[EXCERPT FROM THE TREASURY DEPARTMENT REPORT ON PRIVATE

(1) The existing situation

FOUNDATIONS, 1965]

A number of private foundations have become deeply involved in the conduct of active business enterprises. Ordinarily, the involvement takes the form of ownership of a controlling interest in one or more corporations which operate businesses; ocassionally, a foundation owns and operates a business directly. Interests which do not constitute control may nonetheless be of sufficient magnitude to involve foundations in the affairs of businesses.

Example 1.-The A foundation holds controlling interests in 26 separate corporations, 18 of which operate going businesses. One of the businesses is a large and aggressively competitive metropolitan newspaper, with assets reported at a book value of approximately $10,500,000 at the end of 1962 and with gross receipts of more than $17 million for that year. Another of the corporations operates the largest radio broadcasting station in the State. A third, sold to a national concern as of the beginning of 1965, carried on a life insurance business whose total assets had a reported book value of more than $20 million at the end of 1962. Among the other businesses controlled by the foundation are a lumber company, several banks, three large hotels, a garage, and a variety of office buildings. Concentrated largely in one city, these properties present an economic empire of substantial power and influence.

Example 2.-The B foundation controls 45 business corporations. Fifteen of the corporations are clothing manufacturers; seven conduct real estate businesses; six operate retail stores; one owns and manages a hotel; others carry on printing, hardware, and jewelry businesses.

Example 3.-The C foundation has acquired the operating assets of 18 different businesses, including dairies, foundries, a lumber mill, and a window manufacturing establishment. At the present time it owns the properties of seven of these businesses. Its practice has been to lease its commercial assets by shortterm arrangements under which its rent consists of a share of the profits of the leased enterprise. By means of frequent reports and inspections, it maintains close check upon its lessees' operations.

Example 4.-The D foundation owns a crude oil refining company to which it assigns a book value in excess of $32 million.

Example 5.-The E foundation controls a corporation which operates a large metropolitan department store. For its fiscal year ended January 31, 1963, the store reported gross sales of $78,395,052, gross profit of $32,062,405, and paid wages and salaries of $17,488,211. It stated the book value of its assets at that time to be $55,091,820.

Example 6.-Among the business interests owned by the F foundation is a substantial holding in a corporation which constructs machines for the manufacture of concrete blocks. The corporation has approximately 800 employees; its annual sales have ranged from $12 to $15 million in recent years.

These striking illustrations of foundation participation in business are not isolated phenomena, peculiar to a limited group of very unusual private foundations. On the contrary, the available information indicates that the involvement of foundations in business activities is frequent. Of approximately 1,300 private foundations recently surveyed by the Treasury Department, about 180 reported ownership of 10 percent or more of at least one class of the outstanding stock of a corporation. One hundred and nine foundations in this group own 20 percent or larger interests; 22 40 hold 100 percent interests. Forty-three foundations reported that they possess 10 percent or larger interests in two or more corporations. A recent report on foundations states that, of 543 foundations studied, 111 owned 10 percent or more of at least one class of stock of a corporation. Together these

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12 Further information about the business ownership of those foundations which have assets valued in excess of $10 million is set forth in Appendix A.

13 Patman Report, 1st installment, supra, p. 8.

111 foundations held interests of not less than the described magnitude (most were in fact considerably larger than 10 percent in 263 separate corporations. In other cases, of course, foundations own and operate businesses directly."

(2) Evaluation

Examination of any broad sampling of the commercial ventures of foundations reveals that several kinds of undesirable results frequently follow from them. In the first place, taxable businesses are often placed at a serious competitive disadvantage. Congress recognized this problem in 1950, and, by the Revenue Act of that year, aimed at solving it. The statute which resulted subjects the so-called unrelated business income of foundations and certain other exempt organizations to tax at ordinary rates and removes the immunity formerly enjoyed by “feeder” organizations-entities primarily engaged in business, whose sole claim to exemption is the turning over of profits to exempt entities.

Fourteen years of experience under these rules, however, has demonstrated that organizations which pay careful heed to the exceptions prescribed by the 1950 act and retained in the 1954 code can frequently shield their commercial enterprises from tax. Because of the fact that the unrelated business income tax does not, for example, apply to rents derived from property with respect to which the lessor has no outstanding indebtedness, foundations are able to lease business assets owned free of debt to operating subsidiaries, siphon off most or all of the business profits by means of rent which is deductible by the subsidiary but not taxable to the parent foundation, and thereby accumulate large reservoirs of untaxed capital which can be used to support the future operations of the business. Another exception to the unrelated business income tax immunizes rents stem. ming from a lease whose term is not longer than 5 years even if the lessor has an outstanding indebtedness with respect to the leased assets.

