7.27.17  Taxes on Excess Business Holdings

Manual Transmittal

November 21, 2013

Purpose

(1) This transmits the text for IRM 7.27, Exempt Organizations Tax Manual, Section 17, Taxes on Excess Business Holdings.

Material Changes

(1) IRM 7.27.17 has been updated with discussion of changes to IRC 4943 under the Pension Protection Act of 2006 (PPA) and more extensive discussion of regulations under IRC 4943. These changes include five new subsections (present holdings, present holdings acquired by trust or will, readjustments, donor advised funds, and supporting organizations), plus revisions of existing subsections to provide more detail and clarification..

Effect on Other Documents

IRM 7.27.17, dated August 23, 2001, is superseded.

Audience

TEGE (Exempt Organizations)

Effective Date

(11-21-2013)

Kenneth C Corbin
Acting Director, Exempt Organizations
Tax Exempt and Government Entities

7.27.17.1  (11-21-2013)
Overview

  1. IRC IRC 4943 limits the involvement of private foundations in the active conduct of business enterprises. This IRM provision explains IRC 4943 for the benefit of IRS personnel examining or making determinations regarding private foundations.

7.27.17.1.1  (11-21-2013)
Tax

  1. IRC 4943 provides two levels of tax on the excess business holdings of a private foundation in a business enterprise:

    1. Initial tax — 5% of the greatest amount of excess business holdings on any day during the taxable year.

    2. Additional tax — An additional tax of 200% of the excess business holdings at the end of the taxable year, if the foundation fails to dispose of the excess holdings during the correction period.

7.27.17.1.2  (11-21-2013)
Excess Business Holdings

  1. Excess business holdings are the amount of stock (or other interest) in a business enterprise that a private foundation would have to dispose of, to a person other than a disqualified person, so that the remaining holdings are permitted holdings.

7.27.17.1.3  (11-21-2013)
Permitted Holdings

  1. A foundation and its disqualified persons together may not hold more than 20% of the voting stock of a corporation conducting a business that is not substantially related to the exempt purpose of the foundation. If someone else can be shown to have control of the business, the 20% limit is raised to 35%.

  2. If disqualified persons hold more than 20% of the voting stock, or 35% where someone else has control, a foundation must also dispose of its nonvoting stock.

7.27.17.1.3.1  (11-21-2013)
2% De Minimus Rule

  1. Even if the 20% or 35% limit is exceeded, a foundation will not have excess business holdings if it does not own, actually or constructively, more than 2% of the voting power and more than 2% of the value of the stock of a corporation.

  2. In determining whether the 2% de minimis rule applies, any stock owned by a private foundation that is treated as held by a disqualified person under IRC 4943(c)(4)(B), IRC 4943(c)(5), or IRC 4943(c)(6) is treated as held by the private foundation.

  3. If a private foundation, together with all other private foundations, actually or constructively owns more than 2% of either the voting stock or the value of the outstanding shares of all classes of stock (including stock treated as held by a disqualified person under IRC 4943(c)(4)(B), IRC 4943(c)(5), or IRC 4943(c)(6)) in any business enterprise, the 2% rule does not apply, and all the stock in such business enterprise classified as excess business holdings is treated as excess business holdings.

7.27.17.2  (11-21-2013)
Business Enterprise

  1. A private foundation is not subject to the excess business holdings tax unless it has an equity interest in a business enterprise.

  2. The term "business enterprise" includes the active conduct of a trade or business, including any activity regularly carried on for the production of income from the sale of goods or the performance of services and that constitutes an unrelated trade or business under IRC 513. Where an activity carried on for profit constitutes an unrelated trade or business, no part of such trade or business is excluded from the classification of a business enterprise merely because it does not result in a profit.

7.27.17.2.1  (11-21-2013)
Exclusions

  1. A business enterprise does not include debt, a functionally related business, or a passive holding company.

7.27.17.2.1.1  (11-21-2013)
Debt

  1. A bond or other evidence of indebtedness is not a holding in a business enterprise unless it is an equitable interest in the enterprise. A leasehold interest in real property is not an interest in a business enterprise, even though rent payable under the lease depends on the income or profits derived by another from that property, unless the leasehold interest is an interest in the income or profits of an unrelated trade or business under IRC 513.

7.27.17.2.1.2  (11-21-2013)
Functionally Related Business

  1. A business enterprise does not include a functionally related business as defined in IRC 4942(j)(4).

  2. A functionally related business includes a business that is related for purposes of the tax on unrelated business income. It also includes a business, which although unrelated to the direct activities of the private foundation, is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors that is related to the exempt purposes of the organization.

7.27.17.2.1.3  (11-21-2013)
Passive Holding Company

  1. A business enterprise does not include a trade or business of which at least 95% of its gross income is from passive sources.

  2. If less than 95% of the income of a trade or business is from passive sources, the foundation may substitute for the passive source gross income the average gross income from passive sources for the 10 tax years immediately preceding the tax year in question (or for any shorter period the entity has been in existence).

