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Supporting Organizations After the Pension Protection Act

Taxation of Exempts

Originally Published in Taxation of Exempts.

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New rules make Type III organizations considerably less attractive, and present the choice of staying in or getting out.

The 37-year old rules governing supporting organizations (SOs) were suddenly and sweepingly altered by the Pension Protection Act of 2006 (the “Act”), signed into law on 8/17/06. The Act reformed not only Type III SOs–those “operated in connection with” one or more supporting charities, but also the less controversial Type I (“operated, supervised, or controlled by”) and Type II (“supervised or controlled in connection with”) varieties1. All SOs must now face the choice of remaining subject to the new supporting organization rules, or abandoning the SO format altogether for greener exempt organization pastures.

Type III Sos

Probably the SO variety from which the greatest numbers of lifeboats will now be hastily lowered is the Type III SO.2 Because the nexus of the Type III relationship with the supported charity is considerably more attenuated than in Type I and Type II relationships, Type III SOs have provoked the most controversy and the highest level of scrutiny, at least in recent years.

In contrast to Type I SOs (a majority of the governing body is generally appointed by the supported charity) and Type II SOs (control is generally in the same hands for both the SO and the supported charity) the governing bodies of Type III SOs generally are selected by the individual or family creating the SO. While control of an SO may not be vested (directly or indirectly) in “disqualified persons,”3 the looser nature of the Type III SO/supported charity connection elicited “fantastically intricate and detailed”4 regulations designed to rein in possible abuses. Even before the Act, Type III SOs had a rough road to ride, required as they were to meet both a bifurcated “responsiveness” test (designed to ensure that the SO is responsive to the needs or demands of the supported charity),5 and an even more byzantine “integral part” test (designed to ensure that the SO maintains a significant involvement in the supported charity’s operations, and that the supported charity is in turn dependent on the SO for the type of support it provides).6

The “integral part” test itself can be satisfied in either of two ways, broadly speaking. Under the first alternative prong of the “integral part” test–sometimes called the “but for” prong–it must be the case that, “but for” the involvement of the SO in carrying out its activities, the supported charity would normally be engaged in such activities.7 Under the second alternative prong of the “integral part” test–sometimes called the “substantially all income” prong–the SO must do the following:

  • Make payments of substantially all of its annual net income (i.e., 85% or more) to or for the use of the supported charities.
  • Pay at least one-third of this 85% to a charity deemed to be “attentive” to the SO.
  • If the SO’s support is not restricted to any particular project or program of the supported charity, provide support constituting at least 10% of the overall budget of the “attentive” charity for that year.
  • If the SO supports a particular program or project, provide support constituting at least 50% of the program’s budget, which support must constitute at least 1% of the overall budget of the “attentive” charity that year. In addition, the supported program or project must be an “important and substantial one,” and a “major function” of the “attentive” charity, which in turn must be “dependent” upon the SO to continue the program or project.8

Type III SOs are identified as “activities” Type III SOs or “grantmaking” Type III SOs, depending on whether they satisfy the “but for” prong or the “substantially all income” prong, respectively.

As if having to negotiate these tests and subtests was not enough, Type III SOs have also had to try and cope with two somewhat harsh 2002 Tax Court decisions,9 which made the Type III format even less attractive.

Despite these formidable obstacles, however, Type III SOs have continued for many years to be the SO of choice for individuals and families, principally because they provided an alternative to private foundations, affording higher, “public charity” contribution deduction thresholds10 and freedom from the private foundation excise taxes.11

New restrictions and limitations on Type III SOs

The Act has now changed much of this familiar if unpleasant regime, and while Type III SOs are still permissible, they are decidedly less attractive than they were.

