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SO Much Better?: Supporting organizations may offer the perfect balance of tax benefits and donor control for some planned giving prospects

CASE Currents

Originally Published in CASE Currents.

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Consider the following common scenario: An affluent, elderly woman with strong ties to her alma mater wants to make a gift of a significant portion of her assets.

Like most donors, her motivations for giving are complex. She has a philanthropic nature, but she also wants the best possible tax deduction for her gift. She’s somewhat interested in the growth and proper management of this asset so that it can provide benefits to the campus in perpetuity. And she has several generations of family members for whom she would like to set an example of responsible philanthropy.

This donor has a range of options for giving that include making an outright gift, creating a private foundation, giving to a donor-advised fund, or–an increasingly popular alternative–creating a supporting organization.

After nearly three decades of comparative neglect, the supporting organization has emerged as a hot trend in planned giving. Along with it come strange new terms like 509(a)(3), Type III, and attentiveness test. New SOs are cropping up all over the United States, and a number of long-established private foundations are “rolling over” into this format.

Some planned giving officers may be wondering what all the fuss is about. What exactly are supporting organizations, and how do they fit into the collection of planned giving tools a campus offers its donors?

The Spectrum of Giving

To explain, let’s examine the above-mentioned donor’s options more closely. They vary both in the amount of control she retains over the gift asset and the gifts’ tax deductibility. These two elements are inversely proportionate: The more control she retains, the lower the tax deduction, and vice versa. Her options include:

Outright gifts. She can simply give the asset to her alma mater, with or without restrictions on its use. These gifts have the greatest deductibility: She can deduct cash gifts of up to 50 percent of her adjusted gross income; noncash gifts of up to 30 percent. And if she can’t use the deduction all at once, she can spread it over a five-year period.

But the downside of this high deductibility is lack of control. Although the donor may specify the gift’s ultimate use, she probably won’t have a voice in how the campus invests and manages the gift asset. Also, although family members may be involved in the gift decision, they have no long-term role in the gift’s management or use.

Private foundations. If the donor is very concerned about control and family involvement, her advisers may recommend that she create a private foundation. The foundation can hire her family members to help run it, and they and her investment advisers can continue to manage the foundation’s assets almost as if she had never given them away.

Unfortunately, these benefits come with the price tag of greatly decreased deductibility: just 30 percent of adjusted gross income for cash gifts, 20 percent for publicly traded stock, and only the cost basis (i.e., the original cost) of other noncash assets. In addition, the IRS charges a number of severe excise taxes–up to 200 percent–on some fairly innocuous private-foundation transactions.

Donor-advised funds. The donor could also create a donor-advised fund at a community foundation or the charitable branch of an investment company. A DAF gives her the same deductibility as an outright gift, plus the ability to take the deduction immediately and choose the gift recipient later. But she can only recommend how the DAF distributes the funds–she has no legal control over them or how the DAF invests them before they’re disbursed. (For more on this topic, see “Are You Ready for Donor-Advised Funds?” in the January 1999 CURRENTS, available at www.case.org/currents/freebies/DAfunds.)

Private operating foundations. If the donor wants to roll up her sleeves and conduct her own charitable activities instead of making gifts or grants, she might create a private operating foundation and glean some, but not all, of the advantages of direct charitable gifts. These foundations are very rarely used in conjunction with education institutions, however.

Supporting organizations. These charitable entities operate in a way similar to private foundations, but with additional restrictions that give them the same tax advantages as direct gifts. An increasing number of planners and charities think that, for donors with the interests described above, the supporting organization is the best fit.

The Origins of the SO

Supporting organizations are one of a wide variety of entities that the U.S. Internal Revenue Service exempts from federal income tax under Internal Revenue Code Section 501(c). These tax-exempt organizations range from membership cemetery companies to black-lung trusts, but people are most familiar with 501(c)(3)s, also known as charitable institutions.

