Options to Purchase Partnership Not Self-Dealing

Options to Purchase Partnership Not Self-Dealing

News story posted in Letter Rulings on 4 May 1998| comments
audience: National Publication | last updated: 18 May 2011
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The estate plan of a married couple provides that on their deaths a substantial portion of their estates, which include units in a family limited partnership, will be transferred to the family's private foundation. In order to avoid the potential problems associated with the ownership by a foundation of the partnership units, the couple proposes to grant purchase options to their children. The options will enable the children to purchase partnership units from their parents' estates prior to the units being transferred to the foundation. The strike price for the units will be their fair market value as determined for estate tax purposes and can be evidenced by a minimum down payment and a 30-year promissory note. The IRS has ruled privately that the exercise by the children of the options and subsequent transfer of the promissory notes from the parents' estates to the foundation will not constitute either a direct or indirect prohibited act of self-dealing under IRC 4941.

Ltr. Rul. 9818063

Full Text:

Date: February 4, 1998

In Reference to: CP:E:EO:T:2

DO: * * *
FIN: * * *

LEGEND:
A = * * *
B = * * *
C = * * *
D = * * *
E = * * *
F = * * *
G = * * *
H = * * *
I = * * *

Dear Sir:

[1] This is in reply to your letter of September 3, 1996, as amended by your letter of July 23, 1997, requesting several rulings regarding the proposed distribution of various assets owned by A and B (also referred to as the Taxpayer[s]).

[2] A and B are married and have established C, a Living Trust, to dispose of their property. They are the Trustees of the Living Trust. Substantially all of their property is community property. The Living Trust provides that upon the death of the first Taxpayer two separate trusts will be established. The Surviving Trustor's Trust will represent the surviving Taxpayer's interest in their assets. The decedent's interest in their assets will be placed in a marital deduction trust.

[3] You have represented that the marital deduction trust will qualify for the marital deduction upon election by the executor (trustee) pursuant to section 2056(b)(7) of the Code and that the trustee intends to make this election. D, (the Foundation) has a substantial remainder interest in the estates of A and B. You state that a credit shelter trust may be established, but only if needed for purposes unrelated to this ruling request.

[4] D (The Foundation) has been recognized as exempt from federal income tax under section 501(c)(3) of the Code and has been determined to be a private foundation within the meaning of section 509(a) of the Code. The directors of the Foundation are A, B and their 3 adult children.

[5] E is a general partnership in which the Taxpayers' three children each have an equal interest.

[6] You have stated that the Taxpayers, their three children and E all are "disqualified persons" with respect to the Foundation within the meaning of section 4946(a) of the Code as regards the marital trust and other involved parties.

[7] Substantially all of the assets of A and B are interests in partnerships in which their children, or other related entities, also own partnership interests. The Taxpayers are concerned with potential tax problems which the Foundation might face in connection with owning interests in partnerships with disqualified persons, and in connection with owning interests in partnerships which are engaged in the business of ownership and management of debt-financed rental properties.

[8] Therefore, the Taxpayers desire to arrange for the purchase by their children and/or E of the partnership interests which otherwise would pass to the Foundation.

[9] The Taxpayers' basic estate plan is to provide on the first death for a credit shelter trust (the By Pass Trust) and a marital deduction (QTIP) trust from the decedent's one-half of the trust estate. It is Taxpayers' intent that, at the second death, their entire estate, except for a personal residence and a vacation residence, will be distributed to the Foundation. Taxpayers expect to use their combined available unified credit either during their lives or upon funding of the By Pass Trust with these residences at their deaths.

[10] To facilitate the sale of the partnership interests after their deaths, the Taxpayers' have entered into two option agreements. The first such agreement (referred to as the Agreement) deals with the right of the surviving partners in F to purchase the partnership interest of any deceased partner. The second agreement (the "Purchase Agreement") gives A and B's children, through E an option to purchase most of the remaining interests of A and B's estates in G and H.

[11] F is a partnership which owns a multifamily residential development. A and B are general partners in F, each having equal general partnerships interests. Taxpayers' son also owns a general partnership interest and a limited partnership interest and one of the Taxpayers' daughters has another limited partnership interest. Taxpayers' son, is also the trustee of a limited partnership interest for the benefit of another of the Taxpayers' daughters.

[12] The Agreement contains an option for the surviving partners in F to purchase the partnership interest of any deceased partner. You have represented that upon the first death, the survivor, intends to waive his or her rights to purchase the partnership interest and the children are expected to exercise their rights to purchase the first deceased interest in F. It is also expected that, on the death of the surviving Taxpayer, the children will also exercise the right to purchase the interest of the surviving taxpayer.

