Private foundation gets S corporation stock and ESOP rulings

Plain-English summary

A private foundation expected to receive more than two percent of an S corporation's stock as a gift when a related revocable trust terminated. The IRS ruled that the foundation would have five years to reduce its holdings to the permitted level and could request, but was not assured of, an additional five-year disposition period if it later met the statutory requirements. The S corporation's business activities would not be attributed to the foundation, so the ownership and resulting unrelated business taxable income would not end its § 501(c)(3) exemption. Schedule K-1 income taxed as unrelated business income would not also enter the foundation's net investment income under § 4940. A proposed sale of shares to an employee stock ownership plan would not be self-dealing because the participants, treated as the stock owners, were represented not to be disqualified persons.

Ruling snapshot

• Question: What are the excess-holdings, exemption, investment-income, and self-dealing consequences of receiving and selling the S corporation stock?
• Outcome: Approved on all four requested rulings
• Key authorities: IRC §§ 501(c)(3), 512(e), 4940, 4941, and 4943; Rev. Rul. 81-76

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Release Number: 201441018 Contact Person:
Release Date: 10/10/2014
Date: July 15, 2014 Identification Number:
UIL Code: 501.03-00
507.04-00 Telephone Number:
512.10-00 .
4940.02-01 Employer Identification Number:
4941.00-00
4943.03-04
Legend:
Company =
Trust =
Dear

This is in response to your letter dated March 28, 2014 in which you requested certain rulings with
respect to I.R.C. §§ 501(c)(3), 512(b), 507(b)(1)(B), 4940, 4941, and 4943.

Background:

You are a trust that has been recognized as exempt as being described in § 501(c)(3) and as a
non-operating private foundation under § 509. Your purposes are to make grants to established
public charities within the meaning of §§ 501(c)(3) and 509(a). Your founder and sole trustee is
also the founder and CEO of Company. Company is an S corporation, nearly ninety percent of
which is owned by Trust. Trust is a revocable trust that is currently administering the estate of your
trustee’s late wife. Your founder and trustee is the sole beneficiary of Trust during his lifetime.
Prior to the proposed transaction your funds have primarily been cash contributions from your
founder.

Your trustee plans to terminate Trust, distributing the shares of Company to you, your founder, and
other trusts, the beneficiaries of which include your founder and his family members. The shares
that will be distributed to you will be considered a gift and no consideration will be given by you for
such shares. After the distribution you will own over two percent of the stocks in Company.
Additionally, you have stated that over thirty-five percent of the stocks in Company will be held by
persons who are disqualified persons as to you, including your founder and trustee. As a
shareholder in Company you will receive a Schedule K-1 passing income directly through the S
corporation to you. That income will likely exceed fifty percent of your overall income.
Furthermore, Company proposes to create an Employee Stock Ownership Plan (ESOP) that will
purchase shares from you. Company has six hundred employees that are eligible to participate in
the ESOP. The employees participating in the ESOP will be able to direct the vote of their shares
of Company through the trustee of the ESOP. Additionally, you have stated that no individual that
is a disqualified person as to you will participate in the ESOP.

by Company. Company exists as a separate entity for the valid business purpose of conducting
activities as a broker-dealer and registered investment advisor. Company’s activities are separate,
distinct, and independent from yours. You will not participate in the day-to-day operations of
Company. Furthermore, you will never own more than twenty percent of the stock of Company.

Following the termination of Trust you have stated that you may seek to terminate your private
foundation status and seek to be a supporting organization. You have not yet named an
organization that you would support.

Rulings Requested:

1. You will have five years from the date your holdings in Company exceed two percent to
   reduce your entire holdings in Company to two percent or less to avoid the tax on excess
   business holdings under § 4943. Furthermore, if circumstances arise in which you are
   unable to reduce your holdings in Company to two percent or less during the initial five
   year period, you are eligible to request an additional five year disposition period to avoid
   the tax on excess business holdings via written request to the Secretary pursuant to §
   4943(c)(7).

2. You were organized and operated exclusively for exempt purposes pursuant to § 501 (c)(3)
   and continue to qualify for exemption under § 501(c)(3) because the for-profit unrelated
   business operations of Company, regardless of the amount of unrelated business taxable
   income generated therefrom, will not be attributed to you.

