IRS' Perspective On Control

IRS' Perspective On Control

Article posted in Compliance on 4 October 2000| comments
audience: National Publication | last updated: 15 September 2012
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Summary

This article reviews various issues surrounding supporting organizations, donor advised funds and charitable family limited partnerships as outlined by the IRS in its latest Continuing Professional Education Text. The IRS describes the element of control in these vehicles and proffers how direct and indirect control can be determined.

by: Emanuel J. Kallina, II, Esquire & Jonathan D. Ackerman, Esquire

Introduction

In its recently published Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001 ("CPE Text"), the Internal Revenue Service ("IRS" or "Service") has once again brought up the subject of control and power issues.1 This article focuses on the IRS's comments on these issues with respect to the increasingly popular supporting organization and donor advised fund vehicles, as well as the more controversial charitable family limited partnership vehicle. If you are, or desire to begin, working with any of these vehicles, it certainly makes sense to familiarize yourself with what the IRS is teaching its own employees about these vehicles in its internal educational programs as evidenced by the CPE Text.

With respect to supporting organizations, the CPE Text indicates that the Service is focusing its attention on control of the organization by disqualified persons as defined in Code Section 4946. IRS employees are reminded that inappropriate controls may cause the organization to fail to qualify as a tax exempt entity in the first place. Control issues may arise regarding the structure of the supporting organization's board of directors and the continuing relationship of a disqualified person to the character of the supporting organization's assets. The IRS delineates examples of what constitutes direct and indirect control. The IRS also suggests that type 3 supporting organizations deserve greater scrutiny in some cases, as do donor advised funds applying for status as supporting organizations.

On the topic of donor advised funds, the Service's main concerns this year appear to be with donors' controls over distributions from the donor advised funds. Concerns arise over the degree to which the charity administering the donor advised fund indicates that it will follow a donor's advice and over the donor's ability to control the timing of distributions. The IRS had no comment on the proposed legislation relating to donor advised funds and acknowledged that no such legislation has been introduced in Congress as of August 1, 2000.

The CPE Text notes a number of potential attacks that the IRS may make against charitable family limited partnerships, a vehicle the IRS says is being promoted by "one or more commercial firms." The central issue with these partnerships appears to be the donor's ongoing control over the partnership through his or her status as general partner.

Because the IRS repeatedly references in the CPE Text various control issues for supporting organizations and donor advised funds that were discussed in earlier CPE Texts for 1997 and 2000, you may wish to refresh your memory with a review of those earlier CPE Texts.

Supporting Organization Control Issues

Organization and Operation Tests & Naming Supported Organizations

Before getting to specific examples of control issues for supporting organizations, the CPE Text reminds its readers that an organization's exempt status under Code2 Section 501(c)(3) or 4947(a)(1) must be determined before considering the organization's status as a supporting organization. As indicated below, inappropriate controls may jeopardize exempt status. If the organization doesn't qualify for exempt status, it cannot be a supporting organization. The Service notes that an agent's review of a supporting organization's exemption qualification should be as vigorous as the review undertaken when an organization is claiming public charity status under Code Section 509(a)(1) or 509(a)(2). According to the IRS, the provision of unrelated, non-charitable services such as "facilitating bond issues for community trusts or environmental charities, prepaid tuition programs for a number of private colleges, and job placement services for a group of colleges and their alumni" as a primary activity by an organization applying for exempt status may not be sufficient for tax exempt status unless covered by statute or provided at "substantially below cost." 3

With these points in mind, the Service briefly reviews the organizational and operational requirements for exempt status as applied to supporting organizations, noting that supporting organizations must be "organized and operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more" exempt organizations described in Code Section 509(a)(1) or 509(a)(2) and that a supporting organization's articles of organization must include the following (where "SO" means supporting organization and "SD" means supported organization):

(a) Limit purposes to IRC 509(a)(3)(A) purposes;

(b) Not expressly empower SO to engage in activities not in furtherance of purposes in (a);

(c) State the specified SDs on whose behalf such SO is to be operated; and

(d) Not expressly empower the SO to operate to support or benefit any SD other than those referred to in (c). 4

Citing Regulation Section 1.509(a)-4(e), the Service emphasizes that a supporting organization is operated exclusively for the support of specified supported organizations only if the supporting organization's activities are exclusively those that support or benefit the specified supported organizations. 5

