P. THIRTY YEARS AFTER THE 1969 TRA –

1999 EO CPE Text

P. THIRTY YEARS AFTER THE 1969 TRA –

RECENT DEVELOPMENTS UNDER CHAPTER 42

by

Ron Shoemaker and Bill Brockner

“Chiefs! Our road is not built to last a thousand years, yet in

a sense it is. When a road is once built, it is strange thing how it

collects traffic, how every year as it goes on, more and more

people are found to walk thereon, and others are raised up to

repair and perpetuate it, and keep it alive.”

Vailima Letters. Address to the Chiefs on the Opening of the Road of Gratitude, October, 1894.

Robert Louis Stevenson (1850-1894)

1. Introduction

The Private Foundation provisions in the Internal Revenue Code are now

approaching their pearl anniversary. Enacted in the TRA of 1969, Chapter 42 and related

sections such as IRC 507 and IRC 4947 have provided the Service and the private

foundation community (including 4947 trusts) with a workable and fair regulatory

mechanism. There has been relatively minor tinkering with the provisions either through

statutory change or administrative action. As with any complex body of law, there has

been evolution in interpretation and application to meet changes in society and

technology. There has been a steady increase in the number of entities subject to Chapter

42, especially in the rolls of IRC 4947(a)(2) trusts. There are now over 130,000

organizations that file 990 PFs or 5227s. No one knows whether the private foundation

provisions of the Code, like Robert Louis Stevenson’s road, will survive the next

millennium. Presently, however, Chapter 42 serves as a vehicle in good repair to cross

the bridge into the 21st century regulation of the private foundation sector of the EO

universe.

This topic will provide discussions of recent private foundation developments and

update CPE articles in 1995 (Topic O); 1996 (Topic G); and 1997 (Topic K). Court

cases, private letter rulings (PLRs), technical advice memorandums (TAMs), General

Counsel Memorandums (GCMs), new law and proposed regulations under IRC 664 will

be highlighted. The Topic will also include a listing of Chapter 42 issues that may be

resolved by Key District determination letters.

Thirty Years After the 1969 TRA – Recent Developments Under Chapter 42

2. IRC 4940

Treatment of Distributions from an Employee Qualified Plan or IRA

In PLR 9341008, July 14, 1993, the Service was asked to rule that a private

foundation is not subject to the federal excise tax on investment income under IRC

4940(a) when the donor’s individual retirement accounts (IRAs) pass to the private

foundation. The donor had several IRAs whose designated beneficiary was a private

foundation expected to be exempt under IRC 501(c)(3). As part of this same ruling

request, the Service concluded that proceeds payable from the IRAs will be income in

respect of a decedent to the private foundation under IRC 691(a)(1)(B) when distributed

to the private foundation. As to the 4940 issue, the Service concluded that the private

foundation would not be subject to the federal excise tax on investment income under

IRC 4940 when the donor’s IRAs pass to the private foundation.

PLR 9633006, May 9, 1996, involved virtually the same set of facts as PLR

9341008, except that the properties of the donor passing to a private foundation were

proceeds of a Keogh plan rather than an IRA. On the 4940 issue, the Service reached the

opposite conclusion from the earlier ruling; the private foundation would be subject to tax

on investment income under IRC 4940(a) of the Code on the proceeds from the donor’s

Keogh account which are in excess of the contributions made to the account. The ruling

also held that the Keogh proceeds were income in respect of a decedent to the private

foundation under IRC 691(a)(1)(B), but the private foundation would not recognize tax

because it is exempt under IRC 501(c)(3), subject to UBTI modifications under IRC

512(b).

The Service is presently resolving the conflict between the holdings of these two

private letter rulings. The following supports a view that the position should reflect the

bottom line in PLR 9341008, holding that a distribution from a Qualified Employee Plan

do not constitute income for purposes of IRC 4940(a).

Even though a Qualified Employee Plan distribution typically includes interest,

dividends, capital gains and other earnings, the Service treats the entire distribution as

deferred compensation. The Qualified Employee Plan has received contributions from

employees in respect to personal services. The pension fund also generates investment

income on the employer contributions. However, once a distribution is made to an

employee, the distribution is entirely taxed as deferred compensation. Unlike other trusts,

a pension trust does not pass through the character of income to the recipient of trust

distributions. For example, an employee is taxed on a distribution from a pension plan

even though part consists of interest on tax-exempt municipal bonds. See Rev. Rul. 55­

61, 1955-1 C.B. 40. Also, employees are not entitled to the dividend received exclusion

where part of a pension distribution was attributed to dividends. All the rules applicable

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to pension distributions apply to the distributions as a whole without regard to the source

of payments. See Rev. Rul. 72-3, 1972-1 C.B. 105. Thus, a pension is viewed as a

substitute for earning power and the entire amount of the pension distribution constitutes

deferred compensation. This is its only character. The same considerations are

applicable to IRA distributions for purposes of IRC 4940(a). Finally, deferred

compensation is not listed as an item that is included in gross investment income under

IRC 4940(c) or Reg. 1.512(b)-1(a). Consequently, it is difficult to classify qualified

employee plan distributions including IRA distributions as gross investment income for

IRC 4940 purposes.

A new private letter ruling on this issue will be issued.

3. IRC 4941

A. Personal Services Exception and Foundation Managers Tax

In a recent case, John W. Madden, Jr. v. Commissioner, T.C. Memo 1997-395

(1997), the Court addressed both UBIT and self-dealing issues. This synopsis considers

only the self-dealing issues of that decision.

(1) Personal Services

The Petitioner is a founder of the Museum, an entity exempt under IRC 501(c)(3)

and classified as a private foundation. The Petitioner, his wife, and his daughter are each

foundation managers within the meaning of IRC 4946(b). The Museum displays

sculpture and other artwork, primarily outdoors. Most of the artwork is displayed along

public thoroughfares that run throughout a commercial office building complex. The

museum conducts tours of the artwork and also offers outdoor music concerts and

theatrical and dance performances.

The Museum relies on the building owners (including a company related to the

Petitioner) to provide space inside and outside the commercial complex to display the

sculptures and artwork. The Petitioner owns a 75 percent interest in Greenway

Management Co. (hereafter "GMC"), a service company providing custodial,

maintenance, and janitorial services. GMC performed services for some of the office

buildings in the complex and also contracted with the museum to perform comparable

services for the Museum.

The parties agreed that GMC is a disqualified person as to the museum. The

petitioner had agreed that payments made by the museum to repair artwork owned by the

petitioner constituted acts of self-dealing. The question at issue is whether the furnishing

of maintenance, janitorial, and security services by GMC is an act of self-dealing under

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IRC 4941(d)(1)(C). The Petitioner asserted that the services performed by GMC fall

within the exception of IRC 4941(d)(2)(E) for the performance of personal services.

In its holding, the Court focused on the definition of personal services. It cited the

examples of personal services found under Reg. 53.4941(d)-3(c)(2). The examples

include legal services, investment management services, and general banking services.

