«P. THIRTY YEARS AFTER THE 1969 TRA – RECENT DEVELOPMENTS UNDER CHAPTER 42 by Ron Shoemaker and Bill Brockner “Chiefs! Our road is not built to ...»
1999 EO CPE Text
P. THIRTY YEARS AFTER THE 1969 TRA –
RECENT DEVELOPMENTS UNDER CHAPTER 42
Ron Shoemaker and Bill Brockner
“Chiefs! Our road is not built to last a thousand years, yet in
a sense it is. When a road is once built, it is strange thing how it
collects traffic, how every year as it goes on, more and more
people are found to walk thereon, and others are raised up to
repair and perpetuate it, and keep it alive.”
Vailima Letters. Address to the Chiefs on the Opening of the Road of Gratitude, October, 1894.
Robert Louis Stevenson (1850-1894)
1. Introduction The Private Foundation provisions in the Internal Revenue Code are now approaching their pearl anniversary. Enacted in the TRA of 1969, Chapter 42 and related sections such as IRC 507 and IRC 4947 have provided the Service and the private foundation community (including 4947 trusts) with a workable and fair regulatory mechanism. There has been relatively minor tinkering with the provisions either through statutory change or administrative action. As with any complex body of law, there has been evolution in interpretation and application to meet changes in society and technology. There has been a steady increase in the number of entities subject to Chapter 42, especially in the rolls of IRC 4947(a)(2) trusts. There are now over 130,000 organizations that file 990 PFs or 5227s. No one knows whether the private foundation provisions of the Code, like Robert Louis Stevenson’s road, will survive the next millennium. Presently, however, Chapter 42 serves as a vehicle in good repair to cross the bridge into the 21st century regulation of the private foundation sector of the EO universe.
This topic will provide discussions of recent private foundation developments and update CPE articles in 1995 (Topic O); 1996 (Topic G); and 1997 (Topic K). Court cases, private letter rulings (PLRs), technical advice memorandums (TAMs), General Counsel Memorandums (GCMs), new law and proposed regulations under IRC 664 will be highlighted. The Topic will also include a listing of Chapter 42 issues that may be resolved by Key District determination letters.
Thirty Years After the 1969 TRA – Recent Developments Under Chapter 42
2. IRC 4940 Treatment of Distributions from an Employee Qualified Plan or IRA In PLR 9341008, July 14, 1993, the Service was asked to rule that a private foundation is not subject to the federal excise tax on investment income under IRC 4940(a) when the donor’s individual retirement accounts (IRAs) pass to the private foundation. The donor had several IRAs whose designated beneficiary was a private foundation expected to be exempt under IRC 501(c)(3). As part of this same ruling request, the Service concluded that proceeds payable from the IRAs will be income in respect of a decedent to the private foundation under IRC 691(a)(1)(B) when distributed to the private foundation. As to the 4940 issue, the Service concluded that the private foundation would not be subject to the federal excise tax on investment income under IRC 4940 when the donor’s IRAs pass to the private foundation.
PLR 9633006, May 9, 1996, involved virtually the same set of facts as PLR 9341008, except that the properties of the donor passing to a private foundation were proceeds of a Keogh plan rather than an IRA. On the 4940 issue, the Service reached the opposite conclusion from the earlier ruling; the private foundation would be subject to tax on investment income under IRC 4940(a) of the Code on the proceeds from the donor’s Keogh account which are in excess of the contributions made to the account. The ruling also held that the Keogh proceeds were income in respect of a decedent to the private foundation under IRC 691(a)(1)(B), but the private foundation would not recognize tax because it is exempt under IRC 501(c)(3), subject to UBTI modifications under IRC 512(b).
The Service is presently resolving the conflict between the holdings of these two private letter rulings. The following supports a view that the position should reflect the bottom line in PLR 9341008, holding that a distribution from a Qualified Employee Plan do not constitute income for purposes of IRC 4940(a).
