After a six-year wait, the IRS has issued final and temporary regulations affecting Type III supporting organizations. These regulations, which became effective December 28, 2012, are the culmination of charitable reform efforts brought about by the Pension Protection Act of 2006 (the “PPA”). They provide welcome clarity for many Type III supporting organizations that have been operating amid much uncertainty since that time, as well as private foundations and donor advised funds that support them.
Background on Supporting Organizations
In the world of 501(c)(3) organizations, there are two main categories: public charities and private foundations. Public charities are subject to less regulation and oversight than private foundations, and contributions to them are eligible for more generous deductions. The 501(c)(3) regime was originally set up this way because public charities were believed to require less regulation and oversight due to their public nature (the theory being that the public oversees them through the power of the purse), whereas private foundations are private in nature.
Public charities can include “institutional” charities like hospitals, churches and schools, as well as “publicly supported” charities that receive contributions from a diverse variety of sources (e.g., organizations like the Red Cross and most humane societies) or that rely on their exempt function income for support. Public charities also include “supporting organizations,” which are generally organized and operated to support another public charity (or perhaps multiple public charities), referred to as the “supported organization.”
Supporting organizations are classified as Type I, Type II or Type III, depending on the terms of their relationship with their supported organizations. Type I supporting organizations have a parent-subsidiary relationship with their supported organizations (i.e., the supported organization appoints at least a majority of the directors of the supporting organization). Type II supporting organizations have a brother-sister relationship with their supported organizations (i.e., there is a majority overlap between the officers and directors of each organization). Type III supporting organizations have the most tenuous connection with their supported organizations.
Type III supporting organizations were the subject of significant scrutiny leading up to the adoption of the PPA. Because of their tenuous connection to their supported organizations, they could operate much like private foundations, but with the more generous deduction limits of a public charity, and without the additional regulation and oversight of a private foundation. As is often the case with a good thing, this structure attracted a number of bad actors, who used the Type III structure to circumvent the tax rules and commit taxpayer abuse. The charitable reform provisions of the PPA were designed to shut down these abuses. In the process, however, the new rules significantly complicated the lives of legitimate Type IIIs and the private foundations and donor advised funds that fund them.
Evolution of Regulations for Type III Supporting Organizations
Historically, Type III supporting organizations needed to establish that they were an integral part of a supported organization, and could do that either by (i) establishing that they were conducting activities that the supported organization would normally engage in but for the involvement of the supporting organization (known as the “but-for” test) or (ii) paying out a substantial amount of income to their supported organizations.
Since the PPA, Type IIIs have been considered either functionally integrated or non-functionally integrated, with the latter category being the most heavily regulated, and being substantially less attractive to funders that are private foundations and donor advised funds. However, there has been much uncertainty about the requirements to be considered functionally integrated.
The IRS released different notices and proposed regulations on the issue, most recently in 2009. As a result, it has been widely anticipated that just meeting the old but-for test would not be enough going forward for a Type III organization to be considered functionally integrated. However, there were no certain or final pronouncements about the issue until the finalization of the new regulations in late December.
New Test for Functional Integration
The 2009 proposed regulations suggested significant changes to the test for whether a Type III supporting organization to qualifies as functionally integrated. Rather than meeting the but-for test only, an organization would need to demonstrate either that (i) substantially all of its activities directly further the exempt purposes of the supported organization, and which would normally be engaged by the supported organization but for the involvement of the supporting organization (i.e., a modified and expanded but-for test); or (ii) it is the parent of each of its supported organizations.
The final regulations retain this test, and generally follow the definitions put in place by the proposed regulations in terms of which activities of the supporting “directly further” the exempt purposes of the supported organization. Notably, the final regulations provide that fundraising, managing and investing non-exempt use property, and making grants (except for a fairly narrow exception) are not activities that directly further the supported organization’s exempt purposes. A number of commenters requested different treatment in this area, but the IRS and Treasury Department did not adopt such comments largely on the rationale that an organization that is operating its own direct charitable programs as a means of supporting its supported organization needs more budget flexibility than the distribution requirement for non-functionally integrated organizations would allow—but that organizations who provide support mainly by producing income and distributing it to the supported organization are not consistent with this rationale.