The Court found that the personal services in the regulations were of a professional and

managerial nature as distinguished from the services rendered by GMC. Further, the

Court found that Petitioner’s interpretation of personal services contravened

Congressional intent. In the Court’s terms ". . . any exceptions to the self-dealing

transactions rules should be construed narrowly."

The issue of the expanded definition of personal services for purposes of the

exception provided by IRC 4941(d)(2)(E) has been an issue under debate for several

years. The personal services exception was discussed at some length in the 1995 CPE

Text, Topic O, page 247, 269 to 274. The argument asserted by the Petitioner in the

Madden case, supra, had been asserted by other entities. The argument asserted in

Madden is that any service is a personal service where capital is not a major factor in the

production of income. The Court held that the Petitioner’s argument, if accepted, would

nullify the prohibition against furnishing services in IRC 4941(d)(1)(C). The Court

stated:

"The statute draws an explicit distinction between a ’charge’

for ’furnishing of goods, services, facilities’, see sec.

4941(d)(1)(C) and (2)(C), and the payment of ’compensation’

’for personal services’, see sec. 4941(d)(1)(D) and 2(E).

GMC’s argument equating a charge for services with

compensation for personal services significantly erodes this

distinction."

(2) Foundation Managers Tax- Nature of Knowing

The second self-dealing issue is whether Petitioner, his wife and his daughter are

liable under IRC 4941(a)(2) for the tax on foundation managers with respect to the selfdealing transaction with GMC. Under Reg. 53.4941(a)-1(b)(1), the tax is imposed when

the participating manager knows that the act is an act of self-dealing and the participation

is willful and not due to reasonable cause. Reg. 53.4941(a)-1(b)(3) provides guidelines

as to the foundation manager’s knowing participation in an act of self-dealing. Based on

the facts of the case, the Court concluded that the managers had actual knowledge of

sufficient facts concerning the transactions with GMC. The Court also found that they

acted willfully in not obtaining advice of counsel concerning the implications of the

arrangement with GMC. See also TAM 9627001, July 15, 1996, discussed in part 9.

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However, the tax under 4941(a)(2) was not imposed on certain other acts of selfdealing. Thus, this case provides several examples of when the tax under IRC 4941(a)(2)

may or may not be applied to foundation managers in a given situation.

B. Charitable Remainder Trusts- Income Deferral Issues Revisited

The 1997 EO CPE Text, "Charitable Remainder Trusts: The Income Deferral abuse

and Other Issues", Topic K, page 139, examined whether the income deferral technique

by charitable remainder unitrusts constitutes self-dealing in violation of IRC 4941.

Topic K describes how the net income and makeup provisions of IRC 664 may be

used not to gain flexibility in the normal management of the portfolio, but for a tax

deferral purpose not contemplated by Congress. To achieve a maximum deferral for a

noncharitable beneficiary, a trust’s assets must be manipulated in such a manner so that

the net income and makeup provisions can be used to avoid payout in the early years of

the trust and to realize income, including the makeup amount, only in later years when

the noncharitable income beneficiary may be in a lower tax bracket. This device is called

an income deferral NIMCRUT.

Topic K then continues to suggest that self-dealing may be asserted using the

authority of Reg. 53.4941(d)-2(f)(1) to counter the income deferral NIMCRUT technique

when the facts justify the position. The position suggested was that self-dealing occurs

only under a specific factual situation where the assets were being manipulated for a

specific personal purpose of the disqualified person and income beneficiary. The

manipulation required for the self-dealing act is intentional manipulation.

The income deferral technique under consideration in the article involved two types.

The first type is gain realized on the sale of an appreciated asset of the NIMCRUT at

some time during the term of the trust, presumably after enough time has passed to allow

the trust asset to have appreciated in value significantly prior to its sale. Another form of

income deferral discussed in the article was income earned by a partnership in which the

NIMCRUT holds a significant interest as partner. If the partnership deliberately fails to

distribute partnership earnings to the partners including the NIMCRUT, income could

have been deferred for years. One form of income deferral not discussed in that article

was deferred annuities.

As applied in an actual case in TAM 9825001, June 19, 1998, the Service position

evolved into consideration, to a significant extent, of whether the deferral of income of

the trust has an unreasonable detrimental effect on the charitable interest. The type of

deferred income under consideration in the TAM was a deferred annuity.

An extract of the facts of TAM 9825001 is helpful:

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X is a charitable remainder unitrust, which was intended to qualify under

section 664 of the Internal Revenue Code. X was created by A by a trust

instrument dated June 25, 1990. The trust instrument provides that the

Trustee shall pay to A, and upon A’s death, to A’s wife, a unitrust amount

equal to the lesser of (1) the trust income for the year or (2) eight percent of

the aggregate fair market value of the trust assets for the year. The Trust

instrument includes a make-up provision so that for any year that the

unitrust payment is less than eight percent, the shortfall for prior years may

be made-up in subsequent years when trust income exceeds eight percent.

B is the trustee of X and is also the nephew of A.

Upon the death of the survivor of A or A’s wife, the trust shall terminate

and the balance of trust assets are to be distributed to designated charities.

In December, 1991, X entered into a contract to purchase two deferred

annuity contracts from R, a commercial life insurance company. In one

policy A is named the annuitant and in the other policy A’s wife is named

the annuitant. In other respects the two policies are identical. X is the

owner of the policy and is beneficiary of the policies should either

annuitant fail to reach the maturity date of the policies which is age 80. As

a result of the endorsement of the two policies in 1997, the Trust, X,

became the annuitant. Additional information relating to the policies is

discussed hereafter in greater detail.

Before addressing the income deferral issue raised by the annuity, the Service

addressed another self-dealing issue. In purchasing the annuities, the substantial

contributor A and his wife were named annuitants. The private ruling explains that there

is a real potential for self-dealing in that if the donor and his wife reach age 80, the

contract will be annuitized and A his wife could receive all payments under the contract

leaving nothing to charity. This is the worst case of self-dealing in that the disqualified

persons regain all amounts in the trust and leave nothing to charity. However, TAM

9825001 explains that the annuity contracts are contingent and can be defeated by several

factors including failure of A and his wife to survive to age 80 and by actions of the

trustee of X including a partial withdrawal or surrender of the policy.

TAM 9825001 then goes on to consider the income deferral issue as self-dealing

based on the following extract of additional facts:

At the time X was created by A, it was funded with 86 shares of stock of V,

a business previously owned and managed by A. On March 7, 1997, A

transferred an additional 7 shares of V to X. Consequently, X held 93 of 94

outstanding shares of V.

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In the Summer of 1991, A became aware of a third party’s offer to purchase

V. In September or October of 1991, the trustee of X became aware of the

proposal for the purchase of V, which included payment to A for a five year

period pursuant to an employment agreement and noncompetition

agreement. Since A’s income would be provided for a five year period

without the need for income from X, A and the trustee had discussions with

T, a tax planning consultant, about the possibility of investing X’s assets in

deferred annuities. Based on T’s recommendations, the trustee believed

investing in deferred annuities was a solid choice in light of other

investment alternatives available and the flexibility it offered the trustee to

defer trust income until A’s employment agreement and noncompetition

payments ceased.

