TAX-EXEMPT MAY FORM LLC TO MAKE LOANS.
LTR 9718036
- Institutional AuthorsInternal Revenue Service
- Code Sections
- Subject Area/Tax Topics
- Index Termsunrelated business income
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 1997-12236 (10 original pages)
- Tax Analysts Electronic Citation1997 TNT 86-31
UIL Number(s) 0501.03-00, 0511.00-00
Date: February 7, 1997
Refer Reply to: CP:E:EO:T:3
Employer identification Number:
Key District Office:
LEGEND:
A = * * *
B = * * *
C = * * *
D = * * *
x = * * *
Dear Sir or Madam:
[1] This is in reply to your letter dated July 3, 1996, as supplemented by subsequent correspondences, wherein you request several rulings with respect to the Federal tax consequences of the proposed transaction described below.
FACTS
1. BACKGROUND
[2] You are exempt from Federal income tax under section 501(c)(3) of the internal Revenue Code (hereinafter "Code") under the laws of the state of A and are classified as a publicly supported organization pursuant to an advance ruling. You state that as a publicly supported charity, you finance your activities primarily through the solicitation and receipt of donations and grants from private foundations and public donors.
[3] You state that you are a community development organization whose activities are designed to strengthen the economy of a region that compasses parts of three states, A, B, C. The region covers 55 counties along the D in western A eastern B and northeastern C. You furnished information from a public agency that shows the region to be among the poorest area in the country.
[4] You state that the region is poorer and less developed economically than the rest of this tri-state area. Specifically, the region is plagued by a declining population base, stagnant job growth and low per-capita income. The opportunity for business expansion in the region is constrained by a predominantly unskilled, undereducated workforce and an economy in slow transition from agriculture to industry. You state that the region has a large minority population. You state that, based upon income and education demographics, the residents of the region typically have ranked below national averages, and the statistics are far worse for minority residents.
[5] Your purpose is to strengthen the economy of the region through local business development activities, and, thereby, to improve the quality of life for residents of the region. To accomplish this purpose, you currently provide financing, technical and management expertise and marketing services to businesses, with emphasis on minority entrepreneurs, in the region. The financial assistance includes short-term, long-term, and bridge loans for the funding of business start-up costs, working capital or new product development. The technical, management and marketing services offered include: technology skills training programs, technology extension networks, technology demonstration centers, shared equipment and services, new management techniques training programs, joint marketing efforts and new product development centers. As to minority entrepreneurs, you offer additional services that include recruitment, contract procurement and franchise opportunity programs.
[6] You state that you do not actively participate in the day- to-day operations of businesses to which you provide financial assistance. You state that you make periodic review the performance of the loan recipients to assure that the loaned funds are being used in a manner that furthers your exempt purposes. Occasionally, you would accept an equity interest in a business in exchange for financial assistance. In such cases, you state that you would dispose of any equity interest when the success of the business was reasonably assured.
[7] You state that the recipients of your assistance are selected on the ability of their businesses to provide permanent, full-time employment to residents of the region. Preference is given to those businesses located in areas of highest unemployment and lowest income, those creating the most jobs for the least amount of assistance, and those offering opportunities for minority ownership. You state that you select only businesses that are unable to obtain assistance from conventional sources due to either the depressed nature of the economy in the region or the minority affiliation of the business enterprise. You state that all services and financing are provided by you at non-commercial rates.
[8] You state that, as part of a fundraising efforts, you have targeted commercial banks in the region as a source of funds for your lending activities. You believe that your local banks have a strong interest in participating in economic development projects and may also have substantial incentives to do so under the Community Reinvestment Act.
2. PROPOSED TRANSACTION
[9] In order to attract financial support from local banks to support your said purpose, you propose to form a limited liability company (hereinafter "LLC"), and it will be classified as a partnership for federal income tax purposes.
[10] You state that the purpose and activity of the LLC, like you, will be the following: lend funds only to businesses unable to obtain financing from conventional sources due to either the depressed nature of the economy in the region or the minority affiliation of the business enterprise. The criteria used to evaluate each loan application include the following: 1) each applicant demonstrates that at least 50 percent of the jobs created or retained as a result of a loan will be filled by residents of a county within the region; 2) that county's median family income is less than 80 percent of the national median; 3) 20 percent of that county residents live at or below poverty level; 4) the county rate of unemployment exceeds the national rate by 50 percent or more; or the rate of decline in county population between the years 1980 and 1990 was 10 percent or more. The interest rate for the funds will be below rates offered by commercial banks. The LLC will not be involved in the day-to-day operations of recipients, but will review periodically the performance of the recipients to ensure that loans are being used in a manner consistent with your and the LLC's objectives and exempt purposes.
[11] You will provide, through the LLC, technical and managerial assistance to businesses that take part in the LLC loan program. Such assistance is designed to help these businesses to operate their activities effectively. You will also provide various services to the loan recipients through the LLC, and these services will include the screening of applicants and the rendering of technical and managerial assistance to loan recipients.
