The Maddox Foundation controversy has raised an interesting tax issue: Are the Foundation's investments in the Memphis Xplorers and the Memphis RiverKings, two professional sports teams, excess business holdings under Section 4943 of the Internal Revenue Code, and therefore, potentially subject to confiscatory taxes imposed under the Internal Revenue Code, or do these holdings qualify as either functionally related businesses within the meaning of Section 4942(j)(4) of the Code or as program investments, thereby removing them from the grasps of the excess business holding rules?
We refer to "Inside Baseball" in the title to this post. That is an acknowledgment that this post is very technical in nature. If you are not a tax lawyer or accountant, we recommend that you read the Allegations first and the part labeled "Is Reliance Warranted?" second. This should help your understanding. Unfortuntately, once one goes beyond identifying the "excess business holdings" issue, the analysis becomes very technical. But that really is the point of this post. We are attempting to understand the rationale for the conclusion that the excess business holdings rules do not apply to the Maddox Foundation.
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THE ALLEGATIONS. In a suit filed by State of Tennessee in the Seventh Circuit Court Davidson County, Tennessee (the “Probate Court”), the State of Tennessee made the following allegations:
I. Professional Athletic Teams.
60. On July 19, 2002, Ms. Costa incorporated Maddox Hockey, Inc. (hereinafter “Maddox Hockey”) and Maddox Football, Inc. (hereinafter “Maddox Football”). See Articles of Incorporation, Joint Appendix at Tab No. 15 and 16, respectively. According to the 2002 Form 1120 tax returns for Maddox Hockey and Maddox Football, franchise fees paid for Maddox Hockey and Maddox Football were $1.13 million and $630,000 respectively.
61. Thereafter, on or about September 1, 2002, Ms. Costa executed a document entitled “Grant Agreement.” See Grant Agreement, Joint Appendix at Tab No. 17. Under the terms of the Grant Agreement, $1,500,000 of Foundation assets was given to Maddox Hockey and $601,000 was given to Maddox Football. Ms. Costa executed this document as a grantor on behalf of the Maddox Foundation Corporation. Kevin Ryan executed the document as a grantee on behalf of Maddox Hockey and Maddox Football. As a result of this and other similar conduct, Ms. Costa has used Foundation assets to purchase and operate the Memphis RiverKings, a professional hockey team, by Maddox Hockey, and purchase the Memphis Xplorers, a professional arena football team, by Maddox Football.
62. The purchase price was well above that recommended by Ms. Costa’s financial and legal advisors. In fact, both teams had significant annual losses in the years prior to their purchase. Upon information and belief, the RiverKings sustained losses of approximately $1,000,000 annually prior to the purchase.
63. Ms. Costa has used Foundation assets to fund the Memphis RiverKings, a professional hockey team, by Maddox Hockey, and fund the Memphis Xplorers, a professional arena football team, by Maddox Football. According to Maddox Hockey financial statements, Maddox Hockey owed Maddox Foundation Corporation $2,272,131 as of November 30, 2003. According to Maddox Football financial statements, Maddox Football owed Maddox Foundation Corporation $1,637,817 as of October 21, 2003.
64. Ms. Costa has also allowed Maddox Foundation Corporation assets to be transferred to Maddox Football and Maddox Hockey, including the following wire transfers of funds between these entities [the complaint than lists $1,550,000 in transfers]
65. Maddox Hockey, the RiverKings, have lost $1.4 million since being acquired by the Maddox Foundation Corporation, according to the 2002 Maddox Hockey Form 1120 tax return. Maddox Football, the Explorers, have lost over $883,000 according to the 2002 Maddox Football Form 1120 tax return. Advertising expenses reported for Maddox Hockey and Football were over $262,000 and over $210,000 respectively for same tax year.
66. Upon information and belief, Ms. Costa continues to use the Maddox Foundation Corporation’s assets to fund these failing professional athletic teams.
