Part 8: Self-Dealing
By David A. Handler and Alison E. Lothes
Originally written for WealthManagement.com
In PLR 201407023 (Nov. 18, 2013), the taxpayer established an LLC of which he was the sole member. Those members owning voting units (managing members) managed the LLC. Managing members could invest LLC property, generally exercise the rights of a general partner and determine whether to make distributions (which would be made pro rata to the members, in proportion to their unit ownership). The LLC could be dissolved only with the written approval of members holding at least 50 percent of the units in each member class, voting and non-voting.
The LLC’s sole asset was a promissory note issued by the taxpayer’s daughter. The note was the LLC’s only source of income. The LLC was to be engaged solely in passive activities and not in any business enterprise.
The taxpayer wished to leave non-voting units in the LLC to the private foundation (PF) he established at his death. He requested a ruling on whether the PF’s ownership interest in the LLC would be self-dealing.
Under IRC 4941(d)(1), self-dealing includes the lending of money or other extension of credit between a PF and a disqualified person. Among others, a disqualified person includes a substantial contributor, a PF director or officer and any spouse, ancestor, child or grandchild of the contributor, director or officer. Treas. Regs. Section 53.4941(d)-2(c) provides that an act of self-dealing occurs when a note, the obligor of which is a disqualified person, is transferred by a third party to a PF that becomes the creditor under the note.
Under the regulations, a PF is deemed to control an organization if it or one of its managers may, by aggregating their votes or positions of authority, require the organization to engage in a transaction that would constitute self-dealing. Under the examples in the regulations (Treas. Regs. Section 53.4941(d)-1(b)(8), Example 1) and PLRs, a transaction between an entity controlled by a PF and a disqualified person may constitute indirect self-dealing if the transaction would be self-dealing if it were between the PF and disqualified person directly.
The IRS found that the taxpayer and his daughter were disqualified persons with respect to the PF. However, it held that the PF’s ownership of non-voting units in the LLC wouldn’t constitute an act of self-dealing because the PF wouldn’t have “control” over the LLC for the purposes of the regulations. It found that the PF’s non-voting interest lacked any power to control the operation or management of the LLC. The court didn’t find the PF’s power to participate in a vote for dissolution a necessary veto power that could constitute control. It noted that, because the PF would only receive distributions if the managing members authorized distributions to the members or if the LLC dissolved (which could only be compelled by the other members), it had no right to any distributions of income from the LLC (that is, the income from the note).
Ultimately, the IRS determined that, because the PF didn’t control the LLC, the creditor status of the LLC couldn’t be imputed to the PF, and the PF wasn’t deemed to be making a loan to a disqualified person. Because the loan wasn’t between the PF and a disqualified person, it didn’t constitute self-dealing, direct or indirect. The PLR does note that the liquidation of the LLC, however, could result in a self-dealing transaction, presumably because at that time, the PF would hold a direct interest in the note.
Self-dealing encompasses many types of transactions, and indirect self-dealing expands the scope of what may constitute an impermissible transaction. However, if a PF has a non-controlling interest in an entity, it may not necessarily step into the entity’s shoes for the purposes of the self-dealing rules. This PLR indicates that an LLC could be a useful tool when a PF is involved; if the PF doesn’t control the LLC, it’s possible that the LLC’s transactions may not be imputed to the PF—at least in a loan transaction.