Technical Advice Memorandum Regarding Excess Business Holdings

Technical Advice Memorandum Regarding Excess Business Holdings

News story posted in Technical Advice Memoranda on 22 October 2014| comments
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Summary

The IRS recently released this TAM on excess business holdings. It's based on an interesting set of facts.

FULL TEXT:

Release Number: 201441021
Release  Date:  10/10/2014
Date: July 17, 2014
UIL Code: 4943.00-00

INTERNAL REVENUE SERVICE NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

E.O. Exams Programs and Review Internal Revenue Service
Attn:  EO Mandatory Review MC 4920 DAL
1100 Commerce Street
Dallas, TX  75242

Taxpayer's  Name: ***
Taxpayer's Address: ***
Taxpayer's Identification Number: ***
Tax Years Involved: ***
Date of Conference: ***

LEGEND: 

Foundation = ***
Year1 = ***
Year2 = ***
Year3 = ***
Year4 = ***
Years = ***
w = ***
Y. = ***

ISSUE:

Should the first-tier excise taxes under Internal Revenue Code ("I.RC.") § 4943 on Foundation's excess business holdings for the years at issue be abated in accordance with § 4962?

FACTS:

Foundation is a private operating foundation, exempt from taxation as described in §§ 501(c)(3) and 4942U)(3).  Its board of directors is comprised of the founder, his spouse, and his eldest son. Founder is a disqualified person ("DP") as a result of his contributions to Foundation. Under l.R.C. §4946(a), the directors and other family members are also DPs with respect to the Foundation.  These include founder's brother and his three other sons.

Investment firm, a venture capital firm co-owned by founder, is also a DP with respect to  Foundation pursuant to § 4946(a)(1)(F). Investment firm created eight different investment partnership funds ("funds"} over a number of years to invest in global venture capital investments. Over a six-year period, Foundation invested as a limited partner in four separate Investment firm funds. Disqualified persons invested in four other similar investment firm funds. While Foundation and DPs invested in different funds, seven of the eight funds invested in the same underlying companies.

Foundation engaged legal counsel to establish the organization and prepare its Form 1023 Application for Recognition of Exemption under Section 501(c}(3). Documents provided by  Foundation indicate this legal counsel had a continuing role as legal counsel for a number of years. Foundation also employed in-house counsel.

Separately, investment firm engaged different counsel to vet investment vehicles in which firm wanted Foundation to invest as a limited partner. An engagement letter between investment firm and its counsel presented a three-phase scope of representation. Included in Phase 1was the following work: (1) address legal issues involved in putting founder family funds under administration by investment firm; (2) address legal issues involved in doing same for the Foundation or otherwise providing compensated services to Foundation; and (3) consider effect of founder's roles as founder of Foundation and a principal of investment firm.

According to a letter of engagement post-dated by one year, Foundation also engaged investment firm's counsel to render an opinion concerning the investment firm providing investment advisory services for all or a portion of Foundation's endowment. The scope of engagement further states that:

The terms expressed in this letter shall be retroactive to the commencement of our work for Foundation. You have not engaged us to represent Foundation, and we have not represented Foundation in connection with any other matters, and we hereby acknowledge and agree that in other matters (including those in which Foundation may be involved} we represent investment firm.

The limited partnership interests in the investment funds were issued in private placements pursuant to an exemption from registration under the Securities Act of 1933. Such interests cannot be publicly traded. These securities can be offered only to certain "qualified investors" and are generally illiquid and not freely transferrable. Qualified investors must meet certain minimum income or asset thresholds.

According to information submitted by the Foundation, disqualified persons with respect to  Foundation became limited partners in some of the investment firm funds and DPs also acquired direct interests in portfolio companies held by many of these funds. The combined holdings of Foundation and disqualified persons in portfolio companies exceeded the permitted 20% threshold for excess business holdings under § 4943(c)(2}(A} for Year1, Year2, and Year3.  Foundation states this occurred without being obvious since Foundation and its disqualified persons held partnership interests in eight different funds.

