16 March 2017 Private foundation's coffee and gift shops inside museum are related to charitable purpose, IRS rules In PLR 201710005, the IRS has ruled that: a tax-exempt private operating foundation's plan to construct and operate a coffee shop and gift shop (together, "the Shops") inside a museum it operates will not result in unrelated business taxable income; the expenditures related to the Shops will be qualifying distributions under Section 4942; and the Shops will not constitute excess business holdings under Section 4943. Entity A is a Section 501(c)(3) tax-exempt organization, classified as a private operating foundation under Section 4942(j)(3), that was organized to provide educational services and resources to the public. Entity A plans to construct, own and operate a community cultural center (the Center). The Center will house a museum containing certain historical artifacts, as well as displaying travelling cultural and educational exhibits, and a library. It will also have multi-purpose spaces for music, theater and art performances. The Center will be open to the public and offer free admission. Entity A plans for the Center to also house a gift shop and a coffee shop (the Shops) for use by the Center's visitors and staff. The coffee shop will be accessible only from the Center's atrium with all signage internal to the facility. The gift shop will sell various items associated with the Center (e.g., t-shirts, coffee mugs, documentary videos, and reproductions of artwork and artifacts exhibited at the Center). The coffee shop and atrium (which will house some exhibits and a memorial area) are planned to be open to the public from 6 a.m. to 10 p.m. Displays and pamphlets at the coffee shop will promote the other exhibits at the Center, which are planned to be open from 9 a.m. to 5 p.m. Entity B is a tax-exempt Section 501(c)(3) organization and private non-operating foundation under Section 509(a). Most of Entity A's financial support in the early years of its existence will come from Entity B and from larger local businesses in and around the two cities that sponsor special exhibits at the Center. The IRS ruled that Entity A's operation of the coffee shop (with sales of food and drink) will not constitute an unrelated trade or business under Section 513 and will be substantially related to Entity A's exempt purposes. The IRS compared Entity A's operation of the coffee shop to the facts at issue in Revenue Ruling 74-399, which involved an art museum that operated eating facilities. The IRS noted that Entity A's operation of the coffee shop will help attract visitors to the Center, allow visitors to spend more time there, and benefit employees and staff to increase operating efficiency. Moreover, the IRS noted that the coffee shop will not solicit the patronage of the general public. The IRS also determined that grants from Entity B to Entity A will not be self-dealing transactions, subjecting Entity A and its managers to excise tax under Section 4941. The IRS noted that, under Reg. Section 53.4946-1(a)(8), for purposes of Section 4941, the term "disqualified person" does not include any organization described in Section 501(c)(3). Accordingly, as long as Entities A and B remain qualified under Section 501(c)(3) at the time of each transfer, neither will be treated as a disqualified person for purposes of Section 4941. The IRS ruled that Entity A's expenditures for the construction, operation and maintenance of the Shops will be qualifying distributions under Section 4942. The IRS explained that operating foundations are not subject to the tax imposed by Section 4942 on the undistributed income of a private foundation, but they must still meet the "operating foundation" requirements of Section 4942(j)(3), including making qualifying distributions. Because operation of the coffee shop contributes to Entity A's exempt purpose, funds spent to construct and operate it will be qualifying distributions under Section 4942(g)(1)(A). The IRS determined that the gift shop, as proposed, also contributes to the Center's overall exempt purposes. Accordingly, funds spent for it will also be qualifying distributions under Section 4942(g)(1)(A). In addition, the IRS ruled that the Shops will not constitute excess business holdings that would subject Entity A to excise tax under Section 4943, which imposes a tax on private foundation's excess business holdings in any "business enterprise." Under Section 4943, a "business enterprise" does not include a "functionally related business." Section 4942(j)(4) defines "functionally related business" to include a trade or business that is not an unrelated trade or business under Section 513. Accordingly, because the IRS had determined that the coffee shop is not an unrelated trade or business under Section 513, it constitutes a functionally related business under Section 4942(j)(4). The IRS added that the same applies to the gift shop, which it also concluded was not an unrelated trade or business based on its proposed types of inventory. Because the funds expended by Entity A for the Shops will be qualifying expenditures under Section 4942(g)(1), the IRS determined that they are also not taxable expenditures under Section 4945(d)(5) (which would have subjected Entity A and its managers to excise tax under Section 4945). Finally, the IRS ruled that Entity A's legal, accounting and other expenses related to the rulings requested will be qualifying distributions under Section 4942, and will not be taxable expenditures under Section 4945, provided that Entity A can demonstrate a good faith belief that the expenses were reasonable and that the payment or incurrence of the expenses in such amounts was consistent with ordinary business care and prudence. This ruling clarifies that the cafeteria/coffee shop exception to the unrelated business income (UBI) rules, as detailed in the regulations and Revenue Ruling 74-399, applies to a private operating foundation, and serves as a good synopsis of the relevant UBI and private foundation excise tax concepts. The crux of the UBI portion of this ruling is that the museum coffee shop contributes importantly to the organization's exempt purpose because it attracts visitors to the museum and allows them to spend more time touring the exhibits by providing an alternative to eating away from the museum. It also allows staff to remain onsite during the workday. In addition, the gift shop (as proposed) is an activity carried on as part of the organization's overall exempt educational and charitable purposes. Because the IRS ruled that the activities of the Shops will not be unrelated, the excise tax rules are not violated. Specifically, the costs to construct, maintain and operate the shops are qualifying distributions because they were paid to acquire assets used directly in carrying out the organization's exempt purposes and are thus functionally related to the organization's exempt purpose. Similarly, administrative costs and professional fees that are necessary to carry out the exempt purpose activities are qualifying distributions. Further, because they are qualifying distributions, they are also not taxable expenditures. Finally, there were no excess business holdings because the Shops constitute a functionally related business, which is specifically excluded from the definition of "business enterprise." 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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