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IRM 7.27.17, dated August 23, 2001, is superseded.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

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.

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.

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.

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.

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.

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.

Exclusions

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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

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.

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.

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.

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.

Sole Proprietorship

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

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."

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).

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.

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.

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.

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.

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.

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).

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.

Constructive Ownership

  1. The purchase of holdings by an entity whose holdings are treated as constructively owned by a foundation or a disqualified person under IRC 4943(d)(1) will be treated as purchased by the foundation or disqualified person.

Five-Year Extension of Initial Five-Year Disposition Period

  1. The Service is authorized to allow an additional five-year period for the disposition of an unusually large gift or bequest of either diverse or complex business holdings. Once an application for a five-year extension has been received, the Service will determine whether the plan can reasonably be expected to be carried out within the additional five-year period. Any extension is discretionary with the Service, and all relevant facts and circumstances will be considered.

Requirements

  1. To qualify for the additional five-year period, a foundation must:

    1. Establish that diligent efforts to dispose of the excess holdings have been made in the initial five-year period;

    2. Establish that because of the size and complexity of the holdings, disposition within the initial 5-year period has not been possible except at a price substantially below fair market value;

    3. Before the close of the initial five-year period, submit a plan to the Service for disposing of the excess holdings in question; and

    4. Before the close of the initial five-year period, submit the plan to the State Attorney General (or other appropriate official), and submit any response from this official to the Service.

Constructive Ownership Rules

  1. In computing the holdings in a business enterprise of a private foundation or disqualified person, any stock or other interest owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered as being owned proportionately by or for its shareholders, partners, or beneficiaries.

  2. Any interest in a business enterprise actually or constructively owned by a shareholder of a corporation, a partner of a partnership, or a beneficiary of an estate or trust shall not be considered as constructively held by the corporation, partnership, trust or estate.

Warrants or Other Options

  1. Any corporation, partnership, estate or trust has a warrant or other option to acquire an interest in a business enterprise, such interest is not deemed to be constructively owned by the entity until the option is exercised.

Powers of Appointment

  1. Any interest in a business enterprise over which a foundation or a disqualified person has a power of appointment exercisable in favor of the foundation or a disqualified person shall be considered owned by the foundation or disqualified person holding such power of appointment.

Exception for Estates and Trusts

  1. Any interest actually or constructively owned by an estate or trust is deemed constructively owned, in the case of an estate, by its beneficiaries or, in the case of a trust, by its remainder beneficiaries, except in the case of split-interest trusts, employee benefit trusts and revocable trusts. These exceptions are discussed below. The following is an example of the general rule.

    Example:

    if a trust owns 100% of the stock of corporation A, and if, on an actuarial basis, W's life interest in the trust is 15%, Y's life interest is 25%, and Z's remainder interest is 60%, then Z will be considered to be the owner of 100% of the stock.

  2. No portion of an interest in a business enterprise which was transferred to an IRC 4947(a)(2) trust for the benefit of a private foundation shall be considered as owned by the foundation if the foundation holds only an income interest in the trust; or if the foundation holds only a remainder interest in the trust (unless the foundation can exercise primary investment discretion with respect to such interest) until such trust ceases to be so described.

  3. An interest in a business enterprise owned by a trust described in IRC 401(a), shall not be considered as owned by its beneficiaries, unless disqualified persons control the investment of the trust assets.

  4. An interest in a business enterprise owned by a revocable trust shall be treated as owned by the grantor of such trust.

Estates

  1. Under IRC 4943(d)(1), a beneficiary includes any person (including a private foundation) entitled to receive property of a decedent pursuant to a will or pursuant to laws of descent and distribution.

  2. A person shall no longer be considered a beneficiary of an estate when:

    1. all the property to which the person is entitled has been received by this person;

    2. this person no longer has a claim against the estate; and

    3. there is only a remote possibility that it will be necessary for the estate to seek the return of property or to seek payment from this person by contribution or otherwise to satisfy claims against the estate or expenses of administration.

  3. When a person (including a private foundation) ceases to be a beneficiary, then stock or another interest in a business enterprise owned by the estate shall not thereafter be considered owned by such person.

  4. If any person is the constructive owner of an interest in a business enterprise actually held by an estate, the date of death of the testator or decedent intestate shall be the first day on which such person shall be considered a constructive owner of such interest.