Foundation states it discovered the excess business holdings when new accountants were preparing its Form 990-PF for the tax year ending September 30, Year3. Foundation filed Form 4720 to report excess business holdings for that tax year. While it had not yet corrected the excess business holdings, Foundation made a Request for Abatement under § 4962 of first-tier excise tax of $yt due for FY Year3. In its Form 4720 Return of Certain Excise Taxes under Chapters 41 and 42 of the lnternal Revenue Code and attached Request for Abatement, Foundation stated that it had also discovered excess business holdings during two earlier fiscal years, Year1 and Year2.  Foundation did not submit Forms 4720 for Year1 and Year2 at that time.  The I.RS. rejected Foundation's claim and forwarded  it to the relevant Field Office because corrective action had not been taken and the claim was for more than $.Once the excess business holdings were discovered, Foundation was unable to quickly sell its investments in Investment firm funds due to the restrictions imposed on these private placements.  Foundation ultimately disposed of all of its holdings in the funds during Year4 by donating the shares of the funds to a public charity exempt under §§ 501(c)(3) and 170(b)(1)(A)(ii). This donation of the investment firm funds corrected the taxable events of Year1, Year2, and Year3.

In Year5, Foundation filed Forms 4720 and Requests for Abatement under § 4962 of the first­ tier taxes on excess business holdings during its earlier fiscal years, Year1 and Year2. First-tier excise taxes due for excess business holdings in Year1 and Year2 are $ and $. respectively. Deficiency notices have been issued to the taxpayer for fiscal years Year1, Year2, and Year3. In total, Foundation requests abatement of $ in first-tier taxes for excess business holdings for the three years in question.

Foundation made two arguments in support of its requests for abatement based on reasonable cause:

1. Foundation reasonably relied on legal opinions when it made the investments that caused it to have excess business holdings; and

2. The excess business holdings were caused by ignorance that the taxable events occurred.

Foundation submitted various documents to support its position that it had reasonably relied on legal advice provided by counsel.

LAW:

I.RC. § 4943 imposes a tax of ten percent on the excess business holdings of any private foundation in a business enterprise during any taxable year.

I.RC. § 4943(c)(1) provides 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 the remaining holdings of the foundation in such enterprise to be permitted holdings.

I.RC. § 4943(c)(2)(A)  provides that the "permitted holdings" of any private foundation in an incorporated business enterprise are 20 percent of the voting stock, reduced by the percentage of the voting stock owned by all disqualified persons.

I.RC. § 4943(c)(2)(B) provides that "permitted holdings" in a corporation, where one or more persons who are not disqualified persons with respect to the private foundation have effective control, are not more than 35 percent of the voting stock held by the private foundation and all of its disqualified persons.

I.RC. § 4943(c)(3) provides that "permitted holdings" in a partnership shall be consistent with § 4943(c)(2), except that "profits interest" shall be substituted for "voting stock" and "capital interest" shall be substituted for "nonvoting stock."

I.RC. § 4943(d)(1) provides, in part, that in computing the holdings of a private foundation or a disqualified person with respect thereto, in any business enterprise, any stock or other interest owned, directly or indirectly by a partnership, shall be considered as being owned proportionately by or for its partners.

l.R.C. § 4943(d)(2) defines "taxable period" with respect to any excess business holdings of a private foundation in a business enterprise, as the period beginning on the first day on which there are excess holdings and ending on the earlier of:

(A) The date of mailing of a notice of deficiency, or
(B) The date on which the tax imposed by subsection (a) with respect to such holdings is assessed.

I.RC. § 4943(d)(3)(8) excludes from the term "business enterprise" a trade or business at least 95 percent of the gross income of which is derived from passive sources.

I.RC. § 4946(a) defines disqualified persons with respect to a private foundation.

I.RC. §§ 4946(a)(1)(A), (B), (C), and (D) defines disqualified persons with respect to a private foundation as a substantial contributor; a foundation manager; an owner of more than 20 percent of the total combined voting power of a corporation, the profits interest of a partnership, or the beneficial interest of a trust or unincorporated enterprise that is a substantial contributor; or a family member (as defined in subsection (d)) of any individual described in paragraph (A), (8), or (C).

I.RC. § 4946(a)(1)(E) defines as a disqualified person, a corporation of which persons described in subparagraph (A), (8), (C), or (D) own more than 35 percent of the total combined voting power.

I.RC. § 4946(a)(1)(F) defines as a disqualified person a partnership in which persons described in subparagraph (A), (B), (C), or (D) own more than 35 percent of the profits interest.

I.RC. § 4962(a) provides that if it is established to the satisfaction of the Secretary that:

1. A taxable event was due to reasonable cause and not to willful neglect, and
2. Such event was corrected within the correction period for such event,

then any qualified first-tier tax imposed with respect to such event (including interest) shall not be assessed and, if assessed, the assessment shall be abated and, if collected, shall be credited or refunded as an overpayment.

