Endowment units do not create unrelated business taxable income

Plain-English summary

A charitable remainder unitrust proposed exchanging its assets for contractual units tied to a college's endowment after the college became sole trustee. The trust would have no ownership or control over the endowment assets, no partnership or agency relationship with the college, and only a contractual right to payments under the college's spending policy. The IRS treated those payments as ordinary and routine investment income excluded from unrelated business taxable income under section 512(b)(1), while redemptions would fall under the section 512(b)(5) exclusion for gains or losses from investment property. It ruled that exchanging assets for units, holding the units, receiving payments, and redeeming units would not generate unrelated business taxable income, but expressed no opinion on whether redemption income would be ordinary or capital.

Ruling snapshot

• Question: Would the trust's investment in contractual units tied to the college's endowment generate unrelated business taxable income?
• Outcome: Approved, the exchange, payments, holding, and redemption of units would not generate UBTI.
• Key authorities: IRC §§ 512(b)(1), 512(b)(5), and 664(c), (d)(2); Treas. Reg. § 1.512(b)-1(a)(1), (d)(1)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201613015 Third Party Communication: None
Release Date: 3/25/2016 Date of Communication: Not Applicable
Index Number: 513.00-00, 513.01-00,

513.01-00, 512.00-00, Person To Contact

512.04-00, 664.03-02 , ID No.

Telephone Number:

Refer Reply To:
CC:TEGE:EOEG:E01

PLR-T-103500-15

Date:
December 22, 2015

Legend

Trust =

College =

Agreement =

X =

Y =

Z =

Dear

This letter responds to a letter from your authorized representative dated December 29,
2014, and subsequent correspondence submitted on behalf of Trust, requesting rulings
that Trust's exchange of assets for units with respect to College’s endowment, receipt of
payments with respect to the units, and the holding and redemption of units, as
described below, will not generate unrelated business taxable income to Trust. Trust
represents the facts as follows.


PLR-T-103500-15 2

FACTS

Trust is a charitable remainder unitrust described in § 664(d)(2) of the Internal Revenue
Code of 1986, as amended (“Code”). College is the sole charitable remainder
beneficiary. Under the terms of the trust agreement, Trust’s donor is entitled to an
annual payout of a unitrust amount equal to a percentage of the net fair market value of
Trust’s assets. See § 664(d)(2)(A). The remainder interest in Trust will be distributed to
College as the remainder beneficiary upon the death of the donor.

College is an educational institution recognized as a tax-exempt organization described
in §§ 501(c)(3) and 170(b)(1)(A)(ii) of the Code. College maintains an endowment,
comprised of privately raised moneys, which was established to provide economic
resources for its educational activities. The endowment is heavily diversified in both
domestic and international markets and utilizes alternative investment strategies to
reduce the overall risk of the portfolio and to enhance investment returns. Much of the
income earned by the endowment consists of passive dividends, interest, rents and
long- and short-term capital gains, but some income is debt-financed or otherwise is
treated as unrelated business taxable income within the meaning of § 512 of the Code.

College uses a “unit” concept as a financial recordkeeping device for various College
funds. Each fund is allocated a certain number of units of the endowment. The value of
each unit is determined by dividing the total value of the endowment by the number of
outstanding units. Each fund is entitled to a periodic payment based on the number of
units owned and the annual spending rate. College sets the spending rate to provide a
responsible annual contribution to operations and provide a measure of protection
against declining returns. College’s spending policy provides that income distributed
per unit will typically increase by Y% annually, as long as the resulting amount is more
than Y% and less than Z% of the endowment market value.

