01 February 2017 Private foundation's director appointment qualifies for indirect self-dealing exception In a private letter ruling (PLR 201703003), the IRS has ruled that a regulatory exception to indirect self-dealing applies to a private foundation that plans to appoint as a director the owner of a business with which the foundation will have a licensing agreement via a wholly owned partnership. X hosted a popular television show (the Show) for many years during which he became an American icon. During his career, he negotiated an agreement for the rights (e.g., copyrights, name, likeness, and publicity rights) to the Show and other shows from the network. During X's lifetime, these rights were held by two S corporations (the Corporations), whose parent was a taxable trust in X's name. Y, a family member of X (of a relation not described in Section 4946(d)), worked closely with X on his show over several decades. During the years that he was employed on the Show, Y traveled with X and was a close confidant, advisor and creative partner. Following X's retirement, Y continued working with X to manage the licensing of the episodes of the Show and to distribute episodes of the Show. Y developed a deep encyclopedic understanding of the content of the Show's episodes and other intellectual property associated with it. Based on X's history and close relationship with Y, X granted exclusive rights to market the Show to Y's wholly owned company (the Company). X retained the right to revoke the license agreement. The license agreement included the sole and exclusive rights to license, rent, lease, exhibit, distribute, reissue and deal in the episodes of Show (and any movies created therefrom), as well as all ancillary rights, including merchandising and music rights of the Show. This comprised the whole of the Company's business. A portion of the profits derived from the licensing went to the Company, while the majority of those profits went to the Corporations. Upon X's death, through the administration of his estate and by the terms of the trust that owned the Corporations, the rights and privileges associated with the episodes of the Show held by the Corporations passed to Organization, a 501(c)(3) tax-exempt private foundation dedicated to supporting children, education and health services. The licensing agreements with Company also passed to Organization. After Organization received the rights and privileges associated with the episodes of Show, a separate agreement was entered between Organization and Company concerning publicity rights. This agreement gives Company the exclusive right to license any publicity rights for X's name and likeness. Based on his long and close relationship with X, Y has served as an advisor to Organization since X's death, but never as a director or officer. Y advises Organization on the charitable work in which X was interested and provides non-public anecdotes that Organization can share with donees. Based on Y's unique relationship with X, Organization believes that appointing Y as a director and officer would help it further its charitable purposes. Organization also plans to transfer its rights and licensing agreements relating to the Show into a limited partnership (LP) to give it greater liability protection. LP would retain the license agreements and publicity rights agreement for those rights with Company. A corporation owned by Organization will hold a 1% interest in LP and serve as general partner. The remaining 99% interest will be held directly by Organization, which will receive passive income from LP in the form of royalties and license fees. LP will not engage in any other activities. A third-party report commissioned by Organization concluded that the Company holds a unique advantage for licensing relating to the Show because of Y's relationship and history with X, such that licensing the rights to a firm other than Company would cause substantial economic harm to Organization's revenue. The report notes that, in addition to Y's encyclopedic knowledge of the Show, Company has a proprietary system for searching and accessing materials related to the Show. The report also determined other companies could not match the level of services provided by Company with respect to the Show, nor provide the services at as low of a cost. Organization requested a ruling that, following the transfer of the rights and licensing agreements to LP, Y will be able to serve as a director and officer of Organization without violating the provisions against direct or indirect self-dealing transactions with Organization under Section 4941. The IRS explained that, barring an exception, Y's service as an officer or director of Organization while Organization has the licensing agreements with Company would be an act of self-dealing, to which taxes would apply under Section 4941. The IRS noted, however, that such treatment could be avoided if the exception to self-dealing provided in Reg. Section 53.4941(d)-1(b)(1) applies. Under Treas. Reg. 53.4941(d)-1(b)(1), transactions between a disqualified person and an organization controlled by a private foundation are excepted from indirect self-dealing if they meet three requirements: (1) the transaction stems from a business relationship established before the transaction constituted an act of self-dealing, (2) the transaction will be at least as favorable to the organization controlled by the private foundation as an arm's-length transaction, and (3) either the organization controlled by the private foundation would suffer an extreme economic hardship if it could not do business with the disqualified person, or the products or services provided by the organization controlled by the private foundation are so unique that it would cause extreme