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

Plain-English summary

An educational charity planned to issue contractual units tied to the value and distributions of its endowment to charitable remainder trusts for which it served as trustee and remainder beneficiary. The IRS ruled that issuing the units, making or receiving payments, and holding or redeeming the units would not generate unrelated business taxable income for the charity. The ruling relied on the charity's representations that it would not charge trustee or investment-management fees for the trust arrangements, although third-party management expenses could be charged against the endowment's aggregate return. The IRS did not rule on tax consequences under any other Code provision.

Ruling snapshot

• Question: Would the proposed endowment unit contracts and related payments create unrelated business taxable income for the educational charity?
• Outcome: Approved, no unrelated business taxable income under the stated facts
• Key authorities: IRC §§ 501(c)(3), 511, 512, and 513; Treas. Reg. § 1.513-1; Rev. Rul. 69-528

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Number: 201408034
Release Date: 2/21/2014

Contact Person:

Date: November 25, 2013 Identification Number:

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 I.R.C. § 512(a)(1).

You are exempt under I.R.C. § 501(a) as an organization described in I.R.C. § 501(c)(3) and
have been classified as an educational organization under I.R.C. § 509(a)(1) and I.R.C.

§170(b)(1)(A)(ii).

You are the trustee of 145 Trusts and, as trustee, you are the legal owner of the Trusts’ assets.
You do not assess a trustee’s fee or any other fee for the administrative services you provide to
the Trusts. In addition, you have a sole charitable remainder interest in 140 of 145 of the
Trusts.

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.

Your 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.

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 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 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. You will not charge a fee for internal
management costs of the Trusts’ assets, although you may recover your actual costs of
management of the endowment as a charge against total return.

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 monthly. 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

I.R.C. § 511, in part, imposes a tax on the unrelated business taxable income of organizations
described in I.R.C. § 501(c)(3).

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).

I.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.

I.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.

I.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. § 1.513-1(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 I.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.

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 I.R.C. § 501(c)(3).
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 I.R.C. § 501(c)(3).

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. § 1.513-1(a).

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
monthly.

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 I.R.C.

§ 501(c)(3) 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 I.R.C.

§ 513(a). See Rev. Rul. 69-528, supra. Such an activity would constitute a “trade or business”
under I.R.C. § 513(c) and Treas. Reg. § 1.513-1(b) and would be “regularly carried on” under
I.R.C. § 512(a)(1) and Treas. Reg. § 1.513-1(c). 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 I.R.C. § 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 I.R.C. § 512(a)(1).

The fact that you will engage in the investment activity largely 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 assumption that you will not charge any fee for managing the
investment of the Trusts in your endowment, and that you will not assess a trustee’s fee with
respect to the administration of the Trusts. You may contract with third party management firms
that charge a fee and receive reimbursement of expenses for management services provided to
your endowment. These fees and expenses may be charged against the aggregate return of
the endowment and be reflected indirectly in the payout to the Trusts and others participating in
the endowment.

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,

Manager, Exempt Organizations
Technical Group 3

Enclosure
Notice 437

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