Letter Ruling Alert: A Blueprint for Creating a Taxable Subsidiary

Introduction

Exempt organizations have been creating
taxable subsidiaries for many years to meet
a variety of needs, including spinning off
unrelated businesses, protecting the parent
organization from potential liabilities, and
providing a means of sharing the profits
from money making ventures with employees.
In a recent private letter ruling (LTR
200225046 (March 28, 2002), reprinted on
p. 322), the IRS has provided a comprehensive blueprint for
creating and structuring an exempt organization’s relationship
with such a subsidiary. The ruling not only addresses the
more routine topics of how to protect the tax-exempt status
of the parent organization and whether certain payments from
the subsidiary to the parent will be treated as unrelated business
taxable income, but also provides guidance regarding
how to structure resource sharing arrangements and how to
grant stock and stock options to employees of both the subsidiary
and the parent. Although the Service imposed a few
requirements that go beyond those existing in current law
and did not resolve all of the unrelated business taxable
income questions raised by the facts before it, the ruling
provides both a helpful summary of the legal principles that
apply to taxable subsidiaries and a useful example of the
application of those principles.

Facts

M is a section 501(c)(3) educational organization engaged
in various endeavors relating to a certain subject. It has
dues-paying members from around the world, and serves all
levels of practitioners, educators, and students. Its activities
include producing a magazine and other publications, hosting
workshops, seminars, and conferences, and facilitating the
networking of its members.

M created a taxable entity, N, to operate an Internet portal
(“N.com”) that will serve as a comprehensive source of information,
products, and services targeted at business professionals
working in M’s area of concentration. N’s specific
activities will include establishing links to merchants through
affiliate agreements, providing online recruiting and career
resources, producing industry directories, and providing advertising.
Although not explicitly stated in the ruling, it appears
that M will be transferring essentially all of its Internet
activities to N. M provided three reasons for making this
transfer: to insulate itself from liability arising
from affiliate agreements related to M’s
Web site with third parties; to carry out certain
activities in a manner that would not
affect M’s exempt status under section
501(c)(3); and to minimize M’s potential liability
for unrelated business income tax under
section 511.

The actual creation of N was straightforward.
M caused N to be incorporated as a
for-profit corporation, and then contributed
cash and certain intangible assets to N in
exchange for shares of N’s common stock,
making N a wholly owned subsidiary of M. N will establish
a separate telephone number and separate telephone listing(s),
bank accounts, and stationery, although N will have the same
mailing address as M, at least initially. N will also obtain a
benefits package for its employees and insurance to cover its
operations, and will not comingle or combine its funds and
assets with those ofM. N’s board of directors will have regular
meetings throughout the year, will maintain complete and
accurate minutes of meetings, and will be the sole governing
and policy-making body for N.

Although not stated explicitly, M will presumably appoint
all of the members of N’s board of directors, at least as long
as M is N’s sole shareholder. A majority of the five directors
will not, however, be officers or directors of M. The board
will initially consist of M’s CEO, a member of M’s board or
M’s executive committee, the president/CEO of N, and two
individuals who are not currently directors, officers, or employees
of M. M also has veto power over certain actions by
N as long as M continues to hold more than 50 percent of
N’s outstanding voting stock. These actions include: amending
N’s governing documents; major corporate actions such
as a merger, consolidation, reorganization, dissolution, filing
for bankruptcy, creating a subsidiary, changing taxable status,
and issuing shares of capital stock; removing any director
appointed by M; disposing of any material asset other than
in the ordinary course of business for fair market value consideration;
and any action that could be reasonably expected
to have a material adverse effect on M’s tax-exempt status.

N’s first two employees will be its president/CEO and its
“director, Web site architecture.” Neither of these employees
will be an employee of M, although the director, Web site
architecture had previously worked for M. N’s officers and
employees will be in charge of N’s day-to-day activities.

M and N plan to enter into the following series of agreements
governing financial transactions between them;Msubmitted
copies of the agreements to the Service as part of the
ruling request.

