New IRS ruling critical of impact investing concept

It could have a big impact on social innovation programs and organizations

By Adam Connatser

Earlier this month, the IRS released Private Letter Ruling 202041009. While it may sound somewhat innocuous, the ruling’s bureaucratic label is misleading. In it, the IRS threw stones at the concept of impact investing. What was expected to be a simple confirmation of a nonprofit’s tax-exempt status, actually turned out to be a major blow to a technique commonly used by organizations with a public benefit mission. The fallout may be felt for years.

Wright Connatser works with many social impact groups that rely on impact investing techniques. To us, this is a surprising, and faulty, ruling that will be detrimental to a myriad of groups nationwide that are creating equity in communities of color, feeding the impoverished, delivering healthcare to the underserved, combatting climate change, and many other worthy endeavors.

Impact investing – those investments made into projects with the intent to deliver a benefit to society or the environment, as well as earn a return for the investors — is a powerful tool that serves a vital role in our economy and communities. It allows nonprofits and other enterprises to raise money for projects that make an impact but traditional capital markets eschew because of their size, scale, risk, and/or low return.

A private letter ruling, or PLR, is a written statement that interprets and applies tax laws in response to an organization’s written request. While they are binding only to the organization that requested the ruling, PLRs are used as a guide to the IRS’ positions on the application of tax laws. And “private” is a bit of a misnomer; while a PLR is issued in a specific case, the IRS makes the ruling public, albeit with the organization’s name and some specifics of the case redacted.

This particular ruling denied the requesting organization nonprofit status because of its impact investing practices, specifically, managing funds for a fee where the funds provide market or near-market returns for investors. What the ruling ignores is that these funds assist the underserved and would never have been formed through conventional capital markets because of their small scale, risk, and low projected return.

Also, the logic of the ruling appears to take issue with the function of program-related investments (PRIs), which allow private foundations to make financial investments in charitable causes, but with the expectation of a return on their money. PRIs are an important tool for the nonprofit world as they allow foundations to achieve two objectives simultaneously – leverage their money for societal benefit and earn more money. This is particularly confusing because PRIs are expressly created and authorized by the Internal Revenue Code.

Should a nonprofit utilizing impact investment immediately divest itself of those investments or risk losing its tax-exempt status? No, that isn’t necessary. However, organizations using impact investing, including PRIs, need to be mindful of potential pitfalls down the road. For example, might the case have had a different outcome if the organization had covered its managerial and operational expenses by grants and donations, rather than management fees (even though the fees were below market)?  Our team at Wright Connatser is following this ruling closely and we will be able to counsel organizations on how they can maneuver accordingly.

Editor’s note: Wright Connatser is co-sponsoring a presentation on impact investing with Jennifer Kenning, CEO and co-founder of Align Impact, on Friday, October 30 as part of bigBANG20!, a premier social innovation conference.