Next, the CPE Text indicates that control issues can arise over the naming of supported organizations in a supporting organization's governing document. The IRS describes the degree of specificity required for supporting organizations in naming their supported organizations, noting the differences in this regard between so-called type 1 and type 2 supporting organizations and type 3 supporting organizations. Type 1 supporting organizations are those that are operated, supervised or controlled by the supported organizations. 6 Type 2 supporting organizations are those that are supervised or controlled in connection with the supported organizations. 7 Type 3 supported organizations are those that are operated in connection with the supported organizations. 8

Generally, the Regulations provide that a supporting organization's articles must specify the supported organizations by name. 9 However, type 1 and type 2 supporting organizations may benefit one or more supported organizations by class rather than by name. 10 Also, type 1 and type 2 supporting organizations may not have to designate specific supported organizations where there has been a "historic and continuing relationship" between the organizations which has caused the development of a "substantial identity of interests." 11 The articles of type 1 and type 2 supporting organizations may allow substitutions and additions of supported organizations and may allow the amount of support among different supported organizations to vary. 12 The Service notes that such latitude is allowed only where it has been provided for in the supporting organization's organizing document. 13

According to the IRS, the rules for the naming of specific supported organizations are somewhat more strict with respect to type 3 supporting organizations. However, a provision allowing for substitution of supported organizations in a type 3 supporting organization's articles may be okay as long as the substitution is conditional on the occurrence of an event that is beyond the supporting organization's control. 14 An example of such an occurrence would be the named supported organization's loss of tax exempt status. 15 The amount of support the type 3 supporting organization gives to the various supported organizations may be varied provided the amounts given to at least one of the supported organizations meet the "integral part" test of Regulation Section 1.509(a)-4(i)(3). A type 3 supporting organization's governing instrument may allow the support of a non-publicly supported charity as long as this possibility is a remote contingency and the supporting organization currently benefits Code Section 509(a)(1) and Code Section 509(a)(2) charities. 16 The type 3 supporting organization will fail to continue to qualify as such once it starts supporting the non-publicly supported charity and stops supporting the Code Section 509(a)(1) and Code Section 509(a)(2) charities. 17 Again, any latitude given to a type 3 supporting organization in the naming of supported organizations must be provided for in the organizational document. 18

The IRS gives some examples of the specificity requirements. The IRS first discusses Revenue Ruling 79-197, 19 which deals with a type 1 supporting organization's governing instrument that allowed its substantial contributor to select public charities to receive all of the supporting organization's assets once a specific sum of money had been paid to the named supported organizations. The Ruling concluded that the organization was not qualified under Code Section 509(a)(3) because its articles did not specifically designate the supported organization by name, class or purpose.

Another example cited is the case of Quarrie Charitable Fund v. United States. 20 In this case, the governing instrument allowed the trustee of the supporting organization to transfer income to a charity other than the designated supported organization "when, in the trustee's discretion, the charitable uses would become unnecessary, undesirable, impractical, or no longer adapted to the needs of the public." Noting that it had a problem with the trustee's discretion here, the 7th Circuit Court of Appeals ruled that the organization failed to qualify as a supporting organization.

On the other hand, the IRS also states that some cases described in its 1997 CPE Text found that supporting organizations were supporting specific supported organizations even though the supported organizations were not specifically named in the supporting organizations' governing documents. 21

As a sort of summary of this portion of the CPE Text, the Service observes that its discussion of the organization and operation tests falls under the topic of control and power issues. In addition, the Service notes that if the donor (or other disqualified person) has control or power over the selection of the supported organization outside the parameters allowed by the Regulations, then the supporting organization will not qualify under Code Section 509(a)(3). An example given here is a governing instrument for a type 3 supporting organization which gives descendant disqualified persons the power to substitute one community trust for another community trust when these disqualified persons move to the former community trust's geographic area. The IRS states that the supporting organization fails the organization test. 22

Examples of Inappropriate Control by Disqualified Persons

The IRS leads off its discussion of control of supporting organizations by disqualified persons by noting that planning with type 3 supporting organizations is an area where some have acted aggressively. According to the IRS, a donor may inappropriately seek to avoid having his or her organization be categorized as a private foundation so that it is not subject to the excise taxes found in Chapter 42 of the Code while also attempting to retain control over the organization's assets. The IRS reminds its agents that the inappropriate use of supporting organizations was addressed in the IRS's 2000 CPE Text. 23

