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Aftershocks: Update on Supporting Organizations

Tax Management Estates, Gifts and Trusts Journal

Originally Published in Tax Management Estates, Gifts and Trusts Journal.


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On August 17, 2006, a major seismic event – the Pension Protection Act of 2006 (PPA) — shook the well-settled topography of Code Section 509(a)(3) supporting organizations (SOs),1 and the aftershocks have continued unabetted since. In an unusually intense outpouring of guidance, announcements, and notices, the Service has been grappling with the many questions left unanswered by PPA 2006, provoking strong reactions from the charitable sector, from bar associations, and from elected officials. While major lacuna certainly remain in our understanding of exactly what post-PPA SOs will look like, enough has emerged in the past year and a half to be able to trace and assess the principal thread and direction of these critically important recent developments.

Conversion to Other Form of Public Charity

The first issuance of significance in order following the PPA enactment, IRS Announcement 2006-93, assumed a bit prematurely that SOs would be charging for the exit doors, in light of the fact that, under the PPA, distributions from IRAs to SOs are not excludable from the holder’s income, and that distributions from PFs to some varieties of SOs could henceforth be subject to excise tax as taxable expenditures. The Announcement requires an SO seeking to change its public charity classification due to the PPA changes, to submit a formal written request for reclassification. The request must include a statement requesting reclassification from Code Section 509(a)(3) to another public charity status under Code Section 509(a)(1) or (2), The request must also include either: (a) page one and the signature page of the most recent Form 990 or Form 990-EZ, and pages 2 and 3 (Parts IV and IV-A) of Schedule A of such form; or (b) Form 8734, Support Schedule for Advance Ruling Period. The SO is to write at the top of the request, “509(a)(3) Pension Protection Act,” and mail2 or fax3 the request to the Service. If the SO had already been so chagrined by the PPA changes that it had already filed a regular request for reclassification before the issuance of the Announcement, a statement to that effect is to be provided as well. In a palliative act of generosity, the Service waives the user for the new determination letter requested.

The problem with this formal written request format, of course, is that precious few SOs will likely be able to satisfy the public support tests applicable to Code Section 509(a)(1) or (2) public charities. The impossibility of demonstrating broad public support in the form of donations from the general public is what usually motivated the selection of the SO format in the first place. For many SOs, the exit choice will either be another form of SO (such as a transition from Type III to Type I) or headlong demotion to private foundation status, with the attendant disadvantages of reduced deductibility and the application of the rather unpleasant private foundation excise taxes.4 User fee waiver or not, Announcement 2006-93 accomplished little other than rubbing salt in the wound.

Interim Guidance on Grants from PFs and SOs

Next to come was IRS Notice 2006-109,5 which provided what was termed “Interim Guidance Regarding Supporting Organizations and Donor Advised Funds,” applicable “until further guidance is issued.” Of the two sections of the Notice most relevant to SOs, the first, Section 3, addresses the oblique question of the treatment of grants from private foundations (PFs) or donor advised funds (DAFs) to SOs. Under the PPA, PFs and DAFs are discouraged or barred from making grants to grantmaking Type III SOs, but not to activities Type III SOs (dubbed “functionally integrated” Type III SOs under PPA). Until further guidance is issued, the Announcement provides that a grantor PF or DAF, acting in good faith, is permitted to rely on information from the IRS Business Master File (BMF), or the SO’s current IRS letter of determination in assessing whether an organization is an SO, or is a safer form of public charity under Code Sections 509(a)(1) or (2).6 All well and good for the PF or DAF, but no letters of determination issued to SOs yet indicate whether the SO is a Type I, Type II, or Type III SO, and if the latter, whether the SO is a grantmaking (i.e., more risky) Type III SO, or a “functionally integrated” (i.e., safer) Type III SO. A grantmaking Type III SO is one which supports its supported charities by making grants, while a “functionally integrated” Type III SO is one which carries on activities which, but for the SO’s involvement, would normally be carried on by the supported charity or charities. The PPA concludes in effect that activities are better or more praiseworthy than mere cash in the SO context, and so rewards activities Type III SOs over its check-writing brethren.

