Comments on Precedential Guidance Request

Section of Taxation OFFICERS Chair George C. Howell, III Richmond, VA Chair-Elect William H. Caudill Houston, TX Vice Chairs Administration Charles P. Rettig Beverly Hills, CA Committee Operations Thomas J. Callahan Cleveland, OH Continuing Legal Education Joan C. Arnold Philadelphia, PA Government Relations Peter H. Blessing Pro Bono and Outreach C. Wells Hall, III Charlotte, NC Publications Julie A. Divola San Francisco, CA Secretary Catherine B. Engell Assistant Secretary Katherine E. David San Antonio, TX COUNCIL Section Delegates to the House of Delegates Richard M. Lipton Chicago, IL Armando Gomez Last Retiring Chair Armando Gomez Members Megan L. Brackney Lucy W. Farr Mary A. McNulty Dallas, TX John O. Tannenbaum Hartford, CT Stewart M. Weintraub West Conshohocken, PA Alan I. Appel Larry A. Campagna Houston, TX T. Keith Fogg Villanova, PA Kurt L.P. Lawson Cary D. Pugh John F. Bergner Dallas, TX Thomas D. Greenaway Boston, MA Roberta F. Mann Eugene, OR Carol P. Tello Gary B. Wilcox LIAISONS Board of Governors Pamela A. Bresnahan Young Lawyers Division Travis A. Greaves Law Student Division Melissa M. Gilchrist Hamtramck, MI Victoria A. Judson Associate Chief Counsel (TEGE) Internal Revenue Service 1111 Constitution Avenue, NW 20224 Re: Comments on Precedential Guidance Request Dear Ms. Judson: 4th Floor 1050 Connecticut Ave., N.W. 20005-1022 202-662-8670 FAX: 202-662-8682 E-mail: tax@americanbar.org June 22, 2016 Enclosed please find comments on issues on which precedential guidance is needed. ( Comments ). These Comments are submitted on behalf of the American Bar Association Section of Taxation and have not been approved by the House of Delegates or the Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association. The Section of Taxation would be pleased to discuss the Comments with you or your staff if that would be helpful. Enclosure cc: Sincerely, George C. Howell, III Chair, Section of Taxation Hon. William J. Wilkins, Chief Counsel, Internal Revenue Service William M. Paul, Deputy Chief Counsel (Technical), Internal Revenue Service Sunita Lough, Commissioner (Tax Exempt & Government Entities Division), Internal Revenue Service Tamera Ripperda, Director (Exempt Organizations), Internal Revenue Service Hon. Mark Mazur, Assistant Secretary (Tax Policy), Department of the Treasury Emily McMahon, Deputy Assistant Secretary (Tax Policy), Department of the Treasury DIRECTOR Janet J. In

AMERICAN BAR ASSOCIATION SECTION OF TAXATION COMMENTS ON ISSUES ON WHICH PRECEDENTIAL GUIDANCE IS NEEDED These comments ( Comments ) are submitted on behalf of the American Bar Association Section of Taxation and have not been approved by the House of Delegates or Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association. Principal responsibility for preparing these Comments was exercised by Kimberly M. Eney, Celia Roady, Raquel E. Swartz, and Carolyn (Morey) Ward of the Exempt Organizations Committee of the Section of Taxation. The Comments were reviewed by David A. Shevlin, Chair of the Exempt Organizations Committee and Lisa Johnsen, Vice Chair of the Exempt Organizations Committee. The Comments were further reviewed by Suzanne Ross McDowell of the Section s Committee on Government Submissions; Stewart M. Weintraub, Council Director for the Exempt Organizations Committee; and Peter H. Blessing, the Section s Vice Chair (Government Relations). Although the members of the Section of Taxation who participated in preparing these Comments have clients who might be affected by the federal income tax principles addressed by these Comments, no such member or the firm or organization to which such member belongs has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments. Contact: David A. Shevlin (212) 455-3682 dshevlin@stblaw.com Date: June 22, 2016