The CPE Text states that the IRS believes type 3 supporting organization applicants evidence a "greater proclivity" than type 1 or type 2 supporting organizations for showing facts and circumstances indicating that disqualified persons directly or indirectly control the supporting organizations. The Service suggests that control might "be the most critical or meaningful factor in the plethora of requirements that must be met for an organization to be classified as an IRC 509(a)(3)" supporting organization. In addition, the Service suggests that Code Section 4958 excess benefit transactions might occur when a supporting organization has a board of directors made up of disqualified persons with inadequate procedures for handling conflicts of interest. The Service observes that there are standards in the "rebuttal presumption" rules in the Regulations under Code Section 4958. 24

As regulatory authority for addressing the control issue with respect to supporting organizations, the CPE Text cites Code Section 509(a)(3)(C), which specifies that an organization is not a supporting organization if one or more disqualified persons (as defined in Code Section 4946) other than foundation managers directly or indirectly control the organization. The Service notes that when a disqualified person such as a substantial contributor is named by a supported organization as a foundation manager for the supporting organization, that person will continue to be considered a disqualified person rather than the supported organization's representative. 25

With respect to its authority on the control issue, the Service also quotes Regulation Section 1.509(a)-4(j)(1) which states the following (where "DP" stands for disqualified person and "SO" stands for supporting organization):

Under the provisions of IRC 509(a)(3) a SO may not be controlled directly or indirectly by one or more DPs. An organization will be considered "controlled" for purposes of IRC 509(a)(3), if the DPs, by aggregating their votes or positions of authority, may require such organizations to perform any act which significantly affects it operations or may prevent such organization from performing such act. . . . a SO will be considered to be controlled directly or indirectly by one or more disqualified persons if the voting power of such persons is 50 percent or more of the total voting power of the organization's governing body or if one or more of such persons have the right to exercise veto power over the actions of the organization. However, all pertinent facts and circumstances including the nature, diversity, and income yield of an organization's holdings, the length of time particular stocks, securities, or other assets are retained, and its manner of exercising its voting right with respect to stocks in which members of the governing body also have some interest, will be taken into consideration in determining whether a disqualified person does in fact indirectly control an organization. 26

The IRS then outlines four examples that it believes get to the essence of the control issue with respect to supporting organizations. 27

The first example, which involves indirect control, is taken from Revenue Ruling 80-207. 28 The supporting organization in this example has four directors, two of whom are also employed by a corporation. The supporting organization's substantial contributor (who is a disqualified person and a director of the supporting organization) owns more than 35% of this corporation's voting power. The IRS concludes that the disqualified person indirectly controls the supporting organization because of the employment relationship with the two board members. The CPE Text suggests that this Revenue Ruling "clarifies that all pertinent facts and circumstances" are to be considered when determining whether a disqualified person has direct or indirect control of a supporting organization via his or her influential position. The Service includes the following analysis of this example from Revenue Ruling 80-207:

Because only one of the organization's directors is a disqualified person and neither the disqualified person nor any other director has a veto power over the organization's actions, the organization is not directly controlled by a disqualified person under section 1.509(a)-4(j) of the regulations. However, in determining whether an organization is indirectly controlled by one or more disqualified persons, one circumstance to be considered is whether a disqualified person is in a position to influence the decisions of members of the organization's governing body who are not themselves disqualified persons. Thus, employees of a disqualified person will be considered in determining whether one or more disqualified persons controls 50 percent or more of the voting power of an organization's governing body. 29

In the second example, the issue is the control of the supporting organization's board of directors by a disqualified person. An organization with a five member board has applied for status as a type 1 supporting organization. Two substantial contributors, a husband and wife, are directors of the supporting organization and are disqualified persons under Code Section 4946. The other three directors are directors or officers of the supported organization. However, one of those three people is also a partner in the law firm that represents the two substantial contributors with respect to their personal taxes, as well as the supporting organization and the supported organization. The supporting organization's directors elect one of the substantial contributors as the supporting organization's initial operating CEO. Two of the other three officers of the supporting organization are also disqualified persons. 30

Citing Regulation Section 1.509(a)-4(j)(i), the IRS notes that a person otherwise disqualified with respect to a supporting organization remains a disqualified person despite his or her appointment to a position as foundation manager by a supported organization. With this in mind, the IRS finds that the supporting organization in this example appears to be in the indirect control of the disqualified persons. Also indicating control by disqualified persons are the lawyer's potential lack of independence and objectivity in board of director dealings with the substantial contributors and the disqualified person status of three of the four supporting organization officers. 31

The third example given in the CPE Text involves a supporting organization with a complex trustee structure. The Service notes that the "control issue should be thoroughly analyzed if organizational documents or other facts indicate that" disqualified persons pick the independent (non-disqualified person) board members or committees controlled by disqualified persons nominate board members. Other factors possibly indicating inappropriate control include bylaws preventing the removal of disqualified persons from the board, even for cause. The IRS describes the third example as follows (where "SO3" refers to a type 3 supporting organization, "SD" refers to a supported organization and "DP" refers to a disqualified person):

X is a charitable trust that claims IRC 509(a)(3) status as an SO3 following Rev. Proc. 72-50, 1972-2 C.B. 830. X will provide support to specified SDs as provided in the trust document.