To help resolve this conundrum left in the wake of the PPA, the Notice provides that a PF or DAF is entitled to rely in good faith on a written representation from the SO, accompanied by certain specified documents described in the Notice. These documents must be consistent with written representation, of course, or the PF or DAF cannot meet the “good faith reliance” standard. The PF or DAF must also verify the SO’s listing in IRS Publication 78 or obtain a copy of the SO’s letter of determination. What are these “certain specified documents” from the SO upon which the PF or DAF is entitled to rely? This depends on what the PF or DAF is attempting to determine. In order to establish whether the SO is a Type I or Type II SO, the PF or DAF may rely on a written representation signed by an officer, director or trustee of the SO that the SO to that effect, provide that: (i) the representation describes how the SO’s officers, directors, or trustees are selected (as it is this feature which usually determines whether an SO is a Type I or II versus a Type III), as well as referencing any provisions in the SO’s governing documents that establish a Type I or II relationship with the supported charity or charities; and (ii) the PF or DAF collects and reviews copies of the SO’s governing documents “and, if relevant, of the supported organization(s).” Most PFs and DAFs will likely find even this threshold “ I or II v. III,” inquiry daunting to say the least, and may well just refrain from making grants to any SO, regardless of its Type.

If the SO is a Type III, then to establish that it is a functionally integrated (i.e., safer) Type III, the PF or DAF, acting in good faith, may rely on a written statement signed by an officer, director, or trustee of the SO to that effect, provided that: (i) the SO’s representation identifies the one or more supported organizations with which it is functionally integrated; (ii) the PF or DAF collects and reviews copies of the SO’s governing documents (and, “if relevant,” those of the supported charities), and “any other documents that set forth the relationship” of the SO to its supported charities, if the relationship is not reflected in the SO’s governing documents; and (iii) the PF or DAF collects and reviews a written representation signed by an officer, director or trustee of each of the supported charities with which the SO represents that it is functionally integrated, which describes the SO’s activities and confirms that but for the involvement of the SO, the supported charity would normally be engaged in those activities itself. This Type III determination is even more daunting for the PF or DAF, which can be expected in most cases simply to pass on grant requests from Type III SOs altogether.7

Perhaps recognizing the practical difficulties (not to say the challenging legal distinctions involved) in these complicated Type I, II, and III determinations for the PF or DAF, the Notice also provides an alternative reliance format, under which the PF or DAF may rely on “a reasoned written opinion of counsel” from the attorney for the SO, or from the attorney for the PF or DAF itself, that the SO is a Type I, Type II, or functionally integrated Type III SO.8 This alternative format will drive up the costs for the PF or DAF, or for the grant-seeking SO, and would still seem to leave open the possibility of IRS quibbling regarding whether or not the written opinion of counsel is “reasoned;” perhaps another opinion of other counsel would be required to resolve that issue.

As if these reliance steps were not complicated enough, the Notice goes on to point out that the PF or DAF “may need to obtain” a list of the SO’s supported charities, to determine: (i) whether any of them is controlled by disqualified persons of the PF; or (ii) whether any of them is controlled by the DAF’s donor or donor advisor or related parties.9

Interim Guidance on Existing Contracts and Excess Benefit Transactions

The PPA extended the excess benefit transaction rules under Code Section 4958 specifically to SOs, such that any grant, loan, compensation or similar payment by an SO to a substantial contributor or related person, and any loan provided by an SO to certain disqualified persons, is treated automatically as an excess benefit transaction. What about situations in which an SO was, as of the date of enactment of the PPA, obligated under a binding contract or other undertaking, to pay substantial contributors or related persons for goods or services, or to provide a loan to a disqualified person? Notice 2006-109 provides that, under a transitional relief rule, the IRS will not consider to be an excess benefit transaction, any payment made pursuant to a written contract which was binding as of August 17, 2006, so long as: (i) the contract was binding at all times after August 17, 2006 and before payment was made; (ii) the contract was not modified during such period; and (iii) the payment was made on or before August 17, 2007. Similar rules applied to arrangements involving an employment relationship in existence, or other legal obligation in effect, on August 17, 2006. The Notice warns that, notwithstanding these transitional relief provisions, if the SO pays in excess of reasonable compensation or purchase price, it places in jeopardy its continued tax-exempt status under Code Section 501(c)(3).10