To the IRS, a 501(c)(3) organization is by default a private foundation unless it can classify itself as a public charity, which the IRS defines in a different part of the code, Section 509(a). Public charities qualify for the greatest level of tax deductibility and avoid the private foundations’ excise taxes. Just to confuse things further, the IRS recognizes four different types of public charities (see chart at left):

  • Publicly supported entities [Section 509(a)(1)]. These include schools, colleges, universities, and religious institutions as well as groups like the United Way, although the latter type must demonstrate each year that they receive a certain proportion of public support.
  • Charitable selling entities [Section 509(a)(2)]. These are organizations like museums and symphony orchestras that depend on sales to the public in addition to charitable contributions. They also must prove that they receive public support.
  • Private operating foundations [Section 509(a)(4)]. As mentioned previously, these are foundations that don’t make grants, but conduct their own educational, charitable, or religious activities.
  • Supporting organizations [Section 509(a)(3)]. Essentially, these are entities that support other public charities through grant making or other activities.

As the Tax Code states, SOs are organized and operate “exclusively for the benefit of, to perform the functions of, or to carry out the purposes of” one or more 509(a)(1) or 509(a)(2) organizations. The donors setting up the SO must select which charity or charities it will support.

The Internal Revenue code goes on to state that SOs are “operated, supervised, or controlled by or in connection with” those charities. How a donor meets those requirements is at the heart of the SO’s advantages and disadvantages compared to other types of giving.

Built-in Support

One way the IRS determines whether a charitable institution is an SO is by looking at its organizational structure. An SO must have one of three possible organizational structures, called Types I, II, and III.

Type II SOs are not relevant to this discussion–they’re generally planned giving branches that larger public charities create for autonomy, liability protection, or other reasons. But a donor might be interested in creating either a Type I or a Type III SO. The main difference between them is who appoints the majority of the organization’s board of trustees.

In a Type I SO, the chosen public charities appoint a majority of the board members, ensuring that the charities’ support is “built-in,” so to speak. A typical Type I SO board might consist of the donor, his or her spouse, and three people appointed by the charities who are not part of the donor’s family. But the board could have any number of members, from three to 300 or more.

Some donors may be concerned about the amount of power this structure gives to the charities. Because they have a controlling voice, the charities can override the donor family’s wishes. Also, a change in a charity’s personnel or mission could leave the SO funding activities the donor does not approve of or support.

The alternative is the more complicated Type III SO, in which the donor and his or her family appoints the board. In a Type III SO, the board must still be “independent,” however, meaning the majority of its members are neither part of the donor family, employees of the donor family, nor otherwise controlled directly or indirectly by the donor family. Because they can be trusted friends or advisors, however, donors may feel that these board members are more in tune with their wishes.

Because the IRS does not consider Type III SOs to have “built-in” support, they must establish their supportive nature by proving they are “responsive” to the needs of the chosen charities and that they are an “integral part” of one or more of the charities. (The decision of which charities the Type III SO will support is irrevocable–donors can’t change, remove, or replace a named organization unless that organization loses its charitable status.)

Other Support Indicators

To the IRS, proving responsiveness if fairly straightforward: It requires either that (1) the SO be organized as a trust with the chosen charities as its beneficiaries, or (2) the officers and trustees of the chosen charities play a significant role in the SO’s operation.

An SO can prove that it is an integral part of its chosen charities in one of two ways: through its activities or through its grant making. Unlike private foundations, SOs can conduct their own educational, religious, or charitable activities, but they must be activities the chosen charities would ordinarily do themselves, and the chosen charities must approve of them. For an education institution, this might be fund raising, managing a distance-learning center, or building a new library.

For example, a college that had long wanted to open a branch campus in another town, but lacked the resources to do so, might be delighted with the active assistance of an SO in selecting a site, working with the architects, and so forth.

If the SO makes grants to its chosen charities, the “integral part” test is much more complicated and best explained through an example.

Let’s use a supporting organization that in 1999 had $22,500 in investment income and $2,500 in expenses, including salaries, rent, supplies, utilities, and the like, leaving a net investment income of $20,000.

The first criterion for the “integral part” test is that an SO gives at least 85 percent of its net investment income to one or more of the charities. For this SO, that would mean giving away a minimum of $17,000. The SO can choose to distribute this money among its chosen charities any way it wants, so long as it meets the second criterion.