[13] The option purchase price is based upon a formula equal to the capital account of the deceased partner adjusted to reflect, as the value for the land, an agreed value on the date the Agreement was executed, adjusted by adding back any depreciation deducted after the tenth year following completion of the project.

[14] A cash down payment is required, and the balance is to be evidenced by a nonnegotiable unsecured promissory note to the estate of the deceased partner, with principal payable in several equal annual installments, together with interest at the lowest rate which will not result in the imputation of interest by the Service, but in no event less than a set percent per annum, payable with principal. The first of such installments is to be paid one (1) year after the date of the cash down payment with right of prepayment without penalty.

[15] The second agreement (referred to in this letter as the Purchase Agreement) provides E with the option, upon the death of the surviving Taxpayer, to purchase the partnership interest owned by the Taxpayers in G, H and I. These are three partnerships, in which A and B hold controlling interests, which together hold virtually all of the Taxpayers' remaining assets.

[16] The price at which the option under the Purchase Agreement may be exercised is to be equal to the then fair market value of the interest being purchased, as finally determined for federal estate tax purposes in the estate of the last to die of Taxpayers. The purchase price is to be evidenced by one or more negotiable promissory notes payable in substantially equal annual installments over a period of thirty (30) years. Each promissory note shall bear interest from the date of death of the last to die of Taxpayers at a variable rate (adjusted annually) tied to the LIBOR index for long- term loans within the local real estate industry, including a one- time right for the borrower to freeze the rate, it being the intent that the rate of interest not be less than adequate stated interest pursuant to the relevant provisions of the Code. Interest shall accrue from the date of death of the last to die of Taxpayers and shall be compounded annually until the date of the purchase and sale pursuant to the exercise of the option is consummated. Such compounded interest shall be added to the purchase price and the sum there of will constitute the initial principal balance of the promissory notes.

[17] The promissory notes payable to the trusts shall be secured not only by the interest being acquired but by the entire partnership interest. In other words even though the interests in the partnerships being acquired do not represent one hundred percent of the interests therein it is intended that the security for the promissory notes will represent one hundred percent of each of the partnerships.

[18] The initial principal balance of the promissory notes shall be adjusted retroactively to reflect any increase or decrease in the values for Federal state tax purposes at such time as such values have been finally determined in the estate of the survivor of Taxpayers.

[19] Upon the death of the first to die of Taxpayers, separate trusts will be established pursuant to the Trust Agreement. A trust known as the Surviving Trustor's Trust will be established representing the surviving Taxpayer's interest in the partnerships. Except for the possibility that a portion of the decedent Taxpayer's interest could be included in a credit shelter trust known as the Bypass Trust, the remainder of the decedent Taxpayer's interest in the partnerships will be included in a so called Marital Trust, which will qualify for the marital deduction upon election by the executor (trustee) pursuant to section 2056(b)(7) of the Code ("the QTIP election"). The Taxpayers intend that the QTIP election will be made.

[20] At the time of the death of the first Taxpayer to die, it is expected that the option included in the Agreement to purchase the decedents' interest in F will be exercised by the Taxpayers' children. The transaction will be completed within the period reasonably required for final administration of the trust with respect to the death of the deceased Taxpayer. However, the promissory notes will be retained in the marital (QTIP) trust and not distributed to the Foundation until after the death of the surviving Taxpayer.

[21] Upon the death of the surviving Taxpayer, the partnership interests included in the surviving trustor's trust and in the marital trust will be appraised and a Federal estate tax return will be filed within the period required for such filing and any permitted extensions. The documentation for the exercise of the options described in the Purchase Agreement and the Agreement which were discussed above shall have been prepared prior to the filing of the Federal estate tax return, and will expeditiously be closed by exchanging the partnership interests held in the surviving Taxpayer's trust and in the marital trust for the promissory notes which will then be distributed to the Foundation.

[22] In addition to the foregoing the Taxpayers make the following representations:

1. The trustee of the Trust possesses a power of sale with respect to the assets in the Trust.

2. The trustee is bound by the terms of the Purchase Agreement and the Agreement to sell the property in accordance with the terms of those agreements.

3. The Probate Court having jurisdiction over the Trust and over the Foundation has approved the sale of assets by the Trust and the distribution of the notes by the Trust to the Foundation.

4. The sales will occur before the Trust is considered subject to section 4947 of the Code.

5. The Trust will receive an amount which equals or exceeds the fair market value of the Foundation's interest or expectancy in the assets sold at the time of the transaction, taking into account the terms of the Purchase Agreement and the Agreement subject to which the assets were acquired by the Trust.

