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A Closer Look at the Excise Tax on Excess Business Holdings under I.R.C. Section 4943 on Private Foundations
Prior to the Tax Reform Act of 1969, the only sanction available to the IRS against a private foundation was the revocation of its exempt status. Seeing that as too severe, Congress created a series of six private foundation excise taxes, one of which is the tax on excess business holdings. In this article, attorney Andrew S. Katzenberg of the New York office of Kirkland & Ellis, LLP, explores the excess business holdings in greater detail along with its important exceptions.
By Andrew S. Katzenberg
All charitable organizations under I.R.C. § 501(c)(3) are private foundations unless they qualify as public charities under § 509(a)(1), (2), (3) or (4). Usually private foundations are funded by one person or one family. Because private foundations serve as the charitable alter egos of one individual or one family, six special taxing provisions apply to private foundations that do not apply to public charities -- 1) excise tax based on investment income (§ 4940), 2) taxes on self dealing (§ 4941), 3) taxes on failure to distribute income (§ 4942), 4) taxes on excess business holdings (§ 4943), 5) taxes on investments which jeopardize charitable purpose (§ 4944), and 6) taxes on taxable expenditures (§ 4945). This article will focus on the specifics of excess business holdings under § 4943, its extensive regulations and most importantly, its exceptions.
There is a 10% tax on the value of any “excess business holdings” (EBH) in a “business enterprise” held by any private foundation during each taxable year. The tax on excess business holdings for each taxable year is determined when such holdings are the greatest.
If the Internal Revenue Service (the “IRS”) assesses the tax or mails a notice of deficiency on the tax and the private foundation still has EBH in such business enterprise, then an additional 200% tax is imposed on such EBH still held by the private foundation. This second, confiscatory tax, encourages private foundations to monitor whether they have EBH and to remove such EBH immediately upon detection.
Though the general rule seems straightforward, the real crux of the statute is the definitions which comprise the general rule and ultimately determine whether the tax will apply. There are two key definitions -- “excess business holdings” and “disqualified person” -- which one must navigate in order to avoid subjecting a private foundation to this excise tax.
A private foundation has excess business holdings if the voting stock held by it is greater than the “Permitted Holdings”. Permitted Holdings is 20% of all voting stock reduced by the percentage of voting stock held by all “disqualified persons” (defined below). However, if the private foundation and all disqualified persons own less than 35% of the voting stock and effective control of a corporation is held by one or more persons other than disqualified persons (confirmed by a private letter ruling from the IRS), then 35% is substituted for 20% defining EBH.
Nonvoting stock held by a private foundation (regardless of the amount) is not considered EBH if all disqualified persons do not own more than 20% of the voting stock, otherwise it is all considered EBH. Additionally, the regulations explain that that stock carrying voting rights that vest upon a condition will be considered nonvoting stock until the condition is met. Further, nonvoting stock which can be converted into voting stock will only be considered voting stock after it is actually converted.
In computing the holdings of a private foundation and disqualified persons in a business enterprise, any stock or other interest, whether owned directly or indirectly, by a corporation, partnership, trust or other entity, is considered owned proportionally by or for its shareholders, partners or beneficiaries. For example, if a foundation owned 5% of corporation Y and owned 80% of corporation X which owned 30% of corporation Y, then the foundation’s holdings in corporation Y would be 29% (its 5% plus 80% of 30% which is 24%).
In the case of partnerships or joint ventures, “profit interest” is substituted for “voting stock” and “capital interest” is substituted for “nonvoting stock.” In all other cases such as trusts or associations, “beneficial interest” is substituted for “voting stock.” Thus, the combined holdings of the foundation and disqualified persons in a partnership cannot exceed 20% of the profit interest in the partnership at any point. Moreover, if a disqualified person’s share in profits increases as a result of the profit earned by the partnership (e.g., carried interest), which results in a combined profits interest of more than 20%, the foundation would have EBH.
“Profit interest” is determined in same manner as the distributive share of taxable income in the partnership, and “capital interest” based on one’s interest in the assets that would be distributed to the foundation or disqualified person if it withdrew or upon liquidation of the partnership, whichever is greater (in absence of a provision in the partnership agreement).
