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Rulings Go Beyond ‘Plain Vanilla’ Foundations

Taxation of Exempts

Originally Published in Taxation of Exempts.

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Thus far, 2007 has generated four private letter rulings of more than casual interest relating to private foundations. Unusually, two of the rulings relate to the generally quiet area of private operating foundations under Section 4942(j)(3). A private operating foundation, or POF, is an “elevated” form of private foundation, which, in contrast to its more common “plain vanilla” private (nonoperating) foundation brethren, affords its contributors more attractive, “public charity” deductibility thresholds. A POF must carry on its own charitable activities, and must meet an “income” test (under which it is required to devote 85% of its income or 4.25% of its investment assets to its own charitable activities), and meet any one of three alternative tests–the “assets” test, the “endowment” test, or the “support” test–designed to help ensure its activities justify its elevated status.

Private operating foundations

Ltr. Rul. 200725045 involved a POF emerging from financial hardship that proposed to sell its interest in land underlying condominiums. It was concerned that sale proceeds might be deemed to constitute unrelated business taxable income (UBTI) under Section 511, and potentially have some adverse effect on its exempt status.

The exempt mission of the POF in the ruling was to provide for orphans and other destitute children in its state. It fulfilled these purposes through the operation of nine children’s centers to provide counseling, support, and education to children and their families and caregivers, and to help communities strengthen their systems of care for orphans and destitute children. The foundation owned over 6,000 acres of land, the majority of which was contributed by its founder nearly a century ago. More recently, 25 to 29 years ago, the foundation arranged for the development of three parcels into condominiums; the foundation currently owns the land on which the condos sit, but not the condos themselves. The foundation does not regularly buy or sell realty, but has occasionally sold portions of its land, primarily to government or quasi-government entities.

In analyzing the rulings requested, the Service cited Rev. Rul. 55-449, 1955-5 CB 599, addressing what sort of activities can generate UBTI for an exempt organization. There, the Service found that a church’s construction and sale of 80 homes over a period of 18 months solely to raise funds for the church’s support constituted UBTI. The Service also cited six factors from Adam, 60 TC 996 (1973), which the court enunciated as relevant in determining whether a taxpayer is engaged in the operation of the trade or business of buying and selling land:

The purpose for which the property was acquired.
The frequency, continuity, and size of the sale.
The activities of the owner in the improvement and disposition of the property.
The extent of improvements made to the property.
The proximity of sale to purchase.
The purpose for which the property was held.

The Service ruled that the POF’s sale of the realty would not generate UBTI because (1) the land was received from the founder, (2) the POF had held the land for nearly a century without selling any of it, and (3) the POF had not advertised its interest in the land for sale to the general public.

While this ruling provides welcome additional guidance on what sorts of land sale activities will not trigger UBTI, a POF or other exempt organization contemplating realty sales which involve different elements should proceed with caution because of the fact-sensitive nature of this determination.

Ltr. Rul.200719012 concerned a POF’s proposed transfers of its museums to a Section 509(a)(2) organization, one that satisfies its “public support” requirements in part through ticket sales and the like, and is a common format for museums and symphony orchestras. The foundation wished to confirm that the transfer would not jeopardize its operating foundation status under Section 4942(j)(3), and that it would not trigger the Section 507 termination tax. (This is a particularly unpleasant tax, potentially weighing in at a full 100% of the value of the foundation assets, and so it is best given the widest possible berth. It is also a fairly complicated tax, with plenty of traps for the unwary, and so requires considerable caution.)

The POF operated three museums and a non-commercial radio station; it also made grants for emergency and disaster relief and operated a resource center for public school teachers and a performing arts theater. Its board of directors had decided that the museum programs could benefit from the more efficient operations and attraction of broader public support through the new Section 509(a)(2) organization. The POF proposed to transfer the museums to the new charity at no consideration, and continue to carry on its other charitable activities itself. The new charity would be financially accountable to the POF and provide regular reports as to its operation of the museums. The POF indicated it would not give notice to the Service that it was terminating its status as a private foundation, and would continue to handle its other functions as a POF, as before.

The Service ruled that, as the foundation would not be distributing all of its net assets in the proposed museum transfer, its status as a private foundation would not be terminated under Section 507(b)(1)(A), and that hence it would not be liable for any termination tax under Section 507. Nor, the Service ruled, would the foundation’s transfer of the museums to the new Section 509(a)(2) entity adversely affect the foundation’s ability to continue to comply with the “income” and “endowment” tests under Reg. 53.4942(b)-2(b)(1), which is so critical to the maintenance of its POF status. In addition, the Service confirmed that the foundation’s provision of financial and staff support to the new charity in operating the museums would constitute qualifying expenditures made directly for the active conduct of its exempt purposes under Section 4942(j)(3).

