PLR 202601004

IRS Blesses Family-Led Development of Foundation Assets

The IRS ruled privately that a Private Foundation can engage a disqualified person—in this case, the Founder's son—to oversee the management and development of its complex real estate holdings without incurring self-dealing excise taxes under Section 4941. The favorable determination hinged on the IRS accepting the services as qualifying "personal services" and the compensation as reasonable. The intricate nature of the land, involving zoning regulations and environmental concerns, justified the need for specialized expertise.

A Legacy of Complex Dirt

The favorable determination hinged on the specific facts surrounding the Foundation's real estate holdings. These holdings consisted primarily of complex land parcels within the County. Their development was significantly hampered by various factors, including restrictive zoning regulations, challenging environmental conditions, and the need for changes in their legal status before any commercial or residential use could be realized.

The Founder's son, through his corporation, possessed unique qualifications crucial to unlocking the value of these properties. For over a decade, the Son and his Corporation had worked with the Founder to develop the real estate holdings, gaining extensive knowledge of the physical, legal, and political intricacies of each parcel. The Son had also cultivated long-standing relationships with key municipal officials, regulatory staff, and political leaders across the jurisdictions relevant to the real estate.

To formalize the relationship, the LLCs and Trust entered into six service agreements with the Son's Corporation. These Service Agreements tasked the Corporation with managing every stage of the real estate development lifecycle, from initial strategic planning and feasibility assessments to determining the highest and best use for each parcel, considering zoning, environmental constraints, and market conditions. The Corporation was also responsible for all political interfacing and stakeholder negotiations, securing necessary entitlements, zoning changes, and other land use approvals. Critically, the services did not include construction.

The Service Agreements outlined three distinct compensation methods. Three agreements stipulated that the Corporation would only be compensated if the closing sales price exceeded a commercially determined value (CDV) for the underlying real estate. If the sales price did not surpass the CDV (established through appraisals, valuations, and real estate professional guidance), the Corporation would receive no payment. However, if the sales price exceeded the CDV, the difference would be split between the Corporation and the seller, with the Corporation receiving W% of the excess. Another agreement provided that the Corporation would receive a fee equal to Y% of the increase in property value resulting from a zoning and development agreement negotiated and obtained by the Corporation. The remaining two agreements specified a fee equal to Z% of the gross transaction value upon the disposition of the real estate through various means, including direct sales or leases. The IRS noted that, under all six Service Agreements, the Corporation's compensation was deliberately delayed to incentivize optimal oversight, development, and marketing of the properties to maximize their value.

Defining 'Personal Services' in Real Estate

As the Corporation is owned by the Foundation's son ("Son"), a disqualified person, payments to the Corporation could constitute self-dealing under Section 4941(d)(1)(D), which defines self-dealing to include any direct or indirect payment of compensation by a private foundation to a disqualified person. However, Section 4941(d)(2)(E) provides an exception for compensation paid for "personal services" that are reasonable and necessary to carrying out the foundation's exempt purpose, provided the compensation is not excessive.

The IRS relies on the Tax Court's interpretation of "personal services" in Madden v. Commissioner. In Madden, the court held that the term should be narrowly construed to include only services that are "professional and managerial in nature," distinguishing them from general maintenance, janitorial, and custodial services, which do not qualify for the exception. The court emphasized that one of Congress's goals in enacting Section 4941 was to minimize the need for an arm's length standard by generally prohibiting self-dealing transactions.

The IRS determined that the Corporation's services—property management, rezoning, real estate development, and broker services—were professional and managerial. The IRS noted that these services are analogous to investment management, legal, and broker services, which Treasury Regulations Section 53.4941(d)-3(c) identifies as examples of personal services.

Success-Based Fees Aligned with Exempt Purposes

The IRS also addressed the structure of compensation paid to the Corporation. Despite the fees being calculated as percentages of revenue or property value (success fees), the IRS determined this did not constitute self-dealing under Section 4941, which imposes an excise tax on transactions between a private foundation and disqualified persons. The rationale centered on the alignment of interests: the percentage-based compensation incentivized the Corporation to maximize the value the Foundation ultimately received from the land holdings.

Footnote 3 of the ruling explicitly stated that, assuming the overall compensation was reasonable, this type of incentive structure would not, by itself, result in private inurement or impermissible private benefit. The IRS reasoned that by incentivizing the Corporation to enhance the value of the Foundation's assets, the arrangement furthered the Foundation's exempt purposes. As long as the compensation is deemed reasonable and not excessive, the IRS concluded the arrangement qualifies as payment for personal services, which is an exception to self-dealing prohibitions under Section 4941(d)(2)(E). The IRS has generally held that "personal services" under this section must be professional and managerial in nature, analogous to legal and financial services.

The key takeaway for other foundations dealing with illiquid and complex assets is that performance-based compensation structures are permissible even when paid to disqualified persons, provided the arrangement demonstrably aligns the service provider's interests with the foundation's exempt purposes and the overall compensation is reasonable.