I. Executive Summary AMERICAN BAR ASSOCIATION SECTION OF TAXATION COMMENTS ON ISSUES ON WHICH PRECEDENTIAL GUIDANCE IS NEEDED These comments ( Comments ) are submitted in response to a written request by Victoria A. Judson, Internal Revenue Service Associate Chief Counsel (Tax Exempt and Government Entities). Specifically, the Internal Revenue Service (the Service ) requested comments from the American Bar Association Section of Taxation Exempt Organizations Committee regarding issues on which precedential guidance is needed. The Exempt Organizations Committee has identified two preliminary issues on which precedential guidance is needed for consideration by the Service. First, we recommend that the Service clarify, by revenue ruling, situations in which co-investments between a private foundation and its disqualified persons do not constitute acts of self-dealing within the meaning of section 4941. 1 The revenue ruling would provide that a private foundation s participation in a co-investment arrangement structured with certain protective measures, designed to ensure that its participation is for the benefit of the private foundation and to prevent benefits to disqualified persons, does not constitute self-dealing. The revenue ruling would provide that a co-investment arrangement is categorically distinct from a sale or exchange prohibited by section 4941(d)(1)(A), and that any benefit that accrues to a disqualified person who is a coinvestor as a result of a private foundation s contributions to or withdrawals from an investment fund is incidental or tenuous within the meaning of Treasury Regulation section 53.4941(d)-2(f)(2). In addition, the revenue ruling would provide that compensation paid by the investment fund to disqualified persons for investment management or other services falls within the personal services exception of section 4941(d)(2)(E), as long as such compensation is reasonable. Second, we recommend that the Service clarify, by revenue ruling, the circumstances under which an organization s redomestication would not require it to file a new Form 1023 Application for Recognition of Exemption Under Section 501(c)(3) and a redomesticated organization may continue to rely on its determination letter. First, the revenue ruling would provide that an organization does not need to submit Form 1023 under the following circumstances: (1) the redomestication involves an amendment to the articles of incorporation; (2) the laws of the state of incorporation and the state of redomestication provide that the organization maintains its original date of incorporation and treat the organization as the same entity before and after the redomestication; and (3) the organization maintains the same liabilities following the redomestication. Second, the 1 References to a section are to a section of the Internal Revenue Code of 1986, as amended (the Code ), unless otherwise indicated. 2

revenue ruling would provide that a redomestication does not result in a substantial change in an organization s character, purposes, or methods of operation for purposes of relying on the organization s determination letter. Finally, the revenue ruling would state that, although a redomesticated organization would not need to submit Form 1023, it would still need to report the change to the Service on Form 990. II. Private Foundation Co-Investments 1. Summary The Service should clarify, by revenue ruling, situations in which the tax on selfdealing imposed by section 4941 does not apply to co-investments between a private foundation and its disqualified persons. The Service has issued numerous private letter rulings that permit private foundations (and other entities subject to section 4941, such as charitable remainder trusts) to participate in investment funds structured as limited partnerships and limited liability companies in which disqualified persons with respect to the private foundation are also invested ( co-investments ) and, in some situations, in which the investment fund is itself a disqualified person. However, the private letter rulings have not articulated a consistent rationale for permitting these co-investments, which has left private foundations with concerns that the issue may be unsettled. The existing private letter rulings can be used to provide a basis for a revenue ruling that would enable all private foundations, rather than just those that have obtained private letter rulings, to engage in co-investment arrangements where the participants take appropriate precautionary measures to protect the private foundation s interests. 2. Present Law Section 4941(d)(1) defines self-dealing to include a sale or exchange of property between a private foundation and a disqualified person, 2 the payment of compensation (or payment or reimbursement of expenses) to a disqualified person, 3 and the transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation. 4 Section 4941(d)(2)(E) excludes the payment of compensation by a private foundation to a disqualified person for personal services which are reasonable and necessary to carrying out the exempt purpose of the private foundation from the definition of self-dealing, as long as such compensation is not excessive, and Treasury Regulation section 53.4941(d)-2(f)(2) clarifies that a disqualified person s receipt of incidental or tenuous benefit from a private foundation s use of its income or assets does not constitute an act of self-dealing. 2 I.R.C. 4941(d)(1)(A). 3 I.R.C. 4941(d)(1)(D). 4 I.R.C. 4941(d)(1)(E). 3

