Letter Ruling 9815056, January 13, 1998
Uniform Issue List Information:
UIL No. 4940.00-00
Excise tax based on investment income
UIL No. 4941.00-00
Taxes on self-dealing
UIL No. 4943.00-00
Taxes on excess business holdings
UIL No. 4945.00-00
Taxes on taxable expenditures
Code Secs. 512 , 4940 , 4941 , 4943 and 4945
This is in response to a letter of November 4, 1996, submitted by an authorized representative requesting a ruling on M's behalf concerning the tax consequences of its proposed receipt and subsequent sale of certain donated timber under sections 512(b)(5) , 4940 , 4941 , 4943 , and 4945 of the Internal Revenue Code. The rulings requested are as follows:
1. The amounts realized by M from the dispositions under the Scaled Volume Timber Cutting Contract and the Agreed Volume Timber Cutting Contract will not constitute unrelated business taxable income pursuant to section 512(b)(5) of the Code.
2. M's activities in making the planned dispositions of the donated timber will not constitute a business enterprise for purposes of section 4943 of the Code.
3. M's gains derived from the dispositions of the donated timber will not be subject to the tax imposed by section 4940 of the Code.
4. The possible reversion of the donated timber to the donor due to an external event preventing the intended disposition within the prescribed time will not constitute self-dealing under section 4941 of the Code or a taxable expenditure under section 4945 .
M has been recognized as exempt under section 501(c)(3) of the Code and classified as a private foundation under section 509(a) . M's trustees include N.
N proposes to make contributions of timber to M to enable M to accomplish its charitable purposes. N will contribute the timber to M by delivering donative timber deeds to M. M states that the deeds will convey to M for a period of seven years all timber on a described timber area of less than 120 acres. The conveyance will include easements, licenses, and permits necessary to conduct logging operations for harvesting and removing the timber conveyed. Under the terms of the conveyance, if M fails to complete logging and removal of the timber within seven years, any timber remaining on the timber area will revert to N. M states that N has held the property for substantially longer than one year.
M represents that the purpose of the seven-year reversion provision in the timber deed is to relieve M from the burden of carrying unmanageable and speculative assets and the requirements imposed on owners of timberlands by O state law. Under O state law, timberland owners are subject to an annual fire protection tax and are charged with the responsibility of controlling and extinguishing fires. In addition, O state law requires owners of timber to leave trees in harvested areas as buffers for streams and roads. Timber owners are also required to reforest harvested land under certain circumstances.
Timber that M is unable to liquidate will be considered a non-productive asset. M states that the reversion provision will remove the burdens and responsibilities of maintaining any nonproductive timber assets imposed by O state law. M states that the donations of timber by N in immediately saleable form will allow it to maximize the return from the timber sales and better enable M's directors to further M's charitable purposes.
M proposes to dispose of the donated timber by entering into agreed volume timber cutting contracts or scaled volume timber cutting contracts. The contract for the sale of the donated timber will be executed after the timber is offered for sale to prospective buyers in a competitive bidding process.
M states that it will use the agreed volume contract to sell donated old growth timber, which should be clearcut. M represents that agreed volume contracts are easier and less costly to administer and assures maximum utilization of the timber from such cuts. These contracts will call for a given area to be clearcut. The agreed volume contract establishes a total purchase price based on the volume the parties agree is the entire merchantable volume in the contract area. Timber volume estimates are derived from cruise data provided by M and the buyer's independent cruise of the timber. The term of each contract will be no more than three years.
M states that it will use the scaled volume contract primarily for those tracts that require thinning or selective cutting rather than clearcutting. The term of each contract will be for no more than three years. M states that the terms of the contract authorizes the buyer to cut and remove all designated merchantable timber within the contract area. The buyer agrees to pay M twice monthly for all timber cut and removed in the previous half-month period, based on the unit prices stated in the contract multiplied by the scaled volume of timber cut and removed during the payment period.
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, scientific or educational purposes no part of the net earnings of which inures to the benefit of any private shareholder or individual.
Section 511(a)(1) of the Code imposes a tax on the unrelated business taxable income of organizations described in section 501(c)(3).
Section 512(a)(1) of the Code provides that the term "unrelated business taxable income" is defined as the gross income derived by an organization from any unrelated trade or business (as defined in section 513 ) regularly carried on by it, less certain deductions, and subject to the modifications contained in section 512(b) .
