Private Letter Rulings - Org That Channeled Loan to For-Profit Denied Exemption
GiftLaw Note:
Org was formed to distribute funds to charitable organizations. Org's governing body consists of E, F, G and H, all of whom are related by blood or marriage. Org was to provide short term loans to charitable organizations and long term loans to for-profit entities, the latter of whom would be charged interest. Org made a loan to M, a for-profit mortgage lending business. M had obligated itself to transfer the loaned funds to N, a for-profit LLC. M is partially owned by two of Org's board members, G and E, while its majority owner is P, the father of G and E. P, G and E are all disqualified persons with respect to Org. The Service was asked to rule on whether Org qualified for exemption and, if so, whether the loan to M was (1) an act of self-dealing and (2) a jeopardizing investment.
Charitable organizations must be organized and operated exclusively for charitable purposes. An organization fails this test when it operates for the benefit of private interests, which can include the organization's founder. Here, the Service found that Org operated for the benefit of private interests because it channeled funds to for-profit M for use in its mortgage lending business. This resulted in a benefit to the private interests of E and G, partial owners of M and founders of Org. Even if Org qualified for exemption, the Service ruled that Org's lending money to M constituted an act of self-dealing because disqualified persons—P, G and E—owned M. Also, Org failed to exercise the requisite standard of care and prudence because Org failed to diversify when it made all the loans to a single entity and because it failed to secure the loans. Therefore, Org's loans to M were a jeopardizing investment.
Charitable organizations must be organized and operated exclusively for charitable purposes. An organization fails this test when it operates for the benefit of private interests, which can include the organization's founder. Here, the Service found that Org operated for the benefit of private interests because it channeled funds to for-profit M for use in its mortgage lending business. This resulted in a benefit to the private interests of E and G, partial owners of M and founders of Org. Even if Org qualified for exemption, the Service ruled that Org's lending money to M constituted an act of self-dealing because disqualified persons—P, G and E—owned M. Also, Org failed to exercise the requisite standard of care and prudence because Org failed to diversify when it made all the loans to a single entity and because it failed to secure the loans. Therefore, Org's loans to M were a jeopardizing investment.
6/28/2013 (4/5/2013)
Dear * * *
We have considered your application for recognition of exemption from federal income tax under Internal Revenue Code section 501(a). Based on the information provided, we have concluded that you do not qualify for exemption under Code section 501(c)(3). The basis for our conclusion is set forth below.
ISSUE
Do you qualify for exemption under section 501(c)(3) of the Code? No, for the reasons described below.
ALTERNATIVE ISSUES
If upon appeal exemption is granted, would your loan to a related for-profit entity, M, constitute an act of self-dealing? Yes for the reasons described below.
If upon appeal exemption is granted, would your loans to M constitute a jeopardizing investment? Yes, for the reasons described below.
FACTS
You are a corporation formed on D under the laws of the state of C.
Your Certificate of Incorporation states the purposes for which you were formed are: "To distribute funds to non-profit organizations who are tax exempt under section 501(c)(3) of the Internal Revenue Code or the foreign equivalent to support their charitable and religious activities."
Your governing body is comprised of four individuals, each titled as director: E, F, G and H. All four of your directors are related by blood/marriage as two of your directors are brothers and the other two directors are their spouses.
You adopted non profit Bylaws listing general purposes and operational procedures. Article 5 of your Bylaws outlines your Conflict of Interest policy and procedures regarding interested parties.
Under the activities description given in Form 1023 your stated activities will be the making of contributions to other organizations, the nature of whose activities is such as to qualify them under Internal Revenue Code 501(c)(3). This activity will be conducted by the directors of your organization and will be funded by unsolicited contributions from individuals and/or closely held corporations.
You indicated that directors will choose 501(c)(3) entities with no relationship to your foundation to whom donations would be made. Records will be retained with the date, names and addresses of the recipient organizations and the amount of the donation. Distributions will only be made to exempt 501(c)(3) organizations in good standing and they will be selected by their reputation as helping the community at large. Although your organizing document makes reference to making distributions to foreign entities, you have indicated your intention to not make any gifts to foreign organizations at this time.
Your correspondence provided further detail on your loan making activities. You will provide interest free short term loans to charitable organizations. You will also make long term loans to for-profit entities. If a for-profit entity requests a loan it will be charged interest. You have stated the purpose of the short term loans is to assist non profit organizations by providing interest free working capital and help with their charitable activities. The loans made to for profit entities were long term to generate interest income.
Loans were made to three charities (J, K and L) and one for-profit entity, M. M was not the end user of the loan. You transferred the loan funds to M because M had obligated itself to lend the money to N a for-profit LLC. After receiving the loan from you M entered into a loan agreement with N for x dollars total. y dollars of that amount was advanced to N on S and z dollars was advanced on W. V, an uncle to E and G, arranged for the financing of the transaction between N and M. V is designated as a manager of N and signed the agreement between N and M. Your loans to M were on Promissory Notes signed by E on behalf of the borrower M and were not collateralized in any manner. The loan from M to N was secured by a mortgage on certain real property.
