Paper Focuses on ‘Related Organizations’ in Excise Tax Rules

RELATED ORGANIZATIONS UNDER INTERNAL REVENUE CODE SECTION 4968

Definition of “Related Organization”

For purposes of Code Section 4968, a “related organization” of an applicable educational institution includes any organization which “controls, or is controlled by, such institution, . . . is controlled by 1 or more persons which also control such institution, or is a supported organization (as defined in section 509(f)(3)), or an organization described in section 509(a)(3), during the taxable year with respect to such institution.”

Definition of Control

While control is defined in a variety of different ways in the Code, control for purposes of Code Section 4968 should be interpreted using the principles of Treasury Regulation Section 1.414(c)-5. In the context of stock-corporations, control is generally based on ownership of 80% of a corporation's stock (determined by reference to vote, value or both, depending on the particular provision). See, for example, Code Section 368 and Code Section 1563. However, among groups of tax-exempt organizations, control is more likely to be structured and exercised by means of corporate governance. For that reason, Treasury Regulations Section 1.414(c)-5 provides that control between an exempt organization and another exempt organization exists if at least 80% of the directors or trustees of one organization are controlled by, or are representatives of, the other organization. For these purposes, a trustee or director is treated as a “representative” of another exempt organization if he or she is also a trustee, director, agent, or employee of the other exempt organization. In addition, a trustee or director is considered to be controlled by another organization if the other organization has the general power to appoint and remove the trustee or director. These principles provide a suitable and well-developed framework for measuring control for purposes of Code Section 4968 as well.

The concept of control among tax-exempt organizations is relevant for several other Code provisions as well. However, the measures of control for purposes of these other Code Sections are inappropriate for purposes of Code Section 4968. Code Section 512(b)(13), for example, uses a 50% test for determining whether certain payments from a controlled entity to a controlling entity are unrelated business taxable income (“UBTI”). While the 50% threshold may be suitable in the UBTI context, a higher threshold is needed for purposes of Code Section 4968. The tax imposed by Code Section 4968 is imposed based on the amount of assets and income an applicable educational institution has available for its use and benefit, as discussed in further detail below. Only assets and income the use of which an applicable educational institution (or its controlling persons) can clearly direct should therefore be taken into account for purposes of applying Code Section 4968. A supermajority threshold of 80% is more suitable than a 50% threshold for ensuring that a sufficiently close relationship exists between an educational institution and another organization to warrant treating the assets and income of the other organization as that of the educational institution.

It would likewise be inappropriate to use the concepts for determining control under Code Section 509(a)(3) for purposes of Code Section 4968. The rules of Code Section 509(a)(3) focus on effective control and the existence of veto powers. Code Section 4968 imposes a tax on organizations that, in most cases, are part of a complex array of organizations and governance structures. An objective standard of control is needed to give these organizations certainty as to the amount of tax they are subject to. Such certainty in the applicable rules is needed in particular because, unlike the Code Section 509(a)(3) context and the accompanying determination process, the Code Section 4968 context does not offer a process for IRS review that provides an opportunity for confirmation as to whether a particular arrangement gives rise to “control” in the IRS's view. The veto concept used under Code Section 509(a)(3) is furthermore inappropriate for purposes of Code Section 4968 because Code Section 4968 is clearly concerned with an educational institution's ability to make use of the relevant assets or benefit from the relevant income, not simply to deny another such use or benefit. To ensure consistency with this underlying principle, control for purposes of Code Section 4968 should be based on an educational institution's ability to affirmatively make use of another organizations assets or obtain a benefit from its income.

Lastly, because the concept of control is key to defining income subject to tax under Code Section 4968, control should be defined as part of the regulatory process where notice and comments are requested. The determination of what entities are controlled can be very complex for large universities and thus should not be defined within instructions to forms or other less formal guidance. Also, regulatory guidance provides more certainty for universities as they enter into further functions with different types of organizations.

Entities to be Excluded

To ensure consistency with the purpose of Code Section 4968, certain entities should be completely carved-out from the definition of “related organizations.”

For-profit entities. For-profit corporations should be excluded from the definition of “related organization” because of the potential for double taxation. Income earned by these entities is already subject to tax at the corporate level. Dividends and capital gain generated by these entities is already included in the net investment income of the applicable educational institution under Code Section 4968 when received. Treating for-profit corporations as “related organizations” of an educational institution would subject their income to two levels of tax under Code Section 4968, in addition to regular corporate income tax.

