IRS Private Letter Rulings 201446024 and 201510050; Reminder that Imposition of Self Dealing Taxes Under Section 4941 to Indirect Acts of Self-Dealing May Cause Trap for the Unwary

IRS Private Letter Rulings 201446024 and 201510050; Reminder that Imposition of Self Dealing Taxes Under Section 4941 to Indirect Acts of Self-Dealing May Cause Trap for the Unwary

News story posted in Letter Rulings on 11 June 2015| comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 11 June 2015
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Summary

Richard Fox provides a thorough view of the self-dealing rules by analyzing two recent Private Letter Rulings.

By: Richard L. Fox, Esquire

SUMMARY

The self-dealing provisions under IRC § 4941 impose substantial excise tax where a private foundation and a disqualified person with respect to the foundation engage in a transaction that constitutes an act of self-dealing.  The scope of transactions prohibited by the self-dealing rules is extremely broad and it is immaterial whether a transaction results in a benefit or a detriment to the private foundation in determining whether the transaction is an act of self-dealing. But for certain very narrow exceptions, virtually every financial transaction between a private foundation and a disqualified person will result in an act of self-dealing and imposition of tax.  Charitable remainder trusts described in IRC § 664 and charitable lead trusts described in IRC § 170(f)(2)(B) are also subject to the private foundation self-dealing provisions.

The self-dealing tax regime is not limited to direct transactions between a private foundation and a disqualified person, but extends to indirect acts of self-dealing carried out through some form of a “middleman” or third-party.  While direct acts of self-dealing are generally apparent on their face, indirect acts of self-dealing may result from transactions that are not so obviously self-dealing acts, thereby presenting a trap for an unwary disqualified person (which includes a “foundation manager” of the foundation) who may unwittingly become subject to the two-tier excise tax regime of IRC § 4941 by engaging in an act of self-dealing even though it is indirect.

Two recent private letter rulings address two common situations where caution should be exercised in order to avoid unexpected exposure to an indirect act of self-dealing. Both found there was no self-dealing, one based upon the “estate administration exception” and the other based upon the lack of control by the foundation of the entity which engaged in a transaction with a disqualified person.  (Under IRC § 6110(k)(3), a private letter ruling cannot be cited or used as precedent.)

The first ruling, Ltr. Rul. 201446024, involved a situation where a private foundation was a beneficiary of an estate and a disqualified person with respect to the foundation wanted to engage in a transaction involving property held by the estate in which the foundation, as a beneficiary of the estate, had an interest or expectancy.  No indirect (or direct) act of self-dealing would be found to occur in this ruling because of adherence to a rather strict “estate administration exception” provided under the Treasury Regulations, thereby avoiding an indirect act of self-dealing that would otherwise have occurred.  The estate administration exception was used under a rather complex situation involving placing the notes otherwise passing to the foundation into a limited liability company.  The second ruling, Ltr. Rul. 201510050, dealt with a situation where an entity in which a private foundation had an ownership interest would engage in a transaction with a disqualified person. Under applicable regulations, if a transaction between a disqualified person and a private foundation would result in an act of self-dealing, then the same transaction between an entity that is controlled by the foundation and the disqualified person results in an indirect act of self-dealing.  In Ltr Rul. 201510050, no act of self-dealing occurred because the entity involved was not considered to be controlled by the foundation, under a complex analysis applied in making such a determination. 

DISCUSSION

Background on Self-Dealing Rules under Section 4941

Under IRC § 4941, Congress enumerated a listing of “prohibited” transactions, known as acts of “self-dealing,” between a private foundation and certain individuals and entities that are  “disqualified persons,” defined in IRC § 4946, with respect to the foundation.  An act of self-dealing may result without regard to whether a transaction in question benefits or harms the private foundation.  The scope of the transactions prohibited by the self-dealing rules is so broad that virtually every economic transaction between a private foundation and a disqualified person   is an act of self-dealing, subject to the self-dealing excise tax regime under IRC § 4941. (Self-dealing taxes may also be imposed on any foundation manager who engages in a transaction knowing it to be an act of self-dealing.)  