The foundation, referred to in example 3, is typical of the private foundations which have tailored their acquisitions of businesses to make use of this excep tion. In the ordinary pattern of these acquisitions, the foundation contracts to purchase the stock of a business corporation for future payments, liquidates the corporation, leases its assets to a newly formed operating company for a 5year term, 15 and applies the rents-usually fixed at 80 percent of the before-tax profits of the business-to the discharge of the stock purchase obligation. The ability of the foundation to receive the proceeds of the business operations in the form of tax-free rent enables it to pay a much higher price for the corporation than a nonexempt purchaser could afford.1 A third and rather elaborate exception to the unrelated business income tax immunizes rental income which foundations realize in certain sorts of situations not qualifying for the first two exceptions." All of these foundations compete with similar businesses owned by nonexempt taxpayers, who must pay for their acquisitions, finance their operations, and support their expansion programs with the funds which remain after taxes have been paid.

14 The transfer of businesses to foundations and other exempt organizations has been encouraged by decisions of several courts that, under the arrangements ordinarily employed for these transfers, the transferers are entitled to treat the proceeds which they receive as capital gains. E.g., Union Bank v. United States, 285 F. 2d 126 (Ct. Cls.); Anderson Dairy, Inc. v. Commissioner, 40 T.C. 172; Commissioner v. Brown, 325 F. 2d 313 (C.A. 9th). The Supreme Court now has under consideration the question of whether or not, after such a transaction, the former owners of the business receive capital gains treatment where the exempt organization makes no downpayment other than from the assets of the business itself, has no fixed personal obligation to pay a purchase price, and is required simply to turn over a specified proportion of the future earnings of the business. Commissioner v. Brown, supra, certiorari granted June 8, 1964. Whatever the outcome of that case, however, it seems clear that substantial inducements for the transfer of businesses to foundations will remain. 15 The foundation may or may not control the lessee corporation; the C foundation's practice is to lease to an independent corporation. In either event, the connection of the foundation with the business remains a close one. Since the lease bases the determination of rent upon the profits of the business, the foundation has a direct financial reason to be concerned with the conduct of the enterprise. Because of this interest, the foundation customarily reserves and exercises a right to maintain close supervision over the management of the business. The C foundation typically retains the additional right to approve the holders of a majority of the lessee's stock.

16 Transactions of this kind have received widespread attention-and recommendationin tax literature and other publications. See e.g., "Boosting Profits: Have You Put a Price on Your Business? You May Be Able To Double It-By Selling to a Charity," Prentice-Hall Executives Tax Report, June 24, 1963, p. 6; "Recent Cases Show How Best To Sell a Business to a Tax-Exempt Organization," Journal of Taxation, November 1963, p. 302. 17 Internal Revenue Code of 1954, sec. 514 (b) (3) (B).

Moreover, even if the laws governing the taxation of unrelated business income of foundations and feeder organizations contained no avenues permitting business profits to escape tax, commercial enterprises conducted or controlled by private foundations would still possess significant competitive advantages over those owned by taxable entities. Because contributions to foundations may be deducted by the contributors for Federal income tax purposes, the capitalization of foundation businesses is accomplished with tax-free dollars, rather than after-tax dollars. A corporation which wishes to allocate $1 million of its gross earnings to the establishment of a taxable business subsidiary, for example, would be able to contribute only $500,000 of capital to the subsidiary after Federal income taxes have been paid; but the same corporation could create a foundation to operate the business, deduct its capital contribution, and have a full $1 million available for the business operation. Again, the tax immunity of dividends, interest, and other proceeds stemming from passive sources enables foundations to supply capital to their business endeavors with exempt income. Neither of these benefits is available to nonexempt commercial enterprises. Both benefits contribute materially to the ability of a foundation to subsidize its businesses during periods of difficulty and to expand them during periods of growth. Example 7.-When modernization of its textile mill facilities appeared desirable in 1958, the G foundation had sufficient funds available to make an additional $4 million capital contribution to its operating subsidiary.

Example 8.-The H foundation has been able to sustain the operations of one of its department store subsidiaries with a 1956 loan of $1,400,000 (at 41⁄2 percent interest) and a currently outstanding loan of $200,000 (which bears no interest).

Example 9.-The I foundation has advanced more than $3 million to support the business of one of its foreign subsidiaries.