67. Ms. Costa holds herself out to the public as the owner of these professional athletic teams. For example, according to a press release dated August 17, 2002, Ms. Costa “fell in love with hockey and with the RiverKings,” and, “[a]s a new owner, you’ll see a lot of me.” See Press Release, Joint Appendix at Tab. No. 18. Ms. Costa’s “two children are major hockey fans.” Id.
68. Neither of the investments in professional athletic teams meets the Maddox Foundation Corporation’s athletic purposes, which are restricted to the “fostering of national or international amateur sports competition.” See Articles of Incorporation ¶8a (Joint Appendix at Tab No. 9), nor are they compatible with the purposes of the Maddox Foundation Trust. Likewise, the investments are not in the best interest of the beneficiaries of the Maddox Foundation Trust and would jeopardize the carrying out of any of the exempt purposes of the trust.
69. In fact, prior to the purchase of these sports teams, Ms. Costa was advised to obtain a private letter ruling from the IRS requesting the IRS to determine whether or not the investment could meet a narrow exception so as to be classified as “program related,” thereby avoiding significant tax penalties. Ms. Costa has yet to obtain such a private letter ruling from the IRS and did not even request such a private letter ruling until after she purchased the two professional sports teams.
70. Outside attorneys for the Maddox Foundation Corporation advised Ms. Costa against serving as a member of management for either professional sports teams. However, Ms. Costa refused to follow their advice, and served as the chief executive officer and president of the RiverKings and the operator of the Xplorers. See team management rosters, Joint Appendix at Tab No. 19 and 20, respectively.
TAX LAW BASICS. The excess business holding rules were added to the Internal Revenue Code as part of the Tax Reform Act of 1969 and are among the most complicated provisions in the Code. Generally speaking, Section 4943 imposes a tax on the excess business holdings of a private foundation. A foundation has excess business holdings if it holds more than 20% of the voting stock of a corporation engaged in a trade or business, with that number being increased to 35% under certain circumstances. There are comparable rules for interests in partnerships and other business entities. The rules also contain detailed divestiture provisions.
The initial tax is 5% of the value of the excess business holdings. If the excess holdings are not disposed of by the expiration of the correction period, the private foundation becomes liable for an additional tax equal to 200% of the remaining excess business holdings. See Sections 4961 and 4962.
The tax on excess business holdings does not apply to holdings in a functionally related business as defined in Section 4942(j)(4), to a program investment as defined in Section 4944(c), or to a trade or business that derives at least 95% of its gross income from passive sources, which include dividends, interest, annuities, rents described in Section 512(b)(3), and capital gains described in Section 512(b)(5). See, Section 4943(d)(3); Regulation Sections 53.4943-10(b) and 53.4943-10(c). See also, Regulation Section 53.4944-3. A functionally related business includes any trade or business which is not an unrelated trade or business as defined in Section 513.
THE ARGUMENT IN FAVOR OF THE INVESTMENTS. Obviously the Maddox Foundation and its advisors believe the prohibition against excess business holdings does not apply to the Foundation's investment in the two sports teams, but we don't know what their reasoning is on this point. As far as we can ascertain, the Maddox Foundation has not articulated those beliefs publicly.
We strongly suspect that the Foundation and its advisors are looking to three private letter rulings issued in connection with a series of transactions involving the Kansas City Royals baseball team. Private Letter Rulings LTRs 9530024, 9530025, 9530026 blessed the transactions involving the Royals. The facts and the issues in those rulings were not identical to the ones at issue in the Maddox Foundation case. The owner of the Royals, Ewing Kauffman, died in 1993. Kansas City and its community leaders wanted to assure that the Royals would remain in Kansas City following Mr. Kauffman's death. In a complicated series of transaction, a community foundation acquired a significant interest in the Royals, partly through a purchase of stock and partly through gifts by a trust created by Mr. Kauffman. The remaining interest in the Royals was acquired by a partnership comprised of people local to Kansas City. This partnership held the Class A voting stock in the Royals, giving the partnership apparent management control over the team.
