- The IRS has issued Revenue Procedure 2021-40, 2021-38 IRB 1, adding a private foundation issue to the list of those areas on which the IRS will no longer issue private letter rulings or determination letters.
- The IRS indicated that it is "currently reviewing" its prior ruling position on whether an act of self-dealing occurs when a private foundation (or other entity subject to the self-dealing rules under Internal Revenue Code §4941) owns or receives an interest in a limited liability company or other entity that owns a promissory note issued by a disqualified person.
- This Holland & Knight alert gives background on the self-dealing rules, reviews scenarios and exceptions to the rules, takes a look at previous private letter rulings, and provides considerations for private foundations or other entities that may face such issues.
The IRS issued Revenue Procedure 2021-40, 2021-38 IRB 1 on Sept. 3, 2021, adding a private foundation issue to the list of those areas on which the IRS will no longer issue private letter rulings or determination letters: The IRS indicated that it is "currently reviewing" its prior ruling position on whether an act of self-dealing occurs when a private foundation (or other entity subject to the self-dealing rules under Internal Revenue Code (IRC) §4941) owns or receives an interest in a limited liability company (LLC) or other entity that owns a promissory note issued by a disqualified person.
To understand this new no-rule area, a brief review of the self-dealing rules is necessary. Section 4941 of the IRC subjects private foundations to a number of excise tax provisions, including a tax imposed on "disqualified persons" who engage in certain prohibited "self-dealing" acts with a related private foundation. The general intent of the self-dealing rules is to prohibit nearly all non-gratuitous transfers of property, income, facilities and services, as well as the leasing or extension of credit between private foundations and their disqualified persons. Thus, the term "self-dealing" may apply to a transaction even when the terms of the transaction are entirely fair and reasonable to the private foundation and represent fair market value consideration when viewed from an ordinary business perspective.
The self-dealing excise tax is assessed at the rate of 10 percent of the amount involved with respect to the act of self‑dealing for each year. Notably, the tax is not assessed against the private foundation and instead is assessed against the disqualified person that participates in the act of self‑dealing. In addition, if the act of self-dealing is not corrected (which generally requires undoing or unwinding the transaction) within the applicable taxable period, the excise tax increases to 200 percent of the amount involved in the self-dealing transaction. The tax also may be assessed, at a rate of 5 percent of the amount involved, against any member, director, trustee or officer of the foundation, or against another person having managerial authority over the foundation – referred to collectively as "foundation managers" – if they know that the act is one of self‑dealing, unless the foundation manager's participation was not willful and is due to reasonable cause.
For purposes of IRC §4941, the term "disqualified person" means a person who is: a) a substantial contributor to the foundation; b) a foundation manager; c) an owner of more than 20 percent of an entity that is a disqualified person; d) a family member of a disqualified person; e) an entity that is 35 percent-controlled by a disqualified person; and/or f) a government official. Substantial contributors are defined as persons who contributed or bequeathed an aggregate amount of more than $5,000 to the private foundation, if such amount is more than 2 percent of the total contributions and bequests received by the foundation before the close of the taxable year of the foundation in which the contribution or bequest is received from such person. The family members of a disqualified person include spouses, ancestors, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren and great-grandchildren. It is important to note that the disqualified person status of an individual does not end at death.
Scenarios, Exceptions and Limitations
Consider the self-dealing implications when a grantor has established a private foundation and is a substantial contributor to the foundation during life. The grantor is therefore a disqualified person with respect to the foundation, as are the grantor's children and grandchildren. If a child of the grantor wishes to purchase an asset that has been contributed to the foundation, the purchase would be an act of self-dealing. But what if the grantor leaves the asset to the foundation at the grantor's death? If the grantor's estate plan designates the foundation as its residuary beneficiary, then upon the grantor's death, the foundation would gain an interest or expectancy in the assets then held by the grantor. In that instance, for a child of the grantor desiring to purchase an asset from the grantor's estate, the purchase would be an act of self-dealing absent an exception to the rules.
To avoid the self-dealing rules, a child of the grantor may desire to purchase the asset during the grantor's life before the foundation gains its interest at the grantor's death, but what if the child does not have sufficient assets to make the purchase without the child's anticipated inheritance upon the grantor's death? If the grantor accepts a promissory note from the child in exchange for the asset, and the promissory note passes to the foundation as the residuary beneficiary at the grantor's death, the holding of the note is also an act of self-dealing because the foundation is considered to be extending credit to the disqualified person.
Fortunately, one exception to the self-dealing rules is permitted during the period of the administration and settlement of an individual's estate. This "estate administration" (or "probate") exception, which is set forth in Treasury Regulation § 53.4941(d)-1(b)(3), provides that indirect self-dealing does not include a transaction with respect to a private foundation's interest in estate (or revocable trust) assets, regardless of when title to the property vests, if:
- The estate administrator or trustee either a) possesses a power of sale with respect to the property, b) has the power to reallocate the property, or c) is required to sell the property under the terms of any option subject to which the property was acquired
- The transaction is approved by the probate court having jurisdiction over the estate (or by another court having jurisdiction over the estate, trust or private foundation)
- The transaction occurs before the estate is considered terminated for federal income tax purposes
- The estate or trust receives an amount which equals or exceeds the fair market value for the foundation's interest or expectancy in the property, and
- The transaction either a) results in the foundation's receiving an interest or expectancy at least as liquid as the one it previously had; b) results in the foundation receiving an asset related to the active carrying out of its exempt purposes; or c) is required under the terms of an option that is binding upon the trust or estate.
