College endowment units do not create UBTI for charitable remainder trust

Plain-English summary

A charitable remainder unitrust proposed exchanging assets for contractual units tied to the pooled endowment of the college serving as its trustee and remainder beneficiary. The units would provide periodic payments based on the endowment's spending rate but no ownership, management rights, partnership interest, or liability for the endowment's underlying assets. The IRS treated acquiring and holding the units as ordinary investment activity, even though some underlying endowment assets generated unrelated business taxable income for the college. Payments on the units were passive investment income comparable to income excluded under IRC § 512(b)(1). Redemptions also qualified for the exclusion under § 512(b)(5), so purchasing, holding, receiving payments on, and redeeming the units would not generate UBTI for the trust.

Ruling snapshot

• Question: Would contractual units tracking a college endowment generate unrelated business taxable income for a charitable remainder unitrust?
• Outcome: approved
• Key authorities: IRC §§ 512(b)(1), 512(b)(5), 513, and 664(c); Treas. Reg. §§ 1.512(b)-1 and 1.513-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201729014 Third Party Communication: None
Release Date: 7/21/2017 Date of Communication: Not Applicable
Index Number: 513.00-00, 513.01-00,
512.00-00, 512.04-00, Person To Contact:
664.03-02 --------------------------, ID No. ----------------
-----------------
------------------------------------------------------------ Telephone Number:
------------ ----------------------
--------------------------------------------- Refer Reply To:
------------------------------------- CC:TEGE:EOEG:EO3
--------------------------------------- PLR-134201-16
------------------------------------------------------------ Date:
------------------------------ April 11, 2017

LEGEND
College = ------------------------
Trust = --------------------------------------------------------------------

Dear ------------:

This letter responds to a letter from your authorized representative dated October 26,
2016, and subsequent correspondence, requesting a ruling that Trust’s purchase of
investment units of College’s endowment, the receipt of payments with respect to the
units, and the holding and redemption of units, all as described in this ruling letter, will
not generate unrelated business taxable income to Trust. Trust represents the facts as
follows.

FACTS

Trust is a charitable remainder unitrust described in § 664(d)(2) of the Internal Revenue
Code.1 College is Trust’s sole charitable remainder beneficiary. College acts as the
sole trustee, and in that capacity is the legal owner of the assets of the Trust. Under the
terms of the trust agreement, Trust’s donor and his wife are entitled to an annual payout
of a unitrust amount equal to a percentage of the net fair market value of Trust’s assets.
Upon the death of donor and his wife, the remainder interest in Trust will be distributed
to College as the remainder beneficiary.

College is an educational institution recognized as a tax-exempt organization described
in §§ 501(c)(3) and 170(b)(1)(A)(ii). College’s Trustee Committee on Investment,
working with a consultant and investment managers, has the responsibility for managing
College’s pooled endowment (the “endowment”). The investment objective of the
endowment is to provide a growing stream of income to support College’s programs

1
The Internal Revenue Code of 1986, as amended, to which all subsequent “section” references are
made unless otherwise indicated.
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while at the same time preserving the purchasing power of the endowment.

Presently, Trust’s assets are managed by an outside investment firm. Trust’s returns
generally have been lower than the returns on College’s endowment. As trustee and
remainder beneficiary, College wants to achieve greater economies of scale in the
management of Trust’s assets, a potentially higher and more stable investment return
for Trust, and increased diversification of Trust’s investments. To this end, College
intends to enable Trust to participate indirectly in the return on College’s endowment.

In lieu of a partnership or a direct commingling, College proposes to create a
contractual obligation pursuant to which College will issue a contract right to Trust for its
endowment units (“units”). The value of the units, both at the time of acquisition and at
the time of redemption, will be based on the value of all underlying investment assets
held in the endowment. The value of each unit equals the value of the endowment
divided by the number of outstanding units.

