IRS approves endowment units for a charitable remainder trust

Plain-English summary

The IRS ruled that a charitable remainder trust's contractual units in an organization's endowment would not generate unrelated business taxable income. The trust would have a contractual right to payments and redemption value, but no ownership interest or control over the endowment's underlying assets. The IRS also ruled that redemption of the units would generally produce short-term or long-term capital gain or loss based on the holding period. The ruling did not address other tax consequences of the proposed transaction.

Ruling snapshot

• Question: Would the endowment-unit arrangement avoid unrelated business taxable income and receive capital-gain treatment on redemption?
• Outcome: Approved, subject to the facts and conditions described in the ruling.
• Key authorities: IRC §§ 512, 1221, 1222, and 1234A; Treas. Reg. § 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: 201223021 Contact Person:
Release Date: 6/8/2012

Date: March 14, 2012 Identification Number:
Uniform Issue List:

512.00-00

Telephone Number:

Employer Identification Number:

Legend:

M =

Dear

This is in response to your request for rulings that endowment investment agreements will not
generate unrelated business taxable income under section 512 of the Internal Revenue Code
(the “Code”) and that redemption of endowment units by charitable remainder trusts will be
treated as long or short term capital gain or loss under section 1222 of the Code, depending
upon the applicable holding period.

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 a number of charitable remainder trusts (collectively, “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. You are one such charitable remainder trust in which M is trustee and
remainder beneficiary.

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 portfolio of public domestic and international equity

and fixed income securities, real assets, private equity and hedged strategies.

M proposes to create a contractual obligation, pursuant to which it would issue a contract right
to each of the Trusts to receive a proportionate share, or “unit”, of M’s endowment in exchange
for the investment of the Trusts’ assets in M’s endowment. The contract right would entitle the
Trusts to receive periodic payments based on the units owned by each of the Trusts.

M determines a payout 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 monthly
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 Trust is entitled to an
amount equal to the payout rate multiplied by the number of units it holds.

M seeks to enable the Trusts to be invested in the same manner as M’s endowment. A Trust
would acquire a unit in the 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 M and the Trusts 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 payout rate M establishes for the endowment, with payouts made quarterly. A
Trust could choose either to reinvest all or 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.

Under the contract, the Trusts would not have any ownership interest in the underlying assets of
the endowment. 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. 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 rulings:
The issuance of endowment units by M to you, the making or receipt of payments with respect

to the endowment units, and the holding or redemption of the endowment units, will not
generate unrelated business taxable income to you.

The redemption of endowment units by you will be treated as long or short term capital gain or

loss under section 1222, depending upon the holding period of the endowment units.

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. The ruling issued by this letter relates only to your
participation as a charitable remainder trust in M’s endowment.

LAW

Section 664(c) of the Code provides that a charitable remainder trust shall, for any taxable year,
not be subject to tax unless such trust, for such year, has unrelated business income (within the
meaning of section 512 of the Code, determined as if part III of subchapter F applied to such
trust).

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.

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.

Section 1222 of the Code provides that capital gain or loss is generated upon a sale or

exchange of a capital asset.

Section 1234A of the Code provides that gain or loss attributable to the cancellation, lapse,
expiration, or other termination of a right or obligation with respect to property which is (or on
acquisition would be) a capital asset in the hands of the taxpayer shall be treated as gain or loss
from the sale of a capital asset.

Section 1221 of the Code defines the term “capital asset” as property held by the taxpayer,
regardless of whether it is connected with the taxpayer's trade or business, unless the property
meets one of eight listed exceptions: (1) inventory; (2) property of a character which is subject to
the allowance for depreciation provided in § 167, or real property used in a trade or business;
(3) certain intangible property; (4) accounts receivable acquired in the ordinary course of a trade
or business; (5) certain publications of the United States Government; (6) certain commodities
financial derivatives; (7) certain hedging transactions; and (8) supplies of a type regularly
consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer.

