Thornburg's Charitable UPREIT

Thornburg's Charitable UPREIT

Article posted in Real Property on 15 November 1999| comments
audience: National Publication | last updated: 16 September 2012
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Summary

On October 22, 1999, the PGDC published a yet-to-be-released private letter ruling involving the use of a partnership and a REIT to facilitate transfers of debt-encumbered property to charitable remainder trusts. In this edition of Planned Giving Online, PGDC editors review this new strategy in greater detail, explore the two issues left open in the ruling, and provide a summary of the ruling prepared by the ruling sponsor's legal counsel.

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

Many donors own appreciated property, such as real estate, they would like to use in their charitable gift planning. If the appreciated property is contributed to a charitable remainder trust ("CRT") before it is sold, the donor may avoid taxation on the gains resulting from the sale of the property except to the extent of distributions to the donor. However, such property is often encumbered with debt, which significantly complicates the use of the popular CRT vehicle. This article begins with a discussion of the potential risks of making charitable gifts of debt-encumbered property via CRTs. This is followed by a detailed analysis of a recent private letter ruling containing favorable IRS rulings on this topic.

As discussed more fully below, the risks of funding a CRT with debt-encumbered property include:

  • complete invalidation of the CRT because of grantor trust status or impermissible payments of CRT monies,
     
  • temporary loss of tax-exemption of the CRT in those years when the CRT has unrelated business taxable income resulting from debt financed income,
     
  • partial taxation of the transfer of the property to the CRT because the transfer is deemed to be a bargain sale, and
     
  • imposition of excise taxes because of the violation of the rules against self-dealing.

These risks are significant and could cause the donor to suffer negative tax consequences, including possible recognition of all gain on the appreciated property in the year of transfer to the trust and loss of all charitable deductions.

Risk #1: The CRT will be invalid if it is deemed a grantor trust

A trust is a valid CRT for purposes of IRC 664 if it complies with Treas. Reg. §1.664-1(a)(4), which states in pertinent part:

In order for a trust to be a charitable remainder trust, it must meet the definition of and function exclusively as a charitable remainder trust from the creation of the trust. Solely for the purposes of section 664 and the regulations thereunder, the trust will be deemed to be created at the earliest time that neither the grantor nor any other person is treated as the owner of the entire trust under subpart E, part 1, subchapter J, chapter 1, subtitle A of the Code (relating to grantors and others treated as substantial owners), but in no event prior to the time property is first transferred to the trust.

IRC §677 provides, to the extent a CRT is treated as a "grantor" trust, it will not be a valid CRT:

[A] grantor is, in general, treated as the owner of a portion of a trust whose income is, or in the discretion of the grantor or a nonadverse party, or both, may be applied in discharge of a legal obligation of the grantor. [Emphasis added]1

A private letter ruling in the early 1990s, Ltr. Rul. 9015049, caused a good deal of confusion in the application of the grantor trust rules to CRTs. As Conrad Teitell, a leading commentator in this area indicated, "[s]ince 1970 it was widely believed that a charitable remainder trust funded with mortgaged property qualifies for income, gift and estate tax charitable deductions."2

However, in the referenced ruling, a CRT was funded with mortgaged property, the trustee was required to pay the mortgage and the donor remained personally liable on the debt. The Internal Revenue Service ("IRS") ruled that the trust never qualified as a charitable remainder unitrust, because the trustee would be discharging the donor's legal obligation.3

A sampling of other cases in the grantor trust area indicates that the focus is on whether the trustee actually made payments to reduce the debt,4 or whether the trustee had the power and discretion to make such payments.5

There is also authority for the view that, where the trustee has expressly assumed the debt and the grantor has been discharged from all liability thereunder, the grantor ceases to be taxable as the "owner" of the trust even though the trust pays the debt.6

Notwithstanding all of this authority, the "may be applied" language in Treas. Reg. §1.677(a)-1(d) presents a serious tax risk for any contribution of encumbered property to a CRT. The risk is that the trust will not be a valid CRT. Would this risk be reduced if the CRT was already in existence at the time the encumbered real estate was contributed to the CRT?

Risk #2: The CRT will not be tax-exempt for any calendar year it has unrelated business income

If a charity incurs any unrelated business taxable income, the charity must pay income tax on the unrelated business taxable income.7 A CRT that incurs unrelated business taxable income loses its tax-exempt status in that taxable year, so unrelated business taxable income could be particularly devastating in a year when an appreciated asset is sold.

