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Tuesday June 28, 2016

Article of the Month

Supporting Organizations — Part II

I. Introduction

Supporting organizations have become increasingly popular in recent years because they allow donors to receive the tax benefits of donating to a public charity while still giving donors some of the hands-on involvement available with a private foundation. In order to ensure that supporting organizations are maintaining public charity status, the IRS and Treasury Department have established various rules and tests that apply to each of the three types of supporting organizations. The IRS and Treasury Department released REG-118867-10—a set of proposed regulations that create new requirements and clarify the laws put in place by the Pension Protection Act of 2006 (“PPA”).

Part I of this series covered the basics of supporting organizations, explained the different types of supporting organizations and described the various regulations and tests that apply to each type. This article will provide a comparison between supporting organizations and private foundations, explain the proposed regulations and describe how they may impact existing and future supporting organizations.

II. Supporting Organizations vs. Private Foundations

One way to gain a clearer understanding of supporting organizations (“SOs”) is to compare them to private foundations. SOs might seem similar to private foundations, especially when making payments to multiple charities. However, when comparing SOs to private foundations, there are many important distinctions.

In contrast to public charities, which receive a majority of their support from the public, private foundations are often formed by one individual or a family who invest funds and use those assets to make grants to other charities. Private foundations may be attractive to high net worth individuals who want control over their gifted assets. By creating a private foundation, donors can exercise control over the management and investment of the funds and make contributions to targeted programs of public charities.

However, it is typically more advantageous to structure an organization as a public charity rather than a private foundation because of the restrictions and income tax deduction limitations placed on private foundations. For example, when donors make cash contributions to public charities, they can deduct the value of their contribution up to 50% of their adjusted gross income (or 30% for gifts of appreciated assets). However, when donors contribute cash gifts to private foundations, they can only deduct up to 30% of their adjusted gross income (or 20% for gifts of appreciated assets). Sec. 170(b). Additionally, when appreciated property is donated to a public charity, the deduction is based on the property’s fair market value. However, when appreciated property is donated to a private foundation, the deduction is limited to cost basis (unless the donation is of publicly traded securities, in which case the deduction will based on fair market value). Sec. 170(e). Finally, private foundations are required to pay an excise tax on investment income and make minimum distributions each year, while public charities are not. Sec. 4941.

Although SOs often operate in a fashion similar to private foundations, they are granted public charity status because they provide support to public charities (hereinafter referred to as “supported organizations” or “supported charities”). Sec. 509(a)(3)(A). Thus, even though many (if not most) SOs are funded by one individual or family, SOs will still receive the more favorable tax treatment enjoyed by public charities. SOs enjoy the higher 50% deduction limit, do not have to pay tax on investment income and are not subject to the stringent regulatory requirements placed on private foundations. Additionally, SOs (particularly Type III SOs) offer donors substantial involvement in the use and investment of their contributions.

It should be noted that SO donors still have less control than they would with a private foundation. The main difference is that the supported charities of an SO must be designated upon formation, whereas private foundations can change grant recipients year by year. Reg. 1.509(a)-4(d). Donors should be aware that Type I and Type II SOs offer a lower level of control and involvement with the donated assets, since the majority of the directors on the boards of Type I and Type II SOs must be designated by, or overlap with, the supported charity. Reg. 1.509(a)-4(g)-(h).

III. Pension Protection Act and Proposed Regulations of 2016

In REG-118867-10 (19 Feb. 2016), the IRS published proposed regulations for Type I and Type III SOs. The majority of the newly proposed regulations clarify and emphasize the requirements introduced by the PPA. The regulations also set forth new rules, including additional requirements to meet the responsiveness test for all Type III SOs, new rules regarding the qualification of an organization as a functionally integrated Type III SO and additional rules regarding required annual distributions. The proposed regulations also define the term “control” for purposes of the control test.

A. Responsiveness Test (Type III SOs)

As discussed in Part I of this series, the responsiveness test requires SOs to be “responsive to the needs or demands of the supported organization(s).” The test has two requirements. First, the SO must have a specified relationship with the supported organization. Second, the SO’s officers, directors, or trustees, by reason of this relationship, must have a significant voice in the grant activities, income allocation and investment policies of the SO. Reg. 1.509(a)-4(i)(3).

Following the enactment of the PPA, commenters voiced concern that the responsiveness test would create an administrative burden for those SOs that support multiple charities, and thus, that it would effectively limit the total number of organizations that an SO could support. In the proposed regulations, the IRS emphasized that a Type III SO receives public charity status because it is responsive and significantly involved in the activities of its supported organization(s). As such, if the responsiveness requirements were reduced, this might limit the oversight and accountability of the SO’s operations. Thus, the proposed regulations required an SO to be responsive to “the needs and demands of each of its supported organizations.” Prop. Reg. 1.509(a)-4(i)(3)(i).