The self-dealing taxes are imposed under a two-tier regime, under which substantial and sometime draconian excise taxes may be imposed on the disqualified person engaging in the act of self-dealing.  These taxes are imposed on the disqualified person who participates in the act of self-dealing, not on the private foundation.[1]  IRC § 4941(a) imposes an initial tax of 10% of the amount involved with respect to a self-dealing transaction for each year (or part thereof) in the “taxable period.”[2]  Therefore, the 10% tax could be assessed for multiple years, and the total could be multiples of 10%.  A second-tier tax of 200% of the amount involved is imposed IRC § 4941(b) upon the disqualified person if the act of self-dealing is not “corrected” during the taxable period,[3] with correction basically meaning, with respect to any act of self-dealing, undoing the transaction to the extent possible, but in any case placing the private foundation in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.[4]

Direct Acts of Self-Dealing Between Estates or Trusts and Private Foundation

Direct transactions, such as sales, leases, or loans between a private foundation and an estate or trust that is a disqualified person are prohibited under the self-dealing rules.  Such direct transactions usually do not occur in the context of estate or trust administration, as the parties are typically aware that direct transactions between a private foundations and a disqualified person (that is, the estate or trust itself) are prohibited, and they are no more likely to occur in the estate context than in the normal ongoing administration of a private foundation.  (Under IRC § 4946(a)(1)(G), both a trust and a decedent’s estate is a disqualified person if other disqualified persons hold more than a 35% beneficial interest in the trust or estate.)  There are situations where direct transactions could occur.  For example, if a foundation is the residuary beneficiary of the estate, a loan by the foundation to the executor of an illiquid estate that is a disqualified person with respect to the foundation to pay estate expenses constitutes a direct act of self-dealing. 

Indirect Acts of Self-Dealing Estates or Trusts and Private Foundation

The self-dealing rules apply not only to direct acts of self-dealing, but also to indirect acts of self-dealing carried out by an intermediary or third-party, including one carried out through an estate or trust.  Under IRC § 4941(d)(1)(A), “self-dealing” includes any “direct or indirect” sale, exchange, or lease of property between a private foundation and a disqualified person. While “indirect” self-dealing is not defined in IRC § 4941 or the regulations thereunder, it is clear that the term includes transactions between a private foundation and a disqualified person through some type of intermediary or third-party.  See Treas. Reg. §53.4941(d)-1(b)(3);  Estate of Reis v. Com’r, 87 T.C 1016 (1986); Rockefeller v. United States, 572 F. Supp.  (E.D. Ark. 1982), aff’d, 718 F.2d 290 (8th Cir. 1983), cert. den., 104 S.Ct. 2180 (1984).

Private foundations are often beneficiaries of significant bequests from their founders at their deaths under a will or trust instrument and in many cases are the residuary beneficiaries of an estate (or residuary takers under a trust such as a revocable trust).  A private foundation can be created and receive its initial funding under a will or trust, or an existing foundation can receive substantial additional funding under such instruments. Where an estate plan includes a private foundation as a beneficiary, and particularly as a residuary beneficiary, a host of complicated issues can arise due to the existence of the private foundation excise tax regime under the Internal Revenue Code, presenting a potential trap for the unwary and what has been appropriately described as “something pretty scary.”[5]

For example, where an estate plan that includes a bequest to a private foundation also names “disqualified persons” with respect to the foundation as beneficiaries, such as a spouse or children of the decedent, the administration of the estate may result in an indirect act of self-dealing. This might occur by the allocation of a more liquid asset to the disqualified person than to the foundation, even if expressly permitted under state law and even though the allocation is not an act of self-dealing under state law. In other words, transactions between an estate and a disqualified person with respect to property in which a private foundation has interest or expectancy, even those that may otherwise be considered routine transactions, may constitute indirect acts of self-dealing. 

