"Newman's Own" Exception to Excess Business Holdings Rule Allows Private Foundations to Own 100% of a Business Enterprise

"Newman's Own" Exception to Excess Business Holdings Rule Allows Private Foundations to Own 100% of a Business Enterprise

Article posted in Foundations, Revenue Rulings on 29 October 2018| comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 29 October 2018
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Summary

New Section 4943(g) now allows Private Foundations to overcome the excess business holdings rule. While strict in many ways, it does permit new planning opportunities for advisors and families.

By Richard L. Fox, Esquire

Since the enactment of the “excess business holdings” rule of Section 4943 under the Tax Reform Act of 1969 (the “1969 Act”), a private foundation could not under any circumstances be used to maintain sole ownership of a business enterprise. This absolute prohibition is now no longer in place as result of the enactment of the Philanthropic Enterprise Act of 2017 as part of the Bipartisan Budget Act of 2018, under which an exception to the excess business holdings rule was created to allow a private foundation to own 100% of an operating business provided, however, certain rather stringent requirements are met under new Section 4943(g).  Contrary to rules in effect since the 1969 Act, if the requirements under the new exception are met, owners of companies that want to devote all profits from their businesses to charity may now place their companies under the sole ownership of a private foundation and permanently devote all of their profits for charitable purposes.  This new exception creates what is, in essence, a “philanthropic business enterprise” that is exempt from the excess business holdings rule. 

The new exception to the excess business holdings rule, effective for tax years beginning after December 31, 2017, was championed by the Newman’s Own Foundation, a private foundation to which famed actor and philanthropist Paul Newman bequeathed the sole ownership interest of a for-profit company that produces and sells the Newman’s Own line of food products. While Section 4943(g) was intended to provide a life-line to the Newman’s Own Foundation by allowing it to indefinitely maintain 100% ownership of the for-profit company founded by Paul Newman, and indeed the exception has been commonly referred to as the “Newman’s Own exception,” meeting the requirements of this new provision, particularly the independence requirement, may prove quite challenging, if not insurmountable, in most situations. And, even if a private foundation can meet the requirements of Section 4943(g), the foundation must still have sufficient liquidity to meet the 5% annual payout requirement under Section 4942 with respect to the fair market value of its interest in the for-profit company, thereby creating another possible significant obstacle to a foundation’s 100% ownership of a business enterprise. 

Background on Excess Business Holdings Issue Facing Newman’s Own Foundation

During the year 2008, the Newman’s’ Own Foundation received a 100% ownership interest in the for-profit corporation owning the Newman’s Own line of food products as a result of a bequest made upon the death of its founder, Paul Newman. But for the 5-year grace period provided for bequests under Section 4943(c)(6), the 100% ownership interest in the for-profit corporation would have caused the foundation to become subject to the excise tax provisions under the excess business holdings rule of Section 4943.  The foundation was apparently able to obtain an additional 5-year extension under of time under Section 4943(c)(7) to dispose of the excess business holdings, thereby giving the foundation a grace period extending until the year 2018 before the excess business holdings rule excise tax would be triggered if it did not dispose of the excess holdings before such time.  During the 10-year grace period provided under Section 4943, Robert Forrester, the president and chief executive office of Newman’s Own Foundation, had spent years building support for a legislative solution to the excess business holdings rule that would allow the Newman’s Own Foundation to continue to indefinitely retain 100% ownership of the for-profit Newman’s Own brand company. 

The Solution: Enactment of New Section 4943(g)

Section 4943(g) provided a solution to the excess business holdings rule plaguing the Newman’s Own Foundation by permitting a private foundation to hold 100% ownership of a business enterprise provided, however, that certain rather stringent requirements are met.  While this new exception was championed by the Newman’s Own Foundation, it applies, of course, to any private foundation meeting its requirements, although it was clearly fashioned for the Newman’s Own Foundation situation. The purpose of new Section 4943(g) as expressed by the House Ways and Means Committee is as follows:

In recent years, a new type of philanthropy has combined private sector entrepreneurship with charitable giving, such as through the donation of a private company’s after-tax profits to charity. The Committee believes it is appropriate to encourage this form of philanthropy by eliminating certain legal impediments to its use, while also ensuring that private individuals cannot improperly benefit from amounts intended for a charitable purpose or inappropriately manage a taxable business. The Committee therefore believes it is appropriate to create an exception to the present-law private foundation excess business holdings rules for certain philanthropic business holdings. By so doing, the law will permit private philanthropists to bequeath an entire business to a private foundation, provided that the after-tax profits of the business will be paid to the foundation and certain other requirements are satisfied, while also ensuring that the donor’s heirs cannot improperly benefit from the arrangement.