Although a term of art, unrelated business taxable income generally means income earned from the active operation of a business enterprise. In general, passive income, such as interest, dividends, rents from real property under certain circumstances, certain royalties and gains from a capital asset do not constitute unrelated business taxable income, so long as debt is not incurred to acquire those assets. The incurring of any debt by a CRT generally is very dangerous. As a general rule, no asset subject to debt should be contributed to such a trust.

Accordingly, to the extent that a CRT which has been funded with debt-encumbered property has income for any taxable year, this income may be debt financed income under IRC §514, thus giving rise to unrelated business taxable income, as discussed above. As a result, the CRT will lose its tax-exempt status, and will be subject to income tax under IRC 11 for that taxable year.8 In addition, the gain from the sale of such property is subject to tax as unrelated business income. As such, the sale of debt financed property within twelve (12) months of debt satisfaction will trigger this tax.9

Finally, IRC §514(c)(2)(A) provides that, "[w]here property (no matter how acquired) is acquired subject to a mortgage or other similar lien, the amount of the indebtedness secured by such mortgage or lien shall be considered as an indebtedness of the organization incurred in acquiring such property even though the organization did not assume or agree to pay such indebtedness." Thus, property taken subject to a mortgage or similar lien is debt financed property even if the recipient does not assume the debt or agree to pay it off. However, an exception to this rule is provided under IRC §514(c)(2)(B) where, among other things, the encumbrance is placed on the property more than five years before the date of the gift.

Risk #3: Gift of debt-encumbered property to the CRT results in a bargain sale causing the initial transfer to be partially taxable

The transfer of debt-encumbered property to a CRT may be treated as a bargain sale, which is, effectively, a part gift/part sale. When a charity receives property subject to a debt, even though the charity does not assume or pay the debt, the debt must be treated as an "amount realized" for purposes of determining taxable gain.10 Thus, the difference between the amount realized and the allocated adjusted basis in the contributed property will constitute a taxable gain.11 This gain is recognized by the donor in the taxable year the CRT is funded with the debt-encumbered property.

Risk #4: Use of CRT monies to pay the debt will be a prohibited self-dealing transaction

In general, "self-dealing" is any direct or indirect transaction between a private foundation and a disqualified person 12 involving the (i) sale, exchange, or leasing or property, (ii) lending of money or other extension of credit, (iii) furnishing of goods, services, or facilities, or (iv) payment of compensation or payment/reimbursement of certain expenses.13

IRC §4946(a)(1) defines a "disqualified person" as a person who is (i) a substantial contributor 14 to the private foundation, (ii) a foundation manager 15, (iii) an owner of more than 20 percent of (a) the total combined voting power of a corporation, (b) the profits interest of a partnership, or (c) the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation, (iv) a member of the family 16 of any person described in (i), (ii), or (iii), and (v) corporations, partnerships, trusts or estates in which substantial contributors, foundation managers, grantors of trusts, persons described under (iii), or any members of their families, owning or holding more than 35 percent of the total combined voting power, profits interest, or beneficial interest.

Excise taxes are imposed on disqualified persons who participate in acts of self-dealing with a private foundation. The rate of tax is equal to five percent of the amount involved with respect to the act of self-dealing for each year (or part thereof) in the taxable period.17 The rate of tax will increase to 200 percent if the act is not corrected within the taxable period.18 The tax is to be paid by the disqualified person (other than a foundation manager acting only as such) who participates in the act.19

A participating foundation manager, however, is liable for a tax equal to 2-1/2 percent of the amount involved with respect to the act of self-dealing for each year (or part thereof) in the taxable period, unless the foundation manager's participation is not willful and is due to reasonable cause.20 The rate of tax will increase to 50 percent if the act is not corrected within the taxable year and the foundation manager refuses to agree to part or all of the correction.21 The tax is to be paid by the foundation manager who participated in the act of self-dealing 22 or refused to agree to part or all of the correction.23 The maximum amount imposed on a participating foundation manager with respect to any one act of self-dealing is $10,000.24

As certain private foundation rules apply to a CRT, the transfer of debt-encumbered property to the CRT raises self-dealing issues under IRC §4941.25 Because a CRT is treated as a private foundation for purposes of IRC §4941 and the donor is considered a disqualified person by virtue of being a substantial contributor to the CRT, the self-dealing rules would, on their face, apply to the donor and the CRT. However, an exception is found in Treas. Reg. §53.4941(d)-1(a), which provides that "[t]he bargain sale of property to a private foundation is not a direct act of self-dealing if the seller becomes a disqualified person only by reason of his becoming a substantial contributor as a result of the bargain element of the sale."26

How might a donor who wishes to transfer debt-encumbered property to a CRT avoid some of these issues?

