PLR 1125043: Restructuring transfers preserve exemption and avoid unrelated business income

Plain-English summary

A public charity planned to transfer certain activities and assets to newly formed domestic and foreign for-profit subsidiaries, while retaining control and continuing its core educational and charitable work. The IRS ruled that the restructuring would not jeopardize the organization’s tax-exempt status, that it would continue to qualify under IRC § 501(c)(3), and that the transfers would not create unrelated business taxable income under §§ 511 through 514, subject to the stated caveat about ordinary income under §§ 1245 and 1250. It also treated payments for the distribution of educational products as receipts from the individual purchasers for the support test under § 509(a)(2). The IRS declined to rule on the organization’s future public-charity reclassification, which it said could be addressed in a later determination request.

Ruling snapshot

• Question: What federal tax consequences would follow from the proposed restructuring and related distribution arrangements?
• Outcome: Mixed. Rulings 1 through 4 were favorable; the IRS declined to rule on public-charity reclassification.
• Key authorities: IRC §§ 351, 501(c)(3), 509(a)(2), 511 through 514, 1245, and 1250; Treas. Reg. §§ 1.501(c)(3)-1, 1.501(a)-1, and 1.513-1.

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Release Number: 201125043 Contact Person:
Release Date: 6/24/2011

Date: March 28, 2011 Identification Number:
Uniform Issue List:

501.03-28 Telephone Number:

509.01-01
512.00-00 Employer Identification Number:

LEGEND:

P =

b =

d =

e =

f =

Dear

This letter supersedes our letter to you dated March 15, 2011 in response to your ruling request
dated November 6, 2007, which was subsequently revised and superseded by your letters
dated September 21, 2009, August 11, 2010 and March 7, 2011, requesting rulings related to a
proposed reorganization and transfer of assets, in the manner and for the purposes described
below.

FACTS

You are exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code
(“Code”) and are classified as other than a private foundation. Your primary activities consist of
the development of d; e; and the dissemination of b information, all for the benefit of the general
public. You conduct activities through a global network of controlled organizations. Though
your principal business location is in the United States, you own or control several foreign
subsidiaries, which have significant foreign operations.

In light of growing industry challenges to your manner of operation and the effect of such
challenges on your ability to continue to serve your public b mission, you have decided to
restructure by transferring e and other activities to for-profit subsidiaries. You will keep your
core charitable and public educational activities and retain ownership and management of the
shares of the e businesses and associated businesses.

You state the following reasons for the restructuring. The new structure will allow you to
preserve and increase the value of the e activity, to the benefit of your remaining activities.
Restructuring will enable you to use the stock of the for-profit subsidiaries as “acquisition

currency,” instead of cash or debt, to acquire other entities as part of a geographic and product
line expansion strategy. Restructuring will enable you to attract prospective partners by making
it possible to offer a non-controlling equity investment in a for-profit corporation. Furthermore,
by creating a for-profit subsidiary, you will be able to attract and retain key employees with an
equity-based compensation system.

Under the plan of restructuring, you plan to form one or more domestic stock corporations
(henceforth “DSub”). You will transfer assets to DSub in exchange for % of the stock of
DSub and, possibly, debt issued by DSub. The assets to be transferred will include physical
assets, contracts, and U.S. employees associated with the e activities (comprising f as well as
research and certain other activities associated with f). You will then transfer % of the stock
and debt of DSub to NewCo, a wholly-owned for-profit subsidiary, in exchange for Class A
common stock of NewCo. None of the assets to be transferred by you would be subject to
acquisition indebtedness as defined in section 514(c) of the Code.

In addition, you will form a new foreign corporation or use an existing foreign corporation
(henceforth, “FSub”). You plan to transfer assets to FSub in exchange for 100% of the common
and preferred stock (nonqualified preferred stock within the meaning of section 351(g) of the
Code) of FSub. The transferred assets will include stock of foreign subsidiaries and intangibles
such as trademarks, trade names, intellectual property, and goodwill. It is anticipated that FSub
common stock will be issued in exchange for approximately % of the value of the assets
transferred to FSub, and FSub nonqualified preferred stock will be issued in exchange for
approximately % of the value of such assets. You will subsequently transfer % of the
stock of FSub to NewCo in exchange for Class A common stock of NewCo. FSub will transfer
some of the assets received from you to NewCo.

