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IRS Won’t Rule on Wrapping Disqualified Person’s Note to Foundation in LLC

Oct. 1, 2021, 8:00 AM

The IRS will no longer issue private letter rulings regarding use of a “blocker” limited liability company (LLC) to avoid self-dealing excise tax on notes issued to a foundation by a person with certain connections to the foundation, according to Revenue Procedure 2021-40.

Under tax code Section 4941(d)(1)(B), an impermissible act of self-dealing includes the “lending of money or other extension of credit between a private foundation and a disqualified person.” In interpreting this statute, Treasury Regulation Section 53.4941(d)-2(c)(1) further provides that if a promissory note issued by a disqualified person is subsequently transferred by the obligee to a private foundation, an act of self-dealing occurs as a result of the disqualified person becoming obligated on the note to the foundation.

Example: During his lifetime, a father sells real estate to an irrevocable grantor trust that he establishes for the benefit of his children in return for a promissory note issued by the trust. Under his estate plan, the promissory note is to be transferred to the foundation upon the father’s death, as a result of which the children’s trust would become indebted to the foundation. Because the children’s trust is a “disqualified person” with respect to the foundation, an act of self-dealing would occur upon the transfer of the promissory note to the foundation.

An act of self-dealing is subject to an onerous excise tax regime without regard to whether the transaction at issue was taken in good faith, that the terms of the transaction were fair, and that no profit results to the disqualified person. This includes a 10% first-tier tax under tax code Section 4941(a) on the amount involved, which is imposed for each year the note remains outstanding.

A second-tier tax of 200% of the amount involved is imposed under tax code Section 4941(b) if the act of self-dealing is not “corrected” during the taxable period as defined under Section 4941(e)(1). For this purpose, “corrected” essentially means undoing the self-dealing transaction to the extent possible, but in any case placing the private foundation in a financial position not worse than that in which it would be if the disqualified person were dealing with the foundation under the highest fiduciary standards. Treas. Reg. Section 53.4941(e)-1(c)(1).

Given the punitive nature of the self-dealing tax regime, absent meeting the estate administration exception to self-dealing under Treas. Reg. Section 53.4941(d)-1(b)(3), as discussed further below, the transfer of a promissory note issued by a disqualified person to a private foundation should be avoided at all costs.

In lieu of transferring a disqualified person’s promissory note directly to a private foundation, taxpayers have turned to a transaction that in substance essentially achieves the same result while avoiding the occurrence of an act of self-dealing, which has been approved by the IRS in a multitude of IRS private letter rulings. See, e.g., Private Letter Rulings 200635017, 201407021, 201407023, 201446024, 201723005, 201907004, 202037009, and 202101002. This involves a disqualified person transferring the promissory note to an LLC that is not considered to be controlled by the foundation under the applicable regulations, and then ultimately giving the foundation the nonvoting membership interest having virtually all of the economic interest in the LLC.

Because the promissory note is then held by the LLC, the disqualified person makes payments on the note to the LLC and then, to the extent determined by the voting member, the LLC—often referred to as a “blocker LLC” in this context—can use those note payments to make distributions to the foundation as a nonvoting member. Although the disqualified person ultimately funds the payments made to the foundation, the IRS has ruled that no act of self-dealing occurs in this situation, notwithstanding that an act of self-dealing would occur if the promissory note was transferred by the disqualified person directly to the foundation.

The key to the favorable IRS rulings has been to avoid the LLC from being considered to be controlled by the private foundation under Treas. Reg. Section 53.4941(d)-1(b)(5). This regulation provides, in part, that an organization is controlled by a private foundation if the foundation or one or more of its foundation managers (acting only in such capacity) may, only by aggregating their votes or positions of authority, require the organization to engage in a transaction, which if engaged in with the private foundation, would constitute self-dealing. For these purposes, the regulation provides that an organization will be considered to be controlled by a private foundation if the private foundation has the right to exercise veto power over the actions of such organization relevant to any potential acts of self-dealing.

In PLR 202101002, for example, a private foundation was to receive the net assets of the donors’ estate under their last will and testament of donors. Under the proposed transaction at issue, the donors planned to sell assets to a newly formed irrevocable grantor trust in exchange for a promissory note, which entitled the donors to payments of principle and interest at defined terms. Beneficial interests in the trust were to be held directly or indirectly by descendants of the donors. Both the donors and the irrevocable trust were classified as disqualified persons with respect to the foundation and, therefore, were subject to the self-dealing rules with respect to transactions with the private foundation.

The donors proposed to transfer the promissory note and cash to the LLC in exchange, respectively, for voting and nonvoting membership interests of an LLC. The transfer resulted in the LLC holding the promissory note and receiving the principle and interest payments due under the note from the irrevocable trust. The LLC’s sole asset and source of income were the contributions from the donors and payments under the promissory note. Prior to or at their deaths, the donors planned to distribute the nonvoting membership interest in the LLC to their private foundation. The voting membership interest in the LLC would be contributed to a management trust, with respect to which the foundation would not be a beneficiary.

The power to manage the LLC would be conferred to one or more managers appointed by the holder of the voting interest. The nonvoting membership interest neither possessed management rights nor the right to vote on the appointment or removal of manager. The manager would have the sole authority to make distributions to both voting and nonvoting members after considering the needs of the LLC and the manager’s fiduciary obligations to all members. Any such distributions, and all allocation of profits and losses, were to be made in proportion to the percentage ownership interest held by each voting and nonvoting member. The LLC could be dissolved only upon the written approval of all the members. Thus, as a nonvoting member, the foundation would have the right to receive distributions from the LLC on a proportionate basis but would not have the right to compel distributions in any way.

