Cost-only endowment services do not create unrelated business income

Plain-English summary

A public charity proposed allowing a charitable remainder unitrust to participate indirectly in the charity's diversified endowment through contractual units. The charity would issue units for trust assets, make payments under its normal spending policy, redeem units when requested, and recover only the trust's allocable share of actual management costs. It would not charge a fee or pursue income from providing the investment arrangement. The IRS distinguished a revenue ruling in which an exempt organization regularly sold investment services for profit. It ruled that the cost-only arrangement was not a trade or business under IRC § 513 and would not generate unrelated business taxable income for the charity.

Ruling snapshot

• Question: Would the charity's issuance, payment, redemption, and cost recovery for endowment units create unrelated business taxable income?
• Outcome: Approved, the represented arrangement would not generate unrelated business taxable income.
• Key authorities: IRC §§ 511, 512, 513; Treas. Reg. § 1.513-1; Rev. Rul. 69-528.

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224
Number: 201636042
                                                               Third Party Communication: None
Release Date: 9/2/2016                                         Date of Communication: Not Applicable
                                                               Person To Contact:
Index Number: 513.00-00, 513.01-00,                            ---------------, ID No. ----------
512.00-00, 512.04-00, 664.03-02                                Telephone Number:
                                                               --------------------
                                                               Refer Reply To:
------------------------------------------------------------
                                                               CC:TEGE:EOEG:EO2
----------------
                                                               PLR-T-103431-15
---------------------                                          Date:
----------------------------                                   May 18, 2016
Attn: --------------------------------------


         LEGEND


Charity = --------------------------------------------------------------------
Trust   = -------------------------------------------------------------------------------




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

This letter responds to a letter from your authorized representative dated September 18,
2014, and subsequent correspondence, requesting a ruling that the contractual
arrangement described below will not generate unrelated business taxable income to
Charity. Charity represents the facts as follows.

FACTS

Charity is recognized as a tax-exempt organization described in § 501(c)(3) and
classified as a public charity described in §§ 509(a)(1) and 170(b)(1)(A)(vi) of the
Internal Revenue Code of 1986, as amended (the “Code”). Charity’s primary purpose is
to support a particular religious community and its religious, health, social service, and
educational institutions. Charity provides financial and administrative support to
approximately one hundred and fifty organizations in its region. Charity maintains an
endowment through an investment partnership with other tax-exempt organizations.
The investment partnership holds a widely diversified portfolio of assets including cash,
cash equivalents, domestic and foreign public equities, real estate, domestic and foreign
bonds and other fixed income securities, mutual funds, private equity securities,
emerging markets, and various other alternative investment classes. Much of the
income earned by the endowment fund consists of passive income such as dividends,
interest, and capital gains, but some income has been debt-financed or is otherwise
treated as unrelated business taxable income under § 512. The investment partnership
compensates Charity for indirect services it provides to the investment partnership.
PLR-T-103431-15                                2

Charity reports this compensation as unrelated business taxable income.

Charity pays out a certain amount of its unrestricted endowment fund each year to fund
its operations, creating an “unrestricted annual endowment spending rate.” This annual
spending rate is determined according to the factors in the version of the Uniform
Prudent Management of Institutional Funds Act enacted in Charity’s state. These
include: the duration and preservation of the endowment fund, the purposes of the
institution, general economic conditions, possible effects of inflation or deflation, the
expected total return from investment, other resources of the institution, and the
investment policy of the institution. Each year Charity’s senior managers recommend a
spending rate to the Budget and Administration Committee of its Board of Directors. The
Committee considers and recommends a rate to the full board which votes to adopt that
year’s rate. The spending rate has historically stayed fairly consistent.

Trust is a charitable remainder unitrust described in § 664(d)(2). 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 Charity as the remainder beneficiary.

Charity will become the sole trustee of Trust prior to the exchange for assets for units. In
its capacity as trustee, Charity will want Trust to benefit from its diversified and efficient
investment and allow Trust to earn a return equal to that realized by endowment fund.
To this end, Charity and Trust propose to enable Trust to participate indirectly in the
return on Charity’s endowment by entering into an Agreement that will provide for the
exchange of Trust assets for units with respect to the endowment. The number of the
units assigned to Trust will be based on the value of a unit at the time Trust’s assets are
conveyed to Charity. The endowment fund will be unitized so that the value of the unit
can be determined at any given time. The value of a unit at any time will equal the net
value of the assets in the endowment fund divided by the number of units outstanding at
such time. Charity will not reserve or exclude any part of its unrestricted endowment
fund earnings from the value 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 Charity uses, as described above. The contract will provide that Trust
can choose to either reinvest part of the periodic payments in additional units, or
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. Any income realized by the
endowment fund, but not paid out as part of the annual distributions, and any unrealized
appreciation or depreciation in the endowment fund itself, will be reflected in the value
of the outstanding units.