- Administrative services agreement: N may, at least
during its start-up phase, obtain administrative services
from M in exchange for reimbursing M for the costs
M incurs in providing those services.
- Advertising agreement: M will receive banner advertising
space on N’s Internet portal, and N, in exchange,
will receive a proportionate amount of advertising
space in M’s publications. M will report the value of
the advertising space it receives as unrelated business
taxable income.
- Affiliate agreement: This agreement will govern the
terms of the sale of M products and services on N’s
Internet portal, withMdetermining the pricing for such
items and N receiving a commission on the sale of any
such items through N’s portal.
- Directory agreement: N will receive a non-exclusive,
non-transferable license to M’s directory of service
providers for a term of 10 years, with a 10-year automatic
renewal unless N provides written notice of nonrenewal.
In exchange, N will market, promote, and
make available on the Internet the directory information,
and will pay M an annual royalty with a fixed
minimum plus 50 percent of the gross revenues from
the sale of directory listings in excess of that minimum.
M will also establish standards and guidelines for the
permitted use and depiction of directory information.
- Lease: N’s office, at least initially, will be a separate
area in M’s office, with the rent paid to M set at M’s
cost for that space.
- Licensing agreement: Under this agreement,
   - N will license from M M’s trademark, logos, and
domain name, and certain content from M’s publications,
for use in and relating to N’s Internet portal.
N will also licenseM’s membership database, which
contains contact, financial transaction, and demographic
information about M’s members and which
M does not license or rent to other parties.
   - N will provide on N’s Internet portal anM“members
only” section, links to M Chapter Web sites, and
priority positioning for M’s products and services.
   - N will try to obtain discounts for M’s members on
products and services provided through N’s affiliate
programs with third parties.
   - N will pay M a royalty of 10 percent of “gross
revenues,” as defined in the agreement, with a minimum
royalty guaranteed for the first two fiscal years.
   - N will not provide comparable Web site hosting
services to any other entity selling products or services
targeting those with an interest in M’s subject
matter.
   - M will not license its content to any other Web
site that is directed toward the North American
community.
   - M will have the option of extending the terms of
the Agreement to any foreign jurisdiction that N
seeks to enter for purposes of establishing an Internet
portal.
   - Upon termination, M will be granted a royalty-free
perpetual (but apparently non-exclusive) license to
the software developed to operateN’s Internet portal,
N will assign to M all of N’s third-party affiliate
agreements for its Internet portal, and M will have
the option of purchasing N’s Internet portal hardware
at fair market value.

The Agreement will have a 10-year term, with an
automatic 10-year renewal absent a written notice from
M of nonrenewal.

N will adopt a stock grant plan as part of the compensation
to be paid to its officers, directors, and employees for their
services, subject to the total compensation paid being reasonable,
as determined by a compensation consultant. N may
also in the future seek other investors to provide additional
capital, including through possibly forming one or more joint
ventures. M will offer N stock and stock options to M’s key
employees, subject to the total compensation, including the
fair market value of any N stock or stock option granted,
received by any employee being reasonable.

IRS Conclusions and Rationale
Separate Entities

The Service first addressed the most important aspect of
the creation of N: whether M had succeeded in creating a
separate entity, the activities of which would not be attributable
to M. Relying on the familiar cases of Moline Properties
Inc. v. Commissioner, 319 U.S. 436 (1943) and Britt v. United
States, 431 F.2d 227 (5th Cir. 1970), as well as Krivo Industrial
Supply Co. v. National Distillers and Chemical Corp.,
483 F.2d 1098 (5th Cir. 1973), which involves a lengthy
discussion of when one corporation is an “instrumentality”
of another corporation such that the liability of the first
corporation can be attributed to the second corporation, the
Service concluded that M had succeeded in creating an entity
with a bona fide business purpose and which was not a “mere
instrumentality” of M.

In reaching this conclusion, the Service relied on the fact
that N’s Internet portal would benefit not only the members
ofM but also other professionals, that a majority of N’s board
would not be board members or officers of M, and that the
day-to-day management ofNwould be in the hands of officers
of N who will be independent of M. The Service also relied
on the fact that N would maintain separate books and records,
financial reports, employee benefits, and insurance, and that
financial transactions between N and M would be carefully
documented, with M being fully reimbursed for any use by
N of M’s office space or administrative services.

Given this conclusion, the Service then ruled that neither
the formation nor the initial capitalization of N would adversely
affect M’s tax-exempt status as an organization described
under section 501(c)(3) or result in UBTI to M. The
Service also ruled that N’s taxable income would not be
treated as UBTI to M, any proceeds from the sale of stock
by N would not result in UBTI to M, and any dividends
received by M from N would be excluded from M’s UBTI
by section 512(b)(1).

