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Alternative Corporate Giving Formats

Tax Management Memorandum

Originally Published in Tax Management Memorandum.


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Introduction

Currently, the two most common formats for corporate charitable giving are direct outright gifts and gifts made through corporate private foundations. While these formats afford some advantages, they are by no means the optimal modes available, and the explanation for their widespread use is probably simply lack of information about alternatives. In rather stark contrast to the substantial amount of published materials on sophisticated charitable giving techniques for individuals, corporate charitable giving is, in general, an area markedly underserved by available scholarly legal publications.

In addition to reviewing the relative advantages and disadvantages of the two principal formats of corporate charitable giving, this article surveys a number of alternative, lesser-known formats for corporate charitable giving, including the use of community foundations, private operating foundations, conduit foundations, and supporting organizations. It also compares and contrasts these alternative formats, in terms of a survey of advantages and disadvantages, as well as providing examples of how a corporation might utilize a particular format.

Outright Corporate Charitable Giving

A corporation described in Subchapter C of the Internal Revenue Code is entitled to a charitable contribution deduction against federal income tax under Code Section 170(b)(2). Simply stated, the corporation may deduct the value of property contributed to a public charity qualifying under Sec. 509(a)(1), (2), or (3), up to 10% of its adjusted taxable income for the year in which the contribution is made (Sec. 170(b)(2)). The corporation may carry over for an additional five years any portion of the contribution which is not deducted in the year of the gift (Sec. 170(d)(2)). Any excess deduction not yet utilized within these six years is applied to lower earnings and profits of the corporation.

A corporation may be motivated to make a direct outright charitable contribution to a public charity for a variety of reasons. Most fundamentally, a corporation may make a contribution as a means of supporting charitable activities of which the corporation approves. Eleemosynary acts provide other important advantages to the corporation, as well, including the creation of goodwill in the public and securing favorable press coverage, which can help place the corporation in a positive light as a “good corporate citizen” which “gives something back to the community.” Corporations may also create future consumers of their products by making them available to public or private schools, as in the case of computer equipment and software. A corporation which has opened a new facility in a community may wish to establish good community relations through well-publicized contributions to public charities in the community. A myriad of other corporate motives for making charitable gifts may exist, limited only by the creativity and resourcefulness of the corporation.

The presence of these secondary motives for a corporation’s making charitable gifts, which may be termed “self-serving” in the best sense, usually rescues the contribution from being characterized as a form of corporate “waste.” Indeed, some corporate gifts to charitable organizations which fail the requirements of Sec. 170 for various reasons, may well support a Sec. 162 deduction, as an “ordinary and necessary” business expense (see Sec. 162(b)). While (as usual) the earlier decisions generally took a more rigid view of corporate giving from the perspective of corporate “waste,” the modern trend of decisions is considerably more favorable and flexible. Of course, the charitable gift must be reasonable and consistent with the financial situation and outlook of the corporation; a business on the verge of bankruptcy would not be an ideal candidate for charitable giving, for example.

Example: Direct Outright Gift. Corporation P, wishing to support local schools, donates new computer equipment to the high schools located in the county where the corporate headquarters are established. The donation is made to the county government, which then allocates the computer equipment among the schools in the manner it determines best meets the needs of the students and faculty.

Advantages
The principal advantages of direct outright charitable gifts for a corporation usually includes the following:

  • Simplicity: A direct gift to a public charity involves no “hassles” associated with ongoing interstitial foundation, and may not even require the corporation to dedicate staff and resources to a “corporate giving” office.
  • Flexibility: The corporation can decide to make an outright charitable gift at the time and in the amounts most opportune for it, as circumstances arise and change.
  • Fostering community goodwill and achieving other “secondary” goals as noted earlier.
  • Opportunity for fine-tuning charitable giving to reflect and support corporate goals: The corporation can use direct gifts in a well-targeted fashion designed to support the goals which are most important from the corporation’s perspective, and those most likely to secure secondary benefits noted earlier.