Imposition of Initial Tax on Excess Business Holdings

  1. There is imposed an initial excise tax on the excess business holdings of a private foundation for each taxable year of the foundation that ends during the taxable period.

  2. The amount of such tax is equal to 5% of the total value of all the private foundation's excess business holdings in each of its business enterprises.

    Exception:

    If the foundation establishes that the violation was due to reasonable cause and not due to willful neglect, and corrects the violation, the Service has discretionary authority to abate the first tier excise tax. See IRC 4962.

  3. The initial tax is imposed on the last day of the private foundation's taxable year.

Date of Valuation of Excess Business Holdings

  1. The value of the excess business holdings subject to the initial tax is determined regarding a foundation's holdings in a business enterprise as of the day during the foundation's taxable year when the foundation's excess holdings in such enterprise are the greatest. If the foundation's greatest excess holdings are maintained for two or more days during any taxable year, the value of such excess holdings subject to the initial tax is the greatest value attained by such excess holdings as of any day on which they are maintained.

Additional Tax

  1. In any case in which the initial tax is imposed on the holdings of a private foundation in any business enterprise, if, at the close of the taxable period with respect to such holdings, the foundation still has excess business holdings in such enterprise, an additional tax is imposed equal to 200% of the value of such excess holdings.

Exception—90-Day Period
  1. A private foundation is not subject to the IRC 4943 excise tax on excess business holdings resulting from its purchase of holdings where it did not know, or have reason to know, of prior acquisitions by disqualified persons, but only if the foundation disposes of its excess holdings within 90 days from the date on which it knows, or has reason to know, of the event which caused it to have such excess business holdings, and its purchase would not have created excess holdings but for such prior acquisitions by disqualified persons.

Determination of Whether the Foundation has Disposed of Excess Holdings During the 90-Day Period
  1. In determining whether the foundation has disposed of its excess business holdings during the 90-day period, any disposition of holdings by a disqualified person during the 90-day period is disregarded.

Foundation Knowledge of Acquisitions Made by Disqualified Persons — Facts and Circumstances Test

  1. Whether a private foundation will be treated as knowing, or having reason to know, of the acquisition of holdings by a disqualified person depends on the facts and circumstances of each case.

  2. To make this determination, these factors should be considered:

    1. The fact that the foundation did not discover acquisitions made by disqualified persons through the use of procedures reasonably calculated to discover such holdings.

    2. The diversity of foundation holdings.

    3. The existence of large numbers of disqualified persons who have little or no contact with the foundation or its managers.

Extension of 90-Day Period

  1. The 90-day period shall be extended to include the period during which the foundation is prevented by federal or state securities laws from disposing of such excess business holdings.

Effect of Disposition of Holdings Subject to Material Restrictions

  1. If a private foundation disposes of an interest in a business enterprise but imposes any material restrictions or conditions that prevent the transferee from freely and effectively using or disposing of the transferred interest, then the transferor foundation will be treated as owning such interest until all such restrictions or conditions are eliminated (regardless of whether the transferee is treated for other purposes of the Code as owning such interest from the date of the transfer).

  2. A restriction or condition imposed in compliance with federal or state securities laws, or in accordance with the terms or conditions of the gift or bequest through which such interest was acquired by the foundation, shall not be considered a material restriction or condition imposed by a private foundation.

Taxable Period

  1. The taxable period is the period beginning on the first day on which there are excess holdings and ending on the earlier of:

    1. the date of mailing of a notice of deficiency under IRC 6212 with respect to the excise tax on excess business holdings: or

    2. the date on which the excise tax on excess business holdings with respect to such holdings is assessed.

Correction

  1. Correction is made when no interest in the enterprise held by the foundation is an excess business holding.

Contructive Ownership

  1. Where a foundation has excess business holdings which are constructively held for it by another entity, correction is made when either that entity, the foundation, or a disqualified person dispose of a sufficient interest in the enterprise so that no interest held by the foundation is an excess business holding.

Correction Period

  1. Under IRC 4963(e), the correction period is the period beginning on the first day on which there are excess business holdings and ending 90 days after the date of mailing under IRC 6212 of a notice of deficiency with respect to the additional tax, extended by:

    1. any period in which a deficiency cannot be assessed under IRC 6213(a) (determined without regard to the supplemental proceeding provided for under IRC 4961(b)), and

    2. any other period which the Service determines is reasonable and necessary to bring about correction.

Present Holdings

  1. IRC 4943(c)(4) and the regulations set forth a complex set of grandfather rules pertaining to holdings of a foundation on 5/26/1969 (“present holdings”) that would otherwise be excess business holdings.

  2. These rules generally require some reduction of the foundation’s present holdings during two phases, and thereafter allow for higher-than-normal levels of permitted holdings of such present holdings in some circumstances. The rules place limits, however, on the percentage of ownership measured by value as well as voting power.

  3. Under the downward ratchet rule, however, decreases in present holdings “ratchet down” the maximum permitted holdings (but not below 20 percent).

  4. Similar rules apply under IRC 4943(c)(5) to holdings acquired by trust or will in effect on 5/26/1969, discussed below.

  5. Similar present holdings rules apply to the holdings on 8/17/2006 of donor advised funds and supporting organizations subject to IRC 4943.

  6. The rules are set forth in greater detail below.

Present Holdings—First Phase

  1. Under IRC 4943(c)(4)(A)(i), with respect to the holdings of any private foundation in a business enterprise, if such foundation and all disqualified persons together have holdings in such enterprise in excess of 20 percent of the voting stock on 5/26/69, the percentage of such holdings is substituted for the normal 20 percent or 35 percent permitted holdings level, but not more than 50 percent. This level is known as the substituted level.

  2. The substituted permitted holdings levels apply separately to both the percentage of voting stock and the percentage of value of all outstanding shares of all classes of stock. See IRC 4943(c)(4)(A)(iii). In the case of a corporation that has more than one class of stock outstanding, if the percentage of value held by the private foundation, its disqualified persons, or both, increases over a period of time solely due to changes in the relative value of different classes of stock, then the substituted level is also increased. See Treas. Reg. 53.4943-4(d)(10).

  3. Under IRC 4943(c)(4)(B), all of the foundation’s present holdings in a business enterprise on 5/26/69 are treated as held by a disqualified person during the first phase. Thus, the foundation has until the end of the first phase to reduce the combined present holdings of itself and disqualified persons to 50 percent (for both voting and value) if the holdings are above 50 percent. Any new purchases by the foundation, however, would result in excess business holdings. If disqualified persons hold more than two percent voting power, then the foundation should reduce its voting power to 25 percent by the end of the first phase, to avoid excess business holdings at the start of the second phase. See IRC 4943(c)(4)(D)(i).

  4. The first phase is 20 years (beginning 5/26/1969) if the percentage of voting stock, profits interest, or beneficial interest of the foundation and disqualified persons exceeds 95 percent. See IRC 4943(c)(4)(B)(i) and Treas. Reg. 53.4943-4(c)(1)(i).

  5. The first phase is 15 years if the 20-year period does not apply and the combined percentage interest of the foundation and disqualified persons of any of the following interests exceeds 75 percent (See IRC 4943(c)(4)(B)(ii)):

    1. Voting stock or value of all outstanding shares of all classes of stock of a corporation;

    2. Profits or capital interestsin a partnership or joint venture, of

    3. Beneficial interest in any other unincorporated enterprise.

    Note:

    A substantial contributor or family member who held more than a 15 percent interest on 5/26/1969 can elect to have the first phase be 10 years in these circumstances rather than 15. See IRC 4943(c)(4)(E).

  6. The first phase is 10 years in all other cases. See IRC 4943(c)(4)(B)(iii).

  7. During the first phase, a foundation may acquire additional interests other than by purchase that are treated as held by a disqualified person for varying periods under IRC 4943(c)(5) or IRC 4943(c)(6). In such case, holdings that a foundation disposes are charged first against those holdings it must dispose of in the shortest period. See Treas. Reg. 53.4943-4(a)(2).

  8. A present holding does not lose such status merely because it is converted from a constructive holding to a direct holding (or vice versa), or from one business form to another, such as incorporation of a sole proprietorship. See Treas. Regs. 53.4943- 4(b)(1) and (c)(2).

  9. The first phase is suspended during a judicial proceeding necessary to reform or excuse the foundation from compliance with its governing instrument or other instrument in effect on 5/26/1969 in order to allow disposition of present holdings. See IRC 4943(c)(4)(C).

Present Holdings—Downward Ratchet Rule

  1. IRC 4943(c)(4)(A)(ii) sets forth the “downward ratchet rule”: If the percentage of the holdings of a foundation in a business enterprise subject to the present holdings rules (or the percentage of the combined holdings of a foundation together with all disqualified persons) decreases for any reason, the decreased percentage is substituted as the maximum permitted holdings (but not below 20 percent). The downward ratchet rule thus decreases the substituted level of permitted present holdings in certain situations. It is designed to prevent the foundation from purchasing additional holdings in the business enterprise. Treas. Reg. 53.4943-4(d)(4)(A).

  2. The rule is applied both to percentage of voting stock and to percentage of value. Treas. Reg. 53.4943-4(d)(4)(B).

  3. The rule is applied in all three phases. See Treas. Regs. 53.4943-4(d)(5) and (6).

  4. Under a de minimis rule, a decrease in percentage holdings attributable to issuances of stock (or issuances coupled with redemptions) is disregarded so long as the net percentage decrease does not exceed two percent, and so long as the number of shares held by the foundation is unaffected. See IRC 4943(c)(4)(A)(ii).

  5. See Treas. Reg. 53.4943-4(d)(4) for other special rules regarding transfers of holdings involving disqualified persons, change of foundation managers, and termination of private foundation status under IRC 507.

Present Holdings—Second and Third Phases

  1. Under IRC 4943(c)(4)(D), the second phase is 15 years. The third phase is the period beginning after the second phase and runs indefinitely.

  2. If at any time during the second phase disqualified persons have holdings in excess of two percent voting power (including profits interest in partnership or beneficial interest in other unincorporated enterprise), the foundation’s own holdings cannot exceed 25 percent voting power or value, and the combined holdings of the foundation and disqualified persons cannot exceed 50 percent. These percentages continue as the maximum permitted holdings in the third phase, subject to the downward ratchet rule. See Treas. Reg. 53.4943-4(d)(5).

  3. If disqualified persons do not have holdings in excess of two percent voting power at any time during the second phase, then the foundation must reduce the combined holdings of itself and disqualified persons to 35 percent voting power and value by the end of the second phase. See IRC 4943(c)(4)(D)(ii).

  4. In determining whether disqualified persons have holdings in excess of two percent voting power, holdings treated as held by disqualified persons under IRC 4943(c)(5) and IRC 4943(c)(6) are disregarded. See Treas. Reg. 53.4943-4(d)(5)(ii).

  5. These percentages continue as the maximum permitted holdings into the third phase, subject to the downward ratchet rule, except that if at any time in the third phase disqualified persons have holdings in excess of two percent voting power, the foundation must reduce its holdings to 25 percent voting power and value. See IRC 4943(c)(4)(D)(ii) and Treas. Reg. 53.4943-4(d)(6).

  6. If an acquisition of holdings by a disqualified person results in disqualified person holdings in excess of two percent voting power, then the acquisition is treated as subject to the five-year period under IRC 4943(c)(6)--the foundation has five years to reduce its holdings to permissible levels. See IRC 4943(c)(6) (last sentence).

  7. IRC 4943(c)(4)(D) may limit a private foundation's permitted holdings in a business enterprise to 25 percent of the value of all outstanding shares of all classes of stock during the second phase of the present holdings rules described in IRC 4943(c)(4). Rev. Rul. 81-22, 1981-1 C.B. 510.

Present Holdings Acquired by Trust or Will

  1. IRC 4943(c)(5) sets forth rules similar to the present holdings rules for an interest in a business enterprise which a foundation acquires under the terms of a trust that was irrevocable on 5/26/1969, or under a will in effect on such date.

  2. The first phase begins not on 5/26/1969 but on the date of distribution under the trust or will. For example, if a will is executed in 1968, the testator dies in 1990 with the 1968 will in effect, and on 6/30/1991 the estate distributes property to a foundation under the will that would be an excess business holding of the foundation on 5/26/1969 (if the property had been held by the foundation on such date), then the first phase (10 or 15 years) begins 6/30/1991. Distribution is deemed to occur if an estate or trust is terminated for federal tax purposes. See Treas. Reg. 53.4943-5(b)(1).

  3. The 20-year period for the first phase does not apply; a 15-year period is used instead. In applying the 75 percent thresholds to determine whether the 15-year period applies to interest held by the fouindation on 5/26/1968 are deemed to include an interest to which IRC 4943(c)(5) applies that has been acquired from a person who was not a disqualified person on 5/26/1969. See Treas. Reg. 53.4943-5(b)(1).

  4. IRC 4943(c)(5) does not apply to a business holding acquired after 5/26/1969 by an estate or trust, other than by reason of the death of the decedent. For example, if a foundation is a residual beneficiary under a will in effect 5/26/1969 and the residue of the estate is cash, then the estate’s purchase of stock with the cash for distribution to the foundation is not treated as an interest acquired under the terms of a will in effect on 5/26/1969. See Treas. Reg. 53.4943-5(a)(2).

  5. If a holding passes to a foundation under a trust in effect on 5/26/1969 that was revocable but never revoked, and the holding otherwise would have passed to the foundation under a will in effect on 5/26/1969, then the holding is treated as passing under the will and IRC 4943(c)(5) applies. See Treas. Reg. 53.4943-5(a)(3).

  6. A post-5/26/1969 amendment of a will in effect on 5/26/1969 is disregarded if the amendment is made solely because of:

    1. A reduction in the holding that the foundation was to receive under the will or

    2. Any other change that does not affect the rights of the foundation with respect to the holding.

    Example:

    An interest in a business enterprise was bequeathed to a private foundation under the residuary clause of a will executed before May 26, 1969. After May 26, 1969, a second will expressly revoked the first will and increased the amounts of the specific bequests without changing the residuary clause. The interest in the business enterprise acquired by the foundation on the death of the testator comes within the special transitional rules under IRC 4943(c)(4) and IRC 4943(c)(5) Rev. Rul. 81-119, 1981-1 C.B. 512.

  7. If there is an increase in holdings due to a post-5/26/1969 amendment of the will, then the incremental increase is not treated as a present holding, but IRC 4943(c)(6) would apply. See Treas. Reg. 53.4943-5(a)(4).

  8. In some cases an interest to which IRC 4943(c)(5) applies is also constructively held by the foundation under Treas. Reg. 53.4943-8 prior to distribution to the foundation. To the extent of such overlap, the interest is treated as held by a disqualified person prior to distribution, by reason of IRC 4943(c)(5). In some cases, both IRC 4943(c)(4) and IRC 4943(c)(5) may apply to a holding, again due to the constructive ownership rules; in such case, the first phase ends with whichever period under IRC 4943(c)(4) or IRC 4943(c)(5) ends later. See Treas. Reg. 53.4943-5(b)(2).

  9. The phases for each interest to which IRC 4943(c)(5) applies start independently from those phases for any other interest of the foundation in the same business enterprise to which IRC 4943(c)(4) or IRC 4943(c)(5) applies, which adds complexity to the process. See Treas. Reg. 53.4943-5(c)(2).

Readjustments

  1. Special rules apply to readjustments and prohibited transactions involving business holdings, designed in part to prevent readjustments from becoming a device for foundations to increase business holdings.

  2. A "“readjustment”" includes but is not limited to:

    • Merger or consolidation

    • Recapitalization

    • Acquisition of stock or assets

    • Transfer of assets

    • Change in identity, form, or place of organization, however effected

    • Redemption

    • Distribution of assets or stock

    Note:

    A corporation is treated as involved in a readjustment if, as part of the readjustment, any of its stock is issued or redeemed, or any of its stock or assets are transferred. See Treas. Regs. 53.4943-7(d)(1) and (3).

  3. A" “prohibited transaction”" is one of the following types of transactions involving a business enterprise in which the foundation has a holding:

    1. The business enterprise acquires stock or other ownership or assets of another business enterprise, or redeems its own interest, using either cash or property transferred to it (e.g., a capital contribution) by, or proceeds of a loan made to, or guaranteed by, the foundation, disqualified persons, or both.

    2. The business enterprise acquires at least 40 percent of the voting power or value or assets of another business enterprise, if the acquiring business enterprise’s net assets used in its trade or business are not more than 15 percent of the net assets acquired.

    3. The business enterprise is used as a device to acquire or expand business holdings, which depends on the facts and circumstances. Such use is presumed if the business enterprise acquires 40 percent or more of the voting power, value, or assets of a business enterprise if the consideration for the acquisition consists primarily of nonvoting stock (or similar interest in unincorporated entity) of the acquiring business enterprise.

    See Treas. Reg. 53.4943-7(d)(2).

Readjustments and IRC 4943(c)(6)

  1. An increase in business holdings resulting from a readjustment is generally treated as acquired other than by purchase for purposes of IRC 4943(c)(6). Exceptions apply in the following instances:

    1. Readjustments involving holdings treated as held by a disqualified person prior to the readjustment do not extend the period treated as held by a disqualified person.

    2. An increase to the extent attributable to excess business holdings prior to the readjustment is treated as occurring by purchase by a disqualified person.

    3. An increase involving a prohibited transaction is treated as occurring by purchase by a disqualified person, unless the foundation establishes to the satisfaction of the IRS that effective control of all parties to the transaction was in persons other than the foundation and disqualified persons.

    See Treas. Regs. 53.4943-6(d)(1) and (2).

  2. A redemption by a corporation that is a disqualified person does not result in an acquisition by purchase by a disqualified person based solely on the corporation’s disqualified person status. See Treas. Reg. 53.4943-6(d)(4).

  3. Under a de minimis rule, increases in holdings as a result of redemptions are aggregated as of the end of the tax year to determine excess business holdings, unless the aggregate is one percent or more of voting power or value of stock. See Treas. Reg. 53.4943-6(d)(5).

Readjustments and IRC 4943(c)(4) and IRC 4943(c)(5)

  1. In general, if a foundation or disqualified person has holdings to which IRC 4943(c)(4) or IRC 4943(c)(5) applies, stock of a corporation received by the foundation or disqualified person in a readjustment in exchange for such holdings is treated as such holdings surrendered in the exchange. See Treas. Reg. 53.4943-7(a)(1).

  2. Even if no exchange occurs, the holdings held before the readjustment of any business enterprise involved are treated as exchanged for the holdings held after the readjustment. See Treas. Reg. 53.4943-7(a)(2).

  3. Holdings received in a readjustment will not be treated as the holdings surrendered to the extent that the holdings received represent a greater percentage ownership than the highest percentage ownership (as measured by holdings surrendered in the readjustment) in any business enterprise held prior to the readjustment. See Treas. Reg. 53.4943-7(b)(1)-(3).

    1. The percentage limits are applied separately to voting power and value, and are also applied separately to foundation holdings and combined holdings of the foundation and disqualified persons.

    2. In general, the excess holdings are treated as an interest acquired other than by purchase, to which IRC 4943(c)(6) applies. But if a readjustment includes a prohibited transaction, then the lowest (rather than the highest) percentage of voting power or value in any business enterprise involved in the readjustment is used. See Treas. Reg. 53.4943-7(b)(4).

  4. See Treas. Reg. 53.4943-7 for other special provisions.

Donor Advised Funds

  1. Under IRC 4943(e), donor advised funds are treated as private foundations for IRC 4943 purposes, for tax years beginning after 8/17/2006.

  2. A disqualified person with respect to a donor advised fund includes a donor, a donor advisor, a family member of a donor or donor advisor, or a 35 percent controlled entity of such persons. See IRC 4943(e)(2).

  3. Rules similar to the present holdings provisions under IRC 4943(c)(4), IRC 4943(c)(5), and IRC 4943(c)(6) apply to donor advised funds for their holdings on 8/17/2006.

Supporting Organizations

  1. Under IRC 4943(f), the following types of IRC 509(a)(3) supporting organizations are treated as private foundations for IRC 4943 purposes, for tax years beginning after 8/17/2006:

    1. A non-functionally integrated Type III supporting organization

    2. A Type II supporting organization that accepts a gift from a person (other than an IRC 509(a)(1), IRC 509(a)(2), or IRC 509(a)(4) organization) that directly or indirectly controls a supported organization of the supporting organization, from a family member, or from a 35 percent controlled entity of such persons. Indirect control includes effective control, as where a person, her family member, and her attorney are a majority of the board. See the Joint Committee on Taxation’s Technical Explanation of the Pension Protection Act of 2006, p. 361.

  2. A disqualified person with respect to a supporting organization includes the following:

    1. A person who, within the last five years, was in a position to exercise substantial influence, a family member, or a 35 percent controlled entity of such persons.

