Inherited rental properties avoid UBIT and private-foundation excise taxes

Plain-English summary

A private foundation expected to inherit commercial rental properties through single-member limited liability companies and planned to use another disregarded LLC to manage them. The IRS ruled that qualifying real-property rents and occasional investment sales would be excluded from unrelated business taxable income, assuming no debt-financed income. Paying disqualified-person managers for reasonable, necessary professional management services would not be self-dealing if compensation was not excessive. Because at least 95 percent of the properties' income would be passive rent, the LLCs would not be business enterprises creating excess business holdings. The inherited properties also would not be jeopardizing investments, and carefully documented employee-sharing arrangements with a family-owned management company would not create self-dealing or an indirect benefit.

Ruling snapshot

• Question: How would inherited rental properties, related-party management, disregarded LLCs, and employee-sharing arrangements affect the foundation's UBIT and private-foundation excise-tax obligations?
• Outcome: Approved on all six requested rulings, subject to the stated passive-income, compensation, documentation, and no-debt conditions
• Key authorities: IRC §§ 512(b)(3), 512(b)(5), 4941, 4943(d)(3)(B), 4944, and 4946; Treas. Reg. §§ 53.4941(d)-3 and 53.4944-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201630009
Release Date: 7/22/2016
Index Number: 512.00-00, 4941.04-00, Person To Contact:
4943.03-01, 4944.05-00 -----------------------------
ID No. ------------------
------------------------------------- Telephone Number:
----------------------------------- ----------------------
------------------------------------------------------------ Refer Reply To:
CC:TEGE:EOEG:EO3
PLR-134456-15
Date:
April 22, 2016

Foundation = -------------------------------------
Year 1 = -------
State = -------------------------
Decedent = ---------------------
Date 1 = -----------------------
X = -------------------------
Y = -------------------------------------------

Dear -------------------------------------:

This letter responds to a letter from your authorized representative dated October 6,
2015, and subsequent correspondence, requesting rulings under §§ 512, 4941, 4943,
and 4944 of the Internal Revenue Code.

FACTS

Foundation was established in Year 1, pursuant to the laws of the State. Foundation is
a tax-exempt organization described in § 501(c)(3) and classified as a private
foundation under § 509(a). Foundation’s exempt purpose is to receive funds,
administer investments, and distribute funds to § 501(c)(3) organizations. Foundation’s
funding has come solely from Decedent. Historically, Foundation has invested in cash
and publicly traded bonds and securities.

Decedent died on Date 1, leaving a will providing that Foundation receives, among
other things, commercial real estate properties. The Executor intends to distribute
these real estate properties to Foundation as single member limited liability companies.

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Any debt encumbering the properties will be paid in full by the estate prior to, or
simultaneously with, the transfer of the properties to Foundation.

The real estate properties are primarily office rental properties. The rent received is at
least 95% for the use of real property and any remainder of the rent is attributable to
personal property leased with the real property that is an incidental amount of the total
rents that are received or accrued under various leases. No part of the rent paid
depends in whole or in part on the income or profits derived by any person from the
property leased.

At least in the near term, Foundation intends to continue to hold the properties as part of
a diversified investment portfolio that will also contain cash and publicly traded
securities. The decision to retain or sell any of the real estate properties will be made
by Foundation’s Board of Directors based on the relevant facts and circumstances and
in accordance with their fiduciary duty to prudently manage Foundation’s investments.
The real estate properties will be held as income producing properties and not as
inventory used in a trade or business. The decision to sell or keep any one of the
individual real estate properties will be made on a property-by-property basis, taking into
consideration Foundation’s overall investment portfolio, investment strategy, and capital
appreciation. Foundation may decide to make capital improvements to the real estate
properties as needed, but the real estate properties will not be held for the primary
purpose of improving the properties for immediate resale. Foundation anticipates that
any sales of the real estate properties will be sporadic and occasional.

At this time, Foundation does not anticipate acquiring additional real property in its
investment portfolio. Any such acquisitions will be made by the Board of Directors
based on the relevant facts and circumstances and in accordance with the Board’s
fiduciary duty to prudently manage Foundation’s diversified investment portfolio.

