Transitional rules are provided to prevent holdings of a foundation as of May 26, 1969, that are greater than the 20 percent (or 35 percent) limits permitted under the general rules of section 4943(c)(2), from being subject to the initial tax. The foundation is given time, in three phases, to dispose of its excess business holdings.

First, the transitional rules provide that, all foundation holdings on May 26, 1969, are treated as held by disqualified persons for a certain period of time (the first phase).  Second, the percentage of permitted holdings in a business enterprise is initially increased to a percentage equal to the difference between--

1. The percentage of combined holdings of the foundation and all disqualified persons on May 26, 1969 (up to a 50 percent maximum), and
2. The percentage of holdings of all disqualified persons.

The percentage in (1) is called the substituted level and it applies to both the voting stock, and, separately, to the value of all outstanding shares of all classes of stock.

The main purpose of the substituted level is to indicate what the permitted holdings will be immediately after the end of the first phase, when the holdings are no longer treated as held by disqualified persons.

The substituted level is reduced by dispositions of holdings by the foundation or disqualified persons (but not below 20 percent or 35 percent) after May 26, 1969.

Example.  On May 26, 1969, the Watson Foundation and its disqualified persons owned 49 percent of the voting stock of the Brown Corporation.  The foundation could continue to hold its stock during the first phase.  However, if the foundation disposes of 10 percent of its Brown Corporation stock, its permitted holdings could then not be greater than 39 percent of the stock.

Holdings on May 26, 1969, include business interests acquired later by the foundation under the terms of a trust irrevocable on that date, or under the terms of a will executed before May 27, 1969.

Generally, an active corporation in which a private foundation has excess stock held since May 26, 1969, may acquire new subsidiaries or assets without creating excess business holdings for the foundation.

The first phase is 20 years if the foundation and all disqualified persons owned more than 95 percent of the voting stock of a corporate business (or more than 95 percent of comparable interests in an unincorporated business) on May 26, 1969.

The first phase is 15 years if the foundation (and its disqualified persons) owned on that date more than 75 percent of either the voting stock or the value of all outstanding shares of all classes of stock of a corporation, or more than 75 percent of the profits or capital interests of an unincorporated business.

The first phase is 10 years in all other cases.

Phase one is suspended during the time a judicial proceeding is pending, for the purpose of reforming or excusing the foundation from complying with its governing instrument or any other instrument in effect on May 26, 1969, to allow disposition of excess business holdings.

During the first phase, business interests owned by the foundation on May 26, 1969, are treated as held by a disqualified person, rather than by the foundation.  The combined holdings of the foundation and its disqualified persons must be reduced so that by the end of the first phase they are not greater than either 50 percent of the voting stock or 50 percent of the value of all outstanding shares of a corporation (or 50 percent of comparable interests in an unincorporated enterprise).

Also for holdings acquired under the terms of a will existing before May 27, 1969, or under the terms of a trust irrevocable before May 27, 1969, the first phase begins on the date of actual distribution of the holdings.  However, only the 15–year and 10-year first phase periods apply in these circumstances.

Present holdings greater than 20 percent but less than 50 percent need not be decreased during the first phase, but also may not be increased.

The second phase is the 15-year period immediately following the first phase.  During the second phase, the foundation's ownership of business interests that it held on May 26, 1969, must be reduced so that by the end of the phase the combined holdings of the foundation and its disqualified persons are not greater than 35 percent of the voting stock of a corporation (or 35 percent of the value of all outstanding shares of all classes of stock, or 35 percent of comparable interests in an unincorporated enterprise).

If, at any time during the second phase, the holdings of all disqualified persons together are greater than 2 percent of the voting stock, the holdings of the foundation itself may not be more than 25 percent of the voting stock or 25 percent of the value of all outstanding shares of all classes of stock.

The third phase is the entire period following the second phase.  If a foundation enters the third phase with not more than 2 percent of the voting stock held by all disqualified parties, and any time after the beginning of the third phase these holdings exceed 2 percent, then the 25 percent rule applies.

Separation of phases and special rules.  A private foundation may acquire other interests in a business enterprise, which are also entitled to be treated as held by disqualified persons for varying holding periods (certain holdings acquired under the terms of a trust or will in effect on May 26, 1969, and the initial and additional 5-year periods to dispose of certain gifts, bequests, etc.).  The phase periods for each different interest acquired work independently of one another.  For example, the phases for certain holdings acquired under the terms of a trust or will in effect on May 26, 1969, start independently from those for certain other interests of the foundation in the same enterprise.  In any case, however, holdings the private foundation disposes of are charged first against those holdings it must dispose of in the shortest period to avoid the initial tax thereon.

In certain situations, holdings during the phase periods may become so reduced that they would be permitted holdings subject to the general rules of section 4943 instead of the transitional rules.  For example, when the combined voting levels have been reduced to 20 percent, the provisions concerning nonvoting stock as permitted holdings generally apply.

See Exception, for discussion of a limited exception from the self-dealing rules that applies when disposing of business holdings would otherwise be taxable.

Updated:  April 11, 2007