David T. Leibell and Daniel L. Daniels of Cummings & Lockwood LLC in Stamford, Conn., show just what it takes for a charity to get more time from the Internal Revenue Service to sell an excess business holding:
In two similar rulings, PLR 200438042 and PLR 200438043, both issued Sept. 17, the IRS agreed to grant a private foundation a five-year extension of the usual five-year period for disposing of excess business holdings under Internal Revenue Code Section 4943. The foundation seeking the ruling held a 50 percent membership interest in a securities and futures clearing firm organized as a limited liability company.
Section 4943 imposes a tax on the excess business holdings of any private foundation in a business enterprise during any taxable year. The initial tax rate is 5 percent, but that rate is increased to 200 percent if the holdings are not disposed of in a timely manner. Generally speaking, a foundation has excess business holdings if the foundation and its disqualified persons together own more than 20 percent of the voting stock in a corporation or profits interest in a partnership. (In certain circumstances, this can be increased to 35 percent.) A foundation generally has five years to dispose of excess business holdings. That can be extended for another five years if the excess business holdings consist of an unusually large gift or bequest of diverse business holdings or holdings with complex corporate structures. But three conditions must be met: (1) The foundation must show that even though diligent efforts to dispose of the holdings were made in the initial five-year period, the disposition was not possible (except at a price substantially below fair market value) because of the size and complexity or diversity of the holdings; (2) before the close of the initial five-year period, the foundation must submit a plan to the IRS and the appropriate state attorney general for disposing of all the excess business holdings within the extended period; and (3) the IRS must find that the foundation's plan can reasonably be expected to be carried out before the close of the extension period.
After extensive discussion of the factual background, the Service ruled that the foundation met the requirements for the five-year extension for the following reasons:
First, a preliminary offer for sale of the entire LLC, including the foundation's interest therein, was made 25 months after the gift. The Service found that the range of values was negotiated at arm's length and was meaningful, evidenced by the many months of due diligence undertaken by the prospective purchaser. The Service found that only external events, such as the drastic decline of the economy and the market, precluded that transaction from closing.
Second, the Service concluded that the foundation's holdings in the LLC are diverse and involve complex business structures. The LLC's business activity not only requires substantial capital investment but also membership in numerous stock exchanges and clearing organizations; many governmental regulatory agencies oversee and monitor the LLC's business activities. The result of this diversity and complexity, according to the ruling, is that there are few potential purchasers. Even when a party goes to contract, the due diligence and conditions to closing would result in a substantial period being necessary to close the transaction. Moreover, the Service concluded, the LLC's very business is most susceptible to a downturn in the market and the economy, which in fact occurred as a result of the Sept. 11 attacks; hence, a sale, if possible at all at that time, would have to be at a “fire sale” price.
Also important to the Service's conclusions was the nonmarketable, non-controlling nature of the foundation's interest in the LLC, which the Service believed “serves to deter offers that reflect [the interest's] full fair market value.” The Service noted, in particular, that under the LLC's operating agreement, if any holder of a membership interest seeks to sell or transfer all or any portion of the interest, the LLC and the other common members must be offered the opportunity to purchase the interest at the same terms. While the Service acknowledged that this right is intended to prevent the members from having an unwanted partner, it also serves to discourage potential purchasers whose offers might be thwarted by an existing member's intervention.
The Service also pointed to the fact that a purchaser of the foundation's interest would be admitted as a member of the LLC only with the approval of a majority vote of the managers, a restriction serving to dampen the price a willing buyer would pay for the foundation's interest.
These restrictions led the Service to conclude that any prospective purchaser of the foundation's interest in the LLC would demand substantial discounts on the price it would pay.
The Service also approved the foundation's plan for selling the interest, which is to continue to cooperate with an investment bank in its ongoing engagement to sell the LLC. The Service noted:
the other common members are in agreement with this approach;
the foundation's board of directors is wholly satisfied with the investment bank's attention to the project and performance to date and believes that the inability to date to close a sale has been due to economic circumstances beyond its control;
any sale in the current financial climate would be for a price that is substantially less than the LLC's true value, thereby limiting proceeds available for the charities to be benefited by the foundation;
the Service believed that the sale could be accomplished within the five-year extension period. The investment bank informed the foundation that economic conditions are gradually improving and that it should be able to arrange for a sale of the LLC at a price that approximates its true value within the next three to four years;
the state attorney general's office had no objections to the plan.
For a ruling in which the IRS refused to grant the five-year extension, see PLR 9029067. There, the Service found that the holdings were neither unusually large nor unusually complex and the foundation had failed to show that it had exercised diligent efforts to dispose of the stock during the initial five-year period.