Disadvantages
The disadvantages of making direct outright charitable gifts for a corporation may include the following:

  • The corporation loses “control” over the gifted assets, as they must be owned by the community foundation in order to support the charitable deduction, and there can be no guarantee that the community foundation will honor the “advice” offered by the corporation.
  • Anecdotal data suggests that occasionally, a change of management and style within the community foundation at a future date can become a matter of frustration to a corporation comfortable working with the former management.
  • The format does not afford the advantages, available in other formats considered below, of an independent, stand-alone charitable organization, and so is somewhat limited in the scope of its advantages and utility.

There has also been in recent years some threat to the future validity of donor advised funds which might have given pause to some corporation otherwise interested in this approach, although the clouds seem now to have passed.

Still, for corporations who wish to “put a toe in the water” of more sophisticated charitable giving, the use of a donor advised fund within a community foundation can afford considerable advantages over the straight “direct outright gift” approach.

Private Foundations

Among that minority of corporations which have gone further in their charitable gift planning than direct outright gifts and donor advised funds, the large majority have created private foundations. That most have then not gone much further attests to the advantages and flexibility of the private foundation as a reasonably useful corporate charitable gift planning component.

Briefly stated, a private foundation is an independent entity which can qualify for tax-exempt status as a charitable organization under Sec. 501(c)(3), but which does not meet the various public support and other tests applicable to public charities under Sec. 509(a)(1) and (2), or to supporting organizations under Sec. 509(a)(3). The distinction between a private foundation on one hand, and a public charity on the other, is a crucial one, and one which does not favor the private foundation. It is not too much of an overstatement to say in this regard that private foundations are a sort of “catch-all” or “leftover” category (with no disrespect intended) reserved for entities which qualify as charitable organizations but cannot or do not wish to satisfy the requirements of charities enjoying a more elevated status in the Code. Typically, whatever charitable organization fails the requirements of Sec. 509(a)(1), (2) or (3) automatically becomes a private foundation. There are lots of them out there, and a fair percentage of them are corporate foundations. If a charity is not a public charity, then generally it is a private foundation. But there are some interesting and attractive hybrid categories, such as the private operating foundation (see Sec. 4942(j)(3)), which share some aspects of public charities and some private foundations, and which are discussed in detail below.

Example: PF. Corporation R has been making some direct outright gifts to charities in the community for a number of years, and decides to bring more organization and flexibility to its charitable gift planning. R creates the Corporation R Foundation (Foundation), the goals of which are to support health and education in the regions where R does business. R is the sole initial contributor to the Foundation. The Foundation’s board members are appointed by R, and consist of officers and directors of R. As the Foundation does not meet the public support tests applicable to Sec. 509(a)(1) and (2) organizations, or the control tests applicable to Sec. 509(a)(3) organizations, the Foundation is a private foundation, and is subject to the various excise taxes applicable to private foundations, including those restricting self-dealing, excess business holdings, jeopardy investments, and taxable expenditures. Further, the Foundation must distribute at least 5% of the value of its investment assets on an annual basis “upstairs” to qualified public charities. The Foundation also pays an annual excise tax of 2% on its investment income. Distributions made by the Foundation to regional charities carry the corporation’s name, through the Foundation’s name, and so create public awareness of Corporation R and enhance its status as a “firm that cares” about the communities it serves.

Formation and Maintenance
Steps in its formation and maintenance include the following:

  • Filing of the organizing documents with state (and sometimes local) authorities;
  • Filing of Form 1023, Application for Recognition of Tax-Exempt Status, with the Internal Revenue Service, within 15 months (extendable to 27 months) from the date of creation;
  • Annual filing of Form 990PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation, with the IRS, and a copy, or an alternate form, with state (and sometimes local) authorities; and
  • Board meetings on at least an annual basis.

Pros and Cons
The paramount advantage of the private foundation format for corporate charitable gift planning is control–the corporation, and the corporation alone, can remain fully in charge of all aspects of the operation and management of the private foundation. The major disadvantage of the private foundation format is that this control comes at a price–the private foundation is subject to a number of rather unpleasant excise taxes which don’t apply to public charities or supporting organizations, and donations made to the private foundation are not as favored in the tax laws as those made to public charities and supporting organizations. For many corporations, the control advantage will not be worth the price.