I.RC. § 4963 provides definitions for excise tax, taxable event, correction, and correction period with regard to Chapter 42 taxes. In the case of § 4943, "taxable event" means any act (or failure to act) giving rise to liability under § 4943; the taxable event occurs on the first day on which there are excess business holdings; "correct" means reducing the amount of the excess business holdings to zero; and "correction period" means, with respect to any taxable event, the period beginning on the date on which such event occurs and ending 90 days after the date of mailing under § 6212 of a notice of deficiency with respect to the second tier tax imposed on such taxable event, subject to certain extensions.

Treas. Reg. § 1.507-1(c)(5) provides that no motive to avoid the restrictions of the law or the incurrence of any tax is necessary to make an act (or failure to act) willful. However, a foundation's act (or failure to act) is not willful if the foundation (or a foundation manager, if applicable) does not know that it is an act of self-dealing, a taxable expenditure, or other act (or failure to act) to which chapter 42 applies. Rules similar to the regulations under Chapter 42 (see, for example, § 53.4945-1 (a)(2)(iii) of this chapter) shall apply in determining whether a foundation or a foundation manager "knows" that an act (or failure to act) is an act of self­ dealing, a taxable expenditure or other such act (or failure to act).

Treas. Reg. § 53.4943-2(a)(ii) states that in any case in which a private foundation acquires excess business holdings, other than as a result of a purchase by the foundation, the foundation shall not be subject to § 4943 first-tier tax if it disposes of enough holdings within 90 days from the date on which it knows, or has reason to know, of the event causing excess business holdings, that the foundation no longer has excess business holdings.

Treas. Reg. § 53.4943-2(a)(v) provides that factors considered relevant to a determination that a private foundation did not know or had no reason to know of an acquisition of business holdings by disqualified persons are:  (1) It did not discover acquisitions made by disqualified persons through the use of procedures reasonably calculated to discover such holdings; (2) The diversity of foundation holdings; and (3) The existence of large numbers of disqualified persons who have little or no contact with the foundation or its managers.

Treas. Reg. § 53.4943-3(b)(1) provides that except as otherwise provided in § 4943(c)(2) and (4), the permitted holdings of any private foundation in an incorporated business enterprise are:

(A) 20 percent of the voting stock in such enterprise reduced by
(B) The percentage of voting stock in such enterprise actually or constructively owned by all disqualified persons.

Treas. Reg. § 53.4943-3(b)(3) regarding "permitted holdings" sets out a 35 percent rule where a third person has effective control of a business enterprise.  This rule applies if:

(A) the private foundation and all disqualified persons together do not hold, actually or constructively, more than 35 percent of the voting stock in a business enterprise, and
(8) the foundation establishes to the satisfaction of the Commissioner that effective control of the business enterprise is in one or more persons (other than the foundation itself) who are not disqualified persons.

Treas. Reg. § 53.4943-3(c)(2) provides that "permitted holdings" in a partnership shall be consistent with § 4943(c)(2), except that "profits interest" shall be substituted for "voting stock" and "capital interest" shall be substituted for "nonvoting stock."

Treas. Reg. § 53.4943-10(c) regarding income derived from passive sources, provides, in part, that stock in a passive holding company is not to be considered a holding in a business enterprise even if the company is controlled by the foundation. Instead, the foundation is treated as owning its proportionate share of any interests in a business enterprise held by such company under § 4943(d)(1).

Treas. Reg. § 53.4963-1(e) provides that the correction period with respect to any taxable event shall begin with the date on which the taxable event occurs and shall end 90 days after the date of mailing of a notice of deficiency under § 6212 with respect to the second tier tax imposed with respect to the taxable event.  Subparagraph (3) provides that the correction period may be extended by any period which the Commissioner determines is reasonable and necessary to bring about correction of the taxable event.

Treas. Reg. § 301.6651-1 (c) provides rules for imposition of additional taxes and penalties for failure to file tax returns or pay tax.  It applies a standard of "ordinary business care and prudence."  This section provides that a failure to pay tax will be considered to be due to reasonable case to the extent the taxpayer satisfactorily shows that he or she exercised ordinary business care and prudence for the payment of the tax liability, but was either unable to pay or would have suffered an undue hardship if the liability had been paid on the due date.

In United States v. Boyle, 469 U.S. 241 (1985), the Supreme Court described "willful neglect" "as meaning a conscious, intentional failure or reckless indifference."  To show reasonable cause, the taxpayer must "demonstrate that he exercised 'ordinary business care and prudence."'  Boyle, 469 U.S. at 246 (quoting Treas. Reg. § 301.6651-1(c)(1)).

