Heirs can generally benefit from a step-up in basis of inherited assets to their fair market value (FMV) as of the date of the decedent's death. A recent program manager technical advice (PMTA) makes clear that, for purposes of an excise tax, a private foundation resulting from a charitable organization's ceasing to qualify as a public charity cannot claim a step-up upon the conversion — at least not one that happened in the last 52 years — despite a prior IRS letter ruling approving a step-up in similar circumstances.
PMTA 2022-01 was issued Nov. 18, 2021, and released Feb. 1, 2022. In it, the IRS Office of Chief Counsel was asked whether, for purposes of determining capital gain net income under Sec. 4940, the basis of property held by a tax-exempt organization under Sec. 501(c)(3) that is also a public charity under Sec. 509(c)(1), (2), or (3) is equal to its FMV on the date it no longer qualifies as a public charity and becomes a private foundation.
The resulting foundation would be liable for the excise tax on investment income under Sec. 4940(a), which is imposed currently at a rate of 1.39% on a foundation's net investment income for the tax year. One component of net investment income is capital gain net income. Sec. 4940(c)(1) provides that to the extent consistent with Sec. 4940, net investment income is determined under the principles of Subtitle A of the Code.
Generally, the PMTA notes, when determining gain or loss under Sec. 4940 from the sale or other disposition of property, basis is determined under the usual rules of Secs. 1011 through 1023 (Chapter 1, Subchapter O, Part II), subject to the special rules of Sec. 4940(c)(3)(B) and disregarding Sec. 362(c) (Sec. 4940(c); Regs. Sec. 53.4940-1(f)(2)(B)). (Sec. 4940(c)(3)(B) modifies deductions allowed in determining net investment income, and Sec. 362(c) is a special rule for the contribution of property other than money to a corporation's capital.)
The only provision appearing to support a step-up in basis to FMV of an organization's assets upon becoming a private foundation is Sec. 4940(c)(4)(B), which is a transition rule that applies only to property that was held by a foundation on Dec. 31, 1969 (the date of Sec. 4940's enactment), and continuously thereafter until its disposition, the PMTA notes. The basis of such property is its FMV on Dec. 31, 1969.
The PMTA notes that, under similar facts, IRS Letter Ruling 9852023, issued in 1998, held that the basis of property for the purpose of determining capital gain for the Sec. 4940 excise tax was the property's FMV on the date an organization ceased to be a public charity and became a private foundation.
The letter ruling involved the tax-exempt successor as parent to a publicly traded for-profit health maintenance organization (HMO), of whose stock the corporation had held more than 40% by vote for less than 15 years. The corporation planned to undertake transactions that would result in its conversion to a private foundation. Among other rulings requested, the corporation asked that the adjusted basis of the HMO stock and other assets, the gain on the sale of which would be subject to tax under Sec. 4940(a), would be equal to their FMV upon the conversion.
In the letter ruling, the IRS considered that if the corporation sold the HMO stock before its conversion, any resulting gain would be exempt from both federal income and excise tax. "Current market conditions," however, were likely to prevent a sale of any substantial amount of the stock during that time. Because "the Code and the regulations are silent on this type of circumstance," and the transition rule and its application in a revenue ruling "evidence an objective" that unrealized gains for certain assets "should not be subject to the [Sec.] 4940 excise tax," the letter ruling concluded the stock's adjusted basis would equal its FMV on the date the corporation ceased being a public charity.
In a footnote to PMTA 2022-01, the Office of Chief Counsel stated that it was aware of this letter ruling and summarily dismissed it, stating, "We believe PLR [private letter ruling] 9852023 is incorrect."
Observation: Chapter 1, Subchapter O, Part II, of the Code, where private foundations must look for the "usual rules" in this instance, includes Sec. 1014, which does provide a step-up in basis to FMV. But this provision applies only to property acquired from a decedent (as alluded to above), so it would not be usual in the conversion of a public charity to a private foundation.
Rev. Rul. 76-424, which the letter ruling and PMTA both discussed, involved a decedent's specific and residuary bequests of stock to a private foundation, but the revenue ruling based its decision allowing a step-up in basis to FMV not on Sec. 1014 but on the transitional provision of Sec. 4940(c)(4)(B). The revenue ruling allowed the stock to be considered to have been held by the foundation on Dec. 31, 1969, despite the facts that, (1) under the residuary bequest, the property that ultimately passed to the foundation had not yet been identified by that date, and (2) the stock wasn't distributed until 1971 — a degree of discretion that might have encouraged the even greater latitude of the letter ruling.
- PMTA 2022-01
— Paul Bonner is a JofA news writer.