Payments from Taxable Subsidiary to Exempt Parent
The Service also ruled on the treatment of various payments
received by M from N. Turning first to the Licensing
Agreement, the Service noted that the payments for the intangible
property rights obtained by N from M qualified as
royalties within the meaning of section 512(b)(2), which
provides an exclusion from UBTI for royalties. In reaching
this conclusion, the Service relied on the first situation described
in Rev. Rul. 81-178, 1981-2 C.B. 135, where the
Service found that the licensing of a section 501(c)(5) labor
organization’s trademarks, trade names, service marks, and
copyrights, along with its members’ names, photographs,
likenesses, and facsimile signatures, qualified as royalties
under section 512(b)(2). The Service also relied on the line
of cases concluding that payments for the rental of mailing
lists constitute royalties within the meaning of section
512(b)(2). See Sierra Club Inc. v. Commissioner, 86 F.3d
1526 (9th Cir. 1996); Common Cause v. Commissioner, 112
T.C. 332 (1999); Planned Parenthood Federation of America
Inc. v. Commissioner, 77 T.C.M. (CCH) 2227.

The Service specifically did not rule, however, on whether
the royalty payments might still constitute UBTI under section
512(b)(13). Section 512(b)(13) provides that if a controlling
organization receives a specified payment from a
controlled entity, the payment shall be included in UBTI
notwithstanding sections 512(b)(1), (2), and (3) to the degree
such payment reduces the net unrelated income of the controlled
entity. Specified payments are interest, annuities, royalties,
and rents. Section 512(b)(13)(C). “Control” generally
means, for a corporation, ownership, by vote or value, of
more than 50 percent of stock in such corporation. Section
512(b)(13)(D).

The Service also ruled that the payments received by M
pursuant to the directory agreement qualified as royalties
under section 512(b)(2), and indicated that the rental payments
from N to M under the lease would qualify as rent
under section 512(b)(3), which excludes rent from UBTI. As
with the licensing agreement royalty payments, however, the
Service did not rule regarding whether those payments might
still constitute UBTI under section 512(b)(13). The Service
also did not rule on whether the payments by N to M for
administrative services might constitute UBTI. The Service
did note that M had represented that it would report any
compensation received under the advertising agreement as
UBTI.

Stock and Stock Options

Citing the prohibitions on private inurement found in
section 501(c)(3) and reg. section 1.501(c)(3)-1(c)(2) and on
serving private interests found in reg. section 1.501(c)(3)-
1(d)(1)(ii), the Service also reviewed whether the planned
distribution of stock by N to its employees and of stock and
stock options by M to its employees violated those prohibitions.
The Service first noted that since M and N are separate
legal entities, and the stock to be provided by N to its employees
would constitute reasonable compensation for the
services they would render, the provision of such stock by N
was not incompatible or inconsistent with M carrying out its
exempt purposes. The Service took particular note of the fact
that a compensation consultant would be retained by N to
ensure the reasonableness of the total compensation paid by
N to its directors, officers, and employees.

The Service also concluded that M’s provision of N stock
or stock options would not violate these prohibitions “so long
as the total compensation to be paid by M to an employee is
reasonable in amount.” Relying on M’s representation that
this condition would be satisfied, the Service concluded that
the provision by M of such stock or stock options to its
employees would not adversely affect M’s tax-exempt status
under section 501(c)(3).

Comment

The ruling provides a helpful guide for creating and structuring
financial relationships with a taxable subsidiary. The
discussion of stock and stock options in particular may be
the first instance of the Service ruling on the provision of
stock and stock options of a taxable subsidiary by the exempt
parent to its employees, although the Service has ruled before
on the ramifications of a taxable subsidiary of an exempt
parent providing stock or stock options to the subsidiary’s
employees. (See, e.g., PLR 9722032 (Feb. 28, 1997); Doc
97-15432 (9 pages); or 97 TNT 104-34.) The ruling suggests,
however, that the Service has adopted a few positions that do
not appear to be completely consistent with settled law, and
also leaves several important UBTI issues unresolved.

Separate Entities

The Service’s conclusion that N should be treated as separate
from M for federal tax purposes is clearly correct, and
the detailed description of the creation of N and the financial
relationships between M and N provides helpful information
regarding how to ensure this result. For example, it is useful
to have it confirmed that an exempt parent can have (apparently)
complete control over the selection of the members of
the governing body of the wholly owned subsidiary, and also
have reserved powers over major actions on the part of the
subsidiary, and yet still be able to treat the subsidiary as a
separate entity.

