PLR 1338043: IRS permits a private foundation’s 35% holding limit after finding non-disqualified control

Plain-English summary

A private foundation asked whether non-disqualified persons effectively controlled a corporation in which the foundation and related persons held more than 20% but less than 35% of the voting stock. It also asked whether its permitted holdings could therefore use the 35% limit, reduced by the voting stock held by disqualified persons. The IRS ruled yes. The decision relied on an employee stock ownership plan holding a majority of the corporation’s voting stock, a committee with two non-disqualified members out of three, and a corporate board on which non-disqualified persons held two-thirds of the seats.

Ruling snapshot

• Question: Did non-disqualified persons effectively control the corporation, allowing the foundation’s permitted holdings to use the 35% limit under IRC § 4943(c)(2)(B)?
• Outcome: Approved. The IRS found effective control with non-disqualified persons and approved the requested 35% permitted-holdings calculation.
• Key authorities: IRC §§ 4943, 4946, 507; Treas. Reg. §§ 53.4943-3(b)(3), 53.4946-1(h).

Full text (IRS public release)

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

TAX EXEMPT AND .
GOVERNMENT ENTITIES Date: June 25, 2013

DIVISION
Contact Person:

Number: 201338043
Release Date: 9/20/2013 Identification Number:

Contact Number:

FAX Number:

UIL: 501.02-03
Employer Identification Number:

Legend

Son

Father
Corporation
ESOP

Dear

This is in response to your letter dated July 24, 2012, submitted by your authorized
representative, requesting rulings under I.R.C. § 4943.

Facts

You have been recognized as exempt from federal income taxation under § 501(c)(3) and
classified as a private foundation under § 509(a)(1). Your primary activity is making grants to
various health, human services, and education organizations that are also exempt from taxation
under § 501(c)(3). Your founder and major contributor is Father, who passed away in 2011.
Your board president and director is Son, Father’s son.

Father was also a founder of Corporation, a privately held corporation. Corporation has nine
directors. No familial or outside business relationships exist between any of these directors.

One of Corporation’s directors is Son. Two other directors of Corporation are also on your
board. In total, three of the nine members of Corporation’s board of directors are also on your
board.

At the time of Father’s death, all of the stock that he owned in Corporation was held in a
revocable trust. Following his passing, portions of the stock owned by Father were distributed
to you, to Son, and to a trust the beneficiaries of which are Son and his two children. You have
represented that the combined shares of stock in Corporation owned by you, Son, and the trust
add to just below 35 percent of the total corporate stock.

You represent that the remaining stock in Corporation is owned by non-disqualified persons as
defined in § 4946. All stock that has been issued by Corporation is voting, and over _ percent

of the total stock is owned by an employee stock ownership plan, ESOP, established by -
Corporation for the benefit of its employees. The other shares of stock are owned by individuals
with no connection to you.

ESOP, the majority shareholder in the Corporation, is set up such that its assets are owned by a
trust and it votes its shares of stock through a trustee. A committee, consisting of three
individuals, directs the trustee as to how to vote the interests of trust. The committee's
directives to the trustee are decided by a majority vote, of two of its three members. The three
members are appointed by Corporation’s board of directors. The committee’s present members
are Son and two individuals with no affiliation to you, or your disqualified persons. Each
committee member was duly appointed by Corporation’s board of directors.

Rulings Requested

You requested the following rulings:

1. That effective control of Corporation is in one or more persons who are not disqualified
   persons with respect to you within the meaning of § 4943(c)(2)(B).

2. That your permitted holdings in Corporation are 35 percent of the voting stock reduced by the
   percentage of the voting stock owned by your disqualified persons.

Law

I.R.C. § 507(d)(2) defines the term "substantial contributor" as any person who contributed an
aggregate amount of more than $5,000 to the foundation, if such amount is more than 2 percent
of the total contributions received by the foundation before the close of the taxable year in which
the contribution is received.

I.R.C. § 4943 imposes a tax on the, “on the excess business holdings of any private foundation
in a business enterprise.”

I.R.C. § 4943(c)(1) defines excess business holdings as, “the amount of stock or other interest
in the enterprise which the foundation would have to dispose of to a person other than a
disqualified person in order for the remaining holdings of the foundation in such enterprise to be
permitted holdings.”

I.R.C. § 4943(c)(2)(A) provides, in general, that the permitted holdings of any private foundation
in an incorporated business enterprise are -- (i) 20 percent of the voting stock, reduced by (ii)
the percentage of voting stock owned by all disqualified persons.

I.R.C. § 4943(c)(2)(B) provides, in general, that if (i) the private foundation and all disqualified
persons together do not own more than 35 percent of the voting stock of an incorporated
business enterprise, and (ii) it is established to the satisfaction of the Secretary that effective
control of the corporation is in one or more persons who are not disqualified persons with
respect to the foundation, then § 4943(c)(2)(A) shall be applied by substituting 35 percent for 20

percent.