NewCo will authorize either one or two classes of common stock for issuance. If two classes
are issued — Class A and Class B — Class A will be a high-vote stock whose majority
shareholder will be you. Through majority ownership of NewCo’s Class A stock, you will have
voting control over it and thus indirect control over DSub and FSub. If issued, Class B stock
would be low-vote in nature. Potential shareholders of Class B stock may include you,
employees, and external investors. You could own some of the Class B stock as part of the
normal capitalization process between parent and subsidiary entities, while employees could
own some of the Class B stock as part of an equity compensation plan. In addition, the Class B
stock could be issued to certain investors in return for capital. Likely investors could include
private placement, institutional investors, and strategic investors. Any capital raised in this
process will serve as funds for future growth of NewCo. Future sales of the subsidiary stock to
investors would be at fair market value as determined by a highly-qualified investment banking
firm. If only one class of stock is issued, you will be the majority owner and will control the
subsidiary. There are no plans to reduce your ownership of shares in NewCo, whether there
are one or two classes of stock, to less than a majority interest.

Your Board of Trustees will continue to serve three-year terms and consist of three classes
whose terms expire in succeeding years. All or a majority of the initial members of NewCo’s
Board of Directors will consist of all the Trustees of your Board of Trustees for at least one year
to assure continuity. Thereafter NewCo’s Board of Directors will consist of directors elected

annually by your Board, selected from its own ranks or elsewhere as it determines to be
appropriate, except that the Chair of your Board and your Chief Executive Officer will
automatically be members of NewCo’s Board.

After the restructuring, NewCo will conduct the e activities in a manner not materially different
than the manner in which those activities were conducted by you. You will continue to educate
the public on b and engage in education and outreach programs, conduct research, make
grants to outside organizations and programs that support your exempt purposes, and act as a
b resource. In addition, you will continue to set international, independent d and be the
coordinating body to bring together the expertise and interested parties required to develop new
d.

Currently, d and d-related products and services are distributed to the public by an unrelated
party, P, under a services agreement with you. Under that agreement, P collects purchase fees
from customers and remits the entire amounts collected to you. In return, you pay P a
distribution fee. The agreement provides that you and P intend for P to serve as an
independent contractor, and that nothing in the agreement shall give P any right, ownership, or
interest in any d or d-related products. After the restructuring, you will enter into a distribution
arrangement with NewCo that is similar to your arrangement with P. Specifically, you will
contract with NewCo to distribute d and d-related products and services to customers of
NewCo’s e activities. NewCo will collect the fees from its customers for distributing the d and
transfer those amounts, without offset or compensation, to you.

RULINGS REQUESTED
You have requested the following rulings:

1. Your transfer of the assets and liabilities related to the e activities ultimately to NewCo
   in the manner described above (the “restructuring”) will not jeopardize your tax-exempt
   status as an organization described in section 501(c)(3) of the Code.

2. After the restructuring, you will continue to be an organization described in section
   501(c)(3) of the Code.

3. Your proposed transfer of assets and liabilities ultimately to NewCo will not result in
   any unrelated business taxable income within the meaning of sections 511-514 of the
   Code. Notwithstanding the foregoing, you are not requesting a ruling on the question
   of whether ordinary income recognized by virtue of sections 1245 and 1250, if any, as
   a result of the transfer of assets and liabilities is unrelated business income under
   sections 511 through 514.

4. The income derived by you from the P agreement and from NewCo from the
   distribution of d to the public constitutes substantially related income and is treated as if
   derived directly from the individual purchaser of the educational materials, i.e. the d, for
   purposes of section 509(a)(2) of the Code.