A New Solution: The Thornburg Ruling

A potential transferor to Thornburg Foundation Realty ("Thornburg") recently obtained a private letter ruling approving a transaction that appears to solve the problems surrounding funding a charitable remainder unitrust with debt-encumbered property. The structure of the transaction is as follows:

Step 1: A potential transferor, in this case a limited liability company, which is treated as a partnership for federal income tax purposes ("LLC"), contributes appreciated real property encumbered by debt to a limited partnership ("Partnership") for units in the Partnership ("Units"). The general partner of the Partnership is a non-public real estate investment trust, which is intended to qualify as a real estate investment trust under IRC §856 ("REIT").

Figure 1: Debt-Encumbered Property

Step 2: The Partnership uses an interim-closing-of-the-books allocation method with a semi-monthly convention for allocating partners' varying shares in partnership items. When the debt-encumbered property is contributed to the Partnership, the Partnership will almost immediately pay the debt and close its books on the 15th day of each month. Pursuant to the Partnership's agreement, debt-encumbered property can only be contributed during the first half of each month and charitable donations of the Units in the Partnership can be made only during the second half of each month. The Partnership agreement further provides that limited partners of the Partnership may not convert its Units to shares of common stock in the REIT for a period of two years from the date the limited partner acquires its Units. If the limited partner is a non-profit or CRT and had received the Units for less than full consideration, the two-year period will be calculated from the date that the donor of the Units acquired the Units.

Figure 2: Debt-Encumbered Property

Step 3: The LLC holds the Units for two years and then transfers them to a CRT, which may in turn exchange the Units for common stock in the REIT to hold as an investment or for future sale. The CRT will pay a unitrust amount to the LLC for 20 years and the remainder to a charitable organization described in IRC §§170(b)(1)(A), 170(c), 2055(a), and 2522(a). The unitrust amount will initially be the lesser of trust income or six percent of the net fair market value of the CRT's assets, and will flip to a fixed percentage payout of six percent upon the sale or exchange of Units in the Partnership, or REIT stock, for marketable assets.

Figure 3: Debt-Encumbered Property

The IRS favorably held that:

(i) the LLC is a permissible grantor of the CRT;

(ii) the CRT will qualify as a charitable remainder unitrust;

(iii) the CRT will receive no debt financed property transferred to it by the LLC, therefore the satisfaction of the debt by the Partnership or its general partner during a semi-monthly period for allocating partners' varying shares in Partnership items in which the CRT does not hold any Units will prevent the CRT from holding the Units subject to acquisition indebtedness under IRC §514;

(iv) the conversion of Units to shares of common stock in the REIT will not result in unrelated business taxable income to the CRT;

(v) based solely on the representations of the LLC, the CRT will not recognize unrelated business taxable income from activities of the Partnership;

(vi) ownership of shares of common stock in the REIT resulting in payment out of the earnings and profits of the REIT which constitute dividends within the meaning of IRC §316 will not result in unrelated business taxable income to the CRT by virtue of IRC §512(b)(1); and

(vii) the sale of the common stock of the REIT by the CRT will not result in unrelated business taxable income by the CRT by virtue of IRC §512(b)(5).

However, the IRS left open certain other issues surrounding the Thornburg transaction:

Step-Transaction

The IRS deferred ruling on whether the transfer of Units to the CRT by the LLC, and the subsequent exchange of the Units for common stock of the REIT, should be recharacterized for federal income tax purposes as the conversion of the Units into REIT stock by the LLC followed by the subsequent contribution of the REIT stock to the CRT by the LLC. The IRS observed that the answer to this issue depends on all facts and circumstances surrounding the transfer, and can only be decided on examination of the federal income tax returns of the parties involved. In so stating, the IRS cited Palmer, Blake, Rev. Rul. 78-197, and Notice 99-36.

An analysis of these cases and rulings, and their potential application to the facts in Thornburg, may be helpful here. A discussion of Notice 99-36 appears in the summary of ruling by Thornburg's legal counsel, supra.

