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Part 7. Rulings and Agreements

Chapter 27. Exempt Organizations Tax Manual

Section 17. Taxes on Excess Business Holdings

7.27.17  Taxes on Excess Business Holdings

7.27.17.1  (02-22-1999)
Overview

  1. IRC 4943 limits the involvement of private foundations in the active conduct of business enterprises.

7.27.17.1.1  (02-22-1999)
Tax

  1. IRC 4943 provides two levels of tax on the excess business holdings of a private foundation in a business enterprise:

    1. Initial tax — 5% of the greatest amount of excess business holdings on any day during the taxable year.

    2. Additional tax — An additional tax of 200% of the excess business holdings at the end of the taxable year, if the foundation fails to dispose of the excess holdings during the correction period.

7.27.17.1.2  (02-22-1999)
Excess Business Holdings

  1. Excess business holdings are the amount of stock (or other interest) in a business enterprise that a private foundation would have to dispose of, to a person other than a disqualified person, so that the remaining holdings are permitted holdings.

7.27.17.1.3  (02-22-1999)
Permitted Holdings

  1. A foundation and its disqualified persons together may not hold more than 20% of the voting stock of a corporation conducting a business that is not substantially related to the exempt purpose of the foundation. If someone else can be shown to have control of the business, the 20% limit is raised to 35%.

  2. If disqualified persons hold more than 20% of the voting stock, or 35% where someone else has control, a foundation must also dispose of its nonvoting stock.

7.27.17.1.3.1  (02-22-1999)
2% De Minimus Rule

  1. Even if the 20% or 35% limit is exceeded, a foundation will not have excess business holdings if it does not own, actually or constructively, more than 2% of the voting power and more than 2% of the value of the stock of a corporation.

  2. In determining whether the 2% de minimis rule applies, any stock owned by a private foundation that is treated as held by a disqualified person under IRC 4943(c)(4)(B), IRC 4943(c)(5), or IRC 4943(c)(6) is treated as held by the private foundation.

  3. If a private foundation, together with all other private foundations, actually or constructively owns more than 2% of either the voting stock or the value of the outstanding shares of all classes of stock (including stock treated as held by a disqualified person under IRC 4943(c)(4)(B), IRC 4943(c)(5), or IRC 4943(c)(6)) in any business enterprise, the 2% rule does not apply, and all the stock in such business enterprise classified as excess business holdings is treated as excess business holdings.

7.27.17.2  (02-22-1999)
Business Enterprise

  1. A private foundation is not subject to the excess business holdings tax unless it has an equity interest in a business enterprise.

  2. The term "business enterprise" includes the active conduct of a trade or business, including any activity regularly carried on for the production of income from the sale of goods or the performance of services and that constitutes an unrelated trade or business under IRC 513. Where an activity carried on for profit constitutes an unrelated trade or business, no part of such trade or business is excluded from the classification of a business enterprise merely because it does not result in a profit.

7.27.17.2.1  (02-22-1999)
Exclusions

  1. A business enterprise does not include debt, a functionally related business, or a passive holding company.

7.27.17.2.1.1  (02-22-1999)
Debt

  1. A bond or other evidence of indebtedness is not a holding in a business enterprise unless it is an equitable interest in the enterprise. A leasehold interest in real property is not an interest in a business enterprise, even though rent payable under the lease depends on the income or profits derived by another from that property, unless the leasehold interest is an interest in the income or profits of an unrelated trade or business under IRC 513.

7.27.17.2.1.2  (02-22-1999)
Functionally Related Business

  1. A business enterprise does not include a functionally related business as defined in IRC 4942(j)(4).

  2. A functionally related business includes a business that is related for purposes of the tax on unrelated business income. It also includes a business, which although unrelated to the direct activities of the private foundation, is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors that is related to the exempt purposes of the organization.

