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Hangover for Type III SOs – Treasury Issues Final Regulations for Supporting Organizations

Trusts & Estates

Originally Published in Trusts & Estates.


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Treasury’s holiday gift for the 2012 season came in the form of final and temporary regulations for supporting organizations (“SOs”) published December 28, 2012.1 While a few provisions relate to other varieties of SOs, by far the bulk of the new regulations relate to “Type III” SOs “operated in connection with” publicly supported organizations,2 an area of special focus for the IRS for the last decade or so.3 The regulations climax the Service’s determination to curb what it perceived as abusive practices involving SOs, particularly Type III SOs, and which had prompted new restrictions under the Pension Protection Act of 2006 and proposed regulations issued in 2009.4 While the new regulations adopt many of the provisions in the 2009 proposed regulations, they certainly introduce novelties and nuances of their own.

Gifts from Donors in “Control” of Supported Organizations. Under one of the few provision in the new regulations aimed at Type I SOs which are “[o]perated, supervised, or controlled by” publicly supported organizations,5 as well as at Type III SOs, an organization loses its SO status for any taxable year in which it accepts a contribution from a person who is directly or indirectly in “control” of the governing body of a supported organization.6 Also included in this sensitive class is a “member of the family” of such a “control” individual, as defined in Code Section 4958(f)(4), as well as a 35-percent controlled entity as defined in Code Section 4958(f)(3).7 These provisions expressly exclude organizations described in Code Sections 509(a)(1), (2), and (4) that are in “control” of the supported organization,8 from which SOs may accept contributions.

A subsection in the new regulations entitled, “Meaning of Control,” is expressly “Reserved.”9 Treasury notes that a definition of “control” would be beneficial, and says that it intends to issue proposed regulations “in the near future” that will provide such a definition.10

“Notification” Requirement. Type III SOs with governing instruments that name a number of supported organizations, not all of which receive support from the SO, will face a new challenge under the new regulations in the form of a “notification” requirement. For each of its taxable years, a Type III SO will now be required to provide the following documents to each of its supported organizations, including those which have may received little or no support over the years (or indeed may not even be aware that an SO has named them as a supported organization): (i) a written notice describing the type and amount of all support provided by the SO to the supported organization during the previous taxable year; (ii) a copy of the SO’s Form 990 (or equivalent return) most recently filed as of the date of the notification; and (iii) a copy of the SO’s governing documents in effect on the date of the notification.11 The SO is permitted to redact the names and addresses of any contributors to the SO from its Forms 990s provided to the supported organizations, to maintain donors’ privacy.12 The SO need not keep sending the same governing instruments, year after year, to the supported organizations, unless there have been amendments or modifications in the interim.13 The notification must be postmarked or electronically transmitted by the last day of the fifth calendar month following the close of the SO’s taxable year (i.e., by May 31 in the case of calendar-year SOs).14 The term “electronic media” includes an internet link.15 The notification packet is to be provided to “the principal officer” of the supported organization.16 As the definition of “principal officer” is a bit ambiguous, and could conceivably apply equally to more than one officer, the Type III SO is probably well advised to send the “notification” packet to the President or Chairperson of the supported organization, as well as to the Treasurer or CFO of the organization, for safety’s sake.

“Responsiveness” Test. Type III SOs have long been required to meet a “responsiveness” test. Under the new regulations, this “responsiveness” test consists of two prongs: the “relationship” prong and the “significant voice” prong. A Type III SO meets the “relationship” prong only if one of the following three elements is met: (i) one or more officers, directors or trustees of the SO are elected or appointed by the supported organization’s officers, directors, trustees, or membership; or (ii) one or more members of the supported organization’s governing body are also officers, directors, or trustees of, or hold important offices in, the SO; or (iii) the SO’s officers, directors, or trustees maintain a close and continuous working relationship with the supported organization’s officers, directors, or trustees.17 The “significant voice” prong is met if, by reason of satisfying the “relationship” prong, the supported organization’s officers, directors, or trustees have a “significant voice” in: (i) the SO’s investment policies; (ii) the timing of the SO’s grants; (iii) the manner of the SO’s making of grants; (iv) the selection of grant recipients; and (v) otherwise directing the use of the SO’s income or assets.18

In an Example provided in the new regulations, the “responsiveness” test is treated as satisfied when the SO’s trustee and an officer of the supported organization have quarterly face-to-face or telephonic meetings in which they discuss the supported organization’s projected needs and how the supported organization would like the SO to use its income and invest its assets, in addition to regular communication regarding the SO’s investments and distribution plans. In the Example, the SO’s trustee also provides the supported organization’s officer with quarterly investment statements and an annual accounting statement.19