Haywood Lumber & Mining Co. v. Commissioner, 178 F.2d 769 (2d Cir. 1950) provides that when a corporate taxpayer selects a competent tax expert, supplies him with all necessary information, and requests him to prepare proper tax returns, the taxpayer has done all that ordinary business care and prudence can reasonably demand.  The taxpayer had not "awaited passively for such tax advice," but affirmatively requested the preparation by his consultant of proper returns.  To require the taxpayer to inquire specifically about the personal holding company act nullifies the very purpose of consulting an expert.  The court continues, "we doubt if anyone would suggest that a client who stated the facts of his case to his lawyer must, in order to show ordinary business care and prudence, inquire specifically about the applicability of various legal principles which may be relevant to the facts stated.  The courts have recognized that reliance on the advice of counsel or of expert accountants, sought and received in good faith is 'reasonable cause' for failing to file a tax return."  The court held in favor of the taxpayer.

In Fides v. Commissioner, 137 F.2d 731 (4th Cir. 1943), the taxpayer claimed as an excuse for failing to file a return that its attorneys' belief that it was a personal holding company and therefore not subject to the statute in question.  The court held that a mere statement that taxpayer's counsel entertained a subjective belief, whether well-founded or not, that taxpayer was not subject to the tax statute in question was not sufficient to show reasonable cause relieving the taxpayer of a penalty for failing to file a timely return.  Therefore, the court held in favor of the Commissioner.

In West Side Tennis Club v. Commissioner, 111 F.2d 6 (2d Cir.1940), the court states that the burden of establishing reasonable cause is on the taxpayer, and that the taxpayer had "not shown a timely effort to get advice or to secure a ruling and has rested its case on the finding of the taxpayer's board that the officers and directors believed that it was exempt. But this, without more, was not sufficient." The board had stated, "We do not know the steps taken by petitioner to ascertain its status as a taxpayer, and without knowledge of the basis for the belief of its officers and directors that it was exempt from tax we are in no position to test the reasonableness of the conclusion." The court therefore held in favor of the Commissioner.

In Estate of Liftin v. U.S., 111 Fed.Cl.13 (March 29, 2013), involving a failure to file penalty under § 6651(a), the Court found that information documenting the advice of counsel does not need to be the exact words, but must show that the advice in question was given.  The case partially involved a dispute between the taxpayer and his attorney over whether certain advice had been given.  The attorney in deposition stated that certain advice had been given, but not on the specific issue at dispute.  Taxpayer, of course, argued that it had.  Taxpayer was unable to demonstrate that the advice had been given by the attorney.

In Hale v. Commissioner, 44 T.C.M. (CCH) 1116 (1982), the Tax Court states that the taxpayer bears the burden of showing reasonable cause to avoid penalties for failing to file a timely return under section 6651(a)(1).

In Rembusch v. Commissioner, 38 T.C.M. (CCH) 310 (1979), the court held that the taxpayer has the burden of showing that a failure to file timely returns was due to reasonable cause and not willful neglect.  A mere showing that the delinquency in filing the returns was not due to willful neglect is not sufficient and that there must also be reasonable cause.

In Ely v. Commissioner,  19 T.C.M. (CCH) 743 (1960), the Tax Court notes that it has held that reliance upon the advice of reputable counsel may constitute reasonable cause for failure to file a tax return.  However, reliance upon the advice of counsel does not constitute reasonable cause where the record fails to show that such advisor was qualified and fully informed of all the facts.  The court held that the taxpayer's failure to file a declaration of estimated tax was due to reliance upon an advisor to whom insufficient information was disclosed, or who was unfamiliar with the requirements of the taxing statutes, and neither was a sufficient excuse.

In de Belaieff v. Commissioner, 15 T.C.M. (CCH) 1426 (1956), the court held that ignorance of the law does not constitute reasonable cause.  The taxpayer had shown that failure to file returns was not due to willful neglect, but was instead due to ignorance of the law.  The  taxpayer received advice from her attorneys regarding the tax treatment of income items, which at the time of the advice, was correct.  Subsequently, for the years at issue, there was a change in the law and taxpayer continued to treat the items as nontaxable, even though they were now taxable.  The court found that even though taxpayer had legal representation, the failure by the attorneys to provide advice and the failure by the taxpayer to seek advice, did not constitute reasonable cause.

