PLR 1328035: IRS says an exempt organization’s S corporation ownership will not end its exemption

Plain-English summary

The IRS ruled that a tax-exempt supporting organization could own an interest in a for-profit S corporation through a wholly owned disregarded entity without losing its tax-exempt status. The S corporation items flowing through to the exempt organization would be treated as unrelated business taxable income under IRC § 512(e). The IRS concluded that the holding company and its subsidiaries had genuine business purposes, independent operations, and separate corporate identities, so their activities would not be attributed to the exempt organization. The ruling was based on the submitted facts and representations and did not address unrelated Code provisions.

Ruling snapshot

• Question: Would the organization’s ownership of a for-profit S corporation and the resulting flow-through tax items affect its exemption?
• Outcome: Approved, subject to the stated facts and representations.
• Key authorities: IRC §§ 501, 509, 511, 512, 1361, 1366; Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943); National Carbide Corp. v. Commissioner, 336 U.S. 422 (1949); National Investors Corp. v. Hoey, 144 F.2d 466 (2d Cir. 1944); Britt v. United States, 431 F.2d 227 (5th Cir. 1970); Krivo Industrial Supply Co. v. National Distillers and Chemical Corporation, 483 F.2d 1098 (5th Cir. 1973).

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Contact Person:

Number: 201328035
Release Date: 7/12/2013 identification Number:

Telephone Number:

Date: April 16, 2013
Employer Identification Number:

UIL: 501.03-00; 501.03-11; 512.00-00

Legend:

Center

Group
Network

Health

Dear

This is in reply to your letter of June 30, 2011, in which you request a ruling on the effect to your
tax-exempt status of your proposed ownership (through a wholly-owned disregarded entity) in a
for-profit Subchapter S corporation.

Facts

You are tax-exempt under I.R.C. §501(c)(3), and a §509(a) supporting organization of the
Center and its School of Medicine. The Center is part of a state-chartered university system.
You are a faculty group practice that assists the Center in carrying out its mission, particularly
as it relates to the Center's clinical practice function. You consist of the faculty of the clinical
departments of the Center. Through you, the Center’s faculty is able to enter into contractual
relationships with health plans, community providers, and businesses to provide health care
services and thereby operate a health care delivery system. The health care delivery system,
which you facilitate, promotes the charitable, educational, and research programs of the Center
by providing it with the clinical programs and patient populations with which to educate its
students and conduct research, while also providing healthcare services to the public regardless
of ability to pay.

You are the sole member of the Group, a wholly owned subsidiary that is treated as a
disregarded entity for federal tax purposes. The Group provides professional medical services
as a participating independent physician association (“IPA”) in the Network. The Network is
organized as a for-profit corporation, and serves as a third party administrator providing medical

necessity review organization services to its clients under state licenses. The Group owns

percent of the issued and outstanding common shares of the Network. The Network has
six additional IPA shareholders that are unrelated to the Group. The Network is currently a C
corporation for federal income tax purposes. These six additional IPA shareholders comprise
for-profit corporations and a partnership.

The Network has four wholly owned subsidiaries. Three of the subsidiaries are limited liability
companies that are disregarded as separate entities for federal income tax purposes. The
fourth subsidiary, Health, is a C corporation and insurance company for federal income tax
purposes. All four wholly owned subsidiaries are involved in healthcare or healthcare related
services.

In addition to being a participant IPA in, and shareholder of, the Network, the Group has an
exclusive management agreement with the Network under which the Network provides certain
administrative and contract services to the Group. These services include collecting revenue,
paying claims, contracting with healthcare providers, and performing other administrative
functions necessary to manage the Group. For its services, the Network collects % of all
collected revenues. At the year-end, the Network reconciles its actual management costs
incurred on behalf of the Group and remits any overpayments to the Group. The Group remits
to you the overpayments it receives from the Network.

Proposed Restructuring Transaction

In order to achieve an ownership structure that is eligible for S corporation status, the following
restructuring transaction is proposed:

• A new entity, the “Holding Company,” will be established, and will make an “S”
election as of the date of formation.

• The Group and the other shareholders of the Network will contribute their shares
of the Network to the capital of the Holding Company, thus making the Network a
wholly owned subsidiary of the Holding Company.

• The Holding Company will make a qualified subchapter “S” subsidiary (“QSSS")
election for the Network.

• The Network will distribute its membership interests in its three subsidiaries that
are disregarded entities for federal tax purposes to the Holding Company. The
Network will continue to own all of the issued and outstanding common shares of
Health.

Once the proposed transaction is completed, the Group will hold % of the Holding
Company. The remaining % will be owned by the 54 individuals that currently own the six
other shareholders of the Network. All of the entities involved in the proposed transaction will
continue to operate for the same business purposes as they did prior to the transaction.

The Holding Company will have a board of directors consisting of seven members. The Group
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will have the right to elect one board member and the other unrelated shareholders will elect the
remaining six board members. The Network will have a board of directors consisting of 14
members. The Group will have the right to elect two board members and the other unrelated
shareholders will elect the remaining 12 board members.