5. After the restructuring, you will be recognized as a public charity within the meaning of
   section 509(a)(2) of the Code.

LAW

Section 501(a) of the Code exempts from federal income tax organizations described in section
501(c).

Section 501(c)(3) of the Code describes organizations organized and operated exclusively for
charitable, scientific, testing for public safety, literary, educational, and other specified exempt
purposes.

Section 509(a) of the Code defines the term “private foundation” as a domestic or foreign
organization described in section 501(c)(3) other than an organizations described in section
509(a)(1), (2), (3), or (4).

Section 509(a)(2) of the Code, in pertinent part, describes an organization which (A) normally
receives more than one-third of its support in each taxable year from any combination of (i) gifts,
grants, contributions or membership fees, and (ii) gross receipts from admissions, sales of
merchandise, performance of services, or furnishing of facilities, in an activity which is not an
unrelated trade or business (within the meaning of section 513), not including such receipts from
any person, or from any bureau or similar agency of a governmental unit, in any taxable year to
the extent such receipts exceed the greater of $5,000 or 1 percent of the organization’s support
in such taxable year, and (B) normally receive not more than one-third of its support in each
taxable year from gross investment income.

Section 511 of the Code imposes a tax on the unrelated business taxable income of every
organization described in section 501(c)(3).

Section 512(a)(1) of the Code defines “unrelated business taxable income” as the gross income
derived by any organization from any unrelated trade or business regularly carried on by it, less
the allowable deductions directly attributable to such business activity, with certain
modifications.

Section 512(b)(2) of the Code excludes from unrelated business taxable income all royalties
whether measured by production or by gross or taxable income from the property, and all
deductions directly connected with such income.

Section 512(b)(5) of the Code excludes from unrelated business taxable income all gains or
losses from the sale, exchange, or other disposition of property other than (A) stock in trade or
other property of a kind which would properly be includible in inventory if on hand at the close of
the taxable year, or; (B) property held primarily for sale to customers in the ordinary course of
the trade or business.

Section 512(b)(13)(A) of the Code provides, in pertinent part, that if an organization (the
“controlling organization”) receives or accrues (directly or indirectly) any royalty from another
entity which it controls (the “controlled organization”), notwithstanding section 512(b)(2), the
controlling organization shall include such royalty as an item of gross income derived from an

unrelated trade or business to the extent such payment reduces the net unrelated income of the
controlled entity (or increases any net unrelated loss of the controlled entity). In the case of a
corporation, section 512(b)(13)(D) defines “control” as ownership (by vote or value) of more
than 50 percent of the stock in such corporation.

In the case of an controlled entity which is not exempt from tax under section 501(a), section
512(b)(13)(B)(ii) of the Code defines the term “net unrelated income” as the portion of such
entity’s taxable income which would be unrelated business taxable income if such entity were
exempt under section 501(a) and had the same exempt purposes as the controlling entity.

Section 513(a) of the Code defines unrelated trade or business as any trade or business the
conduct of which is not substantially related (aside from the need of the organization for funds or
the use it makes of the profits derived) to the exercise of the organization's exempt purposes or
functions.

Section 1.501(c)(3)-1(a) of the Income Tax Regulations (“regulations”) provides that in order to
be exempt as an organization described in section 501(c)(3) of the Code, an organization must
be both organized and operated exclusively for one or more of the purposes specified in that
section.

Section 1.501(c)(3)-1(c) of the regulations provides that an organization will be regarded as
“operated exclusively” for one or more exempt purposes only if it engages primarily in activities
which accomplish one or more exempt purposes specified in section 501(c)(3).

Section 1.501(c)(3)-1(c)(2) of the regulations provides that an organization is not operated
exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the
benefit of private shareholders or individuals. Section 1.501(a)-1(c) of the regulations defines
the term “private shareholder or individual” as a person having a personal and private interest in
the activities of the organization.

Section 1.501(c)(3)-1(d)(3) of the regulations defines the term “educational” as including the
instruction of the public on subjects useful to the individual and beneficial to the community.