Example 10.-A recent report on foundations sets forth details of the numerous loans which the J, K, and L foundations made during the period from 1951 through 1961 to various of the business corporations in which they held controlling or substantial interests.18 The total of this indebtedness on December 31, 1956, was $1,897,605. These foundations appear to have entered into at least 36 separate loan transactions with their corporations during the designated period, many involving sums in excess of $100,000. 19

Another advantage which foundation businesses have over their taxable competitors is their freedom from the demands of shareholders for current distributions of earnings. A remarkable number of foundation-owned enterprises proceed from year to year realizing substantial profits, but making negligible or no distributions to their parent organizations.

Example 11.-The A foundation, referred to in example 1, received no dividends for either 1961 or 1962 from its newspaper corporation, its lumber company, or its S, T, or U real estate corporations, despite the fact that all of those companies earned substantial profits during both years.

Example 12.-The M company, a department store, entered its fiscal year ending in 1961 with a retained earned surplus of almost $4 million. During that year and the 2 following years it enlarged this surplus with earnings of $365,819, $193,450, and $149,320, respectively. It paid no dividends to its parent foundation during any of these years.

Example 13.-The dividends which the E foundation, referred to in example 5, has received from its department store subsidiary for the years 1960 through 1963 have ranged from less than 1 to 1% percent of the book value of its equity in the corporation, as reflected on the corporation's February 1, 1962, balance sheet. In each of these years the store's after-tax net income has been considerably more than twice as much as the total dividends paid.

This common willingness of foundations to defer indefinitely the realization of profits from their commercial operations-an attitude frequently not shared by

18 Patman Report, 2d installment, supra, pp. 41-45.

19 The recommendation of Part II-E (2) of this report-that restrictions be imposed upon foundation lending practices-deals with problems fundamentally different from that of unfair competition, and would have limited effect in the area of the present inquiry. Foundation loans to affiliated businesses could frequently be brought within exceptions to that recommendation (as, for example, private placements or obligations secured by first mortgages), and if, in a particular situation, the proposed limitations appeared troublesome, the foundation might well simply decide to furnish funds to its business by means of a capital contribution, rather than a loan.

the shareholders of other businesses-makes it possible for the profits to be invested in modernization, expansion, and other programs which improve the competitive posture of the foundation-owned business."

The various advantages of foundation-held businesses can make them formidable and successful competitors.

Example 14.-The X evening newspaper, owned by a foundation, has one competitor, the Z morning newspaper. Z has been in operation for a number of years and has very substantial financial resources. X, however, appears to have made competitive efforts which neither Z nor other newspapers of comparable size elsewhere in the country have been able to duplicate. X utilizes seven wire services; other newspapers of similar size have from one to three. X publishes seven separate editions each day; Z publishes five; no comparable evening newspaper in the country publishes seven. X's normal subscription rate is $2 a month; Z's has been forced down to $2.25; those of newspapers in comparable cities range from $2.20 to $3. X recently purchased the only other evening newspaper in the city. Its advertising rates appear to remain substantially lower than those of any similar newspaper in the country.

In addition to having adverse effects upon competitors, foundation involvement in business may occasion other, equally objectionable results. Opportunities for abuses of the kind with which parts II A and B of this report deal specifically are frequently greatest where a foundation conducts or controls a business. Temptation for subtle and varied forms of self-dealing proliferate in such a situation. Remote relatives may be employed in the business; friends may be assisted; business acquaintances may be accommodated. However broadly drawn the restrictions upon self-dealing may be, many of the conflicts of interest arising in this area are likely to be sufficiently obscure or sufficiently beyond the realm of reasonable definition to escape the practical impact of the limitations. Making certain that none of the 800 employees of the F foundation's manufacturing business receive special benefits because of a relationship to one of the foundation's donors, or that none of the D foundation's $32 million oil refining business involves the transfer or use of money or property to or by parties related to the creator of the foundation, would entail enormous administrative burdens in itself, even if the danger of less definable abuses were not present. Again, the problem of deferral of charitable benefits has been particularly pronounced in the foundation business setting. We have already noted the competitive advantage which foundation-controlled businesses commonly derive from the willingness of their owners to forego distributions of current profits. That some unconcern with the present realization of business earnings, manifested by many foundations, often delays the progress of funds to charity even when accumulation has no reasonable relation to business needs. The restrictions of existing law upon accumulations of income by businesses become operative only where a corporation is "formed or availed of for the purpose of avoiding the income tax with respect to its shareholders"; where the shareholders of the business are themselves tax exempt, the limitations may not apply. Similarly, the statute which prohibits unreasonable accumulations of income by foundations applies only to accumulations within the foundation itself; it does not prevent retention of earnings in a separate, though controlled, entity." As a consequence, many foundations have permitted large amounts of income to accumulate in their business subsidiaries.

