In Private Letter Ruling 201407021 (released Feb. 14, 2014), a private foundation (PF) asked the Internal Revenue Service to rule on two issues. First, the PF inquired whether a distribution of interest and retention of non-voting units in a limited liability company (LLC) would constitute acts of self-dealing. Second, the PF asked whether its ownership of non-voting units in the LLC would violate the prohibition against ownership of excess business holdings. The IRS ruled that that there would be no self-dealing and no violation of the prohibition against ownership of excess business holdings. Here’s why.
A founder of a PF made capital contributions to an LLC and owned all of its voting and non-voting membership units. The members owning the voting units performed the duties of running the LLC, including investing funds; voting stock; binding the LLC with their signature; and collecting obligations. They also could make distributions as they saw fit. All distributions would be made to both voting and non-voting members in proportion to ownership of units. The LLC could only be dissolved with written approval of members holding at least 50 percent of the units in each voting and non-voting class.
The founder’s daughter executed a promissory note, which was the sole asset of the LLC. The only income of the LLC would be derived from the interest income from the note. The note bore interest at the long-term federal rate, and its principal was due at the end of the note’s term. The LLC didn’t engage in any business enterprise.
At the death of the founder or his wife, which ever occurred later, the founder’s or wife’s estate would transfer a non-voting interest of the LLC to the PF. The PF was concerned whether such transfer would violate Internal Revenue Code Section 4941 (prohibition against self-dealing) and IRC Section 4943 (prohibition against excess business holdings). That concern is the basis of the instant ruling.
IRC Section 4941(d)(1) defines self-dealing as a sale, exchange, loan, transfer or leasing of property between a PF and a disqualified person. Treasury Regulations Section 53.4941(d)-2(c) provides that self-dealing occurs when a note, the obligor of which is a disqualified person, is transferred by a third party to a PF, which becomes the creditor of the note. In this instance, under Section 4946(a)(1), the founder and his daughter are disqualified persons as to the PF. However, the retention of the non-voting interest in the LLC and the receipt of passive income from it doesn’t constitute self-dealing. The arrangement isn’t a loan or an extension of credit. The PF would be acquiring the non-voting units by gift. The PF would only have a right to receive distributions if the LLC dissolved or chose to make distributions. The PF had no right to compel dissolution or distributions. And, due to the lack of voting power, the PF had no control over the LLC. Thus, the retention by the LLC of the note, following the founder or his wife’s death, wouldn’t be an act of direct or indirect self-dealing between the PF and a disqualified person.
Excess Business Holdings
IRC Section 4943 imposes an excise tax on a PF’s excess business holdings. For holdings to constitute excess business holdings, the LLC must qualify as a business enterprise. The LLC’s only holding is the note that generated interest. This is a passive source of income. Under Treas. Regs. Section 53.4943-10(c)(1), if a business derives 95 percent of its income from passive sources, it’s not a business enterprise. Thus, because the LLC isn’t a business enterprise, the PF’s holding of profit interest in the LLC isn’t an excess business holding under Section 4943.