Operating entities. Operating entities, such as hospitals, research organizations, and museums, whether or not controlled by an applicable educational institution, and whether or not a supporting organization of the applicable educational institution, should not be considered “related organizations.” These entities have their own assets dedicated solely for their own use and earn income for their own charitable purposes. Code Section 4968(d)(1)(B) clearly recognizes that assets and income that are not intended or available for use by an applicable educational institution should not be taken into account in applying Code Section 4968. It should make no difference in this regard whether an organization is controlled by, or a supporting organization of, the applicable educational institution. Assets and income that will be used for separate charitable purposes and are therefore not the type of investment assets or income at which Code Section 4968 is aimed. A contrary rule would effectively subject income of, for example, a hospital, to tax under Code Section 4968 simply because it happens to be “controlled” by a university. There is no basis for subjecting some hospital assets and income to this tax but not others, simply based on the fact that they happen to have a particular relationship with a university. This view is supported by the Conference Committee report, which states that “For example, assets of a related organization that are earmarked or restricted for (or fairly attributable to) the educational institution would be treated as assets of the educational institution, whereas assets of a related organization that are held for unrelated purposes (and are not fairly attributable to the educational institution) would be disregarded.”

Split interest trusts. Split interest trusts, such as charitable remainder trusts (CRTs) and charitable lead trusts (CLTs), are separate entities that are governed by the terms of the trust instrument. One or more individuals other than an applicable educational institution hold a legal interest in the assets of the trust. The educational institution may not be aware of and/or may not be irrevocably named as a beneficiary of the trust. Excluding assets and income of CRTs and CLTs for Code Section 4968 is further consistent with the treatment of CRTs and CLTs under the excess business holdings rules. See General Explanation of the Tax Reform Act of 1969, H.R. 13270, 91st Congress, Public Law 91-172 (“[W]here the foundation holds only an income interest or only a remainder interest in a 'split-interest' trust, then that interest will not be attributed to the foundation. To provide otherwise, (i.e., to require attribution without limit) in some cases would result in the foundation being required to divest itself of stock it does not hold.”) Similar to the excess business holdings context, requiring applicable educational institutions to include assets and income of CRTs or CLTs for Code Section 4968 purposes could require such institutions to include assets and income they have no legal right to and no ability to obtain and which they may never be entitled to use or benefit from.

Retirement and other employee benefit plan assets held in trust or otherwise for the exclusive benefit of employees. Assets held by employee benefit plans in trust for employees should be excluded from taxation under Code Section 4968 and the entities holding such assets should not be considered related organizations. These assets may or may not be invested with other assets of an educational institution but, by law, they are dedicated employee assets that the educational institution has no power to spend. Since these assets cannot be used by or for the benefit of the applicable educational institution, consistent with the goals of Code Section 4968, they should not be taken into account for purposes of Code Section 4968.

Supporting Organizations Concerns

The scope of supporting organizations treated as “related organizations” for purposes of Code Section 4968 should be narrowed. As noted, for purposes of Code Section 4968, a “related organization” of an applicable educational institution includes any organization which is “an organization described in section 509(a)(3), during the taxable year with respect to such institution.” This definition picks up any organization “operated, supervised, or controlled” by one or more applicable educational institutions (“Type I supporting organizations”), any organization “supervised or controlled in connection with” one or more applicable educational institutions (“Type II supporting organizations”) and also any organization “operated in connection with” one or more applicable educational institutions (“Type III supporting organizations”).

The inclusion of Type I and Type II supporting organizations is consistent with the overall purposes underlying the enactment of Code Section 4968 and the inclusion of assets and income of related organizations within the scope of Code Section 4968. The treatment of Type III supporting organizations as related organizations, however, is too broad. Type III supporting organizations are not required to be controlled by their supported organizations, nor required to be under common control with the supported organizations. All that is required is that the supported organization have some influence and some involvement in the supporting organization. Type III supporting organizations and their supported organizations are not required to have the type of close relationship that warrants including assets and income of related organizations in the assets and income of applicable educational institutions. This is particularly true if a Type III supporting organization supports multiple different organizations. The definition of “related organization” should therefore be narrowed to exclude Type III supporting organizations.

Additionally, rules should be adopted for allocating assets and income among multiple supported organizations. A supporting organization can be organized and operated to support more than one supported organization. IRC 4968(d)(1)(A) clearly contemplates that, where a supporting organization supports multiple applicable educational institutions, the assets and income of the supporting organization should be taken into account only by one applicable educational institution to avoid double-counting of such assets. A similar rationale should apply to prevent an applicable educational institution from being required to count assets and income that are properly allocable to another supported organization that is not an applicable educational institution. As such, Treasury should adopt a rule that would allocate assets and income of a supporting organization among multiple supported organizations and require the applicable educational institution to take into account only its share of such assets and income. Such allocation could be based on an applicable educational institution's share of the total support provided by the supporting organization to all supported organizations over a defined look-back period (e.g., one year).