Determination 1031036: IRS approved investment fees for a private foundation despite founder control

Plain-English summary

The IRS ruled that an investment trust and its funds were not disqualified persons with respect to a private foundation. The foundation's founder controlled its board and also owned and controlled the investment adviser for the trust. The IRS concluded that fees paid through the trust for investment management would not be direct or indirect self-dealing if the fees were reasonable and not excessive. The ruling depended on the specific ownership and control facts presented.

Ruling snapshot

• Question: Were the investment trust and related investment-management fees subject to the private-foundation self-dealing rules?
• Outcome: Approved
• Key authorities: IRC §§ 4941, 4946(a)(1), and 501(c)(3); Treas. Reg. §§ 53.4941(d)-2(e) and 53.4941(d)-3(c)

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Release Number: 201031036 Contact Person:
Release Date: 8/6/10

Date: 5/12/10 Identification Number:
4941.04-00

4946.01-00 Telephone Number:

Employer Identification Number:

Legend:
Investment Trust =

Founder =
Investment Advisor =

Dear

This is in reply to your ruling request regarding the proper treatment of certain transactions you
wish to conduct under the Internal Revenue Code (“Code”).

FACTS

You are recognized as an organization exempt from federal income taxation under section
501(c)(3) of the Code and are classified as a private foundation. You were formed and funded
by Founder. Founder also controls your board of directors.

You intend to invest some of your assets in the Investment Trust. The Investment Trust is a
registered investment company offering two investment portfolios, a growth fund and a total
return fund. Shares of these portfolios are publicly traded and offered for sale on a continuous
basis. Founder and other disqualified persons own [redacted] percent of the shares of the growth fund
and [redacted] percent of the shares of the total return fund.

The Investment Trust is managed by a board of trustees, who are elected by the Investment
Trust’s shareholders and serve for terms of indefinite duration until death, resignation,
retirement or removal from office. Founder is one of four trustees. None of the other trustees
are disqualified persons with respect to you.

The Investment Trust’s investment advisor, Investment Advisor, is owned and controlled by
Founder. Investment Advisor is paid based on a percentage of the assets under management,
approximately 1 percent, and that fee is passed on to the shareholders of the Investment Trust.

RULINGS REQUESTED

1. The Investment Trust and its funds are not disqualified persons with respect to you
   within the meaning of Section 4946(a)(1) of the Code.

2. The fees paid by you to the Investment Trust for expenses related to your investment in
   the Investment Trust and the compensation paid by the Investment Trust to Investment
   Advisor for its management of the funds will not constitute acts of direct or indirect self-
   dealing under section 4941 of the Code and section 53.4941(d)-2(e) of the Foundation
   and similar excise taxes regulations (“regulations”), so long as such fees are not
   excessive.

LAW

Section 501(c)(3) of the Code provides for the exemption from federal income tax of
organizations that are organized and operated exclusively for charitable and other exempt
purposes.

Section 4941 of the Code imposes an excise tax on each act of self-dealing between a
disqualified person and a private foundation.

Section 4946(a)(1) of the Code provides in pertinent part that the term “disqualified person”
means a person who is: (1) a substantial contributor to the foundation, (2) a foundation
manager, (3) an owner of more than 20 percent of the total combined voting power of a
corporation, the profits interest of a partnership, or the beneficial interest of a trust or
unincorporated enterprise, which is a substantial contributor to the foundation, (4) a member of
the family of any individual described above, or (5) a corporation, partnership, or trust of which
persons described above own more than 35 percent of the total combined voting power, profits
interest or beneficial interest.

Section 4941(d)(1) of the Code provides that the term “self-dealing” means, in part, any direct or
indirect: (1) furnishing of goods, services, or facilities between a private foundation and a
disqualified person, (2) payment of compensation (or payment or reimbursement of expenses)
by a private foundation to a disqualified person, (3) lending of money or extension of credit
between a private foundation and a disqualified person and (4) transfer to, or use by or for the
benefit of, a disqualified person of the income or assets of a private foundation.