6. The sales transactions are required under the terms of the Trust, the Purchase Agreement and the Agreement.

7. The distribution of notes to the Foundation is required by the terms of the trust.

[23] You have requested the following rulings:

1. The exercise of the option contained in the Agreement by A and B's children through E to purchase the partnership interests included in the Trust upon the death of each of the Taxpayers at the price and on the terms and conditions provided in the Agreement will not constitute an act of direct or indirect self-dealing pursuant to section 4941 of the Code.

2. The exercise of the option under the Purchase Agreement by E to purchase the interests in G, H and I upon the death of the second of the Taxpayers at the price and on the terms and conditions provided in the Purchase Agreement will not constitute an act of direct or indirect self-dealing pursuant to section 4941 of the Code.

3. The receipt and holding of the notes distributed to the Foundation pursuant to the exercise of the options contained in the Purchase Agreement and the Agreement will not cause the transaction to constitute an act of direct or indirect self-dealing pursuant to section 4941 of the Code.

4. The delay until the second death, as provided in the Purchase Agreement, in purchasing the interest of the first Taxpayer to die which is included in the Marital (QTIP) Trust (assuming that the QTIP election is made), will not cause the transaction to constitute an act of self-dealing pursuant to section 4941 of the Code.

5. If the exercise of the option contained in the Agreement at the date of death of the first Taxpayer results in the delay of the distribution to the Foundation of the promissory note which will be held in the marital QTIP trust until after the death of the surviving taxpayer, such delay in distribution will not cause the transaction to constitute an act of direct or indirect self-dealing pursuant to section 4941 of the Code.

[24] Section 501(c)(3) of the Code exempts from Federal income tax organization organized and operated exclusively for charitable or educational purposes.

[25] Section 509(a) of the Code provides that, unless specifically excepted, a domestic or foreign organization described in section 501(c)(3) is a private foundation and subject to the excise taxes of Chapter 42.

[26] Section 4941(a) of the Code imposes an excise tax on each act of self-dealing between a disqualified person and a private foundation.

[27] Section 4941(d)(1) of the Code defines self-dealing as including a sale or exchange of property or the extension of credit between a foundation and a disqualified person whether done directly or indirectly.

[28] Section 53.4941(d)-1(a) of the Foundation and Similar Excise Tax Regulations provides that for the purposes of section 4941, the term "self-dealing" means any direct or indirect transaction described in section 53.4941(d)-2 of the regulations.

[29] Section 53.4941(d)-1(b)(1) of the regulations states that indirect self-dealing includes any transaction between a disqualified person and an organization controlled by a private foundation.

[30] Section 53.4941(d)-1(b)(3) of the regulations provides that the term indirect self-dealing shall not include a transaction with respect to a private foundation's interest or expectancy in property (whether or not encumbered) held by an estate (or revocable trust, including a trust which has become irrevocable on a grantor's death), regardless of when title to the property vests under local law, if --

(i) The administrator or executor of an estate or trustee of a revocable trust either --

(a) Possess a power of sale with respect to the property,

(b) Has the power to reallocate the property to another beneficiary, or

(c) Is required to sell the property under the terms of any option subject to which the property was acquired by the estate (or revocable trust);

(ii) Such transaction is approved by the probate court having jurisdiction over the estate (or by another court having jurisdiction over the estate (or trust) or over the private foundation);

(iii) Such transaction occurs before the estate is considered terminated for Federal income tax purposes pursuant to paragraph (a) of section 1.641(b)-3 of this chapter (or in the case of a revocable trust, before it is considered subject to section 4947);

(iv) The estate (or trust) receives an amount which equals or exceeds the fair market value of the foundation's interest or expectancy in such property at the time of the transaction taking into account the terms of any option subject to which the property was acquired by the estate (or trust); and

(v) With respect to transaction occurring after April 16, 1973, the transaction either --

(a) results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up,

(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 any option which is binding on the estate (or trust).

[31] Section 53.4941(d)-1(b)(8) of the regulations, Example (4), describes a situation where a substantial contributor to a private foundation bequeaths one-half of his estate to his spouse and one-half to the private foundation. The estate includes a one-third interest in a partnership, the remaining two-thirds of the partnership are owned by a disqualified person to the private foundation. The one-third interest was subject to an option agreement when it was acquired by the estate. The sale of the one-third interest in the partnership to the disqualified person did not constitute an act of self-dealing because the transaction satisfied the requirements set forth in section 53.4941(d)-1(b)(3).

[32] Section 53.4941(d)-2 regulations discusses specific acts of self-dealing.