It is important, therefore, that any transaction involving property interests under a will or trust having both disqualified persons and a private foundation as beneficiaries be carefully scrutinized to determine whether an indirect act of self-dealing will occur.  Moreover, when an indirect act of self-dealing would otherwise result in such context, it may be imperative to meet the requirements of the available “estate administration exception” (discussed further below) provided under Treas. Reg. § 53.4941(d)-1(b)(3) in order to avoid the application of IRC § 4941.  Where the requirements of this exception are met, which includes obtaining court approval and probably before the transaction occurs, the transaction will not be considered an indirect (or direct) act of self-dealing and will not, therefore, be subject to excise tax under IRC § 4941. 

Estate Administration to Indirect Acts of Self-Dealing

Under the so-called “estate administration exception” of Treas. Reg. § 53.4941(d)-1(b)(3), an indirect self-dealing does not include a transaction involving a private foundation's interest or expectancy in property (whether or not encumbered) held by an estate (or revocable trust, including a trust which has become irrevocable on a grantor's death), regardless of when title to the property vests under local law, if the following five-prong test set forth in Treas. Reg. § 53.4941(d)-1(b)(3) is met:

 (1)      The administrator or executor of an estate or trustee of a (formerly) revocable trust either: (a) possesses a power of sale with respect to the property, (b) has the power to reallocate the property to another beneficiary, or (c) is required to sell the property under the terms of any option subject to which the property was acquired by the estate (or revocable trust);

(2)       The transaction is approved by the probate court having jurisdiction over the estate (or trust) or over the private foundation;

(3)       The transaction occurs before the estate is considered terminated for federal income tax purposes, or in the case of a revocable trust that becomes irrevocable, the transaction occurs before it is considered subject to IRC § 4947;

(4)       The estate (or trust) receives an amount which equals or exceeds the fair market value of the foundation's interest or expectancy in such property at the time of the transaction, taking into account the terms of any option subject to which the property was acquired by the estate (or trust); and

(5)       The transaction either (a) results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up,[6] (b) results in the foundation receiving an asset related to the active carrying out of its exempt purposes, or (c) is required under the terms of any option which is binding on the estate (or trust).[7]

It is important to note that the safe harbor protection otherwise provided under the estate administration exception will be lost if the amount paid by a disqualified person is ultimately determined to be less than fair market value (taking into account the terms of any option).    

Indirect Self-Dealing Between an Entity Controlled by a Private Foundation and a Disqualified Person

Where a private foundation is considered to be in control of another organization, a transaction between the controlled organization and a disqualified person with respect to the foundation is subject to the indirect self-dealing rules of IRC § 4941. This is the case because the organization controlled by the foundation is in essence considered to be acting as an intermediary between the foundation and the disqualified person.

            Example:

Private foundation P owns the controlling interest of the voting stock of corporation X, and as a result of such interest, elects a majority of the board of directors of X.  A disqualified person with respect to P, the private foundation, requested and received a loan in the amount of $4 million from X. The making of the loan by X, a corporation controlled by a private foundation, to Y, a disqualified person with respect to the foundation, constitutes an indirect act of self-dealing between P, the private foundation, and Y, a disqualified person.

The “controlled organization” need not be a private foundation. For example, it may be any type of exempt or nonexempt organization including a school, hospital, operating foundation, social welfare organization or for profit company. Under Treas. Reg. § 53.4941(d)-1(b)(5), an organization will be considered to be controlled by a private foundation:

(1)       if the foundation or one or more of its foundation managers (acting only in such capacity) may, only by aggregating their votes or positions of authority, require the organization to engage in a transaction which if engaged in with the private foundation would constitute self-dealing; or

(2)       in the case of a transaction between the organization and a disqualified person, if such disqualified person, together with one or more persons who are disqualified persons by reason of such a person's relationship (within the meaning of  IRC § 4946(a)(1)(C) through  (G)) to such disqualified person, may, only by aggregating their votes or positions of authority with that of the private foundation, require the organization to engage in such a transaction.