Palmer and Rev. Rul. 78-197

In Palmer 27, the court held that the gain on the sale of the stock of a closely-held company by a charity would not be imputed back to the donor on the corporate redemption of the stock. In Palmer, the donor controlled both the company and the charity. The court found that, in light of the presence of an actual, valid gift and because the foundation was not a sham, the gift of stock was not a gift of the proceeds of redemption.

The taxpayer in Palmer donated appreciated stock in a corporation to a charitable foundation. The taxpayer owned voting control of the corporation and exercised de facto control over the charitable foundation. One day after the gift, the corporation redeemed its stock from the charitable foundation.

The IRS argued the step transaction and the assignment of income doctrines, both well established in the tax law. The step transaction doctrine would disregard the gift and treat it as an intermediary step of a single, integrated transaction, which would cause a taxable gain to the shareholder on the corporate redemption. The IRS further contended that, if the gift was not disregarded, the taxpayer assigned the income from the redemption transaction to the charity, which would cause the taxpayer to recognize the income on the proceeds from the redemption.

The Tax Court cited from Humacid Co., 42 T.C. 894, 913 (1964), that "The law with respect to gifts of appreciated property is well established. A gift of appreciated property does not result in income to the donor so long as he gives the property away absolutely and parts with title thereto before the property gives rise to income by way of a sale..." The Tax Court also stated that, if the putative assignor performs services, retains the property or retains the control over the use and enjoyment of the income, the liability for the tax remains on his shoulders. "However, if the entire interest in the property is transferred and the assignor retains no incidence of either direct or indirect control, then the tax on the income rests on the assignee."

The Tax Court found the step transaction and assignment of income doctrines inapplicable in the Palmer case. In citing seven cases in which similar attacks were rejected by the courts, where a gift of stock was followed by its redemption, the Tax Court concluded that the only question was whether Palmer really made a gift, thereby transferring ownership of the stock prior to the redemption. The Tax Court found that "...the presence of an actual gift [to the charitable foundation] and the absence of an obligation to have the stock redeemed have been sufficient to give such gifts independent significance."

The IRS argued that Palmer's control of the foundation precluded the court from ignoring the interrelated nature of the gift/redemption. But the Tax Court noted that Iowa law required the taxpayer to exercise his control as an officer and director of the foundation in a fiduciary capacity. Further, the Tax Court stated that there was nothing in the record to indicate that the taxpayer exercised command over the use and enjoyment of the foundation property in violation of his fiduciary duty.

The IRS additionally argued that the redemption was anticipated. The Tax Court ended the matter and held that "expectation is not enough."28 At the time of the gift, "...the redemption had not proceeded far enough along for us to conclude that the foundation was powerless to reverse the plans of the petitioner [the taxpayer]. In light of the presence of an actual, valid gift and because the foundation was not a sham, we hold that the gift of stock was not in substance a gift of the proceeds of redemption." [Emphasis added]

The IRS acquiesced to the decision in Palmer and in Rev. Rul. 78-197 stated that the Tax Court was correct.29 In this Revenue Ruling, the IRS specifically acknowledged that the taxpayer in Palmer had voting control of both the corporation and a tax-exempt private foundation. Further, the IRS stated that the gift, followed by the redemption, was "[p]ursuant to a single plan." Nonetheless, the Revenue Ruling concluded:

The Service will treat the proceeds of a redemption of stock under facts similar to those in Palmer as income to the donor only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption. [Emphasis added]

Blake

Subsequent to Palmer, the court in Blake 30 held that the mere prearrangement of the sale caused an imputation of gain to the donor. Many in the planned giving community believe that this case is a good example of the maxim, "bad facts make bad law." In Blake, the donor gave $700,000 of marketable securities to a charity "to purchase the yacht AMERICA". The charity accepted the gift and sold the stock. The charity then purchased from the donor the yacht for $675,000, in a so-called quid pro quo transaction. However, the charity sold the yacht three or four months thereafter for only $200,000.

On the basis of the Tax Court's factual findings, the Second Circuit had little trouble concluding that Blake had expected the charity to purchase his vessel and that he had an enforceable cause of action under promissory estoppel theory, as a matter of law, if the charity refused.

The court treated the transaction as a "unitary one," where the appreciated stock was used for the purpose of purchasing another asset of the donor. Thus, the donor was taxable on the sale by the charity of the $700,000 of marketable securities.