Consequently, in December 1991, X entered into a contract to purchase two

deferred annuity policies from R, a commercial life insurance company.

On January 15, 1992, the following three events occurred more or less

contemporaneously: (1) substantially all the assets of V were sold to an

unrelated purchaser for m; (2) X’s stock holdings in V were redeemed for

n, which X deposited into its account; and (3) X wrote two identical checks

for o for each of the annuities purchased. The representatives for the Trust

made the following representations: (1) C, an attorney who is trusted by A

and B, served as the sole trustee of X from the time after the stock was

contributed to X until before the sale of such stock to the unrelated

purchaser; and (2) soon after the annuity contracts were acquired by X, C

resigned as trustee and B again became the trustee. In fact, C signed as

trustee on the contract to purchase the two deferred annuity policies.

The income deferral issue was posed as follows:

We have examined the transaction with the intention of ascertaining

whether B, acting in concert with A on an ongoing basis, manipulated the

assets of X for the personal benefit of A, by furthering his income,

retirement and tax planning goals. There was a concern that the entire

transaction taken as a whole; the purchase of a deferred annuity, the failure

to make withdrawals from the annuity policies, and the intention to

subsequently make unitrust payments to A under the "make-up" provision

of the Trust; could be construed as an act of self-dealing under section

4941(d)(1)(E) of the Code by virtue of the authority provided by section

53.4941(d)-2(f)(1) of the Regulations.

The Service ultimately concluded in the TAM that the transaction did not constitute

self-dealing for two reasons. First, IRC 4947(a)(2) charitable remainder trusts are

different from regular IRC 501(c)(3) private foundations because a disqualified person

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and income beneficiary of the trust is entitled to receive income from the trust as

provided in the trust instrument. IRC 4947(a)(2)(A) specifically excludes from selfdealing such amounts. Second, the Service did not find that the facts clearly indicated

that the disqualified person and trustee were acting in concert to manipulate the assets for

the benefit of the disqualified person.

As to the first issue, the Service stated in the TAM that "rather than focusing on

whether the income is a use of trust assets, the relevant question is whether deferral of

income is a permitted use." Further, "the presence of an unreasonable effect on the

charitable remainder interest distinguishes a permissible use of trust assets from an

impermissible use."

Thus the negative inference of the ruling is that in some rare situations, the Service

may, perhaps, be willing to find self-dealing. However, to find self-dealing of this sort,

three tests must be satisfied.

The first two tests relate to the "manipulation" requirement based in Reg. 53.4941(d)2(f)(1). (1) For the requisite "manipulation" to occur, the disqualified person and income

beneficiary must control the decision of the trustee as to investment decision. Thus, such

person must be serving as trustee or the facts of the case must establish that such person

is acting in concert with the trustee as to these investment decisions. This is not an easy

burden of proof to carry, as is demonstrated by the facts of the TAM. (2) The second

element of manipulation is that the manipulation of the assets and investments is to serve

the personal advantage and benefit of the income beneficiary beyond merely the receipt

of the income provided by the trust instrument. There must be specific evidence of

manipulation to benefit the income beneficiary in this manner. Again, not an easy burden

of proof to carry.

Finally, (3) the third test is determining whether the deferral is a permitted use,

meaning the lack of a presence of an unreasonable effect on the charitable remainder

interest. As a practical matter, one might speculate that it will be quite a rare situation

where an income deferral NIMCRUT would disadvantage a charity to the extent that it

could be said that there is an unreasonable effect on the charitable remainder interest.

The unreasonable affect on the charitable remainder interest would include an evaluation

of the income realized by the charitable interest as well as the appreciation in value of the

charitable assets over the term of the NIMCRUT. Since the Service does not second

guess the investment decisions of the trustee in this regard, the "unreasonable effect"

means something more than just bad investment judgment.

In the TAM, the Service has, in theory, left open the door to apply the self-dealing

prohibition for the income deferral NIMCRUT in a truly egregious situation. As a

practical matter, the vast majority of income deferral NIMCRUTs adhering to ordinary

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fiduciary standards under state law will not run afoul of this problem. The more realistic

view is that the theory aired in 1997 EO CPE Text as modified, when applied to an actual

case, will rarely be applied. As such, much of the discussion in the 1997 Text suggesting

an aggressive approach on IRC 4941 issues with NIMCRUTS is modified pursuant to

TAM 9825001 and this article.

As discussed below, the Service is still considering whether the partnership or

annuity income deferral technique causes the trust to fail to function exclusively as an

IRC 664 trust.

C. Extension of Credit Prohibition and the Estate Administration Exception

The Service issued PLR 9814050, April 3, 1998, relating to the exception from selfdealing found in Reg. 53.4941(d)-1(b)(3).

The facts of PLR 9814050 provide as follows: A and B are married and have

executed a Living Trust to dispose of their property. The Living Trust provides that upon

the death of the first taxpayer, two separate trusts will be established. The survivor’s trust

will consist of the surviving taxpayer’s property after the death. The second trust is a

marital trust qualifying for the marital deduction under IRC 2056(b)(7). After the death

of the survivor, the marital trust property will pass to a private foundation, called "D",

established by the two taxpayers, A and B. The residue of the estate of the second to die

also passes to D.

The taxpayers, their 3 children, and certain partnerships are disqualified persons as to

D. The main property held by A and B is various partnership interests. To facilitate the

sale of the partnership interests after their deaths, the taxpayers have entered into two

option agreements. The first such agreement deals with the right of the surviving partners

in partnership F to purchase the partnership interest of any deceased partner. A and B’s

children are the remaining partners. The second agreement gives A and B’s children an

option to purchase most of the remaining partnership interests. This option relates to

partnership E.

It is proposed that on the first to die of A and B, the F partners (excluding the

surviving spouse) will purchase the partnership interest with 5 percent cash and the

remainder in an interest bearing promissory note. The notes will be held by the marital

trust for the surviving spouse. The other partnership interests of the first to die will

become assets of the marital trust. On the death of the second to die, the option to

purchase the remaining partnerships, through E, will occur both with respect to the

survivors own trust and with respect to the marital trust. It is represented that both option

purchases will occur in such a way as to qualify for the exclusion from self-dealing

provided by Reg. 53.4941(d)-1(b)(3)(v). This is an important exception. Without the

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existence of an option, specifically allowing for a promissory note, binding on an estate

or trust, an extension of credit relationship would result in acts of self-dealing.

One might question how the option purchase from the martial trust qualifies for the

exclusion from self-dealing since the marital trust is not, on the death of the second to

die, an estate or revocable trust.