Under the contract, Trust will have no ownership interest in the underlying assets of the
endowment or the investment partnership, and no contractual rights with respect to
other trusts also invested in units with respect to the endowment. All endowment
PLR-T-103431-15                              3

investments will continue to be made in Charity’s name, and for Charity’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 Charity’s business
activities, operations, or decisions with respect to the endowment or the investment
partnership. Trust will not have the right to veto or opt out of any of the underlying
endowment investments. When Charity makes decisions regarding the endowment
investments, it will not be acting in its capacity as trustee of Trust. The contract will
provide that, with respect to the issuance of units, Charity 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 Charity, or for which Charity is liable or responsible relating to the
endowment (or its interest in the investment partnership and its assets) other than
bearing its allocable portion of the costs of management as described below. Charity
will indemnify and hold Trust harmless from and against any liability arising out of any
action or inaction by Charity with respect to the endowment (or the underlying assets).
Charity will pay any tax owed on unrelated business taxable income earned by the
endowment’s portfolio.

Charity represents that it will not assess a fee for managing and administering its
endowment fund; however, it expects to recover its actual costs of managing 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.

LAW AND ANALYSIS

Section 501(c)(3) of the Code describes as exempt from federal income tax entities
organized and operated exclusively for charitable, educational, scientific, and certain
other purposes.

Section 511(a) 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
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).

Section 513(a) defines the term “unrelated trade or business” as any trade or business
the conduct of which is not substantially related (aside from the need of 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.
PLR-T-103431-15                               4

Section 513(c) provides that the term “trade or business” includes any activity which is
carried on for the production of income from the sale of goods or the performance of
services. 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(d)(2) defines a charitable remainder unitrust, as a trust (A) 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) 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); (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) 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 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 1.513-1(a) of the Income Tax Regulations (“regulations”) includes gross income
of an exempt organization subject to the tax imposed by § 511 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.

Section 1.513-1(b) provides that for purposes of § 513 the term “trade or business” has
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.

Section 1.513-1(c)(1) 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, 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) provides that, in general, gross income derives from an “unrelated
trade or business,” within the meaning of § 513(a) if the conduct of the trade or business
which produces the income is not substantially related (other than through the
PLR-T-103431-15                              5

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) 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 , 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.

Rev. Rul. 69-528, 1969-2 C.B. 127, describes an organization that was formed to
provide investment services on a fee basis exclusively to organizations exempt under
§ 501(c)(3). The organization received funds from unrelated exempt organizations and
invested the proceeds in stocks, reinvested the income and realized appreciation, and
upon request, liquidated participant’s interests and distributed the proceeds to the
participant. The Service held that providing investment services on a regular basis for a
fee is a trade or business ordinarily carried on for profit. The Service further held that
the activity would constitute an unrelated trade or business even if the services were
regularly provided by one tax-exempt organization for other tax-exempt organizations.
Thus, the Service concluded that the organization was not tax exempt under § 501(c)(3)
because it was regularly carrying on a business of providing investment services that
would be an unrelated trade or business if carried on by any of the tax-exempt
organizations on whose behalf it operated.

Under § 511(a)(1) and (2) an organization described in § 501(c)(3) is subject to the tax
imposed by § 511 on its unrelated business taxable income (as defined in § 512.)
Generally, § 1.513-1(a) provides that gross income of an exempt organization is
includible in the computation of unrelated business taxable income if: (1) is it income
from trade or business; (2) such trade or business is regularly carried on; 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.

The term trade or business has the same meaning for purposes of § 513 as it does for
§ 162, “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(b). Charity has
represented that it will not charge a fee for the investment services it provides to Trust,
although Trust will indirectly bear its portion of the costs that Charity incurs in
administering the endowment. Charity is not pursuing income by providing to services to
Trust by issuing units, making and receiving payments with respect to the units and
redeeming units.
PLR-T-103431-15                               6


Charity’s situation is also distinguishable from the entity in Rev. Rul. 69-528 that
provided investment services on a regular basis for a fee. The IRS held that activity to
be a trade or business carried on for profit, and found that it was unrelated to the entity’s
exempt purpose because the services were provided to unrelated organizations, even
though the services were regularly provided by one tax-exempt organization for the
benefit of other tax-exempt organizations. Charity represents that it will not charge any
fees for the investment services it provides to Trust. Rather, Charity will only recover the
actual costs of managing its endowment fund.

Therefore, Charity’s services provided under the contractual arrangement, as
represented, will not arise to a trade or business within the meaning of § 513, and will
not generate unrelated business taxable income.

CONCLUSION

Based solely on the facts and representations submitted, we rule that the contractual
arrangement described herein, under which the Charity will issue units to the Trust in
exchange for assets of the Trust, make payments on the units, and receive payments to
cover costs allocable to the management of the Trust assets, will not generate
unrelated business taxable income to Charity.

The ruling contained in this letter is 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.

No ruling is granted as to whether Charity qualifies as an organization described in
§ 501(c) and, 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 letter.

This ruling letter is directed only to the taxpayer requesting it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.
PLR-T-103431-15                                7


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

                                       Sincerely,



                                       Andrew F. Megosh, Jr.
                                       Senior Tax Law Specialist
                                       Branch 2
                                       (Tax Exempt & Government Entities)




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