
the laws of Foreign Country as an alternative investment fund within the meaning of
Foreign Country’s local tax laws. Grantee has not applied for or received a
determination letter from the IRS that Grantee is an organization described under IRC
§§ 501(c)(3) or 4942(j)(3). Foundation has not made a good faith determination that
Grantee is an organization described under IRC §§ 509(a)(1)-(3) (other than an
organization described in IRC § 4942(g)(4)(A)(i) or (ii)) or 4940(d)(2).

Foundation represents Grantee is not an organization controlled by Foundation and is
not a disqualified person or controlled by a disqualified person of Foundation. Grantee’s
activities are directed by an investment manager pursuant to a written management
agreement requiring the investment manager to manage the assets of Grantee in
furtherance of charitable purposes, according to an established written investment
policy.

Foundation proposes to make a loan to Grantee in the form of an unsecured line of
credit not exceeding Loan Amount, subject to a written agreement by and between
Foundation and Grantee (the “Loan Agreement”). Grantee will make secondary grants
of the Loan Agreement funds, as unsecured loans, directly to museums, art galleries,
and other arts organizations located in Foreign Country (“Secondary Grantee(s)”). Loan
Agreement funds and all loans to Secondary Grantees will carry interest at below-
market rates as outlined by formulas in the Loan Agreement. The Loan Agreement also
prohibits set-off of assets and permits Grantee to retire the debt by delivering notice to
Foundation of inability to pay any outstanding debt as a result of using all available
funds in furtherance of IRC § 170(c)(2)(B) exempt purposes.

Funds provided by Foundation under the Loan Agreement are restricted by the Loan
Agreement to use in furtherance of Foundation’s charitable purposes within the
meaning of IRC § 170(c)(2)(B) and may not be used to influence legislation or intervene
in political campaigns, consistent with IRC § 170(c)(2)(D). The Loan Agreement
requires Grantee to demonstrate to Foundation that all Secondary Grantee activities
align with Foundation’s charitable mission. The Loan Agreement requires Grantee’s on-
going reporting to Foundation of Secondary Grantee’s use of Loan Agreement funds.

Foundation represents that the Loan Agreement is provided in conjunction with a
network of other creditors to Grantee simultaneously providing similar loans to Grantee
by direct written agreement with Grantee. This network of creditors is a combination of
for-profit financial institutions and non-profit entities (“Funders”). All Funders have
agreed to a written articulation of their rights as creditors to Grantee by and among
themselves (the “Intercreditor Agreement”). The Intercreditor Agreement (i) outlines the
order for which Grantee may draw on all loans provided by Funders, (ii) determines the
order of repayment of all loans, and (iii) commits all lending to the charitable purposes
already established in the Loan Agreement. According to the Intercreditor Agreement,
Foundation is a “mezzanine” lender with repayment rights subordinate to at least one
other Funder.

The Intercreditor Agreement requires Grantee to establish an investment committee
comprised of Funder representatives. Grantee will present Funders with data from all
applicant Secondary Grantees and Funders will make recommendations or request
additional information regarding all Secondary Grantees. Funders will not make
decisions regarding applicant approval. Grantee will make all funding decisions, subject
to investment guidelines established in the Intercreditor Agreement. The investment
guidelines provided require the Grantee to establish a clear charitable purpose to all
Secondary Grantee activities. Grantee will also appoint an investment manager to
oversee lending and provide regular reporting summarizing the program’s impact on
developing the wider arts and cultural sector.

RULINGS REQUESTED

Foundation requests the following rulings:

1. Foundation’s Loan Agreement loan to Grantee qualifies as a program-related
   investment under IRC § 4944; and

2. Foundation’s Loan Agreement loan to Grantee, as a program-related investment,
   is a qualifying distribution under IRC § 4942.

LAW AND ANALYSIS

Requested Ruling 1: Foundation’s Loan Agreement loan to Grantee qualifies as a
program-related investment under IRC § 4944.

Law

IRC § 170(c)(2)(B) refers to organizations organized and operated exclusively for,
among other things, charitable and educational purposes.

Rev. Rul. 64-174, 1964-1 C.B. 183, held exempt under IRC § 501(c)(3) an organization
that created interest in theatre by aiding local communities to establish their own
charitable and educational repertory theatres. The IRS reasoned that cultural
organizations devoted to the promotion of the arts may qualify for exemption as
educational or charitable.

Rev. Rul. 66-178, 1966-1 C.B. 138, held exempt under IRC § 501(c)(3) an organization
created to foster and develop the arts by sponsoring a public art exhibit at which the
works of unknown but promising artists were selected for public display.

IRC § 170(c)(2)(D) provides that attempting to influence legislation and participating or
intervening in any political campaign on behalf of, or in opposition to, any candidate for
public office is not a charitable activity.