Each unit will give Trust a contractual right to receive periodic payments based on the
number of units owned multiplied by the same spending rate that College establishes
for the endowment, allowing Trust to receive an investment return equal to that of the
endowment. Distributions will be made at least quarterly. Trust will be able to choose
either to reinvest part of a distribution in additional units or to redeem units, depending
on Trust’s cash requirements for meeting its minimum distribution. Trust will treat
payouts to its beneficiaries up to the endowment spending amount as ordinary income,
regardless of the character of the underlying income of the endowment (whether capital
gain, ordinary income, or return of capital) and regardless of whether the payout by
Trust is made entirely from distributions of income or in part from redemption of units.

The units will give Trust a contractual right to receive periodic payments from the
endowment, as determined by College, but no interest whatsoever in the underlying
investment assets of the endowment or with respect to other trusts also invested in units
with respect to the endowment. Except for the right to review the payout computation,
Trust will have no power or right of any kind to control, direct, supervise, recommend, or
review College’s business activities, operations, or decisions with respect to the
endowment. Trust will not have the right to veto or opt out of any of the underlying
endowment investments. The proposed contract provides that, with respect to the
issuance of units, College is neither a partner nor an agent of Trust. Trust will not be
liable for any cost, expense, or payment incurred or due by College, or for which
College is liable or responsible, relating to the endowment (or the underlying
endowment assets). College will indemnify and hold Trust harmless from and against
any liability arising out of any action or inaction by College with respect to the
endowment (or the underlying assets). College also will pay any tax owed on unrelated
business taxable income earned by the endowment’s portfolio.

While College will not charge any fee for managing Trust’s assets, College may recover
PLR-134201-16 3

its actual costs of managing the endowment as a charge against the endowment, which
will decrease the value of all the endowment units, including Trust’s units. College also
may recover its actual costs of administering Trust as a charge against Trust.

Trust is representative of a number of charitable remainder annuity trusts and charitable
remainder unitrusts with respect to which College has and will have the sole charitable
remainder interest and for which College will be the trustee. College plans to make units
available to these other trusts on the same terms as described in this letter for Trust,
including that it will not assess a fee for the administrative services it provides to any of
these trusts but may recover its costs.

LAW AND ANALYSIS

Section 664(c)(1) provides that, in general, neither a charitable remainder annuity trust
nor a charitable remainder unitrust shall, for any taxable year, be subject to any tax
imposed by Subtitle A of the Internal Revenue Code. However, § 664(c)(2)(A) provides
that, in the case of a charitable remainder annuity trust or a charitable remainder
unitrust that has unrelated business taxable income (within the meaning of § 512,
determined as if §§ 511 through 515 applied to such trust) for a taxable year, an excise
tax is imposed on such trust or unitrust equal to the amount of such unrelated business
taxable income.

Section 512(a)(1) defines the term “unrelated business taxable income” as the gross
income derived by any organization from any unrelated trade or business regularly
carried on by it, less the allowable deductions which are directly connected with the
carrying on of such trade or business, both computed with the modifications provided in
§ 512(b).

Section 513(a) defines the term “unrelated trade or business” as any trade or business
the conduct of which is not substantially related (aside from the need of the organization
for income or funds or the use it makes of the profits derived) to the exercise or
performance by such organization of its exempt purpose or function.

Section 513(c) provides that the term “trade or business” includes any activity which is
carried on for the production of income from the sale of goods or the performance of
services. An activity does not lose its identity as a trade or business merely because it
is carried on within a larger aggregate of similar activities or within a larger complex of
other endeavors which may, or may not, be related to the exempt purposes of the
organization.

Treas. Reg. § 1.513-1(a) provides that income of an exempt organization subject to the
tax imposed by § 511 is included in its gross income in the computation of unrelated
business taxable income if: (1) it is income from a trade or business; (2) such trade or
business is regularly carried on by the organization; and (3) the conduct of such trade or
PLR-134201-16 4

business is not substantially related (other than through the production of funds) to the
organization’s performance of its exempt functions.

Treas. Reg. § 1.513-1(b) provides that, for purposes of § 513, the term “trade or
business” has the same meaning it has in § 162, and generally includes any activity
carried on for the production of income from the sale of goods or performance of
services.