One troubling aspect of the Service’s reasoning, however,
is that the Service appears to have considered crucial certain
facts that appear to go beyond what is required by the case
law cited by the Service. It is certainly true that to be treated
as a separate entity, the subsidiary must have a bona fide
business purpose, although carrying on actual business activity
also is sufficient. See Moline Properties, 319 U.S. at
438-39. The Service’s reason for apparently relying on the
fact that N will be serving people beyond M’s members to
demonstrate that N had a bona fide business purpose is unclear,
however. It seems reasonable to assume that an exempt
organization could form a wholly owned taxable subsidiary
for the purpose of engaging in business activities that benefit
only the exempt organization’s members, and still have that
subsidiary qualify as a separate entity for tax purposes. For
example, in PLR 199938041 (June 28, 1999), profiled in this
space in March 2000, the Service appeared to have no difficulty
treating a wholly owned taxable subsidiary as a separate
entity for federal tax purposes even though the entity’s role
was to contract with various service providers who provided
services to the exempt parent’s members. A better reading of
the Service’s reliance on the scope of the beneficiaries of N’s
activities may be that providing services to persons other than
M’s members helped demonstrate N’s bona fide business
purpose but was not determinative. (For PLR 199938041, see
The Exempt Organization Tax Review, March 2000, p. 478;
Doc 1999-30923 (16 original pages); or 1999 TNT 186-26.)

The Service’s apparent conclusion that for a subsidiary to
be considered a separate entity it must have both separate
day-to-day management and a majority of board members
who are not officers or employees of the exempt parent, is
even more troubling. The Krivo case, which the Service
apparently relies on for the proposition that a subsidiary
cannot be a “mere instrumentality” if it is to be regarded as
separate for federal tax purposes, imposes no such requirement.
It explicitly provides that stock ownership, and therefore
presumably board control, does not per se resolve the
instrumentality question. See Krivo, 483 F.2d at 1104. More
importantly, the court concluded in that case that even if the
dominant organization shared managerial responsibility for
some of the subservient corporation’s operations, this was
not enough to justify disregarding the subsidiary’s separate
corporate existence. Id. at 1112. Rather, evidence showing
that the dominant organization had “actual, operative, total
control of the subservient corporation” was required. Id. at
1109.

The Service’s reliance on Krivo is also misplaced for
another reason. Krivo was not a tax case; rather it involved
the question of whether a creditor could seek payment from
the dominant corporation for the subservient corporation’s
debt. A case decided after Krivo explicitly noted that disregarding
an entity for liability purposes is subject to a different,
and apparently lower, standard than disregarding an entity
for federal tax purposes. Avco Delta Corp. Canada Ltd. v.
United States, 540 F.2d 258, 264 (7th Cir. 1976), cert. denied
sub nom. Canadian Parkhill Pipe Stringing Ltd. v. United
States, 429 U.S. 1040 (1977). The Supreme Court has affirmed
that in applying the principles of Moline Properties,
“when a corporation carries on business activity the fact that
the owner retains direction of its affairs down [to] the minutest
detail, provides all of its assets and takes all of its profits can
make no difference tax-wise.” National Carbide Corp. v.
Commissioner, 336 U.S. 422, 431-32 (1949).

This conclusion is also consistent with how the Service
treats related organizations in the section 501(c)(3)/501(c)(4)
context, where it has found that overlapping directorates and
personnel do not prevent related organizations from being
treated as separate entities for federal tax purposes as long
as the organizations maintain separate finances and held
themselves out as separate organizations. See, e.g., Ward L.
Thomas & Judith E. Kindell, “Affiliations Among Political,
Lobbying and Educational Organizations,” Exempt Organizations
Technical Instruction Program for FY 2000, at 255,
257-60 (Doc 1999-28450 (12 original pages); 1999 TNT
169-30). There are therefore strong legal grounds for asserting
that even if an exempt organization parent’s officers, directors,
or employees make up the entire membership of the board
of directors of a taxable subsidiary, and even if the exempt
organization controls the day-to-day activities of the taxable
subsidiary through overlapping officers or other mechanisms,
the subsidiary must be treated as a separate entity for federal
tax purposes as long as the appropriate corporate formalities
are observed and the finances of the subsidiary are kept
separate from those of the parent.

Unrelated Business Taxable Income

The Service’s conclusions that various income streams fall
within the section 512(b)(1) and section 512(b)(2) exceptions
to UBTI for dividends and royalties are helpful, if not surprising,
particularly in light of the line of cases concluding
that payments for the use of intangibles such as mailing lists
were royalties within the meaning of section 512(b)(2). The
lack of conclusions with respect to some of the other income
streams is disappointing, however. This is not to fault the
Service, since presumably M intentionally chose not to request
rulings with respect to the other income streams.

With respect to the royalty and rental payments from N
to M, those payments undoubtedly fall within the section
512(b)(13) provision that renders those types of payments
UBTI, in spite of sections 512(b)(1) and 512(b)(2), given that
M will apparently own more than 50 percent of N’s stock, by
voting and value, for at least the immediate future.

