PLR 201703003 No Self-Dealing for Company Owner's New Foundation Positions
1/20/2017 (10/14/2016)
Dear * * *:
This is in response to Organization's letter dated April 4, 2016,
in which Organization requested certain rulings with respect to §§
4941 and 4943 of the Internal Revenue Code.
FACTS
Organization is an exempt organization described in § 501(c)(3) and
classified as a private foundation under § 509(a). Organization is
a foundation under the laws of State 1 dedicated to supporting children,
education, and health services.
X, hosted Show for many years on television, during which he became an
American icon. During X's career he was able to negotiate an agreement
with the television network for the copyrights, name and likeness rights,
and publicity rights to Show and other special shows. During X's life
these copyrights, name and likeness rights, and publicity rights were
held by two corporations (collectively Corporations), S corporations held
entirely by a taxable trust in X's name.
X and Y, are family members that are not described in § 4946(d).
X and Y had an employment relationship that spanned several decades. Over
the decades, Y was employed on Show and started as a summer intern and
worked his way up to producer. During the years that Y was employed on
Show, he traveled closely with X and became his confidant, trusted advisor,
and creative partner.
After X's retirement, Y continued to work with X to manage the licensing
of the episodes of Show and evaluate other projects. Y worked with X to
help distribute episodes of Show. Y gained a deep understanding over time
of the content of the episodes of Show and other intellectual property
(licenses and copyrights) associated therewith, and therefore acquired
an encyclopedic knowledge of all of the episodes of Show.
Based upon their long-term relationship, X decided to grant the exclusive
right to market Show to Company, an organization wholly owned by Y, by
entering into license agreements between Corporations and Company. The
license agreements between Corporations and Company gave Company the sole
and exclusive rights to license, rent, lease, exhibit, distribute, reissue,
and deal in the episodes of Show (and the movies created therefrom) as
well as all ancillary rights, including merchandising and music rights
of Show. The license agreements between the companies provided a profit
share in the revenue from the use of these rights with a majority to Corporations
and the remainder to Company. The license is just over half way beyond
the term of the license. The agreement could have been terminated by X
at any time prior to his death, and the agreement would be terminated
if Y lost control of 100 percent of Company or no longer otherwise controlled Company.
Upon X's death and through the administration of his estate, the rights
and privileges associated with the episodes of Show owned by Corporations
were distributed to Organization by the terms of the trust that owned
Corporations. Additionally, the license agreements between Corporations
and Company were transferred to Organization.
After Organization received the rights and privileges associated with
the episodes of Show, a separate agreement was entered into between Organization
and Company as to publicity rights. This agreement provides Company the
exclusive right to license any publicity rights for X's name and likeness.
Y has been an advisor to Organization . Organization has represented that
at no point has this advisory role risen to the level of managing Organization
as described in 4946(b)(1).
1 Y does not participate in governance or financial decisions regarding
Organization, including, but not limited to investment or operational
expenses. Y's long and close relationship with X enables Y to advise
Organization about the types of charitable work that X desired with regard
to Organization. Additionally, Y's presence as an advisor enables
Y to support Organization's charitable work by providing access to
nonpublic stories about X to share with donees. For these reasons, Organization
represents that Y provides unique attributes that would be beneficial
to furthering Organization's exempt purpose. Organization also states
that appointing Y as an officer and a director is consistent with X's
wishes. Therefore, Organization wants Y to serve as a director and officer
of Organization.
Further, Organization has reviewed its assets and thinks it is in its
best interest to transfer the license agreements, copyrights, publicity
rights agreement and name/likeness rights from the episodes of Show into
a limited partnership, LP. The transfer of the intellectual property rights
into LP will provide greater liability protection to Organization and
its other assets in the event of any litigation related to the intellectual
property rights. LP will receive passive income in the form of royalties
and license fees and will not engage in any other activities or earn income
from any other source. Organization plans on creating a wholly owned corporation
that will then be the generalpartner of LP and hold a one percent share
of the interest of LP. The remaining ninety-nine percent of the ownership
of LP would belong to Organization as a limited partner. LP would engage
in no activities other than holding and managing all of the intellectual
property rights associated with the episodes of Show and would retain
the license agreements and publicity rights agreement for those rights
with Company.