Another Example illustrates how an SO can flunk the “responsiveness” test. Y, a charitable trust trusteed by a bank, makes annual cash payments to its supported organizations. Once a year, the trustee sends the cash payment, the “notification” information, and an accounting statement to the supported organizations. These are deemed insufficient to pass the “responsiveness test.”20

By far the most alarming comment in the new regulations package is the brief observation that Treasury and the Service intend to issue proposed regulations “in the near future” which would amend the “responsiveness” test by “clarifying that Type III supporting organizations must be responsive to all of their supported organizations.”21 For a good many Type III SOs, particularly older Type IIIs whose governing instruments name a number of supported organizations, some of which have not received support as yet from the SO, this proposal will be extremely difficult to satisfy, at least unless the proposed regulation expressly permits Type III SOs to amend their governing instruments to remove named supported organizations.

“Integral Part” Test. Certainly the most complicated provisions of the new regulations are those which relate to the “integral part” test required to be met by Type III SOs. The “integral part” test is divided in the new regulations into two very different set of requirements. There is one set of requirements that apply to “functionally integrated” (“but for”) Type III SOs, and another set of requirements that apply to “non-functionally integrated” (“grantmaking”) Type III SOs, dubbed “NFIs” in the Explanation accompanying the new regulations.22

A “functionally integrated” Type III SO meets the “integral part” test if it satisfies any of the following three elements: (i) it engages in activities, substantially all of which “directly further” the exempt purposes of one or more supported organizations; or (ii) it is the parent of each of its supported organizations; or (iii) it supports a governmental organization.23 A “functionally integrated” Type III satisfies the tricky “directly further” element if it engages in activities, substantially all of which: (i) directly further the exempt purposes of one or more supported organizations to which the SO is responsive, by performing the functions of, or carrying out the purposes of, these supported organizations; and (ii) but for the SO’s involvement, would normally be engaged in by such supported organizations.24 A “functionally integrated” Type III SO is considered the “parent” of a supported organization if the SO exercises a substantial degree of direction over the supported organization’s policies, programs, and activities, and a majority of the supported organization’s officers, directors, or trustees is appointed or elected (directly or indirectly) by the SO’s governing body, members of such body, or officers (acting in their official capacity).25

As to “non-functionally integrated” Type IIIs, or “NFIs” to use the new acronym, the “integral part” test includes a “distribution” or payout requirement.26 On or before the end of each taxable year, an NFI must distribute to, or for the use of, one or more of its supported organizations, an amount at least equal to the NFI’s “distributable amount” for the taxable year.27 Under a new temporary regulation, the “distributable amount” is ordinarily an amount equal to the greater of: (i) 85% of the SO’s adjustable net income for the immediately preceding taxable year, or (ii) the SO’s “minimum asset amount” for such year.28 An SO’s “minimum asset amount” is defined under a new temporary regulation as 3.5% of the excess of: (i) the aggregate fair market value of the SO’s non-exempt-use assets for the immediately preceding taxable year, over: (ii) the acquisition indebtedness as to such “non-exempt-use” assets as determined under Code Section 514(c)(1); increased by: (i) amounts received or accrued during the immediately preceding taxable year as repayments of amounts taken into account by the SO to meet its “distribution” requirement for any taxable year, plus: (ii) amounts received or accrued during the immediately preceding taxable year from the sale or disposition of property to the extent the SO took into account the acquisition of such property to meet its “distribution” requirement for any taxable year, plus: (iii) any amount set aside under Section 1.509(a)-4(i)(6)(v) to the extent it is determined during the immediately preceding taxable year that this amount is unnecessary for the original set-aside purposes, and such amount was taken into account by the SO to meet the “distribution” requirement for any taxable year.29

The “distribution” requirement for the first year an SO is treated as an NFI is, mercifully, zero.30 Treasury may provide, via publication in the Internal Revenue Bulletin, for a temporary reduction in the “distribution” amount in case of a disaster or emergency.31 The new regulations also provide for “reasonable cause” relief.32 To qualify for such relief, the NFI must establish to the Secretary’s satisfaction that: (a) the failure was due solely to unforeseen events or circumstances beyond the SO’s control, or a clerical error, or an incorrect asset valuation; and (b) the failure was due to reasonable cause rather than willful neglect; and finally (c) the distribution requirement is in fact met within 180 days after the SO is first able to distribute its “distributable amount.”33