Section 1.513-1(d)(1) of the regulations states that the determination of whether a trade or
business is substantially related to an organization’s exempt purpose necessitates an
examination of the relationship between the business activities that generate the particular
income in question and the accomplishment of the organization's exempt purposes.

Section 1.513-1(d)(2) of the regulations provides that a trade or business is related to exempt
purposes only where the conduct of the business activity has causal relationship to the
achievement of exempt purposes (other than through the production of income); and it is
“substantially related,” for purposes of section 513, only if the causal relationship is a substantial
one. Thus for the conduct of a trade or business from which a particular amount of gross
income is derived to be substantially related to purposes for which exemption is granted, the
production or distribution of the goods or the performance of the services from which the gross
income is derived must contribute importantly to the accomplishment of those purposes.

Rev. Rul. 75-387, 1975-2 C.B. 216, concerns a blood bank that is recognized as exempt from
federal income tax under section 501(c)(3) of the Code. The blood bank’s principal source of
support is receipts from the sale of blood. The blood bank enters into agreements with the
hospitals it supplies with blood whereby the hospitals are responsible for collecting charges from
the patients and reimbursing the blood bank. Under the agreements, all blood furnished to the
hospitals remains the property of the blood bank until used. The receipts collected by the blood
bank for blood furnished to any patient do not exceed $5,000 or one percent of the blood bank’s
support for any taxable year. The blood sales receipts remitted from each participating hospital
greatly exceed $5,000 or one percent of the blood bank’s support. The blood bank’s blood
sales receipts exceed one third of the blood bank’s support, and it receives not more than one-
third of its support in any taxable year from gross investment income. The ruling states that,
since the blood bank retains both legal title to the blood and control over the hospitals regarding
its return or redirection at any time prior to use, an agency relationship is created between the
hospitals and the blood bank. Therefore, amounts paid to the hospitals are treated as though
they have been paid to the blood bank directly, and each patient is considered a separate payor
for purposes of the $5,000 or one percent of support limitation provide for in section
509(a)(2)(A)(ii).

ANALYSIS

Issue 1: Whether your transfer of assets and liabilities related to the e activities ultimately to
NewCo in the manner described above would jeopardize your tax-exempt status as an

organization described in section 501(c)(3) of the Code.

The facts presented do not reveal that the proposed transfer of assets and liabilities would inure
to the benefit of any member, trustee, or officer of you or to any private individual in violation of
section 1.501(c)(3)-1(c)(2) of the regulations. Your restructuring transactions appear
reasonable and in furtherance of legitimate purposes. In return for transferring assets to DSub,
you will receive percent of the stock and debt of DSub. In return for transferring assets to
FSub, you will receive percent of the common and preferred stock of FSub. In return for the
transfer of its DSub stock and debt and FSub stock to NewCo, you will receive and retain a
majority interest in NewCo. Furthermore, NewCo, will be carrying on the same e activities, in
substantially the same manner as previously carried on by you, activities that correspond to an
exempt purpose under section 501(c)(3) of the Code. Your intended use of NewCo stock as
part of an equity-based compensation system for your employees will not necessarily result in
inurement of your net earnings within the meaning of section 1.501(c)(3)-1(c)(2). An exempt
organization may cause shares of its taxable subsidiary to be issued as part of a reasonable
compensation package. Therefore, the transfer of the assets and liabilities related to the e
activities to NewCo would not jeopardize your exempt status as an organization described in
section 501(c)(3).

Issue 2: Whether you will continue to be an organization described in section 501(c)(3) of the
Code after the restructuring.

Following the restructuring, your activities will consist of developing d and promoting b through

public educational activities. Organizations formed to establish and promote b through the
development of d are entitled to exemption as educational organizations within the meaning of
section 501(c)(3) of the Code and section 1.501(c)(3)-1(d)(3) of the regulations. Furthermore,
you will not only continue to conduct public educational activities, but likely will expand those
activities dedicated to educating the general public on international b issues. Therefore, after
the restructuring, you will continue to meet the operational test of section 1.501(c)(3)-1(c) by
engaging primarily in activities which accomplish one or more exempt purposes.