In the ruling, the IRS first recognized that an act of self-dealing would have occurred if the donors directly transferred the promissory note to the foundation, given that the foundation would have then become a creditor under the note issued by the irrevocable grantor trust, a disqualified person. The IRS then stated that self-dealing would also be present if the donors transferred the promissory note to an entity with respect to which the foundation is considered to “control” under Treas. Reg. Section 53.4941(d)-1(b)(5). Citing Treas. Reg. Sec. 53.4941(d)-1(b)(8), Example (1), the IRS ruled that in that situation, the foundation would be indirectly serving as the creditor under the note by reason of its ownership interest in LLC.

Based upon the fact of the ruling, however, the IRS determined that the foundation would not control the LLC within the meaning of Treas. Reg. Sec. 53.4941(d)-1(b)(5), noting that the only right held by the foundation was the right to receive distributions if the manager decides to make current distributions or in the event the LLC dissolves. The IRS concluded, therefore, that it follows that the “Foundation’s receipt of nonvoting units in LLC will not constitute a loan or extension of credit between a private foundation and a disqualified person within the meaning of section 4941(d)(1) and Treas. Reg. § 53.4941(d)-2(c)(1) since the foundation will not acquire an interest in the promissory note…. Consequently, the proposed transaction will not constitute an act of direct or indirect self-dealing between Foundation and a disqualified person under section 4941.”

The self-dealing rules also apply to an entity not classified as a private foundation, but which is nonetheless subject to Section 4941. In PLR 201907004, for example, the IRS ruled that an act of self-dealing would not apply to a charitable lead annuity trust (CLAT), a split-interest trust subject to the self-dealing rules pursuant to tax code Section 4947(a)(2), in a transaction similar to the one in PLR 202101002. In that ruling, the IRS reached a similar conclusion that the CLAT did not control an LLC holding a promissory note issued by a disqualified person. Accordingly, the IRS concluded that the donor’s proposed inter vivos transfer to the CLAT of a nonvoting membership interest in the LLC would not result in an act of self-dealing.

After years of issuing favorable rulings on the use of a blocker LLC to avoid an act of self-dealing, the IRS is now apparently reconsidering its ruling position. On Sept. 3, 2021, the IRS issued Rev. Proc. 2021-40, which states that the IRS “will not issue rulings on whether an act of self-dealing occurs when a private foundation (or other entity subject to Section 4941) owns or receives an interest in a limited liability company or other entity that owns a promissory note issued by a disqualified person.” Rev. Proc. 2021-40 further stated that the IRS “is currently reviewing its prior ruling position” on this type of transaction and that it “has determined that it is in the interest of sound tax administration not to issue rulings on such transactions while it reviews their proper tax treatment.” Rev. Proc. 2021-40 applies to all ruling requests pending in or received by the IRS on or after Sept. 3, 2021. Any pending ruling will be closed and the user fee returned in full.

Given the issuance of Rev. Proc. 2021-40 and the onerous excise taxes imposed when an act of self-dealing does occur, using a blocker LLC to avoid self-dealing in a transaction described in Rev. Proc. 2021-40 now presents a substantial risk to the disqualified person and prudence would dictate that the transaction not be utilized until further IRS guidance is available.

It may be possible, however, to transfer a disqualified person’s promissory note to a private foundation, but only upon the donor’s death. Under the “estate administration exception” of Treas. Reg. Section 53.4941(d)-1(b)(3), self-dealing does not include a transaction involving a private foundation’s interest or expectancy in property held by an estate (or revocable trust, including a trust that has become irrevocable on a grantor’s death), regardless of when title to the property vests under local law, if the following five-prong test is met:

  1. The administrator or executor of an estate or trustee of a (formerly) revocable trust either: (a) possesses a power of sale with respect to the property, (b) has the power to reallocate the property to another beneficiary, or (c) is required to sell the property under the terms of any option subject to which the property was acquired by the estate (or revocable trust).
  2. The transaction is approved by the probate court having jurisdiction over the estate (or trust) or over the private foundation. (The regulations do not specify whether the required court approval must precede the transaction, although most private letter rulings contain a representation that court approval will be obtained prior to the transaction taking place.)
  3. The transaction occurs before the estate is considered terminated for federal income tax purposes pursuant, or in the case of a revocable trust that becomes irrevocable, the transaction occurs before it is considered subject to Section 4947.
  4. The estate (or trust) receives an amount that equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction, taking into account the terms of any option subject to which the property was acquired by the estate (or trust)
  5. The transaction either: (a) results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up, (b) results in the foundation receiving an asset related to the active carrying out of its exempt purposes, or (c) is required under the terms of any option which is binding on the estate (or trust).

In a multitude of IRS rulings, the estate administration exception has been applied to permit the testamentary transfer to a private foundation of a promissory note under which a disqualified person is the obligor. See, e.g., PLRs 200729043, 199924069, and 201206019.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Richard L. Fox is a shareholder and attorney in the Philadelphia office of Buchanan Ingersoll & Rooney, PC, where he writes and speaks frequently on issues pertaining to philanthropic planning. Richard can be reached at (215) 665-3811 and

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