IRS rules charitable remainder trust units will not create unrelated business taxable income

Plain-English summary

The IRS ruled that a proposed contractual unit arrangement for charitable remainder trusts would not generate unrelated business taxable income to the trusts under the stated facts. The arrangement would let the trusts receive periodic payments tied to units of an educational organization’s endowment without giving them ownership of the underlying investments. The IRS concluded that the relationship was contractual rather than a partnership or agency and that the trusts were not receiving investment-management services for a fee. The ruling was limited to the requesting organization and its specific facts, including the assumption that the arrangement would not materially change.

Ruling snapshot

• Question: Would issuing, paying on, holding, and redeeming endowment units for the charitable remainder trusts generate unrelated business taxable income?
• Outcome: approved
• Key authorities: IRC §§ 501(a), 501(c)(3), 509(a)(1), 170(b)(1)(A)(ii), 511, 512, 513, 514(c)(9)(C), and 6110; Treas. Reg. §§ 1.513-1(a), 1.513-1(b), 1.513-1(c)(1), and 1.513-1(d)

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Number: 201218014 Contact Person:
Release Date: 5/4/2012
Identification Number:

Date: February 8, 2012
Telephone Number:

Uniform Issue List: 512.00-00

Employer Identification Number:

Legend:
M=
Dear

This is in response to your request for a ruling that certain proposed contractual agreements will not generate unrelated business taxable income under section 512(a)(1) of the Internal Revenue Code (the “Code”).

M is exempt under section 501(a) of the Code as an organization described in section 501(c)(3) and has been classified as an educational organization under sections 509(a)(1) and 170(b)(1)(A)(ii).

M is the trustee of six charitable remainder trusts (the “Trusts”) and, as trustee, M is the legal owner of the Trusts’ assets. In addition, M has a remainder interest in each of the Trusts. More specifically, M is the sole charitable remainder beneficiary in five of the Trusts. However, under the terms of the sixth Trust, such Trust will terminate at the death of the survivor of the donors, at which time M, as trustee, is to distribute 50% of the remainder interest to itself and 50% of the remainder interest to one or more educational organizations described in sections 501(c)(3) and 170(b)(1)(A)(ii) of the Code or other organizations treated as qualified organizations under

section 514(c)(9)(C) of the Code.

As a result of the relationship with the Trusts as both trustee and beneficiary, M has a substantial interest in the value of each Trust. Moreover, the donors to the Trusts have funded the Trusts with the intention that M benefit substantially from the remainder value of the Trusts, and that the Trusts’ assets will be managed to achieve the greatest possible return on investment.

M’s endowment is invested in a diversified manner with investments in nontraditional assets such as private equity, flexible capital, natural resources, inflation hedging and real estate as well as more standard asset classes including U.S. and international stocks and bonds. Real estate assets and certain other alternative investments are undertaken primarily through partnership structures. Much of the income earned by the endowment consists of passive income including dividends, interest and long and short-term capital gains, but some income is debt-financed or otherwise is treated as unrelated business taxable income.

M proposes to create a contractual obligation, pursuant to which it would issue a contract right to each of the Trusts for a proportionate share, or “unit”, of M’s endowment. The value of the units would equal the value of the endowment units held by M’s various restricted and unrestricted funds. The contract right would entitle the Trusts to receive periodic payments based on the number of units owned. The Trusts would thereby be able to receive an investment return equal to that of the endowment.

M determines a distribution rate on the endowment each year based in part on the endowment’s investment performance. M calculates the market value of each endowment unit on a quarterly basis. The market value of each endowment unit initially equals the total value of the endowment investments divided by the number of outstanding units and is subsequently adjusted in accordance with the market value of the endowment. Each fund is entitled to an amount equal to the distribution rate multiplied by the number of units it holds.

M seeks to enable the Trusts to invest in the endowment in a manner identical to M’s restricted and unrestricted funds. A Trust would acquire a unit in the endowment which would give it a contractual right against M, but no interest whatsoever in the underlying investment assets of the endowment. The contract between the Trusts and M would provide that the price of the units would equal their value at the time of acquisition. The units would have the same value that M uses for internal accounting purposes.

The contract would provide that each Trust would receive payments on the units held by it based on the distribution rate M has established for the endowment, with payouts made quarterly. A Trust could choose either to reinvest part of the payout, or redeem additional units, depending on its cash requirements. The Trusts will treat payouts as ordinary income, regardless of the character of the underlying income of the endowment, whether capital gain, ordinary income, or return of capital, and regardless of whether the payout is made entirely by distributions of income or in part by redemptions of units. The Trusts will treat redemptions of units (over and above receipt of the distribution amount) as generating long or short-term capital gain (or loss), depending on the holding period of the redeemed units.

Under the contract, a Trust would not have any ownership interest in the underlying assets of the endowment or any contract rights with respect to the other Trusts. The Trusts would have no power or right of any kind to control, direct, supervise, recommend or review M's business activities, operations, or decisions with respect to the endowment, except the right to review the payout computations. They would not have the right to veto or opt out of any of the underlying endowment investments. The contract would provide that, with respect to the issuance of units,

M is neither a partner nor an agent of the Trusts, the Trusts would never be liable for any cost, expense, or payment incurred by M or for which M is liable or responsible relating to the endowment (or the underlying endowment assets), and M would indemnify and hold the Trusts harmless from and against any liability arising out of any action or inaction by M with respect to the endowment (or the underlying endowment assets).

You have requested the following ruling:

The issuance of units by M to the Trusts, the making or receipt of payments with respect to the units, and the holding and redemption of the units, will not generate unrelated business taxable income to you.