In order to dispel the concerns about potential administrative burdens, the proposed regulations offer an example to demonstrate a cost-effective way for a Type III SO to meet the responsiveness test while supporting multiple organizations. The example illustrates a situation in which an SO holds regular meetings throughout the year and invites the officers of its supported charities to attend. By providing officers information prior to the meeting (e.g., the SO’s activities, assets, liabilities, etc.) and encouraging post-meeting contact, the specific voice requirement would be met. Prop. Reg. 1.509(a)-4(i)(3)(iv)(example 3).

Example – Failing Responsiveness Test: Y is a 501(c)(3) organization that provides support to charities A, B and C. Charities A, B and C are each set up as organizations described in section 509(a)(1). Y, the SO, makes annual cash payments to A, B and C. Once a year, Y’s Board sends A, B and C cash payments, the information required under the notification requirement and an accounting statement. Officers of Y have no other communication with A, B or C. Y does not meet the responsiveness test.

Example – Passing Responsiveness Test: Z is s 501(c)(3) organization that provides support to ten different charities, each of which is described in Section 509(a)(1). One of the charities supported by Z is S. One of S’s directors sits on Z’s board of directors as a voting member and participates in Z’s regular board meetings. Officers of Z hold regular face-to-face or phone meetings and invite all ten of its supporting organizations to take part. Prior to the meetings, Z makes available to the supported organizations (including by email) up-to-date information about its activities, including its assets and liabilities, receipts and distributions and investment policies and returns. At the meetings, the supported organizations may ask questions and voice their individual needs or concerns. In addition to these meetings, Z provides each supported organization the name of one of its officers to contact with any questions or to schedule additional meetings to discuss their needs or to talk about how Z should distribute its income and invest its assets. Based on these facts, Z meets the responsiveness test with respect to each of its ten supported organizations.

B. Integral Part Test

As discussed in Part I of this series, the PPA essentially separated Type III SOs into two distinct categories for purposes of satisfying the integral part test: (1) functionally integrated SOs and (2) non-functionally integrated SOs. The integral part test ensures that SOs maintain significant involvement in the operations of their supported organizations and provide support on which the supported organizations are dependent. Reg. 1.509(a)-4(i)(4)-(5).

For functionally integrated Type III SOs, there are three ways that the integral part test can be satisfied: (1) substantially all of the SO’s activities are in direct furtherance of the supported organization’s exempt purpose; (2) the SO is the parent of each of its supported organizations; or (3) the SO supports a government organization. Reg. 1.509(a)-4(i)(4). The proposed regulations focus on the second and third options.

1. Supporting Organization as Parent to Supported Charities

The proposed regulations amend and clarify the requirements for an SO to qualify as a parent of its supported organization. To be recognized as a parent for purposes of the integral part test, the SO and its supported organizations must be part of an integrated system and the SO must engage in typical parent-like activities. The regulations provide an example of a hospital system as a type of integrated system and explain that typical activities of a parent organization could include coordinating supported organizations’ activities, planning, policy development, budgeting and resource allocation. One important requirement set forth by the regulations is that the parent SO must have the ability to appoint or elect a majority of the officers, directors or trustees of the supported organization. Prop. Reg. 1.509(a)-4(i)(4)(iii).

2. Support of a Government Entity

The proposed regulations define and provide rules for Type III SOs that support government supported entities. The Treasury Department and IRS agreed that a governmental SO should be defined as a governmental unit described in IRC Sec. 170(c)(1)-(2) (other than in clauses (vii) and (viii)). This definition clarifies that all agencies, departments and divisions of the governmental unit will be treated as one government SO. Prop. Reg. 1.509(a)-4(i)(4)(iv)(B).

In 2009, REG-155929-06 stated that SOs could support no more than one government organization. In response to commentators’ criticism of this limit, the regulations propose a new rule. Prop. Reg. 1.509(a)-4(i)(4)(iv)(A)(1). An SO can support two or more government organizations and still be considered functionally integrated so long as either:

1. All of its government supported organizations operate within the same geographic region (defined as a city, county, or metropolitan area); or

2. All of its government supported organizations work in close coordination or collaboration with one another to conduct a service, program or activity that the SO supports. To satisfy this requirement, the SO must receive (and keep on file) a letter from each of the government supported organizations that describes their collaborative or cooperative efforts with respect to the particular service, program or activity.

