Does a proposed donation of limited liability company (LLC) membership interests in a decedent’s estate to an irrevocable trust constitute self-dealing? Under the facts presented in Private Letter Ruling 201435017 (released June 6, 2014), the Internal Revenue Service said “no.” In addition, the IRS ruled that such donation didn’t create unrelated business taxable income (UBTI) or result in excess business holdings.
A decedent and her husband formed an irrevocable charitable trust (the trust), which was also classified as a private foundation (PF). The couple had also formed an LLC that owned buildings in an office park. Before the development of the office park and the creation of the LLC, the husband recorded an easement that permitted all tenants of the office park to have access to a road and receive parking rights on the property.
The LLC leased office space in its buildings to multiple tenants. Through various LLCs and trusts, disqualified persons owned other office buildings and land in the office park. They also leased space in their own buildings to tenants.
The decedent and her husband each owned 50 percent of the LLC. When the husband died, his interest passed to his wife. After his wife (the decedent) died, all the LLC interests passed to her estate. Her will provided that the residuary estate, including all the LLC interests, be given to a non-exempt trust. The non-exempt trust, which was a disqualified person, provided for payment of certain devises and state estate taxes, after which the remainder would pass to an irrevocable charitable trust.
The Road and the Parking Areas
The LLC owned property containing a private, ungated road that provided access from a state road to the office park. The road provided access to some of the buildings owned by the disqualified persons, but most of the road was used by individuals accessing buildings owned by the LLC. The LLC also owned property with ungated parking areas. Buildings owned by the disqualified persons had their own adjacent parking for their tenants and visitors.
On receipt of the donation of LLC property, the trust, along with the disqualified persons, intended to enter into separate agreements with third parties to maintain and repair the road. The trust and disqualified persons wouldn’t exchange funds; rather, they would pay third parties directly through an allocation based on rentable square footage. The trust planned to hold the donation of LLC property for passive investment purposes only. The trust anticipated selling the property or entering into an Internal Revenue Code Section 1031 like-kind exchange, due to the property’s high vacancy rate.
The trust asked the IRS to rule on six issues related to the LLC membership interests it received.
Excess Business Holdings
The first ruling related to whether ownership of the LLC interests by the trust (also classified as a PF) constituted excess business holdings under IRC Section 4943. Under Section 4943, excess building holdings of a PF consist of stock or other interests in a business enterprise, which a PF would have to dispose of to a person other than a disqualified person, for the remaining holdings of the PF in such a business enterprise to be permitted holdings. There’s an exception under Section 4943(d)(3)(B), which states that “business enterprise” doesn’t include a trade or business in which at least 95 percent of the gross income is derived from passive sources. In this instance, the trust represented that it would hold the LLC interests for passive investment only, and at least 95 percent of the gross income from the LLC was derived from passive sources. Therefore, the LLC wasn’t a business enterprise under Section 4943(d)(3)(B), and the continued ownership of LLC interests didn’t result in excess business holdings.
The second and third rulings addressed whether rental income from the office park property created UBTI. Under Section 512(a)(1), UBTI is income derived by an organization from an unrelated trade or business. “Unrelated trade or business” is any trade or business not substantially related to the exercise or performance by such organization of its charitable, educational or other purpose constituting the basis for its exemption. (IRC Section 513(a)). In this case, the trust’s ownership and operation of the LLC was an “unrelated trade or business” because it wasn’t substantially related to the trust’s charitable purpose of distributing funds to organizations. However, the rent received from the rental of LLC office space satisfied an exclusion to the UBTI provisions.
Specifically, Section 512(b)(3)(A)(i) excludes from UBTI rents from real property. The trust represented that the rents weren’t attributable to personal property and weren’t determined based on the income or profits derived from any person from the leased property. Furthermore, because the rents weren’t derived from any deb-financed property (which would otherwise be included as UBTI), the rents didn’t create UBTI. The IRS thus held that because the trust met the requirements of the exclusion to UBTI and none of the exceptions to the exclusion applied, the receipt by the LLC of rents didn’t create UBTI under Section 512(b)(3).
Additionally, income from the sale of real property held by the trust through the LLC would be excluded from UBTI. Under Section 512(b)(5), gains or losses from a sale or exchange of property other than property includible in inventory, or property held for sale to customers in the ordinary course of business, are UBTI. In this instance, however, the trust planned to sell or exchange the LLC property to a third party. There was no inventory of real property and no plan to acquire real property. Moreover, once the LLC property was transferred from the trust to the PF, the LLC property was the only property the PF owned. Therefore, the real property held by the PF through the LLC is excluded from UBTI under Section 512(b)(5)(B).
The IRS ruled that the acceptance of the LLC interests by the PF wouldn’t constitute self-dealing under IRC Section 4941, even if the trust were a disqualified person under Section 4946(a)(1)(G). Under the facts presented, the LLC interests were donated to the PF from the decedent’s estate to a trust. The donation from the trust to the PF was without consideration paid or liability assumed. Under the IRC, there’s no prohibition against a disqualified person making a donation to a PF if there are no liens, and it’s an outright gift. Accordingly, the acceptance by the PF of the LLC interests didn’t constitute self-dealing under Section 4941.
The IRS also ruled that the co-location of the LLC’s property in the office park where buildings and real property were also owned by other entities, didn’t constitute self-dealing. The PF didn’t choose to own property in the office park next to disqualified persons; the PF received the LLC interests pursuant to a bequest. In addition, the PF anticipated selling or exchanging the property. Thus, any benefit the disqualified persons received by the co-location of property was tenuous or incidental. Accordingly, the co-location of LLC property next to property owned by disqualified persons didn’t constitute self-dealing under Section 4941.
Moreover, the IRS determined that the access over the road and use of certain parking spaces by disqualified persons, as well as the entering into of separate agreements by the trust and the disqualified persons with third parties to perform maintenance and repairs on the road, didn’t constitute self-dealing under Section 4941. Section 4941 would apply to the use of the LLC’s road and parking for the benefit of visitors to the property owned by disqualified persons. However, most of the road was used by individuals accessing the LLC’s property. And, it was rare that visitors to buildings owned by disqualified persons would park in areas owned by the LLC. Furthermore, the use of the road and the parking was based on a pre-existing, more than 45-year-old easement that was recorded prior to the development of the office park and before the trust’s formation, as well as prior to the existence of any disqualified persons. All of these factors pointed to a benefit the disqualified persons received regarding the road access or use of parking spaces that was incidental or tenuous at best; therefore, there was no self-dealing.
Finally, any separate agreements entered into with third parties to repair and maintain the road didn’t involve transactions between the PF and the disqualified persons. As such, they didn’t constitute self-dealing.