Even though a Qualified Employee Plan distribution typically includes interest, dividends, capital gains and other earnings, the Service treats the entire distribution as deferred compensation. The Qualified Employee Plan has received contributions from employees in respect to personal services. The pension fund also generates investment income on the employer contributions. However, once a distribution is made to an employee, the distribution is entirely taxed as deferred compensation. Unlike other trusts, a pension trust does not pass through the character of income to the recipient of trust distributions. For example, an employee is taxed on a distribution from a pension plan even though part consists of interest on tax-exempt municipal bonds. See Rev. Rul. 55 61, 1955-1 C.B. 40. Also, employees are not entitled to the dividend received exclusion where part of a pension distribution was attributed to dividends. All the rules applicable
316 Thirty Years After The 1969 TRA – Recent Developments Under Chapter 42
to pension distributions apply to the distributions as a whole without regard to the source of payments. See Rev. Rul. 72-3, 1972-1 C.B. 105. Thus, a pension is viewed as a substitute for earning power and the entire amount of the pension distribution constitutes deferred compensation. This is its only character. The same considerations are applicable to IRA distributions for purposes of IRC 4940(a). Finally, deferred compensation is not listed as an item that is included in gross investment income under IRC 4940(c) or Reg. 1.512(b)-1(a). Consequently, it is difficult to classify qualified employee plan distributions including IRA distributions as gross investment income for IRC 4940 purposes.
A new private letter ruling on this issue will be issued.
3. IRC 4941 A. Personal Services Exception and Foundation Managers Tax In a recent case, John W. Madden, Jr. v. Commissioner, T.C. Memo 1997-395 (1997), the Court addressed both UBIT and self-dealing issues. This synopsis considers only the self-dealing issues of that decision.
The Petitioner is a founder of the Museum, an entity exempt under IRC 501(c)(3) and classified as a private foundation. The Petitioner, his wife, and his daughter are each foundation managers within the meaning of IRC 4946(b). The Museum displays sculpture and other artwork, primarily outdoors. Most of the artwork is displayed along public thoroughfares that run throughout a commercial office building complex. The museum conducts tours of the artwork and also offers outdoor music concerts and theatrical and dance performances.
The Museum relies on the building owners (including a company related to the Petitioner) to provide space inside and outside the commercial complex to display the sculptures and artwork. The Petitioner owns a 75 percent interest in Greenway Management Co. (hereafter "GMC"), a service company providing custodial, maintenance, and janitorial services. GMC performed services for some of the office buildings in the complex and also contracted with the museum to perform comparable services for the Museum.
The parties agreed that GMC is a disqualified person as to the museum. The petitioner had agreed that payments made by the museum to repair artwork owned by the petitioner constituted acts of self-dealing. The question at issue is whether the furnishing of maintenance, janitorial, and security services by GMC is an act of self-dealing under
IRC 4941(d)(1)(C). The Petitioner asserted that the services performed by GMC fall within the exception of IRC 4941(d)(2)(E) for the performance of personal services.
In its holding, the Court focused on the definition of personal services. It cited the examples of personal services found under Reg. 53.4941(d)-3(c)(2). The examples include legal services, investment management services, and general banking services.
The Court found that the personal services in the regulations were of a professional and managerial nature as distinguished from the services rendered by GMC. Further, the Court found that Petitioner’s interpretation of personal services contravened Congressional intent. In the Court’s terms "... any exceptions to the self-dealing transactions rules should be construed narrowly."
