PLR 200003048: Titleholding company's note proceeds do not change its exempt status

Plain-English summary

An exempt titleholding company sold two properties for cash and a note, then acquired another property for use by its exempt affiliates. It asked whether using the note proceeds to repay debt, invest, and pay property expenses would affect its exemption. The IRS ruled that those uses, and treating the affiliates' rent-free use as a transfer of income, would not adversely affect its § 501(c)(2) status. Investment and note income were excluded from unrelated business taxable income. The ruling left taxable the portion of gain from the sold properties attributable to debt-financed space rented to other tenants. The IRS did not examine whether the property transactions were at arm's length or fair market value.

Ruling snapshot

• Question: Would the company's use of sale note proceeds affect its exemption or create unrelated business taxable income?
• Outcome: Approved: exemption retained and note proceeds excluded, except for the specified taxable sale gain.
• Key authorities: IRC §§ 501(c)(2), 511, 512, 514; Treas. Reg. §§ 1.501(c)(2)-1, 1.514(a)-1(a)(1)(v).

Full text (IRS public release)

Internal Revenue Service           Department of the Treasury         200003048

SIN 0511.02-00                   Washington, DC 20224

SIN 0512.00-00
SIN 0513.00-00                   NO THIRD PARTY CONTACT

SIN 0514.00-00 Contact Person:
XXXXXXXXXXXXXXXXXXXX XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXX Telephone Number: XXXXXXXXXXXX
XXXXXXXXXXXXXXXXX XXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXXXXXX In Reference to:
OP:E:EO:T:3

Date: OCT 18 1999

Legend:

X= XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX

Y= XXXXXXXXXXXXXXXXXXXXXXX

Z= XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX
T= XXXXXXXXXXXXXXXXXXXXXXX

S1= XXXXXXXXXXXXXXXXXXXXXXXXX

S2= XXXXXXXXXXXXXXXXXXXXXXXXX

Dear Applicant:

This is in response to your ruling letter dated June 30,
1999, as modified and amended by your letter of September 20,
1999, in which you request rulings under sections 501(c)(2), 511,
512, 513, and 514 of the Internal Revenue Code with respect to a
proposed transaction. Specifically you request us to rule as
follows:

1. X's exempt status under section 501(c)(2) of the
Code will not be adversely affected if it uses the cash
proceeds of the S1/S2 note to pay off the T note, and
invest the remaining amounts in long-term investments
such as stocks and bonds, and uses the income from such
investment (together with other income) to pay the
expenses of owning and operating T, and remitting net
income annually to Y in the form of rent-free use of T.
Any income, in excess of the rent-free use, would be
paid to Y periodically.

2. X will not be deemed to receive unrelated business
taxable income under sections 511 through section 514
of the Code when X receives the cash proceeds of the
S1/S2 note except to the extent that such proceeds
constitute unrecognized gain on the sale of S1 and S2.

Facts:

X was incorporated to hold title to property, to collect
income therefrom, and to turn such income over to Y and to Z,
which is Y's affiliate. X is a titleholding company and is
recognized as exempt from federal income tax under section
501(c)(2) of the Code. Y is recognized as exempt from federal
income tax under section 501(c)(6) of the Code. Z is recognized



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X owned 100% of S1 and 50% of the joint venture which owned
S2. S1 and S2 were rented to Y and Z and to other tenants. X
purchased the other 50% interest in the joint venture which owned
S2. Thus, after this transaction, X owned 100% of S2. X then sold
both S1 and S2 to an unrelated third party.

X received cash and a five-year note (the S1/S2 note) for
both S1 and S2. Upon Y's directions, X acquired T for cash and a
note (the T note). Y and Z currently occupy 4 of T's 5 floors. Y
and Z pay no rental payments to X.

Law:

Section 501(c)(2) of the Code recognizes as exempt an
organization organized for the exclusive purposes of acquiring
property and holding title to, and collecting income from such
property, and remitting the entire amount of income from such
property (less expenses) to an organization described in section
501(c) of the Code.