The partnership, the community foundation, and the club agreed under a shareholders' agreement that during the first three years after the plan went into effect, the partnership generally could not sell the Class A stock except to a purchaser who (i) was acceptable to Major League Baseball {MLB); (ii) was a resident of the greater City area; and (iii) agreed to retain the club in the greater Kansas City area (a "resident purchaser"). During the following three years, the partnership was required to use its best efforts to sell the Class A stock to a resident purchaser. If the sale was to a resident purchaser, the purchase price had to be the fair market value as restricted to sale within the greater Kansas City area.
If a resident purchaser was not found in the first six years, the partnership was authorized to sell the Class A shares to a nonresident purchaser, subject to the approval of MLB and at a price not less than that which could be obtained if the club were sold at auction by a national investment banking firm. The partnership could also sell to a nonresident purchaser before expiration of the six years if the class A shareholders determined in good faith that available cash assets would not be sufficient to fund the club's operations (including projected operating deficits) through six full years.
If the plan was not implemented, all the club's stock was be transferred to the donor foundation, a 501(c)(3) organization which was a private foundation. This would occur pursuant to the terms of the trust. In that event, the trustees of the donor foundation would have no alternative but to exercise their fiduciary duty and sell the stock to a buyer willing to pay the highest price. Due to the economics involved, the purchaser was likely to move the team from Kansas City.
The private letter rulings contain many additional details. But in sum, the arrangement was designed to temporarily hold the Royals until a local buyer could be found for the team. The arrangement contemplated a simultaneous sale of all the interests in the team once that buyer was found, with benefits accruing to charitable organizations.
One of the rulings focused on whether the arrangement would jeopardize the community foundation's status as such and whether the arrangement was in furtherance of the community foundation's charitable purposes. The IRS ruled favorably on these points. A significant factor in the ruling was evidence that the taxpayers presented indicating that the transactions lessened the burdens of government. The taxpayer produced affidavits from government officials indicating that they viewed maintenance of a baseball team as a burden of government and that the plan lessened those burdens.
As we have noted, the exemption from the excess business holdings rules focus on whether the transaction is functionally-related or a program investment. While rooted in different terminology, those questions are very similar to the "in furtherance of charitable purposes" question posed in the private letter rulings.
We certainly can understand how the Foundation can argue that keeping two professional sports teams in the Foundation's locale assists community development and therefore could be construed as a program investment. At the same time, we believe that argument can be made for any business that employs people locally. We are not alone in that thinking. In a 1995 article highly critical of the Kansas City private letter rulings, Paul Streckfus, the then-editor of The Exempt Organization Tax Review and a contributing editor to Tax Notes, wrote:
Next, we are told the Royals 'submitted ten affidavits of current and former government officials in which the affiants state that all levels of government have recognized for years that keeping a Major League Baseball team in the City has been a burden of government,' and that a county resolution finds the Royals 'vital to the County and the metropolitan area.' Apparently, these are the key facts that clinch a 'lessening of the burdens of government' rationale for extending section 501(c)(3) exemption to ownership of the Royals.
Let's stop for a moment and think about this. Obviously, every other major league baseball team can now become a charity, not to mention every team in the NFL, the NBA, the NHL, ad nauseam. But is there any business that can't now become a charity? Baltimore has a steel mill (once the world's largest) that is vital to its economy, even more so than the Orioles. Is there any reason why the current owner of the steel mill -- Bethlehem Steel -- cannot sell it to a 'community foundation' for inclusion in its list of charitable endeavors? Baltimore also has a General Motors assembly plant vital to its economy. Why not turn that into a charity, too? (We're not talking about investments here, but charitable activities.)
