School may issue endowment units to charitable trusts without UBTI

Plain-English summary

A tax-exempt school served as trustee and sole charitable remainder beneficiary of a charitable remainder unitrust. It proposed issuing contractual units tied to its pooled endowment so the trust could share the endowment's investment returns without directly owning the underlying assets or forming a partnership. The school would charge no management or trustee fee, although it could recover actual endowment-management and trust-administration costs. The IRS ruled that issuing and making payments on the units and receiving those cost reimbursements would not generate unrelated business taxable income to the school. The same conclusion would apply to similarly structured units issued to other charitable remainder trusts for which the school served in the same roles and charged no fees.

Ruling snapshot

• Question: Would issuing endowment-linked units to charitable remainder trusts and recovering actual costs create unrelated business taxable income for the school?
• Outcome: approved
• Key authorities: IRC §§ 501(c)(3), 512, and 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: 201730019
Third Party Communication: None
Release Date: 7/28/2017
Date of Communication: Not Applicable
Index Number: 512.00-00, 512.04-00,
513.00-00, 513.01-00
Person To Contact:
-------------------------, ID No. --------------
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Telephone Number:
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Refer Reply To:
------------------------------------------------------------ CC:TEGE:EOEG:EO1
---------------------------------------------- PLR-139754-16 Date:
April 26, 2017

School = --------------------------------------
Trust = ------------------------------------------------------

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

This letter responds to a letter from your authorized representative dated December 22, 2016, and subsequent correspondence, requesting a ruling that the issuance of units from School to Trust, the making or receipt of payments with respect to the units, and the holding and redemption of units, all as described in this ruling letter, will not generate unrelated business taxable income to School. School represents the facts as follows.

FACTS

School is an educational institution recognized as a tax-exempt organization described in §§ 501(c)(3) and 170(b)(1)(A)(ii) of the Internal Revenue Code.1 School’s Investment Committee has the responsibility for managing School’s pooled endowment (the "endowment"), in accordance with policies established by the Board of Trustees with day-to-day recording responsibilities maintained by School’s business office. School seeks to invest the endowment to receive maximum long-term benefits to support the education of future School students in perpetuity.

Trust is a charitable remainder unitrust described in § 664(d)(2). School is the sole charitable remainder beneficiary of Trust. Under the terms of the trust agreement, Trust’s donor is entitled to an annual payout of a unitrust amount generally equal to a percentage of the net fair market value of Trust’s assets. Upon the death of donor or a

1
The Internal Revenue Code of 1986, as amended, to which all subsequent “section” references are made unless otherwise indicated.
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term of years, the remainder interest in Trust will be distributed to School as the remainder beneficiary for its general charitable purposes.

School is the sole trustee, and in that capacity is the legal owner of the assets of Trust. Aside from fees, paid to third parties, for services such as investment management and tax preparation, School itself does not, and will not charge any fee for administrative services and management of Trust. However, it may recover actual costs of administering Trust as a charge against Trust.

School is concerned that it cannot deliver investment results matching those of the endowment and that Trust cannot be diversified sufficiently unless they can be commingled alongside all endowment assets. As trustee and remainder beneficiary, School wants to achieve greater economies of scale in the management of Trust’s assets, a potentially higher and more stable investment return for Trust, and increased diversification of Trust’s investments. To this end, School intends to enable Trust to participate indirectly in the return on School’s endowment.

In lieu of a partnership or a direct commingling, School proposes to create a contractual obligation pursuant to which School would issue a contract right to Trust for its endowment units ("units"). 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. Each unit has a value of one dollar. The number of units is adjusted on a quarterly basis, either upwards or downwards, to reflect changes to the value of the endowment, so that the value of a unit is always set at one dollar.

Each unit will give Trust a contractual right to receive periodic payments based on the number of units owned that would adjust based on the underlying value of the endowment, allowing Trust to receive an investment return equal to that of the endowment. Trust can choose to either reinvest part of the distribution in additional units, or redeem units, depending on Trust’s cash requirements for meeting its minimum distribution. Trust will treat payouts to its beneficiaries up to the endowment payout amount and any additional distributions as ordinary income, regardless of the character of the underlying income of the endowment (whether capital gain, ordinary income, or return of capital).

The units will give Trust a contractual right to receive periodic payments from the endowment, as determined by School, but no interest whatsoever in the underlying investment assets of the endowment or with respect to other trusts also invested in units with respect to the endowment. 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 School’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. The proposed contract provides that, with respect to the issuance of units, School is neither a partner nor an agent of Trust. Trust will not be
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liable for any cost, expense, or payment incurred or due by School, or for which School is liable or responsible, relating to the endowment (or the underlying endowment assets). School will indemnify and hold Trust harmless from and against any liability arising out of any action or inaction by School with respect to the endowment (or the underlying assets). School also will pay any tax owed on unrelated business taxable income earned by the endowment’s portfolio.

School will not charge a fee for internal management costs of Trust assets, although it may recover its actual costs of management of the endowment as a charge against the total investment return of the endowment. These charges will decrease the value of Trust’s units. School also does not assess a trustee's fee or any other charge for the administrative services it provides to Trust. However, it may recover the actual costs of administration of Trust as a charge against Trust.

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

LAW AND ANALYSIS

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

Section 512(a)(1) 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.

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.
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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) of the regulations 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.

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.

School’s situation is distinguishable from the entity in Rev. Rul. 69-528, which provided investment services on a regular basis for a fee. School will not charge any fees for managing Trust’s assets; it will only recover the actual costs of managing its endowment as a charge against total investment return and any actual costs of administering Trust as a charge against Trust.

School will receive no income from providing management services to Trust. Accordingly, School’s services provided under the contractual agreement, as represented, will not generate any income that could be characterized as unrelated taxable income within the meaning of § 513.

CONCLUSION

Based solely on the facts and representations submitted, we rule that the contractual arrangement described herein, under which School will issue units to Trust, make payments on the units, and be reimbursed for costs allocable to the management of the endowment or administration of Trust, will not generate unrelated business taxable income to School. The same result will occur with respect to the issuance of any other endowment units to any other charitable remainder trust or charitable remainder unitrust with respect to which School has and will have the sole charitable remainder interest, for which School will be the trustee, and to which School makes units available on the
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same terms as described in this letter for Trust, including that it will not assess a fee for managing its endowment or for the administrative services it provides as trustee.

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.

This letter 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 discussed or referenced in this letter. 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. Additionally, no ruling is granted as to whether School qualifies as an organization described in § 501(c) and/or § 509(a)(1), (2), or (3).

The Associate office will revoke or modify a letter ruling and apply the revocation retroactively if there has been a misstatement or omission of controlling facts; the facts at the time of the transaction are materially different from the controlling facts on which the ruling was based; or, in the case of a transaction involving a continuing action or series of actions, the controlling facts change during the course of the transaction. See Rev. Proc. 2017-1, § 11.05.

Because it could help resolve questions concerning federal income tax status, this letter should be kept in School’s permanent records.

This ruling letter is directed only to the taxpayer that requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent by anyone else.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.
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If you have any questions about this letter, please contact the person whose name and telephone number are shown in the heading of this letter.

Sincerely,

David L. Marshall
Assistant Branch Chief
Exempt Organizations Branch 1
(TEGE Associate Chief Counsel)
Enclosure