Case:

Lucky Lucy finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor (RIA) and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucy was so successful in these markets that she now only manages her own large personal portfolio.

Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and learned that giving to someone in need is even more gratifying than making another million in the futures market. After reading in her favorite charity’s weekly enewsletter about the need for housing in a low-income area that had been destroyed by a flood, Lucy called the charity’s gift planner.

Lucy invested $1,000,000 in stock in a Canadian AI startup with the name Northern Long Shot, Inc. This company is building creative new AI applications. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy thinks that this stock should be sold as soon as possible, but she would like to receive a deduction this year. In addition, she thought that the $5,000,000 could be placed in a private foundation to make loans to low-income individuals who otherwise could not afford to rebuild their homes. Since she wanted to have direct influence over the program, Lucy called her attorney Susan to discuss a potential major gift to a private foundation for low-income housing loans.

Question:

Would this plan work? Can the private foundation receive the gift and sell the Northern Long Shot, Inc. stock? May the funds be used for the low-income housing loans? Is there a better plan?

Solution:

There are several potential issues with Lucy’s plan. A private foundation may receive the Northern Long Shot stock and immediately sell the stock. The cash would then be available for use by the private foundation.

Regarding offering housing loans to low-income individuals, the private foundation must consider the rules relating to Sec. 4944 regarding investments that may jeopardize the charitable interest. Section 4944 imposes a tax on investments that jeopardize the carrying out of any of the exempt purposes of a private foundation. Regulation 53.4944-1(a)(2)(i) states that an investment shall be considered jeopardizing if the foundation managers have failed to exercise ordinary business care and prudence under the facts and circumstances prevailing at the time the investment is made. Because the loans may be deemed risky and some low-income homeowners are at a higher risk of default, this raises the question of whether these loans will be permitted.

However, under Sec. 4944, the program may be permissible if the foundation’s counsel confirms that the loans are compliant with the program-related requirements. To qualify as a program-related investment, counsel must determine that the investment satisfies both required criteria for such a classification. First, the primary purpose of the investment must be to accomplish one or more of the purposes described in Sec. 170(c)(2)(B). Here, the primary purpose of the loans is to combat community deterioration in a manner that is considered charitable within the meaning of Sec. 501(c)(3). Thus, such loans accomplish a purpose described in Sec. 170(c)(2)(B). 

Second, the production of income or the appreciation of property must not be a significant purpose of the loans. Here, the funds invested by the private foundation will be used to provide financing for low-income individuals and will not produce substantial income or appreciation. Thus, counsel may conclude that this is an appropriate use of the private foundation’s investments.

Lucy decided to fund the private foundation. With $5,000,000 in funding and the foundation’s counsel granting approval of the structure of the loans, many low-income persons are now rebuilding both their homes and their shattered lives.