I'm sure the governor of Maryland, if faced with the prospect of losing either the steel mill or the auto assembly plant, will gladly sign an affidavit that any charity owning either or both will be relieving a burden of the government of Maryland. Believe it or not, the Royals rulings actually address this point, although the possibility that the rulings' drafter is being sardonic has not escaped my attention. Regardless of the spirit in which it was written, the rulings contain the following statement on this point: 'While one might argue that the same could be said of any large business enterprise, the governmental units here have shown an intense and unique interest in professional sports franchises.' That's my first point -- so what if Kansas City has objectively manifested that it considers retaining the Royals its burden?
One of the three rulings focuses on whether the private foundation in the transaction would have issues under various Chapter 42 excise taxes, including the excise tax on excess business holdings. The ruling concluded that there would be no tax on excess business holdings imposed on the private foundation because of the transactions in question. However, this aspect of the ruling, although focused on the excess business holdings tax, appears to provide little support for the Maddox Foundation because it is based on the fact that the private foundation in question owned no voting stock, a basic condition that must exist before Section 4943 is an issue. The IRS states,
SECTIONS 4941 AND 4943. No disqualified person with respect to you will own Class A stock in the Club. Accordingly, under section 4943(c)(2) of the Code, the nonvoting Class C stock purchased pursuant to your direction to the Community Foundation and using funds provided by you will be "permitted holdings" during any period in which you are treated as the owner of the stock. Thus, you will not have excess business holdings subject to tax under section 4943(a) and (b). Similarly, because no disqualified person is involved in the Partnership, your participation in the Plan will not involve any transactions with, or otherwise benefit, disqualified persons. Your involvement will therefore not result in any self- dealing transaction subject to tax under section 4941.
The private foundation also asked about the excise tax on jeopardy investments. If the Maddox Foundation and its advisors are relying on this ruling, this may be where they are replacing their reliance. The ruling on this point states:
If you are treated as acquiring Class C stock, your investment in that stock is a "program-related investment" under section 4944(c) of the Code. First, for the reasons discussed above, the primary purpose of acquiring the stock is to accomplish a purpose -- the charitable purpose of lessening the burdens of government -- described in section 170(c)(2)(B). The stock's acquisition significantly furthers that purpose, and would not have been made did it not further that purpose. See Reg. section 53.4944-3(a)(1)(i); section 53.4944-3(a)(2)(i).
Second, given the financial condition of the Club and that your funds will be used to underwrite operating losses, it is unlikely that any private investor would make this investment on the terms proposed, including the provisions of the Shareholder's Agreement restricting transfer to nonresident purchasers for six years. Indeed, if local private investors had been forthcoming, the Plan would not be needed to ensure retention of the Team in City. Given all the facts and circumstances of this investment, we conclude that no significant purpose of the investment is the production of income or the appreciation of property. See Reg. section 53.4944-3(a)(1)(ii); section 53.4944-3(a)(2)(iii).
The statements about program-related investments are also helpful and relevant in the Section 4943 excess business holdings context. The recent New York Times article reports that both teams are producing losses. If the Maddox Foundation is relying on the rationale of these rulings, we assume that it believes the operating losses bring it within the second point made in the above-quoted language.
Another of the three rulings focuses on the donor-advised fund issues as well as several other issues that don't appear to be relevant here.
In sum, we assume that if the Maddox Foundation is relying on these rulings, it is relying primarily on the portion of rulings that pertain to jeopardy investments, drawing from the language that deals with program investments.
IS RELIANCE WARRANTED? Once again, we have not been privy to the discussions between the Foundation and its advisors regarding the basis for claiming that the Foundation's investment in the two sports teams is excluded from the prohibition against excess business holdings. We strongly suspect that the rationale set out in the private letter rulings entered into the considerations largely because the Kansas City Royal rulings are well-known in the exempt organization field. Furthermore, there is not a lot of precedent in this area, so anyone doing legal research would have come across these rulings. However, if anyone knows of other relevant authority, we certainly would appreciate an e-mail.