Organization commissioned a report produced by a third party entertainment
consulting firm that shows that Company holds a unique advantage over
others for licensing rights to these episodes. The report's conclusion
relies on the long relationship between X and Y, the long and continuous
work on the episodes of Show that make up the basis of the intellectual
property, and the trust X put in Y over multiple decades. The report also
provides information on a proprietary system used by Company to search
and access the numbers of interviews, skits, or general themes present
in the episodes. Finally, the report provides that Y, due to his experience
with X, has an encyclopedic knowledge of the episodes providing a real
time response to the types of clips and videos that might be available
to a potential user. For these reasons, the consulting firm concludes
that Company, as run by Y, provides a unique service for the sell, licensing,
and distribution of Organization's intellectual property rights in
X's episodes that could not be matched by other firms or systems without
substantial harm to Organization's income from licensing the rights
to the episodes. The report also concludes that Company can perform the
services at a much lower cost of operations because of Y's deep knowledge
and ability to catalogue, find, and describe the necessary clips on his
own, providing much lower overhead than other firms in that industry.
The lower overhead leads to a return that is at least as favorable as
can be found from other firms offering similar services.
Company's sole business is to license, rent, lease, exhibit, distribute,
reissue, and deal in the Show episodes (and the movies created therefrom)
as well as all ancillary rights, including merchandising and music rights
for these episodes of Show. Company has no other business and is not in
a position to perform similar services for other entertainment material.
Y's knowledge of X's work makes Y uniquely capable of handling
these rights for those episodes, and he could not perform the same services
for other materials as he lacks the requisite knowledge and experience.
RULINGS REQUESTED
The following rulings have been requested:
1. Following the transfer of the license agreements, copyrights, publicity
rights agreement and name/likeness rights to the LP, Y, sole owner of
Company, will be able to serve as a director and officer of Organization
without violating the provisions against direct or indirect self-dealing
transactions with Organization within the meaning of IRC § 4941 and
Treas. Reg. § 53.4941-1(b)(1);
2. Formation of LP and the proposed transfer of the copyrights, license
agreements, publicity rights agreements and name/likeness rights to the
LP will not constitute "excess business holdings" within the
meaning of § 4943.
LAW & ANALYSIS
Section 512(b)(2) of the Code excludes all royalties (including overriding
royalties) whether measured by production or by gross or taxable income
from the property, and all deductions directly connected with such income
from the calculation of unrelated business income tax.
Section 4941(a) of the Code, in part, imposes a tax on each act of self-dealing
between a private foundation and a disqualified person. The tax is imposed
on the disqualified person and, in certain situations; a tax is also imposed
on the foundation manager(s) participating in the act or acts.
Section 4941(d)(1) of the Code provides in part, that the term self-dealing
includes the direct or indirect sale, exchange, or leasing of property
between a private foundation and a disqualified person; furnishing of
goods, services, or facilities between a private foundation and a disqualified
person; payment of compensation (or payment or reimbursement of expenses)
by a private foundation to a disqualified person; and transfer to, or
use by or for the benefit of, a disqualified person of the income or assets
of a private foundation.
Section 4943(a)(1) of the Code imposes a tax on the excess business holdings
of any private foundation in a business enterprise during any taxable
year which ends during the taxable period a tax equal to 10 percent of
the value of such holdings.
Section 4943(c)(1) of the Code provides that the term "excess business
holdings" means, with respect to the holdings of any private foundation
in any business enterprise, the amount of stock or other interest in the
enterprise which the foundation would have to dispose of to a person other
than a disqualified person in order for the remaining holdings of the
foundation in such enterprise to be permitted holdings.
