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Thursday, April 18, 2024
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GiftLaw Pro |
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GiftLaw Note:
University is trustee of certain charitable remainder and charitable lead trusts (the "Trusts"). University is also the sole charitable beneficiary of each of the Trusts. Apart from the Trusts, University maintains an endowment, which it invests in a widely diverse manner. The endowment invests in stocks, bonds and real estate and holds certain partnership interests that produce some debt-financed income. The endowment has historically earned an excellent return on its investments.
University wants the Trusts to participate in the excellent endowment return. University therefore proposes that the Trusts purchase "units" from the University whose value will be tied to the value of the endowment. Ownership of the units will entitle the Trusts to receive periodic payments reflective of the investment return of the endowment. The periodic payments would be received by the Trusts as ordinary income regardless of the character of the income generated by the underlying endowment assets. Ownership of the units will not give the Trusts an ownership interest in the underlying assets of the endowment nor will it give the Trusts any ability to make decisions with respect to endowment investments.
University requests a ruling that the Trusts purchase of the units will not cause them to recognize unrelated business taxable income (UBTI).
Section 664(c) provides that the Trusts are generally not subject to any tax unless they have UBTI. Debt financed income, such as that generated by the partnerships whose interests are held in the endowment, generally is UBTI.
Due to the nature of the Trusts investment in the units, income paid to the Trusts by reason of unit ownership is ordinary in character and does not take on the character of the income of the underlying endowment assets. For this reason, the endowment's debt-financed income does not result in UBTI to the Trusts.
This letter ruling also raises a peripheral UBTI issue. Specifically, by providing units of its endowment to the Trusts, University is offering investment services. If University were to provide these services for a fee to other organizations, any related income would be UBTI. Because University will not charge the Trusts, however, University will not have UBTI as a result of its offering of investment services in this instance.
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Dear Sir or Madam:
This is in response to a letter dated August 11, 2003, and previous correspondence submitted by N and O's authorized representatives requesting a ruling that a proposed contractual relationship will not generate unrelated business taxable income under section 512(a)(1) of the Internal Revenue Code (the "Code") to N and O.
M is exempt under section 501 (a) of the Code as an organization described in section 501 (c)(3) and has been classified as an educational organization under sections 509(a)(1) and 170(b)(1)(A)(ii). N is a charitable remainder unitrust, and O is a charitable lead unitrust
M is the trustee of a number of charitable remainder trusts and charitable lead trusts (collectively, "the Trusts"), and as trustee, M is the legal owner of the Trusts' assets. In addition, M has either a remainder or a lead interest in each of the Trusts. The charitable remainder trusts distribute to individual beneficiaries either a "unitrust" amount equal to a percentage of the market value of trust assets, or an annuity amount, with the remainder interest distributed in either case to M after a term of years or upon the death of the life beneficiaries. The charitable lead trusts pay out a unitrust or annuity interest to charitable distributees, with the remainder interest distributed to individual beneficiaries after a term of years or upon the death of designated individuals.
As a result of its relationship with the Trusts as both trustee and beneficiary, M has a substantial interest in the value of each Trust. Moreover, the donors to the Trusts in each case have funded the Trusts with the intention that M benefit substantially from the assets of the Trusts, and that the assets will be managed to achieve the greatest possible return on investment. In this regard, donors often express their desire for the return on the assets to match the return on M's endowment, or for the assets to participate in the return on the endowment. Donors have expressed their concern when the investment return of a Trust has been lower than the return on M's endowment.
The endowment is invested in a widely diverse manner, including substantial investments in public equities, bonds, private equity, and real estate. Real estate and certain other venture investments are undertaken primarily through partnership structures. Much of the income earned by the portfolio consists of passive dividends, interest, and long and short term capital gains, but some income is debt-financed or otherwise treated as unrelated business taxable income. M has provided information showing that the endowment has significantly outperformed the Trusts on an annualized return basis over the last three, five, and ten years.
M would like to achieve greater economies of scale in the management of the Trusts, a potentially higher investment return for the Trusts, and increased diversification of the Trusts' investments. M seeks to accomplish these goals by enabling the Trusts to participate, albeit indirectly, in the return on M's endowment. M proposes to create a contractual obligation, pursuant to which it would issue a contract right to each of the Trusts for so-called "units." The value of the units would be nominally tied to the value of the endowment. The contract right would entitle the Trusts to receive periodic payments based on the number of units owned. The Trusts would thereby be able to receive an investment return equal to that of the endowment.
