19 October 2017 Private foundation's agreement with developer will not cause property to have acquisition indebtedness In PLR 201740002, the IRS has ruled that a private foundation's obligations to pay certain reimbursement costs and a "success fee" under a "Rezoning Services Agreement" will not cause the real property with respect to which the agreement was entered into to have "acquisition indebtedness" under Section 514. As a result, the agreement will not cause the foundation to incur unrelated business taxable income (UBTI) on lease payments it receives on the property. PF is a Section 501(c)(3) organization classified as a private foundation under Section 509(a). PF owns property (the Property) that it leases to two unrelated business entities. There is no debt on the Property; no part of the corresponding lease is attributable to personal property, and no part of the rent paid depends on the income or profits derived by any person from the Property The Property is located in an area that is rapidly developing and becoming more urbanized. To take advantage of this development, PF would like to have the Property rezoned to allow greater development density. For the Property to be rezoned, PF needs approval from the local county, which would require paying for various development plans to present to the county. A developer (the Developer) owns a property adjacent to the Property, which the Developer would also like to have rezoned. The Developer has a "Rezoning Specialist" as one of its principals. PF has concluded that working with Developer to seek the county's approval for the rezoning of both properties would increase the chances of gaining approval, while lessening the costs to PF. Accordingly, PF has entered into a Rezoning Services Agreement (RSA) with the Developer to pursue rezoning on PF's behalf. Under the RSA, PF will be a co-applicant on the Developer's rezoning application to the county. The Developer will be responsible for all aspects of the process required for gaining final approval for rezoning (Successful Completion). The Developer will consult with PF on all material aspects of the process. The Developer will pay all costs associated with the rezoning process other than those attributable to the Property, for which PF will reimburse the Developer. Upon Successful Completion, PF will also pay the Developer a "success fee" based on the increased value of the rezoned property. PF sought a ruling that the reimbursement fees and success fee that PF would owe the Developer under the RSA will not cause the Property to have "acquisition indebtedness" under Section 514. The IRS explained that Section 514(c)(1) defines acquisition indebtedness to include indebtedness incurred in acquiring or improving property. The IRS noted that Section 514 does not define indebtedness. However, it noted that, in the context of Section 163(a), courts have defined indebtedness as an unconditional and legally enforceable obligation for the payment of money. The IRS definition of indebtedness as "an unconditional and legally enforceable obligation for the payment of money" stems from the 1940 case of Autenreith v. Commissioner, 115 F.2d 856 (3d Cir. 1940), which cites to the predecessor of Section 163 (Section 23(b) of the Revenue Acts of 1934 and 1936). The IRS also noted that the regulations under Section 166, which allows a deduction for any debt that becomes worthless during the tax year, define a "bona fide debt" as a debt arising from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. The IRS concluded that, although the RSA obligates PF to reimburse the Developer for certain costs, as well as pay a success fee in the event of Successful Completion — the RSA, by itself, "does not create an unconditional and legally enforceable obligation for the payment of a fixed or determinable sum of money." Accordingly, the IRS ruled that the RSA does not give rise to acquisition indebtedness with respect to the Property because it alone does not cause PF to incur indebtedness. PF further sought a ruling that the lease proceeds received on the Property will not be subject to tax as UBTI. The IRS explained that generally under Section 512(b)(3) rents from real property are excluded from UBTI. However, under Section 512(b)(4), with respect to "debt-financed property," an amount of the income from rents on the property as determined under Section 514(a) will be included in UBTI. Section 514(b)(1) generally defines debt-financed property as income-producing property with respect to which there is acquisition indebtedness (defined in Section 514(c)(1)). Having already ruled that the RSA does not give rise to acquisition indebtedness, the IRS determined that the RSA will not cause the rents received under the leases on the Property to be includable in PF's UBTI as unrelated debt-financed income under Section 514(a). Although the IRS definition of "indebtedness" found in Autenreith is a long-standing legal principal, it is not one that the IRS cites frequently in the context of administrative guidance. This is especially true in the application of "indebtedness" for purposes of Section 514. Among the few instances in which the IRS has cited Autenreith as applied to Section 514 was General Counsel Memorandum (GCM) 39620, issued in 1987. In GCM 39620, the IRS examined whether an exempt organization's trading in commodity futures contracts gave rise to acquisition indebtedness under Section 514. While examining the property aspects of commodities futures, the IRS noted in the GCM that despite the binding commitments to purchase and sell a commodity, commodity futures contracts are rarely carried out. This is akin to the RSA considered in the current PLR, under which the private foundation was obligated to reimburse certain costs and pay a success fee, but the agreement, standing alone, did not create an unconditional and legally enforceable obligation for the payment of a fixed or determinable sum of money. This ruling illustrates how obligations might be considered indebtedness for purposes of the debt-financed property rules and determination of UBTI. While the obligations under the facts of this ruling were not "unconditional and legally enforceable" using definitions applicable to other parts of the tax law, the ruling demonstrates how specific facts are important to making this determination. A tax-exempt organization is advised to review all relevant guidance, including the application of other Code sections in making informed decisions. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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