The proposed regulations for Type III supporting organizations could have been worse. Still, one new requirement may be disastrous
Few Type III supporting organizations (SOs) are likely to be overjoyed by the new proposed regulations that could soon be governing them. Yet, these anxiously awaited proposed regs1 are significantly better than we might have expected, given some recent, alarming statements made by the Internal Revenue Service.2
Still, one new payout requirement — that Type IIIs distribute at least 5 percent of the value of their non-exempt-use assets annually — may prove to be a substantial burden, particularly in a market that makes earning a 5 percent rate of return unlikely. Indeed, this requirement alone could drive Type IIIs to convert to Type I or II status, or to terminate altogether. That would be a significant loss. In an era when fundraising and making ends meet is increasingly impossible, public charities are depending more heavily on the support of Type III SOs. Meanwhile, individuals and families are depending more heavily on these public charities — and they would be the ultimate losers.
Comments on these proposed regs are due to the IRS by Dec. 23, 2009.3 I strongly recommend that the payout requirement be altered.
But let's look at the whole new package of requirements for Type III SOs. Most of it is not so bad.
Good News, Bad News
The first bit of good news is that the proposed regulations drop suggestions made earlier by the IRS4 that a single “non-functionally integrated” (that is to say, grantmaking) Type III SO be limited to supporting only five organizations. The IRS said that this limit would ensure a “tight nexus” between the SO and its supported organizations. But many of the comments submitted to the Service said that a five-charity limit would be “arbitrary.”5 Ultimately, the drafters of the proposed regulations agreed.
Another break, this one for functionally integrated (that is to say, activities) Type III SOs, is that the proposed regulations drop an earlier proposal6 that they be required to meet both an “expenditure” test and an “assets” test — in addition to the existing “but for” test. These additional tests were to be patterned on similarly named tests applicable to private operating foundations under Internal Revenue Code Sections 4942(j)(3)(A) and (B). Commentators complained that these tests were “unduly restrictive,” as well as “more burdensome than those proposed for non-functionally integrated Type III supporting organizations.”7
But even with these fortunate omissions, a number of aspects of the proposed regs are daunting. To summarize, they provide that all Type III SOs must satisfy:
- a notification requirement by providing certain information to all their supported organizations;8
- a revised version of the “responsiveness test” designed to demonstrate that a Type III is responsive to the needs of its supported charities;9 and
- a revised version of the “integral part test” designed to demonstrate that a Type III is an integral part of its SOs.10 There are two versions of this last test, one for functionally integrated Type IIIs11 and a considerably more complex integral part test for non-functionally integrated Type IIIs.12
Other provisions of the proposed regulations address requirements under the Pension Protection Act of 2006 (PPA) that bar Type III SOs from supporting organizations that are organized outside the United States,13 and that prohibit Type IIIs from accepting gifts or contributions from persons who are in direct or indirect control of a supported organization's governing body.14
Let's examine these new requirements in more detail.
Notification requirement — The proposed regulations would require all Type III SOs (functionally integrated or not) to provide the following information, each year, to all of its supported organizations:
- a written notice addressed to the supported organization's principal officer, indicating the type and amount of support received from the SO in the preceding year;
- a copy of the SO's most recently filed annual return, Form 990; and
- a copy of the SO's governing documents, including its bylaws, as well as any amendments to the governing documents. (This last element of the notification requirement need be satisfied only once, unless the governing documents are amended.)15
It's fine to email this information to the supported charities.16 The information would need to be postmarked or emailed by the last day of the fifth month after the close of the SO's tax year (May 15 for calendar-year Type IIIs).17 The IRS recommends SOs retain proof of delivery in their records.18
While none of these elements seem particularly burdensome, some Type IIIs may be uncomfortable with the first one. Those Type IIIs that do not usually (or ever) provide support to a particular named supported organization may not wish to underscore this lapse to the principal officer of the ignored charity. But that may well be the whole idea behind the proposed requirement: Type IIIs might be encouraged out of sheer embarrassment to be more evenhanded with their largess.
One comment received by the IRS in the drafting stage of the proposed regs suggested requiring that the notification information be provided only to the lead supported organization, to help reduce administrative burdens.19 This suggestion was not incorporated into the proposed regs.
