This summer, the Internal Revenue Service issued final regulations (the “Final Regulations”) that provide guidance under Section 4965 of the Internal Revenue Code, relating to tax-exempt entities’ involvement in prohibited tax shelter transactions. Although tax-exempt investors should still take note of Section 4965 and its implications, the Final Regulations eliminate one of the biggest potential pitfalls for a tax-exempt investor with respect to inadvertently becoming a “party” to a prohibited tax shelter transaction through its investments.
Under Code Section 4965, a prohibited tax shelter transaction is (A) any listed (or subsequently listed) transaction, or (B) any reportable transaction which is a confidential transaction or a transaction with contractual protection. Code Section 4965 imposes penalties on any tax-exempt entity (including a public charity, a private foundation, or other tax-exempt organization) that is a “party” to a prohibited tax shelter transaction and in certain cases also on its managers. (For a more detailed discussion of Code Section 4965, please see the July 2006 Quarles & Brady Tax-Exempt Organizations Update, “New Penalties for Tax-Exempt Entities Participating in Prohibited Tax Shelter Transactions.”)
In July 2007, the IRS issued Proposed Regulations under Code Section 4965 (the “Proposed Regulations”), which set forth three ways in which a tax-exempt entity would be deemed to be a “party” to a prohibited tax shelter transaction. According to the Proposed Regulations, to be considered a “party” the tax-exempt entity must: (i) facilitate a prohibited tax shelter transaction by reason of its tax-exempt, tax-indifferent, or tax-favored status, (ii) enter into a listed transaction and reflect on its tax return a reduction or elimination of its liability for applicable federal employment, excise, or unrelated business income taxes that is derived directly or indirectly from tax consequences or tax strategy described in the published guidance that lists the transaction, or (iii) be identified by published guidance, by type, class, or role as a party to a prohibited tax shelter transaction.
Many tax-exempt organizations pay unrelated business income taxes or private foundation excise taxes on some or all of their investment income. Accordingly, we noted in the July 2007 Quarles & Brady Tax-Exempt Organizations Update, “IRS Issues Guidance Regarding Charitable Organizations Involved in Prohibited Tax Shelter Transactions: Investors Take Note” (the “2007 Quarles Update”), that clause (ii) of the foregoing definition could have significant implications for many tax-exempt organization investors. Because the definition of a “party” in the Proposed Regulations included a tax-exempt entity that reflects on its tax return a reduction or elimination of its own federal tax liability, it appeared that any entity that incurred an unrelated business taxable income (“UBTI”) loss or reduced UBTI income as a result of its investment in a private investment fund would be deemed a party to the prohibited tax shelter transaction if any of that loss or reduction was derived directly or indirectly from tax consequences or tax strategy described in the published guidance that listed the prohibited tax shelter transaction. A tax-exempt entity often will be unable to assess whether its investment in a fund will result in a UBTI loss or reduced UBTI income and whether any such loss or reduction will be derived directly or indirectly from certain tax consequences or tax strategy (which are likely unknown at the time of the investment). Accordingly, we expressed concern in the 2007 Quarles Update that such a tax-exempt entity might be at risk of inadvertently becoming subject to Code Section 4965 as a result of its investments in private funds.
Furthermore, for a private foundation a reduction in the foundation’s one percent or two percent excise tax on net investment income (if derived directly or indirectly from tax consequences or tax strategy described in the published guidance that lists a prohibited tax shelter transaction) also might have resulted in a determination that the foundation was a party to the prohibited tax shelter transaction under the definition in the Proposed Regulations.
In the 2007 Quarles Update, we expressed our hope that changes would be made to minimize the risk to tax-exempt entities investing in typical investment funds.
The Final Regulations Redefine “Party”
The Final Regulations closely track the Proposed Regulations, with the one notable exception of the definition of a “party” to a prohibited tax shelter transaction. The Final Regulations provide that there are two ways in which a tax-exempt organization may be a party if it:
- facilitates a prohibited tax shelter transaction by reason or its tax-exempt, tax-indifferent, or tax-favored status, or
- is identified in published guidance, by type, class, or role as a party to a prohibited tax shelter transaction. This definition eliminates the problematic second prong of the definition set forth in the Proposed Regulations, and the Explanation section regarding the Final Regulations provides some useful insight into the reasoning behind this change.
In the Explanation section, the IRS states that “the IRS and the Treasury Department believe that, as a general rule, a tax-exempt entity that engages in a listed transaction to reduce or eliminate its own tax liability should not be considered a party to a prohibited tax shelter transaction for purposes of [Code S]ection 4965.” The IRS recognizes that, although tax-exempt entities are generally exempt from tax, such entities may be subject to some form of federal taxation in a variety of circumstances. When such circumstances exist, it is legally permissible for tax-exempt entities (like other entities that are not exempt from federal income tax) to seek ways to reduce or eliminate their tax liability. Further, like similarly situated taxable entities, tax-exempt entities that engage in such transactions are subject to certain disclosure requirements. Additionally, the IRS specifically notes that, in the definition of “party” set forth in the Proposed Regulations, the IRS has reserved the right to identify in published guidance specific transactions or circumstances in which a tax-exempt organization that enters into a prohibited tax shelter transaction to reduce or eliminate its own tax liability will be treated as a party to a prohibited tax shelter transaction for purposes of Code Section 4965.
Quarles & Brady LLP Commentary
We are quite pleased that the IRS recognized and responded to our concern regarding the now deleted provision of the Proposed Regulations’ definition of a “party.” We believe this change helps to reduce the likelihood that a tax-exempt investor will inadvertently become a party to a prohibited tax shelter transaction by investing in a private investment fund that, in turn, invests in such a transaction. Tax-exempt investors no longer need to consider avoiding investments in funds that generate UBTI in order to minimize their risk of becoming parties to prohibited tax shelter transactions or adding disclosures to their Forms 990 or 990-PF to address the Proposed Regulations’ definition of “party.” We caution, however, that this change to the definition of “party” in the Final Regulations does not eliminate all risk to tax-exempt investors with respect to prohibited tax shelter transactions. Although the two prongs of the definition in the Final Regulations are less likely to give rise to an issue for a tax-exempt investor than the provision deleted from the Proposed Regulations, it still is possible for a tax-exempt investor to become a party inadvertently. Accordingly, tax-exempt entities should continue to take steps to help protect both the entities and their managers should they inadvertently become involved in a prohibited tax shelter transaction. These might include asking the general partner of the investment fund for a representation that the fund will not invest in or participate in prohibited tax shelter transactions and requesting withdrawal rights from the fund in the event that the tax-exempt entity’s participation in the fund would result in penalties under Code Section 4965. Tax-exempt investors also will need to review the tax information provided by funds in which they invest with respect to potential tax shelter transactions and to comply with any related reporting obligations.