Despite the apparent inconsistencies between Palmer, Rev. Rul. 78-197 and Blake, there are logical interpretations of these and other relevant cases and rulings. An extensive review of the law in the area leads one to the conclusion that these inconsistencies are more perceived than real.

Blake dealt solely with a situation in which there was a gift of an appreciated asset to charity, so that the charity in turn could purchase an asset from the donor. In effect, there was a quid pro quo being required by the donor, in order for the donor to make such a substantial gift. Even the donor admitted this.

In fact, viewed in its entirety, Blake involved a taxpayer who got a charitable deduction of $675,000 for a boat which was really worth $200,000 to $250,000 as evidenced by the sales price three or four months later. If a situation does not involve a quid pro quo, or if it does not involve a scheme to obtain an inflated tax deduction, arguably the result would be the same as in Palmer and Rev. Rul. 78-197, namely that the obligation must be legally enforceable to tax the gain to the donor.

PGDC Summary

As hard as the IRS and Treasury try to issue new Regulations, Revenue Rulings, and Notices, and in the meantime conduct a complete reorganization of their operational structure, taxpayers continue to seek out sources of guidance on unanswered charitable gift planning questions. Private letter rulings have become a major source of guidance. However, a private letter ruling may only be relied upon by the taxpayer to whom the rulings are issued.31

What then can we glean from the Thornburg letter ruling? It contains several wonderful rulings. First, it clarifies that an LLC can be a donor to a CRT. No surprise here, but clarity on any issue is always welcome. Second, the interim-closing-of-the-books method to avoid the receipt of debt financed income is masterful and will likely have application in other case scenarios. Lastly, the Service confirms that REIT distributions out of earnings and profits constitute dividends that are not subject to unrelated business taxable income.

Might the underlying concepts in the ruling have application to other potential charitable gifts? For instance, a partnership interest (or interest in an LLC taxable as a partnership) may be contributed to a CRT after "closing the books." If the partnership interest is resold prior to any incurrence of operating revenue (i.e., "reopening the books"), the CRT will own the net cash proceeds without the incurrence of UBIT. As in the ruling, timing is significant-if the CRT holds the Unit during the first half of a month, it may incur UBIT. In addition, an individual donor or a corporate donor should be comforted by the underlying concepts of the ruling. Thus, an individual or corporation owning debt-encumbered real estate should be able to participate in the Thornburg REIT structure.

As a general rule, if the facts vary from those in any private letter ruling, taxpayer beware. Although a factual variance does not per se cause a problem, continued reliance on a ruling by the taxpayer may be questionable.

In the instant ruling, the Service left several open issues--application of the step transaction doctrine and the two-year holding period requirement:

Step Transaction Doctrine

If an individual directly exchanges units in the partnership for REIT common stock, the individual will realize gain. As a general rule, any exchange is taxable unless a specific nonrecognition provision applies to that exchange (such as a like-kind exchange or corporate reorganization). If, however, the individual first contributes the units to a CRT and the trustee engages in the exchange, the CRT, although realizing gain, will (in the absence of unrelated business taxable income) pay no tax.

If the step-transaction doctrine were applied, the contribution would be effectively ignored with gain attributed directly to the donor.

Many IRS private letter rulings are based on a specific set of facts that constitute a "structure" and may involve the specific timing of certain transfers and/or multiple entities. Thornburg manufactured a structure that avoids the unrelated business taxable income and fulfills personal philanthropic and financial planning goals. Manufacturing structures are common in the real world. Taxpayers need guidance with respect to those structures. However, the Service has been burned by several of the recent "charitable" structures, namely, the accelerated CRT and charitable reverse split dollar.

Even though the Service is reticent to issue rulings in the charitable arena, it should not have avoided this issue by deferring a decision on the step transaction doctrine until the return is filed and all facts and circumstances could be determined. The Service could have ruled that the transfer more closely resembles the facts in Palmer rather than Blake, in that there was no quid pro quo to the taxpayer.

Two-Year Requirement

Example 4 of Treas. Reg. §1.701-2(d) refers to a fact pattern that is similar to the Thornburg structure. The IRS approved the creation of a partnership with a REIT as a general partner. In that example, a direct contribution of debt-encumbered real estate to a REIT would have caused an immediate taxable consequence under IRC §§351(e) and 357. In that regard, the IRS required the partnership interests to be held for two years prior to an exchange with the REIT for its common stock.