Responsiveness test — The PPA abandoned the “charitable trust” alternative of the responsiveness test but left matters somewhat up in the air by not overtly replacing it with the other, “significant voice” alternative.20 The proposed regs fill the gap by adopting the “significant voice” alternative as the sole means by which a Type III SO would be able to satisfy the responsiveness test.
A Type III would meet the test if any one of the three threshold conditions are met:
- One or more officers, directors or trustees of the Type III are elected or appointed by the officers, directors, trustees or membership of the supported organization.
- One or more members of the supported organization's governing bodies are also officers, directors or trustees of, or hold “other important offices” in the Type III organization.
- The Type III's officers, directors or trustees maintain a “close and continuous working relationship” with the supported organization's officers, directors or trustees and, as a result, the supported organization's officers, directors or trustees have a “significant voice” in the Type III's investment policies, the timing and manner of making grants, the choice of recipients, and in otherwise directing the use of the Type III's income or assets.21
This formulation of the responsiveness test would apply to all Type III SOs, including charitable trusts. There had been some speculation that charitable trusts would be afforded a special means of satisfying the test, to replace the rejected “charitable trust” method of compliance. Some commentators told the IRS that the “significant voice” test could be difficult to satisfy due to state law fiduciary requirements relating to trusts.22 But these suggestions failed to persuade the drafters.
Nonetheless, the explanatory discussion of the proposed regs invites comments regarding a specific “responsiveness” rule for charitable trusts.23
An important question left unanswered by the proposed regs is whether, if a Type III supports more than one supported organization (as is usually the case), it's sufficient if only one of the supported charities has a significant voice, or whether all, or perhaps a majority, of the supported charities must. Presumably, the proposed regs contemplate that the supported organization that receives the bulk of the Type III's support (the “attentive” charity, to borrow a term from the integral part test) is the one that would be required to have the significant voice — but this is not made clear.
Two examples are offered to illustrate the revised responsiveness test. Example (1) shows a trust that satisfies the responsiveness test: A bank-trusteed testamentary trust supports a private university. The trustee has discretion as to the timing and amount of distributions. The trustee and an officer of the university have quarterly face-to-face meetings in which they discuss the university's projected needs. In addition, the trustee communicates regularly with the university's officer and provides him with quarterly investment statements and an annual accounting statement, in addition to satisfying the notification requirement under the proposed regulations.24
In contrast, the trust in example (2) flunks the responsiveness test: The trustee sends an annual cash payment to the supported organizations, as well as an accounting statement. The trustee also satisfies the notification requirement elements, but has no other communication with them.25
These examples suggest that many Type IIIs will need to revisit their policies about the frequency and nature of their interactions with the supported organizations.
Integral part test — A Type III SO will constitute an “integral part” of a supported organization if it is, as the proposed regs put it, “significantly involved” in the operations of the supported organization, and if that organization is in turn dependent upon the SO for the type of support provided.26 The proposed regs provide two different versions of the integral part test, depending on whether the Type III is functionally integrated with the supported organization.
A functionally integrated Type III would satisfy the integral part test if it engaged in activities:
- substantially, all of which directly further the exempt purposes of the supported charity; and
- that, but for the Type III's involvement, normally would be engaged in by the supported charity.27
Activities that “directly further” the supported charity's exempt purposes include holding title to, and managing exempt-use property. In general, fundraising, investing or managing non-exempt use assets and making grants, are activities that don't “directly further” the supported charity's exempt purposes,28 unless the assets of the Type III's sole supported charity are subject to the appropriation process of a federal, state, local or Indian tribal government for purposes or programs that are unrelated to the supported charity's exempt purposes.29
In the alternative, a Type III that is the parent of all of its supported organizations would thereby satisfy the integral part test.30 To be recognized as a “parent,” the Type III would need to exercise a substantial degree of direction over the supported charities' policies, programs and activities, and a majority of the supported charity's officers, directors or trustees would need to be appointed, directly or indirectly, by the Type III's governing body or officers.31
Perhaps reflecting the drafters' consciousness that the integral part test provisions for functionally integrated Type III SOs are unusually intricate, the proposed regs provide no less than seven examples.32
On the theory that examples showing organizations fail a test are generally more interesting and instructive, example (4) bears close examination. That example involves an organization created by an individual to provide scholarships for students attending a private secondary school. The school establishes the scholarship criteria, publicizes the program, solicits and examines applications, and chooses the scholarship awardees. The organization merely invests its assets and disburses the actual scholarship funds to the awardees. Based on these facts, the organization does not qualify as a functionally integrated Type III SO.
