Letter Ruling Alert: A New Option for Private Foundation Investing

Facts

The ruling involved 15 private foundations. The private foundations were disqualified persons with respect to each other under section 4946(a)(1)(H).

The subject of the ruling request was an investment plan proposed by the foundations. The foundations planned to form a general partnership in order to make certain investments. Each foundation would make a maximum dollar commitment to the partnership, and the partnership would issue capital calls to the foundations in proportion to their commitments as investment opportunities arose. Participation in distributions and allocation of profits and losses would be in the same proportion. The capital calls would not exceed the initial commitment amounts, but funding of the capital calls up to those amounts would be mandatory upon the request of the manager partner. The managing partner would be one of the foundations; this foundation would also make payments to the partnership to cover the partnership's administrative costs. The same company that provided investment management services to the foundations individually would provide investment management and administrative services to the partnership at no charge. While not stated explicitly in the ruling, the Service's analysis makes it clear that this company was a disqualified person with respect to all of the foundations.

Each foundation would determine its maximum dollar commitment based on its own investment portfolio, but it was anticipated that such commitment would not exceed 20 percent of the foundation's total investment portfolio. Each foundation's other investments would include the normal mix of typical foundation investments: cash, cash equivalents, U.S. government obligations, corporate debt securities, equity mutual funds, and publicly traded corporate stock.

The purpose of the general partnership was to enable the foundations to pool their funds in order to allow them to invest in equity interests in private businesses and private equity funds not otherwise available to them, and to achieve greater diversification in investments. Such investments generally were not available to the foundations individually, except possibly to the one or two largest foundations, because the investments generally required investors to have a minimum financial size and to make a minimum dollar commitment for administrative and securities laws reasons. These investments generally would be made by purchasing limited partnership interests. The foundations' investment management company would not manage any of the limited partnerships.

The foundations anticipated that they might create a new investment partnership along these lines each year. The creation of new partnerships each year would allow each foundation to determine its need for these types of investments on an annual basis, without complicating the administration of the existing investment partnerships.

The general partnership agreement contained a number of significant limitations on the partnership's activities. Only private foundations could be partners. The partnership agreed not make any investments that would result in excess business holdings by a foundation partner and its disqualified persons under section 4943, to not directly engage in an operating business, and to not make any jeopardizing investments that would subject one or more of the foundation partners to tax under section 4944. The partnership also agreed not to engage in property or credit transactions with any disqualified persons of the foundation partners that would constitute self-dealing under section 4941(d)(1)(A) and (B), or to purchase or sell investments in an attempt to provide an advantage to a disqualified person.[1] The partnership also planned to not hold more than a 20 percent interest in any limited partnership.

The partnership was not, however, limited to receiving passive income, such as dividends, interests, royalties, and rents, through its limited partnership interests. In fact, it was anticipated that some of the limited partnerships would engage in active trade or businesses, and that the foundations would pay unrelated business income tax on their allocable share of the income from such activities.

The foundation serving as the managing partner of the general partnership requested rulings that the formation and operation of the general partnership would not (1) constitute an act of self-dealing under section 4941; (2) result in excess business holdings under section 4943; or (3) constitute a taxable expenditure under section 4945.

IRS Conclusions and Rationale

Section 4941

The Service noted that while the 15 foundations were disqualified persons with respect to each other for purposes of section 4943, they were not disqualified persons with respect to each other for purposes of section 4941.[2] The Service then noted that the formation of the general partnership did not involve a sale or exchange or an extension of credit between a private foundation and a disqualified person, or a transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation. As for the investment management services, the Service noted that the provision of services by a disqualified person at no charge does not constitute self-dealing,[3] and that even if general partnership paid the investment company for those services, payment of reasonable compensation to a disqualified person for investment management services is not an act of self- dealing.[4] The Service therefore concluded that the formation and operation of the general partnership did not constitute an act of self-dealing under section 4941.

Section 4945

The Service found that none of the expenditures by the foundations would be for noncharitable purposes as long as both the expenditures by the partnership and the administrative payments by the managing partner to the partnership were reasonable. The Service therefore concluded that the formation and operation of the general partnership did not constitute a taxable expenditure under section 4945.