Presently, Trust’s assets are invested in mutual funds managed by X. College will
become sole trustee of Trust prior to Trust’s exchange of assets for units. In its capacity
as trustee, College will want to achieve greater economies of scale in the management
of Trust's assets, a higher and more stable investment return, and a greater
diversification of investment. To this end, as trustee, College will propose to enable
Trust to participate indirectly in the return on College’s endowment by entering into the
Agreement that will provide for the exchange of Trust assets for units with respect to the
endowment. The number of units Trust will receive will be in proportion to the value of
Trust’s investment with respect to the endowment at the time of the issuance of the
units. Each unit will give Trust a contractual right to receive periodic payments based
on the number of units owned multiplied by the same spending rate that College uses to
fund its various College funds, as described above. The contract will provide that Trust
can choose to either reinvest part of the periodic payments in additional units, or


PLR-T-103500-15 3

redeem units, depending on Trust’s cash requirements for meeting its minimum
distribution. The value of the units, both at the time of acquisition and redemption, will
be based on the value of all underlying investment assets held in the endowment.

Under the contract, Trust will have no ownership interest in the underlying assets of the
endowment and no contractual rights with respect to other trusts also invested in units
with respect to the endowment. All endowment investments will continue to be made in
College’s name, and for College’s benefit. Except for the right to review the payout
computation, Trust will have no power or right of any kind to control, direct, supervise,
recommend or review College’s business activities, operations, or decisions with
respect to the endowment. Trust will not have the right to veto or opt out of any of the
underlying endowment investments. When decisions are made by College regarding
the endowment investments, College will not be acting in its capacity as trustee of Trust.
The contract will provide that, with respect to the issuance of units, College is neither a
partner nor an agent of Trust. Trust will not be or become liable for any cost, expense,
or payment incurred or due by College or for which College is liable or responsible
relating to the endowment (or the underlying endowment assets) other than bearing its
allocable portion of the costs of management as described below. College will
indemnify and hold Trust harmless from and against any liability arising out of any
action or inaction by College with respect to the endowment (or the underlying assets).
College also will pay any tax owed on unrelated business taxable income earned by the
endowment’s portfolio.

College represents that it will not assess a trustee’s fee or any other charges for its
services as trustee of the Trust; however, it may recover actual costs of administration
of the Trust. In addition, College expects to recover its actual costs of management of
the endowment, including the actual costs of management of Trust assets, as a charge
against the total investment return of the endowment. These costs will decrease the
value of Trust’s units.

Trust is representative of a number of charitable remainder trusts with respect to which
College has and will have the sole charitable remainder interest and for which College
will be the trustee. College will make units available to these trusts on the same terms
as described in this letter for Trust. Similarly, College represents that it will not assess a
trustee’s fee or any other charges for the administrative services it will provide as
trustee of any of these trusts.

LAW AND ANALYSIS

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

Section 512(a)(1) of the Code defines the term "unrelated business taxable income" as
the gross income derived by any organization from any unrelated trade or business


PLR-T-103500-15 4

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 § 512(b) of the Code.

Section 512(b)(1) of the Code excludes from the definition of unrelated business taxable
income 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.

Section 512(b)(2) of the Code excludes from the definition of unrelated business taxable
income all royalties (including overriding royalties) whether measured by production or
by gross or taxable income from the property, and all deductions directly connected with
such income.

Section 512(b)(3) of the Code excludes from the definition of unrelated business taxable
income certain rents.

Section 512(b)(5) of the Code excludes from the definition of unrelated business taxable
income all gains or losses from the sale, exchange, or other disposition of property
other than stock in trade or property of a kind which would be property included in the
inventory of the organization if on hand at the close of the taxable year or property held
primarily for sale to customers in the ordinary course of a trade or business.

Section 513(a) of the Code 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 the
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.

Section 513(c) of the Code 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. An activity does not lose its identity as a trade or business
merely because it is 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.

Section 664(c) of the Code provides, in part, that a charitable remainder unitrust shall,
for any taxable year, not be subject to any tax imposed by Subtitle A, unless a trust has
unrelated business taxable income (within the meaning of § 512 of the Code,
determined as if part III of Subchapter F applied to such unitrust), in which case there is
imposed on the unitrust an excise tax equal to the amount of such unrelated business
taxable income.