An entirely different form of the integral part test would apply to non-functionally integrated (that is to say, grantmaking) Type III SOs. A non-functionally integrated Type III would be required to satisfy both:
- a distribution requirement; and
- an attentiveness requirement.34
The provisions elucidating these elements occupy by far the largest portion of the proposed regs, and they are extremely complicated.
Simply stated, a non-functionally integrated Type III would meet the distribution requirement if it distributes, each year, at least 5 percent of the value of its investment assets, with adjustments. Adding some of the complexities to this basic overview, the organization would be required to distribute (to, or for the use of one or more of its supported charities) amounts at least equaling its annual distributable amount for that year, and to do so on or before the last day of such year.35
The organization's annual distributable amount for a year is painstakingly defined as:
- 5 percent of the excess of the aggregate fair market value (FMV) of all of its non-exempt use assets;
- over the acquisition indebtedness as to such assets (determined under IRC Section 514(c)(1) without regard to the taxable year in which the indebtedness was incurred);
- increased by any repayments of amounts taken into account to meet its distribution requirement for any taxable year;
- increased by amounts received from the sale or other disposition of property (to the extent the organization took the acquisition of that property into account in meeting its distribution requirement for any taxable year); and, finally,
- reduced by the amount of taxes, if any, imposed on the organization under IRC Subtitle A.36
For the first year of the Type III's existence, its annual distribution amount, mercifully, is zero.37 If a Type III is unable to meet the distribution requirement, provision is made for a “reasonable cause” exception, under which the organization can attempt to satisfy the IRS:
- that the failure was due solely to incorrect valuation, ministerial error or events beyond the organization's control;
- that the failure had a reasonable cause and was not the result of willful neglect; and
- that the distribution requirement is met within 180 days of discovery of the error (or 180 days after the organization is first able to meet the payout requirement).38
The amount of a distribution to a supported organization is the FMV of the property as of the date of distribution.39 Distributions that count toward the distribution requirement include amounts:
- paid to a supported organization to accomplish its exempt purposes;
- paid to acquire an exempt-use asset for the supported organization; and
- expended by the Type III organization for “reasonable and necessary administrative expenses.”40
A five-year carryover provision permits the Type III organization to use its excess distributions to reduce its distributable amount in any of the five taxable years immediately subsequent to the year in which the excess was created.41
Quite a lengthy run of highly detailed provisions of the proposed regs are devoted to the valuation of assets for purposes of the distribution requirement element of the integral part test applicable to non-functionally integrated Type III SOs.42 Highlights (if that is not too satiric a term in this context) include:
Valuation is to be made in the year before the year of distribution.43
The aggregate FMV of the Type III's non-exempt-use assets is the sum of:
- the average of the FMV on a monthly basis of securities for which market quotations are readily available; plus
- the average of cash balances on a monthly basis; plus
- the FMV of all other assets for the period during the taxable year such assets are held by the Type III SO.44
Certain assets are excluded in the valuation process:
- any future interest, such as a vested or contingent remainder, legal or equitable interest, until constructively received by the organization;
- assets in an estate, until distributed to the organization;
- a present interest in a trust created or funded by another;
- a pledge, regardless of whether it is legally enforceable; and
- assets used or held for use to carry out a supported organization's exempt purposes.45
Whether an asset is used or held for use to carry out the exempt purposes of the supported organization is a question of fact.46 An office building used to provide offices for employees managing endowment funds is not being used for exempt purposes. Allocation is permitted in situations in which property is under split use.47
Qualifying assets include:
- administrative assets; real estate (or a portion thereof) used by the Type III directly in carrying out the supported organization's exempt purposes;
- “physical facilities,” such as works of art owned by the Type III organization and on public display in carrying out the exempt purposes of a supported charity;
- reasonable cash balances necessary to cover current administrative expenses and the like, directly connected to the carrying out of the supported charity's exempt purposes; and
- property leased out by the Type III organization in carrying out the supported charity's exempt purposes (such as renovated apartments leased to low-income tenants).48
Detailed guidance is provided as to the valuation of specific assets, including securities,49 cash balances,50 common trust funds,51 and other assets falling outside these categories.52
In addition to the “distribution requirement,” the proposed regs provide for a related “attentiveness requirement” which non-functionally integrated (grantmaking) Type III SOs would be required to satisfy.