In addition to meeting its “distribution” requirement, in order to meet the “integral part” test the NFI Type III SO must also distribute one-third or more of its distributable amount to one or more of the supported organizations that are “attentive” to the operations of the SO, and to which the SO is “responsive.”34 A supported organization is considered “attentive” to the SO’s operations during a taxable year if, within that taxable year, at least one of the following conditions is satisfied: (i) the SO distributes amounts equal to at least 10% of the supported organization’s total support received during the supported organization’s last taxable year ending before the beginning of the SO’s taxable year; or (ii) the amount of support received from the SO is necessary to avoid the interruption of the carrying on of a particular function or activity of the supported organization, including a “substantial” (though not necessarily primary) program or activity of the supported organization; or (iii) based on all pertinent facts – including the number of supported organizations, the length and nature of the relationship between the supported organization and SO, and the purpose to which the funds are put – the amount of support received from the SO constitutes a sufficient part of the supported organization’s total support as to ensure “attentiveness.”35 Under the regulations, the greater the amount of support received, the more likely the supported organization will be considered to be “attentive” to the SO.36 Evidence of “actual attentiveness” is said to be of “almost equal importance.”37 The practitioner may well wonder why “actual attentiveness,” seemingly the very touchstone at which the regulations should be pointing, is thus given a back seat to the merely theoretical “attentiveness” arrived at via satisfaction of the regulations’ complicated tests. An SO’s distributions to a donor advised fund are disregarded for purposes of satisfying the “attentiveness” test.38

The new regulations provide extended guidance as to the specific types of distributions that are treated as “counting” toward the distribution requirement.39 These include: (i) any amount paid to a supported organization to accomplish its exempt purposes; (ii) any amount paid to perform an activity which satisfies the “substantially all activities which directly further exempt purposes provisions applicable to “functionally integrated” Type III SOs,40 but only to the extent such amount is greater than any income the SO derives from the activity; (iii) any “reasonable and necessary” administrative expenses paid to accomplish the supported organization’s exempt purposes, but not including expenses incurred in the production of investment income; (iv) any amount paid to acquire an “exempt-use asset” described in the temporary regulations;41 and (v) any amount “set aside” for a specific project accomplishing the exempt purposes of a supported organization to which the SO is responsible.42

The new regulations afford an SO a five-year “carryover” of its distributions which are in excess of its distribution requirement.43 This five-year “carryover” can aid an SO in meeting its “distribution” requirement in future years.

Assets, including investment assets, which are not considered “exempt-use assets” are treated as “non-exempt-use assets” under the new temporary regulations, which provide details relating to valuation of such assets under the principles of the Code Section 4942 regulations.44

New transition rules45 relate to the “notification” requirement, the “integral part” test, and judicial proceedings to reform instruments.46

Coping With The New Regulations. For a good many Type III SOs, and particularly NFIs, these new regulations present considerable challenges, and will often require significant changes in how the SOs currently satisfy the applicable requirements. At stake for an SO that fails to meet the new requirements is the bitter pill of potential reclassification as a private foundation.47 While the new regulations may finally satisfy the Service that any perceived abuses of Type III SOs are now effectively eliminated, these new regulations can be expected to spur a new wave of Type III bailouts, in the form of conversions to Type I or II status, or outright dissolution and termination. The potential loss of large numbers of fully functioning SOs would not appear to serve the Congressional intent to promote charitable giving very effectively.

The IRS recognizes three varieties of SOs. A Type I SO is “operated, supervised, or controlled by” one or more supported public charities. The existence of a Type I relationship is typically established by the ability of the supported charity or charities to appoint or elect a majority of the members of the SO’s governing body, though there are alternative options. As the Type I relationship generally affords supported organizations considerable influence over the SO, they tend to prefer this first type of SO relationship.

Type II SOs are the least common, at least in terms of planning for individuals and businesses. Type IIs have their uses, as for example in the context of an existing public charity that wishes to spin off its fundraising arm for greater autonomy or liability protection. In a Type II relationship, the SO is “supervised or controlled in connection with” one or more public charities, and is typically evidenced by the common supervision or control of both the SO and the supported charities, in which board members include the same individuals for both the SO and the supported charity.

Traditionally the most popular form of SO for individual and family donors is the Type III SO, characterized by being “operated in connection with” one or more public charities. As the relationship with the supported charity is more attenuated in a Type III SO, the Treasury Regulations and subsequent rulings set forth a considerably more complicated set of requirements for a Type III SO than for its Type I and II counterparts. The IRS divides Type III SOs into two main subcategories: “functionally integrated” Type IIIs, which carry on activities supporting the supported organizations, and “nonfunctionally integrated” (or “NFI”) Type IIIs, which make grants to the supported organizations, typically to specific projects or programs. Rightly or wrongly, Type III SOs have come under the closest scrutiny by the IRS in comparison with their Type I and Type II cousins.