[33] Section 53.4941(d)-2(a)(1) of the regulations provides that in general the sale or exchange of property between a private foundation and a disqualified person shall constitute an act of self- dealing.

[34] Section 53.4941(d)-2(a)(2) of the regulations provides that for purposes of subparagraph (1) of this paragraph, the transfer of real or personal property by a disqualified person to a private foundation shall be treated as a sale or exchange if the foundation assumes a mortgage or similar lien which was placed on the property prior to the transfer, or takes subject to a mortgage or similar lien which a disqualified person placed on the property within the 10-year period ending on the date of transfer. For purposes of this subparagraph, the term 'similar lien' shall include, but is not limited to, deeds of trust and vendors' liens, but shall not include any other lien if such lien is insignificant in relation to the fair market value of the property transferred.

[35] Section 53.4941(d)-2(c) provides that except as provided in subparagraphs (2), (3), and (4) of this paragraph (not applicable to this ruling), the lending of money or other extension of credit between a private foundation and a disqualified person shall constitute an act of self-dealing. Thus, for example, an act of self- dealing occurs where a third party purchases property and assumes a mortgage, the mortgagee of which is a private foundation, and subsequently the third party transfers the property to a disqualified person who either assumes liability under the mortgage or takes the property subject to the mortgage. Similarly, except in the case of the receipt and holding of a note pursuant to a transaction described in Section 53.4941(d)-1(b)(3), an act of self-dealing occurs where a note, the obligor of which is a disqualified person, is transferred by a third party to a private foundation which becomes the creditor under the note.

[36] Section 4946(a)(1) defines the term "disqualified persons" with respect to a private foundation as including a substantial contributor to the foundation, a foundation manager, and an owner of more than 20 percent of the total combined voting power of a corporation which is a substantial contributor to the foundation. It also includes a member of the family of any individual described above. It also includes a partnership in which persons described above and a trust or estate in which persons described in above hold more than 35 percent of the beneficial interest in.

[37] Section 4946(b) defines the term foundation manager as including an officer, director, or trustee of a foundation or an individual having powers or responsibilities similar to those of officers, directors, or trustees of the foundation.

[38] Section 4946(d) states that the term "a member" of the family of a disqualified person includes the spouse, children of and grandchildren of a disqualified person.

[39] Section 507(d)(2)(A) of the Code defines a substantial contributor as any person who contributed or bequeathed an aggregated amount of more than $5,000 to a 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 by the foundation from such person. In the case of a trust, the term substantial contributor also means the creator of the trust.

[40] Section 4947(a) of the Code provides that certain trusts which are not exempt under section 501(a) of the Code are treated as private foundations and subject to the excise taxes imposed by Chapter 42.

[41] Section 4947(a)(1) provides that trusts, referred to as charitable trusts, which are not exempt from tax under section 501 (a), all of the unexpired interests in which are devoted to one or more of the purposes described in section 170(c)(2)(B), and for which a deduction was allowed under section 170, 545(b)(2), 556(b)(2), 642(c), 2055, 2106(a)(2), or 2522 (or the corresponding provisions of prior law), shall be treated as an organization described in section 501(c)(3).

[42] Section 4947(a)(2) of the Code provides that trusts, referred to as split-interest trusts, which are not exempt from tax under section 501(a), not all of the unexpired interests in which are devoted to one or more of the purposes described in section 170(c)(2)(B), and which have amounts in trusts for which a deduction was allowed under section 170, 545(b)(2), 556(b)(2), 642(c), 2055, 2106(a)(2) or 2522, are subject to the provisions of section 507, 508(e) and, to the extent applicable, 4941, 4943, 4944, and 4945 in the same manner as if such trusts were private foundations.

[43] Section 53.4947-1(b)(2)(ii)(A) of the regulations provides that when an estate from which the executor or administrator is required to distribute all of the net assets in trust for charitable beneficiaries, or free of trust to such beneficiaries, is considered terminated for Federal income tax purposes under section 1.641(b)- 3(a) the estate will be treated as a charitable trust under section 4947(a)(1) between the date on which the estate is considered terminated under section 1.641(b)-3(a) and the date final distribution of all of the net assets is made to or for the benefit of the charitable beneficiaries.

[44] Section 53.4947-1(b)(2)(iii) provides that a split- interest trust in which all of the unexpired interests are charitable remainder interest and in which the charitable beneficiaries have become entitled to distributions of corpus in trust or free of trust shall continue to be treated as a split-interest trust under section 4947(a)(2) until the date on which final distribution of all the net assets is made. However, if after the expiration of any intervening interests the trust is considered terminated for Federal income tax purposes under section 1.641(b)3-(b), the trust will be treated as charitable trust under section 4947(a)(1), rather than a split- interest trust under section 4947(a)(2) between the date on which such final distribution of all of the net assets is made to or for the benefit of the charitable remainder beneficiaries.