7.27.17.2.1.3  (02-22-1999)
Passive Holding Company

  1. A business enterprise does not include a trade or business of which at least 95% of its gross income is from passive sources.

  2. If less than 95% of the income of a trade or business is from passive sources, the foundation may substitute for the passive source gross income the average gross income from passive sources for the 10 tax years immediately preceding the tax year in question (or for any shorter period the entity has been in existence).

  3. Stock in a passive holding company is not a holding in a business enterprise even if the company is controlled by the foundation. Instead, the foundation is treated as owning its proportionate share of any interests in a business enterprise held by the company.

7.27.17.2.2  (02-22-1999)
Gross Income Defined

  1. Gross income from passive sources includes items that are excluded by IRC 512 from unrelated business income, such as dividends, interest, and annuities, royalties, rent, and gains or losses from the disposition of certain property.

  2. Any income classified as passive under this paragraph does not lose its character merely because IRC 512(b)(4) or IRC 514 (relating to unrelated debt-financed income) applies to such income.

  3. Income from passive sources includes income from the sale of goods if the seller does not manufacture, produce, physically receive or deliver, negotiate sales of, or maintain inventories in such goods.

7.27.17.2.3  (02-22-1999)
Sole Proprietorships

  1. A sole proprietorship means any business enterprise:

    1. actually and directly owned by a private foundation;

    2. in which the foundation has a 100% equity interest; and

    3. which is not held by a corporation, trust, or other business entity for the foundation.

  2. A foundation may be considered to own a sole proprietorship even though the foundation is itself a corporation or a trust. However, a sole proprietorship owned by a foundation will not be treated as a sole proprietorship when the foundation owns less than 100% of the equity of the business enterprise.

7.27.17.3  (02-22-1999)
Excess Business Holdings

  1. Excess business holdings is the amount of stock or other interest in a business enterprise that the foundation or a disqualified person would have to dispose of to a person who is not a disqualified person so that the remaining holdings of the foundation in the enterprise are permitted holdings.

7.27.17.3.1  (02-22-1999)
Permitted Holdings in an Incorporated Business Enterprise

  1. The permitted holdings of any private foundation in the voting stock of an incorporated business enterprise are:

    1. 20% of the voting stock in the enterprise reduced (but not below zero) by;

    2. the percentage of voting stock in the enterprise actually or constructively owned by all disqualified persons.

  2. The percentage of voting stock held by any person in a corporation is normally determined by reference to the power of stock to vote for the election of directors. Treasury stock and stock that is authorized but unissued is disregarded.

  3. The fact that extraordinary corporate action (e.g., charter or by-law amendments) by a corporation may require the favorable vote of more than a majority of the directors, or of the outstanding voting stock, of the corporation will not alter the determination of voting power of stock in the corporation.

7.27.17.3.2  (02-22-1999)
Nonvoting Stock

  1. In any case in which all disqualified persons hold, actually or constructively, 20% or less (35% or less when third persons have effective control) of the voting stock of an incorporated business enterprise, any shares of nonvoting stock are permitted holdings of any private foundation in the nonvoting stock of an incorporated business enterprise. All equity interests that do not have voting power attributable to them will be classified as nonvoting stock.

  2. Evidences of indebtedness (including convertible indebtedness), warrants, and other options or rights to acquire stock are not considered equity interests.

7.27.17.3.2.1  (02-22-1999)
Stock with Contingent Voting Rights

  1. Stock carrying voting rights that will vest only when indeterminate conditions have been met will be treated as nonvoting stock until the conditions have occurred that cause the voting rights to vest.

    Example:

    preferred stock that gains voting rights only if no dividends are paid on it.

  2. When the rights vest, the stock will be treated as voting stock that was acquired other than by purchase under IRC 4943(c)(6), but only if the private foundation or disqualified persons had no control over whether those conditions would occur.

7.27.17.3.2.2  (02-22-1999)
Convertible Nonvoting Stock

  1. Nonvoting stock that may be converted into voting stock will not be treated as voting stock until the conversion occurs.