Holdings in sole proprietorships are not permitted. They are per se excess business holdings.
A “disqualified person” with respect to a foundation is:
(a) A “substantial contributor” to the private foundation (a person who contributes an aggregate of more than $5,000, if such amount is more than 2% of all contributions received during the taxable year of the foundation);
(b) A private foundation manager (an officer, director, trustee or person having similar authority);
(c) An owner of more than 20% of the voting power, profit interest or beneficial interest of a corporation, partnership, trust or other enterprise, which is a substantial contributor to the private foundation;
(e) A corporation, partnership, trust or other entity of which persons described in (a) through (d) above own more than 35% of the total combined voting power, profits interest or beneficial interest; and
(f) A related private foundation.
For example, if husband and wife are the sole contributors to the foundation, they, their children, their parents, trusts for the benefit of the foregoing and entities in which the foregoing own more than 35% of the profits or vote are all disqualified persons. Their interests in business enterprises are aggregated with those of the foundation to determine if the foundation has EBH.
There are four exceptions to the general rule which may be available to a private foundation to avoid the excess business holdings tax which can be separated into two categories: complete exemption and temporary exemption. The first two exceptions -- exclusion from the definition of business enterprise and the 2% de minimis rule -- are complete exemptions from the general rule. The second two exceptions -- disposition within 90 days rule and the “other than by purchase” rule -- are temporary exemptions from the general rule and expire after certain time periods as discussed below. Each exception is very specific and should be reviewed anytime it appears that a private foundation may be subject to the tax since one may apply to your situation.
EBH applies to interests in a “business enterprise,” which is any trade or business. However, excluded from this definition (and thus from EBH) are interests in:
(i) A business which is associated with or furthers the exempt purpose(s) of the private foundation (aside from the needs of the private foundations for income or the use it makes of any profits).
(ii) A trade or business that derives at least 95% of its gross income from passive sources.
(iii) Bonds or other debts in a trade or business.
(iv) Program-related investments (PRI).
One exception which has become of increasing interest to foundations are PRIs. A PRI is an investment which (a) the primary purpose is to accomplish one or more of the charitable purposes described in I.R.C. § 170(c)(2)(B), (b) no significant purpose is the production of income or appreciation of property, and (c) does not attempt to influence legislation or participate in a political campaign.
A PRI primary purpose will be considered charitable if it significantly furthers the private foundation’s exempt activities and the investment would not have been made but for the relationship between the investment and the exempt activity. The mere fact that the PRI generates a significant income or capital appreciation will not be determinative that a significant purpose was to produce income.
Once an investment is determined to be a PRI, it does not cease to be a PRI because of a material change in the form or terms of the investment as long as those changes still qualify or the changes are made for the prudent protection of the foundation’s investment.
Examples of PRI in the regulations include urban redevelopment and assisting economically disadvantaged groups. The proposed regulations provided a series of additional examples illustrating more thoroughly as well as broadly what qualified as a PRI. These examples include charitable purposes such as advancing science and combating environmental deterioration, investment in activities that occur in foreign countries, and acceptance of an equity position in conjunction with a loan.
For example, a foundation could make an investment in a pharmaceutical company to develop vaccines that prevents diseases that overwhelmingly affect poor individuals in developing countries. Another example is a foundation depositing money in a bank and then guaranteeing a loan from the bank to a not-profit corporation to build a child care facility in a low-income neighborhood. In both examples, it was economically impractical for conventional sources of funding to be obtained and therefore it was necessary for the foundation to assist.
The other complete exemption is the 2% de miminis rule. A private foundation will not be treated as having excess business holdings as long as its does not hold (together with any “related” private foundations) more than 2% of the voting stock and more than 2% of value of the outstanding shares of all classes of stock, regardless of the holdings of disqualified persons. In the case of a partnership/LLC, the foundation cannot own more than 2% of the profits interest and not more than 2% of the value of the entire partnership/LLC.