M states that it uses a "unit" concept internally with respect to the endowments of the various departments and schools that comprise M. Each department or school owns a certain number of units of the endowment, the value of which is based on the value of the underlying endowment investments. M determines a payout rate on the endowment each year based in part on the endowment's investment performance. Each department is entitled to a payout in an amount equal to the payout rate times the number of units it holds. M sets the value of the endowment units on a monthly basis, and they may be redeemed for value.
M seeks to enable the Trusts to invest in the unit in a manner similar to a department or school of M. A Trust would acquire units from M's endowment, which would give the Trusts a contractual right against M, but no interest whatsoever in the underlying investment assets of the endowment. The contract between M and the Trusts would provide that the price of the units would equal their value at the time of acquisition. The value of the units would be based on the value of all the underlying investment assets held by the endowment and would have the same unit value that M uses for internal accounting purposes.
The contract would provide that each Trust would receive payments on the units held by it equal to the payout rate M establishes for the endowment, with payouts made quarterly. A Trust could choose either to reinvest part of the payout, or redeem additional units, depending on its cash requirements. The Trusts will treat payouts as ordinary income, regardless of the character of the underlying income of the endowment, whether capita gain, ordinary income, or return of capital. The Trusts will treat redemptions of units as generating long or short term capital gain (or loss), depending on the holding period of the unit.
Under the contract, the Trusts would not have any ownership interest in the underlying assets of the endowment, or any contract rights with respect to the other trusts. The trusts would have no power or right of any kind to control, direct, supervise, recommend or review M's business activities, operations, or decisions with respect to the endowment, except the right to review the payout computation. They would not have the right to veto or opt out of any of the underlying endowment investments. The contract would provide that, with respect to the issuance of units, M is neither a partner nor an agent of the Trusts; that the rusts would never be or become liable for any cost, expense, or payment incurred or due by M or for which M is liable or responsible relating to the endowment (or the underlying endowment assets), and M would indemnify and hold the Trusts harmless from and against any liability arising out of any action or inaction by M with respect to the endowment (or the underlying endowment assets),
In a letter dated June 5, 2003, M's representative stated that M determines the payout rate on the endowment based upon the endowment's investment performance and other factors described hereafter. Payout from the endowment is set by M's governing board each year. M has an endowment spending policy that aims to maintain the purchasing power of the endowment while providing a reliable stream of income for operations. Accordingly, M seeks to distribute a certain percentage of the endowment's market value annually.
M follows a guideline for setting each year's distribution. The guideline is made up of the following factors: greatest weight is given to a combination of the prior year's return plus the increase over the past year in the inflation rate, and a lesser weight is given to a xed percent distribution. M's governing body has the final authority to fix each year's distribution. The payout distribution rate over the last ten years has not been tied to performance on investment. M believes that a relatively steady and predictable distribution is preferable to one that changes in any substantial way from year to year.
M currently does not charge a fee for its management services of the endowment fund, and it does not manage funds for any third parties other than entities related to M. M chooses to retain the protection provided by the Philanthropy Protection Act of 1995 and, therefore, does not intend to manage funds for any private individual. M does not manage funds for any charitable organization other than entities affiliated with M (except when a charity is an incidental beneficiary, as described above). M has followed the practice of not imposing any investment management fee.
M also represented that it will not generate income from the investment management of the Trusts. Even if there is a spread between the greater amount of earnings generated by M's endowment compared to a lesser amount of annual payout declared by M on the endowment over the years, any return over and above the endowment payout rate is credited to the principal amount of the endowment and is reflected in an increase in the unit value. M neither reserves nor segregates any part of its endowment earnings from inclusion in the value of the units.
A number of the Trusts have a second charitable recipient in addition to M. In a letter dated July 1, 2003, M's representative stated that any of the Trusts that have a charitable beneficiary in addition to M would not be allowed to purchase units or participate in the unit program based upon the value of M's endowment. Participating Trusts will be those Trusts that have no charitable beneficiary other than M.
You have requested the following ruling:
The issuance of units from M to the Trusts, the making or receipt of payments with respect to the units, and the holding or redemption of the units, will not generate unrelated business taxable income to N and O.