Foundation intends to form a new limited liability company, X, of which Foundation will
be the sole member and which will be treated as a disregarded entity for federal income
and excise tax purposes, to manage the properties Foundation received by bequest.
Specifically, X will provide any of the following services with respect to the management
of the real estate properties held for investment by Foundation:

1. contract negotiations;

2. cash management;

3. debt management including budgeting;

4. negotiation of financing;

5. review of loan agreements and expenditures;

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6. accounting;

7. supervision of property operations and inspections;

8. advertising;

9. leasing and lease negotiations;

10. goodwill relations with tenants and communities;

11. interface with municipalities and compliance with new ordinances;

12. collection of rents;

13. supervision of personnel and human resources;

14. supervision and administration of legal and tax services and other incidental and
    ancillary activities associated with the ownership of passive rental real property; and

15. supervision and administration of a risk management program to frequently review
    Foundation’s real estate investments, including identification and analysis of potential
    real estate acquisitions and services relating to the disposition of property.

X may hire and supervise third party vendors who are not disqualified persons to
provide landscaping; perform capital improvement projects; and provide certain in-
house maintenance services, all of which will be limited to common areas such as
public entrances, exits, stairways, and lobbies. X itself will not perform these services.
X will not provide or arrange for cleaning or janitorial services for the lessees.

Y, a management company owned partially by Decedent and partially by Decedent’s
family, managed the properties during Decedent’s lifetime. Decedent’s interest in Y will
be redeemed upon approval by the Surrogate Court and will not pass to Foundation.

Y will share certain employees including manager, a disqualified person, with X to assist
X with the enumerated property management services. X will enter into a separate
contractual arrangement with each shared employee, based on a reasonable
determination of the value of that employee’s services to X, to provide reasonable
compensation to that employee for services provided to X. The shared employees will
only be compensated by X for work they perform for X, as confirmed by detailed time
records which will require the shared employees to log the time spent for X and Y on a
daily basis. Other than manager, the shared employees will not be disqualified persons.

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Foundation will have sole authority to appoint the managers of X. Foundation expects
to appoint one or more disqualified persons to act as the manager or managers of X
and thereby manage Foundation’s properties. The manager or managers will receive
reasonable compensation for providing the property management services to
Foundation through X.1

At least one such manager will be shared with Y. Any such manager will only be
compensated by X for work done for X, as confirmed by detailed time records which will
require the manager to log the time spent for X and Y on a daily basis. X and Y will
maintain separate employee benefits, including retirement plans as well as health,
dental and disability insurance.

Foundation represents that the property management services the manager or
managers provide will be reasonable and necessary to carrying out Foundation’s
exempt purposes, and the compensation provided to manager or managers for services
provided to X will not be excessive.

RULINGS REQUESTED

(1) Rental income received from the commercial real estate properties will be
    excluded from unrelated business taxable income.

(2) Income received as a result of the sale of these commercial real estate
    properties will be excluded from unrelated business taxable income.

(3) Contracting with X, managed by one or more disqualified persons, to provide
    certain real property investment management services will not constitute an act
    of self-dealing under § 4941.

(4) X and the limited liability companies constituting commercial real estate
    properties will not constitute excess business holdings under § 4943.

(5) The properties will not be considered jeopardizing investments described in
    § 4944.

(6) The sharing of employees, including managers, between X and Y will not
    constitute an act of self-dealing under § 4941, provided that the compensation
    paid by X to each such employee respectively is not excessive in relation to the
    services provided to X.

1
There is no indication in the facts you provided that the manager or managers of X will provide any
services in managing X that are separate from managing the real estate properties held for investment.

PLR-134456-15 5

LAW AND ANALYSIS

Issue 1 – Whether rental income will be excluded from unrelated business taxable
income

Section 511(a) imposes a tax for each taxable year on the unrelated business taxable
income of every organization described in § 501(c), including those described in
§ 501(c)(3).

Section 512(a)(1) provides that the term “unrelated business taxable income” means the
gross income derived by any organization from any unrelated trade or business
regularly carried on by it, less the deductions allowed by Chapter 1 which are directly
connected with the carrying on of such trade or business, both computed with the
modifications provided in subsection (b).

Section 512(b) contains modifications to the unrelated business taxable income rules of
§ 512(a)(1). Section 512(b)(3)(A) provides that, in the case of rents, all rents from real
property and all rents from personal property leased with such real property if the rents
attributable to such personal property are an incidental amount of the total rents
received or accrued under the lease, and all deductions directly connected with such
rents, are excluded from § 512(a).

Section 512(b)(3)(B)((ii) provides that if the determination of the amount of such rent
depends in whole or in part on the income or profits derived by any person from the
property leased (other than an amount based on a fixed percentage or percentages of
receipts or sales), then the rent is not so excluded.

Treas. Reg. § 1.512(b)-1(c)(2)(ii)(b) provides that rents which are excluded from
unrelated business income under § 512(b)(3)(A) include all rents from personal property
leased with real property if the rents attributable to such personal property are an
incidental amount of the total rents received or accrued under the lease, determined at
the time that the personal property is first placed in service by the lessee. For purposes
of the preceding sentence, rents attributable to personal property generally are not an
incidental amount of the total rents if such rents exceed 10 percent of the total rents
from all the property leased.