Background information on PLR 9814050 suggests that the Service based its ruling

on a representation that on the second death, the jurisdiction of the local court will be

invoked and that the purchase will be submitted for court approval. Such procedure

includes the purchase from the QTIP (qualified terminable interest property) trust. On

this issue, the Service ruled that the exercise of the option under the purchase agreement

to purchase the partnership interests on the death of the second of the taxpayers to die

will not constitute an act of direct or indirect self-dealing pursuant to IRC 4941, because

it comes within the exception provided by Regs. 53.4941(d)-1(b)(3)(v).

A similar result was reached in PLR 9752071, October 1, 1997, also involving a

QTIP trust and application of the exception provided by Reg. 53.4941(d)-1(b)(3). This

PLR also held that the exception would apply at the termination of the surviving spouse’s

QTIP trust. PLR 9724018, March 17, 1997, involving a non QTIP marital deduction

trust, reaches the same result. See also PLR 9112012, December 24, 1990.

D. Foundation Manager and Self-dealing - The Sale of Financial Products Between

Related Corporations

Consider the following hypothetical situation. A financial company called "Parent"

directly or through its agents sells to its clients and customers a financial product

involving charitable remainder unitrusts funded with Parent’s life insurance or its other

financial products . The transaction is structured so that the Parent's wholly owned

subsidiary (T1) is appointed to serve as trustee of the CRUT. The funds transferred to the

CRUT by the trust creator is used by the trustee, T1, to purchase the Parent financial

product previously agreed to by the Parent or its agent and the customer. The customer is

advised of the corporate relationship between the Parent and T1 and the fact that the

trustee may purchase the Parent financial products to fund the trust. Does the purchase of

the Parent's financial products constitute a self-dealing transaction under IRC 4941?

If T1 purchased its own financial product or that of its wholly owned subsidiary, T1

would have participated in an act of self-dealing under IRC 4941(d)(1)(A) or (E). T1, as

trustee, is a disqualified person under IRC 4946(a)(1)(B). Purchasing its own product

would fall under a self-dealing transaction described in IRC 4941(d)(1)(A). T1's wholly

owned subsidiary is a disqualified person by virtue of IRC 4946(a)(1)(E). Thus, the

purchase of the subsidiary's financial product is an act of self-dealing under IRC

4941(d)(1)(A).

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However, it is asserted that Parent is not a disqualified person to T1 even though

Parent holds 100 percent of the stock of T1, and, thus has voting control of T1. It is

asserted that there is no so-called "upstream" attribution in this situation. There is no

authority for finding Parent is a disqualified person merely by virtue of its ownership

interest in T1. For example, 4946(a)(1) or (3) would not provide the kind of attribution

for treating Parent, in this hypothetical as a disqualified person.

Notwithstanding this assertion, there is an argument or arguments to be made that

T1’s purchase of Parent’s financial product is an act of self-dealing. In GCM 39107, the

Service applied self-dealing to a situation where a foundation manager utilizes the assets

of private foundations which it manages for its own business advantage. The Foundation

Manager in the GCM is a large bank. The bank negotiates with various borrowers large

loans in the form of master notes. The borrowers are often existing bank customers but

some borrowers may not be current bank customers. The private foundations for which

the bank is trustee provides the assets for funding the Master Notes, and, hence the loans

to borrowers. No fees are charged in this transaction. The Master Notes represent

reasonable investment opportunities for the foundations.

The GCM concluded that the exception for incidental and tenuous benefits under

Reg. 53.4941(d)-2(f)(2) was not applicable. For the bank, the providing of loan

arrangements is an essential and substantial activity of the bank. This activity may not be

considered incidental and tenuous. Further, the GCM concluded that the general banking

exception found in Reg. 53.4941(d)-2(c)(4) is not applicable. The kind of major

investment represented by the Master Notes is not the ordinary banking activity coming

under the banking exception. As a result the GCM concluded that self-dealing occurred

under IRC 4941(d)(1)(E).

The Service reached a similar conclusion in GCM 39632. The goodwill generated by

the foundation manager by use of the private foundation’s assets constituted self-dealing

under IRC 4941(d)(1)(E).

If one views Parent as a customer of T1, the investment of the CRUT assets in the

financial product of the Parent is enhancing the reputation and business standing of T1

with its customer. However, more than generating goodwill with a substantial and

longstanding client, T1 directly receives a business benefit in that the referral of the

CRUT to T1 to serve as trustee is in fact the heart of the business activity conducted by

T1. There is a quid pro quo in this hypothetical. T1 gets the trustee business and it then

invests in the financial products of the Parent.

The counter argument is that in today’s marketplace with an expanded and integrated

role for banks, trust companies, and financial institutions, the investment of the assets of a

CRUT or private foundation with an institution with which the trustee has business

relations as a customer may be unavoidable.

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There is a second argument to find self-dealing. Section 4946(a)(1)(B) defines

foundation manager as a disqualified person. Section 4946(b) of the Code further defines

the term "foundation manager" as an officer, director, or trustee of a foundation (or an

individual having powers or responsibilities similar to those of officers, directors, or

trustees of the foundation). Emphasis added.

In the transactions described above, Parent may be treated as a foundation manager

because it has assumed powers or responsibilities similar to a trustee of the CRUTs. The

entire transaction is prearranged by Parent or Parent’s agents, the insurance salesman.

The customer is sold an insurance product up front with the understanding from the

beginning that the trust will purchase the insurance product of Parent, and at the same

time Parent’s subsidiary, T1, will serve as trustee of the CRUT. The customer is

purchasing Parent’s insurance product rather than negotiating the terms of the trust

document. It is Parent’s agent who has sold the customer on the need for the insurance

product. The trust document is on a prescribed company form in which blanks are filled

in with respect to pertinent information relating to grantor, trust recipient, and trust

payment amount. Parent receives a profit from the sale of the insurance product and

Parent’s agent receives a fee from the commission on the sale of the insurance product.

Since it is Parent or Parent’s agent that arranges with the customer the asset to be

acquired by the trust, the actions of Parent’s agents preempt the actions of the trustee in

the determination of the investment of trust assets. In preempting the trustee in this

regard, Parent’s agent assumes the role of the trustee with respect to this very important

trustee function.

In addition to the factors described in the preceding two paragraphs, Parent is in

control of T1 in that T1 is a wholly owned subsidiary of Parent.

The counter to this argument is that Parent and T1 are truly separate corporations

with separate histories and operations. The facts do not support the conclusion that

Parent is, in substance, acting as trustee.

Just prior to publication of this topic, the EO Division and the EBEO office of Chief

Counsel reached a tentative consensus that under the facts described above, involving a

long term and significant business relationship, the actions of Parent and T1 would

constitute acts of self-dealing under IRC 4941(d)(1)(A) and 4941(d)(1)(E). In any case,

the issue discussed in this part may be a harbinger of many new issues involving a

changing financial world where financial institutions of all varieties are merging.