Section 4943

By far the most interesting aspect of the ruling is the Service's discussion relat ing to section 4943. Section 4943 limits the percentage interest that a foundation and its disqualified persons can together own in a 'business enterprise.'[5] The limit is generally 20 percent, although it increases to 35 percent if the foundation can demonstrate that an unrelated person or persons has effective control over the business enterprise.

For purposes of section 4943, disqualified persons include related private foundations described in section 4946(a)(1)(H). Under this section, one foundation is a disqualified person with respect to another foundation if the two foundations either are controlled by the same person or persons, or substantially all (85 percent) of the contributions received by one foundation were from disqualified persons of the other foundation (not including contributions from entities that are disqualified persons simply because a disqualified person owns a 35 percent interest in them).

The foundations here were disqualified persons with respect to each other under section 4946(a)(1)(H). Their combined ownership interest of 100 percent in the general partnership exceeded the ownership interest allowed by section 4943. Therefore the only way for the planned arrangement to be consistent with section 4943 was if the general partnership did not constitute a 'business enterprise' for section 4943 purposes.

The term 'business enterprise' includes 'the active conduct of a trade or business, including any activity which is regularly carried on for the production of income from the sale of goods or the performance of services and which constitutes an unrelated trade or business under section 513.'[6] Section 513(c) broadly defines a trade or business as 'any activity which is carried on for the production of income from the sale of goods or the performance of services.'[7] The foundation initially argued that the general partnership did not constitute a trade or business, citing the definition of a trade or business in other contexts within the code, but the Service disagreed with this argument, apparently based on the breadth of the section 513(c) definition of a trade or business. The Service also considered whether the general partnership would be excluded from the definition of an unrelated trade or business because of the investment company's volunteer investment management services, but found that the company's services were not a material income- producing factor and so this exclusion did not apply.[8]

The only exceptions to this definition of a business enterprise are functionally related businesses, program-related investments, and businesses that derive at least 95 percent of their gross income from passive sources.[9] The first two exceptions did not apply because the activities of the general partnership and the limited partnerships would not be charitable and therefore would not be related to the foundations' exempt purposes.

With regard to the last exception, the Service initially noted that a strict reading of the relevant statutory and regulatory provisions would limit the application of this provision to gross income from a specified set of passive sources, i.e., sources that produced dividends, interest, annuities, royalties, rent, or gains from the disposition of certain property.[10] Under this strict reading, such sources would not include limited partnership interests. However, the Service then rejected this strict reading and held instead that since the general partnership's only activity would consist of investment in private businesses, mainly as a limited partner in limited partnerships, and since the general partnership would not be managing the businesses of the limited partnerships, the limited partnerships represented passive investments comparable to stock and securities. The general partnership's investments would therefore be limited to passive investments, so the Service concluded that the general partnership was not a business enterprise for purposes of section 4943.

In support of this conclusion, the Service examined the purposes underlining section 4943. Before 1969, private foundations had an unfettered ability to invest in ongoing businesses. A significant number of foundations took advantage of this ability, with the result that foundations controlled a wide variety of business corporations, including banks, hotels, clothing manufacturers, and retail stores. According to a report prepared by the U.S. Treasury Department, of the 1300 foundations surveyed, 180 owned 10 percent or more in an outstanding class of stock of at least one business corporation, and over 100 owned a 20 percent or larger interest.[11]

This ability created a significant planning opportunity for families who controlled businesses and wanted to pass control of the businesses to the next generation while minimizing exposure to estate and gift taxes. Rather than leaving their entire interest in a business to the next generation, and thereby subjecting that interest to estate and gift taxes, the family would instead transfer a significant portion of that interest to a family foundation. The transferred portion would not be subject to estate and gift taxes but would remain under the family's control, through the foundation. In addition, the donating family members might also receive significant charitable contribution deductions for the value of the donated stock.

