Foundation's feeder-fund investment avoids private-foundation excise taxes

Plain-English summary

A private foundation awaiting reinstatement proposed investing all of its donated assets in a foreign feeder corporation that invested through a partnership in diversified fixed securities. One founder and related family members held small interests in the corporation and partnership, and the founder held a 30 percent interest in the investment manager. The IRS ruled that the entities were not disqualified persons because the relevant ownership interests stayed below the statutory thresholds, so the investment and related co-investment would not be self-dealing. It also ruled that the corporation was not a business enterprise for the excess-business-holdings rules because at least 95 percent of its income came from passive sources. Finally, the investment was not jeopardizing because the trustees had exercised ordinary business care and prudence, assuming the foundation regained recognition under IRC § 501(c)(3).

Ruling snapshot

• Question: Would the proposed feeder-fund investment cause self-dealing, excess business holdings, or a jeopardizing investment?
• Outcome: Approved on all four requested rulings, assuming reinstatement of exemption
• Key authorities: IRC §§ 4941, 4943, 4944, and 4946; Treas. Reg. §§ 53.4941(d)-1, 53.4941(d)-2, and 53.4944-1

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Release Number: 201447043 Contact Person:
Release Date: 11/21/2014
Date: August 27, 2014 Identification Number:

UIL Number: 4941.04-00
4943.03-00 Telephone Number:

4944.05-00
Employer Identification Number:

Legend:
Date1 =
Date2 =
Date3 =
Spouse1 =
Spouse2 =
Corporation =
Partnership =
Territory =
LLC =
$X1 =
$X2 =
$X3 =
Z percent =

Dear :

We have considered your ruling request dated January 9, 2014, submitted by your authorized
representative, requesting rulings under I.R.C. §§ 4941, 4943 and 4944.

Facts

You are an organization formed on Date1. On Date2, you received recognition of exemption
under § 501(c)(3) and private foundation status under § 509(a). On Date3, your exempt status
was automatically revoked for failure to file Form 990-PF for three consecutive years. You
have applied for reinstatement of your exempt status, and your application is currently pending.
Your purposes are exclusively charitable, scientific, educational and religious. For purposes of
this ruling we are assuming that your exemption will be reinstated.

Your sole funders are Spouse1 and Spouse2, a married couple (collectively “Funders”).
Funders also serve as your trustees. Once you receive reinstatement of your exempt status,
Funders will donate $X1 to you. This sum will be the entirety of your assets. You will use this
sum to invest $X1 in Corporation. Corporation is a company incorporated under the laws of
Territory and treated as a corporation for U.S. tax purposes. Corporation is a “feeder fund,”

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meaning that multiple investors invest in it with the intent that their money will be invested
further. Corporation has represented to you that 95 percent of its income is from interest,
dividends, or gains or losses from the sale, exchange, or other disposition of property.
Corporation has only voting, participating shares of stock, called Class Y shares. You will buy
Class Y shares of stock. Corporation invests nearly all of its assets in Partnership, a company
incorporated under the laws of Territory and treated as a partnership for U.S. tax purposes.
Partnership holds broadly diversified holdings in fixed securities.

Corporation has net assets of $X2, and Partnership has net assets of $X3. Your proposed
investment of the sum of $X1 in Corporation and Partnership amounts to less than Z percent of
the net assets of both Corporation and Partnership.

Corporation employs the investment management services of LLC. Customarily, LLC receives
a fee from Corporation for its provision of investment management services. Usually, LLC
receives 1 percent of the value of the Class Y shares in Corporation and 20 percent of the
annual increase in value of the Class Y shares. However, LLC will waive this fee with respect to
your investment in Corporation. Thus, Corporation will not pay LLC for LLC’s investment
management services of your investment.

Spouse1 has ownership interests in Corporation, Partnership, and LLC. An individual
retirement account owned by her owns .05 percent of the profit interests, through Class Y
shares, in Corporation. Further, an individual retirement account owned by her father owns .1
percent of the profit interests in Corporation. Also, Spouse1 owns 2.7 percent of the profit
interests in Partnership. Further, Spouse1, her father, and her descendants hold beneficial
interests in trusts that indirectly invest in Partnership. These trusts hold less than 1 percent of
the profit interests of Partnership.

Finally, Spouse1 owns, through her holdings in other entities, 30 percent of the profit interests in
LLC. First LLC’s managing member is a partnership. The general partner of that partnership is
a corporation. Spouse1 owns 50 percent of the voting stock in that corporation. Second, she
has ownership interests in two other entities that are members of LLC.

Rulings Requested

1) That your acquisitions of Class Y shares in Corporation will not constitute direct or
indirect acts of self-dealing within the meaning of § 4941.

2) That direct or indirect co-investment in Corporation by you will not constitute direct or
indirect acts of self-dealing within the meaning of § 4941.

3) That your interest in Corporation will not constitute an interest in a business
enterprise and therefore will not be “excess business holdings,” all within the meaning of
§ 4943.