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4. IRC 4943, 4946, and 4941 – Nonvoting Stock Scenarios

A. Attribution of Stock Holdings and a Twist of Self-Dealing-PLR 9752074

In PLR 9752074, October 3, 1997, the Service addressed the problem of stock of a

corporation held by a private foundation, which constituted an excess business holding

within the meaning of IRC 4943. The facts disclose the following:

a. The HMO was exempt under IRC 501(c)(4). To facilitate a conversion to for

profit status, "B" was formed to serve as the parent company of HMO.

b. In year 1, HMO employees purchased B's voting stock for nominal

amounts from B. Later the employees transferred the voting stock to a

five-year voting trust. The voting trust was subsequently amended to

require that the trust expire in five years, in year 7.

c. In year 2, HMO contributed $x to a recently formed private foundation

("Foundation"). In year 4, HMO contributed $30x to Foundation.

d. In year 3, HMO's state of incorporation approved the conversion of HMO

to a for profit corporation.

i. As a condition to the conversion, the State required HMO to transfer

to the Foundation $6000x and B nonvoting stock. The Foundation

paid a minimal amount for the B nonvoting common stock.

ii. The $6000x consisted of $1500x cash plus two notes equaling $4500x

issued by HMO. (An extension of credit discussed in item 2, below).

e. After the conversion, the voting trust owned all of B's voting stock and the

Foundation owned all of B's nonvoting stock.

f. In year 5, HMO merged with "C", a publicly held company. As a result

of the merger, the voting trust held 26.2 percent of C's class A voting

common stock. The Foundation held C's class B nonvoting common

stock. Only C's class A stock was publicly traded.

g. For various bona fide reasons, the Foundation would not be able to

dispose of its "B" or "C" stock during the initial five year grace period

provided by IRC 4943(c)(6).

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(1) IRC 4943- Attribution of Holdings; Voting Trust Termination

PLR 9752074 stated that assuming, but without so ruling, that A (HMO) and C were

disqualified persons, the nonvoting shares held by the Foundation would have been

treated as excess business holdings under IRC 4943(c)(2)(A). The private ruling did not

explicitly explain that the voting trust is a disqualified person under IRC 4946(a)(1)(C)(i)

by virtue of attribution rules provided by section IRC 4946(a)(3) and IRC 267(c). Since

the voting trust holds all the stock of B and B holds all the stock of HMO, which the

ruling assumes is a disqualified person, the attribution rules treat the voting trust, the

shareholder of B, as a disqualified person as to the Foundation. It is "assumed" that

HMO and B are substantial contributors to the Foundation. For purposes of IRC 4941,

the only IRC 501(c) organizations excepted from the category of "disqualified persons"

are IRC 501(c)(3) organizations. Reg. 53.4946-1(a)(8).

The private ruling goes on to explain that under IRC 4943(c)(6)(A), the Foundation

would be treated as having acquired the nonvoting shares other than by purchase and the

nonvoting shares would be treated as held by a disqualified person for the five year

period. Of course, this simply means that the five year grace period provided by

4943(c)(6)(A) is applicable.

Finally, the ruling explains that when the voting trust expires at the end of the five

year period, the voting control of the stock held by the trust reverts to each of the

individual shareholder beneficiaries. None of these individuals owned, either directly or

indirectly, or together, 20 percent or more of the voting stock of C. Accordingly,

following IRC 4943(c)(2)(A), Foundation’s holding of the C nonvoting stock would

constitute a permitted holding.

(2) IRC 4941 – Extension of Credit

An interesting aspect of this ruling is the PLR's disclaimer paragraph:

These rulings do not address whether A's (HMO's) transfer of the two

promissory notes resulted in continuing acts of self-dealing under IRC

4941(d)(1)(B).

Under IRC 4941(d)(1)(B) the lending of money or other extension of credit is an act

of self-dealing. In PLR 9752074, one may not raise the "first bite" exception in Reg.

53.4941(d)-1(a) because the status of HMO as a disqualified person arose prior to the

transaction in which HMO extended credit to the Foundation. HMO made a substantial

cash gift to the Foundation in year 2.

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It may be argued that Reg. 53.4941(d)-2(c)(3) would apply to except the promissory

notes transaction from self-dealing. This self-dealing exception is contingent, however,

"to the extent motivated by charitable intent and unsupported by consideration." The

Service first had a concern whether HMO and B would be substantial contributors by

virtue of the requirement of the state to transfer the sum of $6000x (consisting in part of

the note of HMO) and the non-voting stock of B to the Foundation since the transfer was

a condition of the state for HMO going public. The Service’s concern was whether the

transfer could be considered a gift or contribution for purposes of IRC 507(d)(2). If the

stock, cash, and note is treated as if received for valuable consideration and not as a

gratuitous transfer, then HMO and B would not be treated as substantial contributors, and

thus not as disqualified persons (but for the earlier year 2 transfer of $x).

This same consideration applies to the self-dealing issue and Reg. 53.5941(d)2(c)(3). May it be said that the transfer is motivated by charitable intent and unsupported

by consideration? The argument could be made that HMO received valuable

consideration, not from the Foundation but from the State. HMO was seeking approval to

operate as a for profit entity. As a condition to this approval, the State required HMO to

make the transfers described. On the other hand, Reg. 53.4941(d)-2(c)(1) provides that

an act of self-dealing occurs where a note, the obligor of which is a disqualified person, is

transferred by a third party to a private foundation which becomes the creditor under the

note. In effect, is not the State the third party in PLR 9752074 which is constructively

transferring the note to the foundation? In the private ruling, the Service did not rule on

this issue since no ruling was requested. However, the appropriate Key District Office

was provided a copy of the PLR.

B. Nonvoting Stock - Permissible Holdings – PLR 9551034

In PLR 9551034, September 28, 1995, the settlors created two trusts. One trust is

created as a charitable trust which is a non-exempt trust under IRC 4947(a)(1). The other

trust, designated as "Z", is a revocable trust which becomes irrevocable on the death of

the last to die of the settlors. Z is a noncharitable trust which will pay all of its income to

the charitable trust annually after Z becomes irrevocable. The settlors owned all the stock

of two corporations, X and Y. The stock of each will be recapitalized in voting and

nonvoting stock. Nine shares of nonvoting stock will be issued for each share of voting

stock outstanding. Upon the death of the last to die of the settlors, all nonvoting stock

will be transferred to the charitable trust and all shares of voting stock will be transferred

to Z. The Trustees of Z will not be disqualified persons in respect to the charitable trust.

At this point, Z will own the voting stock. There will be no charitable, estate, or gift tax

deductions taken. These transfers are to avoid the fragmentation of management.

Under 4947(a)(1) a nonexempt charitable trust shall be treated, in effect, as if it were

a private foundation, subject to the various provisions of chapter 42.

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PLR 9551034 held that the nonvoting stock to be held by the IRC 4947(a)(1) trust

would not constitute excess business holdings since the trust would not hold 20 percent of

the voting stock.

The PLR did not focus on, or even cite, the last sentence of IRC 4943(c)(2)(A) which

provides:

In any case in which all disqualified persons do not own more than 20

percent of the voting stock of an incorporated business enterprise,

nonvoting stock held by the private foundation shall also be treated as

permitted holdings.