X will receive contributions, make investments, and make grants to SDs in the board's discretion, except that grants totaling over $100,000 to single recipients within a 12-month period must be approved either by (1) the vote of at least 2/3rds of the X Board of Trustees, or (2) two majority votes of the Board, one preceding and one following the annual reconstitution of the Board.

X's Board consists of two "Class A" trustees and three "Class B" trustees. The Class A trustees will be A, the grantor/creator, and a family member of A, or an employee of an entity that A owns. Class B trustees cannot include any DPs.

X's Board will be reconstituted every year. The Class A trustees select the successor Class A trustees. Class B trustees are selected by majority action of the Trustee Electors from among nominations approved by the Class B Nominating Committee. The Trustee Electors, who elect their successors, will be officers or directors of an SD, but cannot include DPs. X's Nominating Committee consists of two individuals selected by the Class A trustees and one selected by the Trustee Electors, and may include trustees. A majority of the Nominating Committee approves the slate of candidates, which includes at least two candidates for each position to be filled. The Trustee Electors then vote on the slate. If the Trustee Electors do not elect a Class B trustee position, then the Nominating Committee proposes a different slate of candidates for each unfilled position. If the Trustee Electors do not fill the Class B trustee position after two slates, then the Class A trustees shall elect the Class B trustee to fill the unfilled position. Trustees of either class may be removed, but only for cause and only by the affirmative vote of 2/3rds of the Trustee Electors. A trustee may delegate in writing his or her rights to any other trustee.

A's approval is expressly required to amend X's trust instrument. Given A's power over the trustee selection process discussed above, A can effectively prohibit grants exceeding $100,000 to a single recipient within a 12-month period. Moreover, a trustee may delegate his or her voting rights on substantive matters to A in making distributions upon dissolution.

If individual A is legally competent, X trust instrument may be amended only with his written approval. If he is dead or incompetent, X's board may amend with an 80% vote. The trust instrument provides that A's charitable preferences will be used as a guide. 32

The IRS finds that X fails to meet the control test for qualification as a supporting organization because X is indirectly controlled by a disqualified person. The Service notes that

A has direct control over his own board position and indirect control over the other Class A board positions via employment and family relationships. A is also found to have indirect control over the three Class B board positions via his control over the nominee slate for these positions. Although he cannot control exactly who gets elected from the slate, his control over the slate allows him to make sure that particular persons do not serve on the board. The IRS likens this to a veto power over returning board members, which A might use if the board members do not agree with his ideas. The annual election of the board reinforces A's control ability, which in turn allows him to "steer grants" to his chosen charities. Similarly, the provisions in the trust agreement providing that X ends shortly after A's death or incompetence and that the board should be guided by A's charitable preferences in making the dissolution distributions are also manifestations of A's control. 33

The final example in this section of the CPE Text involves the control of supporting organization assets by disqualified persons. A business owner lends cash to a corporation of which he owns 100%. He receives in return a promissory note secured by real estate owned by the corporation and used in the corporation's business. The corporation also purchases key man insurance on the business owner's life so that the note may be paid off if he dies. The business owner then contributes the note to a type 3 supporting organization. He and his wife are two of the supporting organization's five directors. One director is appointed by the supported organization. The business owner is a disqualified person with respect to the supporting organization because of his status as a substantial contributor. He is also a foundation manager. 34

The Service notes that the business owner controls the supporting organization's asset via his control of the corporation that issued the note. He could make the note worthless by consuming all of the corporation's assets and income or by operating the corporation imprudently. He could also take actions that would impair the security. For example, he could cause the corporation to cash in or cancel the key man policy, cause the corporation to incur other debt secured by the real estate with equal or higher priority to the supporting organization's note or cause the corporation to take actions impairing the value of the real estate. 35

In analyzing this example, the IRS states that a disqualified person's control over a supporting organization should be determined by "all pertinent facts and circumstances." Factors mentioned in the Regulations indicating that a disqualified person's continuing relationship with the assets of a supporting organization is a factor to be considered here include the length of time the supporting organization's assets are retained and the manner of voting shares of stock in which members of the supporting organization's governing board have an interest. 36