Congress also viewed this ability as raising two additional concerns. First, Congress felt that owning a significant or controlling interest in a business would distract a foundation from its purported primary purpose of furthering charitable, educational, or other exempt purposes. Second, Congress felt that foundation-owned businesses would have a unfair competitive advantage over their competitors. This advantage would arise both because foundations could serve as easy sources of capital and because foundations would probably not be very demanding shareholders in terms of requiring high dividend payments, thereby allowing foundation-owned businesses to retain more profits than otherwise would be the case.[12] Therefore as part of the 1969 private foundation legislation, which included most of the provisions found in Chapter 42 of the code, Congress enacted section 4943.

Citing the legislative history summarized above, the Service found that its conclusion was consistent with the purposes of section 4943. The Service relied in particular on the fact that in describing the exception for 'passive holding companies,' i.e., companies receiving substantially all of their income from passive sources, the legislative history provided the following: 'stock in a passive holding company is not to be considered a business holding, even if the holding company is controlled by the foundation. Instead, the foundation is to be treated as owning its proportionate share of the underlying assets of the holding company. The committee also made it clear that passive investments generally are not to be considered business holdings. For example, the holding of a bond issue is not a business holding, nor is the holding of stock of a company which itself derives income in the nature of a royalty to be treated as a business holding.'[13]

The Service noted that the general partnership would not engage directly in an active business, but would merely hold an interest as a limited partner in various limited partnerships. The Service further noted that section 4943 allowed the foundations to own the interests that the general partnership would instead hold, as the general partnership would be limiting its holdings to 20 percent or less and no disqualified persons would be holding an interest in any of the limited partnerships. The Service concluded that it would be inconsistent for the foundations to be able to hold these interests directly but not to be able to hold these interests through a general partnership.

The Service also turned to the constructive ownership rule of section 4943(d)(1) to confirm its conclusion. Section 4943(d)(1) and reg. sections 53.4943-8(a)(1), and -8(d) provide that a private foundation or a disqualified person that owns an interest in a corporation, partnership or other entity is treated as the owner of a pro rata share of any business enterprise owned by that entity. Here, the foundations would be treated as owning the limited partnership interests owned by the general partnership. Since the general partnership agreed to limit its limited partnerships interests so as not to raise excess business holdings issues for any of its partners, applying this rule would not result in the foundations violating section 4943.

As a final note, the Service emphasized that its analysis only applied for section 4943 purposes and not for section 513 (unrelated trade or business taxable income) purposes. This note was important because in reaching this section 4943 conclusion the Service chose not to look through the limited partnerships to their sources of income in order to determine whether the general partnership received passive income, but instead treated the limited partnerships as separate entities and the character of income from the limited partnerships as passive as long as the general partnership's role with respect to the limited partnerships was passive. This treatment is in contrast to the statutorily mandated treatment of partnerships for UBIT purposes.

Under section 512(c)(1), if an unrelated trade or business is carried on by a partnership in which an exempt organization is a partner, the exempt organization partner's share of the partnership's gross income and deductions are included in the partner's unrelated business taxable income. In other words, for UBTI purposes the code treats partnerships as aggregates, with the character of income (related or unrelated) being determined at the partnership level, i.e., by whether the partnership is receiving income from related or unrelated activities. Here in contrast, the Service for purposes of section 4943 treated the limited partnerships as separate entities, with the character of income (passive or active ) being determined at the partner level, i.e., by whether the partner (here, the general partnership) is actively involved in the management of the limited partnership.

Comment

This ruling indicates that the Service is willing to think creatively about the application of section 4943 in order to ensure that foundations are not unduly and unnecessarily limited in their investment options. A purely mechanical reading of section 4943 could have led to the conclusion that limited partnership interests are not passive sources of income and more than 5 percent of the income being received by the foundations originated in active trade or businesses, albeit trade or businesses conducted directly by limited partnerships. Instead, the Service chose to treat the limited partnership interests as themselves passive investments, thereby allowing the general partnership to avoid classification as a business enterprise.

This willingness to think creatively about the application of section 4943 may contain significant planning opportunities for private foundations. Private foundations can use the model contained in this letter ruling to develop similar collaborative investment vehicles. It does not appear necessary, however, for foundations to slavishly follow the pattern in the ruling to avoid any violations of section 4943 or the Chapter 42 provisions.