In Rev. Rul. 76-158, 1976-1 C.B. 354, a private foundation, owning thirty-five percent of the voting stock of a corporation and having a foundation manager personally owning the remaining sixty-five percent but not holding a position of authority in the corporation by virtue of being foundation manager of the private foundation, was determined not to control the corporation for purposes of the self-dealing provisions of IRC § 4941. Therefore, because the foundation manager of the foundation held a majority of the voting stock personally (and therefore could control the corporation without aggregating his votes with those of the foundation) and was not in a controlling position of the corporation by virtue of his foundation manager status, the private foundation was not considered to be in control of the corporation.   

In determining whether control is present, the regulations provide that an organization will be considered to be controlled by a private foundation or by a private foundation and disqualified persons if such persons are able, in fact, to control the organization, even if their aggregate voting power is less than 50 percent of the total voting power of the organization's governing body, or if one or more of such persons has the right to exercise veto power over the actions of such organization relevant to any potential acts of self-dealing.  Treas. Reg. § 53.4941(d)-1(b)(5).

An interesting question is whether a private foundation that is not otherwise considered to “control” another organization under Treas. Reg. § 53.4941(d)-1(b)(5) would be considered to control it where the private foundation, foundation managers or other disqualified person are in a position to influence the decisions of those who are in control of the organization.

In the context of an IRC § 509(a)(3) supporting organization, which may not be controlled by disqualified persons, the IRS has ruled that in determining whether  disqualified persons have indirect control of a purported supporting organization, “one circumstance to be considered is whether a disqualified person is in a position to influence the decisions of members of the organization's governing body who are not themselves disqualified persons. Thus, employees of a disqualified person will be considered in determining whether one or more disqualified persons control 50 percent or more of the voting power of an organization's governing body.”  Rev. Rul. 80-207, 1980-2 CB 193.  In the 2000 IRS Continuing Professional Education Text, the IRS stated that an attorney, who represented the family that formed the foundation, serving on the board of a purported supporting organization caused the supporting organization to be deemed to be controlled by disqualified persons, wherein the IRS stated:  “Under the circumstances, [the supporting organization] appears indirectly controlled by [disqualified persons] as in Rev. Rul. 80-207.  It would be difficult to see how O [the attorney] could remain independent or be objective in his T [the supporting organization] board of director dealings with M or his wife [the disqualified persons].”  

In the context of a donor advised fund (“DAF”) regime, a fund is exempt from DAF treatment if (1) the fund is advised by a committee not directly or indirectly controlled by the donor or donor's advisor (or any related parties), or (2) the fund benefits a single identified charitable purpose. The JCT Technical Explanation stresses that "indirect control" includes the ability to exercise effective control, and offers an example of a committee of five, three of whom are the donor, donor advisor, and an attorney hired by the donor to provide advice regarding the donor's contributions, and concludes that "the committee would be treated as being controlled indirectly by the donor for purposes of such an exception."[8]  No authority is offered for the proposition that a taxpayer's attorney should be treated the same as a related party for purposes of the "control" rules, and Notice 2006-109, 2006-51 IRB 1121 (“Private foundation - requirements for supporting organizations - Type III supporting organizations”), does not include this example or make any reference to it.

Estate Administration Exception for Transfer of Promissory Note of Disqualified Person to Private Foundation

An estate (or revocable trust that becomes irrevocable upon the death of its grantor) may end up owning a promissory note due from disqualified person with respect to a private foundation which, under the term of the decedent’s will (or trust), is required to be distributed to the private foundation.   This may occur, for example, if a decedent, during lifetime, sold assets to a family trust, which itself is a disqualified person, in exchange for an installment note payable to the decedent that remains outstanding at decedent's death.  Upon the distribution of the note to the private foundation, a disqualified person with respect to a private foundation will become an obligor under a promissory note payable to the foundation and the foundation will become a creditor of a disqualified person.  As a general rule, this would result in an indirect act of self-dealing under Treas. Reg. § 53.4941(d)-2(c), which provides that the term “self-dealing” includes a situation “where a note, the obligor of which is a disqualified person, is transferred by a third party to a private foundation which becomes the creditor under the note.”  Treas. Reg. § 53.4941(d)-2(c), however, is subject to an exception in the case of the receipt and holding of a note pursuant to a transaction described in Treas. Reg. § 53.4941(d)-1(b)(3) that occurs during the administration of an estate or revocable trust, including a trust that has become irrevocable upon the death of the grantor.  