For exempt organizations, including charitable remainder unitrusts, income from certain
passive investments, such as interest, dividends, rent, and similarly produced passive
income, is generally excluded from taxation as unrelated business income by
§ 512(b)(1). In addition, gains from sale or exchange of property other than property
that is stock in trade or primarily held for sale to customers in the ordinary course of
business are excluded from the computation of unrelated business taxable income.
See § 512(b)(5). Whether the modifications of § 512 apply is dependent upon the facts
and circumstances of each case. See Treas. Reg. § 1.512(b)-1.

In this case, Trust’s investment in units and holding of the units will not give Trust any
ownership interest or rights in the assets of the endowment. Trust will not have any
power or right to control, direct, supervise, recommend, or review the business
activities, operations, or decisions of College with respect to the endowment, nor can it
veto or opt out of any underlying investment in the endowment. Rather, a unit
represents a mere contractual right to receive periodic payments from the endowment,
as determined by College.

Furthermore, Trust’s investment in units will not create a partnership for federal income
tax purposes. The proposed arrangement between College and Trust has none of the
characteristics that are commonly associated with a partnership, and the contract
between College and Trust specifically states that College is not a partner or an agent
of Trust with respect to the issuance and holding of units.

Although Trust has represented that some of the assets in the endowment are debt-
financed or otherwise treated as producing unrelated business taxable income to
College under § 512, each periodic payment that Trust will receive is based on a
contract giving Trust the right to receive periodic payments calculated by reference to
College’s endowment without regard to the character or performance of the underlying
assets. Therefore, any debt-financing associated with an underlying asset in College’s
endowment is not relevant in determining whether Trust has any unrelated business
taxable income.

Trust’s purchase of units will be an investment activity, and the receipt of payments with
respect to those units will be income from ordinary and routine investments similar to
the type that is excludible from unrelated business taxable income by § 512(b)(1) and
Treas. Reg. § 1.512(b)-1(a)(1). Accordingly, neither the receipt of payments with
PLR-134201-16 5

respect to the units nor the holding of the units will result in the receipt of unrelated
business taxable income to Trust.

In addition, the proposed contract between Trust and College allows Trust to redeem
units for the value of each unit on the date Trust surrenders it to College. Under the
facts of the contractual arrangement, units will be neither inventory nor property that is
primarily held for sale to customers in the ordinary course of business. A redemption of
units will fall within § 512(b)(5) and Treas. Reg. § 1.512(b)-1(d)(1); thus, money Trust
will receive when it redeems units will not be taxed as unrelated business taxable
income.

CONCLUSION

Based solely on the facts and representations submitted, we rule that Trust’s exchange
of assets for units with respect to College’s endowment, receipt of payments with
respect to the units, and the holding and redemption of units will not generate unrelated
business taxable income to Trust.

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 individual with authority to bind the taxpayer. This office has not verified any of
the material submitted in support of the request for rulings, and such material is subject
to verification on examination.

This letter does not address the applicability of any section of the Code or Regulations
to the facts submitted other than with respect to the sections specifically described, and,
except as expressly provided above, no opinion is expressed or implied concerning the
federal income tax consequences of any other aspects of any transaction or item of
income set forth in the letter.

Because it could help resolve questions concerning federal income tax status, this letter
should be kept in Trust’s permanent records.

A copy of this letter must be attached to any tax return to which it is relevant.
Alternatively, if Trust files a return electronically, this requirement may be satisfied by
attaching a statement to the return that provides the date and control number of this
letter.

This letter will be made available for public inspection under § 6110 after certain
deletions of identifying information are made. For details, see the enclosed Notice 437,
Notice of Intention to Disclose. A copy of this letter, showing the deletions that we
intend to make on the version that will be made available to the public, is attached to the
Notice 437. If Trust disagrees with our proposed deletions, it should follow the
instructions in Notice 437.
PLR-134201-16 6

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) 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 Trust’s authorized representative.

                                   Sincerely,



                                   Mike Repass
                                   Senior Technician Reviewer
                                   (TEGE Associate Chief Counsel)

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