3. Your income from Company’s S corporation Schedule K-1 will not be taxed as net
   investment income under § 4940(c)(2), since it is treated as unrelated trade or business
   taxable income.

4. The proposed purchase of your shares in Company by Company’s ESOP will not be an
   act of self-dealing under § 4941.

Law:

I.R.C. § 501(c)(3) provides that organizations may be exempted from tax if they are organized and
operated exclusively for religious, charitable, scientific, testing for public safety, literary, or
educational purposes and “no part of the net earnings of which inures to the benefit of any private
shareholder or individual.”

I.R.C. § 512(e) provides that if an organization described in §§ 1361(c)(2)(A)(vi) or 1361(c)(6) holds
stock in an S corporation such interest shall be treated as an interest in an unrelated trade or
business, and notwithstanding any other provision of this part all items of income, loss, or
deduction taken into account under § 1366(a), and 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. § 4940(a) imposes a tax on each private foundation which is exempt from taxation under §
501(a) for the taxable year, with respect to the carrying on of its activities, a tax equal to 2 percent
of the net investment income of such foundation for the taxable year.

I.R.C. § 4940(c)(1) defines net investment income as the amount by which (A) the sum of the gross

investment income and the capital gain net income exceeds (B) the deductions allowed by
paragraph (3).

I.R.C. § 4940(c)(2) defines gross investment income as the gross amount of income from interest,
dividends, rents, payments with respect to securities loans (as defined in § 512(a) (5)), and
royalties, but not including any such income to the extent included in computing the tax imposed by
§ 511.

I.R.C. § 4941 imposes a tax on each act of self-dealing between a disqualified person and a
private foundation.

I.R.C. § 4941(d)(1) defines self-dealing as the furnishing of goods, services, or facilities between a
disqualified person and a private foundation as well as the payment of compensation by a private
foundation to a disqualified person.

I.R.C. § 4943(a) imposes a tax on the excess business holdings of any private foundation in a
business enterprise during any taxable year which ends during the taxable period a tax equal to 10
percent of the value of such holdings.

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) defines permitted holdings as 20 percent of the voting stock, reduced by the
percentage of the voting stock owned by all disqualified persons. In any case in which all
disqualified persons together do not own more than 20 percent of the voting stock of an
incorporated business enterprise, nonvoting stock held by the private foundation shall also be
treated as permitted holdings.

I.R.C. § 4943(c)(2)(C) provides that a private foundation shall not be treated as having excess
business holdings in any corporation in which it (together with all other private foundations which
are described in § 4946(a)(1)(H)) owns not more than 2 percent of the voting stock and not more
than 2 percent in value of all outstanding shares of all classes of stock.

I.R.C. § 4943(c)(6) provides that if there is a change in the holdings in a business enterprise (other
than by purchase by the private foundation or by a disqualified person) which causes the private
foundation to have excess business holdings in such enterprise, the interest of the foundation in
such enterprise (immediately after such change) shall (while held by the foundation) be treated as
held by a disqualified person (rather than by the foundation) during the 5-year period beginning on
the date of such change in holdings.

I.R.C. § 4943(c)(7) provides that the Secretary may extend for an additional 5-year period the

period under paragraph (6) for disposing of excess business holdings in the case of an unusually

large gift or bequest of diverse business holdings or holdings with complex corporate structures if--
(A) the foundation establishes that--

(i) diligent efforts to dispose of such holdings have been made within the initial 5-
year period, and

(ii) disposition within the initial 5-year period has not been possible (except at a price
substantially below fair market value) by reason of such size and complexity or
diversity of such holdings,

(B) before the close of the initial 5-year period--

(i) the private foundation submits to the Secretary a plan for disposing of all of the
excess business holdings involved in the extension, and

(ii) the private foundation submits the plan described in clause (i) to the Attorney
General (or other appropriate State official) having administrative or supervisory
authority or responsibility with respect to the foundation's disposition of the excess
business holdings involved and submits to the Secretary any response received by
the private foundation from the Attorney General (or other appropriate State official)
to such plan during such 5-year period, and

(C) the Secretary determines that such plan can reasonably be expected to be carried out
before the close of the extension period.