Issue 3: Whether the transfer of assets and liabilities related to the e activities ultimately to
NewCo would result in any unrelated business taxable income within the meaning of section
512 of the Code.

Your proposed transfer of assets and liabilities ultimately to NewCo will not result in any
unrelated business taxable income within the meaning of sections 511-514 of the Code.
Notwithstanding the foregoing, you are not requesting a ruling on the question of whether
ordinary income recognized by virtue of sections 1245 and 1250, if any, as a result of the
transfer of assets and liabilities is unrelated business income under sections 511 through 514.

Issue 4: Whether amounts received by you under service agreements with P and NewCo for
the sale, fulfillment, and distribution services for d and d-related products and services will be
treated as gross receipts received directly from the purchaser of the d or d-related product or
service rather than from P or NewCo for purposes of the $5,000 or one percent limitation under
section 509(a)(2)(A)(ii) of the Code.

Under the services agreement between you and P, P provides sales, fulfillment, and distribution
services for d and d-related products and services. P pays you the gross sales of d and d-
related products and services minus a fee for services. After the restructuring, NewCo will
distribute d to customers of its e activities under an arrangement that is substantially similar to
that between P and you. The agreement provides that P and you intend to create an
independent contractor relationship, and that nothing in the agreement shall give P any right,
ownership, or interest in any d or d-related products. The arrangement is similar to that between
the blood bank and hospitals described in Rev. Rul. 75-387, 1975-2 C.B. 216. P and NewCo
are acting as agents of you. Therefore, amounts paid to P and NewCo for d and d-related
products and services will be treated as though paid directly to you, and each purchaser of d or
d-related products and services will be considered a separate payor for purposes of the $5,000
or one percent support limitation under section 509(a)(2)(A)(ii) of the Code.

Issue 5: Whether after the restructuring, you will be recognized as a public charity within the
meaning of section 509(a)(2) of the Code.

Under Rev. Procs. 2011-4 and 2011-10, the EO Determinations Office issues determination
letters on reclassification of public charity status. After your restructuring occurs, you may
request a determination letter regarding your current public charity status from EO
Determinations, based on your support over the five most recently completed tax years.
Therefore we decline to rule on this issue.

RULINGS
Based on the information submitted, we rule as follows:

1. The transfer of assets and liabilities related to the e activities from you to NewCo in the
   course of restructuring will not jeopardize your tax-exempt status as an organization
   described in section 501(c)(3) of the code.

2. After the restructuring, you will continue to be an organization described in section
   501(c)(3) of the Code.

3. 1. The proposed transfer of assets and liabilities ultimately to NewCo will not result in any
      unrelated business taxable income within the meaning of sections 511-514 of the Code.
      We are not ruling on the question of whether ordinary income recognized by virtue of
      sections 1245 and 1250 of the code, if any, as a result of the transfer of assets and
      liabilities is unrelated business income under sections 511 through 514.

4. Amounts received by you under service agreements with P and NewCo for the sale,
   fulfillment, and distribution services for d and d-related products and services will be

treated as gross receipts received directly from the purchaser of the d or d-related product

or service rather than from P or NewCo for purposes of the $5,000 or one percent
limitation under section 509(a)(2)(A)(ii) of the Code.

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 understanding there will be no material changes in the facts upon
which it is based. Any changes that may have a bearing upon your tax status should be

reported to the Service. This ruling does not address the applicability of any section of the Code

or regulations to the facts submitted other than with respect to the sections described.

Because this letter could help resolve any future questions about tax consequences of your
activities, you should keep a copy of this ruling 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.

In accordance with the Power of Attorney and Declaration of Representative currently on file
with the Service, we are sending a copy of this letter to your authorized representative.

Sincerely,

Ronald J. Shoemaker

Manager, Exempt Organizations
Technical Group 2

Enclosure:
Notice 437