Section 4941(d)(2)(E) of the Code provides that except in the case of a government official, the
payment of compensation (and the payment or reimbursement of expenses) by a private
foundation to a disqualified person for personal services which are reasonable and necessary to
carrying out the exempt purpose of the private foundation shall not be an act of self-dealing if
the compensation (or payment or reimbursement) is not excessive.

Section 53.4941(d)-3(c)(1) of the regulations provides that the payment of compensation (and
the payment or reimbursement of expenses) by a private foundation to a disqualified person for
the performance of personal services which are reasonable and necessary to carry out the

exempt purpose of the private foundation shall not be an act of self-dealing if such
compensation (or payment or reimbursement) is not excessive.

Section 53.4941(d)-3(c)(2) of the regulations contains the following example as Example (2):
C, a manager of private foundation X, owns an investment counseling business. Acting in his
capacity as an investment counselor, C manages X’s investment portfolio for which he receives
an amount which is determined to be not excessive. The payment of such compensation to C
shall not constitute an act of self-dealing.

ANALYSIS

Section 4946(a)(1) of the Code defines a disqualified person as a person who is a substantial
contributor to a foundation, a foundation manager, an owner of more than 20 percent of a
corporation, partnership, or trust that a substantial contributor to the foundation, a member of
the family of any of these individuals, or a corporation, partnership, or trust where any of the
previously described persons own more than a 35 percent interest. The Investment Trust has
not contributed any funds to you and it is not one of your foundation managers or an owner of
more than 20 percent of an entity which is a substantial contributor to you. In addition, Founder
and all other disqualified persons with respect to you do not own more than a 35 percent
interest in the Investment Trust. Therefore, the Investment Trust is not a disqualified person
with respect to you under section 4946(a)(1) of the Code.

As part of your investment in the Investment Trust, you are required to pay a percentage of the
investment management fees charged by Investment Advisor to the Investment Trust. These
fees are compensation to Investment Advisor. Investment Advisor is owned and controlled by
Founder, a disqualified person, therefore Investment Advisor is also a disqualified person under
section 4946(a)(1) of the Code. Thus, under section 4941(d)(1)(D), the compensation you pay
to the investment advisor through the Investment Trust could constitute indirect self-dealing
under some circumstances. The payment of compensation is not self-dealing, however, if it is
for the performance of personal services which are reasonable and necessary to carry out your
exempt purpose within the meaning of section 53.4941(d)-3(c)(1) of the regulations and the
amounts paid are not excessive. Personal services include investment management services,
as illustrated by Example 2 of section 53.4941(d)-3(c)(2). The fees you pay are for investment
management services similar to those identified in example 2 of the regulations. Therefore,
under this exception they would not be considered self-dealing so long as they are not
excessive.

RULINGS

1. The Investment Trust and its funds are not disqualified persons with respect to you
   within the meaning of Section 4946(a)(1) of the Code.

2. The fees paid by you to the Investment Trust for expenses related to your investment in
   the Investment Trust and the compensation paid by the Investment Trust to the
   investment advisor for its management of the funds will not constitute acts of direct or
   indirect self-dealing under section 4941 of the Code and section 53.4941(d)-2(e) of the
   regulations, so long as such fees are not excessive.

This ruling will be made available for public inspection under section 6110 of the Code after
certain deletions of identifying information are made. For details, see enclosed Notice 437,
Notice of Intention to Disclose. A copy of this ruling with deletions that we intend to make
available for public inspection is attached to Notice 437. If you disagree with our proposed
deletions, you should follow the instructions in Notice 437.

This ruling 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 by others as precedent.

This ruling is based on the facts as they were presented and on the understanding that there will
be no material changes in these facts. Because it could help resolve questions concerning your
federal income tax status, this ruling should be kept in your permanent records.

If you have any questions about this ruling, please contact the person whose name and
telephone number are shown in the heading of this letter.

Sincerely,
/s/
Ellen Berick
Acting Manager, Exempt Organizations
Technical Group 1

Enclosure
Notice 437