Ruling Re: Standard Foundation Grants to Private Operating Foundation Contains Major Flaw

• Date: 01 March 2017
• Published date: 01 March 2017
• DOI: http://doi.org/10.1002/npc.30296

Bruce R. Hopkins’ NONPROFIT COUNSEL

5

March 2017

THE LAW OF TAX-EXEMPT ORGANIZATIONS MONTHLY

Bruce R. Hopkins’ Nonprofit Counsel DOI:10.1002/npc

Thereafter, the trustees and beneficiaries of this trust

entered into an agreement dividing the trust into two

trusts for the benefit of the descendants of one child

and the second child. The settlement was contingent on

a favorable state court order and a favorable IRS ruling

that the division would not cause either resulting trust

to lose its generation-skipping tax exemption. The favor-

able order and ruling were received.

Subsequently, the trustees of the trust for the

child filed a petition with the state court requesting

various modifications, including change of the power of

appointment to an inter vivos power and that the child

be allowed to immediately exercise the new power to

grant income and principal of the trust to two private

foundations, causing termination of the trust. The peti-

tion was granted; the distributions to the foundations

were made. The trust claimed charitable contribution

deductions for these gifts.

Law

IRC § 642(c)(1) generally provides that, in the case

of a trust or estate, there is a charitable contribution

deduction for a gift of income made pursuant to the

governing instrument for charitable purposes. A charita-

ble gift not made pursuant to the governing instrument

is thus not deductible (e.g., Crown Income Charitable

Fund v. Commissioner (summarized in the December

1993 issue)). A settlement agreement arising from a will

contest constitutes a governing instrument (Emanuelson

v. US (DC Conn. 1958)). Conversely, a marital deduc-

tion trust was not allowed because the distribution was

made pursuant to the wife’s will, not the husband’s

original will (Brownstone v. US (2nd Cir. 2006)).

Analysis

The IRS stressed that there was no conflict with respect

to the resulting trust following division of the original

trustee. The purpose of the second court order was to

enable the parties to receive the economic benefits they

tried to obtain from modification of the “parent” trust.

Thus, the agency’s lawyers concluded that the payments to

the foundations are not deductible by the trust.

As to the second issue, there was an argument that

the trust, despite the unavailability of the IRC § 642(c)(1)

deduction, was entitled to a distribution deduction (IRC §

661), to the extent of its distributable net income, for the

payments to the charities. Following an extensive analysis

of the “genuine ambiguity” of the statutory provisions and

the legislative history, and the ensuing case law and com-

mentary, the IRS’s lawyers concluded that a sentence in the

tax regulations (Reg. § 1.663(a)-2) establishing the exclusiv-

ity of IRC § 642(c) as the deduction for charitable payments

by trusts and estates “represents a better overall reading of

the law.” Four reasons were given for this conclusion, the

principal one being that a specific statute should be held

to control over the provisions of a general one. [9.22] ◆

RULING RE: STANDARD

FOUNDATION GRANTS

TO PRIVATE OPERATING

FOUNDATION CONTAINS

MAJOR FLAW

A standard private foundation is proposing to make

grants to a private operating foundation. The proposed

grantor was founded by A and B, who serve as two of

its three directors. The proposed grantee has 11 direc-

tors, including A and B. The proposed grantee is newly

formed; the majority of its financial support over the

coming five to 10 years will be derived from the grantor

and local businesses.

One of the rulings in this instance by the IRS is that the

proposed grants will constitute qualifying distributions (IRC

§ 4942(g)(1)), inasmuch as the proposed grantee is not con-

trolled by the proposed grantor (Priv. Ltr. Rul. 201652004).

The IRS noted that even if control was present, the grants

would nonetheless be qualifying distributions if the pass-

through rules (IRC § 4942(g)(3)) are followed.

Other rulings by the IRS in this case are that the

proposed grants are not self-dealing transactions, since

disqualified persons do not include charitable entities

(Reg. § 53.4946-1(a)(8)); will not give rise to net invest-

ment income (IRC § 4940(a)), in the absence of any

consideration from the grantee; and will not constitute

jeopardizing investments (IRC § 4944). The IRS also

ruled that the grantor’s legal, accounting, and other

expenses related to the request for rulings and the pro-

posed grants, if reasonable in amount, will be qualify-

ing distributions and not taxable expenditures (Reg. §§

53.4942(a)-3(a)(2)(i), 53.4945-6(b)(2)).

The basis of this ruling’s flaw is found in this sentence:

“The proposed grants will be made to [g]rantee, which has

been recognized as an operating foundation as defined in

§ 4942(j)(3), and as such, qualifies as an exempt operating

foundation under § 4940(d)(2)” (emphasis added). The

predicate as such is the source of the problem, inasmuch

as qualification as a private operating foundation does not

automatically result in exempt operating foundation status.

Here, the proposed grantee cannot qualify as an exempt

operating foundation, if only because it will not be publicly

supported for at least 10 years.

Thus, the IRS ruled that the proposed grants will not

be taxable expenditures by the grantor (IRC § 4945).

That is not true. The proposed grants will be taxable

expenditures because the proposed grantee is not an

exempt operating foundation. This matter can be recti-

fied by making the grants expenditure responsibility

grants, but the ruling is silent on that point. [12.4]

Note: I had hoped, naively as it turned out, to keep this

flaw under wraps until publication of this issue. Alas,