The section 4943 excess business holdings rules contemplate co-investments between private foundations and disqualified persons in specific circumstances. Sections 4943(c)(1) and 4943(c)(3) define excess business holdings to include the percentage of profits interests in general and limited partnerships that a private foundation would have to dispose of in order for such interests to be permitted holdings. The statute provides that a private foundation generally may hold up to 20% of the profits interest of a partnership, reduced by the percentage held by disqualified persons, thus contemplating co-investment between a private foundation and its disqualified persons. 5 Existing private letter rulings analyzing co-investment arrangements generally evaluate the possibility of self-dealing in two primary contexts: (1) whether a private foundation s contributions to and withdrawals from an investment fund formed as a partnership or limited liability company constitute acts of self-dealing under sections 4941(d)(1)(A) and 4941(d)(1)(E) and (2) whether compensation paid by the investment fund to disqualified persons for investment management or other services constitutes selfdealing under section 4941(d)(1)(D). The rulings conclude that co-investment arrangements between private foundations and disqualified persons in investment funds do not result in self-dealing, including in situations where the investment fund is itself a disqualified person. 6 In each ruling, the private foundation in question has taken protective measures to prevent certain benefits from accruing to disqualified persons by virtue of the private foundation s investment, but it is unclear which of the measures discussed, if any, are required in order to prevent an act of self-dealing. With respect to the analysis of contributions to and withdrawals from an investment fund, the private letter rulings have ruled that co-investment arrangements do not constitute a sale or exchange within the meaning of section 4941(d)(1)(A). 7 Some earlier rulings reached this conclusion with minimal explanation of the reasoning, 8 while later rulings either found that a co-investment arrangement is substantively different from a sale or exchange 9 or that the taxpayer s representations regarding the 5 See I.R.C. 4943(c)(3). 6 See PLR 200420029 (Feb. 19, 2004) and PLR 200043047 (July 18, 2000). 7 With the possible exception of PLR 200548026 (Dec. 2, 2005), which does not explicitly consider whether there was a sale or exchange involved in the co-investment arrangement in question. 8 See PLR 9448047 (Sept. 8, 1994), PLR 9533041 (May 25, 1995), and PLR 200018062 (Feb. 3, 2000). For example, PLR 9533041 (May 25, 1995) explained that the co-investment arrangement between a private foundation and a limited partnership that is a disqualified person with respect to the private foundation does not involve a sale or exchange of property, a leasing of property, a lending of money or other extension of credit, or an agreement to make a payment to a government official, within the meaning of sections 4941(d)(1)(A), (B), and (F) of the Code. The ruling goes on to state that the private foundation s co-investment with the disqualified person does not involve the furnishing of goods, services, or facilities to [the disqualified person] under section 4941(d)(1)(C), rather the arrangement involves services in the nature of brokerage and investment portfolio services performed for the private foundation. 9 See PLR 200318069 (Feb. 3, 2003), PLR 200420029 (Feb. 19, 2004), and PLR 200551025 (Dec. 23, 2005). 4