Advantages
The advantages of creating a corporate private foundation include the following:

  • The foundation provides a permanent, organized vehicle for making charitable contributions.
  • The assets contributed to the foundation are generally beyond the reach of the creditors of the corporation.
  • The foundation is controlled by the corporation.

Disadvantages
The disadvantages of the use of a corporate private foundation fall into two main categories: (1) limitations on deductibility; and (2) applicability of excise taxes.

Limitations on Deductibility
Contributions of appreciated assets to a private foundation are in general deductible only up to the corporation’s cost basis in the donated assets (Sec. 170(e)(1)). An exception is recognized for contributions of publicly traded unrestricted stock, which can be deducted based on fair market value (Sec. 170(e)(5)). Contributions of all other types of appreciated assets–land, personal property, restricted stock, artwork, etc.–are subject to the harsh “reduce-to-basis” rule. This rule must be counted a serious disadvantage of the private foundation format.

Example: Deductibility Limits. Corporation C contributes real estate with a basis of $100,000 and a fair market value of $1,000,000 to its private foundation. Corporation C also contributes unrestricted publicly traded stock with a basis of $50,000 and a fair market value of $500,000 to its private foundation, in the same year. Corporation C’s charitable contribution deduction for these gifts would be $100,000 (not $1,000,000) for the gift of real estate, and $500,000 (not $50,000) for the contribution of the stock.

Excise Taxes
Another key disadvantage of the private foundation format is that private foundations, unlike public charities and supporting organizations, are subject to a variety of rather harsh excise taxes which can severely limit the attractiveness of the private foundation format for the corporation. These excise taxes include taxes on the following:

  • Tax on Investment Income: Private foundations are subject to the Sec. 4940 excise tax on investment income, which in most instances is assessed at 2% of the investment income of the foundation (Sec. 4940(a)). A private foundation may, by meeting certain tests, reduce this tax to 1% of investment income (Sec. 4940(e)(1)). In years in which large capital gains are realized by the foundation, this tax can be particularly bothersome.
  • Self-dealing: Section 4941 imposes a tax on acts of “self-dealing” (Sec. 4941(d)(1)), defined to include most transactions between the foundation and a “disqualified person,” including substantial contributors to the foundation, such as the corporation would ordinarily be. These “self-dealing” transactions include such acts as transferring realty subject to an indebtedness to the foundation, a purchase or sale transaction between the corporation and the foundation, the furnishing of goods or services, and the payment of excessive compensation to a “disqualified person.”
  • Distributions: Section 4942 requires a private foundation to distribute at least 5% of the value of its investment assets each year to Sec. 509(a)(1), (2) or (3) organizations, and to the extent the foundation fails to do so, the excise tax is imposed (Sec. 4942(e)). The tax can be irksome in situations in which the foundation holds assets of uncertain fair market value, making it difficult to determine with certainty whether a full 5% of this uncertain value has been distributed.
  • Excess Business Holdings: Section 4943 limits the safe holdings of a private foundation in any business enterprise to 2% of the ownership interest in the enterprise (Sec. 4943(c)(2)(C)). If, in the aggregate, private foundations and disqualified persons own more than 20% of the ownership interest in a business enterprise (including the corporation which created the foundation), then any excess is taxed under Sec. 4943 (Sec. 4943(c)(2)(A)). This feature greatly reduces the attractiveness of the private foundation format for corporations seeking “safe, friendly” holders of corporate stock, for example.
  • Jeopardy Investments: Investments which the IRS deems to jeopardize the charitable purposes, such as puts, calls and straddles, trigger the Sec. 4944 excise tax on “jeopardy investments” (Sec. 4944(a)).
  • Taxable Expenditures: A significant limitation imposed on private foundations is that in general they are permitted to make distributions only “upstairs” to public charities (Sec. 4945(d)(4)). If a private foundation makes a grant to an individual or to another private foundation, in general this action triggers the excise tax under Sec. 4955 on “taxable expenditures” (Sec. 4945(d)(3), (4)).