Then there is the disposition within 90 days exception which applies to both purchases by a private foundation and by someone other than the private foundation. If a purchase of an interest in a business enterprise by disqualified person causes a private foundation to have EBH (i.e., the foundation’s holdings were not EBH until the disqualified person acquired an interest), no tax is imposed if the private foundation disposes of its EBH within 90 days from the date it knows or has reason to know that it has EBH. If a private foundation acquires EBH as a result of its own purchase because of a previous purchase of a disqualified person that it did not know or have reason to know of, no tax will be imposed if the private foundation disposes of the EBH within 90 days as stated above.
Any disposition by a disqualified person during the 90 day period is disregarded. Therefore, the foundation must dispose of its EBH to qualify.
The second temporary exemption is the “other than by purchase” exception. If a private foundation has EBH because of an event other than a purchase by the private foundation or a disqualified person (i.e., gift, bequest or readjustment), the private foundation has 5 years to dispose of the EBH without penalty. This exception is much broader than it first appears especially when one merely glances over its heading in the Internal Revenue Code (the “Code”) -- “5-year period to dispose of gifts, bequests, etc”. The heading leads to a misconception that this exception is focused on gratuitous transfers when in fact the “etc.” encompasses a vast array of scenarios that can fall under this exception from mergers to stock acquisitions to vesting/exercise of stock options. The 5-year period may be extended for an additional 5 years by the IRS in cases of unusually large transfers of diverse business holdings or holdings with complex corporate structures.
Additionally, it should be noted that there are special rules if a private foundation has holdings from May 26, 1969, for donor advised funds that are treated as private foundations and for supporting organizations that are treated as private foundations which are outside the scope of this article.
Application of the Tax and Exceptions
Similar to the general rule’s deceiving simplicity, the application of the tax can be just as cumbersome. The 10% tax is applied to the EBH of the private foundation. For example, if the foundation has EBH of 15%, then the 10% tax is applied against that 15% interest.
However, determining what is EBH causes the application of actual tax to be confusing and unfortunately the regulations only add to that confusion. Code § 4943(b) states that EBH is the amount of stock that the foundation would need to dispose of, other than to a disqualified person, in order for the remaining holdings to be Permitted Holdings. The regulations state this a little differently. The regulations say “the amount of stock...the foundation, or a disqualified person would have to dispose of...in order for the remaining holdings…to be permitted holdings.” Hypothetically under the regulations, when the disqualified person has more voting stock then the foundation, the amount of stock which would need to be disposed of by the disqualified person to eliminate EBH would result in a greater tax liability than amount of stock which would need to dispose of by the foundation to eliminate EBH. For example, a foundation has a 20% interest and the disqualified person has a 30% interest and under the regulations, both the 20% and 30% interest are considered EBH. Applying a 10% tax on the 30% disposable EBH of the disqualified person will result in a larger tax than a 10% tax on the 20% disposable EBH of the foundation.
There is only one example in the regulations for this provision in which the foundation has greater holdings then the disqualified person, and it does not clarify the ambiguity in regulation. Additionally, none of the examples in the regulations specifically deal with the scenario where the disqualified person has more stock in a business enterprise then the foundation.
This leaves the foundation to choose between basing the tax on the foundation’s or the disqualified person’s EBH. The logical, legally supportable conclusion as well as better result for the foundation is to use its holdings and not the disqualified person’s. First, the Code trumps the regulations. The Code only mentions the disposable holdings of the foundation not the disqualified person. Second, the definition of Permitted Holdings does not allow for Permitting Holdings to be below zero, essentially disregarding the holdings of a disqualified person greater than a 20% interest. Combine this with the fact that there is no authority stating that the foundation needs to use the disqualified person’s EBH holdings instead of its own leads us to this conclusion.
For example, if a foundation and a disqualified person owned 25% and 30% of voting stock respectively, then the Permitted Holdings for the foundation would be 0 (20% - 30% = -5% and the Permitted Holdings cannot be below zero), and the EBH would be the entire 25% interest of the foundation. The 10% tax would be calculated against the 25% of voting stock held by foundation.