As discussed above, under the so-called “estate administration exception” of Treas. Reg. § 53.4941(d)-1(b)(3), an indirect self-dealing does not include a transaction involving a private foundation's interest or expectancy in property (whether or not encumbered) held by an estate (or revocable trust, including a trust which has become irrevocable on a grantor's death), regardless of when title to the property vests under local law, if  the five-prong test set forth above is met.

There are a multitude of rulings where the estate administration exception has been applied to permit the transfer to a private foundation of a promissory note under which a disqualified person is the obligor.   See, e.g., Ltr. Ruls. 200729043; 199924069; and 201206019.  The estate administration exception has been applied even where the estate issues its own notes.  See, e.g., Ltr. Ruls. 9042030, 9042040 and 201446024. Absent the availability of the estate administration exception in this context, an indirect act of self-dealing under IRC § 4941 would result under Treas. Reg. § 53.4941(d)-(2)(c)(1),  whereby an act of indirect act of self-dealing occurs where a note, the obligor of which is a disqualified person, is transferred by a third party to a private foundation which then becomes the creditor under the note.

Ltr. Rul. 201446024: IRS Rules That Estate Administration Exception Applies and that Newly Formed LLC is Not Considered to be Controlled by Private Foundation

In Ltr. Rul. 201446024, the decedent ("Decedent") formed a company ("Company") and an irrevocable trust ("Irrevocable Trust") during his lifetime. Decedent subsequently sold approximately 85% of his interest in the Company to the Irrevocable Trust in exchange for a promissory note ("Note").  The beneficiaries of the Irrevocable Trust were all family members of Decedent and their combined beneficial interest in the trust exceeded 35%, thereby making the Irrevocable Trust a disqualified person with respect to the family’s private foundation ("Foundation") to which Decedent was a substantial contributor.

Decedent also executed a will and a revocable trust (“Revocable Trust”), which became irrevocable upon the decedent’s death.  Under the terms of the will, the residue of the Decedent's estate, including the Note, was to be distributed to the Revocable Trust and under the terms of the trust, the assets would be distributed to several beneficiaries, including the Foundation.  At the Decedent's death, therefore, the Note became part of the residuary estate and the obligor of Note continued to be Irrevocable Trust, a disqualified person with respect to the Foundation.  Because the Irrevocable Trust, a disqualified person with respect to the private foundation, was the obligor of Note, and the Foundation would become the creditor of the Note upon its transfer to the Foundation, an indirect act of self-dealing IRC § 4941 would result under Treas. Reg. § 53.4941(d)-(2)(c)(1) (which prohibits a disqualified person from being an obligor under a note payable to a private foundation), subject to the estate administration exception provided under Treas. Reg. § 53.4941(d)-1(b)(3).

In order to avoid the occurrence of an indirect act of self-dealing by having a disqualified person become the obligor under a note owned by and payable to a private foundation, the executor/trustee proposed the following transactions:

  1.  The Note would be transferred from the decedent’s estate to a newly-formed limited liability company (“LLC”) for which the estate would receive 100 voting and 9,800 non-voting units in LLC.
  1. The executor/trustee, in his individual capacity, would contribute cash equal to 1% of the value of LLC in exchange for 100 non-voting units in LLC.
  1.  The executor/trustee, in his individual capacity, would purchase the 100 voting units of the LLC from the estate for cash equal to a purchase price determined by a qualified appraisal.

