Reference:

Section 4944 -- Special Windfall Exemption Rules

Full Text:

CC:EE-109-85
March 11, 1986
Br3:PGAccettura Date
Numbered: July 18, 1986

Memorandum To:

S. Allen Winborne
Assistant Commissioner
(Employee Plans and Exempt Organizations)

Attention:

Director, Exempt Organizations Technical Division
By memorandum dated November 7, 1985, the Director, Exempt Organizations Technical Division (OP:E:EO) requested our consideration of a proposed technical advice memorandum on the above-captioned case.

ISSUE

Whether a foundation has made jeopardizing investments under IRC 4944(a)(1) where it has financed large purchases of publicly traded stock, through 90-day bank loans, in one corporation of less than "blue chip" quality, of which the foundation managers are employees.

CONCLUSION

We agree with the conclusion in your proposed technical advice memorandum that the foundation has made jeopardizing investments under section 4944(a)(1) where it has financed large purchases of publicly traded stock, through 90-day bank loans, in one corporation of less than "blue chip" quality, of which the foundation managers are employees.

FACTS

The foundation is a tax-exempt private foundation under section 509 and is not an operating foundation under section 4942(j)(3).

At various times over the two year period at issue here, the foundation borrowed large sums from a bank to purchase stock in one corporation. The corporation's stock is publicly traded on the over the counter market. The corporation has over * * * in total assets and over * * * in annual revenues. During the two fiscal years at issue here, the corporation's stock was generally considered to be average in safety and price performance by several leading investment rating services. The foundation's ownership of the corporation's stock has always been less than 2 percent of the total number of shares and total value of the outstanding stock of the corporation.

The Foundation has three trustees who supervise the foundation's investments. All three trustees have connections with the corporation. * * *

For the fiscal year 1982, the foundation's net worth was * * * at the start of the year and * * * at the end of the year. for that fiscal year of 1982, the foundation's stock in the corporation produced * * * of long-term capital gain and * * * of dividends on shares that were not debt-financed and * * * in dividends and * * * of long-term capital losses and * * * of interest expense on shares that were debt financed. For the fiscal year 1983, the foundation's net worth was * * * at the start of the year and * * * at the end of the year. For that fiscal year of 1983, the foundation's stock in the corporation produced approximately * * * of long-term capital gain, * * * of short-term capital gain, * * * of dividends and * * * of interest expense on shares that were debt-financed.

During the 2 years at issue here, the foundation incurred the following amounts of acquisition indebtedness of the corporation's stock: * * *. The 90-day bank loans were at annual rates of interest from about 20 percent declining to about 11 percent. The bank loans met the requirements for the bank under regulation U of the Federal Reserve Board. Regulation U provides generally that no bank shall extend credit, secured directly or indirectly by stock purchased with the extension of credit, in an amount that exceeds 50 percent of the market value of the stock serving his collateral for the extension of credit.

The following are the market prices for the stock over a five year period taking into account a * * *.

For the seven fiscal years 1978 through 1984, the foundation disbursed the following amounts as charitable distributions: * * *.

It appears that the foundation's investment in the corporation comprised an average of about seventy-five percent of the foundation's total investments.

You have only requested our consideration of the conclusion of your proposed technical advice memorandum that the foundation's investments in the corporation are jeopardizing investments under section 4944(a)(1), and that the foundation managers are not subject to tax under section 4944(a)(2).

ANALYSIS

Section 4944(a)(1) provides that if a private foundation invests any amount in such a manner as to jeopardize the carrying out of any of its exempt purposes, there is hereby imposed on the making of such investment a tax equal to 5 percent of the amount so invested for each year (or part thereof) in the taxable period. The section 4944(a)(1) tax is to be paid by the private foundation.

Section 4944(a)(2) provides that in any case in which a section 4944(a)(1) tax is imposed, there is hereby imposed on the participation of any foundation manager in the making of the investment, knowing that it is jeopardizing the carrying out of any of the foundation's charitable purposes, a tax equal to 5 percent of the amount so invested for each year (or part thereof) in the taxable period, unless such participation is not willful and is due to reasonable cause. The section 4944(a)(2) tax shall be paid by any foundation manager who participated in the making of the investment.

Section 4944(b) provides for additional taxes on the making of an investment described in section 4944(a)(1) if the investment is not removed from jeopardy within the taxable period.