[12] You state that the income of the LLC will consist of interest and commitment fees received in respect to loans made by the LLC to qualified applicants, and maybe fees derived from advisory services rendered by the LLC to loan recipients.
[13] You state that you will solicit local banks to invest capital to the LLC in exchange for preferred interest in the profits of the LLC. You expect the LLC to be funded largely by these investors. You also expect to hold about a one percent or greater interest in the LLC.
[14] Pursuant to the LLC's operating agreement called the limited liability company agreement (hereinafter "operating agreement") between the LLC and investors, ownership interest of the LLC will consist of two classes of memberships, class A, owned by investors, and class B, owned entirely by you. The LLC will be governed and operated by a management committee (hereinafter "committee"). The committee will consist of seven members, three appointed by class A members and four by you, the class B member. You will be the controlling partner of the LLC.
[15] Initial capital contributions will be made by you and investors. Under the operating agreement, the capital contributions of the investors in the LLC will be represented by class A membership units with each such unit representing an ownership interest to x dollars. The amounts of the initial capital contributions from investors have yet to be determined.
[16] Under the operating agreement, distributions of net income will be in the following manner. Net income shall first be made to each class A member, i.e. investors, subject to the availability of cash, an amount equal to each unit owned by each class A member. The specific dollar amount has yet to be determined and will be negotiated in the future. The remainder of the net income (which you call "residual profits") will be divided between the two classes of memberships. You state that the percentage of the residual profits allocated to class B membership will be at least 80 percent. Class A membership will be allocated the remainder, and each class A member will receive pro rata of the residual profits in accordance to its membership units.
[17] Under the operating agreement, a member does not have any liability in excess of its share of any assets and undistributed profit of the LLC. You represent that you are not required to make additional capital contributions, to extend loans to or to defray the deficit of the LLC. You further represent that you will not agree to cover any losses incurred by the LLC in excess of operating revenues.
RULING REQUESTED:
[18] You request the following rulings:
1) Your participation as a managing member of the LLC will not
adversely affect your tax-exempt status under section 501 of the
Code;
2) Income derived by you from the lending activities of the LLC
will not be considered-unrelated business taxable income subject
to U.S. federal income tax under section 5ll of the Code.
LAW:
[19] Section 501(c)(3) of the Code provides, in part, for the exemption from federal income tax of organizations that are organized and operated exclusively for charitable, educational, or scientific purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual.
[20] Section 1.501(a)(3)-1(d)(1)(ii) of the Income Tax Regulations provides, in part, that an organization is not organized or operated exclusively for one or more of the purposes specified in subdivision (i) of this subparagraph 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.
[21] Section 1.501(c)(3)-1(d)(2) of the Regulations provides that the term 'charitable' includes the promotion of social welfare by organizations designed to relieve the poor and distressed, to lessen neighborhood tensions, or to combat community deterioration.
[22] Rev. Rul. 74-587, 1974-2 C.B. 162, describes an organization that was formed for the relief of poverty, the elimination of prejudice, the lessening of neighborhood tensions, and the combating of community deterioration in certain economically depressed areas through a program of financial assistance and other aid designed to improve economic conditions and economic opportunities in these areas. In furtherance of these objectives the organization devoted its resources to programs designed to stimulate economic development in high density urban areas inhabited mainly by low-income minority or other disadvantaged groups. The organization made loans and purchased equity interests in businesses unable to obtain funds from conventional sources because of financial risks associated with their location and/or because of being owned by members of a minority or other disadvantaged group. The Internal Revenue Service (hereinafter "Service") held that the organization qualified for exemption under section 501(c)(3) of the Code.
[23] Rev. Rul. 76-419, 1976-2 C.B. 146, describes an organization that was formed for the relief of poverty, dependency, chronic unemployment, and underemployment, and the reduction of community tensions in an economically depressed community. In furtherance of these purposes the organization encouraged industrial enterprises to locate new facilities in the economically depressed area in order to provide more employment opportunities for low-income residents of this area. The organization purchased blighted land in the area and converted it into an industrial park. Lots in the park are leased to industrial enterprises on terms sufficiently favorable to attract tenants to this economically depressed area. Tenants were required by their leases with the organization to hire a significant number of presently unemployed persons in the area and to train them in needed skills. The organization, in selecting tenants for the industrial park, considered only those industrial enterprises whose hiring policies conform to current fair employment legislation. The Service held that the organization furthered exclusively charitable purposes and qualified for exemption under section 501(c)(3) of the Code.
[24] Section 511 of the Code imposes a normal tax and a surtax on the unrelated business taxable income (defined in section 512) of organizations exempt from tax under section 501(c).
[25] Section 512(a)(1) of the Code provides that the term "unrelated business taxable income" means the gross income derived by any organization from any unrelated trade or business (defined in section 513) regularly carried on by it, less the allowable deductions which are directly connected with the carrying on of such trade or business.
[26] Section 513(a) of the Code provides that the term "unrelated trade or business" means, in the case of any organization subject to the tax imposed by section 511, any trade or business the conduct of which is not substantially related to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption.