By virtue of these transactions, the end result was that the Foundation would receive cash and 9,800 non-voting units of LLC in lieu of the Note.  LLC's amended operating agreement provided that upon any default on the Note, the LLC "shall immediately take all necessary actions to foreclose on and collect payment of the Note from the Borrower and/or Guarantor." The facts of the ruling indicated that the executor/trustee would seek court approval from the probate court regarding the sale of the Note to the LLC and the sale of voting units to Executor/Trustee.

The IRS issued the following favorable rulings:

  1. The exercise of the Executor's power to contribute assets from the Estate, specifically the Note, to LLC; the receipt of consideration by the Estate of voting and non-voting units in LLC; the subsequent sale of the voting units for cash equal to fair market value; and distribution of such non-voting units and cash from the Estate through the Revocable Trust to Foundation, will satisfy the requirements for the estate administration exception to self-dealing described in Treas. Reg. § 53.4941(d)-1(b)(3) and, therefore, will not constitute impermissible acts of self-dealing under IRC § 4941.
  1. The LLC's retention of the Note, receipt of payments on the Note, and distributions of such payments will not constitute acts of self-dealing pursuant to Treas. Reg. § 53.4941(d)-1 and will not violate IRC § 4941.

With respect to the first ruling, the IRS reasoned that the exchange of the Note for LLC interests and cash is the type of transaction described in the estate administration exception, that is, a sale or exchange.  It, therefore, was eligible to fall under  the exception from indirect self-dealing that applies where all five conditions of the estate administration exception are met, including the requirement that the transaction results in the foundation "receiving an interest or expectancy at least as liquid as the one it gave up." The liquidity requirement was considered to have been met in this case because the non-voting units in LLC and cash are at least as liquid as the interest in the Note that the Foundation would have otherwise received, given that the non-voting units are backed by Note, all interest payments made on Note would be distributed annually, there are were sale or transfer restrictions on the non-voting units, and the non-voting units could not be changed or burdened because amendments to the operating agreement of LLC that require consent of all members and an opinion of counsel on the tax status of the proposed amendment. Furthermore, the LLC's amended operating agreement provided, in essence, that upon any default on the Note, the LLC will immediately take all necessary actions to foreclose on and collect payment of the Note, which ultimately would place the Foundation in the same position as if it controlled the Note directly.

With respect to the second ruling, the IRS reasoned that, although the obligor on Note would remain the Irrevocable Trust, which was a disqualified person with respect to the Foundation, the Foundation's retention of non-voting units in LLC and its receipt of passive income from LLC were not acts of self-dealing.   The IRS specifically found that the LLC was not controlled by the Foundation because it would only hold non-voting interests, with the only voting interests in LLC held by Executor/Trustee in his individual capacity and not as a foundation manager. The IRS also found that the LLC was not a disqualified person because disqualified persons did not own at least 35% of the beneficial interest in the LLC, notwithstanding that the Executor/Trustee, a disqualified person with respect to Foundation, owned 100% percent of the voting interests in the LLC.

Note:    This is an unusual fact pattern where the estate administration exception was used where a disqualified person issued a note that would otherwise be distributed to a private foundation.   As discussed above, there are many IRS rulings simply allowing the note to be transferred to the private foundation, and principal and interest payments to be made thereunder, under the estate administration exception.  Here, however, the note was not transferred directly to the private foundation but was transferred to an LLC, which was not controlled by the foundation and was not a disqualified person, rather than the interest in the note being distributed to the private foundation.  The taxpayer in this ruling presumably felt more comfortable interposing a non-controlled entity and a non-disqualified person between the private foundation and the disqualified person obligated on the note or may have done so for management purposes, although IRS rulings would indicate that this was not necessary to fall under the estate administration exception.  