Example: Excise Taxes. Corporation X creates a private foundation with a grant of $1,000,000 of real estate subject to a $500,000 mortgage debt on which the corporation is obligated, as well as a 10% interest in the corporation. The private foundation pays S, its president and also the CEO of the corporation, a salary of $600,000. It also makes scholarship grants to children of the Corporation X Board of Directors, and invests in a Bolivian gold mine venture in which one of the officers of Corporation X has an interest. Among the violations of the excise tax rules in this factual setting would be: (1) acts of self-dealing under Sec. 4941; contribution of debt-laden realty; excessive compensation; scholarship grants to children of the Board; (2) excess business holdings under Sec. 4943; (3) jeopardy investment under Sec. 4944 as to the gold mine venture (probably); and (4) taxable expenditures under Sec. 4945 as to the scholarships. The continued tax-exempt status of the private foundation would also be very much in doubt.

“Conduit” Private Foundations

The first of the “unusual” but potentially attractive alternate formats for corporate giving discussed in this article is the “conduit” private foundation. If, within a specified time period, a private foundation distributes to public charities the contributions it has received during the prior year, then the contributions are treated, in effect, as having been made directly to the public charities by the initial donor, with the private foundation serving as a temporary “conduit” and not a permanent destination (Sec. 170(b)(1)(A)(vii)). Because these contributions are deemed to pass through to the public charities, the donors who make contributions to the “conduit” private foundation are deemed to have made gifts directly the ultimate public charity recipients. For this reason, a gift by a corporation of appreciated assets to a “conduit” private foundation are free of the “reduce-to-basis” rule, and may be deducted at fair market value.

Under the applicable rules, a “conduit” foundation must distribute the contributions it received in the prior year to public charities no later than the 15th day of the third month following the close of the prior year. In the case of a “conduit” private foundation on a calendar-year basis, the distributions must occur on or before March 15 of the second year.

Example: “Conduit” PF. Corporation C wishes to contribute real estate valued at $1 million, but with a basis of $500,000, to its private foundation (which uses the calendar year as its fiscal year), but fears that this will reduce its charitable contribution deduction from $1 million to $500,000 under the “reduce-to-basis” rule. In addition, Corporation C has not yet decided which public charities it wishes ultimately to receive the realty. If the private foundation distributes the real estate to charities on or before March 15 of the year after the contributions (affording considerably more time to select public charity recipients), then Corporation C is entitled to a full $1 million deduction, and the “reduce-to-basis” rule does not apply.

Advantages
The principal advantage to a corporation in using such a “conduit” private foundation is that it permits the corporation to make a donation of appreciated assets and still escape the harsh “reduce-to-basis” rule, so long as the assets are distributed to public charities (or expended on foundation administrative expenses) by the applicable date of the following year. The format also permits the corporation in effect to recreate some of the advantages and flexibility of creating a donor advised fund within a community foundation, a format discussed earlier in this article. In addition, the other advantages associated with private foundations in general also apply.

Disadvantages
While contributions to the “conduit” private foundation can escape the “reduce-to-basis” rule, the “conduit” private foundation is still fully subject to the excise taxes summarized above.

Private Operating Foundations

One of the limitations imposed on corporate private foundations is that the foundation is not permitted to carry on its own charitable activities–rather, it must passively make distributions “upstairs” to public charities, and let them apply the funds to charitable activities. A major exception to this rule is the “private operating foundation” (POF), which is permitted to carry on its own charitable activities directly, and which also can escape some of the other restrictions imposed on private foundations (Sec. 4942(j)(3)). This ability to carry on charitable activities directly may be quite attractive in a proactive corporation’s gift planning.

The POF is essentially a hybrid form of private foundation, and is described in Sec. 4942, the provision which imposes the excise tax on failure to make distributions. An exception is recognized in Sec. 4942 for private foundations which use the funds which would otherwise have to be distributed to public charities, to carry on their own charitable activities. The private operating foundation shares some qualities of the public charity, such as freedom from some provisions of the excise taxes and from the harsh “reduce-to-basis” rule that applies to standard private foundations (sometimes called in this context, “private nonoperating foundations”).

In order to qualify as a POF, a foundation must expend substantially all of its income directly for charitable purposes. In addition, the private operating foundation must meet any one of the following three requirements:

  1. It must devote at least 65% of its assets to charitable purposes;
  2. It normally must distribute at least two thirds of its “minimum investment return” (i.e., two thirds of 5% of its investment assets) to qualified public charities; or
  3. It must receive substantially all of its support from the general public, and not more than half its support from gross investment income.