The provisions of Section 4943(g) are aimed at addressing the concerns of Congress in originally enacting Section 4943 that the foundation managers of a private foundation would divert their interest to the maintenance and improvement of the business enterprise and away from their charitable duties, and that the business enterprise would be operated primarily for the benefit of family members of the donor to the foundation.  

Under the Newman’s Own exception under Section 4943(g), the excess business holdings rule “shall not apply with respect to the holdings of a private foundation in any business enterprise” if the following requirements are met:

  • The foundation meets an ownership requirement, generally requiring the foundation to own 100% of the voting stock of the business enterprise and for all of the foundation’s ownership interests in such enterprise to be acquired other than by purchase;
  • All profits of the business enterprise must be distributed to the foundation no later than 120 days after the close of the taxable year; and
  • The business enterprise is operated independently from the private foundation.

Ownership Requirement.  Under the ownership requirement, 100% of the voting stock in the business enterprise must be held by the private foundation at all times during the taxable year and all the private foundation's ownership interests, which would include both voting and nonvoting interests, in the business enterprise must have been acquired by the foundation by means “other than by purchase.” Interestingly, under previous version of bills containing the Newman’s Own exception, the ownership requirement used the heading “Exclusive Ownership” and required that “all ownership interests in the business enterprise are held by the private foundation at all times during the taxable year.” Such ownership interests also had to be acquired “under the terms of a will or trust upon the death of the testator or settlor, as the case may be,” thereby limiting the exception only to testamentary transfers. This is in contrast to the ownership requirement ultimately enacted under the Philanthropic Enterprise Act of 2017, which uses the heading “Ownership” and requires only that “100 percent of the voting stock in the business enterprise is held by the private foundation at all times during the taxable year.” And, rather than limiting the new exception to ownership interests passing to a private foundation upon death of the testator or settlor, such interests need only be acquired by the foundation “other than by purchase,” so that the Newman’s Own exception is available for both inter vivos and testamentary gratuitous transfers.   

Although the ownership requirement is couched in terms of “100 percent of the voting stock of a business enterprise” and a “business enterprise” for purposes of Section 4943 includes a corporation, a partnership, joint venture and sole proprietorship, because voting stock is only issued by a corporation, the new exception appears limited only to a private foundation’s holdings of a corporation.  Also, it would appear that because the 100% ownership requirement applies only to voting stock, the private foundation need not own any nonvoting stock issued by the corporation so that there can be other shareholders besides the private foundation, although such shareholders must own only nonvoting stock. While this conclusion seems valid based on the language of the ownership requirement set forth under Section 4943(g)(2), it appears to run afoul of the requirement under Section 4943(g)(3), discussed below, that all profits of the business enterprise must be distributed to the private foundation.  Therefore, even though nonvoting stock apparently could be issued to shareholders other than the private foundation, such stock could not pay dividends. That would seem to leave room only for the possible issuance to shareholders other than the private foundation of a class of nonvoting stock having no rights to dividends, essentially constituting only an equity or capital interest in the corporation.  

Distribution of Profits Requirement.  Under the distribution of profits requirement, the corporation must, not later than 120 days after the close of the taxable year, distribute an amount equal to its net operating income for such taxable year to the private foundation. The “net operating income” for this purpose is defined as an amount equal to the gross income of the corporation for the taxable year, reduced by the sum of (i) the income tax deductions allowed for the taxable year which are directly connected with the production of such income, (ii) the income tax imposed on the corporation for the taxable year, and (iii) an amount for a reasonable reserve for working capital and other business needs of the business enterprise.  Presumably, regulations will be issued under to provide guidance on meeting the distribution of profits requirement, including what constitutes a reasonable reserve for working capital and other business needs.   Because a private foundation is exempt from income tax under Section 501(a), dividends received by the foundation would not be subject to income tax, but would be subject to the net investment excise tax under Section 4940. 