I.R.C. § 4946(a)(1) provides that a “disqualified person,” with respect to a private foundation,
includes a substantial contributor, as defined under section 507(d)(2); a foundation director,
trustee, or officer; a corporation owned more than thirty-five percent by any of the previous
persons; and any spouse, ancestor, child, grandchild, great grandchild, and any spouse of a child,
grandchild, or great grandchild of that contributor, director, or officer.

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

Treas. Reg. § 1.513-1(b) defines trade or business for purposes of § 513 as having the same
meaning it has in § 162, and generally includes any activity carried on for the production of income
from the sale of goods or performance of services. Activities of producing or distributing goods or
performing services from which a particular amount of gross income is derived do not lose identity
as trade or business merely because they are carried on within a larger aggregate of similar
activities or within a larger complex of other endeavors which may, or may not, be related to the
exempt purposes of the organization.

Rev. Rul. 81-76, 1981-1 C.B. 516, holds that when an employee stock ownership trust holds 30
percent of the stock in a corporation on behalf of the corporation's participating employees, who
direct the manner in which the trust votes the shares, the trust will not be considered a disqualified
person with respect to a private foundation merely because the corporation is a substantial
contributor to the foundation.

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. Id. at 440.

Analysis:

RULING 1: You will have five years from the date your holdings in Company exceed two percent
to reduce your entire holdings in Company to two percent or less to avoid the tax on excess
business holdings under § 4943. Furthermore, if circumstances arise in which you are unable to
reduce your holdings in Company to two percent or less during the initial five year period, you are
eligible to request an additional five year disposition period to avoid the tax on excess business
holdings via written request to the Secretary pursuant to § 4943(c)(7).

The termination of Trust will result in the contribution to you of greater than two percent of the
shares of Company. Section 4943 imposes an excise tax on private foundations that hold greater
than a de minimus amount of shares in a business enterprise where its holdings, combined with
the holdings of disqualified persons as to that private foundation, exceed twenty percent. You
have stated that Company is a business enterprise and that disqualified persons as to you will hold
greater than thirty-five percent of the shares of Company. Section 4943(c)(6) provides a five year
grace period for private foundations to reduce their holdings of shares exceeding the permitted
holdings if those shares are contributed to the private foundation. Here, the shares in Company
will not be purchased by you, but will be contributed by Trust to you as a gift. Since these shares
are gifted to you, you will have five years where you will be able to reduce your holdings in
Company over that time. Should you fail to reduce your holdings in that time, at least to an amount
permitted under § 4943(c)(2)(C), then you can request an additional five years to dispose of your
holdings provided you meet the requirements under § 4943(c)(7).

Under § 4943(c)(7), the Service may extend the initial five-year period for disposing of excess
business holdings for an additional five years if a foundation establishes that: (i) it made diligent
efforts to dispose of such holdings during the initial five-year period, and disposition within the
initial five-year period has not been possible (except at a price substantially below fair market
value) by reason of such size and complexity or diversity of holdings, (ii) before the close of the
initial five-year period it submits to the Service and Attorney General (or other appropriate State
official) having administrative or supervisory authority or responsibility with respect to the
foundation's disposition of the excess business holdings involved a plan for disposing of all of the
excess business holdings involved during the extension, and (iii) the Service determines that such
plan can reasonably be expected to be carried out before the close of the extension period. We
are making no representations as to whether you will qualify for such extension at this time.

RULING 2: You were organized and operated exclusively for exempt purposes pursuant to §
501(c)(3) and continue to qualify for exemption under § 501(c)(3) because the for-profit unrelated
business operations of Company, regardless of the amount of unrelated business taxable income
generated therefrom, will not be attributed to you.

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. It is not the case here that
the corporate structure of Company is a sham allowing the activities of Company to be attributed to
you. Since the activities of Company cannot be attributed to you and the holding of shares of an S
corporation, though resulting in unrelated business taxable income, does not constitute the
performance of an unrelated trade or business, you are still described in § 501(c)(3).

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.