What is more troubling, however, is the Service’s suggestion
that whether the payments by N to M for the provision
of administrative services is UBTI is an open question. Although
the Service may have only been making it clear that
it was not addressing this issue, many related organizations
share such services, on a reimbursement basis, and do not
treat the reimbursements as UBTI. For example, many section
501(c)(3) and 501(c)(4) affiliates routinely share the costs
for such services because it would be highly inefficient to
have, for example, two separate information services departments
or two separate accounting departments. The 501(c)(3)/
501(c)(4) situation may be different because of the related
missions of such affiliates and the constitutional issues that
require that administrative burdens associated with a
501(c)(3) organization creating and maintaining a section
501(c)(4) affiliate be minimal, but it is still the model with
which many exempt organizations are familiar and so use for
their taxable subsidiaries as well. The Service has also appeared
to bless this model, at least in the 501(c)(3)/501(c)(4)
context. See, e.g., Judith E. Kindell & John Francis Reilly,
“Election Year Issues,” Exempt Organizations Technical Instruction
Program for FY 2002, at 335, 368-69 (Doc 2001-
25435 (128 original pages); 2001 TNT 193-50.).

If merely being reimbursed for such services results in
UBTI, this issue needs to be clarified as many organizations
undoubtedly do not viewsuch reimbursements in this fashion.
This is particularly true given that it is probably possible to
avoid creating UBTI if the subsidiary pays the employees of
the exempt parent directly for the portion of their time used
by the subsidiary, with the exempt parent reducing the compensation
it pays proportionately, since then the subsidiary
would not be making any direct payments to the exempt
parent. This solution is awkward, significantly increases the
paperwork of both entities, and may cause employee benefit
or other employment-related problems, so it would not be
advisable absent a clear indication that such reimbursements
are in fact UBTI.

If it were not for the need to report all UBTI on Form 990
and Form 990-T, this issue would also be irrelevant. This is
because if the administrative services are truly provided at
cost, the deductions associated with providing such services
will cancel out the income received from the taxable subsidiary
for such services. It therefore seems to be a relatively
useless exercise to require an exempt parent to report such
reimbursements as UBTI, at least when the payments are
designed merely to reimburse the parent for its costs and so
will not result in any net UBTI that would be subject to tax.

Private Inurement and Private Benefit

The stock and stock option conclusions are certainly reasonable,
although again it is helpful to have these conclusions
spelled out, albeit in a nonprecedential ruling. The key issue
is whether the total compensation paid to each employee,
whether at the exempt parent or the taxable subsidiary level,
is reasonable. Given the Service’s favorable cite to the taxable
subsidiary’s use of a compensation consultant, it is probably
advisable to obtain outside expertise when incorporating such
difficult-to-value items in the compensation of employees of
either the parent or the subsidiary.

It is also useful to see that the Service was apparently
untroubled by the fact that N is only paying M its costs for
office space and administrative services, even though N will
in the near future be owned in part by private individuals (N’s
directors, officers, and employees, as well as M’s key employees).
The Service may simply have assumed that M’s
costs were essentially equal to the fair market value of the
office space and administrative services being provided by
M, given that those costs were primarily or exclusively determined
byM’s arm’s-length arrangements with third parties,
such as M’s landlord and employees. If this was the case, and
the ruling is not clear on this point, it certainly makes determining
the appropriate amounts to pay for such items relatively
easy, as opposed to requiring the entities involved to
determine the fair market value rate for such items based on
market comparables.

The Service may, however, not have commented on this
point for the same reason it left some of the UBTI issues
unresolved — M did not ask for a ruling relating to the
appropriateness of these reimbursement arrangements under
section 501(c)(3). The Service may also not have commented
on this point because the Administrative Services Agreement
and the Lease appeared to be temporary arrangements, expected
to last only as long as it took for N to become sufficiently
established to justify renting its own office space and
hiring its own administrative staff. Given the uncertainty on
this point, probably little weight should be attributed to the
lack of a ruling on this point.

Conclusion

As the number and sophistication of exempt organizations
grows, it is inevitable that they will adopt more complex
corporate structures to manage their tax and liability issues.
This ruling is a good step toward providing exempt organizations
with a better sense of how best to create subsidiaries
while still preserving tax-exempt status and minimizing
UBTI. Although it does not answer every question, and appears
to use a flawed analysis with respect to the issue of the
standard for separate entity treatment although reaching the
correct conclusion in this case, it provides a helpful roadmap
of the relevant legal issues and shows, in part, how to address
them for exempt organizations considering creating taxable
subsidiaries.