Private (nonoperating) foundation rulings

Ltr. Rul. 200722029 considered a somewhat unusual option arrangement and its potential effects for a private (nonoperating) foundation. Husband and wife each created a revocable trust, naming the foundation as beneficiary of a significant portion of the trust estates on the death of the surviving spouse. This presumably was done to help provide liquidity to the estate or trust, a common estate planning concern. Under an option arrangement, husband and wife and their trusts granted to “D” an option to purchase shares of D’s stock from husband, wife, their trusts, or their estates upon the surviving spouse’s death. D is expected to exercise the option during the pendency of the surviving spouse’s estate proceedings, and prior to the time the surviving spouse’s trust would be deemed a charitable trust under Section 4947. (Under Section 4947(a)(1), trusts that have only charitable beneficiaries, but have not asked for a ruling that they qualify as private (nonoperating) foundations, are treated as if they are private (nonoperating) foundations for purposes of the excise taxes under Sections 4940-4945.) On the death of the surviving spouse, the survivor’s children will control the foundation and D.

The foundation sought a ruling that the exercise of the option and the purchase of the option assets will satisfy the requirements for the exception to “self-dealing” under Reg. 53.4941(d)-1(b)(3). While sales between private foundations and disqualified persons usually constitute “self-dealing,” this provision articulates an important exception. The foundation also sought a ruling that its receipt of a promissory note from the surviving spouse’s estate or trust, and its retention of that note and receipt of interest on the note, would not constitute direct or indirect acts of self-dealing under Section 4941.

The Service ruled that Reg. 53.4941(d)-1(b)(3) exception to self-dealing would apply to the transaction, as the requirements of that Section have been satisfied. Specifically:

The executor or trustee would have a power of sale with respect to the option assets.
The option exercise and sale will be approved by a court of competent jurisdiction as a condition of closing.
The option exercise, the sale, and the tendering and receipt of consideration will occur before the estate is considered terminated for federal income tax purposes or, in the case of the revocable trust, before the trust is considered subject to Section 4947.
The option arrangement calls for payment of fair market value consideration for the option assets.
The transaction will be conducted pursuant to an option binding on the survivor’s estate under state law.

The Service also ruled that, because the option transaction would satisfy the requirements of Reg. 53.4941(d)-1(b)(3), the foundation’s receipt of a promissory note from the survivor’s estate or trust, and its retention of the note and receipt of interest, therefore would not constitute direct or indirect self-dealing under Section 4941.

This ruling should stand as a guidepost and a warning for estate planners who may not always realize or remember the full effects on their clients’ private foundations of adding “creative” provisions like these “option” arrangements to other estate planning documents.

Ltr. Rul. 200715014 involved a private (nonoperating) foundation that, because of a divergence in charitable interests and management strategies of its trustees, proposed to distribute one-quarter of the assets to be retained in the foundation. Once again, the transaction raised the potential specter of the Section 507 termination tax, so the foundation sought rulings that the distributions to the three private foundations (1) would not trigger the tax, (2) would not constitute “taxable expenditures” under Section 4945, and (3) would not otherwise trigger excise tax under Section 4941, Section 4942, or Section 4944.

The Service ruled favorably on these questions. As to the Section 507 termination tax issue, the Service held that because the foundation did not give notice to the Service of an intent to terminate, it would retain its private foundation status and would continue to be treated as a private foundation, without becoming subject to the tax.

As the proposed transfers to the new foundations did not appear to be part of a plan to provide excess compensation to the trustees–in that the family trustees would serve without compensation (and only non-family trustees would be paid in accordance with a state funded salary survey)–no self-dealing concerns as to “excess compensation” would arise under Section 4941. The three new foundations would not be considered “disqualified persons” under Section 4946, as the foundations themselves qualify as exempt charitable organizations. The proposed transfers to the three new foundations would not, however, constitute “qualifying distributions” of the original foundation, as the new foundations would be treated as though they were the transferor for purposes of Section 4942. The Service did note that each of the new foundations would be credited for any excess distributions made by the original foundation. The original foundation would exercise “expenditure responsibility” under Section 4945 as to the transfers to the three new foundations for a period of three years, and the transfers would not constitute “taxable expenditures.”

The ruling reminds us once again that considerable caution should be exercised as to any transaction involving the distribution of all or a significant portion of the assets of a private foundation.


Much of the “law” relating to private foundations and private operating foundations continues to come from private letter rulings. Though they lack precedential value, they provide welcome guidance on specific issues facing foundations. The current armful of rulings should provide some comfort and direction for foundations considering sales of realty, transfer of a component function and related assets to another charity, and distribution of a significant portion of the foundation’s assets to other foundations, as well as for estate planners contemplating unusual “creative” elements in their clients’ wills and trusts.

IRS Circular 230 Disclosure: To the extent this message contains tax advice, the U.S. Treasury Department requires me to inform you that any such advice, whether in the body of the message or in any attachment, is not intended or written by my firm to be used, and cannot be used by any taxpayer, for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code. Advice from my firm relating to tax matters may not be used in promoting, marketing or recommending any entity, investment plan or arrangement to any taxpayer.

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