Although section 1221 appears to give broad meaning to the term capital asset, the Supreme
Court has found it “evident that not everything which can be called property in the ordinary
sense and which is outside the statutory exclusions [of section 1221] qualifies as a capital
asset;” rather, “the term ‘capital asset’ is to be construed narrowly in accordance with the
purpose of Congress to afford capital-gains treatment only in situations typically involving the
realization of appreciation in value accrued over a substantial period of time ....” Commissioner
v. Gillette Motor Transport, Inc., 364 U.S. 130 (1960) (citing Burnet v. Harmel, 287 U.S. 103
(1932)). Accordingly, the Court has held that certain interests that are concededly “property” in
the ordinary sense are not capital assets.

On this basis, capital gain treatment has been denied for transactions involving payments in
return for interests carved out of, or related to, an interest retained by the taxpayer. See e.g.,
Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958) (Court denied capital gain treatment on
the disposition of certain mineral payments carved out of established oil and gas interests); Hort
v. Commissioner, 313 U.S. 28 (1941) (Court denied capital gain treatment on the disposition of
a term of years carved out from a fee simple).

The Court also has denied capital gain treatment for transactions on the basis that the
payments at issue were a substitute for ordinary income. In Hort, for example, the taxpayer
inherited a building, and one of the tenants canceled its lease, paying the taxpayer a
cancellation fee. The Court held that the cancellation fee was ordinary income because the
cancellation of the lease involved nothing more than relinquishment of the right to future rental
payments in return for a present substitute payment and possession of the leased premises. Id.
at 32. The Court bolstered this “substitute-for-ordinary-income” doctrine in P.G. Lake, stating,
“The lump sum consideration seems essentially a substitute for what would otherwise be
received at a future time as ordinary income.” P.G. Lake, 356 U.S at 265.

Consistent with the substitute-for-ordinary-income doctrine, the courts have denied capital gain

treatment for transactions involving interests related to compensation for past or future personal
services. See, e.g., Freese v. United States, 455 F.2d 1146 (10th Cir. 1972) (lump sum
representing unpaid commissions due under an employment contract); Elliot v. United States,
431 F.2d 1149 (10th Cir. 1970) (lump sum paid for the surrender of right to future sales
commissions); Holt v. Commissioner, 303 F.2d 687 (9th Cir. 1962) (payment for interest in films
to be produced by taxpayer). Similarly, courts have denied capital gain treatment for interests
relating to income already earned or about to be earned. See, e.g., United States v. Midland-
Ross Corp., 381 U.S. 54 (1965) (earned original issue discount); Lattera v. Commissioner, 437
F.3d 399 (3d Cir. 2006) (lump sum payment for annual installments of lottery prize); Rnodes'
Estate v. Commissioner, 131 F.2d 50 (6th Cir. 1942) (right to dividend that was already
declared).

On the other hand, as the courts have noted, “Simply because the property transferred will
produce ordinary income, and such income is a major factor in determining the value of the
property, does not necessarily mean that the amount received for the property is essentially a
lump-sum substitute for ordinary income.” Guggenheim v. Commissioner, 46 T.C. 559, 569
(1966). In Guggenheim, the court focused on whether the taxpayer transferred substantial
investment risks in the sale of undivided interests in a stallion. In that case, the court noted that
if the value of the stallion subsequently increased, the taxpayer would not share in that increase
with regard to the interests transferred. Instead, the new owners received all the benefits of an
increase in value of the stallion, and all the burdens of a decrease in value. Thus, the court
found that the taxpayer had transferred substantial investment risks and was entitled to capital
gain treatment on the sale of the interests.