In Western Supply and Furnace Co. v. Commissioner, 18 T.C.M. (CCH) 288 (1959), the Tax Court opines that reliance upon the advice of counsel or of expert accountants sought and received in good faith is reasonable cause for failure to file a tax return.  However, the court was not persuaded that a bookkeeper had any special knowledge or training in tax law or that he was otherwise competent in tax matters.  In fact, he testified that he did not know that corporate returns had to be signed by two officers.  Nor is it established in the record that the taxpayer relied upon the advice of the bookkeeper.  The court held that the taxpayer's failure to file proper corporate returns was due to willful neglect and not to reasonable cause.

In Woodsum  v. Commissioner,  136 T.C. No. 29 (2011), the Tax Court held that taxpayers failed to establish reasonable cause and good faith for their substantial understatement of income. Taxpayers' reliance on their return preparer did not constitute reasonable cause for their omission of substantial income.  Further, taxpayers did not show that they relied on advice of their tax preparer in omitting the income from their return.

In Rogers Hornsby v. Commissioner, 26 B.T.A. 591 (1932), the taxpayers filed their income tax return late, having forgotten to file them at the proper date.  The court held that to abate penalties, the late filing had to be due to reasonable cause and not to willful neglect, stating that both conditions must exist.  The court found that forgetting to file tax returns is not reasonable cause for failure to perform such an important act and does not relieve the taxpayer of the penalties for delinquent filing.

H.R. Rep. No. 432 (Pt. 2), 98th Cong., 2d Sess. 1472 (1984), and S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 591 (1984), provide that where the foundation or foundation manager can establish that there was reasonable cause for such a violation and that there was no willful neglect of the rules, the Internal Revenue Service is to have discretionary authority to relieve the foundation or manager from the first-tier penalty tax, provided that the violation is corrected in the manner required in order to avoid liability for second-tier taxes.  A violation which was merely due to ignorance of the law cannot qualify for such abatement.

Delegation Order 7-11(formerly D0-237, Rev. 2) delegates authority to abate substantial first­ tier excise taxes to the Director, Exempt Organizations.  "Substantial qualified first-tier tax amount" is described as a sum exceeding $200,000 for all such tax payments or deficiencies (excluding interest, other taxes, and penalties) involving all related parties and transactions arising from Chapter 42 taxable events within the statute of limitations as determined by the area office involved.  See IRM 1.2.46.12 (11-08-2007).

Analysis

Beginning with Foundation's first fund investment, investment firm and various other DPs of  Foundation invested simultaneously over a number of years in six (6) of the same underlying portfolio companies owned by different investment firm funds.  Because these portfolio companies i@ "business enterprises" pursuant to § 4943(d)(3)(B), holdings by private foundations are subject to the excess business holdings rules of § 4943.  The taxable events at issue occurred when the combined holdings in portfolio companies of Foundation and its disqualified persons exceeded the 20% permitted holdings threshold for excess business holdings under § 4943(c)(2)(A) for the three tax years, Year1, Year2, and Year3.  If the business enterprises were controlled by independent third parties, the permitted holdings threshold would be 35%.  However, Foundation's attorney stated independent control could not be verified and recommended that Foundation use the 20% threshold in reporting these taxable events.

Section 4962(a) provides discretionary authority to the IRS not to assess, or to abate or refund, any "qualified" first-tier tax, if the foundation establishes to the satisfaction of the IRS that the violation:  (1) was due to reasonable cause; (2) was not due to willful neglect; and (3) has been corrected within the appropriate correction period.  Analysis for abatement requires determining whether Foundation meets the threshold prerequisites of § 4962 for the years at issue to consider abatement of first-tier taxes under § 4943 for excess business holdings in each of the three (3) years at issue.  The questions and analysis for each is set forth below.

1. Did Foundation correct the taxable events for each of these years within the correction period?

Under § 4962, the "taxable event" must be "corrected" within the "correction period."  For § 4943, the "taxable event" occurs on the first day on which there are excess business holdings. I.RC. § 4963(e)(2)(B).  To "correct" the taxable event, the private foundation must reduce the amount of the excess business holdings to zero.  I.RC. § 4963(d)(2)(B).   "Correction period" means, with respect to any taxable event, the period beginning on the date on which such event occurs and ending 90 days after the date of mailing under § 6212 of a notice of deficiency with respect to the second-tier tax imposed on such taxable event, subject to certain extensions.
I.RC. § 4963(e)(1).

