In two substantially similar private letter rulings (PLRs 201937003 and 201937004), the IRS has ruled that a private foundation's payment of a reasonable fee to its founder through a disregarded entity for the performance of programmatic, grant-making, and consulting services, in addition to investment management services, will not constitute an act of self-dealing. The IRS reasoned that the services are deemed to be professional types of personal services that are reasonable and necessary to carrying out the foundation's exempt purposes. As such, they meet the exception described in the regulations for IRC Section 4941. PLR 201937004 also concluded that the foundation's expenditures for programmatic, grant-making and consulting services will be considered qualifying distributions under IRC Section 4942 and will not constitute taxable expenditures under IRC Section 4945.

Facts

An IRC Section 509 private foundation (Foundation) was organized to conduct charitable activities under IRC Sections 170(c)(2)(B) and 501(c)(3), in addition to making grants to IRC Section 501(c)(3) organizations. Primarily, Foundation makes grants to and provides consulting services for other charities.

An individual (Founder) created Foundation and remains its primary donor. Founder is considered a substantial contributor to Foundation, as defined in IRC Section 507(d)(2). A board of directors governs Foundation. Certain board members are independent and are considered disqualified persons (IRC Section 4946(a)) because they are foundation managers.

Two of Founder's wholly owned disregarded entities (A and B) provide services to Foundation that enable Foundation to carry out its charitable activities. To date, Founder has donated these services — A and B have not charged Foundation for the services and Founder has absorbed the cost. Going forward, Foundation plans to enter into a contract with A to pay a reasonable fee for the services, rather than accepting free services from Founder; this will enable Foundation to better understand its operating expenses and to ultimately become self-sufficient. In turn, A will contract with B to assist A in delivering investment management and advisory services for the Foundation under A's contractual obligations to Foundation.

A and B are both disregarded entities, separate from their owner under Reg. Section 301.7701-3. In addition to providing services to Foundation, they spend approximately one-third of their time providing services to Founder, Founder's family members, and other tax-exempt organizations. For Foundation, A provides philanthropic program and grant-making services that include facilitating Foundation's grant-making process, updating and maintaining documentation pertaining to grants and grantees, and ensuring that due diligence files are complete. In its charitable consulting activities, Foundation organizes meetings of experts and grant recipients and provides consulting services to other charities.

As provided under the contract between Foundation and A, B will help A deliver investment management and advisory services to Foundation and to other entities as Foundation directs. Through the services of B's employees, Foundation provides public charities with advice regarding investment strategies, asset allocation, and liquidity needs for making grants.

All the entities for which Foundation provides program-related or investment consulting services are (1) US public charities, (2) foreign organizations that would qualify as public charities if they were located in the United States, or (3) entities for which Foundation exercises expenditure responsibility, as defined by IRC Section 4945(h) and its regulations. None of the entities that Foundation serves is a disqualified person with respect to Foundation and none is controlled by Foundation.

Employees of A who provide services to Foundation include highly credentialed individuals "with specific background and skills necessary to provide grant-making services," as well as office and grant management staff.

The independent directors of Foundation's board will review and approve both the contract between Foundation and A and the fees Foundation agrees to pay. (None of the non-independent directors will participate in considering or voting on adoption of the agreement.) Third-party compensation experts will ensure that the fees Foundation pays under the contract are reasonable.

Foundation will document (1) the terms of its services agreement with A and the date it is approved; (2) the names of the independent directors present during debate on the services agreement and who voted on it; (3) data relied on to support the reasonableness of fees; and (4) any actions taken as the services agreement was being considered by any director "who may have had an apparent conflict of interest."

Law and analysis

Self-dealing question — common to both PLRs

A tax is imposed on each act of self-dealing between a disqualified person and a private foundation (IRC Section 4941(a)(1)). A disqualified person includes a person who is a substantial contributor to the foundation (IRC Section 4946(a)(1)).