As discussed above, under the general 5% annual distribution requirement under Section 4942, a foundation must make qualifying distributions with respect to the value of stock held in a corporation.  This is a major issue when considering contributing to a foundation a 100% ownership interest in a corporation having substantial value. Although the corporation must distribute all of its profits to the foundation under the Newman’s Own exception, such profits may not provide sufficient liquidity for the foundation to make qualifying distributions to meet the minimum annual distribution requirements under Section 4942.  If the profits of the corporation are not sufficient to meet the 5% distribution requirement, and the foundation does not otherwise have sufficient assets to satisfy such requirement, the foundation could find itself facing substantial excise tax under Section 4942.  Therefore, even if a private foundation can meet the stringent requirements of the exception to the business holdings rule under new Section 4943(g), the Section 4942 distribution requirement may create a significant obstacle to a foundation’s 100% ownership of a business enterprise. 

Independent Operation Requirement.  Under the independent operation requirement, at all times during the taxable year:

  1. no substantial contributor to the private foundation or family member of such a contributor is a director, officer, trustee, manager, employee, or contractor of the corporation (or an individual having powers or responsibilities similar to any of the foregoing);
  1. at least a majority of the board of directors of the private foundation are persons who are not either:
  1. directors or officers of the corporation, or

  1. family members of a substantial contributor to the private foundation; and

  1. there is no loan outstanding from the business enterprise to a substantial contributor to the private foundation or to any family member of such a contributor.

The independent operation requirement, while apparently workable in the Newman’s Own Foundation situation, has a lot of teeth, creating perhaps an insurmountable challenge to meet in most situations. Under the first prong of this requirement, the corporation owned by the foundation must be independent of the donor family, such that a substantial contributor to the foundation and any family member can have no connection to the corporation in any capacity. So, for example, for a founder of a private foundation who is the sole stockholder of a corporation for which he or she is also a director and officer and who desires to maintain that position during his or her lifetime, a lifetime gift of stock to the foundation would not be workable.  A testamentary transfer would still not work if the founder’s family members will be directors, officers, employees or contractors of the corporation after the founder’s death.  For a family-run business, therefore, unless there is a substantial change in the governance and operations of the company, which in most cases is likely not realistic, the Newman’s Own exception is not a viable option. The more likely candidate is a company that is operated by professional management, unrelated to the founder of the foundation, where family members also do not participate in company affairs in any capacity.

Assuming that a substantial contributor and family members of such contributor are not connected to the corporation so as not to disqualify the foundation under the first prong of the independent operation requirement, under the second prong, the foundation must be considered independent from both the corporation it owns, as well as family members of a substantial contributor.  As indicated above, this is achieved where at least a majority of the board of directors of the foundation are not (a) directors or officers of the corporation, or (b) family members of a substantial contributor.  It would be permissible, therefore, for a minority of the board of directors of the foundation to be (a) directors or officers of the corporation  (provided they are not family members of a substantial contributor) and (b) family members of a substantial contributor.  Provided this prong of the requirement is met, there is nothing that prevents family members of a substantial contributor from constituting the majority of the officers of the foundation, if the directors are so inclined to appoint them.  

Depending upon state law under which a foundation  is governed, it may also be possible for a substantial contributor or family members to retain the right to appoint the directors of the foundation.  Therefore, while family members of a substantial contributor cannot constitute a majority of the directors of a private foundation, they may be able to retain significant control over the foundation by retaining the right to appoint its directors.  Similarly, while a majority of the board of directors of the private foundation  cannot be directors or officers of the corporation, the foundation, as the 100% voting stockholder, has the right to appoint the directors of the corporation and, depending upon state law, have approval rights over fundamental transactions of the corporation.  Still, given that family members cannot comprise the majority of the directors of the foundation, or, as in many cases with private foundations, comprise the entire board, a private foundation seeking to satisfy the independent operation requirement will not have the same degree of control typically accorded family members of a private foundation. 

Conclusion

The Newman’s Own exception to the excess business holding rule under new Section 4943(g) offers a planning opportunity for a donor seeking to transfer 100% ownership of a business enterprise to a private foundation and to ensure that all profits of the business are devoted for charitable purposes. The requirements to meet the exception, however, are quite stringent and, while apparently workable in the Newman’s Own situation, may create an insurmountable challenge in most other situations.  Even if the requirements can be met, the foundation must still have sufficient liquidity to meet the 5% annual payout requirement under Section 4942 with respect to the fair market value of the business enterprise, thereby creating another possible significant obstacle to a foundation’s 100% ownership of a business enterprise. 

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