A recently released Private Letter Ruling offers guidance on what constitutes self-dealing transactions between private foundations (PFs) and certain “disqualified persons.”
To combat the temptation of certain individuals to misuse PFs for non-charitable purposes, the Internal Revenue Code imposes excise taxes on self-dealing transactions between PFs and certain “disqualified persons,” including substantial contributors, PF managers and members of their families. PFs are also required to annually spend or distribute a minimum amount of their investment assets to accomplish their charitable purposes.
Trust Distributes Art Collection to PF
PLR 202204003 (released Jan. 28, 2022), involved the proposed distribution of an art collection from a grantor’s revocable trust to a PF with significant ties to the grantor and his family and the PF’s use of the art collection.
The grantor’s revocable trust owned an art collection that, pursuant to the terms of the trust agreement, would be distributed to one or more not-for-profit organizations on the grantor’s death, as determined by the trust’s art advisor. The trust designated the grantor’s son, who’s also the chairman of the PF’s board, as the trust’s art advisor. The grantor served on the PF’s board of directors and was the former chairman of the board of directors. On the grantor’s death, the trust proposed that it would distribute the art collection, free from any encumbrances and liens, along with additional cash, to the PF.
The PF, which was organized under IRC Section 501(c)(3) for educational, religious, scientific, literary and charitable purposes, had historically supported the arts.
On the receipt of the art collection, the PF anticipated hiring a curator to manage the art collection and would enter into one or more long-term loan arrangements with not-for-profit organizations to display pieces of the art collection to the general public. Whenever pieces from the art collection weren’t under the management or custody of an organization pursuant to a loan arrangement, the artwork would be in transit, in storage for future exhibitions, subject to restoration or available for study and analysis by scholars and art experts. Additionally, the PF would pay the expenses of the artwork while it wasn’t subject to the loan arrangements, monitor and protect copyright and legal ownership and enter into licensing agreements related to the use of the likeness or images of the artwork.
Central to the ruling request, the PF anticipated the exhibitions of various pieces of the art collection would include a recognition or acknowledgement of the grantor’s gift of the art collection to the PF and/or a recognition or acknowledgement of the family for which the PF was named for making it possible for the artwork to be exhibited.
Has the grantor, the grantor’s family members or the grantor’s trust engaged in an act of self-dealing with the PF?
IRC Section 4941 imposes an excise tax on each act of self-dealing between a PF and a disqualified person.
IRC Section 4946(a) defines a “disqualified person,” as including a substantial contributor to the PF, a PF manager (defined as an officer, director or trustee of the PF under IRC Section 4946(b)(1)), and a member of the family of a substantial contributor or a PF manager. According to Section 4946(d) a “member of the family” of a substantial contributor or PF manager includes the individual’s spouse, ancestors, children, grandchildren, great-grandchildren and the spouses of children, grandchildren and great-grandchildren.
Section 4941(d) defines “self-dealing,” as including “any direct or indirect furnishing of goods, services or facilities between a private foundation and a disqualified person;” however, it’s not an act of self-dealing if the furnishing is without charge and if the goods, services or facilities are used exclusively for the purposes specified in IRC Section 501(c)(3).
On the facts at hand, the grantor, the grantor’s son, the trust and other members of the family for which the PF is named are disqualified persons. Looking to each proposed transaction between the disqualified persons and the PF, the taxpayer was concerned with two potential occurrences of self-dealing between the PF and disqualified persons.
Distribution of artwork. There’s no question that distribution of the artwork to the PF constitutes the furnishing of goods to the PF by a disqualified person; however, because the artwork will be used exclusively for the purposes specified in Section 501(c)(3), as described in the analysis regarding the minimum investment returns discussed below, the distribution clearly isn’t an act of self-dealing.
Acknowledgement of the gift by the grantor and/or the recognition of the family PF’s support. Section 4941 defines “self-dealing,” in part, as “any direct or indirect transfer to or use by or for the benefit of, a disqualified person of the income or assets of a private foundation.” According to Treasury Regulations Section 53.4941-2(f), a disqualified person receiving “an incidental or tenuous benefit” from the PF’s income or assets, isn’t, by itself, a use of such asset that would qualify as an act of self-dealing.
The recognition that a substantial contributor might receive as part of the PF’s charitable activities, for example, doesn’t result in an act of self-dealing because the benefit is generally incidental and tenuous.
In its representations to the IRS, the taxpayer proposed to display pieces from the PF’s art collection at art institutions in accordance with its charitable purposes. Such display will include a recognition or an acknowledgement that the grantor gifted the piece to the PF and/or that the family for whom the PF is named made it possible for the artwork to be exhibited. Based on these facts, the IRS concluded the proposed recognition or acknowledgement doesn’t, in itself, result in an act of self-dealing because the recognition that the grantor or the members of the family will receive, arising from the charitable activities of the PF, is merely an incidental and tenuous benefit.