7.27.17.3.3  (02-22-1999)
35% Rule

  1. The 20% rules for permitted holdings in an incorporated business enterprise regarding voting stock and nonvoting stock will be increased to 35% if:

    1. the private foundation and all disqualified persons together do not hold, actually or constructively, more than 35% of the voting stock in the business enterprise; and

    2. the foundation establishes that effective control of the business enterprise is in one or more persons (other than the foundation itself) who are not disqualified persons.

7.27.17.3.3.1  (02-22-1999)
Effective Control

  1. Effective control means the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a business enterprise, whether through the ownership of voting stock, the use of voting trusts, or contractual arrangements, or otherwise. It is the reality of control that is decisive and not its form or the means by which it is exercisable.

7.27.17.4  (02-22-1999)
Permitted Holdings in an Unincorporated Business Enterprise

  1. The permitted holdings of a private foundation in any business enterprise which is not incorporated shall be determined under the principles discussed below that are applicable to holdings in an incorporated business enterprise.

7.27.17.4.1  (02-22-1999)
Partnership or Joint Venture

  1. For a general partnership, a limited partnership, or joint venture, the terms "profit interest" and "capital interest" are substituted for "voting stock" and "nonvoting stock" , respectively.

  2. The interest in profits of a foundation (or disqualified person) is determined in the same manner as its distributive share of partnership taxable income. See IRC 704(b) (relating to the determination of the distributive share by the income or loss ratio) and the regulations thereunder.

  3. In the absence of a provision in the partnership agreement, the capital interest of a foundation (or disqualified person) in a partnership is determined on the basis of its interest in the assets of the partnership that would be distributable to the foundation (or disqualified person) upon its withdrawal from the partnership, or upon liquidation of the partnership, whichever is greater.

7.27.17.4.2  (02-22-1999)
Sole Proprietorship

  1. A private foundation may have no permitted holdings in a sole proprietorship.

7.27.17.4.3  (02-22-1999)
Trusts and Other Unincorporated Business Enterprises

  1. For any other unincorporated business enterprise that is not described in IRM 7.27.17.4, the term "beneficial interest" is to be substituted for "voting stock." Any and all references to nonvoting stock will not apply to any unincorporated business enterprise described below as "trusts" and "other unincorporated business."

7.27.17.4.3.1  (02-22-1999)
Trusts

  1. The beneficial interest of a private foundation or any disqualified person in a trust shall be the beneficial remainder interest of the foundation or person as provided in Reg. 53.4943-8(b).

7.27.17.4.3.2  (02-22-1999)
Other Unincorporated Business Enterprises

  1. The beneficial interest of a private foundation or any disqualified person in an unincorporated business enterprise (other than a trust, a partnership, joint venture, or a sole proprietorship), includes any right to receive a portion of distributions of profits of the enterprise; and if the portion of distributions is not fixed by an agreement among the participants, any right to receive a portion of the assets upon liquidation of the enterprise, except as a creditor or employee.

  2. A right to receive distributions of profits includes a right to receive any amount from the profits (other than as a creditor or employee), whether as a sum certain or as a portion of profits realized by the enterprise.

  3. If there is no agreement fixing the rights of the participants in the enterprise, the interest of the foundation (or disqualified person) in the enterprise will be determined by dividing the amount of all equity investments or contributions to the capital of the enterprise made or obligated to be made by the foundation (or disqualified person) by the amount of all equity investments or contributions to capital made or obligated to be made by all participants in the enterprise.

7.27.17.5  (02-22-1999)
Five-Year Disposition Period

  1. If there is a change in the holdings of a private foundation or its disqualified persons that causes the private foundation to have excess business holdings, the private foundation has a five-year disposition period to reduce its holdings to a permitted level.

  2. The five-year disposition period does not apply if the change in holdings is a result of a purchase by the private foundation or a disqualified person.