Section 664(d)(2) of the Code defines a charitable remainder unitrust, as a trust (A)


PLR-T-103500-15 5

from which a fixed percentage (which is not less than 5 percent nor more than 50
percent) of the net fair market value of its assets, valued annually, is to be paid, not less
often than annually, to one or more persons (at least one of which is not an organization
described in § 170(c) of the Code and, in the case of individuals, only to an individual
who is living at the time of the creation of the trust) for a term of years (not in excess of
20 years) or for the life or lives of such individual or individuals; (B) from which no
amount other than the payments described in subparagraph (A) and other than qualified
gratuitous transfers described in subparagraph (C) may be paid to or for the use of any
person other than an organization described in § 170(c) of the Code; (C) following the
termination of the payments described in subparagraph (A), the remainder interest in
the trust is to be transferred to, or for the use of, an organization described in § 170(c)
of the Code or is to be retained by the trust for such a use; and (D) with respect to each
contribution of property to the trust, the value (determined under § 7520 of the Code) of
such remainder interest in such property is at least 10 percent of the net fair market
value of such property as of the date such property is contributed to the trust.

Section 1.512(b)-1 of the Income Tax Regulations (“regulations”) states that whether a
particular item of income falls within any of the modifications provided in § 512(b) of the
Code shall be determined by all the facts and circumstance of each case.

Section 1.512(b)-1(a)(1) of the regulations excludes from the computation of unrelated
business taxable income: certain investment income including dividends, interest,
payments with respect to securities loans (as defined in § 512(a)(5) of the Code),
annuities, income from notional principal contracts (as defined in § 1.863-7 of the
regulations or regulations issued under § 446 of the Code), other substantially similar
income from ordinary and routine investments to the extent determined by the
Commissioner, and all deductions directly connected with any of the foregoing items of
income.

Section 1.512(b)-1(d)(1) of the regulations excludes from the computation of unrelated
business taxable income: certain investment income including gains or losses from the
sale, exchange or other disposition of property other than (i) stock in trade or property of
a kind which would be property included in the inventory of the organization if on hand
at the close of the taxable year, or (ii) property held primarily for sale to customers in the
ordinary course of a trade or business.

Section 1.513-1(a) of the regulations includes gross income of an exempt organization
subject to the tax imposed by § 511 of the Code 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.


PLR-T-103500-15 6

Section 1.513-1(b) of the regulations provides that for purposes of § 513 of the Code
the term “trade or business” has the same meaning it has in § 162 of the Code and
generally includes any activity carried on for the production of income from the sale of
goods or performance of services.

Section 1.513-1(c)(1) of the regulations provides that in determining whether a trade or
business from which a particular amount of gross income derives is “regularly carried
on” within the meaning of § 512 of the Code, 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.

Section 1.513-1(d)(1) of the regulations provides that, in general, gross income derives
from an “unrelated trade or business,” within the meaning of § 513(a) of the Code 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. This requirement necessitates an examination of the relationship between the
business activities which generate the particular income in question — the activities of
producing and distributing the goods or performing the services involved — and the
accomplishment of the organization’s exempt purposes.

Section 1.513-1(d)(2) of the regulations provides that a 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 (other than
through the production of income), and is "substantially related" for purposes of § 513 of
the Code, only if the causal relationship is a substantial one. 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.

A charitable remainder unitrust described in § 664(d)(2) of the Code pays a fixed
percentage of the value of its assets to an individual for a term of years or a life-time,
and then transfers the remainder to or for the use of an organization described in

§ 170(c) of the Code. Income from such trusts is exempt from federal income tax. See
§ 664(c)(1). However, an excise tax is imposed equal to the amount of any unrelated
business taxable income of the trust. See § 664(c)(2).

For exempt organizations, including charitable remainder unitrusts, income from certain
passive investments, such as interest, dividends, rent, and similarly produced passive
income, is generally excluded from taxation as unrelated business income by

§ 512(b)(1) of the Code. In addition, gains from sale or exchange of property other than
property that is stock in trade or primarily held for sale to customers in the ordinary
course of business are excluded from the computation of unrelated business taxable
income. See § 512(b)(5). Whether the modifications of § 512 of the Code apply is
dependent upon the facts and circumstances of each case. See § 1.512(b)-1.