Bottom line: The new regulations mean that a Type III supporting organization that mainly manages a supported organization’s endowment, or fundraises for the organization, will be considered non-functionally integrated. They will have to meet an annual payout requirement (discussed below), and also deal with other ramifications of being classified as non-functionally integrated. For example, private foundation grants to non-functionally integrated Type III organizations will require expenditure responsibility, so many private foundations may opt out of making grants to such organizations. Similarly, a distribution from a donor-advised fund to a non-functionally integrated Type III organization will require expenditure responsibility, and many organizations disallow their donor-advised funds from making such distributions. As a result, a non-functionally integrated Type III organization that relies on support from private foundations and donor advised funds may need to consider other vehicles for receiving funds from those sources, or become reclassified as a publicly supported charity, or pursue reorganization as a Type I or II supporting organization.
Payout Requirement for Non-functionally Integrated Organizations
A big change from the 2009 proposed regulations is the payout amount for non-functionally integrated Type IIIs. The 2009 proposed regulations largely took the 5 percent payout regime of private non-operating foundations and applied it to the supporting organization world. Many commenters took issue with this, and pointed out that supporting organizations are already subject to a number of requirements and restrictions based on their relationship to their supported organizations that make the 5 percent payout requirement less sensible.
The IRS conceded this point, and put in place a payout regime that will require an organization to distribute annually the higher of (i) 85 percent of adjusted net income or (ii) 3.5 percent of the fair market value of the supporting organization’s non-exempt use assets. These payout regulations are temporary at this point, in order to permit additional opportunity for comment.
Notice to Supported Organizations
Like the 2009 proposed regulations, the final regulations contain a notification requirement for all Type III supporting organizations. This requires the supporting organization to provide annually to each of its supported organizations (i) a written notice addressed to a principal officer describing the amount and type of support provided by the supporting organization; (ii) a copy of the supporting organization’s most recently filed Form 990, 990-EZ or 990-N (as applicable); and (iii) a copy of the organization’s governing documents, including any amendments (though if these documents have been provided and not amended, there is no need to resend each year). The notice requirement is a hard-and-fast rule, even if the two people sending and receiving the notice are the same.
The final regulations contain a number of transition rules:
- Organizations meeting the older payout test (under the pre-December 28 regulations) will be considered non-functionally integrated but can continue to utilize that older test until the first day of their second tax year beginning after the adoption of the new rules;
- Organizations continuing to meet the older but-for test (under the pre-December 28 regulations) will be treated as functionally integrated until the first day of the organization’s second taxable year beginning after the adoption of the new final regulations.
- Organizations that meet the older but-for test for their tax year including December 28, 2012, but that cannot continue to meet that test going forward, will be considered non-functionally integrated as of the first day of the first tax year following adoption of the regulations, but will not have to meet a payout test until their second tax year.
- Although organizations generally are required to submit the notification discussed above by the end of the fifth month following the close of their tax year (without allowing for extensions), for this first year they will be able to factor in extensions to the timeline and get a little additional time for meet this requirement.
Clarification Still To Come
In addition to finalizing the payout amount for non-functionally integrated organizations, the IRS intends to issue proposed regulations to clarify several other points, such as providing a definition of “control” for purposes of the prohibition on certain supporting organizations accepting gifts from controlling persons; specifying types of distributions (including potentially program-related investments) that will count toward the payout amount; providing additional examples of how Type III supporting organizations can satisfy the separate responsiveness test; and how supporting organizations can qualify as functionally integrated by supporting a governmental entity. Comments are due by March 28, 2013.
Leaffer Law Group LLC has been following the progression of these Type III supporting organization regulations closely, and will continue to monitor developments in the area. If you have any questions on the regulations or how they could affect your organization, please contact Karen Leaffer Schauble at firstname.lastname@example.org or Becky Seidel at email@example.com.