Sticky Issues with Co-Investing

More than once, we've been asked the question whether a donor/investor can put their personal capital in the same deal as their charitable capital. This blog addresses a few of the technical considerations involved in such questions.*

To understand the question, it's helpful to understand the wealth picture of a typical donor/investor. At a business or real estate exit, people often use a variety of planning vehicles to hold and manage the proceeds from the sale. There's the personal bucket used for current spending and lifestyle choices (houses, a boat, vacations, etc); the investment or next generation bucket in a trust or family limited partnership; and the charitable bucket in a donor advised fund (DAF) or private foundation (PF). 

Many donor/investors have distinct investment strategies for their various buckets based on different time horizons and growth needs. But for a donor/investors who favors active investing in private equity deals, it isn't always that simple. When a great private equity deal comes along, he must decide whether to allow his investment capital or his charitable capital to get into the deal. It seems like a win-lose proposition. One of the buckets of capital will miss out on the potential growth. What if instead, the donor/investor could allocate capital from both his charitable bucket and his investment bucket into the same deal? Seems like an innocent request and one born from pure motives to maximize growth across all the platforms he is stewarding. 

The IRS, however, sees a high potential for abuse in such cases. To avoid instances where a business owner attempts to prop up her failing company with her charitable funds, the IRS has put in place the following rules: 

Excess Business Holdings

Penalty: 10% tax on the whole value of anything deemed an excess business holding (can be higher if the IRS discovers the EBH issue before the foundation)

Definition: a PF or DAF has excess business holding if it and any disqualified person (see definition below) owns more than 20% of the voting interests of a company

Exceptions: 

1) the investment is closely related to or furthers the charitable purpose of the organization (like a program-related investment or PRI)

OR

2) the PF or DAF owns less than 2% of the voting interests (or profits interest in a partnership)

Triggers (or grace periods):

In the case of purchase - No tax if the charity disposes of its ownership within 90 days when EBH is triggered by purchase

in the case of gift - No tax if the charity disposes of its ownership within 5 years when EBH is triggered by gift (or any transfer other than purchase)

Code section: 4943

Self Dealing with Disqualified Persons

Penalty: up to 200% levied against the foundation managers and disqualified person

Definition: a disqualified person (DQP) is the donor of a PF; the advisor on a DAF; that person’s spouse, children, siblings (sometimes); and any entity which the donor owns more than 35% of the vote (profits interest of a partnership/LLC)

Triggers: 

1) PF selling property to a DQP (DAFs are allowed to do so if the transaction is arms length and for reasonable compensation)

2) a grant, loan, or compensation paid by PF or DAF to DQP

3) Investing in equity of a deal where the DQP is more than a 35% owner is in the gray area and governed by case law. I’m not going to try to address it in this blog, but be aware that treatment of these deals is confusing and closely scrutinized. 

Code section: 4958, 4966, 4967

*This isn't legal advice and is written for educational purposes only. We strongly encourage you to seek your own tax and legal advice.