Based on the facts as presented in PLR 201825004, the IRS has ruled that the reclassification of a Section 509(a)(3)(B)(iii) supporting organization as a private foundation, and certain payments to beneficiaries under a settlement, will not have adverse tax consequences.

Facts

Originally established by A and B as a tax-exempt entity described under Section 501(c)(3) that is classified as a Section 509(a)(3) Type III supporting organization, the taxpayer (Foundation) provided grants to nine designated beneficiary organizations. The Foundation's articles of incorporation stated that only Section 501(c)(3) public charities were eligible to receive grants from the Foundation. Further, no beneficiary could be a disqualified person within the meaning of Reg. Section 53.4958-3(a)(1) and (d)(1). The nine designated beneficiary organizations were all Section 501(c)(3) public charities. Nine individuals sat on the Foundation's board of directors — three selected by the governing bodies of the designated beneficiaries; three non-disqualified persons; and three members of the founders' families.

The Foundation's assets (mostly cash and investments) were held in two funds. The general fund held assets originally contributed by the Foundation's founders, plus any undistributed earnings. No specific restrictions were placed on the general fund. The second fund held assets that B assigned to the Foundation from a trust (Trust), which were subject to restrictions imposed by A's will and must be kept separate from the general fund assets.

According to A's will: (1) the Trust was created for the benefit of B during B's lifetime; when B dies, a portion of the Trust's remaining assets will be transferred to the Foundation; (2) distributions from the Trust in any year were limited to the greater of the residuary estate income for the year or 5% of the residuary estate total as of the first day of the year; (3) any distribution from the Trust must be specifically divided with a particular percentage of the distribution going to each of the nine designated beneficiaries; and (4) any Trust assets that B assigned to the Foundation from the second fund were subject to the other distribution requirements listed in the will.

Final regulations issued in 2012 imposed additional notice requirements that Type III supporting organizations must meet with regard to their supported organizations. In light of the requirements imposed by these regulations, the Foundation decided that "it could be run more efficiently as a private foundation" and sought this ruling from the IRS on the tax consequences of a reclassification from supporting organization status to private foundation status.

In seeking a judicial modification of the Trust to allow for the Foundation's change in status, the Foundation sought to eliminate the will's restrictions on distributions from the Trust. These restrictions limit distributions from the Foundation's second fund to 2.5% or less for some of the nine designated beneficiaries. The Foundation believes it can better achieve its exempt purpose "by focusing the annual distributions on the designated beneficiaries that receive the larger portions of the annual distribution provisions" under the will. In the judicial proceedings, the Foundation offered to make a series of payments to each of the designated beneficiaries slated to receive the smaller percentage shares of the annual distributions in exchange for relinquishing their rights to mandatory distributions from the Foundation's second fund. Most of the smaller designated beneficiaries accepted the offer (the Relinquishing Beneficiaries), but some did not (the Remaining Beneficiaries).

The Foundation entered into a settlement agreement with all the designated beneficiaries explaining the terms of the payments to the Relinquishing Beneficiaries and the continued distributions to the Remaining Beneficiaries. Under this agreement, the Relinquishing Beneficiaries agree that they will no longer be designated beneficiaries of the Foundation's second fund in exchange for two payments, which were determined based on the percentage distribution that the beneficiary would have received from the fund and the fair market value of the Foundation's second fund as of the trust conversion date and as of the final distribution date. The payment amounts were calculated to provide reasonable estimates of the amount that the Relinquishing Beneficiaries would have otherwise received from the Foundation's second fund.

In the settlement agreement, the Remaining Beneficiaries agreed that their percentage shares of the Foundation's second fund would be recalculated to reflect the equivalent shares of distributions made after the Foundation's two funds were combined. The shares would be recalculated again when the Trust terminates at B's death. Calculations for the new distribution amounts would be based on the Remaining Beneficiaries' percentage amounts under the Trust and the fair market value of the Foundation's second fund as of the trust conversion date and the final distribution date, and the fair market value of all net assets held by the Foundation as of the conversion date and the final distribution date. The calculations were intended to result in the same distributions that the Remaining Beneficiaries would have received if the Foundation did not combine the two funds.