We would be very reluctant to place too much reliance on these rulings. While the IRS is not a political animal, we did notice at the top of the rulings that there were congressional contacts regarding the rulings. Given the public nature of the Kansas City Royals situation, this is not surprising. The IRS did receive assurances that the investment was a temporary one and that the charitable entities involved were receiving benefits and that private interests were not trading on the tax-exempt status of the charitable entities involved in the transactions. Consequently, we would not be surprised to see an analysis that is result driven, particularly because private letter rulings are not to be relied on by other taxpayers. This probably explains why Paul Streckfus found the logic in the rulings so "twisted."
More importantly, the Maddox Foundation facts strike us as very different from those in the Kansas City Royals rulings for two basic reasons. First, the Royals transaction was designed to place voting control outside the control and ownership of a private foundation. To the extent there was ownership in the charitable sector, the charities that owned stock were public charities, not private foundations. In the Maddox Foundation case, the Foundation owns voting stock in each of the two teams (according to the Tennessee complaint).
Second, the Royals transaction involved a temporary investment. In essence, the question was not so much whether operating a sports team was charitable, but whether acting as a temporary depository while an appropriate buyer was found was charitable. In our view, the temporary nature of the arrangement made a much stronger case in terms of "lessening the burdens of government" argument. The City of Kansas City did not want to buy the team or operate it, but it clearly saw long-term economic benefit from the team's presence in the city. The arrangement with the community foundation made that possible. We suspect it was probably easier to create the depository structure using a community foundation than a direct purchase by the City of Kansas City. But the focus was on facilitating the eventual transfer of the team to private interests, not on operating a sports team.
We also wonder whether any reliance on the operating loss language in the rulings would be misplaced. When we think of a program investment, we think of a private foundation buying a small manufacturing business to be used to train homeless people in workplace skills. Because of the training aspect, the business operates at a loss, requiring the foundation to subsidize the business. The foundation's primary goal in owning the manufacturing business is training and education rather than the production of widgets for profit. No private business seeking a profit would undertake such an investment on the same terms. We don't really see that logic as being applicable to a professional sports team. All sorts of private interests buy sports teams. Our question: Were the two teams shopped around, with the Maddox Foundation being the high bidder? If so, then we simply can't view this as a program investment. A second question: Did members of local government approach the foundation about the need to purchase the teams?--although we are not sure that is germane.
We are also not convinced that the statement of the facts in the rulings accurately reflects the economics. Specifically, the rulings state that the taxpayers' funds were being used to underwrite operating losses. That is not what really was happening. As we understand the facts, the private foundation gave $10 million to the community foundation to buy the stock in the club. The apparent concern was that the private foundation and the community foundation would be integrated for purposes of analyzing the transaction. However, the $10 million was not used to fund operating deficits directly. Rather it was used to buy stock, with the requirement that seller of the stock use the $10 million and the income therefrom to fund operating deficits and other costs--because dollar amounts are redacted it is not clear how much principal is to be used to fund deficits. When the stock in the team was eventually sold to the hoped-for local investor, the community foundation was to receive a return of the $10 million as the first "distribution" of any sales proceeds. This looks much more like a loan than an outright funding of operating deficits--assuming we understand the facts (which is open to some question given the complexity of the ruling and the shorthand references).
As we have said before, we see a significant tax issue with the Maddox Foundation's purchase and operation of the two teams. That is not to say that the Maddox Foundation will not be successful on the merits if challenged. Fighting any challenge, however, will not be a slam dunk. We will be very interested to see whether these transactions withstand IRS scrutiny.
We are curious why there has been no apparent disclosure of the ruling request that has now apparently been requested. If the ruling had been obtained, we assume the Foundation would have disclosed the fact in view of the implicit criticism contained in the State of Tennessee's legal complaint. Does that mean that the IRS refused to rule or is still considering the issue? Only time will tell.
Finally, keep in mind that the actual investments in the two teams are relatively small compared to the Foundation's reported asset value.
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