IRS determination 1311032: IRS rules that contractual endowment units do not generate UBTI

Plain-English summary

The IRS ruled that a charitable remainder trust’s proposed contractual units in an educational organization’s endowment would not generate unrelated business taxable income. The units would give the trusts contractual payment and redemption rights, but no ownership interest in the underlying investments, partnership rights, or control over the endowment. The IRS concluded that the trusts’ payments would be ordinary income and would not take on the character of the endowment’s underlying income. The ruling was based on the submitted facts and assumed no material changes.

Ruling snapshot

• Question: What did the IRS determine under the cited Code provisions?
• Outcome: approved.
• Key authorities: IRC § 512; IRC § 513; IRC § 501; IRC § 509; IRC § 514

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Uniform Issue List: 512.00-00

Release Number: 201311032 Contact Person:
Release Date: 3/15/2013
Date: December 20, 2012 identification Number:

Telephone Number:

Employer Identification Number:

Legend:
s =
Dear

This is in response to your request for a ruling that certain proposed contractual agreements will
not generate unrelated business taxable income under I.R.C. § 512(a)(1).

S is exempt under I.R.C. § 501(a) as an organization described in I.R.C. § 501(c)(3) and has
been classified as an educational organization under I.R.C. § 509(a)(1) and I.R.C.
§ 170(b)(1)(A)(ii). You are a charitable remainder unitrust.

S is the trustee of 40 Trusts (including you) and, as trustee, S is the legal owner of the Trusts’
assets. In addition, S has a remainder interest in each of the Trusts. More specifically, S is the
sole charitable remainder beneficiary in 39 of the Trusts. However, under the terms of the last
Trust, at termination, S, as trustee, is to distribute % of the remainder interest to itself and

% of the remainder interest to another educational organization described in I.R.C. §
501(c)(3) and I.R.C. § 170(b)(1)(A)(ii) and which qualifies under I.R.C. § 514(c)(9).

As a result of the relationship with the Trusts as both trustee and beneficiary, S has a
substantial interest in the value of each Trust. Moreover, the donors to the Trusts have funded
the Trusts with the intention that S 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.

$’s endowment is invested in a diversified manner with investments in nontraditional assets
such as private equity, real estate and natural resources and other marketable alternatives 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.

S 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 S's endowment. The value of the units
would equal the value of the endowment units held by S’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.

S determines a distribution rate on the endowment each year based in part on the endowment’s
investment performance. S 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.

S seeks to enable the Trusts to invest in the endowment in a manner identical to S’s restricted
and unrestricted funds. A Trust would acquire a unit in the endowment which would give ita
contractual right against S, but no interest whatsoever in the underlying investment assets of the
endowment. The contract between the Trusts and S 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 S
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 S 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 S’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,
S is neither a partner nor an agent of the Trusts, the Trusts would never be liable for any cost,
expense, or payment incurred by S or for which S is liable or responsible relating to the

endowment (or the underlying endowment assets), and S would indemnify and hold the Trusts
harmless from and against any liability arising out of any action or inaction by S with respect to
the endowment (or the underlying endowment assets).

You have requested the following ruling:

The issuance of units by S 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

I.R.C. § 512(a)(1) 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 I.R.C. § 512(b).

|.R.C. § 512(b) 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.

|.R.C. § 513(a) 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.

|.R.C. § 513(c) 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.

Treas. Reg. § 1.512(b)-1(a)(1) provides that dividends, interest, payments with respect to
securities loans, annuities, income from notional principal contracts, other substantially similar
income from ordinary and routine investments to the extent determined by the Commissioner,
and all deductions directly connected with any of the foregoing items of income shall be
excluded in computing unrelated business taxable income.

Treas. Reg. § 1.513-1(a) provides that gross income of an exempt organization subject to the
tax imposed by I.R.C. § 511 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.

Treas. Reg. § 1.513-1(b) provides that for purposes of I.R.C. § 513 the term "trade or business"
has the same meaning it has in I.R.C. § 162 and generally includes any activity carried on for

the production of income from the sale of goods or performance of services.

Treas. Reg. § 1.513-1(c)(1) 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 I.R.C.
§ 512, 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.

Treas. Reg. § 1.513-1(d)(1) provides that, in general, gross income derives from "unrelated
trade or business,” within the meaning of |.R.C. § 513(a), 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.

Treas. Reg. § 1.513-1(d)(2) 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 I.R.C.

§ 513, 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 I.R.C. § 501(c)(3) are subject to tax on their
unrelated business income under I.R.C. § 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 Treas. Reg. § 1.51 3-1(a).

ANALYSIS

S proposes to enter into a contractual relationship with certain Trusts that are charitable

remainder trusts in which S 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 S establishes for its endowment, with payouts made quarterly.
Each Trust would acquire units from S’s endowment, which would give the Trusts a contractual
right against S, but no interest whatsoever in the underlying investment assets of the
endowment. The contract between the Trusts and S 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 S
uses for internal accounting purposes.

Consequently, a Trust could choose either to reinvest part of the payout, or redeem a portion of the units.
the units, depending on its cash requirements. Thus, under the contractual relationship with S,
the Trusts would have a right to the payout declared by S plus the right to redeem the units at
the value that S 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 S’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, S is neither a partner nor an agent of the Trusts, the Trusts would
never be liable for any cost, expense, or payment incurred by S or for which S is liable or
responsible relating to the endowment (or the underlying endowment assets), and S would
indemnify and hold the Trusts harmless from and against any liability arising out of any action or
inaction by S with respect to the endowment (or the underlying endowment assets).

The Trusts do not have a position of ownership in the underlying assets of S’s endowment.
Since the contractual relationship between the Trusts and S is not in the nature of a partnership
or agency, the income earned by the Trusts from the payout S 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. S’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 S 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. I.R.C. § 6110(k)(3) 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,

Theodore R. Lieber
Manager, Exempt Organizations
Technical Group 3
Enclosure
Notice 437