PLR 202601005

IRS Approves Incentive-Based Real Estate Fees for Disqualified Person

Can a Private Foundation pay a disqualified person – in this case, the founder's son – performance-based fees for real estate development without triggering self-dealing taxes under Section 4941 of the Internal Revenue Code? The IRS ruled favorably in Private Letter Ruling (PLR) 202601005, categorizing these development activities as 'personal services' under Section 4941(d)(2)(E), an exception to the self-dealing rules. This ruling involves disregarded entities and a contingent compensation structure, potentially broadening the scope of activities that can qualify as exempt "personal services."

Complex Land, Insider Expertise, and Contingent Pay

The IRS's favorable ruling hinged on specific facts presented by the Foundation. The real estate holdings in question consisted of "complex land holdings" within the County. These properties required significant legal and physical changes, including addressing environmental conditions and securing zoning entitlements before any commercial or residential development could occur. The properties were held by limited liability companies (LLCs), treated as disregarded entities for tax purposes. This meant the IRS viewed transactions involving these LLCs as if they were directly with the Foundation.

The Foundation engaged Corporation, owned by the Founder's son ("Son"), a disqualified person under Section 4941 of the Internal Revenue Code. Section 4941 imposes a tax on self-dealing between a private foundation and disqualified persons. The Son possessed unique qualifications: decades of experience working with the Founder on these specific properties, deep knowledge of their physical, legal, and political characteristics, and established relationships with key municipal officials and regulatory staff.

Crucially, the compensation structure was incentive-based. The six service agreements between the LLCs and Corporation outlined three distinct fee arrangements. First, three agreements stipulated that Corporation would only be compensated if the closing sales price exceeded a "commercially determined value" (CDV) for the underlying real estate. If the CDV was not met, Corporation received no payment. If the sales price surpassed the CDV, Corporation received W% of the difference. The CDV itself was determined using a combination of appraisals, valuations, and real estate professional guidance. A second agreement provided for a fee equal to Y% of the increase in property value directly resulting from a zoning and development agreement negotiated and obtained by Corporation. Finally, the remaining two agreements specified a fee of Z% of the gross transaction value upon disposition of the real estate, covering direct sales, leases, and similar transactions. The IRS acknowledged that these delayed, incentive-based compensation structures were designed to incentivize Corporation to maximize the properties' value, accepting this as reasonable justification for the arrangement.

Professional Services Exception Extended to Development

...ctly resulting from a zoning and development agreement negotiated and obtained by Corporation. Finally, the remaining two agreements specified a fee of Z% of the gross transaction value upon disposition of the real estate, covering direct sales, leases, and similar transactions. The IRS acknowledged that these delayed, incentive-based compensation structures were designed to incentivize Corporation to maximize the properties' value, accepting this as reasonable justification for the arrangement.

The IRS then addressed whether these payments, despite being made to a disqualified person, could be exempt from self-dealing penalties under the "personal services" exception. Section 4941(a)(1) imposes a tax on each act of self-dealing between a disqualified person and a private foundation. Self-dealing, as defined in Section 4941(d)(1)(D), includes the direct or indirect payment of compensation by a private foundation to a disqualified person. A "disqualified person," as defined in Section 4946(a)(1), includes substantial contributors to the foundation, foundation managers, family members of substantial contributors, and corporations where disqualified persons own more than 35% of the voting power.

However, Section 4941(d)(2)(E) provides an exception: compensation paid by a private foundation to a disqualified person for "personal services" is not an act of self-dealing if the services are reasonable and necessary to carrying out the foundation's exempt purpose and the compensation is not excessive. Treasury Regulation § 53.4941(d)-3(c) provides examples of personal services, including foundation manager services, legal services, investment counseling, general banking services, and services of a broker serving as an agent for the private foundation.

The IRS cited Madden v. Commissioner, T.C. Memo. 1997-395, where the Tax Court construed the term "personal services" narrowly. In Madden, the court held that "personal services" are limited to those that are "professional and managerial in nature," explicitly excluding general maintenance, janitorial, and custodial services. The IRS distinguished the services provided by Corporation—property management, rezoning, real estate development, and broker services—from the janitorial services in Madden. Because the services maximized value and were professional in nature, the IRS determined that payments to Corporation under the service agreements would not constitute an act of self-dealing, assuming the compensation was reasonable and not excessive.

Implications: Structuring Development Deals

This ruling offers a potential roadmap for structuring real estate development deals involving private foundations and disqualified persons, but also highlights key areas of caution. The IRS's willingness to apply the "personal services" exception of Section 4941(d)(2)(E) to real estate development and management – fields often viewed as outside the traditional scope of "personal services" like legal or accounting work – is a noteworthy shift. Tax professionals should note that contingent, performance-based fees, which are common in commercial real estate, were deemed acceptable in this case, provided the overall compensation is "reasonable and not excessive" according to the IRS.

However, practitioners must remember that Private Letter Rulings, or PLRs, are directed only to the taxpayer who requested the ruling. Section 6110(k)(3) explicitly states that PLRs cannot be used or cited as precedent. They offer insight into the IRS’s current thinking on a specific fact pattern, but are not binding on other taxpayers. This PLR suggests that the IRS may be open to a broader interpretation of "personal services" than the restrictive view taken in Madden v. Commissioner, T.C. Memo. 1997-395 (which concerned janitorial services). Nevertheless, taxpayers and their advisors should exercise caution and seek independent legal and tax advice before relying on this PLR.