With respect to the facts of the example, the Service indicates that the supporting organization's note and the disqualified person's connection to the note are relevant facts. Because of the control the disqualified person exercises over the supporting organization's assets, the IRS states that it is hard to conclude that the disqualified person does not exercise indirect control over the supporting organization. Citing Revenue Ruling 67-5, 37 the Service also suggests that private inurement issues may be present when a disqualified person is able to use a supporting organization's assets. 38

Donor Advised Funds as Supporting Organizations

The CPE Text indicates that the Service is considering whether supporting organization status is appropriate for donor advised funds associated with Code Section 509(a)(1) or 509(a)(2) public charities. The Service states that supporting organization status may not be appropriate in such cases. The example given is as follows (where "SO3" refers to a type 3 supporting organization and "SD" refers to a supported organization):

X is a charitable trust described in IRC 4947(a)(1). Pursuant to Rev. Proc. 72-50, 1972-2 C.B. 830, X applies for status as a SO3 under IRC 509(a)(3). X's trust instrument provides that the assets are devoted to benefit Christian activities, and that X's primary mission is to support Christian educational activities, such as Christian youth organizations worldwide, with an emphasis on education and scholarship grants. X will receive gifts from its donor founders, invest them, and use the principal and income to support various programs of Christian organizations worldwide.

X's substantial contributor founders are A and B. They are also X's trustees, along with a third trustee. A and B cannot be removed as trustees except upon resignation, death, or incapacitation. Future trustees shall be selected from the direct descendants of A and B. If there are insufficient descendants to constitute a majority, X will be dissolved. X will also be dissolved after the death or permanent incapacitation of the last grandchild of the donors.

The SD named in the trust instrument is Z. Z claims IRC 501(c)(3) and 170(b)(1)(A)(vi) status. Z has the power to enforce the trust agreement and compel an accounting. X may make its grants either through Z or directly, with Z's prior approval, in amounts a majority of X's Trustees determine. Most Board decisions, including trustee selections and grant approvals, must be reviewed by Z. Z cannot unilaterally withhold approval but must provide a valid reason to X for any disapproval. Z has no review approval over X's investment policies.

Z is a relatively large organization with prior year total revenues and expenses in the millions of dollars. Z provides the following public information about its operations:

Here's how we operate: You approach us with a particular project, either educational, scientific, religious, or charitable. Our board reviews it, and if we believe it falls within our purposes, we accept it as a 'foundation account' or a Z foundation.

The control of a "foundation at Z" is in the hands of the Donor/Applicant, or his designee, under the final authority of the Z. For there to be a "completed gift", the final authority has to be given to the charity -- just like it would be if you set up your own "three person Board" in a private foundation. But we make our living by helping you accomplish your bona fide charitable purposes, and we would be swiftly out of business if we crossed up any bona fide charitable suggestions you or your designee might make . . . your foundation can support any qualified charity, except those where your gift will encourage (1) violence (2) promote atheism, or (3) compromise the freedoms guaranteed in our Constitution. We also permit your foundation within this framework to also conduct independent charitable activities. 39

The Service concludes that these facts make it difficult to say that X qualifies for type 3 supporting organization status. X's board is controlled by disqualified persons and they may only be removed by death, incapacitation or resignation or, in the future, by the disqualified persons' descendants. The board must approve most of X's actions. The named supported organization Z has approval power over some decisions, but Z's approval is not unilateral and does not extend to investment decisions. The Service indicates that Z's public acknowledgment that it will not disapprove any charitable proposals that are within its broad guidelines is an unfavorable factor. 40

After stating that X is controlled by disqualified persons, the Service further indicates that X flunks the operation test found in Code Section 509(a)(3)(A) and Regulation Section 1.509(a)-4(e)(1). This failure results because X will make grants to other organizations besides Z. The fact that Z will approve such grants does not cause the grants to be treated as grants from Z given the significant restrictions on Z's approval powers and given the fact that Z cannot make grants of X's assets without the approval of a majority of X's board. 41

In addition, the Service finds that X may fail the integral part test of Regulation Section 1.509(a)-4(i)(3)(ii), the organization test and/or the operation test because X is able to engage in independent activities that would not necessarily promote Z's activities and purposes. X may not be able to meet the responsiveness test of Regulation Section 1.509(a)-4(i)(2)(ii) because of X's ability to make grants to organizations other than Z without Z's authority and because Z does not have a say in X's investment decisions. 42