Treas. Reg. § 1.512(b)-1(c)(3) defines “real property” as all real property, including any
property described in §§ 1245(a)(3)(C) and 1250(c) and the regulations thereunder.

Treas. Reg. § 1.512(b)-1(c)(5) states that payments for the use or occupancy of space
where services are also rendered to the occupant does not constitute rent from real
property.

PLR-134456-15 6

Foundation’s commercial real estate properties are defined as “real property” under
Treas. Reg. § 1.512(b)-1(c)(3). The rental income is from rents of the real property or
from personal property leased with the real property that will be an incidental amount of
the total rents received or accrued under the lease. No part of the rent paid depends in
whole or in part on the income or profits derived by any person from the property
leased. Foundation will not provide services to the lessees. Thus, the income from the
commercial real estate properties Foundation received by bequest consists of rent that
is excluded from unrelated business taxable income by § 512(b)(3) and the regulations
thereunder, provided no income results from debt-financed property.

Issue 2 – Whether income received as a result of the sale of these commercial real
estate properties will be excluded from unrelated business taxable income

Section 512(b)(5) provides that there shall be excluded from the computation of
unrelated business taxable income all gains or losses from the sale, exchange, or other
disposition of property, other than from stock in trade or other property of a kind which
would properly be includible in inventory if on hand at the close of the taxable year, or
property held primarily for sale to customers in the ordinary course of the trade or
business.

In Malat v. Riddell, 383 U.S. 569 (1966), the Supreme Court defined the standard to be
applied in determining whether property is held primarily for sale to customers in the
ordinary course of business. The Court interpreted the word "primarily" to mean "of first
importance" or "principally." By this standard, ordinary income would not result unless a
sales purpose is dominant.

Treas. Reg. § 1.512(b)-1 provides that whether a particular item of income falls within
any of the modifications provided in § 512(b) shall be determined by all the facts and
circumstances of each case.

Foundation intends to hold the real estate properties as part of a diversified investment
portfolio that will also contain cash and publicly traded securities and intends to continue
to hold the properties, at least in the near term. Foundation anticipates that any sales of
the real estate properties will be sporadic and occasional. The decision to retain or sell
any of the real estate properties will be made by Foundation’s Board of Directors based
on the relevant facts and circumstances and in accordance with their fiduciary duty to
prudently manage Foundation’s investments. Any such decision will be made on a
property-by-property basis, taking into consideration the overall investment portfolio,
investment strategy, and capital appreciation. Foundation may decide to make capital
improvements to the real estate properties as needed, but the real estate properties will
not be held for the primary purpose of improving the properties for immediate resale.
The real estate properties will be held as income producing properties and not as
inventory used in a trade or business. See Malat v. Riddell, supra. Accordingly, any

PLR-134456-15 7

income from the sale, exchange, or other disposition of the commercial real estate
properties you received by bequest will be excluded from the computation of unrelated
business taxable income by § 512(b)(5), provided no income results from debt-financed
property.

Issue 3 – Whether paying disqualified persons to provide certain property management
services will constitute self-dealing under § 4941

Section 4941(a)(1) imposes taxes on each act of self-dealing between a disqualified
person and a private foundation. Taxes are imposed on both the self-dealers involved in
an act of self-dealing and on any foundation managers who knowingly participate in an
act of self-dealing. Even though § 4941 does not impose a tax on a private foundation
when an act of self-dealing occurs, a foundation with respect to which there has been
an act of self-dealing is required to report it to the IRS on its annual information return,
which is the Form 990-PF in this case.

Section 4946(a)(1) provides 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
(A), (B), or (C); (E) a corporation of which persons described in (A), (B), (C), or (D) own
more than 35 percent of the total combined voting power; (F) a partnership in which
persons described in (A), (B), (C), or (D) own more than 35 percent of the profits
interest; and (G) a trust or estate in which persons described in (A), (B), (C), or (D) hold
more than 35 percent of the beneficial interest.

Section 4941(d)(1)(D) defines "self-dealing" as any direct or indirect payment of
compensation (or payment or reimbursement of expenses) by a private foundation to a
disqualified person.

Section 4941(d)(1)(E) provides that the term "self-dealing" includes any direct or indirect
transfer to, or use by or for the benefit of, a disqualified person of the income or assets
of a private foundation.