The PLR did not consider the possibility of the status of Z as a disqualified person by

virtue of it becoming a substantial contributor after paying its income to the IRC

4947(a)(1) trust. See also Reg. 1.507-6(c)(1). The bottom line in the PLR may still be

correct if Z never becomes a disqualified person. In any case, the Service is presently

reviewing this issue.

5. IRC 4945

A. Expenditure Responsibility and Partial Transfers Under IRC 507(b)(2)

Under IRC 507(b)(2), in the case of a transfer of assets of any private foundation to

another private foundation pursuant to any liquidation, merger, redemption,

recapitalization, or other adjustment, organization or reorganization, the transferee

foundation shall not be treated as a newly created organization. Thus, generally, the IRC

507(b)(2) transfer is not a termination or relinquishment of private foundation status.

Further, the transferee private foundation succeeds to the aggregate tax benefit of the

transferor private foundation under Reg. 1.507-3(a)(2).

There is some debate, particularly because of conflicting PLRs, however, as to

whether the transferor private foundation in a IRC 507(b)(2) transfer involving a transfer

of less than 100 percent of its assets must exercise expenditure responsibility over the

assets transferred to the transferee foundation.

See for example, PLR 9747027, August 22, 1997, which holds that a transfer of 50

percent of a private foundation’s assets to newly formed private foundation would not

require IRC 4945 expenditure responsibility. In contrast, PLR 9802037, October 14,

1997, holds the opposite. See also the 1989 EO CPE, Topic J, page 124.

Reg. 1.507-3(c)(1) provides that for purposes of IRC 507(b)(2), the terms "other

adjustment, organization, or reorganization shall include any partial liquidation or any

other significant disposition of assets to one or more private foundations. . ."

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For purposes of IRC 507(b)(2), the cut off for a partial transfer is 25 percent of the

private foundation’s net assets. Reg. 1.507-3(c)(2) provides that the term significant

disposition of assets to one or more private foundations includes any disposition for a

taxable year where the aggregate of the dispositions to one or more private foundations

for the taxable year is 25 percent or more of the fair market value of the net assets of the

distributing foundation at the beginning of the taxable year.

However, and generally, Reg. 1.507-3(a)(7) provides that IRC 4945 expenditure

responsibility be exercised. To interpret the provision otherwise would weaken the

4945(d)(4) and (h) rules requiring expenditure responsibility over grants or "transfers"

made by one private foundation to another. Example (2) of Reg. 1.507-3(a)(9)(iii)

describes a situation where all the assets of the transferor foundation are being

transferred to three successor foundations and holds that no expenditure responsibility

need be exercised.

PLR 9401032, Jan. 17, 1994, revoked the holding in PLR 9208021 which relieved

the transferor foundation of expenditure responsibility when it transferred 50 percent of

its assets to a newly created exempt private foundation. With the publication of its

revised IRC 4945 Private Foundation Handbook chapter, the Service believes this issue

will be resolved. Chapter 17.5(3) provides:

Partial transfers of assets from one private foundation to another pursuant to

IRC 507(b)(2) requires that the transferor foundation exercise expenditure

responsibility.

6. IRC 664 Legislation - Charitable Remainder Trusts

Charitable Remainder Trusts described in IRC 664 have interest to the EO

community by virtue of the provisions of IRC 4947(a)(2). Generally, under IRC

4947(a)(2), split interest trusts, in certain respects, are treated as private foundations and

are subject to IRC 4941 and IRC 4945 and, in some situations, certain other provisions of

Chapter 42. For a more detailed description of charitable remainder trusts and IRC

4947(a)(2), see the 1996 EO CPE Text, Topic G, page 159.

Section 1089 of the Taxpayer Relief Act of 1997 (the "Tax Act") amended IRC 664

of the Code in a way that has a bearing on the application of IRC 4941 to split interest

trusts. The Tax Act amended IRC 664(d)(1)(A) and (2)(A) to add the language "nor more

than 50 percent" to describe the permissible income payout to a noncharitable income

recipient annually. IRC 664(d)(1) and (2) were amended to add new paragraph (D)

providing generally that the value of the remainder interest (in such charitable remainder

trust) is at least 10 percent of the net fair market value of property placed in (or

contributed to) the trust.

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The language of the Tax Act limiting the charitable trust income payout to no more

than 50 percent has direct bearing on the problem of accelerated charitable remainder

trusts described in the 1996 EO CPE Text, Topic G.

Congress, in the 1997 Tax Act, attempted a legislative solution to the problem

defined in Notice 94-78 with the amendment of the payout requirement to a maximum of

50 percent annually. The Congressional purpose was described in the General

Explanation of Tax Legislation Enacted in 1997, the Joint Committee on Taxation,

December 17, 1997. The General Explanation states as follows:

The Congress was concerned that the interplay of the rules governing the

timing of income from distributions from charitable remainder trusts (i.e.

Treas. Reg. 1.664-1(d)(4) and the rules governing the character of

distributions (i.e., sec. 664(b)) created the opportunities for abuse where the

required annual payouts are a large portion of the trust and realization of

income and gain can be postponed until a year later than the accrual of such

large payments.

The General Explanation continues with an explanation of the mechanics of the

provision. Under the Tax Act, any charitable remainder trust failing this 50 percent rule

will not be a charitable remainder trust whose taxation is governed by IRC 664, but will

be treated as a complex trust and, accordingly, all its income will be taxed to its

beneficiaries or to the trust.

The General Explanation also addresses the new provision requiring a minimum 10

percent value for the charitable remainder interest.

Congress was concerned that certain charitable remainder trusts had been

created primarily to obtain the tax benefit of the trust’s exemption from

income tax under section 664(c) and not to provide for charity. The

Congress was aware that many charitable remainder trusts have been

created where the actuarial value of the charitable remainder interest at the

time of creation is insignificant.

Additional rules provide relief to charitable remainder trusts that do not meet the 10

percent test. The rules provide for the reformation of the terms of the trust in some cases

or for the application to a court to declare that a trust is void ab initio. It is unclear if any

of these rules have implications with respect to self-dealing, but such prospect appears

unlikely.

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7. Proposed IRC 664 Regulations - Charitable Remainder Trusts

On April 17, 1997, the Service released proposed amendments to the Regulations

under IRC 664 and related provisions. It is expected that the proposed regulations will

become final in 1998. The most significant of the regulations for purposes of Chapter 42

are discussed below.