The modifications contained in section 512(b)(5) of the Code exclude from unrelated business taxable income all gains or losses from the sale, exchange, or other disposition of property other than--
(A) stock in trade or other property of a kind which would properly be includible in inventory if on hand at the close of the taxable year, or
(B) property held primarily for sale to customers in the ordinary course of the trade or business.
Section 512(b)(5) of the Code further provides that the exclusion from unrelated business taxable income shall not apply to "the cutting of timber which is considered, on the application of section 631 , as a sale or exchange of such timber."
Section 1.512(b)-1(d)(1) of the Income Tax Regulations provides, in part, that the exclusion from unrelated business taxable income contained in Code section 512(b)(5) "does not apply with respect to the cutting of timber which is considered, upon the application of section 631(a) , as a sale or exchange of such timber."
Section 631(a) of the Code provides, in general, that the income realized by a taxpayer who disposes of his timber by cutting it himself is taxed as capital gain, provided he has owned such timber or has held a contract right to cut such timber for a period of one year.
Section 631(b) of the Code provides, in general, that in the case of the disposal of timber held by the owner for more than one year under a contract by which the owner retains an economic interest in the timber, the difference between the amount realized from the disposal of such timber and its adjusted depletion allowance shall be considered as though it were a gain or loss on the sale of the timber.
Section 4940(a) of the Code provides for the imposition of a tax on the net investment income of private foundations.
Section 53.4940-1(f)(1) of the Foundation and Similar Excise Tax Regulations provides that in determining capital gain net income (net capital gain for taxable years beginning before January 1, 1977) for purposes of the tax imposed by section 4940 , there shall be taken into account only capital gains and losses from the sale or other disposition of property held by a private foundation for investment purposes (other than program-related investments, as defined in section 4944(c) ), and property used for the production of income included in computing the tax imposed by section 511 except to the extent gain or loss from the sale or other disposition of such property is taken into account for purposes of such tax. For taxable years beginning after December 31, 1972, property shall be treated as held for investment purposes even though such property is disposed of by the foundation immediately upon its receipt, if it is property of a type which generally produces interest, dividends, rents, royalties, or capital gains through appreciation (for example, rental real estate, stock, bonds, mineral interests, mortgages, and securities).
Section 4941(a) of the Code provides for the imposition of tax on each act of self-dealing between a disqualified person and a private foundation.
Section 4941(d)(1)(E) of the Code states that the term "self dealing" means any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation.
Section 53.4941(d)-2(c)(2) of the regulations provides that the term "self-dealing" does not include the lending of money or other extension of credit by a disqualified person to a private foundation if the loan or other extension of credit is without interest or other charge.
Section 53.4941(d)-2(d)(3) of the regulations provides that the furnishing of goods, services, or facilities by a disqualified person to a private foundation shall not be an act of self-dealing if they are furnished without charge. Thus, for example, the furnishing of goods such as pencils, stationery, or other incidental supplies, or the furnishing of facilities such as a building, by a disqualified person to a foundation shall be allowed if such supplies or facilities are furnished without charge.
Section 4943(a)(1) of the Code imposes an excise tax on the excess business holdings of a private foundation in a business enterprise.
Section 4943(c)(1) of the Code states that "excess business holdings" means, with respect to the holdings of any private foundation in any business enterprise, the amount of stock or other interest in the enterprise which the foundation would have to dispose of to a person other than a disqualified person in order for its remaining holdings in the enterprise to be permitted holdings.
Section 4943(d)(3)(B) of the Code provides that the term "business enterprise" does not include a trade or business at least 95 percent of the gross income of which is derived from passive sources.
Section 53.4943-10(c)(2) of the regulations provides that gross income from passive sources includes gains and losses from the disposition of certain property as provided in section 512(b)(5) of the Code.
Section 4946(a)(1) of the Code provides, in part, that the term "disqualified person" shall not include any organization which is described in section 501(c)(3) (other than an organization described in section 509(a)(4) ).
Section 4946(a)(1) B) of the Code defines a disqualified person to include, with respect to a private foundation, a foundation manager.
Section 4946(b)(1) states that the term foundation manager includes a trustee of a foundation having the authority or responsibility over the activities of the foundation.
Section 4945(d)(5) of the Code defines "taxable expenditure" to include an amount paid or incurred by a private foundation for a purpose not specified in section 170(c)(2)(B) .
