In a private letter ruling (PLR 201642001) the IRS has ruled that a grant a private foundation makes to a supporting organization (a Section 501(c)(3) public charity) to build and operate a new performing arts center on land that the supporting organization will buy from a disqualified person with respect to the private foundation using separate funds will not constitute an act of self-dealing under Section 4941.

Background

The private foundation (Taxpayer), a nonstock corporation, provides grants to public charities in several states. Its president and chairman is A; its only other trustee is B.

Supported Organization is a public charity described in Sections 509(a)(1) and 170(b)(1)(A)(vi). It operates an outdoor performing arts theater, displaying a variety of arts performances and education. A is the president and chairman of the board of Supported Organization; B is a director. A majority of the nine members of the board of directors of Supported Organization are independent of Taxpayer. Neither Taxpayer nor any of its disqualified persons controls Supported Organization within the meaning of Section 4942(g) or Reg. Section 53.5942(d)-1(b)(5). Supported Organization receives financial support from Taxpayer.

Supporting Organization, another public charity, is classified under Section 509(a)(3) as a Type 1 supporting organization and was established to support Supported Organization by building and owning a new, expanded performing arts center. Supporting Organization's board of directors is elected by Supported Organization; the two entities currently have the same board, with A as president and chairman of the board and B as a director.

Supporting Organization does not accept gifts from anyone who directly or indirectly controls Supported Organization's governing body, but does receive financial support from Taxpayer. Taxpayer has stipulated that neither it nor any disqualified person with respect to it controls Supporting Organization.

Company A is a real estate developer founded by C. A serves as Company A's president and CEO and owns stock representing more than 35% of the total combined voting power in Company A. Other ownership interests are divided between four separate trusts.

Company A holds an ownership interest in its subsidiary, Company B, along with A, a fund, and one of the trusts that hold an interest in Company A.

Supported Organization wants to update and enlarge the performing arts center by building on property as close to the original venue as possible. It hired a third-party consultant to find viable property. Supported Organization's board carefully evaluated the consultant's recommendations and decided to purchase land owned by Company B that was adjacent to the performing arts center's current location.

Complying with Supporting Organization's conflict of interest policy, A did not participate in any aspect of the decision to buy the land; instead, independent members of Supporting Organization's board voted to approve the purchase the land for a price determined by an independent appraiser.

Taxpayer intends to grant to Supporting Organization funds to be used to build a new performing arts center and pay its initial operating expenses. The grant funds from Taxpayer will be deposited in a segregated account; no part of the grant will be used to buy the land or serve as collateral for the land purchase. No agreement exists between Taxpayer and Supporting Organization or Supported Organization regarding the land purchase. The funds to purchase the land will be raised from public donations, or from government grants, or some combination of both. No portion of the funds used to purchase the land will come from the Taxpayer or any disqualified person with respect to Taxpayer.

Taxpayer asked the IRS to rule that the proposed grant to Supporting Organization for the construction and operation of a new performing arts center on land purchased from Company B (a disqualified person with respect to Taxpayer) using separate funds will not constitute an act of self-dealing under Section 4941.

Law and analysis

An excise tax is imposed on a disqualified person and each foundation manager who knowingly participates in an act of self-dealing between the private foundation and the disqualified person (Section 4941). Self-dealing includes (1) any direct or indirect sale, exchange or leasing of property between a private foundation and a disqualified person or (2) an agreement by a private foundation to transfer money or other property to a government official (Section 4941(d)(1)).

With respect to a private foundation, a disqualified person generally is: a substantial contributor to the foundation; a foundation manager; an owner of more than 20% of the (i) total combined voting power of the corporation, (ii) profits interest of a partnership, or (iii) beneficial interest of a trust or unincorporated enterprise that is a substantial contributor to the foundation; a family member; or a corporation in which any of these entities owns more than 35% total combined voting power (Section 4946(a)(1)).

An organization is considered controlled by a private foundation if the foundation or at least one of its foundation managers may require the organization to engage in a transaction that would constitute self-dealing if engaged in with the private foundation (Reg. Section 53.4941(d)-1(b)(5)). For purposes of Section 4941, a Section 501(c)(3) organization is not considered a disqualified person (Reg. Section 53.4946-1(a)(8)).

Under Reg. Section 53.4941(d)-1(b)(2), indirect self-dealing may not include a transaction between a government official and an intermediary organization that has received a grant from a private foundation that does not control the intermediary, as long as: (1) the private foundation has not earmarked the use of the grant for any named government official; (2) no agreement exists under which "the grantor foundation may cause the selection of the government official by the intermediary organization"; and (3) "the intermediary organization exercises control, in fact, over the selection process and actually makes the selection completely independently of the private foundation." This applies even if the foundation had reason to believe the government persons would benefit from the transaction.

The IRS notes that because A and B were foundation managers of Taxpayer, they constitute disqualified persons with respect to Taxpayer. Company A is also a disqualified person with respect to Taxpayer because A owns more than 35% of the total combined voting power in Company A, and Company B is a disqualified person with respect to Taxpayer under the attribution rules of Reg. Section 53.4946-1(d)(1). Therefore, if Taxpayer purchased land directly from Company B, this would be an act of self-dealing, the IRS points out. Instead, Taxpayer proposed to make a grant to Supporting Organization for construction and operating expenses only. Supporting Organization plans to purchase land from Company B, a disqualified person to Taxpayer, using other funds.

The IRS analogizes the reasoning used in Reg. Section 53.4941(d)-1(b)(2) regarding transactions with government officials to the instant facts "in which a grant is provided by a private foundation to an intermediary [S]ection 501(c)(3) organization that is not controlled by the private foundation … and the intermediary may independently use the grant to construct and operate a performing arts venue on land purchased from a disqualified person with other funds raised for that purpose." Because the grant funds are not being used to purchase the land, they are instead segregated to be used exclusively for the purpose of constructing and operating a new facility and Taxpayer has no control over Supporting Organization's decision to purchase the land, "no act of indirect self-dealing occurs," the IRS concludes.

The IRS ruled that Taxpayer's proposed grant to Supporting Organization for the construction and operation of a new performing arts center on land the Supporting Organization will purchase using other funds from a disqualified person of the taxpayer would not constitute an act of direct or indirect self-dealing under Section 4941. The IRS also stated that the ruling "does not apply if the grant funds are used for purposes other than those specified."

Implications

This private letter ruling is particularly noteworthy because it applied the "grants to intermediaries" exception to indirect self-dealing with a disqualified person, in this case the business of a foundation manager, rather than a government official. The "grants to intermediaries" exception in Reg. Section 53.4941(d)-1(b)(2) generally provides that a grant from a private foundation to an intermediary organization that later indirectly benefits a government official is not an act of self-dealing under Section 4941 if certain safeguards are met. Essentially, the intermediary must have complete and independent control over its selection of de facto beneficiaries, and the foundation cannot earmark any use of a grant to the intermediary organization for any named government official. This applies even if the foundation had reason to believe those individuals would receive some indirect benefit from the transaction.

A private letter ruling is a written statement issued to a particular taxpayer that interprets and applies tax laws to the taxpayer's specific, represented set of facts, and may not be used or cited as precedent by other taxpayers or by IRS personnel. Thus, although the ruling is instructive on how the IRS might rule regarding a particular matter, organizations are cautioned not to rely on the ruling as authority, and to consult with their tax advisors to determine the tax consequences of their own facts and circumstances.

Please contact your Ernst & Young tax professional with any questions.

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