Another tricky application is the 2% de minimis exception. It shields the EBH from the 10% tax. It merely determines if the tax applies or not. The amount over the 2% de minimis exception is not relevant to the calculation of the tax if the tax applies. The tax is on the value of the EBH, which is the amount of holdings that the foundation would need to dispose of in order for the remaining holdings of the foundation to be Permitted Holdings (no longer EBH) -- ignoring the 2% rule for this purpose. For example, if the foundation is 3% over the de minimis exception (owns 5%) and the disqualified person owns 50%, the 2% exception does not apply and the combined holdings of the foundation and disqualified person are 55%. The foundation’s Permitted Holdings is 0 (20% - 50% = -30%), so its EBH would be the entire 5% interest it held. The 10% tax would be based on the value of the 5% interest. However, to eliminate the EBH (after paying the tax and to avoid additional tax), the foundation could dispose of 3% to bring its holdings down to a 2% interest.
Finally, when dealing with partnerships, joint ventures or other unincorporated business entities, one should be very careful in applying the rules since most of the statute and regulations are focused on the specifics of corporate entities. This leaves a large area without specific regulations for guidance and may subject such entities to harsher or more difficult application of the rules and regulations. For example, a foundation which has a 1% interest in both the profit interest and the capital interest of an LLC, receives a 10% annual accruing yield/dividend. Though it is initially covered by the 2% de minimis exception, over time it would fail causing the foundation to be subject to the tax. The 2% de minimis rule looks at both the profit interest and capital interest. As for the profit interest, it is based on the distributive share of partnership income. Since it is accruing, the profit interest of the foundation would slowly be growing because it would receive the additional profit interest on the prior years’ accrued dividends in the LLC causing it to fail the 2% de minimis rule. As for the capital interest, accruing dividends would increase the foundation’s share of the assets in a liquidation of the LLC or withdrawal by the foundation, which increases the foundation’s capital interest. Therefore, the foundation eventually would fail the 2% de minimis test with regards to its capital interest as the dividends accrue as well.
Not only does the accruing dividend effect both the profit interest and the capital interest adversely, not just one or the other, but an accruing dividend would most likely have no effect on the voting stock and nonvoting stock of a corporation. Therefore, an accruing dividend which probably would have no effect on the application and success of the 2% de minimis rule with regards to a corporate entity would have the totally opposite result with regards to a partnership.
Like any good Code section, one should be mindful of all the nuances buried in it and its accompanying regulations. Directors, managers or trustees of private foundations should always consider this rule before investing in a business and should work with legal or tax counsel in order to prevent or minimize taxes from excess business holdings.
About the Author
Andrew S. Katzenberg is an associate at Kirkland & Ellis, LLP in the New York office in the Trusts and Estates practice group focusing on wealth preservation, estate and trust administration and charitable giving. Mr. Katzenberg may be reached at Andrew.Katzenberg@kirkland.com or (212) 446-5977.
 I.R.C. § 4943(a).
 Treas. Reg. § 53.4943-2(a)(2)(ii). The greatest value as of any day that the greatest excess holding is maintained will be used. Id. For example, if a private foundation held a 100 shares in X on January 1 (50 of which were EBH) and sold 50 shares in X on April 6 and sold no more shares during the year, the greatest value in X shares between January 1 and April 6 would be used even if there shares were valued higher after April 6.
 § 4943(b). It is assessed if EBH is still held at the end of a “taxable period,” which begins on the first day which there is EBH and ends on the earlier of (i) the date of mailing of a notice of deficiency respect to the initial tax or (ii) the date on which the initial tax is assessed. § 4943(d)(2).
 § 4943(c)(1).
 § 4943(c)(2)(A). Permitted Holdings cannot be below zero. Treas. Reg. § 53.4943-3(b)(1)(i).
 § 4943(c)(2)(B). Effective control is the reality of control and not its form or means by which it is exercised. For example, where a minority interest held by non-disqualified persons historically elect a majority of a corporation’s board, such persons will be deemed to have effective control. Treas. Reg. § 53.4943-3(b)(3)(ii). It is not enough to show that a foundation and disqualified persons cannot exercise control over the business enterprise. Rather, it must be shown that an unrelated party or a cohesive group of third parties, in fact, exercise control.
 § 4943(c)(2)(A).
 Treas. Reg. § 53.4943-3(b)(2)(ii).