Section 512(b)(5) of the Code provides, as a general rule, that in the computation of unrelated business income, capital gains are to be excluded. The exclusion from unrelated business income of all capital gains does not apply to the cutting of timber which under section 631(a) of the Code is treated as a sale or exchange of such timber. However, the exclusion does not apply to gains realized from the disposal of such timber under section 631(b) . Disposals of timber pursuant to section 631(b) are treated as capital gains regardless of whether such timber is property held by the taxpayer primarily for sale to customers in the ordinary course of the trade or business.
In Zemurray Foundation v. United States, 755 F. 2d 404 (5th Cir. 1985) [85-1 USTC ¶9276 ] the court affirmed the determination of the district court that the capital gains from the foundation's sale of certain timberlands were not includible in the foundation's net investment income for purposes of the excise tax under section 4940 . The court also held that the district court's determination that the timberland at issue was not 'susceptible for use' to produce interest, dividends, rents, or royalties was not clearly erroneous. Additionally, the court held that section 53.4940-1(f)(1) 's category of property does not provide an independent basis of taxation under section 4940 and is valid only to the extent it reaches property which is of a type that generally produces interest, dividends, rents or royalties.
M plans to dispose of its timber interests under timber cutting contracts of the type described in section 631(b) of the Code. M has requested a ruling from the appropriate office within the Service that the sale of its timber interests is a sale described in section 631(b) of the Code. If a favorable ruling is issued, the gain received by M from the sale of its timber interests in timber donated by N will be excluded from unrelated business taxable income under section 512(b)(5) .
The timber interests donated to M are property interests which generally have not produced income from interest, dividends, rents or royalties as provided in section 53.4940 - 1(f)(1) of the regulations. Although the interests held by M are interests in timber rather than timberland as in Zemurray Foundation v. United States, supra, the timber interests held by M, for purposes of section 53.4940-1(f)(1) of the regulations, are not held for the production of income from interest, dividends, rents, or royalties. Therefore, the gains from sale of the timber interests held by M should not be considered capital gain income for purposes of the imposition of tax on net investment income under section 4940 of the Code.
The sale of timber interests will be those interests received from N. The timber interests donated to M were held by N for substantially more than one year. The gross income derived from the sale of M's timber interests constitutes a gain or loss from passive sources as described in section 53.4943 -(10)(c)(2) of the regulations. Therefore, M will not be engaged in a "business enterprise" as provided by section 4943(d)(3) of the Code.
N will donate her timber interests to M. The conveyance will be without charge or consideration. M will enter into timber cutting contracts to derive income from the sale of the donated timber. Any potential reversion to N will not result in an act of self-dealing since it will not be a transfer or use of the income or assets of M. In addition, the transaction will not result in a taxable expenditure by M, since M will not pay any amount or incur any costs with regard to the donation. Under the terms of the conveyance, timber which remains uncut after the seven year period will revert to N, the donor. Thus, the reversion can only occur if the timber has not been removed within seven years, the period for which M has been granted rights to the timber. The reversion will merely be the termination of a property right never permanently held by M. The reversion of interests in uncut timber will relieve M of the burden of paying fire protection taxes, reforestation of harvested land, and other requirements imposed on timber owners under O state law. Therefore, the expiration of M's interests in uncut timber and reversion to N will not be an act of selfdealing under section 4941(d)(1) or a taxable expenditure under section 4945 of the Code.
Based on the above, and assuming the disposal of timber interests held by M is of the type described in section 631(b) of the Code, we rule as follows:
1. The amounts realized by M from the dispositions under the Scaled Volume Timber Cutting Contract and the Agreed Volume Timber Cutting Contract will not constitute unrelated business taxable income pursuant to section 512(b)(5) of the Code.
2. M's activities in making the planned dispositions of the donated timber will not constitute a business enterprise for purposes of section 4943 of the Code.
3. M's gains derived from the dispositions of the donated timber will not be subject to the tax imposed by section 4940 of the Code.
4. The possible reversion of the donated timber to the donors due to an external event preventing the intended disposition within the prescribed time will not constitute self-dealing under section 4941 of the Code or a taxable expenditure under section 4945 .
This ruling applies only to those disposals of timber interests which meet the requirements of section 631(b) of the Code.
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.
Because this letter could help resolve any future questions about M's exempt status and unrelated trade or business activities, please keep a copy of this ruling in the organization's permanent records.
We are informing your key District Director of this ruling.
Sincerely yours, Edward K. Karcher, Chief, Exempt Organizations, Technical Branch 3.