  3. Stock in a passive holding company is not a holding in a business enterprise even if the company is controlled by the foundation. Instead, the foundation is treated as owning its proportionate share of any interests in a business enterprise held by the company.

7.27.17.2.2  (11-21-2013)
Gross Income Defined

  1. Gross income from passive sources includes items that are excluded by IRC 512 from unrelated business income, such as dividends, interest, and annuities, royalties, rent, and gains or losses from the disposition of certain property.

  2. Any income classified as passive under this paragraph does not lose its character merely because IRC 512(b)(4) or IRC 514 (relating to unrelated debt-financed income) applies to such income.

  3. Income from passive sources includes income from the sale of goods if the seller does not manufacture, produce, physically receive or deliver, negotiate sales of, or maintain inventories in such goods.

7.27.17.2.3  (11-21-2013)
Sole Proprietorships

  1. A sole proprietorship means any business enterprise:

    1. actually and directly owned by a private foundation;

    2. in which the foundation has a 100% equity interest; and

    3. which is not held by a corporation, trust, or other business entity for the foundation.

  2. A foundation may be considered to own a sole proprietorship even though the foundation is itself a corporation or a trust. However, a sole proprietorship owned by a foundation will not be treated as a sole proprietorship when the foundation owns less than 100% of the equity of the business enterprise.

7.27.17.3  (11-21-2013)
Excess Business Holdings

  1. Excess business holdings is the amount of stock or other interest in a business enterprise that the foundation or a disqualified person would have to dispose of to a person who is not a disqualified person so that the remaining holdings of the foundation in the enterprise are permitted holdings.

7.27.17.3.1  (11-21-2013)
Permitted Holdings in an Incorporated Business Enterprise

  1. The permitted holdings of any private foundation in the voting stock of an incorporated business enterprise are:

    1. 20% of the voting stock in the enterprise reduced (but not below zero) by;

    2. the percentage of voting stock in the enterprise actually or constructively owned by all disqualified persons.

  2. The percentage of voting stock held by any person in a corporation is normally determined by reference to the power of stock to vote for the election of directors. Treasury stock and stock that is authorized but unissued is disregarded.

  3. The fact that extraordinary corporate action (e.g., charter or by-law amendments) by a corporation may require the favorable vote of more than a majority of the directors, or of the outstanding voting stock, of the corporation will not alter the determination of voting power of stock in the corporation.

7.27.17.3.2  (11-21-2013)
Nonvoting Stock

  1. In any case in which all disqualified persons hold, actually or constructively, 20% or less (35% or less when third persons have effective control) of the voting stock of an incorporated business enterprise, any shares of nonvoting stock are permitted holdings of any private foundation in the nonvoting stock of an incorporated business enterprise. All equity interests that do not have voting power attributable to them will be classified as nonvoting stock.

  2. Evidences of indebtedness (including convertible indebtedness), warrants, and other options or rights to acquire stock are not considered equity interests.

7.27.17.3.2.1  (11-21-2013)
Stock with Contingent Voting Rights

  1. Stock carrying voting rights that will vest only when indeterminate conditions have been met will be treated as nonvoting stock until the conditions have occurred that cause the voting rights to vest.

    Example:

    preferred stock that gains voting rights only if no dividends are paid on it.

  2. When the rights vest, the stock will be treated as voting stock that was acquired other than by purchase under IRC 4943(c)(6), but only if the private foundation or disqualified persons had no control over whether those conditions would occur.

7.27.17.3.2.2  (11-21-2013)
Convertible Nonvoting Stock

  1. Nonvoting stock that may be converted into voting stock will not be treated as voting stock until the conversion occurs.

7.27.17.3.3  (11-21-2013)
35% Rule

  1. The 20% rules for permitted holdings in an incorporated business enterprise regarding voting stock and nonvoting stock will be increased to 35% if:

    1. the private foundation and all disqualified persons together do not hold, actually or constructively, more than 35% of the voting stock in the business enterprise; and

    2. the foundation establishes that effective control of the business enterprise is in one or more persons (other than the foundation itself) who are not disqualified persons.

7.27.17.3.3.1  (11-21-2013)
Effective Control

  1. Effective control means the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a business enterprise, whether through the ownership of voting stock, the use of voting trusts, or contractual arrangements, or otherwise. It is the reality of control that is decisive and not its form or the means by which it is exercisable.

7.27.17.4  (11-21-2013)
Permitted Holdings in an Unincorporated Business Enterprise

  1. The permitted holdings of a private foundation in any business enterprise which is not incorporated shall be determined under the principles discussed below that are applicable to holdings in an incorporated business enterprise.

7.27.17.4.1  (11-21-2013)
Partnership or Joint Venture

  1. For a general partnership, a limited partnership, or joint venture, the terms "profit interest" and "capital interest" are substituted for "voting stock" and "nonvoting stock" , respectively.