Your relationship with Company does not fail the first prong., i.e. that the subsidiary have a
business purpose and conduct some amount of business activity. Company has a valid business
purpose as a broker-dealer and a registered investment advisor. Company has approximately 600
employees performing these tasks and does not use your resources to further its operations.

Your relationship with Company does not fail the second prong, i.e., that the parent not control the
day-to-day operations of the subsidiary. Company maintains activities that are separate, distinct
and independent from you. Company has its own corporate identity and interest, and its own
independent board of directors, and has its own management and employees independent of you.
At no point in time is it represented by Company that it represents you. Furthermore, you will not
own more than ten to twenty percent of Company at any one time, thus you will never control
Company or its Board. The activities of Company are not attributable to you.

RULING 3: Your income from Company’s S corporation Schedule K-1 will not be taxed as net
investment income under § 4940(c)(2), since it is treated as unrelated trade or business taxable
income.

Section 4940 imposes a tax on each private foundation equal to two percent of the net investment
income of such foundation for the taxable year. Section 4940(c)(1) ) defines net investment
income as the amount by which (A) the sum of the gross investment income and the capital gain
net income exceeds (B) the deductions allowed. Finally, § 4940(c)(2) defines gross investment
income as the gross amount of income from interest, dividends, rents, payments with respect to
securities loans (as defined in § 512(a)(5)), and royalties, but not including any such income to the
extent included in computing the tax imposed by § 511. For purposes of the tax imposed under §
4940 your income from your shares in Company, to the extent it is included in § 512(e), will not be
a part of your gross investment income under § 4940(c)(2). Therefore, it will not increase your net
investment income in calculating your two percent tax under § 4940.

RULING 4: The proposed purchase of your shares in Company by Company's ESOP will not be an
act of self-dealing under § 4941.

In Rev. Rul. 81-76, supra, an ESOP owned thirty percent of the stock of a company that was a
substantial contributor to the private foundation in that ruling. Section 4946(a)(1)(C) provides that
an owner of more than twenty percent of the total combined voting power of a corporation or the
profit interests of a partnership that is a substantial contributor is a disqualified person. In Rev.

Rul. 81-76 the ESOP, if it were considered the owner of all of its stock would have been a
disqualified person as to the private foundation. The ruling determined, however, that the ESOP
was not a disqualified person because the stocks were considered to be owned by the employee
participants in the plan rather than by the ESOP, therefore the ESOP did not own more than twenty
percent of the company.

Given that here the employees are able to vote their shares of Company through the trustee of the
ESOP, Rev. Rul. 81-76, supra, supports the conclusion that your ESOP is not a disqualified person
as to you because it only holds Company stock in its capacity as trustee, and the real owners of
the stock are the ESOP’s participants. ESOP participants may be disqualified persons and any
amount attributable to such disqualified persons would constitute a sale to a disqualified person.
You have stated that no ESOP participants will be disqualified persons as that term is defined in §
4946, as to you. Therefore, your proposed sale of Company stock to the ESOP will not be an act
of self-dealing within the meaning of § 4941.

Rulings:

1. You will have five years from the date your holdings in Company exceed two percent to
   reduce your entire holdings in Company to two percent or less to avoid the tax on excess
   business holdings under § 4943. Furthermore, if circumstances arise in which you are
   unable to reduce your holdings in Company to two percent or less during the initial five
   year period, you are eligible to request an additional five year disposition period to avoid
   the tax on excess business holdings via written request to the Secretary pursuant to §
   4943(c)(7).

2. You were organized and operated exclusively for exempt purposes pursuant to § 501(c)(3)
   and continue to qualify for exemption under § 501(c)(3) because your ownership interest in
   Company, a for-profit subchapter S corporation, together with the flow through allocation of
   the 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).

3. Your income from Company’s S corporation Schedule K-1 will not be taxed as net
   investment income under § 4940(c)(2), since it is treated as unrelated trade or business
   taxable income.

4. The proposed purchase of your shares in Company by Company's ESOP will not be an
   act of self-dealing under § 4941.

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.
Specifically, this ruling does not reach any conclusion as to the qualifying distribution status of your
proposed transfer under § 4942(g)(3). 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 representative.

Sincerely,

Mike Seto
Manager, Exempt Organizations
Technical

Enclosure
Notice 437