Example: POF. Corporation O wants to play more than a passive grantmaking role in the charitable community. It wishes to assist the community by building and operating temporary living quarters for parents of desperately ill children receiving treatment in community hospitals and hospitals. As a standard private foundation is not permitted to carry on its own activities, Corporation O instead forms a private operating foundation. Substantially all of the foundation’s annual $100,000 of income is used in building and operating these living quarters, which in turn constitute 70% of the assets of the foundation. The foundation should qualify as a POF.

Advantages
In addition to the advantages of a private foundation summarized earlier, a POF format frees the corporation to carry on direct charitable activities through the foundation and, hence, have more of an “impact” on the community, in contrast to the passive grantmaking function of standard private foundations. Contributions of appreciated assets to POFs are free from the “reduce-to-basis” rule that would otherwise apply (Sec. 170(e)(1)(B)(ii)).

Disadvantages
Somewhat tax-favored as it is, the POF is still fundamentally a private foundation, and most of the excise taxes continue to apply.

Supporting Organizations

In many respects, the optimal format for corporate charitable giving, the supporting organization (SO), is probably one of the least utilized, a situation which is rapidly changing. The unique advantage of the SO is that, unlike private foundations, it is entirely free from the excise tax provisions, and is not subject to the harsh “reduce-to-basis” rule that applies to contributions of appreciated nonstock assets to private foundations. In addition, like the POF explored earlier, the SO affords the “hands-on” corporation with the ability to carry on its own charitable activities, in addition to being permitted to take a more passive role in grantmaking to other charitable institutions. This is because the SO is treated as a public charity, and not a private foundation at all.

The price paid for the unique and powerful advantages afforded by the SO format is some limitations on sheer control–the corporation is not permitted to control the board of the SO. Instead, the corporation may designate others in the community to serve as codirectors with its own representatives. A typical board of a corporate SO would consist of five directors, two of which are representatives of the corporation, and three of which are community leaders, friends, or representatives of the supported charitable organizations. Corporations which have adopted the SO format for their charitable gift planning usually feel the advantages are well worth the price of sharing control.

An SO is an organization which meets the requirements of Sec. 509(a)(3). The principal elements of these tests can be summarized briefly as follows. (Note that the description applies to “Type III” SOs, rather than “Type I or II” SOs, which are probably less common in the corporate setting.)

Control Test
The governing body of the SO must consist of a majority of persons other than disqualified persons (Sec. 509(a)(3)(C)). The corporation and its own representatives (including its officers and directors, as well as employees) are to occupy a minority position on the governing body, with the majority of seats held by appointees of the corporation who are not disqualified persons. Note that this does not mean that the day-to-day activities of the SO cannot be handled by representatives of the corporation, and, in fact, this is commonly the case.

Organizational Test
The organizing instrument of the SO must designate one or more “supported charities” by name. As the list cannot be changed unless one of the named charities ceases to exist as a public charity, it is important to include at least one community foundation in this list, to permit the SO to make contributions to organizations not yet in existence at the time the SO is created, or not known to the corporation at that time. The SO can then create the equivalent of a donor advised fund within the community foundation, to permit advised gifting to these additional unnamed charities.

Responsiveness Test
This somewhat complex test can be simply explained as requiring that the following three elements must be present:

  1. The SO must be a “charitable trust” under state law (this category includes both true trusts and non-profit corporations);
  2. Each supported charity must be a named beneficiary under the SO’s governing instrument; and
  3. Each named supported charity must have the power to enforce the trust and compel an accounting under state law (Regulation Section 1.509(a)-4(j)(2)(iii)).

Meeting these requirements is usually an aspect of drafting the organizing instrument correctly.

Integral Part Test
This one is a bit tricky. The SO must be able to show it maintains a significant involvement in the operations of one or more of the named supported charities, and such charity or charities must, in turn, be dependent on the SO for the type of support which it provides (Reg. Sec. 1.509(a)-4(i)(3)). This test can be met in one of two ways, depending on whether the SO makes grants to other charities (like a private foundation), or carries on its own charitable activities (like a private operating foundation).