Easier ‘responsiveness’ test satisfaction now blocked. No longer can a Type III SO opt for the “easier” of the two prongs of the “responsiveness” test, as nearly all currently do. Effective for tax years beginning after 8/17/06, an SO cannot satisfy the “responsiveness” test simply because it is deemed a “charitable trust” under state law and because the supported charities have the power to enforce the trust and compel an accounting.12 Similarly, the Act requires that Type III SOs must provide each supported charity with such information as the Treasury may require (as yet unknown) effective for tax years beginning after 8/17/06.13

Restriction on contributions from persons in control of supported charity. Nor can a Type III SO maintain its status if it accepts a gift or contribution from a person who directly or indirectly controls a supported charity.14 As it doubtless will be quite difficult, not to say impossible, for an SO to determine with any certainty whether a potential donor is or is not in “indirect” control of a supported charity, the only viable course may be for the SO to decline all contributions proffered by anyone connected with a supporting charity–an odd situation indeed, considering the requirements elsewhere for close and continuing interaction between the SO and its supported charities.

Restrictions on grants from private foundations. Another Act provision will have the similar effect of limiting a Type III SO’s resources. Private foundations are no longer to receive “credit” toward their qualifying distribution requirements under Section 4942 for grants to Type III SOs that satisfy the “substantially all income” prong.15 (This new limitation does not apply to grants made to Type III SOs that satisfy the “but for” prong, which are now termed “functionally integrated” Type III SOs under the Act.) In addition, any such non-credited grants will now be treated as taxable expenditures under Section 4945, requiring the private foundation to exercise expenditure responsibility as to those grants, a further hassle for those grantors. Very few private foundations will likely be anxious to make grants to “substantially all income” Type III SOs after this legislation.

Exposure to excess business holdings excise taxes. In a sharp break with traditional rules distinguishing private foundations from public charities, the Act makes Type III SOs subject to the Section 4943 excise taxes on excess business holdings.16 This means that if a Type III SO owns more than 2% of the ownership interest in any business entity, it will need to navigate the complex rules of Section 4943 to ensure that its ownership interest, when combined with any ownership interests of its disqualified persons, does not exceed the applicable ownership threshold (either 20% or 35%, depending on whether it can be demonstrated that a third party effectively controls the business). This change will be particularly burdensome to Type III SOs that retain interests in businesses donated to them by founders.

Penalties on compensating substantial contributors. An even worse blow to Type III SOs comes in the form of an unusual extension of the excess benefit transaction rules to cover–in an “automatic” fashion–any grant, loan, compensation, or similar payment from an SO to a substantial contributor or a related party.17 This means that the SO cannot, for example, pay even a reasonable compensation to those of its directors, trustees, officers, or employees who are unfortunate enough to have made contributions to the SO, or to have been related to a substantial contributor, without incurring substantial excise tax penalties. As SOs are not infrequently created in part to provide some gainful employment and early resume value to scions of the family (including those who may otherwise be all but unemployable), this provision, which is made retroactive to any such payments occurring on or after 7/25/06, will further limit the allure of Type III SOs.

Donor advised fund limitations. Donor advised funds are now effectively barred by a new excise tax from making grants to “grantmaking” type III SOs (but not to “activities” or, to use the new term, “functionally integrated” Type III SOs),18 effective in tax years beginning after 8/17/06.19 Similarly, any new contributions to donor advised funds held by “grantmaking” Type III SOs (but, again, not “functionally integrated” Type III SOs) are not deductible, effective for contributions made after 2/13/06.20

Other new restrictions. Of less moment for most Type III SOs are new restrictions barring the from supporting foreign charities.21 All of them will, however, be affected by anticipated increases in payout requirements.22

New restrictions and limitations on Type I and Type II SOs

While the changes relating to Type I and Type II SOs were somewhat gentler than those for Type IIIs, the Act throws its share of challenges to these SO varieties as well, though in a somewhat more haphazard fashion.

Cloud over continued deductibility of contributions to SOs. The Act placed the deductibility of future contributions to all three types of SOs—not just Type IIIs—under something of a cloud. Treasury is to conduct a study of the organization and operation of SOs, due by 8/17/07, which is to consider specifically whether the income, gift, and estate tax deductions should remain available for contributions to Type I, Type II, and Type III SOs.23 It is probably unlikely that any future nondeductibility provisions emanating from the study will be applied retroactively to 8/17/06. Still, the uncertainty of exactly what the study will recommend and how Congress will respond in terms of new legislation does not afford the most welcoming of prospects for would-be donors to SOs.