A court ruled that the Foundation's request to modify the Trust would be granted, effective upon the receipt of a private letter ruling (PLR) from the IRS.

Private letter ruling

The Foundation requested rulings on eight issues.

Requested ruling 1. Both the proposed conversion of the Foundation to a private foundation and the transactions described in the settlement agreement will further one or more exempt purposes described in Section 501(c)(3).

Citing two revenue procedures (Revenue Procures 2017-3 and 2017-5; see Tax Alerts 2017-0060 and 2018-0066), the IRS will not rule on whether changes in a public charity's activities will jeopardize, or change its tax exempt status. The IRS further noted that Form 8940 is the appropriate form to use for miscellaneous determinations, including reclassifying a foundation from public charity to private foundation status. Therefore, the IRS does not rule in the PLR on whether the Foundation's proposed conversion affects the Foundation's exempt status or classification.

Requested ruling 2. Neither the proposed conversion of the Foundation to a private foundation nor the transactions described in the settlement agreement will result in Section 4958 excise taxes for the Foundation.

Intermediate sanctions may generally be imposed under Section 4958 on each excess benefit transaction undertaken between a public charity and a disqualified person. An excise tax may be imposed on the disqualified person or an organization manager who knowingly participates in an excess benefit transaction. Failure to correct the excess benefit within the taxable period can result in an additional 200% tax on the disqualified person (Section 4958(b)). Based on the Foundation's representation that none of the beneficiaries are disqualified persons, the PLR concludes that the proposed reclassification and payments to be made under the settlement agreement will not result in an excise tax liability under Section 4958.

Requested ruling 3. Payments made to the Relinquishing Beneficiaries and the Remaining Beneficiaries under the settlement agreement after the Foundation's conversion will not constitute self-dealing under Section 4941.

Each act of self-dealing between a disqualified person and a private foundation may be taxed under Section 4941(a)(1). Tax may be imposed on the self-dealers and any foundation manager who knowingly participates in the act of self-dealing.

Based on the Foundation's assertion that all of its beneficiaries are public charities, the PLR concludes that none of the beneficiaries are disqualified persons to the Foundation, so no transfers to them will be subject to tax due to self-dealing activities.

Requested ruling 4. Payments the Foundation makes to the Relinquishing Beneficiaries and the Remaining Beneficiaries under the settlement agreement after the Foundation converts to private foundation status will be treated as qualifying distributions under Section 4942(g) when the payments are actually made to each beneficiary.

A tax is generally imposed on a private foundation's undistributed income (Section 4942(a)). Undistributed income for any tax year is the amount by which the distributable amount for the tax year exceeds the qualifying distributions made out of the distributable amount for the tax year (Section 4942(c)). Qualifying distributions are: (1) any amount paid to accomplish a charitable purpose described in Section 170(c)(2)(B), other than a contribution to an organization controlled by the Foundation or a disqualified person or a private foundation that is not an operating foundation, or (2) any amount paid to acquire an asset used directly in carrying out one of the charitable purposes described in Section 170(c)(2)(B).

The PLR notes that all of the beneficiaries to the settlement agreement are entities described in Sections 170(c)(1) or 170(c)(2)(B), and the Foundation's articles of incorporation specifically require that an organization to be described under Section 170(c)(1) or under Section 501(c)(3) and Sections 509(a)(1) or 509(a)(2) to receive distributions from the Foundation. Because all of the payments the Foundation makes under the settlement agreement are paid to accomplish purposes described in Sections 170(c)(1) or 170(c)(2)(B), the payments would be qualifying distributions as of the dates the payments were actually made to the beneficiaries.