In the case of a grantmaking SO, the SO must distribute at least 85% of its net income each year to one or more of the named charities, and at least one third of this support must go to the named charity which is “attentive” to the SO. The “attentiveness” aspect of this test can be met either by: (1) giving at least 10% of the named charity’s overall budget for that year; or (2) more easily, by providing more than 50% of some important and significant fund or project of the named charity. Note that this is a considerable simplification of a fairly complex and important area.

In the case of an activities SO, the activities engaged in by the SO must support one or more of the named charities, and it must be the case that, but for the involvement of the SO, the named charity would normally be engaged in these activities.

507 Rollovers
If a corporation has an existing private foundation, and is becoming increasingly disenchanted with the limitations and restrictions placed on it, then it is an easy step to convert the private foundation into an SO, in a process sometimes referred to a “507 rollover.”

Formation and Maintenance
The principal steps involved in the formation and maintenance of an SO are as follows:

  • The governing instrument must be filed with the state (and sometimes local) authorities;
  • Form 1023, Application for Recognition of Exempt Status, is to be filed with the IRS within 15 months (extendable to 27 months) from the date of creation;
  • Annually, Form 990, Return of Organization Exempt from Income Tax, must be filed with the IRS, and a copy (or alternate form of annual return) must be filed with state (and sometimes local) authorities;
  • The governing body must meet at least annually; and
  • Each year, the SO must either carry on charitable activities which, but for the SO’s involvement would normally be carried on by a named charity, or must distribute at least 85% of its net income to one or more named charities, at least one of which must be receiving a sufficient amount of support to establish that it is “attentive” to the SO.

Example: SO. Corporation B wishes to create an entity to accomplish its charitable giving goals, and is not attracted to the private foundation format because of the “reduce-to-basis” rule and the various excise tax restrictions and limitations. Instead, it creates an SO, the Corporation B Supporting Organization, whose board, all selected by the corporation, consists of two representatives of the corporation and three friends (one community leader, one representative of a charity named on the SO document, and one past board member). The corporation lists 20 charities in the community it wishes to support, and also designates at least one community foundation, to permit it to reach future charities not named in the initial list of 20. Each year, the SO distributes at least 85% of its net income (including short-term capital gains realized, but not including long term capital gains realized (Letter Ruling 9714006)) to one or more of the named charities. In the case of one of the named charities, the SO supports a fund to protect an endangered species of salmon, and provides more than half the budget for this fund, which is an important and substantial one to the supported charity. The SO should qualify under Sec. 509(a)(3). The SO is not subject to the excise taxes which plague the private foundation arena, nor to the “reduce-to-basis” rule that discourages gifts of appreciated assets to private foundations.

Advantages
In addition to all the advantages of private foundations and private operating foundations, the SO format:

  • Affords the corporation the unparalleled advantages of complete freedom from the Secs. 4940 through 4945 excise tax rules, and from the harsh “reduce-to-basis” rule applicable to gifts of non-stock appreciated assets to private foundations;
  • Permits great flexibility, as the SO may make grants to the supported charities, and may also carry on its own activities directly; and
  • In addition to supporting public charities qualifying under Sec. 509(a)(1) or (2), permits the SO to also support certain non-charitable tax-exempt entities, such as fraternities, sororities, business leagues, and the like (Sec. 509(a)(4)).

Disadvantage
The sole “disadvantage,” if it can be termed such, is that the corporation is not permitted to exercise sheer control over the board of the SO; instead, it must share control with friends and community leaders and other non-disqualified persons. This shared board control can actually enhance the corporation’s standing in the community, by keeping it in close contact with community leaders and charitable representatives.

Conclusion

Which of these many alternatives will be most attractive to a particular corporation depends wholly on the goals and needs of the particular corporation, of course. In many cases, a corporation may well opt to adopt more than one of these formats simultaneously, to maximize the advantages and flexibility, and to minimize the restrictions and disadvantages. The important thing, of course, is that the corporation’s advisors represent their client well by bringing these important alternatives to the corporation, and by assisting the corporation in making the most well-reasoned and well-informed selection of a format or group of formats which most felicitously meet its goals and objectives.

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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