With respect to jeopardizing investments, Treas. Reg. 53.4944- 1(a)(2)(i) provides the following:

(. . .) an investment shall be considered to jeopardize the carrying out of the exempt purposes of a private foundation if it is determined that the foundation managers, in making such investment, have failed to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long- and short-term financial needs of the foundation to carry out its exempt purposes. In the exercise of the requisite standard of care and prudence the foundation managers may take into account the expected return (including both income and appreciation of capital), the risks of rising and falling price levels, and the need for diversification within the investment portfolio (for example, with respect to type of security, type of industry, maturity of company, degree of risk and potential for return).

The determination whether the investment of a particular amount jeopardizes the carrying out of the exempt purposes of a foundation shall be made on an investment by investment basis, in each case taking into account the foundation's portfolio as a whole. No category of investments shall be treated as a per se violation of section 4944. However, the following are examples of types or methods of investment which will be closely scrutinized to determine whether the foundation managers have met the requisite standard of care and prudence: Trading in securities on margin, trading in commodity futures, investments in working interests in oil and gas wells, the purchase of "puts" and "call," and "straddles," the purchase of warrants, and selling short. The determination whether the investment of any amount jeopardizes the carrying out of a foundation's exempt purposes is to be made as of the time that the foundation makes the investment and not subsequently on the basis of hindsight. Therefore, once it has been ascertained that an investment does not jeopardize the carrying out of a foundation's exempt purposes, the investment shall never be considered to jeopardize the carrying out of such purposes, even though, as a result of such investment, the foundation subsequently realizes a loss.

The provisions of section 4944 and the regulations thereunder shall not exempt or relieve any person from compliance with any Federal or State law imposing any obligation, duty, responsibility, or other standard of conduct with respect to the operation or administration of an organization or trust to which section 4944 applies. Nor shall any State law exempt or relieve any person from any obligation, duty, responsibility, or other standard of conduct provided in section 4944 and the regulations thereunder.

The requisite standard of care and prudence required in section 53.4944-1(a)(2)(i) requires a case by case determination which involves some subjective evaluation. The prudent man rule is an investment standard which varies somewhat from state to state. It is defined in Black's Law Dictionary (5th ed. 1979) as ". . . the trustee may invest in a security if it is one which a prudent man of discretion and intelligence, who is seeking a reasonable income and preservation of capital, would buy." The Dictionary of Banking and Finance by Jerry Rosenberg (1982) states a virtually identical definition of the prudent man investment rule.

In this case, there are several key facts to consider in determining whether the foundation's investments were jeopardizing investments within the meaning of section 4944(a)(1) and section 53.4944-1(a)(2)(i). The first is the utilization of large loans to purchase stock. The second is the entire debt-financed investment, and a substantial majority of all investments, being made in the stock of one corporation of which the foundation managers are employees. The third factor is the type of stock involved in this case. We then must determine whether these factors, separately or in combination, cause the foundation's investments to be jeopardizing investments.

With regard to the first factor, the foundation procured hundreds of thousands of dollars in loans from a bank to purchase large quantities of stock in the corporation of which the foundation managers were fairly high level employees. The corporation's stock is traded publicly on the Over the Counter Market. During the period at issue the corporation's stock was considered to be an investment of average risk. At no time could the stock have been considered either an extremely high risk stock or a high quality "blue chip" stock. The bank loans were 90 day loans with the purchased stock utilized as collateral. Although the corporation's stock was considered to be an investment of average risk, the heavily leveraged method of purchase substantially increased the risk.

While bank loans of the type in this case do not have exactly the same character as the demand nature of margin trading they are obviously dissimilar from direct, debt-free, stock purchases. The regulations for bank loans are similar to those for margin trading since they both involve "leveraged" investments. We are of the opinion that the purchase of stock through loans is close enough to purchasing securities on margin to require close scrutiny pursuant to section 53.4944-1(a)(2)(i). This is particularly true when they are of a large size in proportion to the foundation's assets. That close scrutiny involves consideration of whether the investment met the requisite standard of care and prudence which would not jeopardize the carrying out of the foundation's exempt purposes.