Section 1.501(c)(2)-1(a) of the Income Tax Regulations
provides, in pertinent part, that a corporation described in
section 501(c)(2) cannot have unrelated business taxable income
as defined in section 512 other than income which is treated as
unrelated business taxable income solely because of the
applicability of section 512(a)(3)(C); or debt financed income
which is treated as unrelated business taxable income solely
because of section 514.

Section 1.501(c)(2)-1(b) of the regulations provides that a
corporation described in section 501(c)(2) of the Code cannot
accumulate income and retain its exemption, but must turn over
the entire amount of such income, less expenses, to an
organization which is itself exempt from tax under section 501(a)
of the Code.

Section 511 of the Code imposes a tax on the unrelated
business taxable income of organizations exempt from federal
income tax under section 501(c).

Section 512(a)(1) of the Code defines "unrelated business
taxable income" as the gross income derived by an organization
from any unrelated trade or business regularly carried on by it,
less the allowable deductions.

Sections 512(b)(1),(b)(2) and (b)(3) of the Code provide, in
pertinent part, that there shall be excluded from unrelated
business taxable income dividends, interest, annuities,
royalties, and rents from real property.


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Section 512(b)(5) of the Code provides that there shall be
excluded from unrelated business taxable income all gains from
the sale, exchange, or other disposition of property, other than
property which would properly be includible in inventory if on
hand at the close of a taxable year, or property held primarily
for sale to customers in the ordinary course of trade or
business.

Section 513(a) of the Code defines the term "unrelated trade
or business" as any trade or business the conduct of which is not
substantially related (aside from the need of such organization
for income or funds or the use it makes of the profits derived)
to the exercise or performance by such organization of its
charitable, educational, or other purpose or function
constituting the basis for its exemption under section 501.

Section 514(a)(1) of the Code provides that there shall be
included with respect to each debt-financed property as an item
of gross income derived from an unrelated trade or business an
amount which is the same percentage (but not in excess of 100
percent) of the total gross income derived during the taxable
year from or on account of such property as (A) the average
acquisition indebtedness (as defined in subsection (c)(7)) for
the taxable year with respect to the property is of (B) the
average amount (determined under regulations prescribed by the
Secretary) of the adjusted basis of such property during the
period it is held by the organization during such taxable year.

Section 514(b)(1) of the Code provides that for purposes of
this section, the term "debt-financed property" means any
property which is held to produce income and with respect to
which there is an acquisition indebtedness (as defined in
subsection (c)) at any time during the taxable year (or, if the
property was disposed of during the taxable year, with respect to
which there was an acquisition indebtedness at any time during
the 12-month period ending with the date of such disposition),
except that such term does not include--

(A) (i) any property substantially all the use of which
is substantially related (aside from the need of the
organization for income or funds) to the exercise or
performance by such organization of its charitable,
educational, or other purpose or function constituting
the basis for its exemption under section 501 (or, in
the case of an organization described in section
511(a)(2)(B), to the exercise or performance of any
purpose or function designated in section 501(c)(3)),
or (ii) any property to which clause (i) does not
apply, to the extent that its use is so substantially

related;


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Section 1.514(a)-1(a)(1)(v) of the regulations provides that
if debt-financed property is sold or otherwise disposed of, there
shall be included in computing unrelated business taxable income
an amount with respect to such gain (or loss) which is the same
percentage (but not in excess of 100 percent) of the total gain
(or loss) derived from such sale or other disposition as:

(a) The highest acquisition indebtedness with respect
to such property during the 12-month period, preceding
the date of disposition, is of

(b) The average adjusted basis of such property.

The tax on the amount of gain (or loss) included in unrelated
business taxable income pursuant to the preceding sentence shall
be determined in accordance with the rules set forth in
Subchapter P, Chapter 1 of the Code (relating to capital gains
and losses). See also section 511(d) and the regulations
thereunder (relating to the minimum tax for tax preferences).

Rev. Rul. 76-335, 1976-2 C.B. 141 holds that a subsidiary of
an exempt title-holding corporation whose exclusive purpose is
the holding of title to investment property, collecting the
income therefrom, and turning over such income, less expenses, to
its parent, qualifies for exemption under section 501(c)(2) of
the Code.

