Charitable trust may track a school's endowment without generating UBTI

Plain-English summary

A charitable remainder unitrust had a school as its trustee and sole charitable remainder beneficiary. The school proposed issuing contractual endowment units so the trust could receive returns matching the school's pooled endowment without directly owning the underlying investments or entering a partnership. The trust would have no control over the endowment, and the school would remain responsible for taxes on unrelated business taxable income earned inside the endowment portfolio. The IRS ruled that buying and holding the units and receiving periodic payments would be ordinary passive investment activity excluded from unrelated business taxable income. Redeeming the units also would not create unrelated business taxable income because the units were not inventory or property held for sale to customers.

Ruling snapshot

• Question: Would the charitable remainder trust generate unrelated business taxable income by buying, holding, receiving payments on, and redeeming contractual units tied to the school's endowment?
• Outcome: approved
• Key authorities: IRC §§ 512, 513, and 664(c); Treas. Reg. §§ 1.512(b)-1 and 1.513-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201730022 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:
664.03-02 -------------------------, ID No. --------------
Telephone Number:
--------------------------------------------------------- ----------------------
------------------------- Refer Reply To:
---------------------------------------- CC:TEGE:EOEG:EO1
------------------------------------------------------------ PLR-139753-16
--------------------------------------------- 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 Trust’s purchase of
investment units of School’s endowment, the 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 Trust. Trust represents the facts as
follows.

FACTS

Trust is a charitable remainder unitrust described in § 664(d)(2) of the Internal Revenue
Code.1 School is Trust’s sole charitable remainder beneficiary. School acts as the sole
trustee, and in that capacity is the legal owner of the assets of the 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 term of years, the remainder interest in Trust will be
distributed to School as the remainder beneficiary for its general charitable purposes.

School is an educational institution recognized as a tax-exempt organization described
in §§ 501(c)(3) and 170(b)(1)(A)(ii). School’s Investment Committee has the
responsibility for managing School’s pooled endowment (the "endowment"), in

1
The Internal Revenue Code of 1986, as amended, to which all subsequent “section” references are
made unless otherwise indicated.
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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.

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 which 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
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
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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 the 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 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.

Section 664(c)(1) provides that, in general, neither a charitable remainder annuity trust
nor a charitable remainder unitrust shall, for any taxable year, be subject to any tax
imposed by Subtitle A of the Internal Revenue Code. However, § 664(c)(2)(A) provides
that, in the case of a charitable remainder annuity trust or a charitable remainder
unitrust that has unrelated business taxable income (within the meaning of § 512,
determined as if §§ 511 through 515 applied to such trust) for a taxable year, an excise
tax is imposed on such trust or unitrust equal to the amount of such unrelated business
PLR-139753-16 4

taxable income.

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.

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). In addition, gains from a 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 apply is dependent upon the facts
and circumstances of each case. See Treas. Reg. § 1.512(b)-1.

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

Furthermore, Trust’s investment in units will not create a partnership for federal income
tax purposes. The proposed arrangement between School and Trust has none of the
characteristics commonly associated with a partnership, and the contract between
School and Trust, specifically states that College is not a partner or an agent of Trust
with respect to the issuance and holding of units.

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
School under § 512, each periodic payment that Trust will receive is based on a
contract giving Trust the right to receive periodic payments calculated by reference to
School’s endowment without regard to the character or performance of the underlying
assets. Therefore, any debt-financing associated with an underlying asset in School’s
endowment is not relevant in determining whether Trust has any unrelated business
PLR-139753-16 5

taxable income.

Trust’s purchase of units will be an investment activity, and the receipt of payments with
respect to those units will be income from ordinary and routine investments similar to
the type that is excludible from unrelated business taxable income by § 512(b)(1) and
Treas. Reg. § 1.512(b)-1(a)(1). 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 School allows Trust to redeem
units for the value of each unit on the date Trust surrenders it to School. Under the
facts of the contractual arrangement, units will be neither 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) and Treas. Reg. § 1.512(b)-1(d)(1); 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 School’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 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 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.
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
PLR-139753-16 6

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.

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