7.27.17.5.1  (02-22-1999)
Foundation Has No Excess Business Holdings Prior to Change in Holdings

  1. If a private foundation has no excess business holdings (determined without regard to the five-year disposition period) in a business enterprise immediately prior to a change in holdings in such enterprise to which the five-year disposition period applies, the entire interest of the foundation in the enterprise (immediately after such change) shall (while held by the foundation) be treated as held by a disqualified person during the five-year period beginning on the date of such change.

7.27.17.5.2  (02-22-1999)
Private Foundation Has Excess Business Holdings Prior to Change in Holdings

  1. If a private foundation has excess business holdings (determined without regard to the five-year disposition period) in a business enterprise immediately prior to a change in holdings in such enterprise to which IRC 4943(c)(6) applies, the entire interest of the foundation in the enterprise (immediately after such change) shall (while held by the foundation) be treated as held by a disqualified person during the five-year period beginning on the date of such change.

    Exception:

    If and as soon as any holdings in such enterprise become excess business holdings (determined as if the IRC 4943(c)(6) change had not occurred) during the five-year period, such excess holdings shall no longer be treated as held by a disqualified person under IRC 4943(c)(6), but shall constitute excess business holdings.

7.27.17.5.3  (02-22-1999)
Acquisitions by Will or Trust

  1. For holdings in a business enterprise acquired by a private foundation under the terms of a will or trust, the five-year disposition period does not commence until the date of distribution of holdings from the estate or trust to the foundation. An interest to which the five-year disposition period applies that is constructively held by a foundation prior to the date of distribution is treated as held by a disqualified person prior to such date.

7.27.17.5.4  (02-22-1999)
Transfers From One Private Foundation to Another

  1. The five-year disposition period does not apply to any transfer of holdings in a business enterprise by one private foundation to another private foundation that is related to the first foundation under IRC 4946(a)(1)(H).

7.27.17.5.5  (02-22-1999)
Certain Transfers That are Part of a Plan

  1. The five-year disposition period does not apply to an increase in the holdings of a private foundation in a business enterprise that is part of a plan whereby disqualified persons will purchase additional holdings in the same enterprise during the five-year period beginning on the date of the change, for example, to maintain control of the enterprise, since the increase will be treated as caused in part by the purchase of the additional holdings.

7.27.17.5.6  (02-22-1999)
Constructive Ownership

  1. The purchase of holdings by an entity whose holdings are treated as constructively owned by a foundation or a disqualified person under IRC 4943(d)(1) will be treated as purchased by the foundation or disqualified person.

7.27.17.6  (02-22-1999)
Five-Year Extension of Initial Five-Year Disposition Period

  1. The Service is authorized to allow an additional five-year period for the disposition of an unusually large gift or bequest of either diverse or complex business holdings. Once an application for a five-year extension has been received, the Service will determine whether the plan can reasonably be expected to be carried out within the additional five-year period. Any extension is discretionary with the Service, and all relevant facts and circumstances will be considered.

7.27.17.6.1  (02-22-1999)
Requirements

  1. To qualify for the additional five-year period, a foundation must:

    1. Establish that diligent efforts to dispose of the excess holdings have been made in the initial five-year period;

    2. Establish that because of the size and complexity of the holdings, disposition within the initial 5-year period has not been possible except at a price substantially below fair market value;

    3. Before the close of the initial five-year period, submit a plan to the Service for disposing of the excess holdings in question; and

    4. Before the close of the initial five-year period, submit the plan to the State Attorney General (or other appropriate official), and submit any response from this official to the Service.

7.27.17.7  (02-22-1999)
Constructive Ownership Rules

  1. In computing the holdings in a business enterprise of a private foundation or disqualified person, any stock or other interest owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered as being owned proportionately by or for its shareholders, partners, or beneficiaries.