Footnotes

  • 1 T.D. 9605. The new regulations, together with an “Explanation,” are reproduced online at: http://www.gpo.gov/fdsys/pkg/FR-2012-12-28/pdf/2012-31050.pdf.
  • 2 Code Section 509(a)(3)(B)(iii).
  • 3 For a review of earlier developments regarding SOs, see Treacy, “What’s Left of SOs,” Trusts & Estates (October 2006).
  • 4 The 2009 proposed regulations are discussed in Treacy, “Not SO Bad – Proposed SO Regulations,” Trusts & Estates (December 2009), pp. 54ff.
  • 5 Code Section 509(a)(3)(B)(i).
  • 6 Treas. Reg. Section 1.509(a)-4(f)(5)(i)(A).
  • 7 Treas. Reg. Section 1.509(a)-4(f)(5)(i)(B), (C).
  • 8 Treas. Reg. Section 1.509(a)-4(f)(5)(i)(A).
  • 9 Treas. Reg. Section 1.509(a)-4(f)(5)(ii).
  • 10 Explanation, 2. Gifts from Controlling Donors, T.D. 9605.
  • 11 Treas. Reg. Section 1.509(a)-4(i)(2)(iii).
  • 12 Explanation, 3. Requirement to Notify Supported Organizations, T.D. 9605.
  • 13 Treas. Reg. Section 1.509(a)-4(i)(2)(C).
  • 14 Treas. Reg. Section 1.509(a)-4(i)(2)(iii).
  • 15 Explanation, 3. Requirement to Notify Supported Organizations, T.D. 9605.
  • 16 Treas. Reg. Section 1.509(a)-4(i)(2)(iv).
  • 17 Treas. Reg. Section 1.509(a)-4(i)(2)(iv).
  • 18 Treas. Reg. Section 1.509(a)-4(i)(3)(iii).
  • 19 Treas. Reg. Section 1.509(a)-4(i)(3)(iv), Example 1.
  • 20 Treas. Reg. Section 1.509(a)-4(i)(3)(iv), Example 2.
  • 21 Explanation, 4. Responsiveness Test (emphasis added).
  • 22 Explanation, 5. Integral Part Test—Non-Functionally Integrated Type III Supporting Organizations.
  • 23 Treas. Reg. Section 1.509(a)-4(i)(4)(i).
  • 24 Treas. Reg. Section 1.509(a)-4(i)(4)(ii).
  • 25 Treas. Reg. Section 1.509(a)-4(i)(4)(iii).
  • 26 Treas. Reg. Section 1.509(a)-4(i)(5).
  • 27 Treas. Reg. Section 1.509(a)-4(i)(5)(ii)(A).
  • 28 Temp. Reg. Section 1.509(a)-4T(i)(5)(ii)(B).
  • 29 Temp. Reg. Section 1.509(a)-4T(i)(5)(ii)(C).
  • 30 Treas. Reg. Section 1.509(a)-4(i)(5)(ii)(D).
  • 31 Treas. Reg. Section 1.509(a)-4(i)(5)(ii)(E).
  • 32 Treas. Reg. Section 1.509(a)-4(i)(5)(ii)(F).
  • 33 Treas. Reg. Section 1.509(a)-4(i)(5)(ii)(F)(1)-(3).
  • 34 Treas. Reg. Section 1.509(a)-4(i)(5)(iii)(A).
  • 35 Treas. Reg. Section 1.509(a)-4(i)(5)(iii)(B)(1)-(3).
  • 36 Treas. Reg. Section 1.509(a)-4(i)(5)(iii)(B)(3).
  • 37 Treas. Reg. Section 1.509(a)-4(i)(5)(iii)(B)(3).
  • 38 Treas. Reg. Section 1.509(a)-4(i)(5)(iii)(C).
  • 39 Treas. Reg. Section 1.509(a)-4(i)(6).
  • 40 See Treas. Reg. Section 1.509(a)-4(i)(4)(ii).
  • 41 See Temp. Treas. Reg. Section 1.509(a)-4T(i)(8)(ii).
  • 42 Treas. Reg. Section 1.509(a)-4(i)(6).
  • 43 Treas. Reg. Section 1.509(a)-4(i)(7).
  • 44 Temp. Treas. Reg. Section 1.509(a)-4T(i)(8).
  • 45 Treas. Reg. Section 1.509(a)-4(i)(11).
  • 46 Treas. Reg. Section 1.509(a)-4(i)(11)(ii)(E).
  • 47 Explanation, 7. Consequences of Failure to Meet Requirements.

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