PLR-T-103500-15 7

In this case, the investment of the assets of Trust in units and holding of the units will
not give Trust any ownership interest or rights in the assets of the endowment. An
investment in units will not give Trust any power or right to control, direct, supervise,
recommend, or review the business activities, operations, or decisions of College with
respect to the endowment, nor will it give Trust the right to veto or opt out of any
underlying investment in the endowment. Likewise, an investment in units will not give
Trust a proprietor’s interest in the profits and losses of the endowment. Rather, a unit
will represent a mere contractual right to receive periodic payments from the
endowment as determined by College.

Furthermore, the investment of Trust assets in units with respect to the endowment will
not be characterized as a partnership for federal income tax purposes. College and
Trust will not hold themselves out as partners, or manifest any intention to join together
in the conduct of an enterprise. On the contrary, the contract between College and
Trust will specifically state that College is not a partner or an agent of Trust with respect
to the issuance and holding of units. Furthermore, the proposed arrangement between
College and Trust has none of the characteristics that are commonly associated with a
partnership.

Since Trust’s investments in units with respect to the endowment do not give Trust any
ownership interest in the underlying assets of the endowment and since the relationship
between College and Trust will not be in the nature of a partnership or agency, the
payments from the College out of the endowment will reflect ordinary income and not
take on the character of the income of the underlying assets. Although Trust has
represented that some of the assets in the endowment are debt-financed or otherwise
treated as producing unrelated business taxable income to the College under § 512 of
the Code, the character of the assets owned by the endowment will not determine the
character of College’s payments to Trust. Trust will only have a right to the amount of
income from the endowment that College determines in its sole discretion pursuant to
the unit payout under its spending policy. The payment that Trust will receive is based
on a contract, not on the character or performance of the underlying assets. Therefore,
any debt-financing associated with an underlying asset in the endowment is not relevant
in determining whether Trust has any unrelated business taxable income.

The exchange by Trust of its assets for units will be an investment activity and the
receipt of payments with respect to those units will be income from ordinary and routine
investments of the type that is excludible from unrelated business taxable income by
reason of § 512(b)(1) of the Code and § 1.512(b)-1(a)(1) of the regulations.
Accordingly, neither the receipt of payments with respect to the units nor the holding of
the units will result in the receipt of unrelated business taxable income to Trust.

In addition, the proposed contract between Trust and College allows Trust to redeem
units and receive from College the value of a unit on the date when Trust surrenders it
to College. Under the facts of the contractual arrangement, units will be neither


PLR-T-103500-15 8

inventory nor property that is primarily held for sale to customers in the ordinary course
of business. A redemption of units will fall within § 512(b)(5) of the Code and

§ 1.512(b)-1(d)(1) of the regulations and be treated as gain or loss recognized in
connection with the investment activities of Trust. Thus, money Trust will receive when
it redeems units will not be taxed as unrelated business taxable income.

CONCLUSION

Based solely on the facts and representations submitted, we rule that Trust's exchange
of assets for units with respect to College’s endowment, receipt of payments with
respect to the units, and the holding and redemption of units will not generate unrelated
business taxable income to Trust.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an individual with authority to bind the taxpayer. This office has not verified any of
the material submitted in support of the request for rulings, and such material is subject
to verification on examination.

Except as expressly provided above, no opinion is expressed or implied concerning the
federal income tax consequences of any other aspects of any transaction or item of
income set forth in the ruling. In particular, no opinion is expressed or implied
concerning whether income or loss from a surrender or redemption of units is treated as
ordinary income or loss or as gain or loss from the sale or exchange of a capital asset.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to Trust’s authorized representative.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

Sincerely,

Mary Jo Salins

Acting Branch Chief, Exempt Organizations
Branch 1

(Tax Exempt & Government Entities)