Ltr. Rul. 201510050: IRS Rules That Transaction Between a Disqualified Person and Entity is Not an Indirect Act of Self-Dealing Because Entity is Not Considered to be Controlled by Private Foundation

In Ltr. Rul. 201510050, a private foundation (“Foundation”) owned a 49.9 percent interest in a partnership (“Partnership), which owned nearly 6,000 acres of farmland and wetland, almost entirely consisting of wetlands. The other partners in Partnership included a disqualified person (“DP”) with respect to the Foundation, who owned .1 percent of the partnership, his sister (“Sister”) who owned 3.56 percent of the partnership, and another private foundation, which owned 46.44 percent of the Partnership, to which Sister was a substantial contributor.[9]  Both private foundations were founded by DP and Sister's mother, who was a substantial contributor to both foundations, which also made her a disqualified person.  As a result, both DP and Sister were disqualified persons with respect to both private foundations owning interests in the Partnership.

DP and Sister were also partners in several other partnerships, in all owning a total of approximately 16,000 acres of land, including the 6,000 acres owned by the Partnerships.  DP and Sister had been unable to determine the appropriate use of the land held by these partnerships for a number of years. The inability to agree on this matter led to years of contentious court battles over the appropriate use and disposition of the land held by these partnerships.  After years of litigation, the court issued an order that all the partnerships were to be liquidated and all of the land held by them is to be sold as one unit.  The proceeds from such a sale would then be divided among the partners in accordance with their respective percentage interests and total acreage owned by the particular partnerships.  A Special Master was appointed, who determined that these lands would be sold in a public auction.  The auction was to be conducted by the local county where the land is located. 

DP proposed to bid in the public auction in an attempt to buy the full amount of the land, including the 6,000 acres owned by Partnership.  In the event DP would have the highest bid, he would purchase the land from Partnership, which would result in proceeds going to both private foundations, with respect to which DP was a disqualified person.  The issue before the IRS was whether an the Partnership was considered to be an organization controlled by the Foundation, in which case the purchase of assets by DP from the Partnership would be constituted an indirect act of self-dealing between the DP and the Foundation. 

In its analysis under Treas. Reg. § 53.4941(d)-1(b)(5), the IRS stated that an organization is considered to be controlled by a private foundation by either the private foundation and/or foundation managers of the foundation in one of following four separate ways:

(1)       the private foundation alone can control the organization;

(2)       the private foundation, by aggregating its votes or positions of authority with those of one or more foundation managers (acting only in such capacity) can control the organization;

 (3)      a foundation manager (acting only in such capacity) alone can control the organization; or

(4)       the foundation managers (acting only in such capacity), by aggregating their votes or positions of authority with one another, can control the foundation.

The IRS further noted, as discussed above, that under Treas. Reg. § 53.4941(d)-1(b)(5), an organization is also controlled by a private foundation in the case a transaction between the organization and a disqualified person, if such disqualified person, together with one or more other persons who are disqualified persons by reason of such person's relationship to such disqualified person, may by aggregating their votes or positions of authority with that of the foundation, require the organization to engage in such a transaction.

In determining whether the Partnership in this situation was controlled by a private foundation, the IRS first noted that the private foundation did not control the partnership on its own as it did not own over fifty percent of the voting interest of the Partnership.   Second, the IRS noted there were no foundation managers who owned a voting interest in the Partnership in their capacity as a foundation manager so that the foundation could not aggregate its voting shares with any such disqualified person.  Therefore, the IRS stated that the foundation did not meet any of the four tests for foundation control under Treas. Reg. § 53.4941(d)-1(b)(5) by virtue of a foundation and/or its foundation managers (acting in their capacity as such) having control of the Partnership.

The IRS also did not find the presence of Foundation control over the Partnership by virtue of DP, as a party to the transaction, being able to aggregate his votes with the Foundation, as well as with one or more other persons who are disqualified persons with respect to the Foundation by reason of such a person's relationship (within the meaning of IRC § 4946(a)(1)(C) through (G)) to such disqualified person.  In this context, the IRS noted that the Sister was not a disqualified person with respect to the Foundation by virtue of being the DP’s sister, because a sister is not a covered relationship under IRC § 4946(a)(1)(C) thought (G).   And, the IRS noted that by combining the Foundation’s voting interest with that of DP, the Foundation and the DP owned in the aggregated exactly half of the voting interest of the partnership, which the IRS stated did not create control. 

