Transfer of Disqualified Person's Note via Noncontrolled Trust to Foundation Ruled Not Self‐Dealing

• Published date: 01 August 2017
• DOI: http://doi.org/10.1002/npc.30350
• Date: 01 August 2017

Bruce R. Hopkins’ NONPROFIT COUNSEL

3

August 2017

THE LAW OF TAX-EXEMPT ORGANIZATIONS MONTHLY

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

Showing that it regarded this case as purely one

of statutory construction, the Court observed that

the respondents’ construction of the statute “runs

aground” on the surplusage canon—the “presumption

that each word Congress uses is there for a reason.”

The Court wrote that the employees “ask us to treat

[certain] words as stray marks on a page—notations

that Congress regrettably made but did not really

intend.”

A detailed analysis of the sparse legislative history of

the amended statute rounded out the Court’s opinion,

with it noting that, if the hospitals’ view of that history

is correct, “our construction of the text fits Congress’s

objective to a T.” ◆

TRANSFER OF DISQUALIFIED

PERSON’S NOTE VIA

NONCONTROLLED TRUST

TO FOUNDATION RULED

NOT SELF-DEALING

The IRS ruled that the proposed contribution by a

founder of a private foundation, by means of a distribu-

tion from a revocable trust on the founder’s death to

the foundation of the nonvoting interests in a limited

liability company, the only asset of which is a promis-

sory note from a disqualified person with respect to the

foundation, will not constitute an act of direct or indirect

self-dealing (Priv. Ltr. Rul. 201723005).

Facts

This private foundation (Foundation) was created by

an individual (Founder) and her husband. The husband

has died. The Foundation’s directors are the Founder, her

two sons, and an independent individual.

The Founder sold membership interests in the limited

liability company (LLC) to an irrevocable trust (Trust 1) in

exchange for a promissory note (Note). The Founder’s

descendants are beneficiaries of Trust 1. The Founder

desires that, following her death, any part of the princi-

pal and interest on the Note that then remains unpaid

be used to benefit the Foundation.

To that end, the Founder contributed the Note to

the LLC in exchange for voting and nonvoting interests

in it, which were subsequently transferred to a revocable

trust (Trust 2). The Founder is the settlor and sole trustee

of Trust 2; she holds a revocation power in the form of

a power to direct the trustee to distribute the assets of

Trust 2 to her during her lifetime. The Founder’s descen-

dants are beneficiaries of Trust 2.

The LLC will hold and administer the Note, receiving

payments of interest and principal. The sole asset and

source of income of the LLC is and will be the Note.

The power to manage the affairs of the LLC is vested

in its manager, who is selected and subject to removal

by the voting members of the company. One of the

Founder’s sons is the manager. The members of the LLC

holding nonvoting interests do not possess any manage-

ment rights or rights to vote on the manager. The LLC

may be dissolved only with the written approval of all

voting and nonvoting members.

The Founder proposes that, at the time of her death,

Trust 2 (which will then become irrevocable) distribute to

the Foundation all of the nonvoting interests in the LLC,

which will have a profit-sharing ratio of 99 percent. Trust

2 will retain its voting interests in the LLC, which have a

profit-sharing ratio of 1 percent.

Law and Analysis

Trust 1 and Trust 2 are disqualified persons with

respect to the Foundation because they are trusts in

which the Founder’s descendants, who also are disquali-

fied persons, hold more than a 35 percent beneficial

interest (IRC § 4946(a)(1)(G)).

An act of self-dealing would occur if the Foundation

transferred the Note to the Foundation, which would

become the creditor under the Note (IRC § 4941(d)

(1), concerning extensions of credit). If the Foundation

will control the LLC (Reg. § 53.4941(d)-1(b)(5)), then

the Foundation will be indirectly serving as the credi-

tor under the Note by reason of its ownership interest,

thus causing an indirect act of self-dealing (Reg. §

53.4941(d)-1(b)(8), Example (1)). The Foundation, how-

ever, the IRS ruled, will not control the LLC, due to lack

of voting power.

As holder of the nonvoting interests, the Foundation

will not have any management rights or right to vote on

the LLC’s manager; Trust 2 will have these rights. The

Foundation will have a right to receive distributions only

if the LLC dissolves or chooses to make current distribu-

tions, but the timing and amount of these distributions

will be uncertain and could not be compelled by the

Foundation. Thus, the Foundation and its managers (act-

ing only in that capacity) will not have sufficient votes or

positions of authority to cause the LLC to engage in a

transaction.

The Foundation will not have the power to compel

dissolution of the LLC, since it may only be dissolved by

written approval of all of its members. The IRS wrote

that the “power associated with the nonvoting interest

of [the] LLC as a necessary party to vote on the liquida-

tion of the LLC is not considered equivalent to a ‘veto

power’ because the power cannot be exercised over an

action relevant to any potential act of self-dealing.”

Accordingly, the IRS ruled, the Foundation’s receipt

from Trust 2, on the Founder’s death, of nonvoting

interests in the LLC will not constitute a loan or other

extension of credit between a private foundation and

a disqualified person because the Foundation will not