[Code of Federal Regulations]
[Title 26, Volume 7]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.503(b)-1]

[Page 52-54]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.503(b)-1  Prohibited transactions.

    (a) In general. The term prohibited transaction means any 
transaction set forth in section 503(b) engaged in by any organization 
described in paragraph (a) of Sec. 1.503(a)-1. Whether a transaction is 
a prohibited transaction depends on the facts and circumstances of the 
particular case. This section is intended to deny tax-exempt status to 
such organizations which engage in certain transactions which inure to 
the private advantage of (1) the creator of such organization (if it is 
a trust); (2) any substantial contributor to such organization; (3) a 
member of the family (as defined in section 267(c)(4) of an individual 
who is such creator of or such substantial contributor to such 
organization; or (4) a corporation controlled, as set forth in section 
503(b), by such creator or substantial contributor.
    (b) Loans as prohibited transactions under section 503(b)(1)--(1) 
Adequate security. For the purposes of section 503(b)(1), which treats 
as prohibited transactions certain loans by an organization without 
receipt of adequate security and a reasonable rate of interest, the term 
adequate security means something in addition to and supporting a 
promise to pay, which is so pledged to the organization that it may be 
sold, foreclosed upon, or otherwise disposed of in default of repayment 
of the loan, the value and liquidity of which security is such that it 
may reasonably be anticipated that loss of principal or interest will 
not result from the loan. Mortgages or liens on property, accommodation 
endorsements of those financially capable of meeting the indebtedness, 
and stock or securities issued by corporations other than the borrower 
may constitute security for a loan to the persons or organizations 
described in section 503(b). Stock of a borrowing corporation does not 
constitute adequate security. A borrower's evidence of indebtedness, 
irrespective of its name, is not security for a loan, whether or not it 
was issued directly to the exempt organization. However, if any such 
evidence of indebtedness provides for security that may be sold, 
foreclosed upon, or otherwise disposed of in default of repayment of the 
loan, there may be adequate security for such loan. If an organization 
subject to section 503(b) purchases debentures issued by a person 
specified in section 503(b), the purchase is considered, for purposes of 
section 503(b)(1), as a loan made by the purchaser to the issuer on the 
date of such purchase. For example, if an exempt organization subject to 
section 503(b) makes a purchase through a registered security exchange 
of debentures

[[Page 53]]

issued by a person described in section 503(b), and owned by an unknown 
third party, the purchase will be considered as a loan to the issuer by 
the purchaser. For rules relating to loan of funds to, or investment of 
funds in stock or securities of, persons described in section 503(b) by 
an organization described in section 401(a), see paragraph (b)(5) of 
Sec. 1.401-1.
    (2) Effective dates. The effective dates for the application of the 
definition of adequate security in paragraph (b)(1) of this paragraph 
are:
    (i) March 15, 1956, for loans (other than debentures) made after 
March 15, 1956;
    (ii) January 31, 1957, for loans (other than debentures) made before 
March 16, 1956, and continued after January 31, 1957;
    (iii) November 8, 1956, for debentures which were purchased after 
November 8, 1956;
    (iv) December 1, 1958, for debentures which were purchased before 
November 9, 1956, and held after December 1, 1958;
    (v) If an employees' pension, stock bonus, or profit-sharing trust 
described in section 401(a) made a loan before March 1, 1954, repayable 
by its terms after December 31, 1955, and which would constitute a 
prohibited transaction if made on or after March 1, 1954, the loan shall 
not constitute a prohibited transaction if held until maturity 
(determined without regard to any extension or renewal thereof);
    (vi) January 1, 1960, for loans (including the purchase of 
debentures) made by supplemental unemployment benefit trusts, described 
in section 501 (c)(17);
    (vii) January 1, 1970, for loans (including the purchase of 
debentures) made by employees' contribution pension plan trusts 
described in section 501(c)(18).
    (3) Certain exceptions to section 503(b)(1). See section 503(e) and 
Sec. 1.503(e)-1, 1.503(e)-2, and 1.503(e)-3 for special rules providing 
that certain obligations acquired by trusts described in section 401(a) 
or section 501(c) (17) or (18) shall not be treated as loans made 
without the receipt of adequate security for purposes of section 
503(b)(1). See section 503(f) and Sec. 1.503(f)-1 for an exception to 
the application of sections 503(b)(1) for certain loans made by 
employees' trusts described in section 401(a).
    (c) Examples. The principles of this section are illustrated by the 
following examples: (Assume that section 503 (e) and (f) are not 
applicable.)