Extensive investments through loans involve the foundation in substantial debt. While debt is not inherently jeopardizing and can, in fact, be beneficial, when it becomes as large as it is in this case there is a danger that an unexpected drop in the corporation's stock could cause the foundation to lose substantial sums in repaying the loan or, at worst, force the foundation into bankruptcy. Either result, of course, would seriously impair the foundation's ability to carry out its exempt purposes in both the long-and short-term. The loans involved here were 90-day loans. 90-day loans are less risky than trading on margin. However, we can not ignore the fact that the loans had the potential of seriously disturbing the ability of the foundation to carry out its exempt purposes. In fact, we note that over the last 3 years the foundation's charitable distributions have declined apparently due to the leveraged transactions involved here.

In this case, the foundation claims that the loans were not especially risky and, in fact, proved to be quite beneficial to the portfolio of the foundation. Further, the managers of the foundation claim that, as employees of the corporation, they had additional knowledge of the earnings of the corporation, its stability and stock exchange performance potential based on that knowledge. While this additional information argument may have some appeal one can easily argue that it is counter balanced by the possible bias the foundation managers have in favor of stock in the corporation in which they are high level employees and in which they are possibly personal owners of stock.

Our concern really rests in the combined impact of three factors: the large loans to buy the stock, the lack of sufficient diversification of the foundation's investments and the nature of the corporation involved as less than of "blue chip" quality. When these three factors are considered together, we are of the opinion that the investments do not indicate the exercising of the requisite standard of care and prudence. The large loans invested in one corporation of other than "blue chip" quality did jeopardize the carrying out of the exempt purposes of the foundation. The investments involved risks beyond those of a prudent investment. Additionally, section 53.4944- 1(a)(2)(i) states clearly that the success, or failure, of the investment is not relevant in determining whether it was a jeopardizing investment at the time it was made. In this regard, section 53.4944-1(a)(2)(i) mirrors S. Rep. No. 91-552, 91st Cong., 1st Sess. 46 (1969), 1969-3 CB 453-454. Also, there was no indication in the file that the foundation managers provided any explanation for the lack of diversity in the stock purchased with the large loans at regular intervals over several years. In re Muellers' Trust, 135 NW 2d 854, 863 (Wis. 1965), states, "a trustee can not ignore the rule requiring diversification merely because a particular stock is a prudent investment in terms of quality."

One other concern we have is whether there could have been self- dealing involved in this case which may be relevant to whether section 4944(a)(2) tax is due. For instance, as high level employees, it is likely that the foundation's managers own stock in the corporation as part of their personal stock portfolios. In fact, one of the foundation managers so states in the background file. As personal owners of the corporation's stock the foundation managers would certainly have a financial interest in its price performance. Under section 4946(a)(1)(B) the foundation managers are disqualified persons with respect to the foundation. Since the foundation was purchasing large blocks of stock, it is possible that these large purchases increased the market price for the stock or caused others to buy in response to the large purchase. This increase in price could have aided the personal financial situation of foundation managers. Section 53.4941(d)-2(f)(1) states that "the purchase or sale of stock . . . by a private foundation shall be an act of self-dealing if such purchase or sale is made in an attempt to manipulate the price of the stock . . . to the advantage of a disqualified person."

Obviously, the background file does not indicate that this has been the case. However, we think consideration should be given to requesting additional information on the buying and selling of the corporation's stock by the foundation managers for their own account. Regardless, in the future, we think consideration should be given to this issue where the purchases by a foundation are of a size to influence the market either directly or indirectly through the likely development of other buying and selling based on the large size of the foundation's transaction. This suspicion is heightened where the foundation managers have an obvious connection to the corporation whose stock is being bought or sold by the foundation.

Although we are of the opinion that the investments were jeopardizing investments, we agree with your conclusion that a section 4944(a)(2) tax on the foundation managers is not appropriate. On the facts as stated in the background file we can not conclude that the foundation managers made the investments willfully or without reasonable cause. However, we believe that if consideration of the foundation managers personal purchases of stock in the corporation indicate any attempt to personally profit from the large transactions made by the foundation we believe that would be evidence of a willful and knowing attempt to jeopardize the carrying out of the foundation's exempt purposes within the meaning of section 4944(a)(2).

We, therefore, agree with those parts of your proposed technical advice memorandum which state that the leveraged investments in the corporation were jeopardizing investments under section 4944(a)(1) and the foundation managers were not liable for section 4944(a)(2) tax.

James J. McGovern
Director

By: James L. Brokaw
Chief, Branch No. 3
Employee Plans and Exempt
Organizations Division

Enclosure:
Administrative Files