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Wednesday May 25, 2016

Article of the Month

Supporting Organizations — Part I

I. Introduction


Historically, the government has divided charities into two distinct camps: public charities and private foundations. In general, it is more advantageous for a charity to be categorized as a public charity rather than a private foundation due to the more favorable tax treatment afforded to public charities. Section 509(a) supporting organizations share similar characteristics with private foundations but are granted public charity status because they provide support to public charities. Supporting organizations have become more popular in recent years because they allow donors to make significant gifts and remain involved in the use or investment of the gifted funds, while still receiving the tax advantages of donating to a public charity rather than a private foundation.

Due to the increasing popularity of supporting organizations, the IRS and Treasury Department have established various rules and regulations to ensure compliance and prevent abuse. The Pension Protection Act of 2006 (“PPA”) made specific changes to the requirements of Type III supporting organizations. On February 19, 2016 the IRS and Treasury Department issued REG-118867-10, which both clarified previous statutory changes enacted by the PPA and proposed new requirements for supporting organizations.

This article is the first in a two-part series about supporting organizations. This month’s article will provide an overview of supporting organizations, describe the different types of supporting organizations and clarify the various tests and requirements that must be met for each type of supporting organization. Next month’s article will provide a comparison between supporting organizations and private foundations and explain how the proposed regulations may impact existing and future supporting organizations.

II. Defining Supporting Organizations


A supporting organization is a uniquely structured type of public charity that provides assistance to other exempt Sec. 501(c)(3) organizations. Sec. 509(a)(3)(A). A 509(a)(3) supporting organization (hereinafter referred to as “SO” or “SOs”) allows donors to make significant gifts and remain involved with the use or investment of the gifted funds, all while receiving the tax advantages of donating to a public charity rather than a private foundation. The key feature of an SO is its strong relationship with the organization it supports (hereinafter referred to as the “supported organization” or “supported charity”). This relationship enables the supported organization to supervise the activities of the SO. Such activities include distributing money to, performing the functions of, or carrying out the purposes of one or more public charities. Therefore, it is the SO’s link to its supported organization that enables the SO to maintain its status as a public charity.

In order to qualify as a 509(a)(3) SO, the organization must meet certain requirements. In addition, an SO must be classified as either a Type I, Type II or Type III SO. Sec. 509(a)(3)(B). Type I SOs share the closest relationship with their supported charities, while Type III SOs are the least controlled by their supported charities. As such, additional rules apply to Type III SOs.

III. Tests for Supporting Organizations


To be classified as an SO, every organization (Type I, Type II and Type III) must pass four tests – the organizational, operational, control and relationship tests. Reg. 1.509(a)-4.

A. Organizational Test

Under the organizational test, an SO’s articles of incorporation must:

1. Limit the SO to be organized exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified 509(a)(1) or 509(a)(2) organizations;

2. Avoid expressly empowering the SO to engage in any activities that do not further its stated purpose; and

3. Identify the supported organization.

For the third requirement, if the SO is classified as Type III, then the SO must name its supported organizations in its articles. Type I and Type II SOs can either name their supported charities or designate them by class or purpose. In addition, Type I and Type II SOs can support charities outside the United States. Conversely, Type III SOs cannot. Reg. 1.509(a)-4(b)–(d).

B. Operational Test

The operational test requires the SO to be operated for the sole benefit of its supported organizations. To meet this test, an SO must engage solely in activities that support or benefit its supported organizations. For example, an SO may make direct grant payments to one of its supported charities or it could provide services to individuals who are part of the charitable class benefited by the supported charity. However, the regulations make it clear that any grants, services or facilities provided must benefit the supported charity, not just the direct recipients. Reg. 1.509(a)-4(e).

C. Control Test

To past the control test, the SO cannot have a disqualified person in control. Reg. 1.509(a)-4(f)(5). A disqualified person in this context includes:

1. Substantial contributors to the supported organization. This includes those who have given more than $5,000 to the supported charity (if this amount is more than 2% of the supported charity’s total annual contributions).

2. An owner of more than 20% of the combined voting power of a corporation, profits interest of a partnership, or beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to an SO.

3. A creator of a trust who is a substantial contributor to an SO.

4. A family member of a person listed above.

5. A corporation, partnership or trust in which one of the above persons owns more than 35% of the combined voting power, profits interest, or beneficial interest, respectively.

IRC Sec. 4946.

Control in this context is defined by the IRS as the “practical ability to require the organization to perform any act which significantly affects its operations, or to prevent any such act.” Sec. 1.509(a)-4(j). As a general rule, control will be found where disqualified persons have either 50% of the voting power or a veto power over the SO’s activities. Foundation managers who are considered disqualified persons only as a result of being foundation managers (and not for other reasons) are not treated as disqualified persons for purposes of the control test. IRM Sec. 4.76.3.8.5.

