## Facts

- P is a tax-exempt private foundation under I.R.C. §§ 501(c)(3) and 509(a).
- M and N are “business enterprises” for purposes of I.R.C. § 4943.
- Each corporation has 100 shares of voting stock outstanding (one vote per share).
- P owns 15% of the voting stock of each corporation.
- Disqualified persons with respect to P (as defined in I.R.C. § 4946(a)) own 20% of the voting stock of each corporation.
- Thus, P plus disqualified persons collectively own 35% of the voting stock of each corporation.
- Situation 1 (M): the remaining 65% of voting stock is held by C, an unrelated person who is not a disqualified person; C elects a majority of M’s board.
- Situation 2 (N): the remaining 65% is held by many unrelated individuals; there is no voting trust or agreement, no single holder has enough shares to direct management, and no holder has historically elected a majority of the board.
- No special transitional provisions of I.R.C. § 4943(c)(4)–(6) apply.

## Issues

1. When may a private foundation apply I.R.C. § 4943(c)(2)(B)’s 35% permitted holdings rule by establishing that “effective control” is in one or more persons who are not disqualified persons?
2. Does effective control exist in Situation 1 (majority unrelated shareholder) and Situation 2 (widely dispersed unrelated ownership without coordinated voting)?

## Decision

- The IRS concluded that the 35% permitted holdings rule applies in Situation 1.
- The IRS concluded that the 35% permitted holdings rule does not apply in Situation 2.
- The IRS stated that effective control may be shown by proving an unrelated person or cohesive group in fact controls the enterprise.
- The IRS stated it is insufficient to show only that the foundation and disqualified persons lack effective control.

## Legal Principles

- I.R.C. § 4943 imposes excise tax consequences when a private foundation holds “excess business holdings” in a business enterprise, measured against “permitted holdings.”
- Under I.R.C. § 4943(c)(2)(A), permitted holdings generally are limited to 20% of a corporation’s voting stock, reduced by voting stock owned by disqualified persons.
- Under I.R.C. § 4943(c)(2)(B), the permitted holdings limit increases to 35% only if it can be established that effective control of the enterprise is in one or more non-disqualified persons.
- “Effective control” for § 4943(c)(2)(B) requires affirmative evidence that an unrelated person (or cohesive unrelated group acting in fact together) controls management or board outcomes; dispersion among unrelated holders, without coordinated voting or a history of board control by any holder, does not satisfy the requirement.
- Majority voting power with demonstrated ability to elect a majority of directors is sufficient evidence of effective control by a non-disqualified person.

## Conclusion

The IRS ruled that a private foundation may use the 35% permitted holdings rule only upon an affirmative showing that a non-disqualified person (or cohesive non-disqualified group) actually controls the business enterprise; a single unrelated 65% shareholder who elects the board satisfies this standard, while widely dispersed unrelated ownership without coordinated control does not.


Rev. Rul. 81-111, 1981-1 C.B. 509 (1981)