The issuance of a private letter ruling may involve significant negotiation; the taxpayer attempts to gain clarity of the tax consequences with maximum flexibility, while the Service attempts to limit the application of the ruling and prevent abuse. In this case, the inclusion of the two-year holding period may be evidence of that negotiation. Maybe the Service believes that if the donor were to hold onto the Units for two years, the opportunity for abuse would diminish. In tax parlance, the Units would be "old and cold." However, it is hard to imagine any abuse would occur if the exchange took place immediately or ten years later.

Additional Considerations

There are additional considerations because of Thornburg's current structure. The Thornburg entities are relatively new. Thus, until the REIT accumulates a diversified portfolio of properties, the source of Partnership or REIT distributions will be limited to a small number of properties. The contributor to the Partnership will not know the nature or amount of the rental income or the character of the real property to be ultimately owned by the REIT. Such an investment is known as a "blind pool." Thus, such an investment depends upon the utmost confidence in the REIT's real estate managers, who are apparently top-notch real estate professionals.

In addition, the REIT is a privately-held entity. Although the REIT anticipates "going public," a public market does not yet exist for its common stock. Therefore, the CRT may find it difficult to sell the stock and reinvest the proceeds into a diversified portfolio of marketable securities until the REIT shares are capable of being sold on a public stock exchange.

One consequence is the delay of the flip from a NIMCRUT into a Standard CRT as defined in the ruling. In that event, a donor may want to determine the nature and desirability of the real estate currently held by the REIT, because until the REIT shares can be sold, the donor/income beneficiary will depend on the partnership distributions or REIT dividends. Lastly, the valuation rules adopted by the Final Regulations require inclusion of specific trust language that requires an independent trustee or qualified appraisal of certain trust assets for purposes of establishing the annual unitrust amount.32

Notwithstanding these issues, a new solution may now be available to an old and vexing problem--one that may lead to a significant increase in real property gifts.


Appendix I - Summary of Ruling by Legal Counsel

Following is the text of a letter from Terry L. Simmons, Esquire to the Thornburg Foundation Realty, Inc. describing the ruling and addressing open issues:

Thompson & Knight, L.L.P.
1700 Pacific Ave., Suite 3300
Dallas, Texas 75201

October 13, 1999

Mr. Garrett Thornburg
Thornburg Foundation Realty, Inc.
150 Washington Avenue, Suite 220
Santa Fe, NM 87501

Re: Summary of September 24, 1999 Private Letter Ruling

Dear Garrett:

As requested, I am setting out in this letter a summary of the private letter ruling we recently received. In this ruling, the IRS responded positively to the request of a property owner as to the tax consequences of using Thornburg Foundation Realty, Inc.'s structure to transfer his debt-encumbered real estate to a charitable remainder trust. This summary should be helpful to you as you discuss this ruling with people interested in the Thornburg Foundation Realty, Inc. structure.

SUMMARY OF PRIVATE LETTER RULING

A limited liability company ("Company") expects to transfer debt-encumbered property (the "Property") to Foundation Realty, LP (the "Operating Partnership") in exchange for partnership interests ("OP Units"). Thornburg Foundation Realty, Inc. ("Thornburg" or the "REIT") is the general partner of the Operating Partnership and will operate as a real estate investment trust and, as such, will operate as a pass-through entity with no federal income tax at the corporate level. The OP Units will be convertible, after two years, into Thornburg common stock on a one-to-one basis.

After the initial exchange for OP Units, the Operating Partnership will satisfy the debt encumbering the Property with contributions from its General Partner, and continue to hold and manage the Property on a debt-free basis. The Company will eventually contribute the OP Units to a charitable remainder unitrust (the "Trust") which may convert the OP Units to Thornburg common stock (subject to the two-year restriction). The Trust will be for a 20-year term, during which the Company, as settlor, will receive a "unitrust amount"; at the end of the term, the remainder interest goes to charity. The "unitrust amount" payable each year is the lesser of Trust income or 6% of the net value of the Trust assets, and the "unitrust amount" changes or "flips" to a fixed 6% rate when and if the Trust converts the OP Units or the Thornburg stock to marketable assets, by sale or otherwise.