As discussed above, Foundation became aware of the excess business holdings when preparing its Form 990-PF for Year3.  Foundation self-reported the excess business holdings and corrected its excess business holdings for tax years, Year1, Year2, and Year3 when it donated all of its Investment firm holdings to a tax-exempt school in Year4.  While the IRS issued notices of deficiency for Year1, Year2, and Year3 first-tier taxes, correction was made during the correction period as described in § 4963.
 

2. Was the taxable event due to reasonable cause and not to willful neglect?

Willful Neglect

Section 4962 does not define "willful neglect."  Section 6653(3) (or, for returns due after December 31, 1989, § 6662(c)) defines "negligence" for purposes of the negligence penalty as including any failure to make a reasonable attempt to comply with the provisions.  In the generally accepted legal sense, negligence is the failure to do something that a reasonable person, guided by those considerations that ordinarily regulate the conduct of human affairs, would do, or doing something that a prudent and reasonable person would not do.  "Willful" is defined in several places, for example, in § 53.4945-1(a)(2)(iv),  as "voluntary, conscious, and intentional," and in § 1.507-1(c)(5), which provides that no motive to avoid the foundation restrictions is necessary to make an act or failure to act willful, but that an act or failure to act is not willful if the foundation does not know that it is an act to which the foundation rules apply.  In United States v. Boyle, 469 U.S. 241 (1985), the Supreme Court described "willful neglect" "as meaning a conscious, intentional failure or reckless indifference."  Thus, the term "willful neglect" implies a voluntary, conscious, and intentional failure to exercise the care that a reasonable person would observe under the circumstances to see that the standards were observed, despite knowledge of the standards or rules in question.

A finding that a violation was caused by willful neglect will preclude abatement of the first-tier tax, but a mere finding of no willful neglect does not, in itself, justify abatement.  Ignorance of the law is a clear example of the operation of this principle:  the fact that a foundation's managers or directors did not know that an act or failure to act was a violation demonstrates that it was not due to willful neglect.  But it does not meet the reasonable cause requirement.

There is no evidence that the taxable events occurred due to a voluntary, conscious, and intentional failure to exercise the care that a reasonable person would observe.  Foundation claims ignorance of the law regarding excess business holdings.  This demonstrates a lack of willful neglect in accumulating excess business holdings, but it does not demonstrate reasonable cause, as discussed below.

Reasonable Cause:

Neither § 4943 nor § 4962 define "reasonable cause."  However, regulations under other Chapter 42 Code sections indicate that the standard should be "ordinary business care and prudence."  See y,,, Treas. Reg. §§ 53.4941(1)-1(b)(5), 53.4944-1(b)(2)(iii), 53.4945-1(a)(2)(v), 53.4955-1(b)(6) and 53.4958-1(d)(6). Under § 301.6651-1(c) and other provisions that impose a reasonable cause standard, determining whether reasonable cause was shown requires consideration of all the facts and circumstances.  In addition, § 301.6651-1(c)(1) discusses whether a taxpayer has exercised ordinary business care and prudence in providing for the payment of tax liability when it invests funds in speculative or illiquid assets, as Foundation has done in this case.

The Supreme Court also used this "ordinary business care and prudence" definition of reasonable cause in determining whether a taxpayer was entitled to relief from failure to file penalties.  United States v. Boyle, 469 U.S. 241 (1985).  However, the burden of establishing reasonable cause is on the taxpayer.  See West Side Tennis Club v. Commissioner, 111 F.2d 6 (2d Cir. 1940); Hale v. Commissioner, 44 T.C.M. (CCH) 1116 (1982).

Generally, reliance in good faith on the advice of counsel may establish reasonable cause and show an absence of willful neglect.  Pursuant to United States v. Boyle, 469 U.S. 241 (1985), a taxpayer must demonstrate that it relied on advice it sought from its own counsel.  Where the taxpayer has obtained advice from a competent tax professional on the specific tax matter and the taxpayer has provided the advisor with all the necessary and relevant information to make a determination, the taxpayer has done all that ordinary business care and prudence can reasonably demand.  Haywood Lumber & Mining Co. v. Commissioner, 178 F.2d 769 (2d Cir. 1950).  In addition, the advice must be obtained in a timely manner.  See West Side Tennis Club v. Commissioner, 111 F.2d 6 (2d Cir 1940), Western Supply and Furnace Co. v.
Commissioner, 18 T.C.M. (CCH) 288 (1959), Ely v. Commi ssioner, 19 T.C.M. (CCH) 743 (1960). However, a mere statement that taxpayer's counsel entertained a subjective belief that taxpayer was not subject to the tax statute in question is not sufficient to show reasonable cause.  Fides  v. Commissioner, 137 F.2d 731 (4th Cir. 1943).