I.R.C. § 4946(a)(1) provides, in part, that the term ‘disqualified person' means, with respect to a
private foundation, a person who is-

(A) a substantial contributor to the foundation,

(B) a foundation manager,

(C) an owner of more than 20 percent of —
(i) the total combined voting power of a corporation,
(ii) the profits interest of a partnership, or

(iii) the beneficial interest of a trust or unincorporated enterprise, which is a substantial
contributor to the foundation,

(D) a member of the family of any individual described in subparagraph (A), (B), or (C),

(E) a corporation of which persons described in subparagraph (A), (B), (C), or (D) own more
than 35 percent of the total combined voting power,

(F) a partnership in which persons described in subparagraph (A), (B), (C), or (D) own more
than 35 percent of the profits interest,

(G) a trust or estate in which persons described in subparagraph (A), (B), (C), or (D) hold more
than 35 percent of the beneficial interest, and

(H) only for purposes of § 4943, a private foundation —

(i) which is effectively controlled (directly or indirectly) by the same person or persons
who control the private foundation in question, or

(ii) substantially all of the contributions to which were made (directly or indirectly) by the
same person or persons described in subparagraph (A), (B), or (C), or members of their
families, who made (directly or indirectly) substantially all of the contributions to the
private foundation in question.

I.R.C. § 4946(b)(1) provides that the term “foundation manager” means, with respect to a private
foundation, an officer, director, or trustee of a foundation (or an individual having powers or
responsibilities similar to those of officers, directors, or trustees of the foundation).

I.R.C. § 4946(d) provides that for purposes of § 4946(a)(1), the family of any individual shall
include his spouse, ancestors, lineal descendants, and spouses of lineal descendants.

Treas. Reg. § 53.4943-3(b)(3)(i) provides that a private foundation’s permitted holdings in an
incorporated business enterprise may be raised to 35 percent from 20 percent if:

(A) The private foundation and all disqualified persons together do not hold, actually or
constructively, more than 35 percent of the voting stock in the business enterprise, and

(B) The foundation establishes to the satisfaction of the Commissioner that effective
control (as defined in paragraph (b)(3)(ii) of this section) of the business enterprise is in
one or more persons (other than the foundation itself) who are not disqualified persons.

Treas. Reg. § 53.4943-3(b)(3)(ii) defines the term "effective control" for purposes of § 4943 as
“the possession, directly or indirectly, of the power to direct or cause the direction of the
management and policies of a business enterprise, whether through the ownership of voting
stock, the use of voting trusts, or contractual arrangements, or otherwise.” It goes on to say, “It
is the reality of control which is decisive and not its form or the means by which it is exercisable.
Thus, where a minority interest held by individuals who are not disqualified persons has
historically elected the majority of a corporation's directors, effective control is in the hands of
those individuals.”

Treas. Reg. § 53.4946-1(h) defines member of the family for purposes of § 4946 to include a
spouse, ancestors, lineal descendants, spouses of his lineal descendants.

Rev. Rul. 81-111; 1981-1 C.B. 509 considered two situations where a private foundation and its
disqualified persons held a combined 35 percent of voting stock in a corporation. In the first
situation, the remaining 65 percent of the voting stock was held by a single individual. In the
second situation, the remaining 65 percent was held by multiple individuals, who had not
entered into any type of agreement concerning their voting rights. In the first situation, the
Agency found that effective control was not with disqualified persons. A single non-disqualified
person, by virtue of holding a majority of corporate stock, could elect the corporate board. In the
second situation, the Agency came to the opposite conclusion. It said that none of the non-
disqualified stockholders “alone ha[d] sufficient voting stock holdings in [the corporation] to
direct or cause the direction of [its] management and policies..., nor has one of these individuals
historically elected the majority of [the] board of directors.” It concluded that without any type of
voting agreement between the non-disqualified persons, they did not have effective control over
the corporation.

Analysis

As a private foundation, under § 4943 you are subject to an excise tax on your excess business
holdings. Under § 4943(c)(2)(A), your permitted holdings in Corporation are limited to 20
percent of the voting stock, less the percentage of voting stock owned by all disqualified
persons. Under § 4943(c)(2)(B) and § 53.4943-3(b)(3)(i), your permitted levels of voting stock
in Corporation may be raised to 35 percent, if you demonstrate that the private foundation and
all disqualified persons together do not hold, actually or constructively, more than 35 percent of
the voting stock in the business enterprise, and the foundation establishes that effective control
of the business enterprise is in one or more persons, other than the foundation itself, who are

not disqualified persons.

