Individual Seeks Guidance on NII Tax, Public Charity Conversions

May 24, 2021

Internal Revenue Service
Attn: CC:PA:LPD:PR (Notice 2021-28)
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20224

Re: Recommendation for the 2021–2022 Priority Guidance Plan Pursuant to Notice 2021-28

To Whom It May Concern:

Pursuant to Notice 2021-28, 2021-18 I.R.B. 1, I am respectfully recommending for inclusion in the 2021–2022 Priority Guidance Plan guidance clarifying the tax basis consequences under Section 4940 of the Internal Revenue Code of 1986, as amended (the “Code”), when a public charity converts to a private foundation and becomes subject to the net investment income tax.

Need for Recommended Guidance

Clarification of the tax consequences under Code Section 4940 of the conversion of a public charity to a private foundation is necessary because taxpayers that have converted to private foundations have no clear guidance from the Internal Revenue Service (“IRS”) regarding the basis of assets for purposes of calculating the 1.39% net investment income tax under Code Section 4940. The recommended guidance would reduce recordkeeping burdens for taxpayers that convert, either voluntarily or involuntarily, to private foundation status and simplify administrative of the net investment income tax for the IRS. Furthermore, the guidance would affect a significant number of taxpayers, as numerous organizations convert from public charities to private foundations, either by failing to satisfy the financial tests under Code Sections 170(b)(1)(A)(vi) and 509(a)(1), or 509(a)(2), by converting from a supporting organization to a private foundation, or by voluntarily relinquishing public charity status.

Conversions of Public Charities to Private Foundations

Public charities described in Code Sections 509(a)(1) and 170(b)(1)(A)(vi) obtain their public charity status by meeting certain financial tests designed to demonstrate their “public support.” Failure to continuously satisfy these financial tests can result in reclassification as a private foundation and 170(b)(1)(A)(vi) if it receives at least one-third of its support from public sources¹ or receives at least 10% of its support from public sources and certain facts and circumstances indicate that the organization is publicly supported.² An organization meets the public charity test under Code Section 509(a)(2) if it receives at least one-third of its total support from public sources and derives no more than one-third of its support from investment income and unrelated business activities.³ Public support under both Code Section 170(b)(1)(A)(vi) and Code Section 509(a)(2) is measured on a five-year rolling basis.⁴ If a 170(b)(1)(A)(vi) or 509(a)(2) organization fails to meet either of these financial tests for two consecutive years, it will be reclassified as a private foundation as of the first day of the second consecutive tax year.⁵

In addition to involuntary reclassification for failure to meet the requisite financial tests, some organizations voluntarily relinquish their public charity status.⁶ For example, a supporting organization may decide to sever its relationship with the supported public charity. Upon severing its relationship with the supported public charity, the former supporting organization will be reclassified as a private foundation.⁷ As a private foundation, the former supporting organization is subject to the Chapter 42 excise tax regime, including the net investment income tax under Code Section 4940.

IRS Guidance on Special Basis Step-ups

Code Section 4940(c)(4)(B) and Revenue Ruling 76-424

The Tax Reform Act of 1969, P.L. 91-172, 93 Stat. 487 (the “TRA”) categorized Code Section 501(c)(3) organizations as either “public charities” or “private foundations.” The TRA subjected private foundations to a tax on net investment income. Code Section 4940(c) defines a private foundation's net investment income as the amount by which a private foundation's “gross investment income” and its “capital gain net income” exceed its allowable deductions. The TRA resulted in many charitable organizations being newly classified as private foundations and thus subject for the first time to the net investment income tax. To ease the transition to the new tax on net investment income, the TRA provided that in determining a private foundation's capital gain net income, the basis of property held by the private foundation on December 31, 1969 “shall be deemed to be not less than the fair market value of such property on December 31, 1969.” Thus, the TRA essentially provided a special “step-up” or “fresh start” basis for private foundations. Treasury Regulations promulgated three years later further clarified that the basis for determining gain from the sale or other disposition of property would be the greater of (A) the fair market value on December 31, 1969, or (B) the basis as determined under the normal basis rules in Part II of Subchapter O.⁸ In Revenue Ruling 76-424, 1976-2 C.B. 367, the IRS ruled that appreciated stock distributed to a private foundation in 1971, in satisfaction of a specific bequest from the estate of an individual who died in 1967, would be considered held by the private foundation on December 31, 1969 and thus, the basis of the stock for purposes of computing capital gain includible in net investment income would be the fair market value of the stock on December 31, 1969.

Code Section 4968 and Notice 2018-55

The 2017 Tax Reform Act⁹ imposed a new excise tax on the net investment income of certain higher education institutions.¹⁰ The excise tax is modeled on the private foundation net investment income tax.¹¹ In June 2018, the IRS published Notice 2018-55, 2018-26 I.R.B. 773, announcing its intent to propose regulations stating that for purposes of calculating net investment income, the basis of property held by an applicable educational institution would be deemed to be no less than the fair market value of such property on December 31, 2017. The IRS subsequently issued regulations providing that the basis of property (other than a partnership interest) held by an applicable educational institution would be the greater of (A) the fair market value on December 31, 2017, or (B) the basis as determined under the normal basis rules in Part II of Subchapter O.¹²

Private Letter Ruling 9852023

In Priv. Ltr. Rul. 9852023, the IRS ruled that when a supporting organization described in Code Section 509(a)(3) ceased to be a public charity and was treated as a private foundation, the basis of the stock and other assets held by the organization would be equal to the fair market value of such property on the date the organization ceased to be a public charity. The ruling states:

[T]he special transitional rule for assets of public charities that were owned on December 31, 1969 and Rev. Rul. 76-424, evidence an objective that the gains on sale of certain assets, such as those held by U [the taxpayer], that were earned but unrealized prior to the time that the organization ceases to be a public charity and becomes a private foundation should not be subject to the section 4940 excise tax.

Except for the taxpayer in Priv. Ltr. Rul. 9852023, the IRS has not issued rulings to other taxpayers regarding the basis of stock and other assets held by an organization that converts from a public charity to a private foundation. As noted above, these conversions affect numerous Code Section 501(c)(3) organizations, including those that convert to private foundations and those considering or anticipating a conversion. Broadly applicable guidance would provide certainty to these organizations.

Recommended Guidance

Upon the conversion of a Code Section 501(c)(3) organization from a public charity to a private foundation, the basis of property held by the organization should be equal to the greater of (a) fair market value on the date of the conversion to a private foundation, or (b) the basis as determined under the normal basis rules in Part II of Subchapter O. The foregoing guidance would simplify recordkeeping requirements for public charities, which are not subject to the net investment income tax and, as such, may have no reason to calculate basis in assets and may be unable to obtain information regarding the basis of donated assets. The foregoing guidance would also simplify the IRS's administration of the net investment income tax under Code Section 4940. Moreover, such guidance would be consistent with the principles set forth in Code Section 4940(c)(4)(B) and recent IRS guidance regarding the newly enacted net investment income tax for applicable educational institutions under Code Section 4968.

Thank you in advance for your consideration of this request. If you have any questions about this request, please do not hesitate to contact the undersigned at (410) 244-7604. I welcome the opportunity to further discuss this request.

Sincerely,

Christopher N. Moran, Esq.

cc (via email):
Emily M. Lesniak, Office of Associate Chief Counsel (IRS — P&A)
Emily.M.Lesniak@irscounsel.treas.gov

Janine Cook, Deputy Associate Chief Counsel (IRS — EEE)
Janine.Cook@irscounsel.treas.gov