As a final comment on this example, the Service notes that Z's own Code Section 509(a)(1) and Code Section 170(b)(1)(A)(vi) status may be in jeopardy if service to organizations such as X is a primary activity of Z. 43

Disclosure Requirements

The CPE Text also indicates that the Regulations under Code Section 6104(d) finalized earlier this year44 and effective on March 13, 2000, clarify that supporting organizations "are subject to the disclosure requirements in the same manner as all other tax-exempt organizations." This includes supporting organizations formed as charitable trusts under Code Section 4947(a)(1) by virtue of the procedures outlined in Revenue Procedure 72-50. 45

Donor Advised Fund Control Issues

The CPE Text notes two main control issues related to donor advised funds. These issues relate to the extent to which the charity administering the donor advised fund follows the donor's advice on where to make distributions and when to make distributions. 46

This section of the CPE Text begins by observing the growing popularity of donor advised funds. As with supporting organizations, donor advised funds were discussed in the 2000 CPE Text. In the 2000 CPE Text, the Service noted that the following factors were important when it gave its blessing to certain donor advised funds during that year:

i. The organization expects that its grant distributions for the year will equal or exceed five percent of its average net assets on a fiscal year rolling basis. If this level of grant activity is not attained, the organization will identify the named accounts from which grants over the same period totaled less than five percent of each account's average assets. The organization will then contact the donor?advisors of these accounts to request that they recommend grants of at least this amount. If a donor?advisor does not provide the qualified grant recommendations, the organization is authorized to transfer up to five percent of assets from the donor?advisor's named account to the charity selected by the organization.

ii. The organization will add language to its promotional materials which indicates that the organization will investigate allegations of improper use of grant funds for the private benefit of donor?advisors.

iii. The organization will add language to its grantee letters to the effect that grants are to be used by grantees exclusively in furtherance of charitable purposes, and cannot be used for the private benefit of donor?advisors. 47

In addition, the IRS stated that these applications had all included representations subjecting them to the conditions imposed on private foundations under Code Sections 494248 and 4945, 49 which was also very important to the Service when it gave its blessing to them. 50

In the 2001 CPE Text, the Service states that it has seen more and more exemption applications and private letter ruling requests involving donor advised funds and it is closely scrutinizing these cases "especially their public charity status under IRC [Sections] 509(a)(1) and 170(b)(1)(A)(vi)." The Service notes that it is continuing to review such exemption applications and private letter ruling requests "using the principles similar to the material restriction or condition requirements of Reg. 1.507-2(a)(8)," which deals with restrictions and conditions on assets a public charity receives from a private foundation. 51

With this in mind, the Service says that there is support in Regulation Section 1.507-2(a)(8)(iv)(A)(1) and Example (4) of Regulation Section 1.507-2(a)(8)(v) for treating as a negative factor applications with contractual or promotional material indicating that the donor advised fund will follow a donor's advice all the time so long as the distribution is to a public charity. Specifically, Example (4) reads as follows:

The U Private Foundation transferred all of its net assets to Z Bank as trustee for the R Community Trust, a community trust which is a public charity described in section 170(b)(1)(A)(vi). Under the terms of the transfer, Z is to hold the assets in trust for R and distribute the income to those public charities described in section 170(b)(1)(A)(i) through (vi) that are designated by B, the creator of U. R's governing body has no authority during B's lifetime to vary B's direction. Under the terms of the transfer, it is intended that Z retain the transferred assets in their present form for a period of 20 years, or until the date of B's death if it occurs before the expiration of such period. Upon the death of B, R will have the power to distribute the income to such public charities as it selects and may dispose of the corpus as it sees fit.

Under paragraph (a)(8)(iv)(A) or (D) of this section, as a result of the restrictions imposed with respect to the transferred assets, there has been no distribution of all U's net assets within the meaning of section 507(b)(1)(A) at the time of the transfer. In addition, U has not transferred its net assets to a component part of R Community Trust, but rather to a separate trust described in §1.170A-9(e)(14). 52

The IRS notes that the foundation's creator in Example 4 has retained the right to determine which charities will receive distributions from the funds transferred under the terms of the transfer. The community trust, on the other hand, has "no right during the lifetime of the creator to vary his direction as to distribution of funds to the ultimate charity....the community trust/transferee is precluded from determining the charitable distributee different than that designated by the creator of the transferor and, thus, precludes the transfer as being treated as part or a component fund of the community trust." 53

The Service suggests comparing Example 4 to the situation found in Private Letter Ruling 200028038, 54 which involved a favorable ruling. The IRS notes that the community trust in the Ruling follows the requirements of Regulation Section 1.507-2(a)(8) and plans to adopt an annual distribution requirement of 5%.