A. "Flip" Unitrusts

The proposed regulations explain the purpose for allowing the so-called "flip"

unitrusts as follows:

The governing instrument of a CRUT must specify the method of

computing the uniturst payments. Section 664(d)(3) provides that the

income exception methods (either the net income method or the NIMCRUT

method) may be used to pay the unitrust amount "for any year." The

legislative history, however, provides that the method used to determine the

unitrust amount may not be discretionary with the trustee. [citation

omitted]

Some donors may fund a CRUT with unmarketable assets that produce little

or no income. These donors often want the income beneficiary or

beneficiaries of the CRUT to receive a steady stream of payments based on

the total return available from the value of the assets. The donors

recognize, however, that the CRUT cannot make these payments until it can

convert the unmarketable assets into liquid assets that can be used to pay

the fixed percentage amount. These donors establish CRUTs that use one

of the income exception methods to calculate the unitrust amount until the

unmarketable assets are sold. Following the sale, the donors may prefer

that the CRUT use the fixed percentage method to calculate the unitrust

amount. A trust using such a combination of methods would be a "flip

unitrust."

The proposed regulations permit the donor to establish a "flip unitrust" provided

certain specific requirements are met. These conditions are roughly summarized as

follows:

1. At least 90 percent of the fair market value of the assets held in the trust

immediately after the initial contribution or any subsequent contribution

(prior to the switch in methods) must consist of unmarketable assets

(within the meaning of IRC 731(c)).

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2. The governing instrument must provide that the CRUT use an income

exception method until the earlier of (a) the sale of specified

unmarketable assets or group of unmarketable assets contributed at the

time the trust was created or (b) the sale of unmarketable assets such

that immediately following the sale, any remaining unmarketable assets

total 50 percent or less of the fair market value of the trust’s assets.

3. The CRUT must switch exclusively to the fixed percentage method for

calculating all remaining unitrust payments payable to any income

beneficiary at the beginning of the first taxable year following the year

in which the earlier of the above events occurs.

4. Any makeup amount described in IRC 664(d)(3)(B) is forfeited when

the trust switches to the fixed percentage method.

The issue of concern for Chapter 42 purposes has, in prior years involved the flip

trust where the income beneficiary and disqualified person have applied to the court for

reformation of the trust document (or have unilaterally "reformed" the trust document). A

court ordered reformation improves the income position of the income beneficiary where

the trust document is amended to provide for a fixed payment payout under IRC

664(d)(2)(A) in place of the lesser of trust income or fixed payment payout provided

under IRC 664(d)(3)(A) originally provided in the trust document.

By allowing the change of the terms of the trust, it is arguable that the reformation of

the trust (and the subsequent higher fixed payment amount) is an act of self-dealing under

IRC 4941. For example, a NIMCRUT that is invested in low yield assets falling short of

the fixed percentage payment, when amended to allow exclusively the higher fixed

payment percentage (rather than the lesser of trust accounting income or fixed percentage

payment) may necessitate the use of trust principal to supplement trust income to meet

the fixed payment payout. Thus, arguably, by allowing the reformation to provide for the

fixed payment payout, less assets would then be left to charity.

It is clear that the self-dealing prohibition does not apply to the proper income payout

to the noncharitable income beneficiary. See Reg. 53.4947-1(c)(2). It is also true that the

action of the disqualified person to receive more than the amount provided as the proper

unitrust amount (the income payout) is an act of self-dealing. See IRM 7752:(18)73(2).

Thus, if a donor, trustee, or beneficiary controlling the NIMCRUT arbitrarily distributes

income in excess of the unitrust amount or acts in concert with others to change the terms

of the trust to provide for a higher unitrust amount, such person or persons may be

engaging in an act of self-dealing. By the same token, the unauthorized payment of a

fixed percentage amount when the trust is operating under income exception method

which would require the income distribution of the lesser trust accounting income, may

similarly constitute an act of self-dealing.

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An income exception CRUT containing a "flip" unitrust provision in the trust

document complying with the requirements of the proposed IRC 664 regulations, as

finalized, that converts to a fixed percentage method pursuant to the terms of that trust

document will not be engaging in an act of self-dealing. The provision of the proposed

regulations relating to flip trusts eliminates this self-dealing problem because the terms of

the noncharitable income interest are established up front in the trust document and the

conversion to fixed percentage method occurs automatically on the events described in

the proposed regulations. The proposed regulations limit the discretion of the trustee to

change the payment method other than by the sale of trust assets for which the trustee has

a fiduciary duty as to all parties. In applying the self-dealing prohibition, the Service

does not normally question the investment decisions of the trustee or foundation manager.

See discussion in 3.B. above.

A conversion of an income exception CRUT to a fixed percentage method for a trust

that does not have a trust provision meeting the requirements of the proposed regulations

as finalized will not be insulated from the assertion that such conversion is an act of selfdealing.

The amendments allowing a flip trust apply to CRUTS created after the final

regulations are published. The Transition Rules to the proposed regulations allow a

NIMCRUT created before such effective date which has a flip provision already existing

in the trust document to amend or reform its trust document to comply with the final

regulations. In response to comments on the proposed IRC 664 regulations, Chief

Counsel is also considering allowing other existing NIMCRUTs to amend the trust

document to add a flip provision on the theory that such trusts should not be

disadvantaged with respect to existing trusts containing some form of flip provision in the

trust document.

B. Time for Paying Annuity or Unitrust Amount

The proposed regulations would amend existing IRC 664 regulations to provide that

the payment of the annuity and unitrust amount determined under the fixed percentage

method must be made before the close of the taxable year in which it is due. For CRUTS

using an income exception method, the proposed regulations continue to provide that if

the CRUT pays the unitrust amount within a reasonable time after the close of the trust’s

taxable year, the trust is not deemed to have engaged in an act of self-dealing, to have

unrelated debt-financed income, to have received an additional contribution, or to have

failed to function exclusively as a charitable remainder trust.

The intent of these proposed regulations is to address the problem of accelerated

charitable remainder trusts described in Notice 94-78, which was discussed in the

preceding material of this article under part 6. The tax scheme described in Notice 94-78

is effective only for CRATs and CRUTs using the fixed percentage method. Thus, since

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CRUTS utilizing the income exception method are not used as a vehicle to further such

scheme, the proposed regulations allow NIMCRUTS to continue to pay the unitrust

amount after the year end.

For 1997, Notice 97-68, 1997-48 I.R.B. 11, modifies these requirements for certain

trusts. The modifications permitted under Notice 97-68 address only those trusts that are

not deemed as abusive accelerated charitable remainder trusts within the meaning of

Notice 94-78.

Thus, the problem associated with accelerated charitable remainder trusts is

addressed both by the legislation described above under part 6 of this article and by the

proposed regulations.

C. Appraising Unmarketable Assets

The legislative history for the charitable remainder trust rules indicates that an

independent trustee should value a trust’s unmarketable assets. The proposed regulations

address the issue by providing that if a charitable remainder trust holds unmarketable

assets and the trustee is the grantor of the charitable remainder trust, a noncharitable

beneficiary, or a related or subordinate party to the grantor or the noncharitable

beneficiary with the meaning of IRC 672(c), the trustee must use a qualified appraisal, as

defined in Reg. 1.170A-13(c)(3), from a qualified appraiser, as defined in Reg. 1.170A13(c)(5), to value the such assets. Others not in the relationship prescribed in the

preceding sentence need not use a qualified appraisal.