Finally, although the Foundation and the DP only held a fifty percent voting interest, the IRS looked at whether the Foundation and the DP should be considered to control the Partnership because if the DP’s sister’s voting interests were aggregated with the Foundation and DP’s voting interest, a more than 50 fifty voting interest would exist.  The IRS refused to count the Sister’s voting interest in determining whether the Foundation and the DP did, in fact, control the Partnership as “it can be shown through repeated disputes between Sister and DP over the direction of the Partnership and the land it owns” that the Foundation and the DP, based on the facts and circumstances, were not in a position to exercise control over the Partnership.   Instead, the IRS stated that “the relevant factors all indicate that the transaction will occur at arm's length and in the absence of control by one of the parties.”

In conclusion, the IRS found that the Foundation did not control the Partnership within the meaning of Treas. Reg. § 53.4941(d)-1(b)(5) so there could be no indirect act of self-dealing. And since the Foundation was not disposing of the property itself, there could be no direct act of self-dealing as well.  Therefore, the IRS ruled that the “sale of the underlying assets of the partnership to DP, should he get the winning bid, will not result in ‘self-dealing’ as defined in § 4941.”

CONCLUSION

Ltr. Ruls. 201446024 and 201510050 demonstrate the complexities involved in situations where disqualified persons contemplate entering into transactions involving estates or trusts that have private foundation as a beneficiary or with an entity controlled by a private a foundation, thereby potentially resulting in an indirect act of self-dealing. In the estate context, it is imperative to ensure compliance with the estate administration exception to avoid what would otherwise be an indirect act of self-dealing.  Where a disqualified person contemplates engaging in a transaction with an entity in which a private foundation has an ownership interest, it is critical to ensure that that the foundation is not considered to be in control of the entity; otherwise, an indirect act of self-dealing will result.  Given the potential recurring 10% first-tier excise tax and the 200% second-tier excise tax and the complexity of these rules, these matters must be taken seriously and appropriate planning should be undertaken.



[1]     IRC § 4941(a)(1), second sentence, provides:  “…The tax imposed by this paragraph shall be paid by any disqualified person (other than a foundation manager acting only as such) who participates in the act of self-dealing.”

[2] “Taxable period” is defined at IRC § 4941(e)(1), which generally starts at occurrence of the act of self-dealing and ends upon the earliest of (a) the date of mailing a notice of deficiency with respect to the imposition of the 10% first- tier tax; (b) the date on which the 10% first-tier tax is assessed, or (c)  the date on which correction of the act of self-dealing is completed.

[3]  IRC § 4941(b)(1).

[4] IRC § 4941(e)(3). 

[5] See Blattmachr, “Something Pretty Scary: Application of Certain Private Foundation and UBTI Rules in Estate Planning and Administration,” U. of Miami Est. Plan. Inst. at Chapter 10 (1992).  See also  Thomas, “Avoiding the Private Foundation Self-Dealing Penalties in Trust and Estate Administration,” 6 Taxation of Exempts 251 (May/June 1995) (“Because of the relationships among the donor, family members, business entities, in which the donor has an interest, and the private foundation – all of which may also be beneficiaries under the trust instrument or will – the administration of the trust or estate can be minefield for possible self-dealing transactions prohibited under Section 4941”). 

[6] In Ltr. Rul. 200148080, the independent appraiser who valued the fair market value of the property to be received by the private foundation under the estate administration exception also provided a certification that the property received by the foundation was at least as liquid as the property that it was giving up.   

[7] This requirement applies with respect to transactions occurring after April 16, 1973.

[8]  Staff of the Joint Committee on Taxation, Technical Explanation of H.R. 4, the "Pension Protection Act of 2006," as passed by the House on July 28, 2006, and as considered by the Senate on August 3, 2006, JCX-38-06, page 361.

[9] IRC § 507(d)(2) provides that a substantial contributor means any person who contributed or bequeathed an aggregate amount of more than $5,000 to the private foundation, if such amount is more than two percent of the total contributions and bequests received by the foundation.

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