Section 4941(d)(2)(E) and Treas. Reg. § 53.4941(d)-3(c)(1) provide that the payment of
compensation (and the payment or reimbursement of expenses) by a private foundation
to a disqualified person for personal services which are reasonable and necessary to
carrying out the exempt purpose of the private foundation shall not be an act of self-
dealing if the compensation (or payment or reimbursement) is not excessive.

PLR-134456-15 8

Treas. Reg. § 53.4941(d)-3(c)(2) provides examples of "personal services" for purposes
of Treas. Reg. § 53.4941(d)-3(c)(1). These include legal services, investment
counseling services, and general banking services.

In Madden v. Commissioner, T.C. Memo 1997-395, the Tax Court ruled that
maintenance, janitorial, and security services provided by a disqualified person to a
private foundation are not "personal services" for purposes of the exception to self-
dealing. Citing § 4941’s legislative history, the Court noted that one of Congress’s
stated goals in enacting § 4941 was to minimize the need for an arm’s length standard
by generally prohibiting self-dealing transactions between private foundations and
disqualified persons and that any exceptions to the self-dealing transactions rules
should be construed narrowly. The Court stated that the regulations under § 4941
contemplate only personal services that are professional and managerial in nature, and
concluded that maintenance, janitorial, and custodial services do not meet the definition
of "personal services" allowed under § 4941.

Foundation will contract with X, managed by one or more of Foundation’s disqualified
persons, to manage Foundation’s real estate properties. While the disqualified person
manager or managers will be compensated by X, because X is a disregarded entity, for
purposes of the analysis under § 4941, Foundation will be providing compensation to a
manager or managers who are disqualified persons.

Payment of compensation by a private foundation to a disqualified person is an act of
self-dealing under § 4941(d)(1)(D). However, § 4941(d)(2)(E) provides an exception to
self-dealing for the payment of compensation by a private foundation to a disqualified
person for personal services which are reasonable and necessary to carrying out the
exempt purpose of the private foundation. Foundation received the real estate
properties by bequest and, as such, they became part of Foundation’s investment
portfolio. Foundation does not intend to actively pursue other real estate investments
which, historically, have not been part of Foundation’s investments. Treas. Reg.
§ 53.4941(d)-3(c)(2) provides examples of allowable personal services that consist of
legal services, investment counseling services, and general banking services.
Additionally, Madden v. Commissioner, supra, indicates that services that are
professional and managerial in nature are the types of personal services that are
allowed under § 4941. The property management services provided to Foundation by
one or more disqualified persons, through X as a disregarded entity, are professional
and managerial services that, under the current facts, are reasonable and necessary to
administering Foundation’s investments and thus in carrying out Foundation’s exempt
purposes. Thus, the payment of compensation for these personal services to a
manager who is a disqualified person will not be an act of self-dealing as long as the
compensation is not excessive.

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Issue 4 – Whether X and the limited liability companies constituting commercial real
estate properties will constitute excess business holdings under § 4943

Section 4943 imposes a tax annually on the value of a private foundation's excess
holdings in a business enterprise. Excess business holdings are generally determined
with reference to a foundation's own holdings and the holdings of all of its disqualified
persons, as defined in § 4946.

Section 4943(d)(3)(B) provides that the term "business enterprise" does not include a
trade or business at least 95% of the gross income of which is derived from passive
sources. Gross income from passive sources includes, among other things, items
excluded from unrelated business taxable income by § 512(b)(3).

Foundation’s gross income from the commercial real estate properties, owned and
managed by limited liability companies that are disregarded entities, will be at least 95%
passive rental income that is excluded from unrelated business taxable income by
§ 512(b)(3). Thus, under these facts, the limited liability companies (including X), which
are disregarded entities, will not constitute business enterprises that could trigger
excess business holdings under § 4943.

Issue 5 – Whether the limited liability companies constituting commercial real estate
properties will be considered jeopardizing investments described in § 4944

Section 4944(a) imposes a tax on private foundations that invest any amount in such
manner as to jeopardize the carrying out of any of its exempt purposes.

Treas. Reg. § 53.4944-1(a)(2)(ii)(a) provides that § 4944 shall not apply to an
investment made by any person which is later gratuitously transferred to a private
foundation.

Because Foundation received the commercial real estate properties by bequest, they
will not be jeopardizing investments described in § 4944.

Issue 6 – Whether the sharing of employees, including managers, between X and Y will
constitute an act of self-dealing under § 4941

Section 4941(a)(1) imposes taxes on each act of self-dealing between a disqualified
person and a private foundation. Taxes are imposed on both the self-dealers involved in
an act of self-dealing and on any foundation managers who knowingly participate in an
act of self-dealing.

