Page images

demands of shareholders for current earnings, that foundation managers' attention is diverted to business interests and/or family control, and that there are various forms of "self dealing" which arise from the relationship of the foundation with the business.

The Treasury Report recommended that a twenty percent limit should be placed on the voting interest that a private foundation may have in a business enterprise.

When hearings were held on the Treasury Report, later in 1965, comments were made on many of the different proposals contained in the Report; but with respect to the proposals relating to business holdings, the commentators were almost unanimous in their criticism of the divestiture requirements which would apply as the result of the twenty percent limit on business holdings.

When similar proposals were presented to the Congress during its consideration of the Tax Reform Act of 1969, Congressional attention was focused on two wellpublicized situations, one involving the struggle between the James Irvine Foundation and Mrs. Joan Irvine Smith, a principal stockholder in the Irvine Company and the other involving what appeared to be a holding company in Texas. The impact of the divestiture requirement on many other foundations and companies did not receive the same attention. Little consideration seems to have been given to the fact that the Congress had already enacted limitations on the conduct of unrelated businesses by private foundations (which provisions were further tightened in the 1969 Act) and that in the course of development of the 1969 Act rules against "self dealing" and requiring current distributions by foundations to public charities were also enacted.

As enacted, § 4943 is very complex and the summary below can only highlight the difficulty in its application and the resulting problems which are described more fully later in this statement.


Private foundations and disqualified persons (including, for this purpose, certain related foundations, S 4946 (a) (1) (H)) may not own together more than 20% (35% if a third person has effective control) of the voting stock of a business corporation, except as provided below for holdings as of May 26, 1969.

Holdings in excess of permitted limits which are acquired after May 26, 1969 by gift or bequest must be disposed of by the foundation within five years. Post-May 26, 1969 purchases of stock by a foundation or a disqualified person which create or increase aggregate holdings beyond permitted limits do not qualify for the five-year grace period, and may immediately result in tax penalties on the foundation. Where disqualified persons together own more than 20% (or 35%) of the voting stock of a corporation, the limitations on foundation holdings apply to nonvoting stock as well as voting stock based on value.

A general de minimis rule permits a foundation (together with related foundations) to hold not more than the greater of 2% of the voting stock and 2% of the value of all outstanding stock of a corporation. Holdings in a "functionally related business" or a business deriving 95% of its gross income from "passive sources" (both defined terms) do not constitute excess business holdings.

Similar rules apply to interests held by trusts, partnerships and other unincorporated organizations.

Holdings in proprietorships are entirely prohibited. This has the practical effect of prohibiting the conduct of an "unrelated trade or business", which public charities are permitted to do, subject to the payment of an unrelated business income tax.

Where a foundation does not reduce its business holdings to the maximum permissible limits within the required period of time, an annual initial tax is imposed on it equal to 5% of the value of the excess holdings. If the holdings are not reduced appropriately within a defined correction period, an additional tax of 200% of such value is imposed.

A "Grandfather Clause" provides special rules where the business holdings of a foundation (or a foundation and disqualified persons) exceeded the 20% (or 35%) limit on May 26, 1969. These special rules also apply to holdings acquired under trusts irrevocable on, or certain wills executed by, May 26, 1969, even though the actual ransfer to the foundation occurs later.

In general, grandfathered holdings are permitted to be retained, but are subject to reduction under certain circumstances as described below.

If, on May 26, 1969, the combined holdings of disqualified persons and the foundation exceed 50%, the holding are to be reduced over several phases. The first phase reduction periods are: 20 years where a foundation held more than 95% of the voting stock of the corporation; 15 years where the combined foundation and disqualified persons' holdings exceeded 75%; and 10 years where the combined holdings exceeded 50%. At the end of the first phase, the combined holdings cannot exceed (i) 50% of the voting stock of the corporation or, if less, (ii) 50% of the value of all outstanding shares.

After the expiration of the first phase, a second phase set of divestiture requirements become operational. If disqualified persons never own more than 2% of the corporate voting stock after the close of the first phase, the voting stock held by the foundation must be reduced to not more than 35% within an additional 15-year period. If disqualified persons do own more than 2% at any time after the close of the first phase, the stock held by the foundation must be reduced to 25%. Where May 26, 1969 aggregate holdings do not exceed 50% but exceed the 20% or 35% limits, a further decrease is generally not required if foundation holdings never exceed 25%, but may be required if there is an increase in the foundation or disqualified person level of holdings.