Generally, this attentiveness requirement is satisfied if the non-functionally integrated Type III SO distributes a third or more of its annual distributable amount to the one or more supported charities that are attentive to its operations, and to which the Type III is responsive.53 For these purposes, a supported charity is “attentive” to the Type III's operations if it receives annually from the Type III an amount of support that represents a sufficient part of the supported charity's total support (or, in the case of support of a particular department or school of a university, hospital, or church, of that department or school's total support).54
Attentiveness is established if:
- the Type III SO annually distributes an amount to the supported charity that is 10 percent or more of the supported charity's total support; or
- the Type III's support is necessary to avoid the interruption of a particular substantial function or activity, even if it is not the supported charity's primary program or activity; or
- the amount of support is sufficient, based on a consideration of all pertinent factors, including the number of supported charities, the length and nature of the relationship with the Type III organization, and the purpose for which the funds are applied.55
Evidence of actual attentiveness is “of almost equal importance” to these “sufficient” factors.56 Distributions to donor-advised funds do not establish attentiveness.57
Transition Rules, Effective Date
A functionally integrated Type III SO that satisfies the current Treasury regulations relating to the integral part test58 will be treated as meeting the requirements of the proposed regs' formulation of the integral part test until the first day of its first taxable year that begins after the date the proposed regulations become final or temporary.
A non-functionally integrated Type III SO that satisfies the current integral part test59 will be treated as meeting the requirements of the proposed regs' formulation of the integral part test until the first day of its second taxable year that begins after the date the proposed regs become final or temporary.60 The extra year afforded to non-functionally integrated Type IIIs is designed to permit them to use the first year to value their assets under the new valuation regime.61 Accordingly, for the first taxable year after the proposed regs become final or temporary, the annual distributable amount for non-functionally integrated Type III SOs is zero.62
A separate transition rule applies to the excise tax provisions on excess business holdings under IRC Section 4943, which were made applicable to Type III SOs under the PPA.63 With regard to the unfortunate former Type III SOs that were demoted to private foundation status because of their failure to satisfy the PPA requirements as of Aug. 17, 2007, the present holdings of such private foundations are to be determined under the same rules applicable to Type III SOs pursuant to IRC Section 4943(f)(7).64
The proposed regs become effective on the date of publication of the Treasury decision adopting them as final or temporary regulations.65 Type III SOs that fail to meet the requirements of the proposed regs once they are adopted as final or temporary, will be demoted to private foundation status, and will be subject to the termination tax provisions of IRC Section 507.66
Reliance on Prior Guidance
Private foundations are permitted to continue to rely upon the grantor reliance standards with regard to distributions to functionally integrated Type III SOs, as provided in Section 3.0 of Notice 2006-109,67 until the proposed regs are adopted as final or temporary.68
As of Sept. 24, 2009, the date of publication of the proposed regs, the IRS will issue determination letters regarding a Type III's qualification as functionally integrated, only to Type III SOs that meet the integral part test requirements of Proposed Regs. Section 1.509(a)-4(i)(4).69
Organizations that already have received favorable functionally integrated letters of determination may continue to rely upon the letter until final or temporary regs are adopted, provided that the organization continues to meet the requirements of Prop. Regs. Section 1.509(a)-4(i)(4) or under an earlier IRS announcement.70
Challenging as they are for Type III SOs, the proposed regs could easily have been considerably worse, had they not dropped the five-charity limit and the “asset” and “expenditure” tests announced earlier.
Of the new burdens imposed by the proposed regs, the notification requirement and the updated iteration of the responsiveness test should not present any insurmountable obstacles for most Type IIIs. Nor is the proposed version of the integral part test for functionally integrated Type III SOs likely to be perceived as particularly troublesome.
