IRS has privately ruled that an organization's transfer of the assets and liabilities associated with one of its primary activities to a newly created for-profit subsidiary won't jeopardize its exempt status under Code Sec. 501(c)(3) or result in any unrelated business taxable income (UBTI) under Code Sec. 511.
Background on exempt organizations. Under Code Sec. 501(c)(3), a corporation organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes is exempt from federal income taxes so long as: (i) it engages primarily in activities that accomplish one or more exempt purposes (Reg. §1.501(c)(3)-1(c)); (ii) no part of its net earnings inure to the benefit of a private individual (Reg. §1.501(c)(3)-1(c)(2)); and (iii) no substantial part of its activities involves lobbying or political activities (Reg. §1.501(c)(3)-1(c)(3)). Contributions to Code Sec. 501(c)(3) organizations are deductible from the donor's income taxes. Code Sec. 501(c)(3) organizations are either public charities or private foundations. All Code Sec. 501(c)(3) organizations are considered private foundations unless they qualify for an exception under Code Sec. 509(a).
One such exception is Code Sec. 509(a)(2), which describes an organization that: (A) normally receives more than 1/3 of its support in each tax year from any combination of (i) gifts, grants, contributions or membership fees, and (ii) gross receipts from admissions, sales of merchandise, performance of services, or furnishing of facilities, in an activity which is not an unrelated trade or business, not including such receipts from any person, or from any bureau or similar agency of a governmental unit, in any taxable year to the extent such receipts exceed the greater of $5,000 or 1% of the organization's support in such tax year, and (B) normally receives not more than 1/3 of its support in each taxable year from gross investment income.
Background on UBTI. In general, Code Sec. 511 imposes a tax on the unrelated business income of Code Sec. 501(c)(3) tax-exempt organizations. Under Code Sec. 512, UBTI includes gross income derived from an unrelated trade or business activity or transaction that a tax-exempt organization carries on regularly. The three part test in Reg. §1.513-1(a) provides that income derived from an activity is UBTI if the activity: (1) is a trade or business; (2) is regularly carried on; and (3) isn't substantially related to the tax-exempt organization's exercise or performance of its tax-exempt functions or purpose.
Facts. Org. is exempt from federal income tax under Code Sec. 501(c)(3) and is classified as other than a private foundation. It engages in several primary activities, all for the benefit of the general public, which it conducts through a global network of controlled organizations. Org.'s principal business location is in the U.S., but it owns or controls several foreign subsidiaries with significant foreign operations.
Org. decided to restructure by transferring certain of its activities to for-profit subsidiaries in order to preserve and increase the value of the transferred activity. The restructuring will allow Org. to attract prospective partners by offering a non-controlling equity investment in a for-profit corporation, as well as attract and retain key employees with an equity-based compensation system. Org. will keep its core charitable activities and retain ownership and management of the shares of the e businesses and associated businesses.
Org. plans to form one or more domestic stock corporations (“DSub”), to which it will transfer assets (including physical assets, contracts, and U.S. employees associated with the transferred activities) in exchange for stock and possibly debt. Org. then plans to transfer a percentage of the stock and debt in DSub to a wholly-owned for-profit subsidiary (“NewCo”) in exchange for its common stock.
Org. also plans to form a new foreign corporation or use an existing foreign corporation (“FSub”) and transfer assets to it in exchange for 100% of its common and preferred stock. The transferred assets will include stock of foreign subsidiaries and intangibles such as trademarks, trade names, intellectual property, and goodwill. Org. will then transfer some of the FSub stock to NewCo in exchange for common stock, and FSub will transfer some of the assets received from Org. to NewCo.
NewCo will authorize issuance of either one or two classes of common stock. If two classes are issued, Class A will be a high-vote stock with Org. as the majority shareholder, giving Org. voting control over NewCo and thus indirect control over DSub and FSub. If issued, Class B stock would be low-vote, and it would be held by potential shareholders including Org., employees, and external investors.
After the restructuring, NewCo will conduct the transferred activities in a manner not materially different from Org., and Org. will continue with the remainder of its exempt activities. Org. will also enter into a distribution agreement relating to one of its exempt activities with NewCo, and NewCo will provide the services currently provided to Org. by an unrelated service provider.
IRS rules favorably. With respect to the proposed transactions, IRS ruled as follows:
(1) Org.'s transfer of the assets and liabilities related to one of its exempt activities to NewCo won't jeopardize Org.'s status as an organization described in Code Sec. 501(c)(3). IRS reasoned that, under the facts presented, the proposed transfer wouldn't inure to the benefit of any of Org.'s officers or other private individuals in violation of Reg. §1.501(c)(3)-1(c)(2), and the restructuring transactions appeared reasonable and in furtherance of legitimate purposes.
(2) After the restructuring, Org. will continue to be an organization described in Code Sec. 501(c)(3). IRS found that since Org. will not only continue its other exempt activities, but will likely expand them, it will continue to meet Reg. §1.501(c)(3)-1(c)’s operational test.
(3) Org.'s proposed transfer of assets and liabilities to NewCo won't result in any UBTI under Code Sec. 511 – Code Sec. 514. IRS noted, however, that Org. didn't request a ruling as to whether ordinary income recognized under Code Sec. 1245 and Code Sec. 1250 as the result of the transfer, if any, is UBTI.
(4) Amounts paid under service agreements with Org.'s current service provider, and later with NewCo, for distribution services relating to its exempt activities will be treated as though paid directly to Org., and each purchaser of the associated products and services will be considered a separate payor for purposes of the $5,000 or 1% support limitation under Code Sec. 509(a)(2)(A)(ii). IRS found it significant that the service agreement states that the parties intend to create an independent contractor relationship, and that nothing in the agreement gives the service provider any right, ownership, or interest in the distributed products.
However, IRS declined to rule on Org.'s fifth ruling request regarding whether it will be recognized as a public charity under Code Sec. 509(a)(2) following the restructuring, noting existing procedures under Rev Proc 2011-4, 2011-1 IRB 123, and Rev Proc 2011-10, 2011-2 IRB 294, for requesting determination letters on reclassification of public charity status.
References: For exempt organizations generally, see FTC 2d/FIN ¶D-4000; United States Tax Reporter ¶5014; TaxDesk ¶670,600; TG ¶9867. For unrelated business income tax, see FTC 2d/FIN ¶D-6800; United States Tax Reporter ¶5114; TaxDesk ¶681,000; TG ¶20875.