[27] Section 1.513-1(d)(2) of the regulations provides that a trade or business is "related" to exempt purposes only where the conduct of the business activities has causal relationship to the achievement of exempt purposes (other than through the production of income). Further, it is "substantially related," for purposes of section 513 of the Code, only if the causal relationship is a substantial one. For this relationship to exist, the production of goods or the performance of the services from which the gross income is derived must contribute importantly to the accomplishment of exempt purposes. Whether the activities productive of gross income contribute importantly to such purposes depends in each case upon the facts and circumstances involved.
[28] Section 1.501(c)(3)-1(e) of the regulations provides that an organization may meet the requirements of section 501(c)(3) of the Code although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513.
[29] An organization is not operated exclusively for an exempt purpose if more than an insubstantial part of its activities are in furtherance of a nonexempt purpose. Better Business Bureau v. United States, 326 U.S. 279, 283 (1945).
ANALYSIS:
ISSUE 1:
[30] The first issue is whether your exemption under section 501(c)(3) is adversely affected by your proposed participation in the LLC. There are two requirements this said proposed transaction must satisfy before a conclusion can be made that your exemption will not be adversely affected. First, the LLC arrangement must serve charitable purposes, and, second, the LLC arrangement must permit you to act exclusively in furtherance of your exempt purposes without benefiting more than incidentally the limited partners of the LLC.
[31] Concerning the first requirement, the operating agreement of the LLC provides that its purpose is to strengthen the economy of the region through business and job creation so as to relieve poverty and unemployment that negatively affects the residents of the region. The Service has recognized as exempt from federal income tax certain economic development corporations on the rationales that these organizations relieve the poor and distressed, lessen neighborhood tension, eliminate prejudice and discrimination or combat community deterioration. See Rev. Rul. 76-419 and Rev. Rul. 74-587, supra. To determine whether a community development organization furthers these said charitable purposes, an analysis must be made whether assistance is being provided 1) to aid an economically depressed or blighted area; 2) to benefit a disadvantaged group, such as minorities, the unemployed or underemployed; and 3) to aid businesses that have actually experienced difficulty in obtaining conventional financing due to deteriorated area where they were or would be located or to the minority composition of the businesses.
[32] The information furnished shows that the region where the LLC will conduct its activities has a depressed economy and one of the poorest area in the country. The LLC represents, as described above, that it will only provide loans to businesses that cannot obtain financing from conventional sources due to either the depressed economy of the region or the minority affiliation of the business enterprises. Also, the loans provided will be below market rates. Given such data, we conclude that the LLC serves the charitable purposes as described in Rev. Rul. 76-419 and Rev. Rul. 74-587, supra.
[33] Concerning the second requirement, the information furnished shows that the arrangement under the operating agreement would permit you to act exclusively in furtherance of your exempt purposes without benefiting more than incidentally the limited partners of the LLC. Our conclusion is based on the following factors.
[34] First, the management of the LLC will reside with a committee comprised of seven members, the majority of whom will be appointed by you. Hence, you will be able to maintain control of the LLC and to deter the LLC from orienting toward a profit direction on behalf of the limited partners, the investors. Second, under the operating agreement, you are not required to make additional capital contributions, extend loans to or to defray the deficit of the LLC, if there is any. Further, under the operating agreement you will have no personal obligation for the repayment of the capital of the limited partners. You also represent that you will not cover any losses incurred by the LLC in excess of operating revenues. Your liability will be limited to the amount you will invest in the LLC, and that amount, you expect, would approximately be one percent interest in the LLC. Thus, your assets will be insulated from potential claims against the LLC. Fourth, although the profit distribution arrangement under the operating agreement is a two-tier structure -- certain amount of profit first goes to the limited partners and the remainder divided between you and limited partners -- there is no indication that this arrangement provides a disproportionate allocations of profits in view of the amount of the ownership interest, one percent, you will have in the LLC. Therefore, the private benefit to the limited partners is incidental to the public interest being served by the LLC.
ISSUE 2:
[35] You will receive distributions from the LLC, and those distributions are net income-consisting of interest and fees. received from loans made by the LLC to loan recipients. Since the said net income are derived from activities that further your exempt purposes, this income of the LLC will not be treated as unrelated business taxable income.
[36] We rule as follows:
1) The participation by you as a managing member of the LLC will not adversely affect your tax-exempt status under section 501(c)(3) of the Code;
2) Income derived by you from the lending activities of the LLC will not be considered unrelated business taxable income subject to the tax under section 511 of the Code.
[37] This ruling does not address the applicability of any section of the Code or regulations to the facts submitted other than with respect to the sections described.
[38] We are informing your key District of this ruling. Please keep this letter in your permanent records.
[39] This ruling is directed only to the organization that requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.
Sincerely,
Edward K. Karcher
Chief, Exempt Organizations
Rulings Branch 3
- Institutional AuthorsInternal Revenue Service
- Code Sections
- Subject Area/Tax Topics
- Index Termsunrelated business income
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 1997-12236 (10 original pages)
- Tax Analysts Electronic Citation1997 TNT 86-31