  2. Any interest in a business enterprise actually or constructively owned by a shareholder of a corporation, a partner of a partnership, or a beneficiary of an estate or trust shall not be considered as constructively held by the corporation, partnership, trust or estate.

7.27.17.7.1  (02-22-1999)
Warrants or Other Options

  1. Any corporation, partnership, estate or trust has a warrant or other option to acquire an interest in a business enterprise, such interest is not deemed to be constructively owned by the entity until the option is exercised.

7.27.17.7.2  (02-22-1999)
Powers of Appointment

  1. Any interest in a business enterprise over which a foundation or a disqualified person has a power of appointment exercisable in favor of the foundation or a disqualified person shall be considered owned by the foundation or disqualified person holding such power of appointment.

7.27.17.7.3  (02-22-1999)
Exception for Estates and Trusts

  1. Any interest actually or constructively owned by an estate or trust is deemed constructively owned, in the case of an estate, by its beneficiaries or, in the case of a trust, by its remainder beneficiaries, except in the case of split-interest trusts, employee benefit trusts and revocable trusts. These exceptions are discussed below. The following is an example of the general rule.

    Example:

    if a trust owns 100% of the stock of corporation A, and if, on an actuarial basis, W's life interest in the trust is 15%, Y's life interest is 25%, and Z's remainder interest is 60%, then Z will be considered to be the owner of 100% of the stock.

  2. No portion of an interest in a business enterprise which was transferred to an IRC 4947(a)(2) trust for the benefit of a private foundation shall be considered as owned by the foundation if the foundation holds only an income interest in the trust; or if the foundation holds only a remainder interest in the trust (unless the foundation can exercise primary investment discretion with respect to such interest) until such trust ceases to be so described.

  3. An interest in a business enterprise owned by a trust described in IRC 401(a), shall not be considered as owned by its beneficiaries, unless disqualified persons control the investment of the trust assets.

  4. An interest in a business enterprise owned by a revocable trust shall be treated as owned by the grantor of such trust.

7.27.17.7.4  (02-22-1999)
Estates

  1. Under IRC 4943(d)(1), a beneficiary includes any person (including a private foundation) entitled to receive property of a decedent pursuant to a will or pursuant to laws of descent and distribution.

  2. A person shall no longer be considered a beneficiary of an estate when:

    1. all the property to which the person is entitled has been received by this person;

    2. this person no longer has a claim against the estate; and

    3. there is only a remote possibility that it will be necessary for the estate to seek the return of property or to seek payment from this person by contribution or otherwise to satisfy claims against the estate or expenses of administration.

  3. When a person (including a private foundation) ceases to be a beneficiary, then stock or another interest in a business enterprise owned by the estate shall not thereafter be considered owned by such person.

  4. If any person is the constructive owner of an interest in a business enterprise actually held by an estate, the date of death of the testator or decedent intestate shall be the first day on which such person shall be considered a constructive owner of such interest.

7.27.17.8  (02-22-1999)
Imposition of Initial Tax on Excess Business Holdings

  1. There is imposed an initial excise tax on the excess business holdings of a private foundation for each taxable year of the foundation that ends during the taxable period.

  2. The amount of such tax is equal to 5% of the total value of all the private foundation's excess business holdings in each of its business enterprises.

    Exception:

    If the foundation establishes that the violation was due to reasonable cause and not due to willful neglect, and corrects the violation, the Service has discretionary authority to abate the first tier excise tax. See IRC 4962.

  3. The initial tax is imposed on the last day of the private foundation's taxable year.

7.27.17.8.1  (02-22-1999)
Date of Valuation of Excess Business Holdings

  1. The value of the excess business holdings subject to the initial tax is determined regarding a foundation's holdings in a business enterprise as of the day during the foundation's taxable year when the foundation's excess holdings in such enterprise are the greatest. If the foundation's greatest excess holdings are maintained for two or more days during any taxable year, the value of such excess holdings subject to the initial tax is the greatest value attained by such excess holdings as of any day on which they are maintained.

