26 March 2019 Transaction enabled trust to acquire nonvoting interests of LLC by gift rather than by self-dealing, IRS rules In a private letter ruling (PLR 201907004), the IRS has ruled that a trustor's proposed transfer to a trust of nonvoting interests in a limited liability company will not constitute an act of self-dealing under Section 4941. Trustor transferred business assets to certain beneficiary trusts established for his descendants, in exchange for promissory notes paying interest only for 30 years, followed by a principal balloon payment. Trustor assigned the promissory notes to a limited liability company (LLC) in exchange for nonvoting interest in LLC. LLC will hold and administer the promissory notes, and as a result will receive the interest and principal payments due. In addition, LLC 2 contributed cash to LLC in exchange for voting interests in LLC. Trustor and LLC 2 are the only members of LLC. Trustor's descendants are the members of LLC 2. Trustor's daughter serves as manager of LLC and trustee of one of the beneficiary trusts (Trust). The only interest she holds in LLC is through her interests in LLC 2, not in her capacity as trustee of Trust. A majority of the voting interests in LLC (i.e., LLC 2) could elect to remove her as manager of LLC. To dissolve LLC, all members holding either voting or nonvoting interests must provide written approval. Trustor proposes to transfer his nonvoting interests in LLC to Trust, a charitable lead annuity trust (CLAT) that annually distributes a guaranteed annuity to a Section 501(c)(3) public charity. Any remainder interest will be distributed to Trustor's descendants. Trustor claims Trust is subject to Section 4941 under Section 4947(a)(2). The IRS imposes an excise tax on each act of self-dealing between a disqualified person and a private foundation and on a foundation manager who knows of the self-dealing transaction (Section 4941(a)). Section 4947(a)(2), defining split-interest trusts, provides that Section 4941 will apply as if a trust were a private foundation if the trust:
Reg. Section 53.4941(d)-1(b)(5) provides that an organization is considered controlled by a private foundation if the foundation or one or more of its managers may together require the organization to engage in a transaction that if engaged in with a private foundation would constitute self-dealing. An organization is considered controlled by a private foundation if the foundation has the right to veto the actions of the organization relevant to any potential acts of self-dealing. In addition to the general rule of Section 4941(d)(1)(B) that lending money or otherwise extending credit between a private foundation and a disqualified person constitutes an act of self-dealing, Reg. Section 53.4941(d)-2(c)(1) states that an act of self-dealing occurs if a third-party transfers a note, on which the obligor is a disqualified person, to a private foundation that becomes the creditor of the note. The IRS explained that because Trust qualifies as a split-interest trust under Section 4947(a)(2), it is subject to Section 4941 as if it were a private foundation. Further, Trustor is a disqualified person with respect to Trust as a substantial contributor because he created Trust. Trustor's daughter is a disqualified person with respect to Trust because she is a foundation manager. The IRS noted that an act of self-dealing would occur if Trustor transferred the promissory notes to Trust, but because Trustor assigned the promissory notes to LLC and intends to transfer nonvoting interests in LLC to Trust, "Trust will acquire the nonvoting interests in LLC by gift rather than through a self-dealing transaction." The result would be different had Trust controlled LLC, but because Trust has no management or voting rights with regard to LLC, control is not an issue. Therefore, the IRS concluded that Trust's receipt from Trustor of nonvoting interests in LLC will not constitute a loan or extension of credit between a private foundation and disqualified person and, therefore, will not constitute an act of self-dealing. This ruling indicates potential succession or gifting planning opportunities for trusts treated as private foundations. However, it is essential for trustees of split-interest trusts recognized under Section 4947(a)(2) to understand what constitutes self-dealing and who within any proposed structure may be deemed a disqualified person. Not knowing these rules could have severe financial consequences in that resulting excise taxes can be substantial. Although this private letter ruling disqualifies transfers of non-voting interests as self-dealing, the ruling is particularly narrow. The ruling only addresses the issue of indirect or direct self-dealing when a trust is treated as a private foundation. The ruling cannot be interpreted to apply to any trust not subject to private foundation rules. In addition, the ruling failed to address other important considerations such as issues involving income (both to individuals and to the foundation), and the valuation of any assets for estate or gift tax purposes. Therefore, caution should be exercised before relying on the ruling for anything supplementing the specific self-dealing issues addressed. The private letter ruling only addresses the issue of indirect or direct self-dealing in the foundation context. The ruling did not address other important considerations. The income (both individual and to the foundation, e.g., excise tax), estate, and gift tax issues were specifically not addressed in the ruling. Caution should be exercised before relying on the ruling for anything more than the self-dealing issue. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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