Private foundations are not allowed to make jeopardizing investments, which essentially means they cannot be reckless or imprudent with their invested endowment. So no big bets on penny stocks and pork bellies! The IRS defines jeopardizing investments as “investments that show a lack of reasonable business care and prudence in providing for the long- and short-term financial needs of the foundation for it to carry out its exempt function.” So, in order to avoid jeopardizing investments, private foundations should simply invest in a sensible and measured way. To accomplish this, foundation managers and their investment advisors should follow established investment strategies and consider standard investment concepts like expected return, the power of compound growth, the relationship of risk and return, the advantage of low costs, and the benefits diversification.
There are no bright line tests that determine whether an investment is a jeopardizing one. To make a determination each investment should be considered on an individual basis by taking into account all the relevant facts and circumstances including the investment's relationship with the foundation’s portfolio as a whole. The determination is made at the moment the investment is purchased—is the investment a reasonable choice at that exact moment? It does not matter if the investment goes on to make a lot of money or lose a lot of money—but rather the focus is on whether the investment was reasonable the day it was made. For example, lottery tickets are universally considered to be terrible investments and are perhaps the epitome of a jeopardizing investment. If a foundation buys a lottery ticket and wins the jackpot this does not change the fact that at the moment the lottery ticket was purchased it was a terrible investment and therefore a jeopardizing one. Because investments are judged based on the facts and circumstances at the moment of purchase, it is very important for foundation managers to maintain records documenting the reasoning behind why the investments were made. There is no specific asset class or type of investment that is instantly treated as an intrinsic violation, but the IRS has historically scrutinized the following investments very closely:
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, and
6. Selling short.
Purpose of the Jeopardizing Investment Rules
The jeopardizing investment rules were implemented to safeguard foundation assets and provide the IRS with an enforcement mechanism in case a private foundation is managing its assets in a reckless or foolish way. Before the jeopardizing investment rules were instituted the only substantial enforcement mechanism to assure foundations manage their assets appropriately was via the state attorney generals. Generally speaking, the various state attorney generals have the power to punish imprudent private foundations but they typically only get involved if the investment behavior is truly egregious.
Exceptions to the Jeopardizing Investment Rules
The jeopardizing investment rules do not apply under the following situations:
• The foundation receives an investment as a gift from a third party
• The foundation acquires the investment as a result of a corporate reorganization
• The investment is classified as a program-related investment
Penalties for Violating the Jeopardizing Investment Rules
The penalties for violating the jeopardizing investment rules are designed to punish both the foundation as well as the foundation managers who approve the investment decisions. If a private foundation is found to make a jeopardizing investment, there is a tax levied on the foundation of 10% of the amount invested. This tax can be imposed each year the investment is on the foundation’s books. Additionally, any foundation manager who “knowingly, willfully and without reasonable cause” participated in the making of the investment can also be subject to 10% tax on that investment (up to a maximum of $10,000). This penalty tax is also applied each year the jeopardizing investment is on the foundation’s books. The individual penalty can apply if the foundation manager is negligent in attempting to understand the risks involved of the investment in question.
Furthermore, if the foundation does not take appropriate steps to dispose of a jeopardizing investment, the IRS can impose a second-level tax on the foundation equal to 25% of the amount of the investment. Individual foundation managers who do not allow the disposal of the jeopardizing investment can also be found liable for this second level tax, which is 10% of the investment (up to a maximum of $20,000).
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