The issue of the expanded definition of personal services for purposes of the exception provided by IRC 4941(d)(2)(E) has been an issue under debate for several years. The personal services exception was discussed at some length in the 1995 CPE Text, Topic O, page 247, 269 to 274. The argument asserted by the Petitioner in the Madden case, supra, had been asserted by other entities. The argument asserted in Madden is that any service is a personal service where capital is not a major factor in the production of income. The Court held that the Petitioner’s argument, if accepted, would nullify the prohibition against furnishing services in IRC 4941(d)(1)(C). The Court
(2) Foundation Managers Tax- Nature of Knowing The second self-dealing issue is whether Petitioner, his wife and his daughter are liable under IRC 4941(a)(2) for the tax on foundation managers with respect to the selfdealing transaction with GMC. Under Reg. 53.4941(a)-1(b)(1), the tax is imposed when the participating manager knows that the act is an act of self-dealing and the participation is willful and not due to reasonable cause. Reg. 53.4941(a)-1(b)(3) provides guidelines as to the foundation manager’s knowing participation in an act of self-dealing. Based on the facts of the case, the Court concluded that the managers had actual knowledge of sufficient facts concerning the transactions with GMC. The Court also found that they acted willfully in not obtaining advice of counsel concerning the implications of the arrangement with GMC. See also TAM 9627001, July 15, 1996, discussed in part 9.
However, the tax under 4941(a)(2) was not imposed on certain other acts of selfdealing. Thus, this case provides several examples of when the tax under IRC 4941(a)(2) may or may not be applied to foundation managers in a given situation.
B. Charitable Remainder Trusts- Income Deferral Issues Revisited The 1997 EO CPE Text, "Charitable Remainder Trusts: The Income Deferral abuse and Other Issues", Topic K, page 139, examined whether the income deferral technique by charitable remainder unitrusts constitutes self-dealing in violation of IRC 4941.
Topic K describes how the net income and makeup provisions of IRC 664 may be used not to gain flexibility in the normal management of the portfolio, but for a tax deferral purpose not contemplated by Congress. To achieve a maximum deferral for a noncharitable beneficiary, a trust’s assets must be manipulated in such a manner so that the net income and makeup provisions can be used to avoid payout in the early years of the trust and to realize income, including the makeup amount, only in later years when the noncharitable income beneficiary may be in a lower tax bracket. This device is called an income deferral NIMCRUT.
Topic K then continues to suggest that self-dealing may be asserted using the authority of Reg. 53.4941(d)-2(f)(1) to counter the income deferral NIMCRUT technique when the facts justify the position. The position suggested was that self-dealing occurs only under a specific factual situation where the assets were being manipulated for a specific personal purpose of the disqualified person and income beneficiary. The manipulation required for the self-dealing act is intentional manipulation.
The income deferral technique under consideration in the article involved two types.
The first type is gain realized on the sale of an appreciated asset of the NIMCRUT at some time during the term of the trust, presumably after enough time has passed to allow the trust asset to have appreciated in value significantly prior to its sale. Another form of income deferral discussed in the article was income earned by a partnership in which the NIMCRUT holds a significant interest as partner. If the partnership deliberately fails to distribute partnership earnings to the partners including the NIMCRUT, income could have been deferred for years. One form of income deferral not discussed in that article was deferred annuities.
As applied in an actual case in TAM 9825001, June 19, 1998, the Service position evolved into consideration, to a significant extent, of whether the deferral of income of the trust has an unreasonable detrimental effect on the charitable interest. The type of deferred income under consideration in the TAM was a deferred annuity.
An extract of the facts of TAM 9825001 is helpful:
X is a charitable remainder unitrust, which was intended to qualify under section 664 of the Internal Revenue Code. X was created by A by a trust instrument dated June 25, 1990. The trust instrument provides that the Trustee shall pay to A, and upon A’s death, to A’s wife, a unitrust amount equal to the lesser of (1) the trust income for the year or (2) eight percent of the aggregate fair market value of the trust assets for the year. The Trust instrument includes a make-up provision so that for any year that the unitrust payment is less than eight percent, the shortfall for prior years may be made-up in subsequent years when trust income exceeds eight percent.
B is the trustee of X and is also the nephew of A.
Upon the death of the survivor of A or A’s wife, the trust shall terminate and the balance of trust assets are to be distributed to designated charities.