Section 4943(c)(2)(A) of the Code defines permitted holdings as 20 percent
of the voting stock, reduced by the percentage of the voting stock owned
by all disqualified persons. In any case in which all disqualified persons
together do not own more than 20 percent of the voting stock of an incorporated
business enterprise, nonvoting stock held by the private foundation shall
also be treated as permitted holdings.
Section 4943(c)(2)(B) of the Code provides that, if the private foundation
and all disqualified persons together do not own more than 35 percent
of the voting stock of an incorporated business enterprise, and it is
established to the satisfaction of the Secretary that effective control
of the corporation is in one or more persons who are not disqualified
persons with respect to the foundation, then subparagraph (A) shall be
applied by substituting 35 percent for 20 percent.
Section 4943(d)(1) of the Code provides that in computing the holdings
of a private foundation, or a disqualified person (as defined in section
4946) with respect thereto, in any business enterprise, any stock or other
interest owned, directly or indirectly, by or for a corporation, partnership,
estate, or trust shall be considered as being owned proportionately by
or for its shareholders, partners, or beneficiaries.
Section 4943(d)(3)(B) of the Code provides that, for purposes of §
4943, the term "business enterprise" does not include a trade
or business at least 95 percent of the gross income of which is derived
from passive sources. For purposes of subparagraph (B), gross income from
passive sources includes, in part, the items excluded by § 512(b)(2).
Section 4946(a)(1) of the Code provides that the term "disqualified
person" means with respect to a private foundation, a person who
is . . . (B) a foundation manager (within the meaning of subsection (b)(1))
. . . (E) a corporation of which persons described above (including foundation
manager) own more than 35 percent of the combined voting power.
Section 4946(b)(1) of the Code provides that the term foundation manager
means with respect to a private foundation (1) an officer, director, or
trustee of a foundation (or an individual having powers or responsibilities
similar to those officers, directors, or trustees of the foundation).
Section 53.4941(d)-1(a) of the Foundation and Similar Excise Tax Regulations
provides in part that the term "self-dealing" means any direct
or indirect transaction described in section 53.4941(d)-2 of the Regulations.
Section 53.4941(d)-1(b)(1) of the Regulations provides in part that the
term "indirect self-dealing" shall not include transactions
described in section 53.4941(d)-2 between a disqualified person and an
organization controlled by a private foundation if --
(i) The transaction results from a business relationship which was established
before such transaction constituted an act of self-dealing (without regard
to this paragraph),
(ii) The transaction was at least as favorable to the organization controlled
by the foundation as an arm's length transaction with an unrelated
person, and
(iii) Either --
(a) The organization controlled by the foundation could have engaged in
the transaction with someone other than a disqualified person only at
a severe economic hardship to such organization, or
(b) Because of the unique nature of the product or services provided by
the organization controlled by the foundation, the disqualified person
could not have engaged in the transaction with anyone else, or could have
done so only by incurring severe economic hardship.
Section 53.4943-10(a)(1) of the Regulations provides generally that the
term "business enterprise" includes the active conduct of a
trade or business, including any activity which is regularly carried on
for the production of income from the sale of goods or the performance
of services and which constitutes an unrelated trade or business under
§ 513.
Section 53.4943-10(c) of the Regulations provides that the term "business
enterprise" does not include a trade or business at least 95 percent
of the gross income of which is derived from passive sources. For these
purposes, gross income from passive sources includes the items excluded
by sections 512(b)(1) (relating to dividends, interest, and annuities)
and 512(b)(3) (relating to rent) and any income classified as passive
for these purposes does not lose its character merely because section
514 (relating to unrelated debt-financed income) applies to such income.
Stock in a passive holding company is not to be considered 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 such company under section
4943(d)(1).