 § 4943(d)(1).
 § 4943(c)(3). Permitted holdings in unincorporated entities will be determined under the regulations established by the IRS. Id.
 Treas. Reg. § 53.4943-3(c)(2).
 § 4943(c)(3)(B)
 § 4946.
 § 4946(a)(1)(A). Substantial contributor also means the creator of a trust. § 507(d)(2)(A).
 § 4946(b)(1).
 § 4946(a)(1)(C).
 The family of a person includes only his spouse, ancestors, children, grandchildren, great grandchildren and the spouses of children, grandchildren, great grandchildren. § 4946(d).
 § 4946(a)(1)(D).
 § 4946(a)(1)(E), (F) and (G).
 § 4946 (a)(1)(H). A private foundation is considered related if:
(i) it is effectively controlled (directly or indirectly) by the same person or persons who control the private foundation in question, or
(ii) substantially all of the contributions made to it were made (directly or indirectly) by the same person or persons who made (directly or indirectly) substantially all of the contributions to the private foundation in question. Id. Substantially means 85% or more and each person has contributed at least 2%. Treas. Reg. § 53.4946-1(b)(2).
 Treas. Reg. § 53.4943-10(a)(1).
 Treas. Reg. § 53-4942(a)-3(c)(iii). Also known as a “functionally related business.” Id. For example, a foundation which promotes nutrition and healthy living which owns an interest in a company that runs all natural fruit shops.
 § 4943(d)(3).
 Treas. Reg. § 53.4943-10(a)(2).
 Treas. Reg. § 53.4943-10(b).
 Organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.
 Treas. Reg. § 53.4944-3(a)(1).
 Treas. Reg. § 53.4944-3(a)(2)(i).
 Treas. Reg. § 53.4944-3(a)(2)(iii).
 Treas. Reg. § 53.4944-3(a)(3)(i).
 Treas. Reg. § 53.4944-3(b).
 Prop. Treas. Reg. § 53.4944-3(b), 77 Fed. Reg. 23,429 (April 19, 2012). Other examples include establishing a line of credit on behalf of another organization, serve as guarantor of a loan, potential for a high rate of return and recipients of funds do not need to be within a charitable class. Id.
 Id. Example 11.
 Id. Example 18.
 As defined in endnote 20.
 § 4943(c)(2)(C).
 § 4943(c)(3).
 Treas. Reg. § 53.4943-2(a)(1)(ii). The 90 day period will be extended to include the period by which the private foundation is prohibited from disposing of such EBH by federal or state securities laws. Treas. Reg. § 53.4943-2(1)(iii).
 Treas. Reg. § 53.4943-2(a)(1)(ii).
 Treas. Reg. § 53.4943-6(d).
 § 4943(c)(6). During the 5 year period, all interest in such business held by the foundation is treated as held by a disqualified person, which in effect gives the private foundation a 0 interest in such business so that it cannot have any EBH. If the private foundation has EBH prior to the non-purchase transfer, such prior EBH will not be constructively treated as held by a disqualified person but will continue to be viewed as held by the private foundation.
 § 4943(c)(6).
 Treas. Reg. § 53.4943-6(a)(2). See also Treas. Reg. § 53.4943-6(d)(1) and Treas. Reg. § 53.4943-7(d)(1).
 § 4943(c)(7). In order to obtain the additional 5 year extension, a private foundation must meet the following three (3) requirements: (i) the private foundation establishes that it made diligent efforts to dispose of such holdings within the initial 5 year period and disposition within the initial 5 year period has not been possible (except for substantially below market value) by reason of the size and complexity or diversity of such holdings, (ii) the private foundation submits to the IRS a plan for disposing all of the EBH, as well as to the Attorney General of the state or other appropriate state officials having administrative or supervisory authority over the private foundation and (iii) the IRS determines that such plan can reasonably be carried out within the extension period. Id.
 § 4943(c)(4).
 § 4943(e).
 § 4943(f).
 § 4943(a)(1).
 Treas. Reg. 53.4943-3(a)(1) (emphasis added).
 Treas. Reg. 53.4943-3(a)(2).