IRC § 4944(a) imposes an excise tax on the making of an investment by a private
foundation in such a manner jeopardizing the private foundation’s ability to carry out of
any of its exempt purposes.

IRC § 4944(c) provides that program-related investments do not jeopardize the carrying
out of a private foundation’s exempt purpose because the primary purpose of the
investment is to accomplish one or more of the purposes described in IRC §
170(c)(2)(B), and no significant purpose of the program-related investment is the
production of income or the appreciation of property.

Treas. Reg. § 53.4944-3(a)(1) provides that a “program-related investment” is an
investment which possesses the following characteristics:

   (i) The primary purpose of the investment is to accomplish one or more of the
   purposes described in IRC § 170(c)(2)(B);

   (ii) No significant purpose of the investment is the production of income or the
   appreciation of property; and

   (iii) No purpose of the investment is to accomplish one or more of the purposes
   described in IRC § 170(c)(2)(D).

Treas. Reg. § 53.4944-3(a)(2)(i) provides that an investment is made primarily to
accomplish one or more purposes described in IRC § 170(c)(2)(B) if the investment (i)
significantly furthers the accomplishment of the private foundation’s exempt activities
and (ii) the investment would not have been made but for the relationship between the
investment and that accomplishment of the foundation’s exempt activities.

Treas. Reg. § 53.4944-3(a)(2)(iii) provides that in determining whether a significant
purpose of an investment is the production of income or the appreciation of property, it
is relevant whether investors solely engaged in the investment for profit would be likely
to make the investment on the same terms as the private foundation. The fact that an
investment produces significant income or capital appreciation is not, however, in the
absence of other factors, conclusive evidence of a significant purpose involving the
production of income or the appreciation of property.

Treas. Reg. § 53.4944-3(b) example 16 involves a private foundation’s below-market
interest-bearing loan to a limited liability company electing treatment as a partnership.
Under the terms of the loan, the limited liability company is required to use the proceeds
from the loan to provide training to economically disadvantaged farmers in a developing
country. The terms of the loan are consistent with the private foundation’s IRC §
170(c)(2)(B) exempt purposes. Even though the loan is to a commercial entity, the
investment would not have been made but for the relationship between the investment
and the accomplishment of the foundation’s exempt purposes. The loan accomplishes
the private foundation’s exempt purposes and no significant purpose of the loan is the
production of income. The loan is a program-related investment.

Treas. Reg. § 53.4944-3(b) example 17 involves a private foundation’s below-market
interest-bearing loan to a social welfare organization formed to develop interest in art by
conducting weekly community art exhibits. The private foundation provides the loan to
the social welfare organization to assist the social welfare organization with the
purchase of a new community exhibition space. The private foundation’s primary
purpose in making the loan is to promote the arts and no significant purpose of the loan
involves the production of income or the appreciation of property. The loan furthers the
private foundation’s exempt purposes and would not have been made but for the
relationship between the loan and the accomplishment of those exempt purposes. The
loan is a program-related investment.

Analysis

IRC § 4944(a) imposes an excise tax on the making of an investment in such a manner
jeopardizing the Foundation’s ability to carry out of any of its exempt purposes.
Foundation’s Loan Agreement loan to Grantee is a program-related investment within
the meaning of IRC § 4944(c) and, therefore, not subject to the IRC § 4944(a) excise
tax.

IRC § 4944(c) provides that a program-related investment will not jeopardize the
carrying out of Foundation’s exempt purpose if the primary purpose of the investment is
to accomplish a purpose described in IRC § 170(c)(2)(B). Amounts paid for educational
and charitable purposes are included in IRC § 170(c)(2)(B). Organizations devoted to
the promotion of the arts may qualify for exemption as educational or charitable. Rev.
Rul. 64-174 and Rev. Rul. 66-178. The purpose of Foundation’s loan to Grantee is to
further Foundation’s mission of advancing the arts and art education in Foreign Country
by empowering local artists and cultural institutions to expand public access to a
broader range of art and widen engagement with art by a cross section of the public.
Accordingly, Foundation’s Loan Agreement furthers the accomplishment of
Foundation’s § 170(c)(2)(B) exempt purpose.

The Loan Agreement terms significantly further the accomplishment of Foundation’s
IRC § 170(c)(2)(B) exempt purposes while demonstrating the investment would not
have been made but for the relationship between the investment and that
accomplishment of Foundation’s exempt purposes. Treas. Reg. § 53.4944-3(a)(2)(i). As
discussed above, Foundation’s loan to Grantee furthers Foundation’s exempt purpose.
Additionally, the interest rates associated with the Loan Agreement are capped below
commercial market rates. The Loan Agreement and Intercreditor Agreement prohibit the
use of loan funds for purposes not described in IRC § 170(c)(2)(B), including purposes
described in IRC § 170(c)(2)(D). Foundation’s Loan Agreement is consistent with Treas.
Reg. § 53.4944-3(b) examples 16 and 17.