D. Application of Section 2702 to Certain Charitable Remainder Unitrusts

The proposed regulations amend estate and gift tax regulations under IRC 2702 to

address a perceived abuse due to the fact that charitable remainder trusts were previously

excluded from coverage by IRC 2702 regulations. The proposed regulations are intended

to prevent the shifting of a beneficial interest in a charitable remainder trust from one

noncharitable beneficiary to another noncharitable beneficiary who is a family member.

E. Prohibition of Allocating Precontribution Gain to Trust Income.

For the income exception unitrust, the proposed regulations require that the proceeds

from the sale of trust assets must be allocated to such trust’s principal and not its income,

at least to the extent of the fair market value of the asset when contributed to the trust.

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F. Request for Comments on Income Exception CRUTs Holding Certain

Investments

Part 3.B. of this article, set forth above, describes the problem of income deferral

associated with the NIMCRUT. That discussion addresses whether the income deferral

attribute may be addressed under a self-dealing theory under IRC 4941. The same

income deferral problem is also addressed in the proposed regulations in the context of

IRC 664. That is, "whether investing the assets of an income exception CRUT to take

advantage of the timing difference between the receipt of trust income and income for

federal tax purposes causes the trust to fail to function exclusively as a charitable

remainder trust."

The proposed regulations indicate that this is currently a matter of study by IRS and

Treasury, and comments are requested on drafting future guidance on this issue. Thus,

the proposed regulations do not contain concrete proposals to amend the IRC 664

regulations. Further, the proposed regulations may be taking a somewhat narrower scope

in dealing with the type of income deferral techniques under study. The study is limited

to income deferral by virtue of receipt of trust income from a partnership or a deferred

annuity contract. In contrast, one of the examples of income deferral in the self-dealing

context, discussed above under Part 3.B., involved the realization of income on the sale

of an appreciating asset held by the NIMCRUT.

The proposed regulations state that the Service would publish a no-rule position on

the income deferral issue in Rev. Proc. 97-23. In Rev. Proc. 97-23, 1997-1 C.B. 654, the

Service stated that it will not issue advance rulings on whether a unitrust that will

calculate the unitrust amount under IRC 664(d)(3) qualifies as a IRC 664 charitable

remainder trust when a grantor, a trustee, a beneficiary, or a person related or subordinate

to a grantor, a trustee, or a beneficiary can control the timing of the trust’s receipt of

income from a partnership or a deferred annuity contract for an income deferral purpose.

The study initiated by the proposed regulations is not complete and the proposed

regulations under IRC 664 that will likely become final in 1998 probably will not address

this issue. Perhaps there may be some resolution of the IRS and Treasury study on this

issue in the following year.

8. Key District Determinations Under Chapter 42

In recent years, Headquarters has delegated a number of private letter ruling issue

areas to the Key District including some areas under Chapter 42. Section 7.04 of Rev.

Proc. 98-4, 1998-1 I.R.B. 113, 125, continues this trend. The Key District Director now

issues determination letters involving:

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A. Advance approval of grant making procedures under IRC 4945;

B. Exempt operating foundations described under IRC 4940(d); and

C. Advance approval of voter registration programs described in IRC

4945(f).

9. Abuse Case - IRC 4941, 4944, 501(c)(3), 507(a)(2) – TAM 9627001

TAM 9627001, dated July 15, 1996, involved a commercial commodities and

securities trader (A) which formed and funded private foundation M which was

controlled by A and his family. A and his family owned an investment partnership that

acted as a futures commission merchant. A and his family used the assets of M as

collateral to meet the margin requirements imposed on A and his family's personal trading

account contracts.

The TAM's first focus was on IRC 4941 and held that the collateralization was selfdealing, following Janpol v. Commissioner, 101 T.C. 518 (1993), which held that

guarantees are to be included within the terms "lending of money or other extension of

credit" in IRC 4975(c)(1)(B). TAM concluded that the Tax Court's interpretation of the

Employee Plan prohibited transaction provision was equally applicable to the parallel

Exempt Organizations self-dealing provision under IRC 4941(d)(1)(B).

The TAM turned to IRC 4944, a provision often viewed as having a less meaningful

detrimental effect on foundation wrongdoing than IRC 4941. The TAM resoundingly

held that the collateralization constituted a jeopardizing investment:

Following Janpol v. Commissioner, supra, and our discussion under section

4941 above, guarantees or collateralizations constitute a loaning of money

which is an investment activity for purposes of section 4944. All of M's

assets were placed in a margin account for the purpose of collateralizing A's

investments in futures contracts which are "closely scrutinized" investments

under the regulations. Placing all of M's investments assets at risk in A's

undermarginalized accounts did nothing to improve M's investment

portfolio or economic posture, but, instead, jeopardized the exempt

purposes of M ...

We do not believe that a "prudent trustee" approach was applied here and

view this type of investment move, which would produce no potential

economic gain for M as the very type of act that Congress prohibited when

it enacted section 4944. See General Explanation of the Tax Reform Act of

1969, prepared for the staff of the Joint Committee on Internal Revenue

Taxation, December 3, 1970, page 46, and section 53.4944-1(a)(2) or the

regulations.

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The TAM continued, holding A was subject to the IRC 4944(a)(2) manager’s tax:

Under these facts and the standards under section 53.4944-1(b)(2) of the

regulations, A, as an experienced commodities trader, clearly knew the facts

pertaining to the collateralizing transaction. It appears evident that A either

knew that the transaction would be a jeopardizing investment, or at least,

from a reasonable person’s standpoint, A was negligent in not verifying

whether such a transaction was not in violation of section 4944. A has

provided no evidence that he made any attempt to obtain a written legal or

qualified investment counsel opinion that the transaction, a transaction

involving all of M’s assets, would not be a jeopardizing investment ...

In regard to exempt status, the TAM concluded that the M should have its IRC

501(c)(3) exemption revoked:

The transfer of M’s assets for use by its disqualified persons resulted in the

earnings of M impermissibly inuring to the benefit of insiders ... and a

family partnership controlled by insiders .... M allowed A (who is M’s

president/director, principal contributor, and founder) and the other insiders

to use M’s assets as collateral without consideration.

Finally, the TAM suggested involuntary termination under IRC 507(a)(2):

We also believe that consideration should be given to involuntarily

terminating M’s private foundation status since the transactions described

above resulted in M and A engaging in a willful and flagrant act giving rise

to liability for tax under sections 4941 an 4944 of the Code. A voluntarily,

consciously, knowingly, and intentionally committed acts in violation of the

self-dealing and jeopardizing investment rules.

This case demonstrates that the Service is not hesitant to use the panoply of remedies

that Chapter 42 and related Tax Reform Act of 1969 provisions provide, as well as

revocation of exempt status, when the facts and circumstances warrant such action. For

other examples of the application of Chapter 42 remedies in abuse situations, see 1995

EO CPE Text, Topic O, page 313.

339