    Example 1. A, creator of an exempt trust subject to section 503, 
borrows $100,000 from such trust in 1960, giving his unsecured 
promissory note. The net worth of A is $1,000,000. The net worth of A is 
not security for such loan and the transaction is a prohibited 
transaction. If, however, the note is secured by a mortgage on property 
of sufficient value, or is accompanied by acceptable collateral of 
sufficient value, or carries with it the secondary promise of repayment 
by an accommodation endorser financially capable of meeting the 
indebtedness, it may be adequately secured. However, subordinated 
debentures bonds of a partnership which are guaranteed by the general 
partners are not adequately secured since the general partners are 
liable for the firm's debt and their guaranty adds no additional 
security.
    Example 2. Assume the same facts as in example 1 except that A's 
promissory note in the amount of $100,000 to the trust is secured by 
property which has a fair market value of $75,000. A's promissory note 
secured to the extent of $75,000 is not adequately secured within the 
meaning of section 503(b)(1) since the security at the time of the 
transaction must be sufficient to repay the indebtedness, interest, and 
charges which may pertain thereto.
    Example 3. Corporation M, a substantial contributor to an exempt 
organization subject to section 503, borrows $150,000 from such 
organization in 1960, giving its promissory note accompanied by stock of 
the borrowing corporation with a fair market value of $200,000. Since 
promissory notes and debentures have priority over stock in the event of 
liquidation of the corporation, stock of a borrowing corporation is not 
adequate security. Likewise, debenture bonds which are convertible on 
default into voting stock of the issuing corporation do not constitute 
adequate security under section 503(b)(1).
    Example 4. B, creator of an exempt trust subject to section 503, 
borrows $100,000 from such trust in 1960, giving his secured promissory 
note at the rate of 3 percent interest. The prevailing rate of interest 
charged by financial institutions in the community where the transaction 
takes place is 5 percent for a loan of the same duration and similarly 
secured. The loan by the trust to the grantor is a prohibited 
transaction since section 503(b)(1) requires both adequate security and 
a reasonable rate of interest. Further, a promise to repay the loan plus 
a percentage of future profits which may be greater than

[[Page 54]]

the prevailing rate of interest does not meet the reasonable rate of 
interest requirement.
    Example 5. N Corporation, a substantial contributor to an exempt 
organization subject to section 503 borrows $50,000 on or after March 
16, 1956, from the organization. If the loan is not adequately secured, 
the organization has committed a prohibited transaction at the time the 
loan was made. If the loan had been made on or before March 15, 1956, 
and is continued after January 31, 1957, it must be adequately secured 
on February 1, 1957, or it will be considered a prohibited transaction 
on that date. However, if the exempt organization were an employees' 
trust, described in section 401(a), and the loan were made before March 
1, 1954, repayable by its terms after December 31, 1955, it would not 
have to be adequately secured on February 1, 1957. Moreover, if the 
exempt organization were a supplemental unemployment benefit trust, 
described in section 501(c)(17), and the loan were made before January 
1, 1960, repayable by its terms after December 31, 1959, it would not 
have to be adequately secured on January 1, 1960.
    Example 6. An exempt organization subject to section 503 purchases a 
debenture issued by O Corporation, which is a substantial contributor to 
the organization. The organization purchases the debenture in an arm's 
length transaction from a third person on or after November 9, 1956. The 
purchase is considered as a loan by the organization to O Corporation. 
The loan must be adequately secured when it is made, or it is considered 
as a prohibited transaction at that time. If the organization purchased 
the debenture before November 9, 1956, and holds it after December 1, 
1958, the debenture must be adequately secured on December 2, 1958, or 
it will then be considered as a prohibited transaction. However, if the 
organization were an employees' trust described in section 401(a), and 
if the debenture were purchased before March 1, 1954, and its maturity 
date is after December 31, 1955, the debenture does not have to be 
adequately secured. Moreover, if the organization were an employees' 
contribution pension plan trust described in section 501(c)(18), and if 
the debenture were purchased before January 1, 1970, and its maturity 
date is after December 31, 1969, the debenture does not have to be 
adequately secured.

[T.D. 7428, 41 FR 34621, Aug. 16, 1976]