Requested ruling 5. Payments the Foundation makes to the Relinquishing Beneficiaries and the Remaining Beneficiaries under the settlement agreement after the Foundation converts to private foundation status will not constitute taxable expenditures under Section 4945(d).

Based on the Foundation's contention that all of the beneficiary organizations are public charities described in Section 509(a)(1) or 509(a)(2), and that no portion of any payment made under the agreement may be used for lobbying, influencing the outcome of elections, for grants to individuals other than education scholarships, or in any other manner for noncharitable purposes, the PLR concludes that the payments made to the beneficiaries are not taxable expenditures under Section 4945.

Requested ruling 6. Payments the Foundation makes to the Relinquishing Beneficiaries and the Remaining Beneficiaries under the settlement agreement after the Foundation converts to private foundation status will not result in termination of the Foundation's private foundation status under Section 507(a) and will not result in termination tax liability under Section 507(c).

Private foundation status generally is terminated only if a foundation: (1) notifies the Treasury Secretary of its intent to terminate, or (2) has engaged in either willful repeated acts (or failures to act) or a willful flagrant act (or failure to act) giving rise to tax liability under Chapter 42 and the Secretary notifies the organization that it is liable for tax under Section 507(c), which the organization pays, or the entire amount is abated (Section 507(a)).

The Foundation asserted that it did not intend to terminate its private foundation status, and the IRS found no indication that the Foundation had committed any willful repeated acts or willful flagrant act giving rise to tax under Chapter 42. Therefore, the PLR ruled that private foundation status will not be terminated under Section 507 and the Foundation will not be subject to termination tax under Section 507(c), as long as the Foundation refrains from committing any willful repeated acts or willful flagrant acts.

Requested ruling 7. For the calendar year including the date the Foundation converts to a private foundation, the Foundation's liability for excise tax under Section 4940 will apply only to net investment income earned during the part of that year in which the Foundation was classified as a private foundation and the Foundation's distributable amount under Section 4942 will be computed for the same period.

Section 4940(a) imposes an excise tax on a private foundation's net investment income for the tax year, and Section 4942(a) generally imposes a tax on the undistributed income of a private foundation for the tax year.

Because excise taxes under Sections 4940 and 4942 apply only to private foundations, the PLR notes that the Foundation would only be subject to them after it is reclassified as a private foundation, and the distributable amount under Section 4942 would be computed based on the short taxable period following the reclassification to private foundation status.

Requested ruling 8. The Foundation will be required to file both a Form 990 to report activity during the portion of its conversion year when it is classified as a Type III supporting organization and a Form 990-PF to report activity occurring during the portion of the year after it is reclassified as a private foundation.

Because the Foundation will be classified as a public charity for the first portion of the year of conversion and as a private foundation for the second portion of the year, the PLR concludes that a Form 990 and Form 990-PF must be filed to report the Foundation's activities as appropriate for each portion of the year.

Implications

This ruling offers an example of potential implications when a public charity converts to a private foundation. Organizations that voluntarily or involuntarily undertake such a conversion should be aware of the differing rules for public charities and private foundations, and the timing of the conversion. This PLR verifies that, generally, the organization must follow public charity rules and file a Form 990 for all activity up to and until the date of the conversion and must follow all private foundation rules, including filing a Form 990-PF for all activity immediate following the date of conversion.

This ruling also serves as a reminder that the IRS will not ordinarily issue a determination letter: (1) to a tax-exempt 501(c)(3) organization seeking recognition under a different subsection; (2) when an organization exempt under Section 501(c) requests a determination to relinquish its exempt status under Section 501(a); or (3) regarding whether changes in an organization's activities or operations will affect or jeopardize the organization's exempt status. Organizations seeking reclassification of foundation status under 509(a) should continue to use Form 8940 to request this change, including a voluntary request to change from a public charity to a private foundation, to terminate an organization's private foundation status, or to change the organization's Section 509(a)(3) supporting organization type.

A PLR 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 circumstances, 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 situations.

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

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