Generally, a private foundation's payment of reasonable compensation to a disqualified person for personal services that are reasonable and necessary to carrying out the foundation's exempt purpose are not considered self-dealing (IRC Section 4941(d)(2)(E)). "Personal services" defined in the regulations include investment counseling and general banking services (Reg. Section 53.4941(d)-3(c)(2)). The Tax Court held in Madden v. Commissioner, 74 T.C. Memo. 1997-395, that maintenance, janitorial, and security services are not considered personal services. (In the instant case, A outsourced its maintenance and janitorial services.)

Applying these rules, the Founder is a disqualified person with respect to Foundation. Unless an exception applies, any payment of compensation to Founder constitutes an act of self-dealing. However, the IRS specifically states in the PLR 201937003 ruling that "programmatic, grant-making and charitable consulting activities (to both Foundation and other charities) are reasonable and necessary services that enable Foundation to carry out its charitable purposes." As long as the compensation is reasonable and not excessive, the payment for the services falls within the IRC Section 4941(d)(2)(E) exception to the self-dealing rules.

The IRS analogized the facts at issue here (Foundation paying A for investment-related services provided by B) with those presented in Example 2 in Reg. Section 53.4941(d)-3(c)(2), and concluded that "payments by Foundation to A for B's investment services provided to Foundation will be payment for reasonable expenses necessary to carry out the exempt purposes of Foundation as long as the compensation is necessary and reasonable to carrying out Foundation's investment program and not excessive under [IRC Section] 4941(d)(2)(E)."

Therefore, the IRS ruled that Foundation's reasonable payment to A for the services that include programmatic, grant-making, charitable consulting, and investment advisory enabled Foundation to fulfill its exempt purpose and will not constitute a prohibited act of self-dealing under IRC Section 4941.

Qualifying distribution issue (PLR 201937004)

A private foundation's undistributed income for any tax year is taxed under IRC Section 4942(a). A "qualifying distribution" from a private foundation is defined (IRC Section 4942(g)(1)(A)), in part, as any amount paid to accomplish one or more charitable purposes under IRC Section 170(c)(2)(B), which include "religious, charitable, scientific, literary, or educational purposes."

The IRS concluded in PLR 201937004 that, assuming Foundation's payments to A accomplished one of the purposes enumerated in IRC Section 170(c)(2)(B), the payment of expenses will be considered qualifying distributions under IRC Section 4942.

Taxable expenditures issue (PLR 201937004)

A private foundation's taxable expenditures are taxed under IRC Section 4945. Included in a taxable expenditure is any amount that a private foundation pays or incurs for any purpose other than one listed under IRC Section 170(c)(2)(B). Generally, a taxable expenditure under IRC Section 4945(d)(5) does not include a payment that constitutes a qualifying distribution under IRC Section 4942(g). Because the IRS determined that the funds Foundation spent for programmatic, grant-making, and charitable consulting services constitute qualifying distributions under IRC Section 4942, the IRS further ruled these expenditures would not be treated as taxable expenditures under IRC Section 4945(d)(5) and will not subject Foundation to IRC Section 4945 excise tax.

Implications

Although determinations provided in private letter rulings apply only to the recipient, they do yield some insight into the IRS's latest thoughts and analysis on certain issues. In this instance, the IRS's ruling — that the payment of compensation to a disregarded entity owned by a disqualified person for programmatic, grant-making, and charitable consulting services are professional services of a personal nature that meet the exception to self-dealing as described in IRC Section 4941(d)(2)(E) — may be viewed as an expansion of the "personal services" exception for private foundations. Previously, the Madden case only described what services were not deemed to be professional and managerial in nature in the context of self-dealing. The examples cited in the regulations specify only a few types of services defined as professional and managerial and do not include programmatic management activities such as grant making and charitable consulting. By including these activities within the "personal services" exception of IRC Section 4941(d)(2)(E), the IRS may have provided an opportunity for private foundations with similar fact patterns to obtain a similar determination.

If you have any questions about how this may affect your organization, contact an EY Tax professional listed below.

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