D. Relationship Test: Three Types of Supporting Organizations

There are three types of SOs. The PPA requires an SO to indicate which type of SO it is when it files its annual Form 990. Reg. 1.509(a)-4(i)(2). Whether an SO is Type I, II or III will depend on the relationship and degree of control between the SO and its supported organization(s). Type I affords the supported organization the most control over the SO, while Type III offers the least. As such, Type III SOs are more heavily regulated.

A Type I SO is under the direct control of the supported organization, creating a “parent-subsidiary” type relationship. A Type II SO is under common control with the supported organization, creating a “brother-sister” type organization. A Type III SO is not necessarily controlled by the supported organization; rather it is operated "in connection with" the parent charity. It must meet the responsiveness test, the integral part test and satisfy a notification requirement. Reg. 1.509(a)-4(f).

IV. Three Types of Supporting Organizations


A. Type I – Direct Control, The Parent-Subsidiary Relationship

A Type I SO has a parent-subsidiary relationship with the charity it supports, meaning that the parent charity directly controls, supervises or operates the SO. This relationship will often result where the supported organization has the power to appoint or elect a majority of the SO’s directors or trustees. Reg. 1.509(a)-4(g).

Example: Charity is supported by the Thomas Trust. The trustee of Thomas Trust was selected by Charity. The Thomas Trust manages the fundraising and investments of Charity, allowing it to focus on its core charitable mission of providing support, education and care to youth in the community. As such, the Thomas Trust is a Type I SO.

B. Type II – Common Control, The Brother-Sister Relationship

A Type II SO is supervised or controlled in connection with its supported organization. This effectively creates a "brother-sister" relationship between the SO and the charity it supports. There must be some degree of common supervision or control among the governing bodies of the organizations. This may be established by showing that the SO's officers, directors or trustees overlap with those of the supported charity. Type II SOs are often created by public charities that would like to establish another charitable organization to help carry out certain activities. Reg. 1.509(a)-4(h).

Example: Charity is supported by the Golightly Trust. The Golightly Trust manages the fundraising and investments of the charity. Holly, Paul and Doc sit on Charity’s board of directors and also manage the trust. As such, the trust is a Type II SO that is "supervised or controlled in connection with" the charity.

C. Type III – Operated in Connection With

A Type III SO is operated “in connection with” one or more publicly supported organizations. A Type III SO is not directly controlled by the supported organization. However, there must still be sufficient ties between the SO and the supported organization in order for the SO to maintain its status as a public charity. Therefore, the SO must meet three additional requirements to establish a relationship with the supported organization. A Type III SO must meet the responsiveness test, the integral part test and satisfy a notification requirement. Reg. 1.509(a)-4(i)(1).

1. Responsiveness Test

The responsiveness test ensures that a Type III SO is responsive to the needs and demands of its supported organization(s). There are two parts to this test.

Part one of this test will be satisfied if one of three requirements is met:

1. At least one officer, director or trustee of the SO is appointed by the supported organization;

2. At least one member of the governing body of the supported organization also serves as an officer, director or trustee of the SO; or

3. The governing body of the SO maintains a close working relationship with the governing body of the supported organization.

Part two of this test will be met if the supported organization has a significant voice in how the SO manages and uses its assets. In other words, based on the relationship found in part one, the supported organization has a say in the SO's investment policies, grant timing, grant making, selection of recipients, or is able to direct the use of income or assets. Reg. 1.509(a)-4(i)(3).

2. Integral Part Test

The integral part test focuses on the level of involvement of the SO in the supported organization’s activities. The PPA created two different categories of Type III SOs under this test: (1) functionally integrated and (2) non-functionally integrated. The distinction is important because non-functionally integrated SOs are treated less favorably. Specifically, if a private foundation makes a distribution to a non-functionally integrated SO, it will not be considered a qualifying distribution for purposes of fulfilling the private foundation's required annual distributions and may be considered a taxable expenditure. Additionally, non-functionally integrated SOs are subject to excess business holding rules and must meet annual payout requirements. Reg. 1.509(a)-4(i)(4)-(5).

Whether a Type III SO will be considered functionally integrated or non-functionally integrated will depend on how it meets the integral part test. A functionally integrated SO will meet the test due to the activities of the organization (i.e., performing the function of, or carrying out the purpose of, the supported organization). In contrast, a non-functionally integrated SO will pass the test based on the distribution of funds it makes to the supported organization.