Section 4946(a)(1) provides 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

PLR-134456-15 10

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
(A), (B), or (C); (E) a corporation of which persons described in (A), (B), (C), or (D) own
more than 35 percent of the total combined voting power; (F) a partnership in which
persons described in (A), (B), (C), or (D) own more than 35 percent of the profits
interest; and (G) a trust or estate in which persons described in (A), (B), (C), or (D) hold
more than 35 percent of the beneficial interest.

Section 4941(d)(1)(D) defines "self-dealing" as any direct or indirect payment of
compensation (or payment or reimbursement of expenses) by a private foundation to a
disqualified person.

Section 4941(d)(1)(E) provides that the term "self-dealing" includes any direct or indirect
transfer to, or use by or for the benefit of, a disqualified person of the income or assets
of a private foundation.

Y’s employees are not disqualified persons but Y is a disqualified person because it is
owned by decedent’s family. X’s time-sharing arrangements with Y for these
employees to assist X with property management services, which are treated as
Foundation’s time-sharing arrangements since X is a disregarded entity, will provide
each shared employee with compensation that is not excessive based on a reasonable
determination of the value of that employee’s services to X, confirmed by detailed time
records logging the time spent for X and Y on a daily basis, and accompanied by
separate benefit arrangements. Accordingly, the time-sharing arrangements and the
compensation provided by X to the employees will not constitute self-dealing to Y under
§ 4941 because there will be no indirect benefit to Y.

The same is true of any managers of X that are shared with Y, even if the managers are
disqualified persons with respect to Foundation. Since the time-sharing arrangement
with Y provides the manager or managers will only be compensated by X for work done
for X, as confirmed by detailed time records which will require the manager to log the
time spent for X and Y on a daily basis and accompanied by separate benefit
arrangements, the time-sharing arrangements and the compensation provided by X to
any such manager will not constitute self-dealing to Y under § 4941 because there will
be no indirect benefit to Y. The time-sharing arrangements and the compensation
provided by X to any such manager will also not constitute self-dealing to the managers
who are disqualified persons as long as the compensation is not excessive, for the
reasons discussed above under Issue 3.

PLR-134456-15 11

CONCLUSION

Based solely on the facts and representations submitted by the Trust, we conclude that:

(1) Rental income received from the commercial real estate properties will be
excluded from unrelated business taxable income.

(2) Income received as a result of the sale of these commercial real estate
properties will be excluded from unrelated business taxable income.

(3) Contracting with X, managed by one or more disqualified persons, to provide
professional and managerial real property investment management services will
not constitute an act of self-dealing under § 4941, provided that any
compensation paid to a disqualified person for these personal services is not
excessive.

(4) X and the limited liability companies constituting commercial real estate
properties will not constitute excess business holdings under § 4943.

(5) The properties will not be considered jeopardizing investments described in
§ 4944.

(6) The sharing of employees, including managers, between X and Y will not
constitute an act of self-dealing under § 4941, provided that the compensation
paid by X to each such employee respectively is not excessive in relation to the
services provided to X.

The rulings contained in this letter are based upon information and representations
submitted by or on behalf of Foundation (accompanied by a penalty of perjury statement
executed by an individual with authority to bind Foundation) and upon the
understanding that there will be no material changes in the facts. 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.

No ruling is granted as to whether Foundation qualifies as an organization described in
§§ 501(c) or 509(a).

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 specifically described, and,
except as expressly provided in this letter, no opinion is expressed or implied
concerning the federal income tax consequences of any aspects of any transaction or
item of income set forth above.

PLR-134456-15 12

Because it could help resolve questions concerning federal income tax status, this ruling
should be kept in Foundation's permanent records.

A copy of this letter must be attached to any tax return to which it is relevant.
Alternatively, if Foundation files its return electronically, this requirement may be
satisfied by attaching a statement to the return that provides the date and control
number of this letter.

This ruling will be made available for public inspection under § 6110 after certain
deletions of identifying information are made. For details, see the enclosed Notice 437,
Notice of Intention to Disclose. A copy of this ruling, showing the deletions that we
intend to make on the version that will be made available to the public, is attached to the
Notice 437. If Foundation disagrees with our proposed deletions, it should follow the
instructions in the Notice 437.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to Foundation's authorized representatives.

This letter is directed only to Foundation. Section 6110(k)(3) provides that it may not be
used or cited as precedent by any other taxpayer, including disqualified persons, limited
liability companies, and corporations.

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.

                                   Sincerely,


                                   Virginia G. Richardson
                                   Senior Tax Law Specialist
                                   (Tax Exempt & Government Entities)

Encl.:
Notice 437, Notice of Intention to Disclose
Redacted copy of this letter

cc: