Issue IRC Section 4943 – Taxes on excess business holdings - private foundations, donor advised funds, and certain IRC Section 509(a)(3) organizations are subject to excise tax under IRC Section 4943 for excess business holdings in business enterprises. IRC Section and Treas. Regulation IRC Section IRC Section 4943, Taxes on excess business holdings Treas. Regulation Section 53.4943-1, General rule, purpose Section 53.4943-2, Imposition of tax on excess business holdings of private foundations Section 53.4943-3, Determination of excess business holdings Section 53.4943-4, Present holdings Section 53.4943-5, Present holdings acquired by trust or will Section 53.4943-6, Five-year period to dispose of gifts, bequests, etc. Section 53.4943-7, Special rules for readjustments involving grandfathered holdings Section 53.4943-8, Business holdings; constructive ownership Section 53.4943-9, Business holdings; certain periods Section 53.4943-10, Business enterprise, definition Section 53.4943-11, Effective/applicability date Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources) Administrative Materials Rev. Rul. 2002-28, 2002-1 C.B. 941, held that a complete transfer of assets from one PF to another PF that is effectively controlled by the same persons may cause the transferee PF to have excess business holdings and be subject to excise tax under §4943(a) based upon the facts and circumstances of the situation. In such a transfer all DPs of the transferor PF are treated as DPs of the transferee. Also, in any Section 507(b)(2) transfer, the substantial contributors of the transferor PF are treated as substantial contributors of the transferee. Section 1.507-3(a)(3). In addition, in any Section 507(b)(2) transfer the transferee's holding period in the transferred assets for purposes of Sections 4943(c)(4), 4943(c)(5) and 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. Section 1.507-3(a)(6). Rev. Rul. 81-111, 1981-1 C.B. 509, considered two situations where a PF and its DPs held a combined 35 percent of voting stock in a corporation. In the first situation, the remaining 65 percent of the voting stock was held by a single individual. In the second situation, the remaining 65 percent was held by multiple individuals, who had not entered into any type of agreement concerning their voting rights. In the first situation, the ruling found that effective control was not with DPs. A single non-DP, by virtue of holding a majority of corporate stock, could elect the corporate board. In the second situation, the ruling came to the opposite conclusion. It said that none of the non-DP stockholders alone had sufficient voting stock holdings in the corporation to direct or cause the direction of its management and policies, nor has one of these individuals historically elected the majority of the board of directors. It concluded that without any type of voting agreement among the non-DPs, they did not have effective control over the corporation. IRS Website Taxes on Excess Business Holdings Issue Under what circumstances do Private Foundations (PFs) have excess business holdings? Background The excess business holdings rules were enacted by Congress in the Tax Reform Act of 1969 to limit individuals’ ability to retain control of a business enterprise by setting up a private foundation (PF) and transferring substantial ownership of that business enterprise to the PF. Tax Reform Act of 1969, P.L. 91-172. Section 4943(a) imposes on the excess business holdings of any PF in a business enterprise during any taxable year which ends during the taxable period an initial tax equal to 10 percent of the value of such holdings. Section 4943(b) provides that in any case in which an initial tax is imposed in subsection (a) with respect to the holdings of a PF in any business enterprise, if, at the close of the taxable period with respect to such holdings, the PF still has excess business holdings in such enterprise, a tax is imposed equal to 200 percent of such excess business holdings. Section 4943(c)(1) provides that the term “excess business holdings” means, with respect to the holdings of any PF in any business enterprise, the amount of stock or other interest in the enterprise which the PF would have to dispose of to a person other than a disqualified person (DP) in order for the remaining holdings of the PF in such enterprise to be permitted holdings. Section 4943(c)(2)(A) states permitted holdings of any PF in an incorporated business enterprise are (i) 20 percent of the voting stock, reduced by (ii) the percentage of the voting stock owned by all DPs. In any case in which all DPs together do not own more than 20 percent of the voting stock of an incorporated business enterprise, nonvoting stock held by the PF shall also be treated as permitted holdings. Section 4943(c)(2)(B) provides if: (i) the PF and all DPs together do not own more than 35 percent of the voting stock of an incorporated business enterprise, and (ii) it is established to the satisfaction of the Secretary that effective control of the corporation is in one or more persons who are not DPs with respect to the PF, then subparagraph (A) shall be applied by substituting 35 percent for 20 percent. Section 4943(c)(2)(C) states that a PF shall not be treated as having excess business holdings in any corporation in which it, together with all other PFs which are described in Section 4946(a)(1)(H), owns not more than 2 percent of the voting stock and not more than 2 percent in value of all outstanding shares of all classes of stock. Section 4943(c)(3) provides that for a partnership or joint venture, profits interest is substituted for voting stock, and for any other unincorporated enterprise, beneficial interest is substituted for voting stock. Sections 4943(e) and (f) generally treat donor advised funds and certain Section 509(a)(3) supporting organizations as PFs for purposes of Section 4943. A PF with excess business holdings in a business enterprise will be subject to the excise tax based on the amount of the excess holdings if the conditions in set forth in Section 4943 are not met. Analysis The excess business holdings of a PF are the amount of stock or other interest in a business enterprise that exceeds the permitted holdings. Section 4943(c). A PF is generally permitted to hold up to 20 percent of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by DPs. Section 4943(c)(2)(A). Two exceptions to the general rule: 35% rule where third person has effective control. If the PF establishes to the satisfaction of the Commissioner that one or more third persons, who are not DPs, have effective control of a corporation, the PF and all DPs together may own up to 35 percent of the corporation's voting stock. Effective control means the power, whether direct or indirect, and whether or not actually exercised, to direct or cause the direction of the management and policies of a business enterprise. It is the actual control which is decisive, and not its form or the means by which it is exercisable. Sections 4943(c)(2)(B) and 53.4943-3(b)(3). 2% de minimis rule. A PF is not treated as having excess business holdings in any corporation in which it, together with certain other related PFs, owns not more than two percent of the voting stock and not more than two percent of the value of all outstanding shares of all classes of stock (the de minimis rule). Section 4943(c)(2)(C). Nonvoting stock as permitted holdings. Nonvoting stock, or capital interest for holdings in a partnership or joint venture, is a permitted holding of a PF if all DPs together hold no more than 20 percent (or 35 percent as described earlier) of the voting stock of the corporation. Section 4943(c)(2)(A). In the case of a partnership or joint venture, “profits interest” shall be substituted for “voting stock”, and “capital interest” shall be substituted for “nonvoting stock.” Section 943(c)(3). All equity interests which do not have voting power shall be classified as nonvoting stock. Section 53.4943-3(b)(2)(ii). Definition of “Business Enterprise”. The term business enterprise, in general, includes the active conduct of a trade or business, including any activity that is 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 Section 513. The term does not include a functionally related business, a trade or business that obtains at least 95 percent of its gross income from passive sources, or program-related investments. Sections 4943(d)(3) & 53.4943-10(a)(1) and see unrelated business income tax rules at Sections 513 & 1.513-1(b). Interest in sole proprietorships. A PF is not permitted any holdings in sole proprietorships that are business enterprises unless excepted under Section 4943 or the regulations thereunder. Attribution of business holdings. For determining the holdings in a business enterprise of either a PF or a DP, any stock or other interest owned directly or indirectly by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. Sections 4943(d)(1) & 53.4943-8. (This rule does not apply to certain income interests or remainder interests of a PF in a split-interest trust.).In making its computations, the foundation must determine its proportionate interest and that of all disqualified persons in each class of stock, in relation to the proportion that the voting interest of each class has to all votes in the corporation. For example, if the PF owns 50 percent of the outstanding shares of a class of stock that has 60 percent of the voting rights in a corporation, the PF's holdings in the voting stock would be 30 percent. Dispositions of certain excess holdings within 90 days. A PF that acquires excess business holdings, other than as a result of a purchase by the PF (or as a result of purchase by the PF if it did not know or have reason to know of prior acquisitions by DPs), will not be subject to the taxes on excess business holdings if it disposes of the excess business holdings within 90 days from the date on which it knows, or has reason to know, of the event that caused it to have the excess holdings. This 90-day period will be extended to include the period during which a PF is prevented by federal or state securities laws from disposing of the excess business holdings. The 90-day disposition period applies, for example, when a DP acquires additional holdings. The amount of holdings the PF must dispose of is not affected by disposals by DPs during the 90 day period. Section 53.4943-2(a)(1)(ii) and (iii). Correction. If the holdings of a PF and its DPs exceed the permitted percentage, the PF must correct the situation so that its excess holdings are eliminated, such as by selling investments to reduce the holdings to the permitted level, or having DPs dispose of their interests. Section 53.4943-9(c). For purposes of the 90-day rule, however, the amount of holdings the PF must dispose of is not affected by disposals by DPs during the 90 day period. Section 53.4943-2(a)(1)(ii). 5-year period to dispose of gifts. If excess holdings arise other than from a purchase, such as through a gift or bequest of stock, the owners have five years in which to dispose of the excess holdings.Sections 4943(c)(6) & 53.4943-6(a)(1). The IRS may extend this period for five more years for an unusually large gift or bequest if the foundation establishes that the facts and circumstances warrant the extension of additional time. Section 4943(c)(7). Generally, such donations are of closely held stock or real property that prove challenging for the owner to dispose of within the time frames. Amount of tax. The tax on excess business holdings is equal to ten percent of the value of the excess holdings, determined as of that day during the tax year when the PF’s excess holdings were the greatest. Pension Protection Act of 2006 (Pub. L. No. 109-208) The PPA expanded Section 4943 to apply to donor advised funds and certain Section 509(a)(3) supporting organizations as well as PFs. Donor Advised Funds. Donor-advised funds are subject to the excess business holding rules pursuant to Section 4943(e). Supporting Organizations. Certain Section 509(a)(3) supporting organizations, are subject to Section 4943 excise taxes on excess business holdings under Section 4943(f) Effective for tax years beginning after 8/17/06. Issue Indicators or Audit Tips Issue Indicators Review 990-PF, Part VII-B for reporting of excess business holdings. Review stock ownership of both the PF and the DPs as noted on the Form 990PF. Review prior-year returns for consistent reporting and disposal of assets that may be under-reported to avoid §4943 issues. Verify whether asset disposals were made to DPs (possible acts of self-dealing). Audit Tips The five-year clock starts ticking when the business interest or stock is contributed. If the proposed sale falls through, there may be a problem. A business that is a DP with respect to the PF cannot redeem shares from the PF (that would be self-dealing), unless an incorporated business offers to redeem from all the owners on the same terms and meets the self-dealing exception under Sections 4941(d)(2)(F) and 53.4941(d)-3(d). Also, absent a cash contribution, loan, or the PF’s receipt of dividends from the business, the PF may have no cash with which to make the annual distribution for charitable purposes of five percent of the value of the PF’s net investment assets required under Section 4942.