First, it is necessary to determine which parties involved with Corporation are disqualified
persons with respect to you. Under § 4946 (a)(1)(A) a disqualified person means, with respect
to a private foundation, a person who is a substantial contributor to the foundation, a foundation
manager, an owner of more than 20 percent of (i) the total combined voting power of a
corporation which is a substantial contributor to the foundation; a member of the family of any
individual described in above, a corporation in which persons described in above or own more
than 35 percent of the total combined voting power. Section 507(d)(2)(A) defines a substantial
contributor as any person who contributed or bequeathed an aggregated amount of more than
$5,000 to a private foundation, if such amount is more than two percent of the total contributions
and bequests received by the foundation before the close of the taxable year of the foundation
in which the contribution or bequest is received by the foundation from such person. Here, Son
and all other of your directors and officers are disqualified persons, as they are foundation
managers. Son’s two children, as the lineal descendants of an officer and director, are also
disqualified persons. See Treas. Reg. § 53.4946-1(h). Finally, the trust is a disqualified person
because Son and his children themselves are disqualified persons and hold more than 35
percent of the beneficial interest of the trust. See I.R.C. § 4946(a)(1)(G).

You own voting stock in Corporation. Disqualified persons with respect to you, Son and the
trust, also own voting stock in Corporation. You have represented that combined, these shares
add up to greater than 20 percent but less than 35 percent of the total stock in Corporation.
Thus, unless you meet the requirements set forth above for the 35 percent permitted holdings,
your ownership of stock in Corporation will subject you to tax for excess business holdings. To
determine if your permitted holdings of Corporation’s voting stock is 20 percent or 35 percent, it
is necessary to examine whether effective control of Corporation for purposes of § 4943 is with
non-disqualified persons. Effective control means the possession, directly or indirectly, of the
power to direct or cause the direction of the management and policies of a business enterprise,
whether through the ownership of voting stock, the use of voting trusts, or contractual
arrangements, or otherwise. It is the reality of control that is decisive and not its form or the
means by which it is exercisable. See Treas. Reg. § 53.4943-3(b)(3)(ii). You have represented
that the combined ownership of the voting stock of Corporation held by you and all related
disqualified persons pursuant to § 4946, either actually or constructively, is less then 35 percent.
Therefore, in order to use the 35 percent limitation you must establish that effective control of
business enterprise is in one or more persons, other than the foundation itself, who are not
disqualified persons.

Like the first situation in Rev. Rul. 81-111, there is a single majority shareholder of Corporation.
ESOP holds over 50 percent of Corporation’s total voting stock. Its one vote has a greater
impact on the management and policies of Corporation than those of you and your disqualified
persons combined. ESOP, with just its one vote, has the authority to affect the management
and policies of Corporation. It is able with its vote to elect and remove each and every member
of the board of directors with or without cause. The question remains whether ESOP is
controlled by your disqualified persons, such that they, through their authority over the majority
shareholder of Corporation, effectively control Corporation. The vote of ESOP is directed by the
vote of a committee. The vote of that committee is determined by the vote of two of its three

members. One member of the committee is a disqualified person; the two others members are
not. The arrangement of the committee is unlike the second situation in Rev. Rul. 81-111.
There, voting rights were spread out among multiple non-disqualified persons. Here only two
non-disqualified persons are involved. The vote of those two non-disqualified persons on the
committee would decide the vote of over 50 percent of the voting rights in Corporation and
ultimately direct its management and policies.

This committee that directs the vote of ESOP, the majority shareholder, is appointed by
Corporation's board of directors. None of the board members has familial or outside business
relationships with any other director. Non-disqualified persons represent two-thirds of the
board’s membership. Disqualified persons hold only a minority of seats and their votes alone
would not be adequate to appoint individuals to the committee that directs the vote of ESOP.

Overall, non-disqualified committee members have the authority to affect the vote of
Corporation’s majority shareholder. Non-disqualified board members have the authority to
decide the composition of this committee and affect general corporate management and policy.
Given the above facts, you have demonstrated that effective control of Corporation is with
individuals who are not disqualified persons. Accordingly, your permitted holdings in
Corporation are no more than 35 percent of its total stock, reduced by the percentage of stock
owned by your disqualified persons.

Rulings

1. Effective control of Corporation is in one or more persons who are not disqualified persons
   with respect to you within the meaning of § 4943(c)(2)(B).

2. Your permitted holdings in Corporation are 35 percent of its voting stock reduced by the
   percentage of the voting stock in Corporation owned by all disqualified persons as defined in §
   4946.

This ruling will be made available for public inspection under I.R.C. § 6110 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. I.R.C. § 6110(k)(3) 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 resolve questions concerning your federal income tax status,
this ruling should be kept in your permanent records.

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 representatives.

Sincerely,

Ronald J. Shoemaker
Manager, Exempt Organizations
Technical Group 2

Enclosure: Notice 437