The second donor advised fund control issue discussed in the CPE Text pertains to the control donors have over the timing of distributions from donor advised funds. The IRS notes that "many, if not most" donor advised funds "have implicit or explicit contractual relationships with their donor advisors that require that distributions from the [donor advised funds] may only be made with the recommendation of the donors. Put another way, distributions from donors may only be triggered by donor recommendations." 55

The IRS states that it is considering whether such a "triggering mechanism" should be a negative factor. It cites Regulation Section 1.507-2(a)(8)(iv)(A)(1) as authority that it should be, noting:

Specifically, Reg. 1.507-2(a)(8)(iv)(A)(1) provides that an adverse factor includes, with respect to distributions, the reservation of a right by a disqualified person to direct the timing of distributions to public charities described in IRC 509(a)(1) or (2). The purpose of this material restriction or condition requirement of the Regulation is to ensure that the transfer has relinquished dominion and control ("ownership") of the transferred property. It would be logical to assert that if a [donor advised fund] is unable to initiate a charitable distribution to a public charity, it lacks dominion and control or "ownership" over the property. 56

The Service indicates that the promotion of specific giving programs by donor advised funds may be the equivalent of requests or demands for distributions. This would depend on how vigorously such programs are carried out as well as the timing of the promotional communications. 57

On the positive side, the Service observes that the requirement some donor advised funds have adopted for distributions of 5% of the net fair market value of fund assets annually in a manner similar to the Code Section 4942 distribution requirements applicable to private foundations may be a favorable factor with respect to control issues. The 5% minimum standard may allow a donor advised fund to initiate a distribution because a donor's failure to recommend a distribution would cause funds to be transferred from the donor advised fund to the charity's unrestricted account. 58

Finally, the CPE Text references the President's proposal for legislation to regulate donor advised funds issued earlier this year. 59 The Service makes no further comment on the proposal but merely notes that a number of comments were received and that, as of August 1st, no such bills had been introduced in Congress. 60

Charitable Family Limited Partnership Control Issues

The CPE Text references the July 13, 1999, Wall Street Journal article describing the charitable family limited partnership scheme and suggests that this scheme may have superseded charitable split dollar insurance programs as the "favorite charity sham." Benefits to donors touted by promoters of the charitable family limited partnership include avoiding capital gains taxes on sales of appreciated assets, continuing control of assets, deducting a charitable contribution and reducing estate taxes. 61

The Service describes a charitable family limited partnership transaction as follows:

Donor "D", having substantially appreciated assets, which are often not readily marketable, such as real estate or proprietary interest in a closely held business, sets up a donor family limited partnership ("DFLP"). D transfers highly appreciated assets to DFLP in exchange for both a general and limited partnership interest with the general partnership interest comprising a very modest 1 or 2 percent of the total partnership interests. The DFLP agreement usually provides for a term of 40 to 50 years.

D contributes a large percentage of the DFLP interest to charity "Z", usually as much as 95 to 98 percent, in the form of a limited partnership interest. D will usually retain the general partnership interest. D may also retain a modest limited partnership interest or transfer such an interest to D's children. D obtains an independent appraisal of the value of the partnership interests in order to establish the fair market value of the IRC 170(c) charitable contribution deduction. Z receives whatever assets are held by DFLP at the end of the partnership term, assuming the partnership interest was not sold prior to the expiration of the partnership term.

D claims an IRC 170(c) tax deduction based on the value of the gift of the partnership interest to Z. The value likely has been discounted to take into account the lack of Z control and management of partnership operations as well as the lack of marketability of the limited partnership interest in the context of a closely held business. 62

The IRS states that control is the key, noting that the donor retains control of the partnership through his or her position as general partner. As a limited partner, the charity does not participate in the partnership's day to day operations and management. The Service observes that the donor may receive compensation income for running the partnership and notes that it is the charity's tax exempt status that allows most of the capital gains taxes on the sale of appreciated assets to be avoided. The charity may or may not receive any current distributions from the partnership and it may have an interest in an appreciating asset which will be sold or exchanged at the end of the partnership term. 63

Another factor mentioned by the Service as involved in the charitable family limited partnership technique is that the partnership agreement gives the partnership the right to sell the underlying property to the donor or the donor's family at a specified price. The Service indicates that this is "essentially a put option" and notes that, while it could benefit the charity, many view the option as mainly for the benefit of the donor and the donor's family. 64