Suspension of Issuance of Letters of Determination

On February 22, 2007, a Memorandum from Robert Choi, Acting Director, EO Rulings and Agreements, announced the suspension of the issuance of determination letters for Type III SOs seeking favored “functionally related” status. The suspension applied to new Forms 1023 as well as requests for change in foundation status. The suspension became effective immediately upon the issuance of the Memorandum “and will last until guidance is available.” The Memorandum put even greater weight on the complicated provisions of Notice 2006-109, as it denied Type III SOs, and those wishing to make donations or grants to them, of an important means of establishing their bona fides as functionally integrated entities escaping some of the worst of the PPA amendments.

SO Study – Request for Public Comments

Section 1226 of the PPA directed Treasury to report back to Congress by August 17, 2007 with its study on the organization and operation of SOs and DAFs. This study was the subject of IRS Notice 2007-21, inviting submission of public comments by April 9, 2007 on a variety of topics under review, including: (a) the advantages and disadvantages of SOs to the charitable sector, compared with PFs and other charitable giving arrangements; (b) the continued availability of the charitable deduction for donations to SOs in circumstances involving payment or use of contributed assets for salaries, loans or other personal benefits to the donor, as well as instances in which the donor has investment control over the assets, and where non-liquid assets are given; (c) appropriate payout requirements for SOs; and (d) the advantages and disadvantages of “perpetual existence” for SOs. Comments were received from a number of sources, including the New York State Society of Certified Public Accountants,11 the Council on Foundations,12 the National Committee on Planned Giving (NCPG),13 and the New York Bar Association.14

Payout Requirements

IRS Announcement 2007-8715 described rules regarding payout requirements applicable to grantmaking Type III SOs (as opposed to functionally related Type III SOs carrying on activities for their supported charities) which Treasury and the IRS anticipated proposing. The anticipated payout requirement, modeled on the current payout requirements applicable to PFs under Code Section 4942, will be set at a minimum of 5% of the aggregate fair market value of all of the SO’s assets, other than those assets used or held for use directly in supporting the charitable programs of the supported charities. The valuation of assets for these purposes is expected to be determined in a manner similar to that under Code Section 4942(e)(2) and Section 53.4942(a)-2(c)(4) of the Treasury Regulations. Amounts the SO pays “to accomplish the exempt purposes of its supported organizations” is anticipated to be considered as distributed to or for the supported organizations’ use for these purposes.

Limit of 5 Supported Charities

Announcement 2007-87 also set forth the anticipated limitation of the number of organizations supported by grantmaking Type III SOs to five such organizations. This anticipated 5-charity limit is said to be designed to ensure a “tight nexus” between the SO and its supported organizations. As to SOs already in existence on the date the regulations are proposed, these may continue to support more than 5 charities, so long as at least 85% of the SO’s total payout requirement is distributed to or for the use of 5 supported charities. In elegant understatement, the Announcement recognized that these anticipated rules “may effect existing donee relationships,” and solicited comments on whether transitional rules were needed.

Qualification as a “Functionally Integrated” Type III SO

Announcement 2007-87 did not expend its full force solely on grantmaking Type III SOs; in addition, the Announcement sets forth the anticipated “functionally integrated” tests. A functionally integrated Type III SO is expected to be defined as a Type III SO which meets three tests: (1) the “but for” test of Section 1.509(a)-4(j)(3)(ii) of the Treasury Regulations; (2) an expenditure test similar to the test applicable to private operating foundations (POFs) under Code Section 4942(j)(3)(A); and (3)an assets test also based on the equivalent POF test under Code Section 4942(j)(3)B)(i). Under the anticipated expenditure test, the functionally integrated Type III SO would be required to expend directly for the active conduct of activities supporting its supported charities, substantially all of the lesser of: (a) the SO’s adjusted net income; or (b) 5% of the aggregate value of all of the SO’s assets, other than those which are used or held for use directly in supporting charitable programs of the supported charities. The anticipated assets test would require the SO to devote at least 65% of the aggregate value of all of its assets directly for the active conduct of the activities directly furthering the exempt purposes of the supported charities. The expenditure and assets tests are designed to substitute for the current “integral part” test applicable to SOs, again to strengthen the “nexus” between the SO and its supported charities. The Announcement recognizes that the expenditure and assets tests may present problems for functionally integrated Type III SOs that oversee or facilitate the operation of an integrated system which includes one or more charities, such as some hospital systems, and indicates that allowances will be made in the proposed regulations for such entities, so that they too can qualify as “functionally integrated” Type III SOs.