7.27.17.8.2  (02-22-1999)
Additional Tax

  1. In any case in which the initial tax is imposed on the holdings of a private foundation in any business enterprise, if, at the close of the taxable period with respect to such holdings, the foundation still has excess business holdings in such enterprise, an additional tax is imposed equal to 200% of the value of such excess holdings.

7.27.17.8.2.1  (02-22-1999)
Exception—90-Day Period

  1. A private foundation is not subject to the IRC 4943 excise tax on excess business holdings resulting from its purchase of holdings where it did not know, or have reason to know, of prior acquisitions by disqualified persons, but only if the foundation disposes of its excess holdings within 90 days from the date on which it knows, or has reason to know, of the event which caused it to have such excess business holdings, and its purchase would not have created excess holdings but for such prior acquisitions by disqualified persons.

7.27.17.8.2.2  (02-22-1999)
Determination of Whether the Foundation has Disposed of Excess Holdings During the 90-Day Period

  1. In determining whether the foundation has disposed of its excess business holdings during the 90-day period, any disposition of holdings by a disqualified person during the 90-day period is disregarded.

7.27.17.8.3  (02-22-1999)
Foundation Knowledge of Acquisitions Made by Disqualified Persons — Facts and Circumstances Test

  1. Whether a private foundation will be treated as knowing, or having reason to know, of the acquisition of holdings by a disqualified person depends on the facts and circumstances of each case. The following factors will be considered:

    1. The fact that the foundation did not discover acquisitions made by disqualified persons through the use of procedures reasonably calculated to discover such holdings.

    2. The diversity of foundation holdings.

    3. The existence of large numbers of disqualified persons who have little or no contact with the foundation or its managers.

7.27.17.8.4  (02-22-1999)
Extension of 90-Day Period

  1. The 90-day period shall be extended to include the period during which the foundation is prevented by federal or state securities laws from disposing of such excess business holdings.

7.27.17.9  (02-22-1999)
Effect of Disposition of Holdings Subject to Material Restrictions

  1. If a private foundation disposes of an interest in a business enterprise but imposes any material restrictions or conditions that prevent the transferee from freely and effectively using or disposing of the transferred interest, then the transferor foundation will be treated as owning such interest until all such restrictions or conditions are eliminated (regardless of whether the transferee is treated for other purposes of the Code as owning such interest from the date of the transfer).

  2. A restriction or condition imposed in compliance with federal or state securities laws, or in accordance with the terms or conditions of the gift or bequest through which such interest was acquired by the foundation, shall not be considered a material restriction or condition imposed by a private foundation.

7.27.17.10  (02-22-1999)
Taxable Period

  1. The taxable period is the period beginning on the first day on which there are excess holdings and ending on the earlier of:

    1. the date of mailing of a notice of deficiency under IRC 6212 with respect to the excise tax on excess business holdings: or

    2. the date on which the excise tax on excess business holdings with respect to such holdings is assessed.

7.27.17.11  (02-22-1999)
Correction

  1. Correction is made when no interest in the enterprise held by the foundation is an excess business holding.

7.27.17.11.1  (02-22-1999)
Contructive Ownership

  1. Where a foundation has excess business holdings which are constructively held for it by another entity, correction is made when either that entity, the foundation, or a disqualified person dispose of a sufficient interest in the enterprise so that no interest held by the foundation is an excess business holding.

7.27.17.11.2  (02-22-1999)
Correction Period

  1. Under IRC 4963(e), the correction period is the period beginning on the first day on which there are excess business holdings and ending 90 days after the date of mailing under IRC 6212 of a notice of deficiency with respect to the additional tax, extended by:

    1. any period in which a deficiency cannot be assessed under IRC 6213(a) (determined without regard to the supplemental proceeding provided for under IRC 4961(b)), and

    2. any other period which the Service determines is reasonable and necessary to bring about correction.


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