In a recent case, Woodsum v. Commissioner, 136 T.C. No. 29 (2011), the Tax Court held that the taxpayers failed to establish reasonable cause and good faith for their substantial understatement of income.  The taxpayers, one of whom was financially sophisticated, though not a tax expert, claimed they reasonably relied on professional advice in good faith and so, should not be liable for accuracy-related penalties.

The Court in Woodsum quoted Neonatology Associates.  P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff'd. 299 F.3d 221 (3d Cir. 2002):

for a taxpayer to rely reasonably upon advice...the taxpayer must prove by a preponderance of the evidence that the taxpayer meets each requirement of the following three-prong test: (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment.

In determining reasonable cause and good faith, the Woodsum court zeroed in on whether the taxpayer proved reliance on professional advice.  According to § 1.6664-4(c)(2), "advice" is any communication, including the opinion of a professional tax advisor, setting forth the analysis or conclusion of a person, other than the taxpayer, provided to (or for the benefit of) the taxpayer and on which the taxpayer relies, directly or indirectly, with respect to the imposition of the § 6662 accuracy-related penalty. Advice does not have to be in any particular form. However, to constitute advice within the definition of the regulation, the communication must reflect the adviser's "analysis or conclusion" --·- that is, the taxpayer relied in good faith on the adviser's judgment  [emphasis added.]  Neonatology Associates, 115 T.C. at 99.

Even more recently, in Estate of Liftin v. U.S., 111 Fed.Cl.13 (March 29, 2013), involving a failure to file penalty under § 6651(a), the Court found that information documenting the advice of counsel does not need to be the exact words, but must show that the advice in question was given.  The case partially involved a dispute between the taxpayer and his attorney over whether certain advice had been given.  The attorney in deposition stated that certain advice had been given, but not on the specific issue at dispute.  Taxpayer, of course, argued that it had.  Taxpayer was unable to demonstrate that the advice had been given by the attorney.

From this line of legal precedent, it is clear that to rely on advice of counsel to support a reasonable cause argument for abatement of excise tax under § 4962, a taxpayer must demonstrate by a preponderance of the evidence that it: (1) engaged a competent advisor; (2) provided that advisor with all relevant and accurate information needed to provide an opinion; and (3) actually received and relied on the advice of the advisor.

a) Did Foundation reasonably rely on legal opinions when it made the investments that caused it to have excess business holdings?

As discussed above, investment firm sought advice of tax counsel in connection with formation of its investment funds.  Foundation states that its officers and directors relied on the legal advice rendered to investment firm in making its investments in the funds.  Foundation states that it reasonably thought that the investment structure had been appropriately vetted by experienced tax counsel.  Thus, Foundation did not know that excess business holdings could arise over time through cross-ownership of portfolio companies by newer investment firm funds in which Foundation and its disqualified persons continued to invest.  Foundation further argues that the oversight by investment firm counsel misled Foundation into thinking it was safe to invest through the investment firm funds, and that Foundation exercised ordinary business care and prudence in relying on the advice and investing in the funds.

Foundation has demonstrated it engaged two different law firms for a limited scope of activities. It also had the services of in-house counsel.  The record shows an opinion letter to Foundation on the specific matter of whether payment to Founder and investment firm for advisory investment services would be self-dealing under §4941.  This opinion letter predated by approximately one year the engagement letter between Foundation and this law firm, which primarily represented investment firm.

The record shows a third-party communication referencing advice to Foundation by its independent legal counsel regarding § 4944 jeopardizing  investments.  However, there is no direct information, such as memoranda, documents, or other evidence that shows affirmatively what information was provided by Foundation to its legal counsel for review, or whether its legal counsel provided advice to Foundation regarding § 4944 or other sections of the private foundation rules.

Foundation has not submitted any written, contemporaneous record of legal advice by its independent legal counsel or in-house counsel, to Foundation regarding §4943 excess business holdings, or reliance on such information as averred by the taxpayer.   Foundation did not submit affidavits of any attorneys or staff with direct knowledge of alleged advice and/or reliance.

Reliance on erroneous legal advice may be reasonable cause for abatement. However, in this case, the record fails to show such (erroneous) advice was directly given to Foundation or that Foundation relied on such' advice as averred by taxpayer.

According to the guidelines set forth in legal precedents discussed above, Foundation's argument that it relied on the advice of counsel does not establish reasonable cause to allow abatement under § 4962 of the first-tier tax for excess business holdings under § 4943.