IRC § 4944(c) requires that no significant purpose of Foundation’s Loan Agreement is
the production of income or the appreciation of property. The Loan Agreement terms
provided indicate that investors solely engaged in investing for profit would not be likely
to make this investment on the same terms as Foundation. Treas. Reg. § 53.4944-
3(a)(2)(iii). The restrictions and terms in the Loan Agreement demonstrate Foundation’s
Loan Agreement has no significant purpose involving the production of income or the
appreciation of property, consistent with Treas. Reg. § 53.4944-3(b) example 16.

Foundation’s Loan Agreement is an investment which possesses the following
characteristics: (i) the primary purpose of the investment is to accomplish one or more
of the purposes described in IRC § 170(c)(2)(B); (ii) no significant purpose of the
investment is the production of income or the appreciation of property; and (iii) no
purpose of the investment is to accomplish one or more of the purposes described in
IRC § 170(c)(2)(D). Treas. Reg. § 53.4944-3(a)(1). Accordingly, loans granted by
Foundation in the manner described above are program-related investments within the
meaning of IRC § 4944(c).

Requested Ruling 2: Foundation’s Loan Agreement loan to Grantee, as a program-
related investment, is a qualifying distribution under IRC § 4942.

Law

IRC § 4942(a) imposes an excise tax on the undistributed income (distributable income
less any “qualifying distributions”) of private foundations qualifying for exemption from
tax under IRC § 509(a).

IRC § 4942(g)(1)(A) defines qualifying distributions to mean, in relevant part, any
amount paid by a private foundation to accomplish one or more exempt purposes as
described in IRC § 170(c)(2)(B), other than any contribution, including grants, to an
organization directly or indirectly controlled by the private foundation or its disqualified
persons within the meaning of IRC § 4946(a)(1) and Treas. Reg. § 53.4946-1(a)(1).

Treas. Reg. § 53.4942(a)-3(a)(2)(i) provides that qualifying distributions include
program-related investments, defined in IRC § 4944(c).

Treas. Reg. § 53.4942(a)-3(a)(2)(i)(a)-(c) provides that any payment, including a
program-related investment, cannot be treated as a qualifying distribution if paid to (i)
any organization controlled by the contributor or one of their disqualified persons, or (ii)
private non-operating foundations (and certain supporting organizations) that do not
satisfy the distribution requirements of Treas. Reg. § 53.4942(c).

Treas. Reg. § 53.4942(a)-3(a)(6) provides that distributions, for IRC § 170(c)(2)(B)
purposes, to a foreign organization that has not received a determination letter
confirming that it is an organization described in IRC §§ 509(a)(1)-(3) or 4942(j)(3) will
be treated as distributions made to an organization described in IRC §§ 509(a)(1)-(3) or
4942(j)(3) if the distributing foundation has made a good faith determination that the
recipient organization is an organization described in IRC §§ 509(a)(1)-(3) or 4942(j)(3).

Treas. Reg. § 53.4942(b)-1(b)(1) provides that private foundation grants to for-profit
organizations generally are an indirect means of carrying out the grantor private
foundation’s own exempt purposes if the for-profit organization uses the grant in
furtherance of the grantor’s exempt purposes. These grants will be qualifying
distributions pursuant to IRC § 4942 when paid to the grantee if they are not made to
organizations controlled by the grantor.

Treas. Reg. § 53.4942(a)-3(c)(4) provides that where a grantee uses grant funds to
make a subsequent payment to a secondary grantee, the subsequent payment will not
be treated as a grant by the private foundation to the secondary grantee if the
distributing private foundation does not earmark the use of the grant funds for any
named secondary grantee and does not otherwise retain power to cause the selection
of the secondary grantee. Whether or not the private foundation has “reason to believe”
a secondary grantee will benefit from the original grant, the private foundation has not
made a grant to the secondary grantee as long as the original grantee exercises control,
in fact, over the selection process.

Treas. Reg. § 53.4942(a)-3(a)(3) explains that furnishing support to an organization
does not determine “control,” even if that support carries restrictions and involvement by
the private foundation. Control, for purposes of applying Treas. Reg. § 53.4942(a)-
3(a)(3), is determined by the private foundation’s involvement with the grantee. Under
Treas. Reg. § 53.4942(a)-3(a)(3), “an organization is ‘controlled’ by a foundation or the
foundation’s disqualified persons if any of such persons may, by aggregating their votes
or positions of authority, require the [grantee] organization to make an expenditure, or
prevent the [grantee] organization from making an expenditure, regardless of the
method by which the control is exercised or exercisable.”

