In a previous blog post, I wrote about how the decision between whether a social enterprise should be structured as a for-profit or a non-profit is becoming less relevant since the lines are blurring between the two. One of the big reasons why the lines are blurring is because the types of investors, like foundations, that typically supported non-profits are increasingly testing tools that allow them to support for-profits with strong social and environmental impacts.
How is it possible for a philanthropic foundation to support a for-profit entity, even if it is one that has a strong social impact? Aren’t foundations required to make grants only to non-profit organizations that have received 501(c)3 status from the IRS? Aren’t they subject to onerous oversight from the IRS if they go beyond traditional grantmaking to traditional nonprofits, involving mysterious requirements like “expenditure responsibility” that you’ll likely need a tax specialist and an attorney to understand? Won’t the IRS “hold in escrow” the first-born child of the Foundation’s Board Chair if a for-profit diverts philanthropic resources for private gain??
The short answer is “no.” It's actually quite straightforward for foundations to support for-profit social enterprises through tools like loans and other debt-instruments that both help social enterprises launch and achieve scale, but ensure that philanthropic dollars are paid back to foundations.
With the help of Teresa Araco Rogers from Harp Weaver (a philanthropic advisory firm), we looked into the actual compliance burden associated with a philanthropic foundation making a loan to a for-profit social enterprise, and our team put together a helpful infographic to describe the process.(Click the image above to download the full size of these infographics on Program Related Investments)Bottom line, and quite surprisingly, making a loan to a for-profit is basically similar to making a grant, with a few tweaks to conform to the “expenditure responsibility” regulations from the IRS.
The Foundation must conduct a “pre grant inquiry” into the social enterprise and management it plans to support with the loan. The inquiry must cover the “identity, prior history and experience (if any)” of the grantee and its managers, and give the foundation reasonable assurance that the loan recipient will use the funds as they said they would. In other words, the foundation has to do what it probably already does before it makes a significant grant commitment to any organization, 501(c)3 or not.
If the Foundation decides to proceed, they must come to a written agreement of terms for the loan, including the social impact they expect to see. This is not too different than any grant agreement. To make it extra easy, the Council on Foundations has published a form version of an expenditure responsibility agreement for a grant. A loan agreement would have to have additional terms about interest rates and repayment, of course, but there are plenty of good examples of form loan docs out there as well.
The for-profit social enterprise/loan recipient must file an annual expenditure responsibility report with the Foundation. This sounds scary, but the IRS only requires the recipient to answer seven questions, and these are not hard questions: question 1 is “What is your name?” Question 2 is “When did you get the loan?” Question 6 is “What is the date of the report?” The other four questions aren’t that much more difficult.
The Foundation essentially then just has to staple the grantee’s report to the back of their 990 each year.
And finally, if the Foundation finds out that funds aren’t being used as intended, they have to take reasonable steps to recover the money.
If you’re interested in finding out more, you can read more on the IRS website, from Adler & Colvin, or the actual regulations themselves. I’m not a lawyer and this blog shouldn’t be taken as legal or tax advice, but from a practitioner’s point of view, the compliance barriers for a Foundation jumping into the world of impact investing are fairly low.