applicable State law principles led to the conclusion that there was no sale or exchange involved. 10 The Service has relied on similarly varied rationales in finding that these coinvestment arrangements do not involve a prohibited transfer to or use for the benefit of a disqualified person within the meaning of section 4941(d)(1)(E). Several private letter rulings rely on the exception for incidental or tenuous benefits under Treasury Regulation section 53.4941(d)-2(f)(2), 11 while another does not delve into the issue in much detail. 12 In analyzing whether compensation paid by the investment fund to disqualified persons for investment management or other services constitutes selfdealing, the rulings rely on the personal services exception of section 4941(d)(2)(E). 13 Several of the private letter rulings that considered co-investments between private foundations and disqualified persons found it significant that section 4943 expressly contemplates and permits joint or co-investments by disqualified persons and private foundations. 14 Some rulings noted that [i]n joint or co-investment situations, when a private foundation makes an initial investment, acquires an additional interest in the partnership entity after its formation and initial funding or withdraws its interest, there is neither an economic benefit to the other investors nor does the ownership or holdings of the other investors change in any economic or other material respect. 15 3. Reasons for Change A private foundation might take part in co-investment arrangements with disqualified persons to achieve various business objectives, including to participate in investment funds that would not otherwise be available to the private foundation, to take advantage of economies of scale, and to diversify their portfolios. Private foundations that participate in such arrangements informally rely on several private letter rulings authorizing co-investments, but do so without a clear understanding of the terms that the Service views as important to minimize the risks of inappropriate benefits to disqualified 10 PLR 200043047 (July 18, 2000) and PLR 200423029 (March 11, 2004). 11 See PLR 9448047 (Sept. 8, 1994), PLR 200043047 (July 18, 2000), PLR 200423029 (March 11, 2004), and PLR 200551025 (Dec. 23, 2005). 12 See PLR 200018062 (Feb. 3, 2000). 13 See PLR 9533041 (May 25, 1995), PLR 200318069 (Feb. 3, 2003), PLR 200420029 (Feb. 19, 2004), PLR 200548026 (Dec. 2, 2005), and PLR 200551025 (Dec. 23, 2005). PLR 200548026 (Dec. 23, 2005) finds that the partnership s compensation of disqualified persons is not an indirect act of self-dealing under I.R.C. 4941(d)(1)(E), as the private foundation would be permitted to compensate the disqualified persons directly under I.R.C. 4941(d)(1)(D) by application of I.R.C. 4941(d)(2)(E). 14 PLR 200551025 (Dec. 23, 2005); see also PLR 200043047 (July 18, 2000), PLR 200423029 (March 11, 2004) and PLR 200548026 (Dec. 2, 2005). 15 PLR 200551025 (Dec. 23, 2005); see also PLR 200420029 (Feb. 19, 2004). 5

persons and without confidence that the arrangement will not ultimately be determined by the Service to result in self-dealing. They are also aware that private letter rulings are not precedential guidance. Issuance of a revenue ruling providing that private foundations are permitted, under certain conditions, to co-invest alongside disqualified persons in a vehicle that is itself a disqualified person would provide much needed clarity and guidance to the sector and would reduce the number of private letter rulings requested from the Service. 4. Recommendation We recommend that the Service issue a revenue ruling providing that a private foundation s participation in a co-investment arrangement structured with protective measures designed to ensure that its participation is for the benefit of the private foundation and to prevent impermissible benefits to disqualified persons, does not constitute self-dealing. These protective measures could include measures designed to ensure appropriately proportional allocation of income and expenses as between the foundation and the disqualified person(s). The revenue ruling would build on private letter rulings that state that a co-investment arrangement is categorically distinct from a sale or exchange prohibited by section 4941(d)(1)(A), 16 and would provide that any benefit that accrues to a disqualified person who is a co-investor as a result of a private foundation s contributions to or withdrawals from an investment fund is incidental or tenuous within the meaning of Treasury Regulation section 53.4941(d)-2(f)(2). In addition, the revenue ruling would provide that compensation paid by the investment fund to disqualified persons for investment management or other services falls within the personal services exception of section 4941(d)(2)(E), as long as such compensation is reasonable. Such a ruling would be consistent with the position taken by the Service in numerous private letter rulings and with Congressional intent as evidenced by the rules of section 4943. The ruling would necessarily be limited to transactions that are permitted by section 4943. We recommend that the facts of the ruling include the following: (1) the investment fund is itself a disqualified person because disqualified persons own more than 35 percent of the investment fund s profits interests and (2) disqualified persons investing in the co-investment arrangement with the private foundation are able to satisfy all minimum investment thresholds without reference to the private foundation s investment. 16 See PLR 200318069 (Feb. 3, 2003), PLR 200420029 (Feb. 19, 2004), and PLR 200551025 (Dec. 23, 2005). 6