RULING 1
Barring any exceptions, appointing Y as an officer or director of Organization
would result in a situation whereby payments under the license agreements
would be acts of self-dealing that are prohibited by Chapter 42 of the
Internal Revenue Code. Section 4941 imposes a tax on an act of self-dealing
between a private foundation and a disqualified person. Section 4946 defines
a disqualified person as any foundation manager, which the code defines
as any officer, director, or trustee of the foundation, and any company
that is at least thirty-five percent owned by a foundation manager. If
Y were appointed as an officer or director of Organization, then Y would
become a disqualified person as a foundation manager and his wholly owned
corporation, Company, would also become a disqualified person.
Section 4941(d)(1)(D) provides that self-dealing includes, in part, the
compensation by a private foundation for the services of a disqualified
person. Congress initially created the prohibition on self-dealing so
as to prevent any need for costly and ambiguous fair-market evaluations
between the private foundations and insiders that Congress saw as creating
opportunities for avoiding taxes. General Explanation of the Tax Reform
Act of 1969, p. 31 (December 3, 1970). Currently, Organization is a private
foundation that owns the intellectual property rights to the various episodes
featuring X, and it grants to Company the exclusive right to license,
lease, and otherwise exploit the copyrights,name and likeness rights,
and publicity rights in exchange for a majority interest in the profits
therefrom through the license agreements and publicity rights agreement.
If Y and Company become disqualified persons through Y's appointment
as a director of Organization, transactions under the license agreements
and the publicity rights agreement would constitute acts of self-dealing
between a private foundation and its disqualified persons, unless one
of the self-dealing exceptions apply, such as the exception described
in § 53.4941(d)-1(b)(1).
Based on the information provided, after the transfer to LP, the license
agreements and the publicity rights agreement between LP and Company will
satisfy the exception to self-dealing found in § 53.4941(d)-1(b)(1).
Section 53.4941(d)-1(b)(1) requires three findings for a transaction to
be excepted from indirect self-dealing: (1) the transaction must stem
from a business relationship that was established before the transaction
constituted an act of self-dealing; (2) the transaction must be at least
as favorable to the organization controlled by a private foundation as
an arm's length transaction; and (3) either the organization controlled
by the private foundation would suffer an extreme economic hardship if
it could not do business with the disqualified person, or the products
or services provided by the organization controlled by the private foundation
are so unique that it would cause extreme economic hardship for the disqualified person.
First, the transactions under the agreements must be indirect acts of
self-dealing between a subsidiary organization of a private foundation
and a disqualified person. Organization's proposed transaction will
transfer its copyrights, license agreements, publicity rights agreements
and name/likeness rights to LP, creating an indirect relationship between
a subsidiary organization of the Organization and disqualified person
to which the exception may apply.
Second, the three requirements of the exception in § 53.4941(d)-1(b)(1)
are met. Under these facts, Organization's business relationship with
Y and Company related to the licensing of the rights to the Show episodes
began more than five years prior to Organization's ownership of the
rights to the episodes. The original license agreement did not involve
any private foundations thus Chapter 42 of the Internal Revenue Code did
not apply; the business relationship was established long before the possible
applicability of any self-dealing rules. Further, the publicity rights
agreement stems directly from the license agreement and the business relationship
established therein. Organization has also provided an independent study
showing that the gains from the agreements are at least as favorable as
could be achieved through an arm's length transaction and that the
services provided by Company and Y are highly unique, and could not be
obtained elsewhere without a significant loss in economic value for Organization
and could not be provided by Company to others. The fact that Organization
is transferring these rights to LP, such that the transactions at issue
will be between an organization controlled by Organization and the disqualified
persons, does not alter the finding of the requisite prior business relationship
and the showing of economic harms within the meaning of § 53.4941(d)-1(b)(1)(i)-(iii).
2
Accordingly, based on the representations, the license agreements and
publicity rights agreement between Company and LP will not result in indirect
acts of self-dealing for purposes of section 4941 due to the exception
in § 53.4941-1(b)(1), if Organization appoints Y as a director and officer.