Type I SOs—restrictions on donations from persons in control of supported charity. Type I SOs are subject to the same new restrictions on accepting contributions from those in direct or indirect control of a supported charity as type III SOs, discussed above. These restrictions do not apply to Type II SOs, however—at least not yet.

Excise tax penalties fo compensation to substantial contributors. All three types of SOs, not merely Type IIIs, are subject to the new extension of the Section 4958 excise taxes to any form of compensation or payment to substantial contributors and related parties, discussed above.

Donor advised fund limitations. As is true of “grantmaking” Type III SOs, donor advised funds are subject to a new excise tax if they make distributions to Type I and Type II SOs that are controlled by the fund donor or any “advising” person designated by such donor.24

Type II SOs’ excess business holdings. As is true of grantmaking Type III SOs, Type II SOs are now subject to the excise tax on excess business holdings under Section 4943, though Type I SOs remain exempt from these provisions.

Potential restrictions on grants from PFs to Type I and II SOs. A private nonoperating foundation’s (PF’s) grants to Type I and Type II SOs are potentially subject to the same disadvantages as grants to Type III SOs, discussed above. These limitations will apply if a disqualified person of the PF controls the Type I or II SO.

Bailing out of SO status

While a number of SOs will decide to tighten their belts and gamely try their best to survive these changes and the higher levels of scrutiny they would seem to forebode, many more will begin looking for the exit. What are the options available to a SO that simply has had enough?

Conversion to Type I or Type II status. One option, involving potentially the least upheaval for a Type III SO, is to try and become a Type I or Type II SO. For some Type IIIs, this could be merely a leap from the frying pan into the flame, as the Act imposes some fairly daunting restrictions on Type I and Type II SOs, as indicated above. Still, it may be attractive for a Type III SO to amend its organizing documents, permitting one or more of its supported charities to appoint a majority of its governing board, or at least approve of a list of candidates suggested by the SO’s founders or outgoing directors (if that still works), and enabling it to satisfy the basic requirements applicable to a Type I SO.

In more limited situations, a Type III SO might be willing to revise its organizing instrument to permit common control of its own board and the board of one or more of the supported charities, thus satisfying the Type II SO requirements. Either of these conversions generally will require that the SO file a new Form 1023 with the Service, although given the expected flight from Type III SO status, Treasury may well promulgate a more streamlined process.25

Conversion to private operating foundation. Another option will be for the SO to convert to private operating foundation (POF) status under Section 4942(j)(3). POFs, which must spend the bulk of their resources in carrying on their own exempt activities, offer attractive “public charity” deductibility thresholds for contributions. A POF is still a private foundation, however, and as such it is still subject to the private foundation excise taxes. In time, a POF can earn the right to become an “exempt” POF and win its freedom from the Section 4940 excise tax on net investment income, at least.

As noted, what are now called “functionally integrated” Type III SOs currently satisfy their “integral part” test duties by carrying on activities that, but for the SO’s involvement, would normally be carried on by the supported charity.26 It may be that the transitions from such support activities to more autonomous POF activities will be a smooth and natural one for such organizations. A POF conversion is probably less attractive for a grantmaking Type III SO–one that satisfies the “integral part” test under the “substantially all income” prong. A move from a Type III activities organization to a POF activities organization is considerably less problematic than a move from a Type III grantmaking organization to a hands-on POF activities organization, and most grantmaking Type IIIs will probably have little interest in undertaking the institutional overhaul involved in a switch to carrying on their own activities. Depending on how Type I or II SOs are currently supporting their supported charities–through grant support or through activities–similar considerations will apply.

Conversion to ‘conduit’ private foundation. Probably the most straightforward move for a grantmaking Type III SO will be to convert to a “conduit” private foundation.27 This is a variety of private foundation that, as the name implies, acts as a conduit in channeling the contributions it receives to public charities qualifying under Section 509(a)(1) or (a)(2). As long as the organization distributes the contributions it receives during the year to public charities by the 15th day of the third month of the next year, contributors enjoy full “public charity” deductibility thresholds.28 Type I and Type II SOs that provide financial support to the supported charities may also find the “conduit” private foundation format attractive.