Health will have a board of directors consisting of six members. Three of the members will be
selected by the Network’s board of directors from among its members, and the other three
members will be selected from the Network's senior management team. The three subsidiaries
of the Holding Company that are disregarded entities for federal income tax purposes will be
managed by a non-shareholder manager selected by the Holding Company.

The Holding Company and its subsidiaries will each develop, maintain, and manage its own
financial systems independent of you and the Group. The Holding Company and its
subsidiaries will each be operated by a professional staff with expertise in the relevant business
areas, which are independent and unrelated to you. Neither you nor the Group will be involved
in the day-to-day management of the Holding Company or any of its subsidiaries.

Ruling requested

You have requested the following ruling:

Your ownership, through your wholly-owned disregarded entity, Group, ina for-profit
Subchapter “S” corporation, together with the flow-through allocation of “S” tax items
subject to the unrelated business income tax, has no effect on the your tax exempt
status.

Law

I.R.C. § 501(c)(3) provides for the exemption from federal income tax of organizations that are
organized and operated exclusively for religious, charitable, scientific, or educational purposes,
provided no part of the net earnings inure to the benefit of any private shareholder or individual.

Treas. Reg. § 1.501(c)(3)-1(a)(1) provides that, in order to qualify as an organization described
in § 501(c)(3), an organization must be both organized and operated exclusively for one or more
of the purposes specified in such section. If an organization fails to meet either the
organizational test or the operational test, it does not qualify for exemption.

Treas. Reg. § 1.501(c)(3)-1(c)(1) provides that an organization will be regarded as “operated
exclusively” for one or more exempt purposes only if it is engaged primarily in activities which
accomplish one or more of such exempt purposes specified in § 501(c)(3). An organization will
not be so regarded if more than an insubstantial part of its activities is not in furtherance of an
exempt purpose.

I.R.C. § 511(a) imposes a tax on the unrelated business taxable income of organizations
exempt from federal income tax under I.R.C. §501(c).

I.R.C. § 512(e) provides that if an organization described in § 1361(c)(6) holds stock in a S
corporation— (A) such interest shall be treated as an interest in an unrelated trade or business;
and, (B) notwithstanding any other provisions of this part— (i) all items of income, loss, or
deduction taken into account under §1366(a), and (ii) any gain or loss on the disposition of the
stock in the S corporation shall be taken into account in computing the unrelated business
taxable income of such organization.

I.R.C. § 1361(c)(6) provides that, for purposes of subsection (b)(1)(B) (which defines the term
“small business corporation”), an organization which is (A) described in § 401(a) or 501(c)(3),
and (B) exempt from taxation under § 501(a), may be a shareholder in an S corporation.

In Moline Properties, Inc. v. Comm’r, 319 U.S. 436, 438-39 (1943), the Supreme Court said that
“[T]he doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be
to gain an advantage under the law of the state of incorporation or to avoid or to comply with the
demands of creditors or to serve the creator's personal or undisclosed convenience, so long as
that purpose is the equivalent of business activity or is followed by the carrying on of business
by the corporation, the corporation remains a separate taxable entity.... In general, in matters
relating to the revenue, the corporate form maybe disregarded where it is a sham or unreal. In
such situations the form is a bald and mischievous fiction.” In response to the argument that a
corporation is a mere agent of its sole stockholder, the court said that “the mere fact of the
existence of a corporation with one or several stockholders, regardless of the corporation's
business activities, does not make the corporation the agent of its stockholders. /d. at 440.

In National Carbide Corp. v. Comm’r, 336 U.S. 422, 437 (1949), the Supreme Court said that a
finding of a “true agency” relationship turns on several factors. “Whether the corporation
operates in the name and for the account of the principal, binds the principal by its actions,
transmits money received to the principal, and whether receipt of income is attributable to the
services of employees of the principal and to assets belonging to the principal are some of the
relevant considerations in determining whether a true agency exists. If the corporation is a true
agent, its relations with the principal must not be dependent upon the fact that it is owned by the
principal, if such is the case. Its business purposes must be the carrying on of the normal duties
of an agent.”

In National Investors Corp. v. Hoey, 144 F.2d 466, 468 (2nd Cir. 1944), the court said that “to be
a separate jural person for purposes of taxation, a corporation must engage in some industrial,
commercial, or other activity besides avoiding taxation; in other words, that the term
‘corporation’ will be interpreted to mean a corporation which does some ‘business’ in the
ordinary meaning; and that escaping taxation is not ‘business’ in the ordinary meaning.”

In Britt v. U.S., 431 F.2d 227, 237 (5th Cir. 1970), the court said that “business activity is
required for recognition of the corporation as a separate taxable entity; the activity may be
minimal.”

In Krivo Indus. Supply Co. v. Nat’l Distillers & Chem. Corp., 483 F.2d 1098, 1106 (5th Cir.
1973), the Court said that “the control required for liability under the ‘instrumentality’ rule
amounts to total domination of the subservient corporation, to the extent that the subservient
corporation manifests no separate corporate interests of its own and functions solely to achieve

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the purposes of the dominant corporation.”