Foundation has not proven by a preponderance of the evidence that it met all three prongs of the test in Neonatology Associates, 115 T.C. 43, 99 (2000), aff'd., 299 F.3d 221 (3d Cir. 2002). Foundation submitted no evidence it provided necessary and accurate information to its advisers. Moreover, much of the legal advice presented in the record was provided to the investment firm, not to Foundation. Finally, Foundation provided no evidence it actually relied on its advisers' judgment.

b) The excess business holdings accumulated due to ignorance of the law should be abated due to reasonable cause

In the alternative, Foundation asserts that the taxable event occurred due to ignorance of the law that was due to reasonable cause.  Foundation states that the overlapping investments by various Investment firm funds which caused the excess business holdings "would not have been intuitively obvious" since each fund "was its own separate silo, reporting to its own set of investors, and there was no mechanism in place to re-aggregate the interests in portfolio companies."  Foundation argues that:

. . .the implications of a complicated cross-ownership structure of eight separate investment funds making investments . . . some of which invested in the same portfolio companies, escaped the attention of anyone in a position to know the relevant rules.

However, the legislative history of the private foundation statutes indicates the intent of Congress that a Chapter 42 violation due to ignorance of the law does not qualify for abatement under § 4962(a).  See  H.R. Rep. No. 432 (Pt. 2), 98th Cong., 2d Sess. 1472 (1984), and S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 591 (1984).

According to the regulations promulgated under § 4943, factors considered relevant to a determination that a private foundation did not know or had no reason to know of an acquisition of business holdings by disqualified persons are: (1) It did not discover acquisitions made by disqualified persons through the use of procedures reasonably calculated to discover such holdings; (2) The diversity of foundation holdings; and (3) The existence of large numbers of disqualified persons who have little or no contact with the foundation or its managers.  Treas. Reg. § 53.4943-2(a)(v).

Foundation's ignorance argument fails to establish reasonable cause.  First, Congressional intent indicates ignorance of law by the board is not a qualification for abatement.  Second, Foundation's situation does not meet the guidelines of § 53.4943-2(a)(v).  Foundation's board was closely tied to the creation and management of the funds.  The insiders were "qualified investors" and one was also co-manager of the funds.  Investment firm's LLC Agreement specifies that the agreement of both [emphasis added] managers is required on all matters. Founder is one of the managers of investment firm and is both board member and disqualified person as substantial contributor to Foundation.  The founder and his family are closely involved with Foundation and are investors in the portfolio companies, both directly and indirectly, through various of the investment firm funds and individually.  Foundation's own disqualified persons and board members were those individuals making or in control of making those very investments that caused the excess business holdings to accrue.

Foundation has not demonstrated it used procedures reasonably calculated to discover problematic holdings.  The Foundation's holdings in investment firm funds were not overwhelmingly diverse --- rather, it was the lack of diversity in investments by all investment firm funds and DPs that caused excess business holdings to accrue.  Finally, there were a limited number of disqualified persons, all of whom had substantial contact with the foundation and its managers.

3. Did Foundation make an affirmative showing of all facts alleged as reasonable cause for the taxable event(s)?

Foundation's engagement of counsel partially supports a reasonable cause argument based on ordinary business prudence. As noted above, reliance on erroneous legal advice may also suffice to show reasonable cause. However, the record fails to provide clear evidence of what advice (erroneous or not) legal counsel provided to its client, Foundation, or that Foundation actually relied on such advice.

Based on the record and analyses presented above, Foundation has failed to show that the taxable event was due to reasonable cause and should be abated. The taxpayer bears the burden of establishing reasonable cause. West Side Tennis Club, 111 F.2d 6 (2d Cir.1940);  Hale, 44 T.C.M. (CCH) 1116; Woodsum, 136 T.C. No. 29 (2011). Moreover, Foundation did not show it  relied on advice of qualified counsel nor does its claim of ignorance of the law establish reasonable cause and good faith for Foundation's accumulation of excess business holdings.

Based on the foregoing facts, we find that:

Foundation has not met the requirement of § 4962(a) that its excess business holdings pursuant to § 4943 for the years at issue were due to reasonable cause. Thus, Foundation does not satisfy the requirements for abatement of the assessed first-tier taxes. Accordingly,
the request to abate the assessed first-tier taxes is denied by the Director, Exempt Organizations.

A copy of this memorandum is to be given to Taxpayer. Section 6110(k)(3) of the Internal Revenue Code provides that it may not be used or cited as precedent.

-END-

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