  2. The interest in profits of a foundation (or disqualified person) is determined in the same manner as its distributive share of partnership taxable income. See IRC 704(b) (relating to the determination of the distributive share by the income or loss ratio) and the regulations thereunder.

  3. In the absence of a provision in the partnership agreement, the capital interest of a foundation (or disqualified person) in a partnership is determined on the basis of its interest in the assets of the partnership that would be distributable to the foundation (or disqualified person) upon its withdrawal from the partnership, or upon liquidation of the partnership, whichever is greater.

7.27.17.4.2  (11-21-2013)
Sole Proprietorship

  1. A private foundation may have no permitted holdings in a sole proprietorship.

7.27.17.4.3  (11-21-2013)
Trusts and Other Unincorporated Business Enterprises

  1. For any other unincorporated business enterprise that is not described in IRM 7.27.17.4, the term "beneficial interest" is to be substituted for "voting stock." Any and all references to nonvoting stock will not apply to any unincorporated business enterprise described below as "trusts" and "other unincorporated business."

7.27.17.4.3.1  (11-21-2013)
Trusts

  1. The beneficial interest of a private foundation or any disqualified person in a trust shall be the beneficial remainder interest of the foundation or person as provided in Reg. 53.4943-8(b).

7.27.17.4.3.2  (11-21-2013)
Other Unincorporated Business Enterprises

  1. The beneficial interest of a private foundation or any disqualified person in an unincorporated business enterprise (other than a trust, a partnership, joint venture, or a sole proprietorship), includes any right to receive a portion of distributions of profits of the enterprise; and if the portion of distributions is not fixed by an agreement among the participants, any right to receive a portion of the assets upon liquidation of the enterprise, except as a creditor or employee.

  2. A right to receive distributions of profits includes a right to receive any amount from the profits (other than as a creditor or employee), whether as a sum certain or as a portion of profits realized by the enterprise.

  3. If there is no agreement fixing the rights of the participants in the enterprise, the interest of the foundation (or disqualified person) in the enterprise will be determined by dividing the amount of all equity investments or contributions to the capital of the enterprise made or obligated to be made by the foundation (or disqualified person) by the amount of all equity investments or contributions to capital made or obligated to be made by all participants in the enterprise.

7.27.17.5  (11-21-2013)
Five-Year Disposition Period

  1. If there is a change in the holdings of a private foundation or its disqualified persons that causes the private foundation to have excess business holdings, the private foundation has a five-year disposition period to reduce its holdings to a permitted level.

  2. The five-year disposition period does not apply if the change in holdings is a result of a purchase by the private foundation or a disqualified person.

7.27.17.5.1  (11-21-2013)
Foundation Has No Excess Business Holdings Prior to Change in Holdings

  1. If a private foundation has no excess business holdings (determined without regard to the five-year disposition period) in a business enterprise immediately prior to a change in holdings in such enterprise to which the five-year disposition period applies, the entire interest of the foundation in the enterprise (immediately after such change) shall (while held by the foundation) be treated as held by a disqualified person during the five-year period beginning on the date of such change.

7.27.17.5.2  (11-21-2013)
Private Foundation Has Excess Business Holdings Prior to Change in Holdings

  1. If a private foundation has excess business holdings (determined without regard to the five-year disposition period) in a business enterprise immediately prior to a change in holdings in such enterprise to which IRC 4943(c)(6) applies, the entire interest of the foundation in the enterprise (immediately after such change) shall (while held by the foundation) be treated as held by a disqualified person during the five-year period beginning on the date of such change.

    Exception:

    If and as soon as any holdings in such enterprise become excess business holdings (determined as if the IRC 4943(c)(6) change had not occurred) during the five-year period, such excess holdings shall no longer be treated as held by a disqualified person under IRC 4943(c)(6), but shall constitute excess business holdings.

7.27.17.5.3  (11-21-2013)
Acquisitions by Will or Trust

  1. For holdings in a business enterprise acquired by a private foundation under the terms of a will or trust, the five-year disposition period does not commence until the date of distribution of holdings from the estate or trust to the foundation. An interest to which the five-year disposition period applies that is constructively held by a foundation prior to the date of distribution is treated as held by a disqualified person prior to such date.

7.27.17.5.4  (11-21-2013)
Transfers From One Private Foundation to Another

  1. The five-year disposition period does not apply to any transfer of holdings in a business enterprise by one private foundation to another private foundation that is related to the first foundation under IRC 4946(a)(1)(H).

7.27.17.5.5  (11-21-2013)
Certain Transfers That are Part of a Plan

  1. The five-year disposition period does not apply to an increase in the holdings of a private foundation in a business enterprise that is part of a plan whereby disqualified persons will purchase additional holdings in the same enterprise during the five-year period beginning on the date of the change, for example, to maintain control of the enterprise, since the increase will be treated as caused in part by the purchase of the additional holdings.


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