M is partially owned by two of your board members, G and E. The majority owner of M is P, the father of G and E. Total ownership by percentage is broken down as follows:
E -- * * *%
O -- * * *%
P -- * * *%
Q -- * * *%
G -- * * *%
Others -- * * *%
In total, the R family owns * * *% of M with G and E owning * * *%. Since P is the father of G and E, disqualified persons own more than * * *% of M.
T is a corporation * * *% owned and controlled by G and E and therefore * * *% owned by your board. T, has contributed the majority of funds to you.
U is the second largest donor to you. U is a 501(c)(3) Private foundation and you indicated that you have no relationship to U. However you did indicate that T has also made substantial contributions to U.
Throughout the 20* * * fiscal year T donated approximately $* * * to you, and U donated y dollars. E provided a loan to you which was repaid in full with no interest. Loan repayments to you totaled approximately $* * *.
You made approximately $* * * in donations, $* * * in loans to other organizations, and the loans to M.
On S, U gave y dollars to you. T gave what appears to be y dollars + * * *% to U, 4 days later. Ten days after receiving y dollars, you made a loan to M for the same amount. On the same day, M entered into the agreement with N and made an initial distribution of funds for y dollars. Thirty days later, T gave z dollars to you. On the same day another payment was made to M for z dollars under the agreement.
LAW
Section 501(a) of the Internal Revenue Code of 1986 provides for the exemption from federal income tax for organizations described in Section 501(c)(3). Such organizations are recognized as exempt if they are organized and operated exclusively for religious, charitable, and educational purposes.
Section 1.501(c)(3)-1(a)(1) of the Income Tax Regulations states that, in order to be exempt as an organization described in section 501(c)(3) of the Code, an organization must be both organized and operated exclusively for one or more of the purposes specified in such section. If an organization fails to meet either the organizational test or the operational test, it is not exempt.
Section 1.501(c)(3)-1(c)(1) of the regulations provides that an organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3) of the Code. An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.
Section 1.501(c)(3)-1(c)(2) of the regulations provides that an organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.
Section 1.501(c)(3)-1(d)(1)(ii) of the regulations states that an organization is not organized or operated exclusively for one or more exempt purposes unless it serves a public rather than a private interest. Thus, to meet the requirement of this subdivision, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.
In Salvation Navy v. Commissioner, T.C.M. 2002-275 (2002), the court found that one of the reasons why the organization did not qualify for exemption from federal income tax was because it could not provide that its net earnings would not inure to the benefit of a private individual which was its founder.
In Old Dominion Box Co. v. United States, 477 F2d 344 (4th Cir. 1973) cert. denied 413 U.S. 910 (1973), the court held that operating for the benefit of private parties constitutes a substantial non-exempt purpose.
Leon A. Beeghly v. Commissioner, 35 T.C. 490 (1960), provided that where an exempt organization engages in a transaction with a related interest and there is a purpose to benefit the private interest rather than the organization, exemption may be lost even though the transaction ultimately proves profitable for the exempt organization.
In Better Business Bureau of Washington, D.C., Inc. v. United States, 326 U.S. 179, the Supreme Court held that the presence of a single non-exempt purpose, if substantial in nature, will destroy a claim for exemption regardless of the number or importance of truly exempt purposes.
LAW REGARDING ALTERNATIVE ISSUES
Section 53-4941(d)(1) of the regulations defines self-dealing as any direct or indirect transaction described in § 53.4941(d)-2. For purposes of this section, it is immaterial whether the transaction results in a benefit or a detriment to the private foundation.
Section 53-4941(d)-2(c) indicates that the lending of money or other extension of credit between a private foundation and a disqualified person shall constitute an act of self-dealing.
Section 53-4944-1(2) of the regulations indicates that an investment shall be considered to jeopardize the carrying out of the exempt purposes of a private foundation if it is determined that the foundation managers, in making such investment, have failed to exercise "ordinary business care and prudence", under the facts and circumstances prevailing at the time of making the investment, in providing for the long and short term financial needs of the foundation to carry out its exempt purposes. In the exercise of the requisite standard of care and prudence the foundation managers may take into account the expected return, the risks of rising and falling price levels, and need for diversification within the investment portfolio.
Rev. Rul. 77-161, 1977-1 C.B. 358
This ruling held that a loan by a private foundation to a disqualified person constitutes an act of self dealing but is not a taxable expenditure within the meaning of section 4945(d)(5) of the Code. The private foundation made a loan to a disqualified person to generate income to be used solely for the foundation's charitable purposes. The loan was made at a reasonable rate of interest, adequately secured and otherwise met prudent investment standards.