According to the Service, some of the potential tax issues raised by the charitable family limited partnership technique include problems under Code Sections 170, 65 501(c)(3), 66 51167 and 4958. 68 If the charity is a private foundation, self dealing issues may arise under Code Section 4941 and excess business holdings issues may arise under Code Section 4943. In addition, there may be "clear tax abuse" in some cases, depending on the partnership agreement and the operation of the partnership. The Service suggests that examinations of charities holding interests in charitable family limited partnerships "should include close scrutiny of the partnership agreement as well as the manner of operation, valuation, management compensation and other matters relating to the legal relationships." 69

Conclusion

This article has outlined various control issues that the IRS has noted in its most recent CPE Text for its employees with respect to supporting organizations, donor advised funds and charitable family limited partnerships. Based on the CPE Text, it appears the IRS may be focusing increased scrutiny on type 3 supporting organizations in some cases. In addition, it is very questionable whether the IRS would give supporting organization status in a transaction described in the CPE Text involving a donor advised fund and a publicly supported charity. With respect to donor advised funds themselves, the main control issues noted by the Service are the donors' ability to control distributions both as to recipients and timing. Inappropriate control is also one of the Service's central concerns with the charitable family limited partnership vehicle.

With "control" as the thread of Topic G of the CPE Text, a level of concern does arise where the charitable family limited partnership, which is basically a new and untested structure, is linked together with a supporting organization and a donor advised fund. Nevertheless, a review and consideration of the Service's current thinking is always valuable in planning the creation and use of any of these vehicles.


Footnotes


  1. See Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  2. All references to the Code are to the Internal Revenue Code of 1986, as amended from time to time.back

  3. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  4. See Treas. Reg. § 509(a)-4(c) and (d).back

  5. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  6. See Treas. Reg. § 1.509(a)-4(g).back

  7. See Treas. Reg. § 1.509(a)-4(h).back

  8. See Treas. Reg. § 1.509(a)-4(i).back

  9. Treas. Reg. § 1.509(a)-4(d).back

  10. See Treas. Reg. § 1.509(a)-4(d)(2)(iii), Examples 1 and 2.back

  11. Treas. Reg. § 1.509(a)-4(d)(2)(iv).back

  12. Treas. Reg. § 1.509(a)-4(d)(3).back

  13. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  14. Treas. Reg. § 1.509(a)-4(d)(i)(a).back

  15. Id.back

  16. Treas. Reg. § 1.509(a)- 4(d)(4)(i)(b).back

  17. See Treas. Reg. § 1.509(a)-4(d)(4)(c)(ii) and (iii).back

  18. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  19. 1979-1 C.B. 204.back

  20. 603 F.2d 1274 (7th Cir. 1979).back

  21. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  22. Id.back

  23. Id.back

  24. Id.back

  25. See Treas. Reg. § 1.509(a)-4(j)(1).back

  26. Treas. Reg. § 1.509(a)-4(j)(1).back

  27. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  28. 1980-2 C.B. 113.back

  29. Rev. Rul. 80-207, 1980-2 C.B. 113.back

  30. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  31. Id.back

  32. Id.back

  33. Id.back

  34. Id.back

  35. Id.back

  36. Treas. Reg. § 1.509(a)-4(j)(I).back

  37. 1967-1 C.B. 123.back

  38. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  39. Id.back

  40. Id.back

  41. Id.back

  42. Id.back

  43. Id.back

  44. See Treas. Dec. 8861, 2000-5 I.R.B. 441.back

  45. 1972-2 C.B. 830; see Treas. Reg. § 301.6104(d)-1(b)(2).back

  46. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  47. See Topic P in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2000.back

  48. Relating to undistributed income.back

  49. Relating to taxable expenditures.back

  50. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  51. Id.back

  52. Treas. Reg. § 1.507-2(a)(8)(v) Example (4).back

  53. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  54. April 14, 2000.back

  55. Topic G in Part I of Exempt Organizations Technical Topics in IRS Exempt Organizations Continuing Professional Education Text for Fiscal Year 2001.back

  56. Id.back

  57. Id.back

  58. Id.back

  59. General Explanation of the Administration's Fiscal Year 2001 Revenue Proposals.back

  60. Id.back

  61. Id.back

  62. Id.back

  63. Id.back

  64. Id.back

  65. Relating to the income tax charitable deduction.back

  66. Relating to private inurement and private benefit.back

  67. Relating to unrelated business taxable income.back

  68. Relating to excess benefit transactions.back

  69. Id.back

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