Conversion to public charity. Some few very enterprising SOs may wish to consider a conversion to full public charity status under Section 509(a)(1) or (a)(2). This path involves less obstacles if the SO happens to be a church,29 a school,30 a hospital,31 or, more plausibly, a medical research organization,32 as such organizations enjoy a sort of “automatic” public charity status.

Other types of organizations must satisfy the “public support” tests applicable to non-“automatic” public charities. A common way of doing so is to establish that the organization “normally” receives at least 1/3 of its overall support from government sources or from the general public.33 New organizations are afforded a five-year “advance ruling period” in which to work their way up to satisfaction of the “public support” tests, but it is not clear that established SOs seeking to convert to public charity status will be granted an additional five years in this regard, and the Service’s position appears to be that they will not, at least if they have been in existence for at least five years as an SO. An SO that has been in existence for less than five years may conceivably be afforded a shortened “advance ruling period” for what remains of the five-year period, and no doubt these and similar issues will be worked out in rulings that can be expected to follow the exodus from SO status prompted by the Act.

For older SOs needing the five-year grace period, the conversion to public charity status may have to involve two steps–termination of the SO followed in essence by the creation of an entirely new organization in its place. The second step would involve reincorporation of an entity with a different structure, governance, and purposes to be sufficiently and genuinely distinguishable from the old entity as not to suggest an element of sham.

Conversion to private foundation. Probably among the least attractive exit strategies for most SOs will be to convert to a PF–a private nonoperating foundation as opposed to a “conduit” private foundation, discussed above. PFs occupy the most modest position in the Section 501(c)(3) hierarchy, and are considerably less attractive than SOs in several important ways: (1) PFs are subject to the Section 4940-4945 excise taxes; (2) the deductibility of contributions to PFs are limited to 30% of the donor’s adjusted gross income for cash gifts, 20% for gifts of appreciated assets; 34 and (3) contributions of appreciated assets other than publicly traded stock are limited in deductibility to the donor’s basis in the assets.35

Still, if the large inter vivos contribution years are behind the SO, if the SO is to be supported principally by testamentary contributions, or if the SO is funded by C corporations for which the deductibility limitations for contributions to PFs generally may be no worse than for contributions to SOs,36 a conversion to PF status may well hold considerable interest. The Service may convert less energetic SOs to PFs anyway, without the need for any action on their part, if they can no longer satisfy the applicable SO tests.37

While it apparently occurs rarely, there is some precedent for a conversion from SO status to PF status. Ltr. Rul. 9052055 involved an SO supporting a university. After the founder’s death, his widow wished to expand the number of charities the organization could support. The organization amended its governing instruments, dropping all references to the university as the supported organization. The Service ruled that the organization would be reclassified as a PF as of the effective date of the amendments. The newly converted PF was then required to file two returns for the tax year of the conversion—a Form 990 for the portion during which it was still an SO, and a Form 990-PF for the remainder of the year, when it was a PF.

Conversion to donor advised fund. Particularly where the relationship with the supported charity has been close and felicitous, an SO may well wish to consider a conversion to being a donor advised fund (DAF) within the supported charity as an alternative to outright dissolution. This actually is a genteel form of dissolution, and should follow the procedures outlined in the “dissolution” discussion below. While the Act makes a number of changes to the laws regarding DAFs, they may still hold considerable attraction for an appropriate SO. DAFs afford the outgoing SO board–or some individual, family, or delegation designated by them–the ability to “advise” (not direct) the host public charity, which is often a community foundation, as to how it might decide to expend the income generated by the former SO assets for use in the community. This continuing “no hassle” role might be attractive to an SO board that is tiring of the fight, and anxious to unburden itself from the cares of actively managing an SO.