Analysis

IRC § 4942(a) imposes an excise tax on Foundation’s undistributed income
(Foundation’s distributable income less any qualifying distributions). Foundation’s Loan
Agreement loan to Grantee is a qualifying distribution under IRC § 4942 equal to
amounts actually distributed to Grantee for IRC § 170(c)(2)(B) purposes.

Ruling #1 concludes that Foundation’s Loan Agreement loan to Grantee is a program-
related investment. Foundation’s Loan Agreement, as such, is an indirect means of
furthering Foundation’s exempt purpose, as provided in Treas. Reg. § 53.4942(b)-
1(b)(1), because Foundation’s involvement with Grantee’s use of Loan Agreement
funds is limited to screening potential Secondary Grantees and receiving regular
reporting from Grantee for the purpose of enforcing the terms of the Loan Agreement.
Foundation’s Loan Agreement will therefore create qualifying distributions in amounts
equal to any funds transferred from Foundation to Grantee at the time of transfer if the
Foundation (i) does not control Grantee, and (ii) Grantee is not an entity otherwise
described in Treas. Reg. § 53.4942(a)-3(a)(2)(i)(a)-(c).

Foundation represents that Grantee is not an organization controlled by Foundation,
within the meaning of Treas. Reg. § 53.4942(a)-3(a)(3) and is not a disqualified person
(or controlled by a disqualified person). The Loan Agreement restricts Grantee’s use of
Loan Agreement funds to IRC § 170(c)(2)(B) exempt purposes and provides Foundation
a position on Grantee’s advisory committee created to receive reporting regarding
Grantee’s use of Loan Agreement funds. Nothing in the documentation provided,
however, creates a formal interest or position of decision-making authority for
Foundation in Grantee. Although Foundation is permitted to receive information related
to prospective and actual Secondary Grantees as well as provide input to Grantee,
Foundation has no authority to approve or reject Secondary Grantees.

Grantee is not a private non-operating foundation (or supporting organization).
Foundation represents that Grantee has not applied for or received a determination
letter from the IRS that it is an organization described in IRC §§ 501(c)(3) or 4942(j)(3).
Foundation has also not made a good faith determination that Grantee is an
organization described in IRC §§ 509(a)(1)-(3) or 4942(j)(3). Treas. Reg. § 53.4942(a)-
3(a)(6).

By application of Treas. Reg. § 53.4942(a)-3(c)(4), Foundation’s Loan Agreement loan
is considered only as to Grantee because Foundation does not have any authority to
earmark Loan Agreement funds to any Secondary Grantee. Foundation and
Foundation’s disqualified persons, as noted, are given no formal decision-making
authority or other interest in Grantee aside from Foundation’s ability to enforce the
terms of its Loan Agreement. Proscriptive agreement terms and conditions provided in a
grant agreement are not sufficient to create a control relationship between Foundation
and Grantee (or, similarly, any prospective or actual Secondary Grantee).

Foundation’s Loan Agreement loan to Grantee is a program-related investment,
therefore, Loan Agreement funds actually paid to Grantee constitute qualifying
distributions within the meaning of IRC § 4942(g)(1)(A).

CONCLUSION

1. Foundation’s Loan Agreement loan to Grantee is a program-related investment
   under IRC § 4944; and

2. Foundation’s Loan Agreement loan to Grantee, as a program-related investment,
   is a qualifying distribution under IRC § 4942.

The rulings contained in this letter are based upon information and representations
submitted by or on behalf of Foundation and accompanied by a penalty of perjury
statement executed by an appropriate party, as specified in Rev. Proc. 2021-1, 2021-1
I.R.B. 1, § 7.01(16)(b). This office has not verified any of the material submitted in
support of the request for rulings, and such material is subject to verification on
examination. The Associate Office will revoke or modify a letter ruling and apply the
revocation retroactively in the following situations: (i) there has been a misstatement or
omission of controlling facts; (ii) the facts at the time of the transaction are materially
different from the controlling facts on which the ruling is based; or (iii) the transaction
involves a continuing action or series of actions and the controlling facts change during
the course of the transaction. See Rev. Proc. 2021-1, § 11.05.

Except as specifically set forth above, no opinion is expressed or implied concerning the
federal tax consequences of the proposed transaction under any other provision of the
Code or Treasury Regulations.

This letter is directed only to Foundation. IRC § 6110(k)(3) provides that it may not be
used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to Foundation’s authorized representatives.

If you have any questions about this ruling, please contact the person whose name and
telephone number are shown in the heading of this letter.

                                            Sincerely,



                                            James Zelasko
                                            Branch Chief
                                            Exempt Organizations Branch 2
                                            (Employee Benefits, Exempt Organizations, and
                                            Employment Taxes)

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