4) That our acquisition of Class Y shares in Corporation will not jeopardize the carrying
out of any of your exempt purposes within the meaning of § 4944.

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Law

I.R.C. § 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 2 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.

I.R.C. § 512(b)(1) provides that there shall be excluded all dividends, interest, payments with
respect to securities loans (as defined in subsection (a)(5)), amounts received or accrued as
consideration for entering into agreements to make loans, and annuities, and all deductions
directly connected with such income.

I.R.C. § 512(b)(5) excludes in general all gains or losses from the sale, exchange, or other
disposition of property.

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

I.R.C. § 4941(d)(1) defines self-dealing to include the furnishing of goods, services, or facilities
between a disqualified person and a private foundation, the payment of compensation by a
private foundation to a disqualified person, or use of the private foundation's assets, by or for
the benefit of a disqualified person.

I.R.C. § 4943(a) imposes a ten percent excise tax 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) defines "permitted holdings" as twenty percent of the voting stock of any
corporation reduced by the percentage of stock owned by all disqualified persons and states
that if 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)(B) provides that the permitted holdings are 35 percent if one or more third
persons who are not disqualified persons have effective control of the corporation.

I.R.C. § 4943(d)(3) stipulates that "business enterprise" does not include a trade or business
where at least ninety-five percent of the gross income is derived from passive sources. For
purposes of this section, passive income includes income from the sources described in §§
512(b)(1), (2), (3), and (5).

I.R.C. § 4944(a)(1) imposes a tax on any amount invested by a private foundation in a manner

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that jeopardizes the carrying out of any of the foundation's exempt purposes.

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.

I.R.C. § 4946(d) defines family member to include a person’s spouse, ancestors, children,
grandchildren, great grandchildren, and the spouses of children, grandchildren, and great
grandchildren.

Treas. Reg. § 53.4941(d)-1(b)(5) provides in part that an organization is controlled by a private
foundation if the foundation or one or more of its foundation managers (acting only in such
capacity) may, only by aggregating their votes or positions of authority, require the organization
to engage in a transaction which if engaged in with the private foundation would constitute self-
dealing.

Treas. Reg. § 53.4941(d)-2(d)(3) provides that the furnishing of goods, services, or facilities by
a disqualified person to a private foundation shall not be an act of self-dealing if they are
furnished without charge.

Treas. Reg. § 53.4944-1(a)(2)(i) provides in part an investment shall be considered to
jeopardize the carrying out of the exempt purposes of a private foundation if it is determined that
the foundation managers, in making such investment, have failed to exercise ordinary business
care and prudence, under the facts and circumstances prevailing at the time of making the
investment, in providing for the long- and short-term financial needs of the foundation to carry
out its exempt purposes. In the exercise of the requisite standard of care and prudence the
foundation managers may take into account the expected return (including both income and
appreciation of capital), the risks of rising and falling price levels, and the need for diversification
within the investment portfolio (for example, with respect to type of security, type of industry,
maturity of company, degree of risk and potential for return). The determination whether the
investment of a particular amount jeopardizes the carrying out of the exempt purposes of a
foundation shall be made on an investment by investment basis, in each case taking into
account the foundation's portfolio as a whole. No category of investments shall be treated as a
per se violation of § 4944.

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Analysis

Ruling 1: That your initial acquisition of Class Y shares in Corporation will not constitute direct or
indirect acts of self-dealing within the meaning of § 4941.

Under § 4941(d)(1), self-dealing is defined as the furnishing of goods, services, or facilities
between a disqualified person and a private foundation, the payment of compensation by a
private foundation to a disqualified person, or use of the private foundation’s assets, by or for
the benefit of a disqualified person. Your acquisitions of Class Y shares in Corporation will not
be acts of self-dealing

Spouse1 and Spouse2 are disqualified persons with respect to you. They donated to you an
amount of more than $5,000 that represented more than 2 percent of your total contributions
during a recent fiscal year. Thus, under § 507(d)(2)(A), they are substantial contributors, and
under § 4946(a)(1)(A) they are disqualified persons. Under, § 4946(f), Spouse1’s father and her
descendants are disqualified persons as well. Finally, under § 4946(a)(1)(G), trusts benefiting
these individuals are disqualified persons.

Corporation is not a disqualified person with respect to you. Under § 4946(a)(1)(E), a
corporation in which substantial contributors hold 35 of the voting power is a disqualified person.
You represented that Spouse1 owns only .05 percent of profit interests through her indirect
ownership of Class Y shares of voting stock. Further, you represented that Spouse1’s father
has indirect ownership in Corporation amounting .1 percent of the profit interests. You also
represent that Corporation issues only voting shares of stock, called Class Y shares, meaning
that that a stockholder’s profit interests is equal his or her voting rights. Since Spouse1’s and
her father’s combined ownership of voting rights in Corporation is under 35 percent, Corporation
is not a disqualified person.