LAW

Section 512(a)(1) of the Code defines the term “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 which are directly connected with the carrying on of such trade or business, both computed with the modifications provided in section 512(b).

Section 512(b) of the Code sets forth so-called “modifications,” which are excluded from the computation of unrelated business taxable income. These modifications include dividends, interest, royalties, rent from real property and gain from the sale of property.

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 exempt purpose or function.

Section 513(c) of the Code provides that the term “trade or business” includes any activity which is carried on for the production of income from the sale of goods or the performance of services.

Section 1.513-1(a) of the Income Tax Regulations provides that gross income of an exempt organization subject to the tax imposed by section 511 of the Code is includible in the computation of unrelated business taxable income if: (1) it is income from a trade or business; (2) such trade or business is regularly carried on by the organization; and (3) the conduct of such trade or business is not substantially related (other than through the production of funds) to the organization's performance of its exempt functions.

Section 1.513-1(b) of the regulations provides that for purposes of section 513 of the Code the term "trade or business" has the same meaning it has in section 162 and generally includes any activity carried on for the production of income from the sale of goods or performance of services.

Section 1.513-1(c)(1) of the regulations provides that in determining whether trade or business from which a particular amount of gross income derives is "regularly carried on," within the meaning of section 512 of the Code, regard must be had to the frequency and continuity with which the activities productive of the income are conducted and the manner in which they are

pursued. For example, specific business activities of an exempt organization will ordinarily be deemed to be "regularly carried on" if they manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of non-exempt organizations.

Section 1.513-1(d)(1) of the regulations provides that, in general, gross income derives from "unrelated trade or business," within the meaning of section 513(a) of the Code, if the conduct of the trade or business which produces the income is not substantially related (other than through the production of funds) to the purposes for which exemption is granted. The presence of this requirement necessitates an examination of the relationship between the business activities which generate the particular income in question -- the activities, that is, of producing or distributing the goods or performing the services involved -- and the accomplishment of the organization's exempt purposes.

Section 1.513-1(d)(2) of the regulations provides that trade or business is "related" to exempt purposes, in the relevant sense, only where the conduct of the business activities has a causal relationship to the achievement of exempt purposes, and is "substantially related," for purposes of section 513 of the Code, only if the causal relationship is a substantial one. Thus, for the conduct of 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. Where the production or distribution of the goods or the performance of the services does not contribute importantly to the accomplishment of the exempt purposes of an organization, the income from the sale of the goods or the performance of the services does not derive from the conduct of related trade or business. Whether activities productive of gross income contribute importantly to the accomplishment of any purpose for which an organization is granted exemption depends in each case upon the facts and circumstances involved.

As noted previously, organizations described in section 501(c)(3) of the Code are subject to tax on their unrelated business income under section 511. In order for such an organization's income to be subject to the unrelated business income tax, three requirements must be met: (1) the income must be from a trade or business; (2) the trade or business must be regularly carried on; and (3) the conduct of the trade or business must not be substantially related to the organization's exempt purpose or function. See section 1.513-1(a) of the regulations.

ANALYSIS

M proposes to enter into a contractual relationship with certain Trusts that are charitable remainder trusts in which M has an interest as a beneficiary and serves as trustee of the Trusts. Under such a contractual relationship, each Trust would receive payments on the units held by it based on the distribution rate M establishes for its endowment, with payouts made quarterly.

Each Trust would acquire units from M’s endowment, which would give the Trusts a contractual right against M, but no interest whatsoever in the underlying investment assets of the endowment. The contract between the Trusts and M would provide that the price of the units would equal their value at the time of acquisition. The units would have the same value that M uses for internal accounting purposes.

Consequently, a Trust could choose either to reinvest part of the payout, or redeem a portion of the units, depending on its cash requirements. Thus, under the contractual relationship with M, the Trusts would have a right to the payout declared by M plus the right to redeem the units at the value that M uses for internal accounting purposes.

As stated above, under the contract, a Trust would not have any ownership interest in the underlying assets of the endowment or any contract rights with respect to the other Trusts. The Trusts would have no power or right of any kind to control, direct, supervise, recommend or review M’s business activities, operations, or decisions with respect to the endowment, except the right to review the payout computations. They would not have any right to veto or opt out of any of the underlying endowment investments. The contract would provide that, with respect to the issuance of the units, M is neither a partner nor an agent of the Trusts, the Trusts would never be liable for any cost, expense, or payment incurred by M or for which M is liable or responsible relating to the endowment (or the underlying endowment assets), and M would indemnify and hold the Trusts harmless from and against any liability arising out of any action or inaction by M with respect to the endowment (or the underlying endowment assets).

The Trusts do not have a position of ownership in the underlying assets of M’s endowment. Since the contractual relationship between the Trusts and M is not in the nature of a partnership or agency, the income earned by the Trusts from the payout M establishes for the units reflects ordinary income and does not take on the character of the income of the underlying assets or debt-financed or unrelated business taxable income. M’s endowment would pay any tax owed on unrelated business taxable income earned by the endowment portfolio.

In view of the foregoing, we rule as follows:

The issuance of units from M to you, the making or receipt of payments with respect to the units, and the holding and redemption of the units, will not generate unrelated business taxable income to you, a “charitable remainder trust.”

This ruling is based on the understanding that there will be no material changes in the facts upon which it is based.

We express no opinion as to the tax consequences of the proposed transaction under any other section of the Code.

Pursuant to a Power of Attorney on file in this office, a copy of this letter is being sent to your authorized representatives. A copy of this letter should be kept in your permanent records.

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.

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

Sincerely,

Director, Exempt Organizations

Enclosure
Notice 437