Analysis

For taxable years beginning before January 1, 1998, tax exempt organizations described in §
501(c)(3) could not be shareholders in an S corporation. In 1996, Congress enacted the Small
Business Job Protection Act, Pub. L. No. 104-188, 110 Stat. 1755, authorizing the ownership of
S corporation stock by tax-exempt organizations described in § 501(c)(3). The Joint Committee
on Taxation’s General Explanation of Tax Legislation Enacted in the 104th Congress (JCS-12-
96), December 18, 1996, Sec. 1316, p. 130, describes the reason for the change in law as
follows—

The Congress believed that the present-law prohibition of certain tax-exempt
organizations being S corporation shareholders may have inhibited employee ownership
of closely-held businesses, frustrated estate planning, discouraged charitable giving, and
restricted sources of capital for closely-held businesses. The Congress sought to lift
these barriers by allowing certain tax-exempt organizations to be shareholders in S
corporations. However, the provisions of subchapter S were enacted in 1958 and
substantially modified in 1982 on the premise that all income of the S corporation
(including all gains on the sale of the stock) would be subject to a shareholder-level
income tax. This underlying premise allows the rules governing S corporations to be
relatively simple ... because of the lack of concern about “transferring” income to non-
taxpaying persons. Consistent with this underlying premise of subchapter S, the
provision treats all the income flowing through to a tax-exempt shareholder, and gains
and losses from the disposition of the stock, as unrelated business taxable income.

As a result of the legislation, tax-exempt organizations described in § 501(c)(3) are allowed to
be shareholders in an S corporation under § 1361(c)(6). Furthermore, under § 512(e), items of
income or loss of an S corporation will flow through to tax-exempt shareholders as unrelated
business taxable income regardless of the source or nature of such income. In addition, gain or
loss on the sale or other disposition of stock of an S corporation will be treated as unrelated
business taxable income. These provisions, however, do not cause the for-profit activities of the
S corporation to be attributed to the tax-exempt shareholder. See Moline Properties, Inc., 319
U.S. at 440. In determining whether the activities of a for-profit S corporation subsidiary is
attributable to its tax-exempt parent, the separate identity principles annunciated in Moline
Properties, Inc. v. Comm’r should apply lest the intent of Congress to remove barriers for
investment in S corporations by tax-exempt entities be frustrated.

For federal income tax purposes, a parent corporation and its subsidiaries are treated as
separate and distinct taxable corporate entities as long as each entity has a valid business
purpose and engages in at least a minimal amount of business activity. See Moline Properties,
Inc., 319 U.S. at 438; National Investors Corp., 144 F.2d at 468; Britt, 431 F.2d at 234.
However, where the parent corporation so controls the affairs of the subsidiary that it is merely
an instrumentality of the parent, the corporate identity of the subsidiary may be disregarded.
See, Krivo, 483 F.2d at 1106.

Hence, the activities of a for-profit subsidiary will not be attributed to its tax-exempt parent
unless (1) the subsidiary lacks a business purpose, or (2) the subsidiary is an arm or agent of
the parent.

In your case, your relationship with the Holding Company does not fail the first prong, i.e., that
the subsidiary have a business purpose and conduct some amount of business activity. The
Holding Company and its four subsidiaries have been, or will be, organized to perform bona fide
and substantial business functions. The Holding Company and all of its subsidiaries maintain
activities that are separate, distinct, and independent from you. Therefore, their existence may
not be disregarded for tax purposes.

Additionally, your relationship with the Holding Company does not fail the second prong, i.e.,
that the parent not control the day-to-day operations of the subsidiary. The Holding Company
has its own corporate identity and interests, and its own independent board of seven directors,
only one of which is chosen by you. The other six directors are chosen by unrelated
shareholders. Furthermore, each of the Holding Company's subsidiaries has its own
management and employees independent of you. Furthermore, neither your investment in the
Holding Company nor your management agreement with the Network exhibits any of the
attributes of a “true agency’ relationship identified in National Carbide Corp., 336 U.S. at 437.
Therefore, neither the Holding Company nor its subsidiaries can be considered a sham or under
your “total domination.” Consequently, the activities of the Holding Company and its
subsidiaries would not be attributable to you.

Conclusion
In light of the foregoing, we rule as follows:

Your ownership interest in the Holding Company, a for-profit subchapter S corporation,
through Group, together with the flow-through allocation of the Holding Company's “S”
tax items subject to the unrelated business income tax, would have no effect on your
tax-exempt status as an organization described in § 501(c)(3).

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 facts as they were presented and on the understanding that there will
be no material changes in these facts. 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 it could help resolved questions concerning your federal income tax status,
this ruling should be kept in your permanent records.

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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 currently on file with the Internal Revenue Service, we
are sending a copy of this letter to your authorized representative.

Sincerely,

Peter A. Holiat
Acting Manager, Exempt Organizations

Technical Group 1

Enclosure
Notice 437