Private Letter Rulings - Endowment Units Not UBTI
GiftLaw Note:
M, a tax-exempt educational organization, is an irrevocable remainder beneficiary and serves as the trustee of a number of charitable remainder trusts (CRTs). In an effort to receive the best possible return on trust investments, M proposes to invest CRT proceeds in its endowment. Most of the endowment earnings consist of passive investments, though some are debt-financed, resulting in unrelated business tax. M proposes to allow the CRTs to purchase "units" in its endowment. While the CRTs would not have any ownership rights to the endowment's underlying assets, they would receive periodic payments based on the units owned by each. Thus, each CRT would receive an investment return equal to that of the M endowment. M requested a ruling that the issuance of endowment units would not result in the imposition of unrelated business income tax to the CRTs.
In order for there to be unrelated business taxable income (UBTI), three factors must be present. First, the income must be from a trade or business. Second, the trade or business must be regularly carried on. And third, the conduct of the trade or business must not be substantially related to the exempt purpose of the organization.
The Service ruled that if M were to charge a fee for investment advice or management of the CRTs endowment units, the service would rise to the level of a trade or business regularly-carried on. However, M is not proposing to charge a fee. Therefore, no UBTI would be created under the arrangement as proposed. Finally, because the CRTs will have no ownership in the assets of the endowment, the relationship between M and the trusts does not establish a partnership or agency agreement. Income earned by the CRTs will be all ordinary income; no UBTI will flow through the endowment to the CRTs.
In order for there to be unrelated business taxable income (UBTI), three factors must be present. First, the income must be from a trade or business. Second, the trade or business must be regularly carried on. And third, the conduct of the trade or business must not be substantially related to the exempt purpose of the organization.
The Service ruled that if M were to charge a fee for investment advice or management of the CRTs endowment units, the service would rise to the level of a trade or business regularly-carried on. However, M is not proposing to charge a fee. Therefore, no UBTI would be created under the arrangement as proposed. Finally, because the CRTs will have no ownership in the assets of the endowment, the relationship between M and the trusts does not establish a partnership or agency agreement. Income earned by the CRTs will be all ordinary income; no UBTI will flow through the endowment to the CRTs.
This is in response to N's request for a ruling that certain proposed contractual relationships will not generate unrelated business taxable income under section 512(a)(1) of the Internal Revenue Code (the "Code").
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).
M is the trustee of a number of charitable remainder trusts (collectively, "the Trusts"), and as trustee, M is the legal owner of the Trusts' assets. In addition, M has a remainder interest in each of the Trusts. N is one such charitable remainder trust in which M is trustee and remainder beneficiary.
As a result of the relationship with the Trusts as both trustee and beneficiary, M has a substantial interest in the value of the Trusts. Moreover, the donors to the Trusts 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.
M's endowment is invested in a diversified manner, with investments in domestic and international public equities, fixed income, real assets, hedge funds, and private equity. 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 proposes to create a contractual obligation, pursuant to which it would issue a contract right to each of the Trusts for a proportionate share, or "unit", of M's endowment. The cumulative value of the units would be the dollar value of the assets held by the individual Trusts combined with the units of the endowment held by the various departments and schools making up M's institution. The contract right would entitle the Trusts to receive periodic payments based on the units owned by each of the Trusts. The Trusts would thereby be able to receive an investment return equal to that of the endowment.
M determines a spending rate on the endowment each year based in part on M's projected needs. M calculates the market value of each endowment Unit on a quarterly basis. The market value of each endowment Unit initially equals the value of the gift or contribution to the endowment and is subsequently adjusted in accordance with the market value of the endowment. Each department and division is entitled to an amount equal to the spending rate times the number of units it holds.
M seeks to enable the Trusts to invest in the endowment in a manner identical to M's departments or schools. A Trust would acquire a Unit in the endowment which would give the Trusts a contractual right against the University, but no interest whatsoever in the underlying investment assets of the endowment. The units would have the same 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 spending rate M has established for the endowment, with payouts made at least quarterly or more frequently as appropriate. 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 capital gain, ordinary income, or return of capital, and regardless of whether the payout is made entirely by distributions of income or in part by redemption of units. The Trusts will treat redemptions of units (over and above receipt of the spending rate) as generating long or short-term capital gain (or loss), depending on the holding period of the redeemed units.
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 computations. 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 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).
N has requested the following ruling:
The issuance of units by 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.
LAW
Section 664(c) of the Code provides that a charitable remainder trust shall, for any taxable year, not be subject to any tax imposed by this subtitle unless such trust, for such year, has unrelated business income (within the meaning of section 512 of the Code, 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).
ANALYSIS
As noted previously, organizations described in section 664 of the Code are subject to tax on their unrelated business income taxable within the meaning of 512. In order for such an organization's income to be subject to the unrelated business income tax, three requirement 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 section 1.513-1(a) of the regulations.
M proposes to enter into a contractual relationship with certain Trusts that are charitable remainder 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 spending rate M establishes for its endowment with payouts made in accordance with the trust instruments.
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 units would have the same value that M uses for internal accounting purposes.
Consequently, a Trust could choose either to reinvest part of the payout, or redeem a portion of the 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. 69-528, supra. Such an activity would constitute a "trade or business" under sections 513(c) 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 of the Trusts at the same time that it engages in investment activity for its own benefit as the remainder beneficiary 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 computations. 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 in the underlying assets of M's endowment. Since the contractual relationship between M and the Trusts is not in the nature of a partnership or agency, the income earned by the Trusts from the payout M establishes for the units reflects ordinary income and does not take on the character of the income of the underlying assets or 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, a "charitable remainder trust."
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's authorized representatives. A copy of this letter should be kept in its 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.
Sincerely,
Robert C. Harper, Jr.
Manager
Exempt Organizations
Technical Group 3