IRS rules endowment unit contracts will not create unrelated business taxable income

Plain-English summary

The IRS ruled that an educational organization’s proposed contractual units for charitable remainder trusts would not generate unrelated business taxable income to the organization. The organization would issue contract rights tied to units of its endowment and make periodic payments, while the trusts would receive no ownership interest in the underlying investments. The IRS found that the arrangement was not an investment-management service provided for a fee and therefore did not constitute an unrelated trade or business under the stated facts. The ruling was limited to the organization that requested it and assumed that it would not charge management or trustee fees.

Ruling snapshot

• Question: Would issuing, paying on, holding, and redeeming endowment units for the charitable remainder trusts generate unrelated business taxable income to the organization?
• Outcome: approved
• Key authorities: IRC §§ 501(a), 501(c)(3), 511, 512, 513, and 514(c)(9)(C); 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: 201218015 Contact Person:
Release Date: 5/4/2012
Identification Number:

Date: February 8, 2012
Telephone Number:

Uniform Issue List: 512.00-00

Employer Identification Number:

Dear

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

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

You are the trustee of six Trusts and, as trustee, you are the legal owner of the Trusts’ assets.
In addition, you have a remainder interest in each of the Trusts. More specifically, you are 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
you, as trustee, are to distribute 50% of the remainder interest to yourself 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, you have a
substantial interest in the value of each Trust. Moreover, the donors to the Trusts have funded
the Trusts with the intention that you 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.

The 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.

You propose to create a contractual obligation, pursuant to which you would issue a contract
right to each of the Trusts for a proportionate share, or “unit”, of your endowment. The value of
the units would equal the value of the endowment units held by your 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.

You determine a distribution rate on the endowment each year based in part on the
endowment’s investment performance. You calculate 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.

You seek to enable the Trusts to invest in the endowment in a manner identical to your
restricted and unrestricted funds. A Trust would acquire a unit in the endowment which would
give it a contractual right against you, but no interest whatsoever in the underlying investment
assets of the endowment. The contract between the Trusts and you 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 you use 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 you establish 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 your 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,
you are neither a partner nor an agent of the Trusts, the Trusts would never be liable for any
cost, expense, or payment incurred by you or for which you are liable or responsible relating to
the endowment (or the underlying endowment assets), and you would indemnify and hold the
Trusts harmless from and against any liability arising out of any action or inaction by you with
respect to the endowment (or the underlying endowment assets).

You have requested the following ruling:

The issuance of units by you 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.

Section 6.14 of Rev. Proc. 2011-4 provides that the Service will not issue letter rulings
pertaining to unrelated business income tax issues arising when charitable lead trust assets are
invested with charitable organizations. Thus, the word “Trusts” as used in this letter refers only
to your charitable remainder trusts, and the ruling issued by this letter relates only to the
participation by your charitable remainder trusts in your endowment.

LAW

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

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.

Rev. Rul. 69-528, 1969-2 C.B. 127, describes an organization that was formed to provide
investment services on a fee basis exclusively to organizations exempt under section 501(c)(3)
of the Code. It receives funds from the participating exempt organizations, invests in common
stocks, reinvests income and realized appreciation and, upon request, liquidates a participant's
interest and distributes the proceeds to the participant. The Rev. Rul. states that providing
investment services on a regular basis for a fee is a trade or business ordinarily carried on for
profit. If the services were regularly provided by one tax-exempt organization for other
tax-exempt organizations, such activity would constitute unrelated trade or business. The Rev.
Rul. holds that the organization is not exempt under section 501(c)(3).

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

You propose to enter into a contractual relationship with certain Trusts that are charitable
remainder trusts in which you have an interest as a beneficiary and serve 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 you establish for your endowment, with payouts made
quarterly.

Each Trust would acquire units from your endowment, which would give the Trusts a contractual
right against you, but no interest whatsoever in the underlying investment assets of the
endowment. The contract between the Trusts and you 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 you
use 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
you, the Trusts would have a right to the payout declared by you plus the right to redeem the
units at the value that you use for internal accounting purposes.

Generally, an organization that otherwise qualifies for recognition of exemption under section
501(c)(3) of the Code and provides investment services on a regular basis for a fee to other
exempt or nonexempt organizations would be engaged in an unrelated trade or business under
section 513(a). See Rev. Rul. 69-528, supra. Such an activity would constitute a “trade or
business” under Code section 513(c) and section 1.513-1(b) of the regulations and would be
“regularly carried on” under Code section 512(a)(1) and section 1.513-1(c) of the regulations.
Thus, if you charged a fee for investment management services provided to organizations
unrelated to you or generated income from the management of the funds invested by such
organizations, these activities could result in unrelated business taxable income under section
512(a)(1). Here, however, you are not charging a fee for services and not otherwise receiving
income from the services provided to the Trusts. Thus, under these circumstances, you will not
receive unrelated business taxable income under section 512(a)(1).

The fact that you will engage in the investment activity for the benefit of individuals who are co-
beneficiaries of the Trusts at the same time that you engage in investment activity for your own
benefit as the remainder beneficiary limits the scope of the service provided to “others” and
distinguishes it from a commercial venture.

In view of the foregoing, we rule as follows:

The issuance of units from you 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.

This ruling is based on the following assumption:

1. You will not charge any fee for managing the investment of the Trusts in your
   endowment. Other third party management firms charge a fee and receive
   reimbursement of expenses for management services provided to your endowment.
   These fees and expenses are charged against the aggregate return of the endowment
   and will be reflected indirectly in the payout to the Trusts and others participating in the
   endowment. You will also not assess a trustee’s fee with respect to the administration of
   the Trusts.

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