Tax News
Fund Principals – Here is What not to Do in Your Private Foundations
November 24, 2014
Administrative Actions
It is common for high profile private equity or hedge fund principals to run private foundations or other charitable organizations. The principals would be “disqualified persons” but the foundations would nonetheless have some room for investing in the underlying investment funds sponsored by the principals without triggering UBTI and excise taxes. The charitable organization sponsored by the principal then will either be subject to 2% private foundation excise tax on its investment income, or no tax, if for example the organization is classified as a supporting organization under IRC 509(a)(3). This obviously provides a great tax advantage that could tempt some individuals to cut corners. Treasury just issued LTR 201447049, which depicts one striking example of what not to do in your private foundation.

So, in this ruling, a donor applied for exempt status and for a classification as either a private foundation or a supporting organization. The donor had all the correct bells and whistles in the declaration of trust. The trust was irrevocable and it had to distribute a % of its adjusted net income to a primary charity and make additional distributions to various public organizations. Moreover, upon dissolution of the trust, the remaining assets were to be distributed to IRC 501(c)(3) organizations.

That was all fine until the donor, who was also the trustee, decided to make a loan to itself. This loan was for the entire amount for which the trust was funded. There was no indication of any board approval, the donor had full control of the assets, the assets were used for meeting donor’s business expenses, and lastly, there was no record that the donor repaid any of the money back to the trust. To boot, the trust did not make any of the required distributions to the primary charity. Treasury took an issue with all of this. It ruled that the “loan” was in substance a distribution. There was no intent to repay the loan, there was no interest charged or accrued, no fixed maturity date, no collateral and so on. All and all, this was a classic example of private shareholder inurnment and an organization not operated exclusively for exempt purposes. End result: exempt status, revoked! Here is the kicker. The revocation was retroactive because the trust did not disclose on its exempt status application that essentially all of its assets will be loaned back to the donor.

You would say, by golly, the facts here are so egregious. How would someone even think that this would pass the giggle test? Well, apparently this taxpayer’s advisers did. While indeed these facts are striking, the moral of the story here is to closely monitor your client’s dealings with their private foundations. There are many instances when the line of what’s permissible and what is not could be rather blurry. A retroactive revocation of exempt status could be very costly, and considering the IRS’ great interest in exempts, no practitioner I am sure, would want his or hers clients to end up on the cumulative bulletin. The ruling can be found here.
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Tags: 501(c)(3), 509(a)(3), private foundation