Rev. Rul. 77-429, 1977-2 C.B. 189, restates and updates Rev.
Rul. 67-104 to provide, in pertinent part, that an exempt title
holding corporation may retain part of its income each year to
apply to indebtedness on property to which it holds title; the
transaction will be treated as if the income had been turned over
to the exempt parent and the latter had used such income to make
a capital contribution to the title holding corporation which, in
turn, applied such contribution to the indebtedness.

Rationale:

As provided in Rev. Rul. 77-429, supra, an exempt title
holding corporation may retain part of its income each year to
apply to indebtedness on property to which it holds title. In
this case X will use part of the interest income and principal
from the S1/S2 note to pay off the note on T. Under the
circumstances, the transaction will be treated as if X turned
income over to its exempt parents and they used such income to
make a capital contribution to X. Accordingly, we conclude that
X's exempt status under section 501(c)(2) of the Code will not be
adversely affected if it uses the cash proceeds from the S1/S2
note to pay off T's note. Similarly, we conclude that X's exempt
status will not be adversely affected if X uses its investment
income to pay the expenses of owning and operating T. As stated



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in Rev. Rul. 76-335, supra, a titleholding corporation is not
restricted to investing solely in real property. Therefore,
investment of a portion of the S1/S2 note proceeds in stocks and
bonds will not adversely affect X's exempt status.

Even though section 1.501(c)(2)-1(b) of the regulations
requires X to turn over its annual income to Y and Z, we conclude
that their rent-free use of T is analogous to X's making direct
annual payments to Y and Z.

We conclude that X's retention of funds necessary for annual
maintenance and renovation of T is also permissible since section
501(c)(2) of the Code explicitly permits the payment of such
expenses by a title-holding corporation.

X's income from investments and its income from the S1/S2
note are excluded from unrelated business taxable income pursuant
to section 512(b)(1) of the Code. However, since S1 and S2 were
debt-financed, those portions of S1 and S2 which were not
occupied by Y and Z generated unrelated business taxable income
pursuant to section 514 of the Code. Therefore, a portion of any
gain on the sale of S1 and S2 will be taxable.

Pursuant to section 1.514(a)-1(a)(1)(v) of the regulations,
the taxable portion of the gain is the same percentage (but not
in excess of 100 percent) of the total gain derived from the sale
as the highest acquisition indebtedness with respect to such
property during the 12-month period preceding the date of sale,
is of the average adjusted basis of the property. In your case,
because only a portion of S1 and S2 generated debt-financed
rental income, only that portion of the gain from the sale which
pertains to that part of S1 and S2 is taxable under this rule.
Pursuant to section 1.514(a)-1(a)(1)(v) of the regulations, the
tax on the amount of gain from S1 and S2 shall be determined in
accordance with the rules relating to capital gains and losses as
set forth in Subchapter P, Chapter 1 of the Code.

Conclusions:

We were not asked and we have not considered whether X's
purchase of the 50% interest in the joint venture which owned S2,
X's sale of S1 and S2, and X's purchase of T were arms-length
transactions at fair market value.

Accordingly, based upon the information submitted and the
representations made we rule that:

1. X's exempt status under section 501(c)(2) of the
Code will not be adversely affected if it uses the cash
proceeds of the S1/S2 note to pay off the T note,
invests the remaining amounts in long-term investments



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such as stocks and bonds, and uses the income from such
investment (together with other income) to pay the
expenses of owning and operating T, and remitting net
income annually to Y in the form of rent-free use of T.
Any income, in excess of the rent-free use, would be
paid to Y periodically.

2. X will not be deemed to receive unrelated business
taxable income under sections 511 through section 514
of the Code when X receives the cash proceeds of the
S1/S2 note except to the extent that such proceeds
constitute unrecognized gain on the sale of S1 and S2.

This ruling letter is directed only to the organization that
requested it. Section 6110(k) (3) of the Code provides that it may
not be used or cited as precedent. We are sending a copy of this
ruling letter to your key District Director and to your attorney.

Sincerely yours,
Robert C. Harper, Jr.

Chief, Exempt Organizations
Technical Branch 3