The second criterion for the “integral part” test is the so-called “attentiveness test”: At least one of the supported charities must receive enough funding from the SO that it’s motivated to be attentive to the SO. To the IRS, this means that the SO’s grants are either a “substantial proportion” of the charity’s funding (the IRS has not defined what constitutes a substantial proportion) or they’re placed into a special, earmarked fund at the charity.

To continue this example, say the SO chooses to distribute $15,000 of the required $17,000 to an independent school. If the $15,000 is a substantial portion of the school’s total revenue that year, then this SO meets the attentiveness test.

If that $15,000 went to a major university, on the other hand, it’s probably just a small piece of the university’s total revenue. To meet the attentiveness test in this circumstance, the SO should work with the university to choose an important project or activity for which its $15,000 will constitute at least 50 percent of the funding. To continue the above example, if the project is the purchase of medieval art books for the university library, the total purchase can’t exceed $30,000. The university would then create an earmarked fund–in this case, the Medieval Art Book Fund–for the SO’s grant targeted to that project or activity.

Donor Benefits

Supporting organizations are attractive to some donors because of their perceived advantages over the other gift options described earlier, including:

  • Greater tax deductibility. Gifts to an SO enjoy the highest level of tax deductibility–that reserved for public charities. Besides the higher income-tax deductible limits, SO gifts enjoy 100 percent deductibility from gift and estate taxes.
  • Opportunity for family involvement. The SO can bring a family together in the positive context of helping others through charitable efforts. A donor can have the SO hire family members to manage the daily activities of the organization, such as evaluating various projects of the chosen charities. So long as the SO pays the family members reasonable compensation that’s commensurate with the nature of the tasks involved and in keeping with the resources of the SO, these hires should not run afoul of the IRS.
  • Increased asset control. Because donors, their families, and trusted advisers are likely to serve on the board and the staff of the supporting organization, donors retain some influence over the investment, management, and distribution of the donated funds, even after their death–something that’s not possible with an outright gift or DAF.
  • Fewer regulations. A supporting organization is free of the many excise taxes on self-dealing, excess business holdings, jeopardy investments, and the like that complicate private foundation management. An SO’s annual tax filings and maintenance tasks are also generally less complex than a foundation’s. And, unlike private foundations, supporting organization donors have the option of undertaking their own charitable activities as well as making grants.
  • Immortality. Last but not least, an SO gives a donor the opportunity to create a charitable institution focused on his or her very specific and very personal philanthropic goals and permanently associates the family name with those goals.

Campus Benefits

Although setting up earmarked funds, appointing board members, and otherwise working with a supporting organization may seem like a lot of trouble, campuses can realize several benefits from SOs:

  • Larger gifts. Because SOs provide donors with substantial control, they may be more willing to give a larger part of their assets–either now or through their estates–than they would in an outright gift or even a charitable remainder trust format.
  • Irrevocability. Once donors have designated the charitable beneficiaries of their supporting organizations, they can’t change their minds unless the chosen organizations lose their charitable status. This important feature means that an SO is the proverbial “gift that keeps on giving.” And if, several generations down the line, the donor’s family decides to terminate the SO by giving away all its assets, the chosen charities are the likely beneficiaries.
  • Closer ties to donors and their families. Both Type I and Type III SOs practically require that campus representatives work closely with donors and their families, either by serving on a board together or otherwise collaborating to meet mutually agreed-upon goals. These are excellent opportunities for maintaining goodwill and perhaps cultivating additional gifts.
  • A wide-open market. Currently, few organizations actively promote SOs as a form of planned giving. Development officers should, when appropriate, recommend that donors consider creating an SO instead of a private foundation, as the remainder beneficiary of a charitable remainder trust, as the lead charity in a charitable lead trust, or in conjunction with other planned giving tools. A campus that educates its prospects about this opportunity may have the edge in getting major gifts.

IRS Circular 230 Disclosure: To the extent this message contains tax advice, the U.S. Treasury Department requires me to inform you that any such advice, whether in the body of the message or in any attachment, is not intended or written by my firm to be used, and cannot be used by any taxpayer, for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code. Advice from my firm relating to tax matters may not be used in promoting, marketing or recommending any entity, investment plan or arrangement to any taxpayer.

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