Section 664(c) of the Code provides that a charitable remainder annuity trust and a charitable remainder unitrust shall, for any taxable year, not be subject to any tax imposed by this subtitle, unless such trust, for such year, has unrelated business taxable income (within the meaning of section 512, determined as if part III of subchapter F applied to such trust).
Section 512(a)(1) of the Code defines the term "unrelated business taxable income" as the gross income derived by any organization from any unrelated trade or business regularly carried on by it, less the allowable deductions which are directly connected with the carrying on of such trade or business, both computed with the modifications provided in section 512(b).
Section 512(b) of the Code sets forth so-called "modifications," which are excluded from the computation of unrelated business taxable income. These modifications include dividends, interest, royalties, rent from real property, and gain from the sale of property.
Section 513(a) of the Code defines the term "unrelated trade or business" as any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its exempt purpose or function.
Section 513(c) of the Code provides that the term "trade or business" includes any activity, which is carried on for the production of income from the sale of goods or the performance of services.
Section 1.513-1(a) of the Income Tax Regulations provides that gross income of an exempt organization subject to the tax imposed by section 511 of the Code is includible in the computation of unrelated business taxable income if: (1) it is income from a trade or business; (2) such trade or business is regularly carried on by the organization; and (3) the conduct of such trade or business is not substantially related (other than through the production of funds) to the organization's performance of its exempt functions.
Section 1.513-1(b) of the regulations provides that for purposes of section 513 the term "trade or business" has the same meaning it has in section 162 and generally includes any activity carried on for the production of income from the sale of goods or performance of services.
Section 1.513-1(c)(1) of the regulations provides that in determining whether trade or business from which a particular amount of gross income derives is "regularly carried on," within the meaning of section 512 of the Code, regard must be had to the frequency and continuity with which the activities productive of the income are conducted and the manner in which they are pursued. For example, specific business activities of an exempt organization will ordinarily be deemed to be "regularly carried on" if they manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of non-exempt organizations.
Section 1.513-1(d)(1) of the regulations provides that, in general, gross income derives from "unrelated trade or business," within the meaning of section 513(a) of the Code, if the conduct of the trade or business which produces the income is not substantially related (other than through the production of funds) to the purposes for which exemption is granted. The presence of this requirement necessitates an examination of the relationship between the business activities which generate the particular income in question -- the activities, that is, of producing or distributing the goods or performing the services involved -- and the accomplishment of the organization's exempt purposes.
Section 1.513-1(d)(2) of the regulations provides that trade or business is "related" to exempt purposes, in the relevant sense, only where the conduct of the business activities has a causal relationship to the achievement of exempt purposes, and is "substantially related," for purposes of section 513 of the Code, only if the causal relationship is a substantial one. Thus, for the conduct of trade or business from which a particular amount of gross income is derived to be substantially related to purposes for which exemption is granted, the production or distribution of the goods or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of those purposes. Where the production or distribution of the goods or the performance of the services does not contribute importantly to the accomplishment of the exempt purposes of an organization, the income from the sale of the goods or the performance of the services does not derive from the conduct of related trade or business. Whether activities productive of gross income contribute importantly to the accomplishment of any purpose for which an organization is granted exemption depends in each case upon the facts and circumstances involved.
Rev. Rul. 69-528, 1969-2 C.B. 127, describes an organization that was formed to provide investment services on a fee basis exclusively to organizations exempt under section 501(c)(3) of the Code. It receives funds from the participating exempt organizations, invests in common stocks, reinvests income and realized appreciation, and upon request liquidates a participant's interest and distributes the proceeds to the participant. The Rev. Rul. states that providing investment services on a regular basis for a fee is a trade or business ordinarily carried on for profit. If the services were regularly provided by one tax-exempt organization for other tax-exempt organizations, such activity would constitute unrelated trade or business. The Rev. Rul. holds that the organization is not exempt under section 501(c)(3).
As noted previously, under section 664 of the Code, charitable remainder annuity trusts and charitable remainder unitrusts are not subject to any tax imposed by this subtitle, unless such trust has unrelated business taxable income (within the meaning of section 512). In order for such a trust's income to be subject to the unrelated business income tax, three requirements must be met: (1) the income must be from a trade or business; (2) the trade or business must be regularly carried on; and (3) the conduct of the trade or business must not be substantially related to the organization's exempt purpose or function. See Reg. 1.513-1 (a).