The core requirement of this exception is obtaining court approval prior to the closure of an estate's administration. In this context, court approval refers to the court issuing an order permitting or directing the transaction in question involving the foundation's interest in satisfaction of the foundation's expectancy in the residue of the grantor's estate (or revocable trust). Typically, a request for such approval would take the form of a petition for an order from the probate court; however, it could also take the form of a petition for declaratory judgment in general civil court.
The estate administration exception has several pertinent limitations. First, the exception is limited to the time in which the estate administration is open for federal income tax purposes, which may or may not correspond to the actual amount of time it takes to wind up the deceased grantor's affairs. Second, court approval will require a filing that will generally be available for public inspection. Wealthy clients may not wish for this aspect of their estate plan to be disclosed. Third, the exception requires a determination of fair market value for the foundation's interest or expectancy in the property, which may not be readily available.
Previous Private Letter Rulings
As an alternative to the estate administration, some taxpayers have used the creation of a "blocker limited liability company" to prevent the self-dealing rules from being applied. In this scenario, the grantor sells an asset to a child and accepts a promissory note in return. The grantor establishes an LLC and contributes the promissory note to the LLC during the grantor's lifetime, in exchange for voting and non-voting LLC units. At the grantor's death, the foundation typically receives the non-voting units in the LLC rather than the promissory note directly. This strategy has been discussed in various Private Letter Rulings (PLRs), including PLRs 201907004 and 202101002 (also see PLRs 202037009, 201723005 and companion ruling 201723006, and 201407021 and companion ruling 201407023).
In PLR 201907004, the IRS addressed a request for a ruling that a proposed lifetime transfer of non-voting LLC interests to a charitable lead annuity trust (CLAT) – an entity treated as a private foundation – would not violate the self-dealing rules, even when the only assets of the LLC were promissory notes from disqualified persons. In that case, the grantor established trusts for his descendants to which he sold business interests in exchange for interest-only promissory notes. The grantor then assigned those notes to an LLC that issued both voting and non-voting interests. In the ruling request, the grantor proposed funding his CLAT with the non-voting LLC interests. Upon review, the IRS determined that a direct transfer of the promissory notes to the CLAT would result in an act of self-dealing because the CLAT would become a creditor of disqualified persons pursuant to the notes. However, because the CLAT would instead receive non-voting LLC interests, the IRS concluded that this transfer would not be deemed a loan or extension of credit between a private foundation and disqualified person because the CLAT would not be able to exercise control over the LLC (or the notes). As a result, the CLAT's receipt of those non-voting LLC interests would not be considered an act of self-dealing.
Similarly, in PLR 202101002, the IRS addressed a request for a ruling that that the self-dealing rules would not be violated if assets were sold to an irrevocable trust in exchange for a promissory note that then would be transferred to an LLC in exchange for an ownership interest in the LLC, including non-voting interests, where the non-voting interests subsequently would be gifted to a private foundation. As a non-voting interest holder, the foundation would have only the right to receive distributions from the LLC and would have no control over the entity. Upon review, the IRS again determined that no act of self-dealing would be deemed to have occurred under this proposal because the foundation – as the holder of only non-voting units – would not control the LLC. As in PLR 201907004, the receipt of non-voting LLC interests by the foundation consequently would not be considered a loan or extension of credit between a private foundation and a disqualified person. In addition, the IRS ruled that the foundation's receipt of distributions from the LLC also would not constitute self-dealing under these circumstances.
Thus, until Sept. 3, there was at least some authority suggesting that contributions of non-voting interests in a "blocker LLC" to a private foundation could be used to avoid acts of self-dealing where a promissory note is transferred to an LLC in order to avoid the note passing directly to the foundation.
Conclusion and Considerations
Unfortunately, PLRs are not binding on the IRS for anyone other than the taxpayer who requested them. Section 6100(k)(3) of the IRC provides that PLRs may not be used or cited as precedent, even if the factual circumstances of the PLR are identical and any expressed conditions are followed exactly. Therefore, practitioners ordinarily would advise their clients to obtain their own PLRs to confirm that a "blocker LLC" would accomplish the purpose of avoiding any acts of self-dealing.
Now, however, the IRS has announced that it will no longer offer letter rulings on this scenario. In some cases, the IRS adds items to the no-rule list when the IRS determines that a certain practice has become commonly accepted. In other cases, a decision not to issue letter rulings on a particular issue is indicative of an intent to study and perhaps disallow a practice permitted under prior rulings. Here, the initial impression is the latter, that the IRS is considering whether to change its position on the permissibility of the use of a "blocker LLC" in these circumstances. Thus, for now, the only option for these transactions to proceed may be by using the estate administration exception.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.