Dissolution. No doubt some SOs faced with the new Act provisions simply will call it quits and dissolve. This process typically requires a supermajority vote of the governing body (depending on the applicable state law and the organization’s governing documents). That is followed by the satisfaction of all valid outstanding debts and the distribution of all remaining assets to qualifid public charities (usually the designated supported charities) selected by the dissolving board. From a federal law perspective, an SO need not meet any particular set of requirements to dissolve. It must inform the IRS that it has terminated by checking the “final return” box on the first page of Form 99038 and describing the termination in an attachment to Part VI, line 79. An SO’s dissolution should not trigger a termination tax under Section 507.39


The stringent new rules under the Act have made Type III SOs–and to a lesser extent Type I and Type II SOs–considerably less attractive. While some SOs will opt to stand their ground and meet these new challenges, others will need to consider exit routes. These will likely include conversion to a private operating foundation, a “conduit” private foundation, a donor advised fund within one of the formerly supported charities, or perhaps even a public charity. Other SOs may accept relegation to the “default” status as private foundations, or choose to dissolve altogether. It is critically important that, faced with the new restrictions and limitations, SOs begin at once to consider their options and develop strategies either for maintaining their existing status, converting to another form of exempt organization, or terminating their existence. If they do not do so quickly, they are likely to find their options slipping away.


  • 1See Reg 1.509(a)-4(f)(4). The Type I, II, and III designations—first proposed by the author (see Treacy, “Supporting Organizations: A Good Alternative to Private Foundations,” 24 Estate Planning 17 (January 1997)–have now been formally adopted in the Act. See, e.g., Act section 1241(a).
  • 2For a detailed discussion of how the law relating to Type III Sos, as well as Type 1 and II Sos, see Treacy, 871-2nd T.M. (BNA), Supporting Organizations.
  • 3Section 509(a)(3)(C); see also Section 4946 regarding “disqualified persons.”
  • 4Windsor Foundation, 40 AFTR2d 77-6004 at 77-6005 (DC Va., 1977).
  • 5Reg. 1.509(a)-4(i)(2).
  • 6Reg. 1.509(a)-4(i)(3).
  • 7Reg. 1.509(a)-4(i)(3)(ii).
  • 8This summary of the “substantially all income” prong of the “integral part” test draws upon the regulations and various IRS rulings over the years, which are described in detail in Treacy, supra note 2 at A-25 through A-30.
  • 9Cuddeback Memorial Fund, TCM 2002-300; Lapham Foundation, Inc., 389 F.3d 606, 94 AFTR2d 2004-6880 (CA 6, 2002).
  • 10See Section 170(b)(1).
  • 11See Sections 4940-4945.
  • 12Act section 1241(c).
  • 13New Section 509(f)(1)(A).
  • 14New Section 509(f)(2), effective 8/17/06.
  • 15Amended Section 4942(g), effective for distributions and expenditures after 8/17/06.
  • 16New Section 4943(f), effective for tax years beginning after 8/17/06.
  • 17New Section 4958(c)(3).
  • 18New Sections 4966, 4967
  • 19Act section 1231(c).
  • 20New Sections 170(f)(18), 2055(e)(5), 2522(c)(5).
  • 21Act section 1241(b).
  • 22Act section 1241(d).
  • 23Act section 1226.
  • 24See new Section 4966(d)(4)(a)(ii).
  • 25This could conceivably involve the use of Form 8734, for example.
  • 26 Act section 1243(a).
  • 27 Sections 4945(d)(3), (4).
  • 28 Section 170(b)(1)(A)(vii).
  • 29 Section 170(b)(1)(A)(i).
  • 30 Section 170(b)(1)(A)(ii).
  • 31 Section 170(b)(1)(A)(iii).
  • 32 Section 170(b)(1)(A)(iii).
  • 33 See Section 170(b)(1)(a)(iv). See also “IRS Outlines Changing the Basis for Exemption in Response to the PPA,” page 192 of this issue. New Announcement 2006-93, 2006-48 IRB 1017, is unclear about whether the procedures it outlines are available for changing an SO’s type (see above).
  • 34 Section 170(b)(1)(B), Section 170(b)(1)(D).
  • 35 Section 170(e).
  • 36 Section 170(b)(2).
  • 37 See Section 509(a).
  • 38 Section 6043(b).
  • 39 Ltr. Rul. 200043053.

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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