Further, we find that Corporation is not controlled by you under the definition in Treas. Reg. §
53.4941(d)-1(b)(5). You do not have adequate votes or positions of authority with respect to
Corporation to cause Corporation to engage in a transaction that, if you undertook, would be an
act of self-dealing. Further, LLC’s relationship with Corporation does not render Corporation as
under LLC’s or Spouse1’s control. LLC’s relationship with Corporation is contractual, involving
fee for services, and not a delegation of authority.

Also, Partnership and LLC are not disqualified persons with respect to you. Under §
4946(a)(1)(F), a partnership in which substantial contributors hold 35 of the profits interest is a
disqualified person. You represented that Spouse1 owns 2.7 percent of the profits interest in
Partnership. You further represented that Spouse1’s father and descendants have ownership
interests amounting to under 1 percent of the profit interests in Partnership. Since Spouse1’s,
Spouse1’s father’s, and Spouse1’s descendants’ ownership of the profits interest in Partnership
combined is under 35 percent, Partnership is not a disqualified person. Further, you represented
that Spouse1 owns 30 percent of the profits interest in LLC. Since Spouse1’s ownership of the
profits interest in LLC is under 35 percent, LLC is not a disqualified person.

You are proposing to buy shares of stock in Corporation. In doing so, you will engage in

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financial transactions with Corporation. Since Corporation is not a disqualified person, these
transactions are not acts of self-dealing.

Also, Corporation will invest in Partnership. This investment amounts to an indirect financial
transaction between you and Partnership. Since Partnership is not a disqualified person, this
transaction is not an act of indirect self-dealing.

Corporation will pay LLC for its investment management services. Since LLC is not a
disqualified person, this transaction is not an act of self-dealing. Further, since LLC intends to
waive any fees with respect to your investments, under § 53.4941(d)-2(d)(3), your proposed
transaction is not self-dealing.

Your proposal to buy shares of Class Y stock in Corporation does not involve your transacting
business with any disqualified person. Accordingly, these actions will not be self-dealing.

Ruling 2: That direct or indirect co-investment in Corporation by you will not constitute direct or
indirect acts of self-dealing within the meaning of § 4941.

Under § 4941(d)(1) self-dealing is the furnishing of goods, services, or facilities between a
disqualified person and a private foundation, the payment of compensation by a private
foundation to a disqualified person, or use of the private foundation’s assets, by or for the
benefit of a disqualified person. As stated above, Spouse1 and Spouse2 are disqualified
persons. Financial transactions between and either of them and you would be self-dealing.
However, your plan does not include transactions between yourself and Spouse1 or Spouse2.
Rather, you will invest directly and indirectly in entities, in which Spouse1 holds interests.
These investments by you as outlined above will not be self-dealing

Ruling 3: That your interest in Corporation will not constitute an interest in a business enterprise
and therefore will not be “excess business holdings,” all within the meaning of § 4943.

Your plan does not involve your ownership of excess business holdings. Under § 4943(a), a
private foundation is subject an excise tax on its excess holdings in a business enterprise. Your
holdings in Corporation will not subject you to this tax. Under § 4943(d)(3), the term "business
enterprise" does not include an entity where at least ninety-five percent of the gross income is
derived from passive sources, and the term passive sources means sources described in §§
512(b)(1), (2), (3), and (5). Sections 512(b)(1) and (5) exclude all dividends, interest, and gains
or losses from the sale, exchange, or other disposition of property. You have represented that
Corporation invests substantially all of its income in Partnership and it earns at least ninety-five
percent of its gross income from passive sources. Accordingly, Corporation is not a business
enterprise for purposes of § 4943 and your ownership in it will not be excess business holdings.

Ruling 4: That our acquisition of Class Y shares in Corporation will not jeopardize the carrying
out of any of your exempt purposes within the meaning of § 4944.

Under § 4944(a)(1), a private foundation is subject to tax an if it invests its assets in a manner
that jeopardizes its ability to carry out its exempt purposes. Your purchase of stock in
Corporation will not subject you to this tax. Section 53.4944-1(a)(2)(i) states that no category of

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investments is per se jeopardizing. Further, the regulation states that a jeopardizing investment
occurs if the foundation managers, in making such investment, failed to exercise ordinary
business care and prudence. You indicated that that you will purchase stock in Corporation
which will then invest your assets in Partnership. You stated that Partnership has broad
diversity of reasonable investments and given the information in the file you have indicated that
your trustees have exercised ordinary business care and prudence in their investment of your
assets.

Rulings

1) Your initial acquisition of Class Y shares in Corporation will not constitute direct or indirect
acts of self-dealing within the meaning of § 4941.

2) Direct or indirect co-investment in Corporation by you will not constitute direct or indirect
acts of self-dealing within the meaning of § 4941.

3) Interest in Corporation will not constitute an interest in a business enterprise and therefore
will not be “excess business holdings,” all within the meaning of § 4943.

4) Your acquisition of Class Y shares in Corporation will not jeopardize the carrying out of any
of your exempt purposes within the meaning of § 4944.

These rulings are based on the assumption of your receiving recognition of exemption under §
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 resolve 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,

Michael Seto
Manager,
EO Technical

Enclosure
Notice 437