Example 15.-In 1962 the Y foundation had amassed almost $9,700,000 of undistributed earnings in one of its business subsidiaries, and more than $5,800,000 in another.

Example 16.-By the end of 1963 the O foundation had accumulated profits of $3,808,957 in its department store subsidiary.

When these funds will find their way to charity is, at best, a matter of conjecture. The moderate pressure provided by the payout requirement recom

20 The requirement recommended in the preceding section of this report-that foundations make annual charitable disbursements at least equivalent to a prescribed percentage of the value of their assets-would not remove this advantage of foundation businesses. In many cases foundations will be able to comply with this requirement by making payments from contributions, income derived from nonbusiness assets, or proceeds arising from the liquidation of other holdings. Such foundations will have no greater reason to make demands upon their commercial subsidiaries for the distribution of business earnings.

21 Even if the accumulation restrictions of existing law were extended to these situations, their enforcement would require an arduous, case-by-case examination of each separate set of facts.

mended in the preceding section of this report-which, after all, merely fixes a basic floor for foundation performance in distributions-affords only a partial solution to the aggravated deferral problem which exists in the foundation business context.

The problem has another facet. A number of foundations have revealed a willingness to commit charitable funds to business operations which are failing or, at least, producing consistent losses.

Example 17.-The P foundation continues a printing and lithographing business which lost $66,000 in 1959, $36,000 in 1960, $142,000 in 1961, $150,000 in 1962, and an additional amount in 1963.

Example 18.-Twenty-four of the 53 business corporations controlled by the B foundation referred to in example 2, in 1956 lost money in that year, and most of those 24 showed net earnings deficits from previous years' operations. Fifteen of the 45 corporations which the foundations controlled in 1963 either had net losses in that year or had net operating loss carryovers to that year.

Example 19.-A construction subsidiary of the F foundation referred to in example 6, lost $22,920 in 1960, $17,133 in 1961, $41,023 in 1962, and $49,408 in 1963. At the end of 1962 the corporation's earned surplus account showed a net deficit of $199,818.

In all of these situations, charity bears the loss.

Participation by foundations in active business endeavors may also give rise to a problem of a different character. As the Introduction to this Report has pointed out, the private foundation is uniquely qualified to provide a basis for individual experimentation and the exercise of creative imagination. The framework of institutionalized charities can, in the nature of things, afford only limited scope for the development of individual insights, the testing of new approaches, the exploration of uncharted areas. But the private foundation— easily established, inherently flexible, and available even to those with relatively restricted means can be utilized for precisely these ends.

Indeed, many would argue that the private foundation derives the principal justification for the favorable tax treatment accorded it from its particular suitability for use by those who are concerned with, and devoted to the development of new areas for social improvement. This special virtue of the foundation assumes that the individual or group in control will, in fact, be devoted to the development of these new areas; that the primary concern will be with social aims. But where a foundation becomes heavily involved in business activities, the charitable pursuits which constitute the real reason for its existence may be submerged by the pressures and demands of the commercial enterprise. The directors of a foundation which owns 26 widely diverse businesses must of necessity devote a very considerable portion of their time and energies to the supervi sion of business affairs; and charity's claim upon their attention may well suffer. Business may become the end of the organization; charity, an insufficiently considered and mechanically accomplished afterthought. Little may remain to distinguish the directors of such a foundation from the self-perpetuating management of a publicly owned business corporation, without the balance supplied by watchful shareholders. Unrestricted involvement in business may, then, undermine the very ability of the private foundation to make its unique contribution to our society.

It is quite true that, occasionally, beneficial consequences have stemmed from the business activities of a particular foundation. The Internal Revenue Service has, for example, discovered several instances in which foundation businesses have been profitable, their proceeds have been applied to charitable operations without undue delay, and private benefits for the foundation's donors or controllers have been avoided. In these situations it may well be true that charity has been advanced, and no one else harmed, by the ability of the foundation to carry on business endeavors.

On the other hand, the fact that the large majority of private foundations do not own businesses-and that their charitable endeavors suffer no noticeable disadvantage from the lack of business ownership-suggests persuasively that foundations have no real need to engage in business. Other sources of income and other kinds of investments, less inimical to the accomplishment of their charitable objectives, are available to them. Indeed, the Treasury Department has encountered widespread opinion, among foundations themselves and those familiar with their affairs, that business participation is altogether inappropriate for private foundations. Hence, the obvious, fundamental, and common abuses

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