Grandfathered holdings are subject to reduction by operation of the "downward ratchet" rule. The rule, in effect, provides that if there is any increase in the holdings of disqualified persons, the holdings of the Foundation must be decreased accordingly and can never go up again to the former grandfathered or otherwise permitted level over 20% (or 35%), even if the holdings of disqualified persons are thereafter reduced.


In the fourteen years since the enactment of the Tax Reform Act of 1969 there has been ample time to observe the results of that Act and the time has now come to reexamine the policy and effect of certain of its provisions, particularly S 4943. In this Part of this statement, consideration will be given to the policy issues existing under the changed conditions of today; and in the next Part consideration will be given to practical problems arising from the application of the statute and corrective action that should be taken.

The following points or issues require examination to determine whether § 4943 currently represents sound policy:


Required Divestiture has Dried up an Important
Source of Assets for Charitable Purposes.

It is generally recognized that since the 1969 Act the rate at which new foundations have been created has decreased substantially. One of the principal reasons for this decrease is that the transfer of family business holdings to a foundation (whether during life or at death) would necessitate the divestiture of such holdings (or of their control) regardless of how beneficial the holding of such assets would be to charity and the community served.

It is fundamental that no one is required to make charitable gifts; they are voluntary. When the advantages of making a charitable gift or bequest in the form of property, such as stock in a family business, are lessened, and, in fact, such a gift is made disadvantageous by reason of a government directive forcing divestiture within a fixed time, the property is not likely to be given to charity at all but rather retained in private hands. Various studies have been conducted which establish that the tax laws can create an incentive to encourage charitable gifts or can have the opposite result when the making of such gifts is rendered more difficult under the tax laws.


In 1969, Congress placed limitations on the income tax deduction for gifts of appreciated property (such as stock in a family business) to a private foundation; but $ 4943 goes even further as a form of regulation by requiring the divestiture of such stock into the hands of strangers. Such divestiture penalizes gifts to the foundation not only by requiring a sale to outsiders but also because the required divestiture is likely to result in a loss in value, as in the case of any other forced sale. At a time when the country generally recognizes greater private resources are needed to be used to meet public needs, the penalizing nature of $ 4943 stands out in stark contrast and as inconsistent with public policy in a pluralistic society.

Effect Upon Small Businesses

By its policy of forcing divestitive, S 4943 confronts the owners of businesses with the fact that maintenance of an interest in the business is not encouraged and that contribution of such interest to charity, in the form of a family or other private foundation, is discouraged.

The result is that the alternative which is encouraged is a sell-out to a larger business, generally in the form of a tax free exchange of stock.

In fact, $ 4943 goes further, for if stock is contributed to a family foundation, the tax laws themselves become a vehicle to force a change in control of the business. Since there is a limit on the holdings of both "disqualified persons" and the foundation, an acquisition of stock by a dissident disqualified person can force the foundation to sell the stock, in order to avoid a penalty tax under S 4943 -. which penalty can be several times the value of the stock. Further such a sale can only be made to persons who are not family members.

Thus the owners of a business who put stock in a foundation may find that they have created the very vehicle which makes the business a takeover target. In this respect, the policy of $ 4943 is in sharp contrast to the efforts of the Congress in other provisions under the tax law (most notably IRC $ 6166) to ease the tax burden on family businesses so that divestiture is not required due to a tax provision.

C. The Effect Upon Community Resources, Employment and other Local Benefits

Typically, family or private foundations have been formed by individuals to fulfill a belief that wealth derived from a community should be returned for the benefit of that community. Whether this concept is entirely inspired by benevolence or is "good business", the result is the same. The foundation, which is created to hold stock in a local business and receive dividends which are distributed in support of local charities, creates in the community not only a very substantial stake in the foundation but also in the business.

In many cases, the effect of $ 4943 is to threaten that community system because forced divestiture of stock is likely to place the control of a business in the hands of interests that have no ties to the community and which view the business solely from the standpoint of the bottom line. Cases have been presented to the Congress where local businesses, whether in the form of a hotel, a newspaper, or a manufacturer which is a substantial employer in the community, are faced with a threat that control will pass out of local hands and into those who do not have the same or traditional interest in the community. Certainly such

« PreviousContinue »