APPLICATION OF LAW
You operate for the benefit of private interests by channeling funds from one related for-profit to another related for-profit through you. The loans you provide to the related for-profit M are used by it to operate its mortgage lending business thereby resulting in inurement to G and E its owners. Therefore you are not operated exclusively for charitable purposes as described in section 501(c)(3) of the code and fail the operational test under 1.501(c)(3)-1(a)(1) of the regulations. Since your primary purpose is to operate for the benefit of insiders you also are not as described in 1.501(c)(3)-1(c)(1) of the regulations.
You obtained funds from a related for-profit and then channeled these funds as a loan to another related for-profit which is owned by your board members and their family members.. As a result your earnings inured to your directors and you operated for the benefit of private interests such as your creators and their family. Therefore you are not as described in section 1.501(c)(3)-1(c)(2) and 1.501(c)(3)-1(d)(1)(ii) of the regulations.
As shown in Salvation Navy v. Comm. and Old Dominion v. U.S., the transactions conducted through you benefitted private interests. The loans that, in the normal course of business, would have been made directly to M were directed through you. The transactions generated charitable contributions, while still allowing access to the funds through loans to related for-profit entities. The loans also served the private interests of the other for-profit M owned by G and E and members of the R family by providing it funds to operate its business. The timing of the transactions, the amounts and the fact that the loans were unsecured clearly demonstrate the transactions were structured for the private benefit of insiders. In addition your investment in M was made to satisfy an obligation of M to N which was an arrangement orchestrated by V an uncle of E and G.
Similar to Leon Beeghly v. Comm., the loans you made to M were to satisfy an obligation M had to provide funding to N. Although the loans to M would generate interest income for you the purpose of these loans was to benefit the end user, N. M would also benefit from this transaction by using the funds for its own business purposes and earning interest therefrom.
As in Better Business Bureau of Washington, D.C., Inc. v. United States, 326 U.S. 179, and Sections 1.501(c)(3)-1(a)(1) and 1.501(c)(3)-1(c)(1) You are set up to operate for the non-exempt purpose of receiving funding from a for-profit entity, turning around and providing loans to another for-profit entity both of which are owned by your directors and their family. You operate to serve the private interests of these for-profit entities and also allow your income to inure to the benefit of your directors and family members by providing loans to for-profit businesses that are owned by your directors and family members. Substantially all of your income was used to provide loans to related for-profit entities, which represents a significant non-exempt purpose.
APPLICATION OF LAW ON ALTERNATIVE ISSUES
The loans to M clearly constitute an act of self-dealing based on Section 53-4941(d)(1) and Section 53-4941(d)-2(c) of the regulations. As in Revenue Ruling 77-161, you made a loan to a disqualified person which resulted in an act of self dealing.
The loans made by you also constitute a jeopardizing investment as described in Section 53-4944-1(2) of the regulations. Your loans to M were made to enable M to satisfy its obligation to N without consideration of your long and short term needs to carry out your exempt purposes. Also in making this investment you have failed to exercise the requisite standard of care and prudence, taking into account the expected return, the risks of falling price levels and the need for diversification of the investment portfolio. There was no diversification in your investments, the loans were unsecured, all made to a single entity which was involved in mortgage lending. Therefore it is clear that the required ordinary business care and prudence was not exercised by you in making this loan.
APPLICANT'S POSITION
You indicated that the loans were never intended for M's use but rather for unrelated third party entities. The purpose of these loans, backed by mortgages on real property was to produce interest revenue for your charitable purposes. The loans were channeled through M because they had been providing mortgage loans for years and had the infrastructure necessary for making such loans relatively quickly. All interest on the loans has been remitted entirely to you. Soon afterward you realized the problem of making loans through related entities. You immediately discontinued the practice and make all loans directly to unrelated parties.
SERVICE RESPONSE TO APPLICANT'S POSITION
You provided funds to M so that they can make mortgage loans on real property. M is a for-profit entity which is * * *% owned by disqualified persons. Therefore in effect you financed M so that they could operate their mortgage business which they have been conducting for years. Therefore you operated for the private benefit of M and your earnings inured to the directors and owners of M because they were able to use your funds to operate their business and to earn profits therefrom. Your loans to M were unsecured. In addition, had you been exempt, the loans made to M would constitute self-dealing and also a jeopardizing investment. You indicate you now make loans directly to unrelated third parties. The making of loans to unrelated third parties is not an exempt purpose. You did not provide any information as to the nature of these loans and the purpose and terms of these loans.
CONCLUSION
Based on the above facts and law we conclude that you do not qualify for exemption under Section 501(c)(3) of the Code because you are operating for a substantial non exempt purpose. Your operations result in private benefit to for-profit organizations and your earnings inure to your directors and family members who are owners of these for-profit businesses that contribute to you as well as receive funds from you.
CONCLUSION-ALTERNATIVE ISSUES
We further conclude that, if upon appeal exemption is granted, the lending of money to a related company results in a self-dealing transaction. In addition the lack of requisite care and prudence in making the purported investment in the related company indicates that the investment would be a jeopardizing investment.
Sincerely,
Lois G. Lerner
Director, Exempt Organizations