In United States v. Dresser Industries, Inc., 324 F 2d. 56 (5th Cir. 1963), the court distinguished
between proceeds from the present sale of the future right to earn income, which is capital gain,
and the present sale of the future right to earned income, which is ordinary income. Id. at 59. In
that case, the court found that the sale of an income-producing asset was not merely the sale of
the right to income already earned; instead, the taxpayer had an asset that would produce
income in the future. Thus, the court held that the taxpayer's sale of the asset generated capital
gain. Id. Similarly, in Commissioner v. Ferrer, 304 F 2d. 125 (2d Cir. 1962), the court held that
the taxpayer's surrender of a lease of a play constituted the sale or exchange of a capital asset,
despite the fact that receipts from the play would have been ordinary income. Ferrer at 132. In
its rejection of the government's argument against capital gain treatment, the court noted that
there was no equivalence between amounts paid for the surrender of the lease and the income
that would have been realized by its retention. Id. at 133.

ANALYSIS

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

You would acquire units from M’s endowment, which would give you a contractual right against
M, but no interest whatsoever in the underlying investment assets of the endowment. The
contract between you 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, you could choose either to reinvest all or part of the payout, or redeem a portion
of the units, depending on your cash requirements. Thus, under the contractual relationship
with M, you 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, you would not have any ownership interest in the
underlying assets of the endowment or any contract rights with respect to any other Trusts. You
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. You 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 you, you 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 you 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 do not have a position of ownership in the underlying assets of M’s endowment. Because
the contractual relationship between M and you is not in the nature of a partnership or agency,
the income earned by you 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 would pay any tax owed on unrelated business taxable
income earned by the endowment portfolio, with no deduction taken for any payments made to
you.

With respect to the proper characterization under section 1221 of the unit, the bundle of contract
rights represented by each unit is property, and may be treated as a capital asset for purposes
of section 1221. In the present case, none of the listed exceptions in section 1221 applies. The
most important characteristic of the unit is that significant investment risks are associated with,
and included in, each unit. With respect to each unit there is an opportunity for appreciation as
well as a risk of loss. Each unit represents a substantial investment by you, and each unit has
an ascertainable basis. The value of each unit is directly tied to the endowment's investment
performance; poor performance will detract from the value of a unit, while performance above
the payout rate set by M will increase the value of each unit. The opportunity for appreciation,
risk of loss, and basis in each unit are characteristics similar to other contract rights that are

treated as capital assets (for example, other financial derivatives, mutual fund shares or
corporate stock). Further, the benefits and burdens associated with each unit are similar to
those associated with the property held to be capital assets in Guggenheim, Dresser and Ferrer.

In addition, although you will receive ordinary income in the form of the quarterly payouts that
are based in part upon the number of units owned by you, consideration received upon a
redemption of a unit is not a substitute for what would otherwise be received as an ordinary
income payout, whether due and payable or about to be due and payable to you under the
terms of the contract. Rather, the amount paid for a unit upon a redemption is equal to the
value of the unit on the date of redemption. Unit value on any given date is equal to overall
asset value of the endowment divided by the number of units outstanding. In addition, the unit
is not an interest related to compensation for past or future personal services. Instead, the unit
is an asset that will produce income in the future.

Finally, the unit does not represent a carve-out of a larger estate retained by you. The
appreciation of each unit is attributable to M’s overall endowment property appreciation, much of
which, in turn, is attributable to increases in the value of capital assets in M’s endowment. The
contract provides specifically that you do not have any ownership interest in or rights to M’s
endowment.

Accordingly, we conclude that the unit is a capital asset for purposes of section 1221.
Furthermore, section 1234A will apply to treat gain or loss from the cancellation, lapse,
expiration, or other termination of the unit as gain or loss from the sale of a capital asset. Thus,
in general, the redemption of the unit by you will generate short-term or long-term capital gain or
loss to you, depending on the holding period of the unit.

In view of the foregoing, we rule as follows:

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

2. The redemption of endowment units by you will be treated as long or short term capital
   gain or loss under section 1222, depending upon the holding period of the endowment

units.

This ruling letter 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 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 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