What are jeopardizing investments for private foundations?
Private foundations are prohibited from making jeopardizing investments, meaning they cannot manage their endowment recklessly or imprudently. So no big bets on penny stocks and pork bellies! The IRS defines jeopardizing investments as those showing a “lack of reasonable business care and prudence” in meeting the foundation’s long- and short-term financial needs to carry out its charitable purpose. When evaluating investments, foundation managers must consider criteria such as expected return (income and capital appreciation), the risks of price fluctuations, and the importance of portfolio diversification. Engaging qualified investment advisors and legal counsel can significantly reduce the risk of making jeopardizing investments.
To avoid such risks, private foundations should adopt sensible, well-measured investment strategies. Foundation managers and their advisors should follow established principles, including the power of compound growth, risk-return balance, low-cost investing, and diversification. There are no definitive tests for determining whether an investment is jeopardizing; each investment must be assessed individually, considering all relevant facts and its relationship to the portfolio as a whole. The assessment is made at the time of purchase, focusing on whether the investment was reasonable at that moment—not on its eventual financial outcome.
For instance, buying a lottery ticket is almost universally deemed a terrible investment and epitomizes a jeopardizing investment. Even if that ticket wins a jackpot, it remains an imprudent decision at the time of purchase. While this example is extreme, more plausible scenarios, such as speculative venture capital investments, may also cross the line into jeopardizing investment territory. These investments require thorough analysis to ensure alignment with the foundation's goals and risk tolerance.
Because investments are evaluated based on the circumstances at purchase, it is critical for foundation managers to document the reasoning behind their decisions. Robust documentation not only demonstrates due diligence but also serves as a critical safeguard for managers. While no specific asset class or type of investment is automatically considered a violation, the IRS has historically subjected certain investments to heightened scrutiny, including:
1. Trading in securities on margin,
2. Trading in commodity futures,
3. Investing in working interests in oil and gas wells,
4. Buying puts, calls, and straddles,
5. Buying warrants,
6. Selling short, and
7. Engaging in highly speculative ventures.
While these types of investments are not automatically prohibited, they may attract IRS scrutiny. The IRS evaluates whether the investment was reasonable based on the portfolio as a whole, not in isolation.
Purpose of the Jeopardizing Investment Rules
These rules were designed to safeguard foundation assets and provide federal enforcement mechanisms against reckless or imprudent management. Before their implementation, state attorneys general were the primary enforcers of asset management standards. While the rules create federal uniformity, foundations must also comply with state fiduciary obligations. State intervention typically occurs only in cases of truly egregious investment behavior.
Exceptions to the Jeopardizing Investment Rules
The jeopardizing investment rules do not apply under the following situations:
• Investments received as gifts or donations from third parties,
• Investments acquired during corporate reorganizations, and
• Program-related investments (PRIs), which are made primarily for charitable purposes with financial gain as a secondary goal.
For example, a foundation receiving stock through a corporate reorganization or as a gift is not required to evaluate the investment unless it actively alters the terms of the acquisition or provides consideration. Similarly, PRIs—such as low-interest loans to support affordable housing—are exempt because they primarily serve a charitable purpose.
Penalties for Violating the Jeopardizing Investment Rules
Violating jeopardizing investment rules can lead to penalties for both the foundation and its managers. The foundation may face a 10% tax on the invested amount each year the investment remains on its books. Additionally, managers who “knowingly, willfully, and without reasonable cause” participated in the decision may be taxed 10% of the investment amount, up to $10,000 annually. Managers share joint and several liability for these penalties, but reliance on sound legal or investment advice can mitigate this risk.
If the foundation fails to promptly dispose of a jeopardizing investment, the IRS may impose a second-tier tax of 25% on the foundation and an additional 10% on responsible managers, up to $20,000.
Establishing Sound Investment Policies:
Foundations can mitigate risks by developing clear, written investment policies. These policies should outline acceptable investments, define risk tolerance, and specify prohibited investment activities, such as trading on margin or speculative investments. They should also mandate diversification to minimize exposure to high-risk assets and provide a framework for ongoing monitoring and adjustments. Additionally, seeking advice from qualified investment and legal advisors can play a pivotal role in ensuring investments are not only compliant with IRS regulations but also tailored to the foundation’s unique goals and risk profile. Expert guidance can help identify potential pitfalls, optimize investment strategies, and reinforce the foundation’s commitment to prudent financial management.
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