By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney, Washington, DC
Self-dealing arises under §4941 when a disqualified person (i.e., a manager, substantial contributor, owner and members of their families or certain related entities) has entered into certain financial transactions, including a sale, with a private foundation. The transaction may be direct or indirect. Thus, if a foundation has expectancy in an estate, and disqualified persons with respect to the foundation purchase assets from the estate, the potential for indirect self-dealing exists. If self-dealing is found then an escalating (and ultimately confiscatory) series of excise taxes may be imposed on disqualified persons and foundation managers.
However, applicable Treasury regulations1 provide that transactions (such as sales) occurring during the period of administration of an estate regarding a foundation's interest or expectancy in property held by such estate are not indirect self-dealing if five requirements are satisfied. This exception to the self-dealing rules is commonly referred to as the "estate administration exception." The five requirements with respect to a sale by an estate are as follows:
PLR 201446024 illustrates the application of the estate administration exception to self-dealing where one of the assets of the estate that is distributable to a private foundation is a note, the obligors on which are disqualified persons. This situation commonly arises where a decedent, during his lifetime, has sold assets to a family trust (grantor or non-grantor) in exchange for an installment note that remains outstanding at decedent's death.
During his life, "Decedent" formed "Company" and "Irrevocable Trust." Decedent subsequently sold approximately 85% of his interest in Company to Irrevocable Trust in exchange for a promissory note ("Note"). The current beneficiaries of Irrevocable Trust are all family members of Decedent and thus their combined beneficial interest in Irrevocable Trust is greater than 35%, making Irrevocable Trust a disqualified person with respect to a family foundation ("Foundation") to which Decedent was a substantial contributor.2
Decedent also executed a pour-over will and Revocable Trust. The terms of the will provided that upon Decedent's death, the residue of Decedent's estate, including Note, would pass to Revocable Trust and thereafter the assets would be distributed to several beneficiaries including "Foundation." Accordingly, at Decedent's death, the Note became part of the residuary estate and the obligor of Note continued to be Irrevocable Trust.
Because Irrevocable Trust is the obligor of Note and Foundation will become the creditor of Note, Decedent's Executor/Trustee represented that an act of self-dealing under §4941 will result when Note is transferred to Foundation under Reg. §53.4941(d)-(2)(c)(1), which provides that "except in the case of the receipt and holding of a note pursuant to a transaction described in §53.4941(d)-1(b)(3) [estate administration exception], an act of self-dealing occurs where a note, the obligor of which is a disqualified person [Irrevocable Trust], is transferred by a third party [the estate or Revocable Trust] to a private foundation which becomes the creditor under the note."
To avoid the act of self-dealing, the Executor/Trustee proposes to contribute Note to a new entity LLC for which the estate will receive 100 voting and 9,800 non-voting units in LLC. Simultaneously, 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. Further, Executor/Trustee, in his individual capacity, would buy the 100 voting units in LLC from the Estate for cash equal to a purchase price determined by a qualified appraisal. In the end, Foundation would receive cash and 9,800 non-voting units of LLC instead of Note from the Revocable Trust. LLC's amended operating agreement provides in essence, that upon any default on the Note, LLC "shall immediately take all necessary actions to foreclose on and collect payment of the Note from the Borrower and/or Guarantor." Executor/Trustee will seek court approval from the probate court regarding the sale of the Note to LLC and the sale of voting units to Executor/Trustee.
Executor/Trustee additionally represented that LLC will engage in only passive investment activities, and not in the operation of any business enterprise, and at least 95% of its gross income will be from passive investments including interest (presumably including interest on the Note) and dividends. LLC's operating agreement allocates profits and losses in proportion to the number of units held by each member and all payments received on Note will be distributed annually to members. Any amendment to LLC's operating agreement would require consent of all members and an unqualified opinion of counsel that such an amendment would not jeopardize any member's tax status.
On the above facts, the IRS issued the following rulings:
1. Sale of Note. 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, and therefore will not constitute impermissible acts of self-dealing.
2. Retention of Note by LLC. LLC's retention of the Note, receipt of payments on the Note, and distributions of such payments, including to Foundation, will not constitute acts of self-dealing pursuant to Reg.§ 53.4941(d)-1 and will not violate §4941.
3. Excess Business Holdings. The Foundation's ownership of non-voting units in LLC will not constitute a violation of the prohibition against ownership of excess business holdings under §4943.
Sale of Note. 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 – i.e., a sale or exchange. It therefore is eligible for the exception from indirect self-dealing that applies where all five conditions of the applicable regulation (described above) 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 is met in this case because the non-voting units in LLC and cash are at least as liquid as the interest Foundation would have received, given the following: The non-voting units are backed by Note, all interest payments made on Note will be distributed annually, there are no sale or transfer restrictions on the non-voting units, and the non-voting units cannot 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, LLC's amended operating agreement provides in essence, that upon any default on the Note, LLC `shall immediately take all necessary actions to foreclose on and collect payment of the Note from the Borrower and/or Guarantor,' which places Foundation the same position as if it controlled the Note directly
Note : We note that the liquidity requirement may be avoided if the transaction is "required under the terms of any option which is binding on the estate." Entering into such an option prior to death may be advisable in situations where a post-mortem sale or exchange is anticipated.
Retention of Note by LLC. As noted above, an extension of credit between a private foundation and a disqualified person and the receipt and holding by a private foundation of a note, the obligor of which is a disqualified person, may itself be an act of self-dealing. In PLR 201446024, the IRS reasoned, that although the obligor on Note remains Irrevocable Trust, which is a disqualified party in relation to Foundation, Foundation's retention of non-voting units in LLC and its receipt of passive income from LLC is not an act of self-dealing because:
Furthermore, the IRS determined that LLC is not a disqualified person with respect to Foundation because Foundation, as the holder only of nonvoting interests in LLC does not control LLC for purposes of the 35% test cited above, and Executor/Trustee's beneficial interest in LLC amounts to only 2% - far less than the 35% threshold. [Note, however, that Executor/Trustee, a disqualified person with respect to Foundation owned 100% percent of the voting interests.]
Therefore, Foundation's retention of non-voting units in LLC and its receipt of passive income from LLC is not an act of either direct or indirect self-dealing under the Code and applicable Treasury regulations.
Excess Business Holdings. Only interests in a "business enterprise" may be excess business holdings for purposes of §4943, and the term "business enterprise" does not include a business with at least 95% of its gross income derived from passive sources.3 Since LLC will engage in only passive investment activities, and not in the operation of any business enterprise, and at least 95% of its gross income will be from passive investments including interest and dividends, Foundation's holdings of non-voting units are not interests in a business enterprise and do not constitute "excess business holdings."
PLR 201446024 provides something of a roadmap for navigating the shoals of self-dealing in a situation – increasingly common – where an installment note from an inter vivos sale to a trust is an asset of an estate that is left in part to a private foundation. Query, however, whether the transaction could have been structured differently –and perhaps more simply - if there was a binding option in existence on the date of the decedent's death.
For more information, in the Tax Management Portfolios, see Berry, 470 T.M., Private Foundations — Self-Dealing (Section 4941), and in Tax Practice Series, see ¶6870, Taxes on Self-Dealing Transactions.
1 Reg. §53.4941(d)-1(b)(3).
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