The more bitter pill is the proposed integral part test facing non-functionally integrated Type III SOs with its complex valuation provisions the and requirement that these Type IIIs distribute at least 5 percent of the value of their non-exempt-use assets annually. Here's hoping that the IRS rethinks this hurdle.
Gerald B. Treacy, Jr., is a partner in Poulsbo, Wash.'s Treacy Law Group, PLLC and of counsel to Seattle's MPBA
- Proposed Regulations Sections 1.509(a)-4(a)(5)-(6), (f)(5) and (i), Prop. Regs. Sections 53.4943-11(f), (g) and 74 Federal Register 48672 (Sept. 24, 2009).
- See, for example, Internal Revenue Service Announcement 2007-87, 2007-9 Internal Revenue Bulletin 611.
- Written comments and requests for a public hearing are to be submitted to: CC:PA:LPD:PR (REG-155929-06), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044. Submitted materials can also be hand delivered weekdays between 8am and 4pm to CC:PA:LPD:PR (REG-155929-06), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, D.C.?They can also be submitted electronically via the Federal eRulemaking Portal at <www.regulations.gov/ (IRS REG-155929-06)>.
- Explanation of Provisions, 74 Fed. Reg. at p. 48677.
- IRS Announcement 2007-87, 2007-9 IRB 611.
- Supra, note 5 at p. 48676.
- Prop. Regs. Section 1.509(a)-4(i)(2).
- Prop. Regs. Section 1.509(a)-4(i)(3).
- Prop. Regs. Section 1.509(a)-4(i).
- Prop. Regs. Section 1.509(a)-4(i)(4).
- Prop. Regs. Section 1.509(a)-4(i)(5).
- Prop. Regs. Section 1.509(a)-4(i)(10). See Internal Revenue Code Section 509(f)(1)(B)(i).
- Prop. Regs. Section 1.509(a)-4(f)(5). See IRC Section 509(f)(2)(B)(i).
- Prop. Regs. Section 1.509(a)-4(i)(2)(i)-(iii). The notification requirement implements IRC Section 509(f)(1)(A), added by the Pension Protection Act (PPA).
- Prop. Regs. Section 1.509(a)-4(i)(2)(iv).
- Prop. Regs. Section 1.509(a)-4(i)(2)(v).
- Explanation of Provisions, 74 Fed. Reg. at p. 48675.
- Treasury Regulations Section 1.509(a)-4(i(2)(ii).
- Prop. Regs. Section 1.509(a)-4(i)(3)(ii), (iii).
- See supra, note 18.
- Prop. Regs. Section 1.509(a)-4(i)(3)(iv).
- Ibid. Prop. Regs. Section 1.509(a)-4(i)(3)(v) provides a transitional rule for pre-Nov. 20, 1970 organizations, for which additional facts and circumstances, including the existence of a historic and continuing relationship between the supporting and supported organizations, may be taken into account.
- Prop. Regs. Section 1.509(a)-4(i)(1)(iii).
- Prop. Regs. Section 1.509(a)-4(i)(4)(i)(A).
- Prop. Regs. Section 1.509(a)-4(i)(4)(ii).
- Prop. Regs. Section 1.509(a)-4(i)(4)(iii), which provides further details as to this interesting but probably quite rare situation. See also Prop. Regs. Section 1.509(a)-4(i)(4)(iv), Examples (6) and (7).
- Prop. Regs. Section 1.509(a)-4(i)(4)(i)(B).
- Ibid. See Prop. Regs. Section 1.509(a)-4(i)(4)(iv), Example (1).
- Prop. Regs. Section 1.509(a)-4(i)(4)(iv).
- The other examples relate to the following aspects of the integral part test: Example (1), the “parent” alternative; Examples (2), (3) and (5), the “but for” element; and Examples (6) and (7), the “government appropriation” exception.
- Prop. Regs. Section 1.509(a)-4(i)(5)(1)(A). A special exception applies to pre-Nov. 20, 1970 trusts, which will meet the test if, for taxable years beginning after Oct. 16, 1972, the trustee provides written annual reports to all of the supported organizations, including a detailed list of the assets and the income they produce. Prop. Regs. Section 1.509(a)-4(i)(9). The drafters may have had a particular organization in mind.