economic hardship for the disqualified person. Because Organization is transferring its rights and agreements to LP, the IRS noted, any acts of self-dealing between Y and Organization would be indirect. The transactions, however, would not be considered indirect self-dealing if the exception to indirect self-dealing under Reg. Section 53.4941(d)-1(b)(1) applies. The IRS determined that the transactions meet the requirements to qualify for the exception. Specifically, the IRS noted: (1) Y's licensing of the Show began before Organization's ownership of the associated rights; (2) an independent study has determined that Company is uniquely situated to provide the services on an arm's-length basis; and (3) Organization would suffer a significant economic hardship if the services had to be obtained from a party other than Company. Accordingly, the IRS ruled that the exception under Treas. Reg. 53.4941(d)-1(b)(1) applies, and the licensing and publicity rights agreements between the Company and LP will not result in indirect acts of self-dealing under Section 4941 if Organization appoints Y as a director and officer. The IRS also ruled that the formation of LP and the proposed transfer of the rights and agreements to LP will not constitute "excess business holdings" under Section 4943. The IRS explained that 100% of Organization's income from LP will be derived from royalties, which are considered passive income. Accordingly, LP will not be deemed to be a business enterprise under Section 4943(d)(3)(B), so Organization's ownership of LP interests will not constitute excess business holdings. While this ruling involves a unique fact pattern, the concepts discussed by the IRS and the arguments put forth by the private foundation in question can extend to other situations. The two key points involved indirect self-dealing and excess business holdings. Section 4941 of the Code imposes a tax on acts of self-dealing between a private foundation and a disqualified person, whether engaged in directly by the private foundation or indirectly through an organization controlled by the foundation. This ruling illustrates one exception to indirect self-dealing, which is found in Reg. Section 53.4941(d)-1(b)(1). Under this exception, a transaction between an organization controlled by a private foundation and a disqualified person is excepted if it meets each of three requirements: i. The transaction results from a business relationship established before such transaction constituted an act of self-dealing; ii. The transaction is at least as favorable to the organization controlled by the foundation as an arm's-length transaction with an unrelated person; and a. The organization controlled by the foundation could have engaged in the transaction with someone other than a disqualified person only at a severe economic hardship, or The existence of an established business relationship is typically based on an objective set of facts. Determining whether a transaction is at least as favorable to the organization controlled by a private foundation as an arm's-length transaction often presents a greater challenge. The private foundation here overcame this obstacle by commissioning an independent report from a consulting firm. This report determined that the services could be performed at a much lower cost to the foundation because of Y's "deep knowledge and ability to catalogue, find, and describe the necessary clips on his own, providing much lower overhead than other firms in that industry." The report also helped to satisfy the third prong of the test by establishing that Company provided a unique service for the sale, licensing and distribution of Organization's intellectual property rights in that it could not be matched by other firms or systems without substantial harm to the private foundation's income from licensing the rights to the Show. This position coincides with prior letter rulings pertaining to the controlled organization exception in which the disqualified person was in a similar inimitable position. See PLR 198650090 (certain leased land used as a parking lot adjoined a disqualified lessee's office building, and to obtain parking space, the disqualified lessee could not have engaged in the transaction with anyone else) and PLR 198439095 (unique nature of the disqualified person's contractual rights were such that a proposed transaction could not be engaged in with anyone else). Transactions between the private foundation itself and a disqualified person would not meet this exception under the regulation; rather, it must be a transaction between a disqualified person of the foundation and an organization controlled by the foundation. Section 4943 imposes a tax on any excess business holding of a private foundation for any interest in a business enterprise exceeding 20% when combined with the holdings of all disqualified persons. When at least 95% of the venture's gross income is derived from passive sources, however, it is not considered a business enterprise. Passive sources include income from interest, dividends, annuities, royalties, certain rents and gains on the sale of certain property. Here, the private foundation fully owned the limited partnership whose sole activity was holding intellectual property rights and collecting the related royalties. Since over 95% of the partnership's income was derived from passive sources, it did not meet the definition of a business enterprise under Section 4943(d)(3)(B); thus, the private foundation's ownership of partnership interests in the limited partnership did not constitute excess business holdings. 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. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg
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