Here, M proposes to enter into a contractual relationship with certain Trusts that are either charitable remainder trusts or charitable lead trusts in which M has an interest as a beneficiary and serves as trustee of the Trust. Under such a contractual relationship, each Trust would receive payments on the units held by it equal to the payout rate M establishes for its endowment, with payouts made quarterly.
Each Trust would acquire units from the M endowment which would give the Trusts a contractual right against M, but no interest whatsoever in the underlying investment assets of the endowment. The contract between M and the Trusts would provide that the price of the units would equal their value at the time of acquisition. The value of the units would be based on the value of the underlying investment assets held by the endowment and would have the same unit value that M uses for internal accounting purposes. A Trust could choose either to reinvest part of the payout, or redeem additional units, depending on its cash requirements. Thus, under the contractual relationship with M, the Trusts would have a right to the payout declared by M plus the right to redeem the units at the value that M uses for internal accounting purposes.
Generally, an organization that otherwise qualifies for recognition of exemption under section 501 (c)(3) of the Code and provides investment services on a regular basis for a fee to other exempt or nonexempt organizations would be engaged in an unrelated trade or business under section 513(a). See Rev. Rul. 69-258, supra. Such an activity would constitute a "trade or business" under sections 513(c)(3) and 1.513-1(b) of the regulations, and would be "regularly carried on" under sections 512(a)(1) and 1.513-1(c). Thus, if M charged a fee for investment management services provided to organizations unrelated to M or generated income from the management of the funds invested by such organizations, these activities could result in unrelated business taxable income under section 512(a)(1). Here, however, M is not charging a fee for its services and not otherwise receiving income from the services it provides to the Trusts. Thus, under these circumstances, M will not receive unrelated business taxable income under section 512(a)(1).
The fact that M will engage in the investment activity for the benefit of individuals who are co-beneficiaries R the Trusts (income or remainder, depending on which kind of trust is being considered) at the same time that it engages in investment activity for its own benefit as the income or remainder beneficiary (again depending on the kind of the trust) limits the scope of the service provided to "others" and distinguishes it from a commercial venture.
As stated above, under the contract, the Trusts would not have any ownership interest in the underlying assets of the endowment nor any contract rights with respect to the other trusts. The Trusts would have no power or right of any kind to control, direct, supervise, recommend or review M's business activities, operations, or decisions with respect to the endowment, except the right to review the payout computation. They would not have any right to veto or opt out of any of the underlying endowment investments. The contract would provide that, with respect to the issuance of the units, M is neither a partner nor an agent of the Trusts, that the Trusts would never be or become liable for any cost, expense, or payment incurred or due by M or for which M is liable or responsible relating to the endowment (or the underlying endowment assets), and M would indemnify and hold the Trusts harmless from and against any liability arising out of any action or inaction by M with respect to the endowment (or the underlying endowment assets).
The Trusts do not have a position of ownership of the assets. There is no suggestion that the contractual relationship between M and the Trusts is in the nature of a partnership or agency relationship. Thus, the income earned by the Trusts from the payout M establishes for the endowment reflects ordinary income and does not take on the character of the income of the underlying assets as debt-financed or unrelated business taxable income. M would pay any tax owed on UBTI earned by the endowment portfolio, with no deduction taken against UBTI for any payments made to the Trusts.
In view of the foregoing, we rule as follows:
The issuance of units from M to the Trusts, the making or receipt of payments with respect to the units, and the holding or redemption of the units, will not generate unrelated business taxable income to N and O.
This ruling is based on the understanding that there will be no material changes in the facts upon which it is based.
We express no opinion as to the tax consequences of the proposed transaction under any other section of the Code
Pursuant to a Power of Attorney on file in this office, a copy of this letter is being sent to N and O's authorized representatives. A copy of this letter should be kept in their permanent records.
This ruling is directed only to the organization that requested it. Section 6110(k)(3) of the Code provides that it may not be used or cited by others as precedent.
If there are any questions about this ruling, please contact the person whose name and telephone number are shown in the heading of this letter.
This letter supersedes our letter dated August 25, 2003.
Sincerely,
Robert C. Harper, Jr.
Manager, Exempt Organizations
Technical Group 3
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