Lastly, the regulations clarify that a substantial part (rather than “substantially all”) of the SO’s total activities must directly further the exempt purposes of its governmental supported organization(s). The regulations note that this test may allow SOs to conduct more fundraising and other financial activities than is permitted under the “substantially all” test. The general rule holds that fundraising, making grants and investing/managing non-exempt-use assets does not qualify as “directly furthering” the supported government organization’s exempt purpose under the “directly further” requirement. Prop. Reg. 1.509(a)-4(i)(4)(iv)(E)(3).

C. Non-Functionally Integrated (NFI)

As mentioned in Part I of this series, non-functionally integrated SOs may still pass the integral part test if they satisfy the distribution and attentiveness requirements. Reg. 1.509(a)-4(i)(5)(i). Under the distribution requirement, a non-functionally integrated Type III SO must distribute the greater of 85% of its adjusted net income or 3.5% of the value of noncharitable assets for the preceding taxable year. Reg. 1.509(a)-4(i)(5)(ii). Excess distributions may be carried forward for up to five years.

First, the proposed regulations remove a provision that allowed SOs to reduce the required distributable amount by the taxes due under subtitle A of the Code. The provided reasoning explains that the unrelated business activity that generates the tax does not further the supported organization’s exempt purposes. As a result, the regulations make clear that taxes paid on unrelated business income are not treated as a distribution to a supported organization. Prop. Reg. 1.509(a)-4 Explanation Sec. 2(D)(ii).

Second, the proposed regulations create an exclusive list clarifying what expenditures qualify under the distribution requirement. Prop. Reg. 1.509(a)-4(i)(6). Because the Pension Protection Act of 2006 did not specifically address whether fundraising expenses count toward the distribution requirement, the proposed regulations seek to clarify this issue. While, as a general rule, fundraising expenses incurred by an SO do not count toward the distribution requirement, the proposed regulations carve out an exception to this rule. The regulations state that, “reasonable and necessary expenses incurred by the SO to solicit contributions that a supported organization receives directly from donors count toward the distribution requirement, but only to the extent that the amount of such expenses does not exceed the amount of contributions actually received by the supported organization as a result of the solicitation activities of the SO.” Prop. Reg. 1.509(a)-4(i)(6)(iii).

D. Control Test

The proposed regulations define the term “control” for purposes of Sec. 509(f)(2), which prohibits Type I and Type III SOs from accepting contributions from persons who, alone or together with certain related persons, directly or indirectly control the governing body of its supported organization(s).

The proposed regulations clarify that a supported organization would be considered “controlled” by a person if that person, alone or by aggregating his or her votes or positions of authority with certain related persons, can require (or prevent) the governing body of the supported organization to perform any act that significantly affects its operations. Prop. Reg. 1.509(a)-4(f)(5)(2). The regulations explain that all facts and circumstances will be taken into account in order to make this determination but that, generally, the supported organization will be considered controlled by one or more persons if (1) the voting power of such persons is 50% or more of the total voting power of such governing body or (2) if one or more of such persons have the right to exercise veto power over the actions of the governing body of the supported organization. Prop. Reg. 1.509(a)-4(f)(5)(2).

E. Notification Requirement

In order to ensure that Type III SOs are responsive to the needs of their supported organizations, they must provide certain documents to their supported organizations on an annual basis. This includes a description of the support they provided (including the type and amount), a copy of the SO’s Form 990 and a copy of the SO’s most recently amended documents. Reg. 1.509(a)-4(i)(2).

The proposed regulations do not change the content that must be provided. Instead, the regulations clarify that these documents must be delivered by the last day of the fifth month of the taxable year after the taxable year in which the SO provided the support it is reporting. Prop. Reg. 1.509(a)-4(i)(2)(iii).

IV. Conclusion

While private foundations and SOs share some similarities, the restrictions and income tax deduction limitations placed on private foundations may make SOs a more desirable option for donors. The regulations proposed on February 19, 2016 (REG-118867-10) impact both Type I and Type III SOs. The proposed regulations set forth new rules and clarify the requirements introduced by the Pension Protection Act of 2006. Specifically, the proposed regulations affect the responsiveness test, control test, distribution requirements and the classification as a Type III functionally or non-functionally integrated SO.

Published June 1, 2016
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Previous Articles

Supporting Organizations — Part I

The Benefits of Charitable Lead Trusts: Part III

The Benefits of Charitable Lead Trusts: Part II

The Benefits of Charitable Lead Trusts: Part I

Early Termination of a Charitable Remainder Trust: Part II