In a recent private letter ruling1 the Internal Revenue Service concluded that certain hedge fund interests owned by and donated to a private foundation (PF) didn’t constitute unrelated business taxable income (UBTI), an excess business holding or a jeopardizing investment.
While no adverse consequences resulted for this PF, it’s important to remember that certain circumstances (outlined below) may trigger liability for such taxes.
The PLR concerned interests in a limited liability company (LLC) that solely engaged in the operation of a hedge fund. The LLC, which constituted a partnership for federal tax purposes, had three classes of membership interests — Classes A, B, and C. The LLC bought and sold various publicly-traded instruments, including stocks, stock indices, exchanged-traded funds, real estate investment trusts, mutual funds, bonds, currencies and derivatives of these instruments. The sole owner of the Class B interests, which represented 10 percent of the LLC’s income interest, proposed donating her entire interest to a PF, which already owned a membership interest in Class A.
The PF represented that neither its LLC interest nor the LLC 's holdings constituted debt-financed property. In addition, the PF represented that it derived all of its income from passive sources of the types excepted from UBTI.
In this ruling, the IRS concluded that:
1. The LLC's investment activities didn’t generate UBTI under Internal Revenue Code Section 512 with respect to its Class A membership interest or a proposed gift of the Class B membership interest.
2. Neither the PF's ownership of Class A membership interests in the LLC nor proposed ownership of Class B interest in the same entity would trigger liability for the excess business holding excise tax under IRC Section 4943, and
3. A proposed donation of the Class B membership interest in the LLC wouldn’t result in a jeopardizing investment under IRC Section 4944.
The IRS first noted that any trade or business not substantially related to an organization's tax- exempt function generally gives rise to UBTI. However, since the income in this case qualified for exception as investment income under IRC Section 512(b), it didn’t constitute UBTI.
With respect to the excess business holdings excise tax, the IRS noted that if a trade or business derives 95 percent of its income from passive sources, then it doesn’t constitute a business enterprise for purposes of this tax. As a result, the PF's holdings in the LLC didn’t result in excess business holdings tax under Treasury Regulations Section 53.4943-10(c)(1), regardless of the PF’s percentage ownership of the LLC.
As a final point, the IRS noted that the jeopardizing investments tax doesn’t apply to investments donated to a PF. In the ruling, the donor transferred the LLC interest, without any debt or any other encumbrance, for no consideration. Therefore, it didn’t constitute a jeopardizing investment under Treas. Regs. Section 53.4944-1(a)(2)(ii)(a).
As a result, the IRS concluded that existing and proposed ownership of the LLC interests didn’t trigger liability under the UBTI, excess business holding and jeopardizing investment rules. However, advisors should remember that the following circumstances would pose issues for a PF:
· Debt-financed income. Purchasing investments via margin or other debt financing may generate income subject to unrelated business income tax (UBIT).2 Therefore, while this wasn’t the case in the recent PLR, PFs should understand that purchasing investments with borrowed fund3 or owning an interest in a pass-through entity that receives debt-financed income4 may generate UBIT for the foundation.
· Active trade or business. Owning an interest in a pass-through entity, such as an LLC, partnership, or S corporation, which in turn invests in an active trade or business (e.g., an operating interest in an oil well) may also result in UBIT for the PF.5
Excess business holdings. While the excess business holdings tax doesn’t apply to entities deriving all of their income from passive investment income sources, it would apply to certain interests in a business enterprise.6 Accordingly, PFs should plan carefully when considering any interest in a closely-held business.
· Jeopardizing investments purchased by the PF. While the jeopardizing investments tax doesn’t apply to investments donated to a PF, it may apply to certain investments purchased by a PF.7 Therefore, in considering investments to purchase and/or hold, PFs should favor a highly-diversified portfolio and avoid relying on a single investment or asset class that could jeopardize its ability to fulfill its tax-exempt function.8
· Self-dealing. One issue not addressed in the PLR concerns the excise tax for self-dealing, which applies to certain transactions between PFs and disqualified persons.9 Disqualified persons include any foundation officer, director, or trustee, as well as substantial contributors.10 Since self-dealing generally includes compensation paid by a PF to a disqualified person,11 founders of a PF should understand that receiving any investment management fees from the PF may potentially constitute a self-dealing transaction, and they should therefore seek counsel in reviewing any fee paid by the PF to a disqualified person.
Credit Suisse Securities (USA) LLC (CSSU) does not provide tax or legal advice. We urge you to consult with your own tax or legal advisors to ensure proper interpretation and application of all legislation, laws, rules and regulations and to obtain advice specific to your personal financial situation. This information is for educational purposes only and is intended to provide a general overview of the topics discussed. Information and opinions expressed by us have been obtained from sources believed to be reliable. CSSU makes no representation as to their accuracy or completeness and CSSU accepts no liability for losses arising from the use of the material presented. References to legislation and other applicable laws, rules and regulations are based on information that CSSU obtained from publicly available sources that we believe to be reliable, but have not independently verified.
1. Private Letter Ruling 201329028 (April 23, 2013).
2. Internal Revenue Code Section 514.
3. IRC Section 514 (b)(1).
4. IRC Section 512(c)(1); Revenue Ruling 74-197.
5. IRC Sections 512(c); 512(e)(1)(A); Rev. Rul. 98-15, 1998-1 CB 718.
6. IRC Section 4943.
7. IRC Section 4944.
8. Treasury Regulations Section 53.4944-1.
9. IRC Section 4941.
10. IRC Section 4946(a), (b). “Substantial contributor” means any person who contributed more than $5,000 to a private foundation, if such amount exceeds 2 percent of the total contributions and bequests received by the foundation. IRC Sections 4946(a)(2), 507(d)(2).
11. IRC Section 4941(d)(1)(D).