The Operating Partnership will utilize a semi-monthly closing of the books accounting method that will require contributions of property to the Operating Partnership to be made only in the first half of any month and the debt on such property to be satisfied by the Operating Partnership during the same half-month during which the property is contributed. Thus, the Operating Partnership will never hold debt-encumbered property during the second half of any month. The Company requested rulings on seven points and has received a favorable response on six of the seven points in a September 24, 1999 private letter ruling from the Internal Revenue Service (the "Service"). The Service did not rule either way on one issue, referred to as the Palmer issue, which is discussed further below. The favorable rulings include the following (numbered as in the private letter ruling):

A. The Company is a permissible grantor of the Trust. The import of this ruling is that a limited liability company can be a settlor of a charitable remainder trust.

B. The Trust will qualify as a charitable remainder trust under the Internal Revenue Code and, as such, is generally exempt from tax. This ruling means that the Trust, as proposed, with its 20-year term and its "flip" provisions, meets the requirements of recently-published regulations under the Internal Revenue Code to qualify as a charitable remainder trust. (Of course, its operations will also have to meet the requirements for charitable remainder trusts.)

C. [See discussion of the Palmer issue below.]

D. The Trust will not recognize UBTI from any debt burdening properties transferred to the Operating Partnership if it does not hold the OP Units in any semi-monthly period when such properties are transferred to the Operating Partnership. The ruling approves of the Operating Partnership's semi-monthly closing of the books method for allocating the debt-financed income between segments of the month. Thus, the ruling provides clear guidance that the Trust, or presumably other charities (the "Non-Profits") holding a limited partnership interest, such as an Op Unit, would not have UBTI if the partnership had received any property subject to debt that was paid off in the first half of the same month that the Non-Profit received its OP Units.

E. The exchange of OP Units for Common Stock of Thornburg will not result in unrelated business taxable income ("UBTI") for the Trust. Thus, the conversion to Thornburg stock by any Non-Profit should not result in any income tax to the Non-Profit or adversely affect the federal tax exemption of the Non-Profit.

F. The IRS concluded that the Trust, when holding OP Units, will not recognize UBTI from the proposed operational activities (as opposed to passive debt-financed income) of the Operating Partnership. This means that the proposed method of operation of the Operating Partnership will not generate UBTI for Non-Profits.

G. Ownership and sale of Common Stock of Thornburg will not result in UBTI to the Trust. This means that when Non-Profits which own or sell Common Stock of Thornburg receive dividends or sales proceeds from a sale of the stock, those amounts will not be deemed UBTI for those Non-Profits.

Two other issues should be noted. As mentioned above, the Service declined to rule as to whether the contribution of the OP Units by Company to the Trust, followed by the subsequent exchange of the OP Units for Thornburg Common Stock, would be recharacterized as an exchange of the units in the Operating Partnership by Company for Thornburg common stock followed by a contribution of Thornburg common stock to the Trust (referred to as the Palmer issue).

The Service indicated that a determination with respect to that issue depends on all facts and circumstances surrounding the transactions and could only be decided upon examination of the tax returns of the parties involved. The Service cited the Palmer line of cases and also Revenue Ruling 78-197, in which the Service acquiesced in the court's ruling in Palmer that the transactions in that case should not be recharacterized as one transaction, provided there was no binding obligation on the charitable donee at the time of the contribution (and there was no other basis for compelling the charitable donee) to dispose of the contributed property. Clearly, the argument that the transactions with respect to the Company fall within the purview of Revenue Ruling 78-197, and, therefore, should not be recharacterized, is a very persuasive one.

In connection with the Palmer issue, the Service also refers to a recent notice (Notice 99-36) issued with respect to charitable split-dollar insurance arrangements, which discusses an abusive charitable tax planning technique. The Service, however, does not apply Notice 99-36 to the proposed transactions of the Company, and has given no indication whatsoever that the proposed transactions of the Company would or should be characterized as abusive. In fact, during the course of discussions with the Service relating to the ruling request, one of the IRS attorneys stated that the hesitance of the Service to rule on an inherent factual matter such as a Palmer-type gift was reflective of a new conservatism on this subject, and was not at all a comment on the [ transaction and did not indicate that the Service would challenge the transaction in court. One author of the ruling stated positively that the Thornburg method "would be a good thing for charities."

The other issue which should be noted is the Service's requirement that the Partnership Agreement include a two-year holding period for the OP Units in order for the Company to obtain the ruling.