    2. A substantial contributor, a family member, or a 35 percent controlled entity of such persons.

    3. An organization effectively controlled by the same persons who control the IRC 509(a)(3) organization.

    4. An organization substantially all of the contributions to which were made by the supporting organization’s officers, directors, trustees, key employees, substantial contributors, greater-than-20-percent owners of substantial contributors, and/or their family members.

  3. Rules similar to the present holdings provisions under IRC 4943(c)(4), IRC 4943(c)(5), and IRC 4943(c)(6) apply to supporting organizations for their holdings on 8/17/2006.

  4. The excess business holdings of a supporting organization are exempt from IRC 4943 if the IRS determines that such holdings are consistent with the organization’s exempt purpose. Favorable factors include a reasoned determination by the state attorney general that disposition of the holdings would have a severe detrimental impact on the community, and a supporting organization’s binding commitment to pay five percent of its assets each year to its supported organizations. See the Joint Committee on Taxation’s Technical Explanation of the Pension Protection Act of 2006, p. 361.

  5. Excess business holdings do not include holdings of a Type III supporting organization permanently held as of 11/18/2005 for the benefit of the community under the direction of a state attorney general.

Digest of Published Rulings

  1. Private foundation's self dealing; excess business holding. In the proposed sale to a disqualified person of a private foundation's 15 percent interest in a corporation, in which the foundation and all disqualified persons with respect to the foundation have combined holdings of 45 percent of the voting stock as of May 26, 1969, the disqualified person would be taxed on self dealing imposed by IRC 4941, in a similar situation which the total combined holdings of the foundation and disqualified persons are 55 percent, the foundation has excess business holdings under IRC 4943(c)(4), and section 101(1)(2)(B) of the Tax Reform Act of 1969 would apply to except the proposed sale from the provisions of IRC 4941. Rev. Rul. 75 25, 1975 1 C.B. 359.

  2. Private foundations; excess business holdings. IRC 4943(c)(4)(D) may limit a private foundation's permitted holdings in a business enterprise to 25 percent of the value of all outstanding shares of all classes of stock during the second phase of the present holdings rules described in IRC 4943(c)(4). Rev. Rul. 81-22, 1981-1 C.B. 510.

  3. Private foundations; excess business holdings; effective control. For purposes of computing the 35 percent permitted holdings rule of IRC 4943(c)(2)(B), effective control in one or more persons who are not disqualified persons may be demonstrated by proving that some unrelated party or cohesive group of third parties, in fact, exercises control over the business enterprise. It is not enough to show that the private foundation and disqualified persons cannot exercise such control. Rev. Rul. 81-111; 1981-1 C.B. 509.

  4. Private foundations; excess business holdings; acquired by will. Interest in a business enterprise was bequeathed to a private foundation under the residuary clause of a will executed before May 26, 1969. After May 26, 1969, a second will expressly revoked the first will and increased the amounts of the specific bequests without changing the residuary clause. The interest in the business enterprise acquired by the foundation on the death of the testator comes within the special transitional rules under IRC 4943(c)(4) and IRC 4943(c)(5). Rev. Rul. 81-119; 1981-1 C.B. 512. 5.

  5. Private foundations; self-dealing, sale to disqualified person. The sale to a disqualified person of stock by a private foundation owned by it continuously since May 26, 1969, but not constituting excess business holdings on that date, is excepted under Treas. Reg. 53.4941(d)-4(b)(1) from the prohibition against self-dealing under IRC 4941. Rev. Rul. 86-53; 1986-1 C.B. 326. 6.

  6. Private foundation transfers of assets. Whether IRC 507(b)(2) transfers cause a transferee foundation to have excess business holdings and be subject to tax under IRC 4943(a) depends on the facts and circumstances. In making these determinations, the disqualified persons of a transferee foundation are determined in part by treating the transferee as though it were the transferor. In addition, the transferee's holding period in the transferred assets for purposes of IRC 4943(c)(4), IRC 4943(c)(5) and IRC 4943(c)(6) includes both the period during which the transferor foundation held such assets and the period during which the transferee foundation holds such assets. Rev. Rul. 2002-28, 2002-1 C.B. 941. 7.

  7. Private foundation transfers of assets. A private foundation’s transfer of all of its net assets to one or more public charities described in IRC 509(a)(1), IRC 509(a)(2), or IRC 509(a)(3), does not result in excess business holdings and is not subject to tax under IRC 4943. Rev. Rul. 2003-13, 2003-1 C.B. 305.