- Prop. Regs. Section 1.509(a)-4(i)(5)(ii)(A).
- Prop. Regs. Section 1.509(a)-4(i)(5)(ii)(B)(1)-(4).
- Prop. Regs. Section 1.509(a)-4(i)(5)(ii)(C). The Treasury may provide for an emergency temporary reduction in the annual distributable amount if a disaster or emergency strikes. Prop. Regs. Section 1.509(a)-4(i)(5)(D).
- Prop. Regs. Section 1.509(a)-4(5)(ii)(E)(1)-(3).
- Prop. Regs. Section 1.509(a)-4(i)(6).
- Prop. Regs. Section 1.509(a)-4(i)(6)(i)-(iii).
- Prop. Regs. Section 1.509(a)-4(i)(7)(i).
- Prop. Regs. Section 1.509(a)-4(i)(8). These provisions were drawn generally from the Treasury regulations. issued under IRC Section 4942, except that set-asides are not permitted. See Explanation of Provisions, 74 Fed. Reg. at p. 48677.
- Prop. Regs. Section 1.509(a)-4(i)(8)(i)(A).
- Prop. Regs. Section 1.509(a)-4(i)(8)(i)(A)(1)-(3).
- Prop. Regs. Section 1.509(a)-4(i)(8)(i)(B)(1)-(5).
- Prop. Regs. Section 1.509(a)-4(i)(8)(i)(C)(1).
- Prop. Regs. Section 1.509(a)-4(i)(8)(i)(C)(2)(i)-(iv). “Reasonable necessary cash balances” for this purpose will in general be deemed to be equal to 1.5 percent of the fair market value (FMV) of all of the Type III SO's assets, other than assets used to carry out the supported charity's exempt purposes.
- Prop. Regs. Section 1.509(a)-4(i)(8)(C)(iii)(A).
- Prop. Regs. Section 1.509(a)-4(i)(8)(C)(iii)(B).
- Prop. Regs. Section 1.509(a)-4(i)(8)(C)(iii)(C).
- Prop. Regs. Section 1.509(a)-4(i)(8)(C)(iii)(D). See Examples (1) and (2) of Section 1.509(a)-4(i)(5)(C)(iv) of the proposed regs for illustrations of the operation of the “distribution requirement.”
- Prop. Regs. Section 1.509(a)-4(i)(5)(iii)(A).
- Prop. Regs. Section 1.509(a)-4(i)(5)(iii)(B).
- Prop. Regs. Section 1.509(a)-4(i)(5)(iii)(B)(1)-(3).
- Prop. Regs. Section 1.509(a)-4(i)(5)(iii)(B)(3). One may well wonder why actual attentiveness does not carry the day.
- Prop. Regs. Section 1.509(a)-4(5)(iii)(C). Examples (3) and (4) of Section 1.509(a)-4(i)(5)(iv) of the proposed regs demonstrate the application of the attentiveness requirement.
- Treas. Regs. Section 1.509(a)-4(i)(3)(ii).
- Treas. Regs. Section 1.509(a)-4(i)(3)(iii).
- Prop. Regs. Section 1.509(a)-4(i)(11)(i)-(ii).
- Explanation of Provisions, 74 Fed. Reg. at p. 48678.
- Prop. Regs. Section 1.509(a)-4(i)(11)(iii).
- IRC Section 4943(f).
- Prop. Regs. Section 53.4943-11(f). Another provision applies a special transitional rule for pre-Nov. 20, 1970 SOs created as trusts, under which trusts qualifying as Type III SOs under the transitional rules at Section 1.509(a)(i)(9) of the proposed regs will be treated as functionally integrated Type III supporting organizations for purposes of IRC Section 4943(f)(3)(A). Prop. Regs. Section 53.4943-11(g).
- Prop. Regs. Section 1.509(a)-4(i)(12).
- Supra, note 61. Comments are requested as to whether exceptions or special rules under IRC Section 507 are needed for PPA-demoted Type III SOs. Ibid.
- IRB 2006-51 (Dec. 18, 2006).
- Explanation of Provisions, 74 Fed. Reg. at p. 48679.