A Treasury Regulation involving partnerships, referred to as the "partnership anti-abuse regulation" gives one example of a partnership involving a REIT, and that example contains such a two-year restriction in its facts. The Service will only issue a ruling with respect to a partnership like the Operating Partnership (i.e., involving a REIT) if the facts are identical to the facts in the single example in the Regulation. However, Thornburg believes that the Operating Partnership is clearly not an "abusive" partnership and, therefore, the two-year holding period is not relevant. However, Thornburg will offer each potential donor the choice to receive Operating Units with or without the two-year restriction.

SUMMARY

This analysis was prepared in coordination with Michael E. Shaff of Jeffers, Shaff & Falk, LLP as to partnership and REIT issues and is intended merely to summarize a private letter ruling issued to a single taxpayer. To summarize, although other potential participants may not formally rely on a private letter ruling issued to a single taxpayer, the points discussed in this ruling should give potential donors a measure of comfort regarding potential future transactions with the Operating Partnership and Thornburg. Of course, as in any transaction of this nature, prospective donors are encouraged to consult with their own tax advisors.

Sincerely,

Terry L. Simmons, Esq.


  1. Treas. Reg. §1.677(a)-1(d)back

  2. See Teitell, C., Philanthropy & Taxation, Deferred Giving, &1.14.back

  3. Also, see Rev. Rul. 54-516, 1954-2 CB 54 for a prior and consistent IRS holding, and Compare, Ltr. Rul. 8931023, in which the IRS apparently ruled by implication that a CRT which held mortgaged property would not be disqualified.back

  4. Helvering v. Blumenthal, 296 U.S. 552, rev'g per curiam, (CA-2), 35-1 USTC &9270, Russell v. Comm'r, 5 T.C. 974 (1945), Loeb v. Comm'r, 159 F.2d 549 (1946), Wiles v. Comm'r, 59 T.C. 289 (1972) and Jenn v. U.S., 70-1 USTC & 9264 (1970)back

  5. Anesthesia Serv. Medical Group v. Comm'r, 85 T.C. 60 (1985), Russell, supra, Loeb, supra, and Rev. Rul. 75-257, 1975-2 CB 251.back

  6. Edwards v. Greenwald, 217 F. 2d 632 (5th Cir. 1955).back

  7. IRC §§511-514back

  8. See IRC §664(c) and Treas. Reg. §1.664-1(c).back

  9. See Treas. Reg. §1.514(b)-1(a).back

  10. Treas. Reg. §1.1011-2(a)(3); See also, Ltr. Rul. 8931023back

  11. See Treas. Reg. §1.1011-2(b)back

  12. IRC §4946(a)(1)back

  13. IRC §4941(d)back

  14. Any person who (i) contributed or bequeathed an aggregate amount of more than $5,000 to the private foundation, if such amount is more than 2 percent of the total contributions and bequests received by the foundation during the taxable year, or (ii) in the case of a trust, the creator of the trust. IRC §507(d)(2)back

  15. An officer, director, or trustee of a private foundation (or an individual having powers or responsibilities similar to those of officers, directors, or trustees of the foundation). IRC §4946(b)back

  16. Includes spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren. IRC §4946(d)back

  17. IRC §4941(a)(1)back

  18. IRC §4941(b)(1)back

  19. IRC §§4941(a)(1) and 4941(b)(1)back

  20. IRC §4941(a)(2)back

  21. IRC §4941(b)(2)back

  22. IRC §4941(a)(2)back

  23. IRC §4941(b)(2)back

  24. IRC §4941(c)(2)back

  25. See Code §4947(a)(2).back

  26. Also, see Ltr. Rul. 7807041.back

  27. Palmer v. Commissioner, 62 T.C. 684 (1974)back

  28. Hudspeth v. United States, [73-1 USTC 9136], 471 F.2d 275 (8th Cir. 1972). See also, W. B. Rushing, 52 T.C. 888 (1969), aff'd [71-1 USTC 9339] 441 F.2d 593 (5th Cir. 1971).back

  29. Rev. Rul. 78-197, 1978-1 CB 83.back

  30. Blake v. Commissioner, 697 F.2d 473 (2d Cir. 1982), aff'g 42 TCM 1336 (1981)back

  31. See Ackerman, Jonathan, D., How to Get a Private Letter Ruling--The Ten Commandments of the Letter Ruling Process, Vol. 2, No. 3, 3rd Quarter 1998, The Journal of Gift Planning, for a comprehensive analysis regarding the effect of a private letter ruling.back

  32. Treas. Reg. §1.664-1(a)(7)back

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