III. Redomestication and the Circumstances That Do Not Require Filing a New Form 1023 1. Summary The Service should clarify, by revenue ruling, the circumstances under which an organization s redomestication would not require it to file a new Form 1023 Application for Recognition of Exemption Under Section 501(c)(3) ( Form 1023 ) and a redomesticated organization may continue to rely on its determination letter. Redomestication is a mechanism under state law for a nonprofit organization to change its state of domicile. Redomestication typically does not require the formation of a new legal entity. A nonprofit organization may consider changing its state of domicile for practical reasons that do not involve a change in the organization s character, purposes, or methods of operation. 2. Present Law Section 508(a) requires a new organization to notify the Secretary that it is applying for recognition of exemption from federal income taxation under section 501(c)(3). This notification requirement provides the basis for a new organization to submit Form 1023 to the Service. If an organization qualifies for exemption under section 501(c)(3), the Service will issue a determination letter. Treasury Regulation section 1.501(a)-1T(a)(2) allows an organization to rely on its determination letter so long as there are no substantial changes in its character, purpose, or methods of operation, and the determination letter is not otherwise revoked. The Service takes the position that Form 1023 must be submitted by a new legal entity formed as a result of a nonprofit reorganization, regardless of whether that entity will carry out the same purposes and activities as the predecessor organization. In Revenue Ruling 67-390, 17 the Service ruled that a new legal entity was created under the following scenarios, each of which required the submission of a new application for exemption: (1) the conversion of a trust to a corporation to carry out the same purposes and continue the same operations; (2) the incorporation of an unincorporated association to continue the same operations; (3) the reincorporation of a state law corporation by an Act of Congress to carry out the same purposes; and (4) the reincorporation of a state law corporation under the laws of a new state with no change in purposes. In recent guidance, the Service distinguished between a redomestication and a nonprofit reorganization involving the formation of a new legal entity as described in the scenarios in Revenue Ruling 67-390. In Private Letter Ruling 201446025, 18 the Service ruled that, under certain circumstances, a redomestication does not require the filing of Form 1023 and an organization can continue to rely on its determination letter. In the 17 Rev. Rul. 67-390, 1967-2 CB 179. 18 PLR 201446025 (Nov. 14, 2014). 7

ruling, the redomestication process required an amendment to the articles of incorporation (as opposed to filing new articles of incorporation), the laws of the state of incorporation and the state of redomestication provided that the organization maintained its original date of incorporation and treated the organization as the same entity before and after the redomestication, and the organization maintained the same liabilities following the redomestication. The Service also ruled that the redomestication did not represent a substantial change in the organization s character, purposes, or methods of operation for purposes of its reliance on the determination letter. 3. Reasons for Change The possible need to file Form 1023 may deter a nonprofit organization lacking an enduring nexus to its state of incorporation from pursuing redomestication. There is no practical or legal reason for the tax laws to impose a burden on a nonprofit organization seeking to redomesticate when the redomestication will not result in the creation of a new legal entity or a substantial change in the character, purposes, or methods of operation of the organization. In addition, the Form 990 series annual information return ( Form 990 ) already provides a process for an organization to report significant changes in its governing documents to the Service. Finally, issuance of precedential guidance could help reduce the number of Forms 1023 submitted to the Service, thereby increasing efficiencies in the processing of applications. 4. Recommendation We recommend that the Service issue a revenue ruling, based on the principles of Private Letter Ruling 201446025, explaining the circumstances under which redomestication would not require an organization to file Form 1023 and a redomesticated organization may continue to rely on its determination letter. First, the revenue ruling would provide that an organization does not need to submit Form 1023 under the following circumstances: (1) the redomestication involves an amendment to the articles of incorporation; (2) the laws of the state of incorporation and the state of redomestication provide that the organization maintains its original date of incorporation and treat the organization as the same entity before and after the redomestication; and (3) the organization maintains the same liabilities following the redomestication. Second, the revenue ruling would provide that a redomestication does not result in a substantial change in an organization s character, purposes, or methods of operation for purposes of relying on the organization s determination letter. Finally, the revenue ruling would state that, although a redomesticated organization would not need to submit Form 1023, it would still need to report the change to the Service on Form 990. 8