Minimum Investment Calculation
Will the value of the art collection be included in the calculations to determine the amount of income the PF must distribute? IRC Section 4942 imposes an excise tax on the undistributed net income of a PF. This tax can be significant – up to 30% of such undistributed income. To determine its undistributed income, a PF subtracts its qualifying distributions from its distributable amount.
According to Section 4942(d), the distributable amount is calculated as follows:
The minimum investment return is 5% of: the aggregate fair market value of all of the PF’s assets reduced by the debt associated with the acquisition of such assets. According to Section 4942(d), assets used (or held for use) directly in carrying out the PF’s exempt purpose are excluded from the assets taken into account in determining the minimum investment return. Therefore, the PF’s distributable amount decreases if it holds assets “used (or held for use) directly in carrying out the foundation’s exempt purpose.”
Pursuant to Treas. Regs. Section 53.4942(a)-2(c)(3)(i), an asset is “used (or held for use) directly in carrying out the foundation’s exempt purpose” only if that asset is actually used by the PF in carrying out its exempt purposes or, if its immediate use isn’t practical, the PF has definite plans to use such asset within a reasonable period of time. Treas. Regs Section 53.4942(a)-2(c)(3)(ii)(c) lists works of art owned by the PF that are on public display as an example of assets “used or held for use directly in carrying out the foundation’s exempt purpose.” Furthermore, Revenue Ruling 74-498 held that a collection of paintings owned by a PF formed to further the arts that’s loaned under an active loan program for exhibition in museums, universities and similar institutions is an asset “used directly in carrying out the foundation’s exempt purpose” and therefore the value of the paintings was excluded from the computation of the PF’s minimum investment return.
Whether an asset is included or excluded from the computation of the PF’s minimum investment return can have a significant impact on the amount the PF must distribute, and if the PF fails to distribute such amount, significant penalties apply. In analyzing whether the art collection would be used (or held for use) directly in carrying out the PF’s exempt purpose, the IRS looked at the history of the PF’s charitable activities and the role the PF would have in managing the art collection and entering into loan arrangements.
PF’s charitable activities. The taxpayer characterized the PF as having a long history of furthering its exempt educational and charitable purposes by supporting the arts through grant-making and other efforts. The proposed activity – entering into long-term loan arrangements with one or more museums, galleries, libraries, PFs, universities or other not-for profit organizations to display the art collection – is consistent with these exempt purposes.
PF’s role in managing the art collection and entering into loan arrangements. The IRS emphasized the active role that the PF would have in entering into loan arrangements with not-for-profit organizations, managing the art collection, providing for the art collection’s exhibition and display and holding the art collection for display in its determination that the art collection will be used, or held for use, directly in carrying out the exempt purposes of the PF.
The PF anticipated hiring a curator to manage the collection, and the PF staff would be responsible for selecting not-for-profit organizations to publicly exhibit pieces in the art collection; evaluating and funding the acquisition of additional artwork; overseeing the insurance, care, maintenance and preservation of the artwork; supporting costs associated with providing adequate space for exhibition of the artwork; and helping selected not-for-profit organizations publicize the exhibitions of the artwork in the art collection. In selecting not-for-profit organizations, the PF would evaluate the organization’s ability to safeguard the artwork while on exhibition and in transit, the facilities the organization would have to exhibit the artwork, the cultural and artistic value that the artwork would have on the organization and its greater community and the organization’s ability to maximize the general public’s exposure to the art collection.
In addition to entering into the loan arrangements, the PF would pay for expenses when the artwork wasn’t subject to a loan arrangement, monitor and protect the copyright and legal ownership of the artwork and consider and potentially enter into licensing agreements related to the use of the likeness or images of the artwork. When artwork wasn’t subject to a loan arrangement, the work would be in transit, in storage for future exhibitions, subject to restoration or available for study and analysis by scholars and experts.
Because of the active role the PF would have in the management of the art collection and the loan program, the IRS determined that the artwork would be used, or held for use, directly to carry out the PF’s exempt purposes and may be excluded from the minimum investment return calculation.
PFs and Related Individuals Beware
Based on the facts of the PLR, neither the distribution of the art collection to the PF nor the recognition that the donor or the members of the family for which the PF was named would receive would constitute acts of self-dealing. Furthermore, the close connection between the PF’s charitable activity, the valuable art collection that it would hold and the PF’s active participation in the management and use of the art collection help the PF reduce its distributable amount.
For an outsider reading the PLR, one thing is clear: the requirements under Sections 4941 and 4942, the Treasury regulations and the revenue rulings thereunder provide an intricate web of rules and calculations of which PFs must be aware. Donors, officers, directors and trustees of PFs and their family members must be very cautious about receiving any benefit or making contributions to the PF to avoid the harsh penalties that come with acts of self-dealing, even if such acts are unintentional. Failure to heed the rules and regulations can land taxpayers in a minefield of steep excise taxes and penalties that result from participating in self-dealing activities or failing to distribute the proper amount of income from the PF.