[45] The Foundation is a private foundation within the meaning of section 509(a) of the Code by reason of the nature of its support. The two estates and marital trusts are considered private foundations by reason of section 4947 of the Code.

[46] A, B, C, E and the three children of A and B are all disqualified persons, within the meaning of section 4946 of the Code, with respect to D. E and the children of A and B have options to purchase from C assets in which D has an interest or expectancy. These assets will be purchased with promissory notes which ultimately will be distributed to D. Therefore, unless otherwise excepted, the exercise of the option, and the receipt and holding of the notes by D, will be an act of direct and indirect self-dealing within the meaning of section 4941 of the Code.

[47] Section 53.4941(d)-1(b)(3) of the regulations provides a specific exception to the rules regarding self-dealing where the transaction involves situations which take place during the administration of an estate or revocable trust. The submitted information and representations you have made establish that the conditions described in the regulations have been or will be satisfied. Furthermore, you have obtained an order from the local court having jurisdiction over this matter which instructs the Trustees as to the sale and distribution of trust assets in the manner and under the terms and conditions described in your request for a ruling. Accordingly, the sales and purchase arrangement comes within an exception to the rules against self-dealing.

[48] Similarly, the acceptance by the Foundation, the estate of the first Taxpayer to die and the marital trust of promissory notes in exchange for the properties described in this ruling request is also excepted from the definition of self-dealing. See section 53.4941(d)-2(c) of the regulations which provides that in the case of the receipt and holding of a note pursuant to a transaction described in Sec. 53.4941(d)-1(b)(3), an act of self-dealing does not occur where a note, the obligor of which is a disqualified person, is transferred by a third party to a private foundation which becomes the creditor under the note.

[49] The fact that the ultimate distribution of assets to the Foundation will not take place until after the death of the initial surviving Taxpayer does not establish that the distribution to charity has been unnecessarily delayed. The terms and conditions of the distributions have been approved by the local state courts.

[50] Accordingly, based on the information submitted and the representations you have made we have concluded that:

1. The exercise of the option contained in the Agreement by A and B's children through E of the right to purchase the partnership interests included in the Trust upon the death of each of the Taxpayers at the price and on the terms and conditions provided in the Agreement will not constitute an act of direct or indirect self- dealing pursuant to section 4941 of the Code.

2. The exercise of the option under the Purchase Agreement by E to purchase the interests in G, H and I upon the death of the second of the Taxpayers at the price and on the terms and conditions provided in the Purchase Agreement will not constitute an act of direct or indirect self-dealing pursuant to section 4941 of the Code.

3. The receipt and holding of the notes distributed to the Foundation pursuant to the exercise of the options contained in the Purchase Agreement and the Agreement will not cause the transaction to constitute an act of direct or indirect self-dealing pursuant to section 4941 of the Code.

4. The delay until the second death as provided in the Purchase Agreement in purchasing the interest of the first Taxpayer to die which is included in the Marital (QTIP) Trust (assuming that the QTIP election is made), will not cause the transaction to constitute an act of self-dealing pursuant to section 4941 of the Code.

5. If the exercise of the option contained in the Agreement at the date of death of the first Taxpayer results in the delay of the distribution to the Foundation of the promissory note which will be held in the marital QTIP trust until after the death of the surviving taxpayer, such delay in distribution will not cause the transaction to constitute an act of direct or indirect self-dealing pursuant to section 4941 of the Code.

[51] This ruling is directed only to the organization that requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

[52] This ruling is limited to the applicability of the provisions of section 4941 and 4946 of the Code. As regards the marital deduction provisions of section 2056(b)(7) and the deemed transferor provisions of section 2044 we have accepted your representation that you have or will satisfy the requirements of these provisions.

[53] In this ruling we have not determined whether the methodology you are using to determine fair market value of the assets is proper. We merely have accepted your representation that the involved notes will reflect fair market value.

[54] We are informing your key District Director of this ruling. Because this letter could help resolve any question about your exempt status, you should keep it in your permanent records.

[55] If you have any question about this ruling, please contact the person whose name and telephone number are shown in the heading of this letter. For other matters, including questions concerning reporting requirements, please contact your key District Director.

Sincerely Yours,

Garland A. Carter
Chief, Exempt Organizations
Technical Branch 2

Date Published: 05-01-98

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