Consequence of Failure to Meet Anticipated Tests

Announcement 2007-87 indicates that the proposed regulations will clarify that a Type III SO failing to meet these new grantmaking or functionally integrated tests will be demoted to PF status.

Failing the “Responsiveness Test”

Section 1241(c) of the PPA eliminated one of two alternative “responsiveness” tests for Type III SOs, the so-called “charitable trust” test, effective August 17, 2007. Under this alternative test, which was probably by far thealternative most commonly utilized by Type III SOs, the responsiveness requirements were met if the SO was a charitable trust under state law, each supported charity was named as a beneficiary under the governing trust document, and each beneficiary had the power to enforce the trust and compel an accounting. The other, more subjective, alternative test, the “but for” test, is now the only test available for establishing the “responsiveness” requirement applicable to Type III SOs. Briefly stated, that test requires that, through at least one appointed or common director, trustee, or officer, the supported charity has a “significant voice” in the making, timing and recipients of grants, and in the investment of the SO’s assets.

Under IRS Notice 2008-6,16 an SO’s failure to meet the “but for” test by the August 17, 2007 deadline will result in a demotion of the SO to PF status, unless it can successfully qualify as a public charity under Code Sections 509(a)(1) or (2). To help mitigate the record-keeping difficulties of making a mid-year change of status, the Notice provides that trusts which were relegated to PF status during 2007 by failing to meet the “but for” test, may continue to file Form 990 for taxable years beginning before January 1, 2008. The newly demoted PF need not file a short-year Form 990-PF for the latter portion of 2007, but must commence filing such form for its first taxable year beginning on or after January 1, 2008, and must write “Notice 2008-6 status change” at the top of its first such Form 990-PF. Type III SOs which successfully transition from the old “charitable trust” test to the “but for” test prior to the August 17, 2007 deadline, are to continue filing Form 990 as SOs.

Footnotes

  • 1The author discussed PPA 2006 in these pages, in Treacy, Gerald B., “Supporting Organizations After the Pension Protection Act,” Taxation of Exempts (Jan./Feb. 2007), pp. 163 ff.
  • 2Mailed requests are to be sent to: IRS-TEGE, Attn: Adjustments Unit, Room 4024, P.O. Box 2508, Cincinnati, OH 45201.
  • 3Faxed requests are to be sent to: IRS-TEGE, Attn: Adjustments Unit, Room 4024, Fax: (513) 263-3522.
  • 4I.R.C. Sections 4940-4945.
  • 5I.R.B. 2006-51 (December 18, 2006).
  • 6Notice 2006-109, section 3.01.
  • 7Id.
  • 8Id.
  • 9Id. Section 3.02 of Notice 2006-109 sets forth preliminary standards for determining whether a disqualified person with respect to a PF controls an SO or one of its supported organizations, and for determining whether a donor or donor advisor (or related person) with regard to a DAF controls an SO.
  • 10Notice 2006-109, Section 4.
  • 11Letter of Thomas E. Riley, President (April 6, 2007).
  • 12Letter of Steve Gunderson, President and CEO (April 9, 2007).
  • 13Letter of Tanya Howe Johnson, President and CEO (April 9, 2007).
  • 14Letter of Patrick C. Gallagher, Chair (June 6, 2007), which included a Report by the Tax Section of the New York State Bar Association.
  • 15I.R.B. 2007-40 (October 1, 2007).
  • 16I.R.B. 2008-3 (January 22, 2008).

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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