(a). Functionally Integrated (FI)

An SO will be deemed functionally integrated if it satisfies one of the three following tests: (1) The Activities/But for Test; (2) the Parent-Like Activities Test; or (3) Support of Government Entity Test. Reg. 1.509(a)-4(i)(4).

i. Activities/But for Test

To be considered a functionally integrated Type III SO under this test, the SO must meet two requirements:

1. Substantially all of the SO’s activities must be in direct furtherance of the supported organization’s exempt purpose (this does not include fundraising or grant making); and

2. Substantially all of the SO’s activities must be activities that, but for the involvement of the SO, would normally be performed by the supported charity.

Reg. 1.509(a)-4(i)(4)(ii)(2).

Example: SO holds title to building used by Charity for community programs. The SO’s main activities involve holding and maintaining the building. This allows Charity to focus on furthering its exempt purpose. The SO is functionally integrated because, but for the SO, the charity itself would have to hold and maintain the building.

ii. Parent-Like Activities

To be considered a functionally integrated Type III SO under this test, the SO must meet two requirements:

1. The SO must have the power to appoint a majority of the officers, directors or trustees of the supporting organization; and

2. The activities performed by the SO should create a substantial degree of direction over the policies, programs and activities of the supported organization. In this sense, the activities of the SO can be considered “parent-like.”

Reg. 1.509(a)-4(i)(4)(iii).

Example: SO acts as a parent organization to a healthcare system. The SO supervises and coordinates the operations of the system’s hospitals and appoints the hospital’s board members. Since the SO has a substantial degree of direction over the policies, programs and activities of the hospital, the activities of the SO can be considered “parent-like” and, therefore, the SO is functionally integrated.

iii. Support of a Governmental Entity

The third way that a Type III SO can be considered functionally integrated is by supporting a government entity. Reg. 1.509(a)-4(i)(4)(iv). The PPA reserved this section pending further guidance. Notice 2014-4 provided interim guidance and was further developed by the proposed regulations released in February of 2016 (which will be discussed in more detail in part two of this article). Notice 2014-4 provided a two-part test:

1. At least one supported organization must be a governmental entity to which the SO is responsive; and

2. The SO must engage in activities for, or on behalf of, the governmental supported organization. The SO performs the functions of, or carries out the purposes of, that governmental supported organization, which, but for the SO would normally be carried out by the government supported organization itself. Notice 2014-4 Sec. 3(1)-(2).

(b). Non-functionally integrated (NFI)

If an SO does not meet one of the functionally integrated tests, it may still be considered a Type III non-functionally integrated SO if it distributes a certain amount each year to one or more charitable organizations. For example, this could be a situation where a donor sets up a trust as an SO and that trust makes distributions to various charities. Here, there are two requirements that must be met: (1) the minimum payout requirement and (2) the attentiveness requirement. Reg. 1.509(a)-4(i)(5)(i).

i. Minimum Payout Requirement

Under the minimum payout requirement, a non-functionally related Type III SO must distribute either 85% of its adjusted net income for the prior taxable year or its minimum asset amount for the preceding taxable year (3.5% of the aggregate fair market value of the organization’s non-exempt use assets with certain adjustments). Reg. 1.509(a)-4(i)(5)(ii).

ii. Attentiveness Requirement

Under the attentiveness requirement, the distributions made by the SO must be substantial enough (at least 1/3 of the SO’s distributable amount) that the supported organization has “sufficient reason to pay attention to the SO’s role in its operations.” Reg. 1.509(a)-4(i)(5)(iii). The IRS provides three ways that this may be accomplished:

1. The distributions from the SO equal at least 10% of the supported organization’s total support for the year;

2. The distribution from the SO was necessary in order to avoid interruption to a substantial function or activity of the supported organization; or

3. Based on all facts and circumstances (including actual evidence of attentiveness) the SO’s distribution to the supported organization was sufficient to ensure attentiveness.

3. Notification

In addition to the responsiveness test and the integral part test, Type III SOs must annually provide the following documents to the organizations they support:

1. A written notice describing the type and amount of support provided by the SO during the preceding taxable year;

2. A copy of the SO’s most recently filed Form 990 or 990-EZ; and

3. A copy of the SO’s most recently amended governing documents.

Reg. 1.509(a)-4(i)(2).

V. Conclusion


For donors who wish to remain involved with the use or investment of gifted funds and desire the tax advantages of donating to a public charity rather than a private foundation, an SO is an effective vehicle to accomplish these goals. In order to obtain public charity status, the SO must pass the organizational, operational, control and relationship tests. Additionally, Type III SOs have further requirements that must be met to remain in compliance with IRS rules and regulations. If all tests and requirements are met, then an SO can be utilized to support a public charity while fulfilling the philanthropic goals of the donor.


Published May 1, 2016

Previous Articles

The Benefits of Charitable Lead Trusts: Part III

The Benefits of Charitable Lead Trusts: Part II

The Benefits of Charitable Lead Trusts: Part I

Early Termination of a Charitable Remainder Trust: Part II

Early Termination of a Charitable Remainder Trust: Part I

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