For example, it was not necessary for the investment management company to provide its services at no charge even though it was a disqualified person with respect to the foundations. As the Service noted in the ruling, payment of reasonable compensation for the investment company's management services is allowed under the self-dealing rules of section 4941.[14]

It also appears that the general partnership did not need to limit itself to holding a 20 percent or less interest in any limited partnership. If the general partnership was only a limited partner in the other partnerships, and the rest of the partners in the limited partnership were unrelated to the general partnership, unrelated persons should have effective control of the limited partnerships. Therefore, the higher, 35 percent limit on excess business holdings should apply.

Presumably other types of investments could also be considered passive investments for purposes of determining whether an organization is a section 4943 business enterprise. For example, interest in a limited liability company might be a passive investment if certain conditions are met, such as the interest not granting any right to participate in the governance of the LLC.

In sum, the Service has indicated in this ruling that it will not be limited to a strict reading of the passive source income exception to the definition of a business enterprise under section 4943. Instead, the Service will apply a definition of passive sources that is consistent with the purposes and constructive ownership rules of section 4943 but does not unduly limit the definition of passive source income. This flexibility provides an opportunity for private foundations and their advisors to think creatively about possible investment structures that could further foundation investing while passing muster under section 4943. As always, however, it is advisable when going beyond the clear statutory and regulatory language to consider obtaining a private letter ruling, as the foundations did here, to confirm that the Service would agree that a particular investment arrangement is consistent with section 4943 and the other provisions of Chapter 42 of the code.

Endnotes

[1] See reg. section 53.4941(d)-2(f)(1) (including in the definition of self- dealing the purchase or sale of stock or other securities by a private foundation if the purchase or sale is made in an attempt to manipulate the price of the stock or other securities to the advantage of a disqualified person).

[2] See section 4946(a)(1)(H) (stating that the related foundation provision only applies for purposes of section 4943); reg. section 53.4946- 1(a)(8) (stating the for purposes of section 4941 only, the term 'disqualified person' does not include any organization described in section 501(c)(3), other than an organization described in section 509(a)(4) (public safety organizations)).

[3] See section 4941(d)(2)(C).

[4] See section 4941(d)(2)(E); reg. section 53.4941(d)-3(c)(2), Example (2).

[5] For section 4943 purposes, disqualified persons include a private foundation's substantial contributors and managers, a 20 percent owner of a substantial contributor, a family member of a person in one of these two categories, an entity owned 35 percent or more by the persons in these two categories or their family members, and certain related private foundations. Section 4946(a)(1).

[6] Reg. section 53.4943-10(a)(1).

[7] See reg. section 1.513-1(b) (stating that under section 513 the term 'trade or business' has the same meaning it has in section 162 (relating to deductions for trade or business expenses)). Certain exceptions apply to the section 513 definition of trade or business, but none of them are relevant here. See section 513(d)-(i).

[8] See section 513(a)(1) (excluding from the definition of an unrelated trade or business a trade or business in which substantially all the work is performed for the organization by volunteers (noncompensated); Rev. Rul. 78- 144, 1978-1 C.B. 168 (holding that this exclusion does not apply when the volunteer labor is not a material income-producing factor for the business).

[9] Section 4943(d)(3); reg. section 53.4943-10(b).

[10] See section 4943(d)(3); reg. section 53.4943-10(c)(2).

[11] U.S. Treasury Department, Report on Private Foundations (Feb. 2, 1969), at 31.

[12] See Staff of the Joint Comm. on Taxation , 91st Cong., 2d Sess., General Explanation of the Tax Reform Act of 1969, at 40-41 (Comm. Print 1970); S. Rep. No. 552, 91st Cong., 1st Sess. 38-39 (1969); H.R. Rep. No. 413 (Part. 1), 91st Cong., 1st Sess. 27 (1969).

[13] S. Rep. No. 522, 91st Cong., 1st Sess. 41 (1969).

[14] Section 4941(d)(2)(E); reg. section 53.4941(d)-3(c)(2), Example (2).

This article first appeared in the Exempt Organization Tax Review, November 1999, p. 257, and was reprinted with permission.