RULING 2
Section 4943 taxes any excess business holding of a private foundation
for any interest in a business enterprise that exceeds twenty percent
when combined with the holdings of all disqualified persons. Organization
will own over thirty-five percent of both the corporation and LP and would
have excess business holdings if either the corporation or LP were a business
enterprise.
Section 4943(d)(3)(B) excludes from the definition of a business enterprise
any trade or business at least 95 percent of its gross income is derived
from passive sources. Section 4943(d)(3)(B) and the regulations thereunder
provide that passive sources include those sources of income that are
excluded from unrelated business income under § 512(b)(1), (2), (3),
and (5). Section 512(b)(2) excludes all royalties from unrelated business income.
Organization's subsidiary corporation owns an interest in LP. Since
Organization's proportionate share of the subsidiary corporation is
100 percent, under section 4943(d)(3) and § 53.4943-10(c)(1), Organization
is treated as owning the full one percent of the LP owned by the subsidiary
corporation. Organization is thus considered to own 100 percent interest in LP.
The subsidiary corporation exclusively has passive income under §
53.4943-10(c) because all of its income is derived from ownership of LP;
thus, under § 53.4943-10(c)(1), Organization's ownership of the
subsidiary corporation constitutes stock in a passive holding company
that is not considered a holding in a business enterprise.
LP's sole activity is the holding of the rights associated with X's
episodes of Show and collecting royalties associated with the use therefrom
generated under the agreements with Company. One hundred percent of the
income from LP is derived from royalties, which are considered passive
income under § 512(b)(2) . Since over 95 percent of the partnership's
income derives from passive sources, it is excluded from being a business
enterprise under § 4943(d)(3)(B); thus Organization's ownership
of partnership interests in LP does not constitute excess business holdings.
CONCLUSION
In light of the foregoing, we rule as follows:
1. Following the transfer of the license agreements, copyrights, publicity
rights agreement and name/likeness rights to the LP, Y, sole owner of
Company, will be able to serve as a director and officer of Organization
without violating the provisions against direct or indirect self-dealing
transactions with Organization within the meaning of IRC § 4941 and
Treas. Reg. § 53.4941-1(b)(1);
2. Formation of LP and the proposed transfer of the copyrights, license
agreements, publicity rights agreements and name/likeness rights to the
LP will not constitute "excess business holdings" within the
meaning of § 4943.
This ruling will be made available for public inspection under section
6110 of the Code after certain deletions of identifying information are
made. For details, see enclosed Notice 437, Notice of Intention to Disclose.
A copy of this ruling with deletions that we intend to make available
for public inspection is attached to Notice 437. If you disagree with
our proposed deletions, you should follow the instructions in Notice 437.
This ruling is directed only to the organization that requested it. Section
6110(k)(3) of the Code provides that it may not be used or cited by others
as precedent.
The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement
executed by an appropriate party. While this office has not verified any
of the material submitted in support of the request for rulings, it is
subject to verification on examination.
No ruling is granted as to whether Organization qualifies as an organization
described in § 501(c), and except as expressly provided herein, no
opinion is expressed or implied concerning the tax consequences of any
aspect of any transaction or item discussed or referenced in this letter.
This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)
of the Code provides that it may not be used or cited as precedent.
In accordance with the Power of Attorney on file with this office, a copy
of this letter is being sent to your authorized representative.
Sincerely,
Theodore Lieber
Senior Tax Law Specialist
(Tax Exempt & Government Entities)
cc:
* * *
FOOTNOTES
1 While Y has never acted as a director for Organization, Y had been appointed
as a director of Organization's predecessor foundation by X. Y resigned
as the director of the predecessor foundation during the administration
of X's estate. Subsequently, the predecessor foundation merged into
Organization.
2 In this regard we note that an indirect relationship between subsidiary
organizations and disqualified persons would have existed without the
formation of LP if X's estate had transferred the Corporations owning
the rights and privileges to the Show to Organization, rather than the
rights and privileges separately.