Proposed Regulations for Type III Supporting Organizations

September 29, 2009

On September 23, 2009, the Internal Revenue Service (IRS) and the Treasury Department released a Notice of Proposed Rulemaking including proposed regulations regarding the changes made to Type III supporting organizations under the Pension Protection Act of 2006 (PPA).

Summary

The proposed regulations address the changes made by the PPA and provide guidance regarding functionally integrated and non-functionally integrated Type III supporting organizations:

  • The proposed regulations set forth the types of information that a Type III supporting organization must provide to the organization(s) it supports.
  • The proposed regulations confirm the elimination of the special rule that allowed certain charitable trusts to meet the responsiveness test for classification as a Type III supporting organization, but retain the transitional rule allowing certain supporting organizations in existence before November 20, 1970, to qualify as Type III supporting organizations.
  • The proposed regulations set forth the criteria that must be satisfied by a “functionally integrated” Type III supporting organization. To be considered a functionally integrated organization, the organization must engage in activities substantially all of which directly further the exempt purposes of the supported organization(s) to which it is responsive. Additional guidance is provided on the types of activities that are considered to “directly further” the exempt purposes of a supported organization.
  • Alternatively, an organization may be considered functionally integrated if it is the parent of, and exercises a substantial degree of control over, each of its supported organizations.
  • As required by Congress in the PPA, the proposed regulations do impose a minimum distribution requirement on “non-functionally integrated” Type III supporting organizations. Non-functionally integrated organizations must meet a distribution requirement and an attentiveness test. The proposed regulations retain the transitional rule for trusts established before November 20, 1970.

The new regulations, when finalized, will be particularly relevant to organizations that conduct certain activities on behalf of their supported organizations, such as fundraising, investment and management of non-exempt-use assets, and grant making. Organizations that support colleges or hospitals, as well as charitable trusts with institutional trustees, will likely be affected by the proposed regulations.

Type III Supporting Organizations

Internal Revenue Code section 509(a)(3) defines a supporting organization as an organization that satisfies an organizational test, an operational test, a relationship test, and a disqualified person test.

The proposed regulations address the relationship test, which mandates that a Type III supporting organization be “operated in connection with” one or more public charities. The PPA stated, and the proposed regulations clarify, that a supporting organization will not be considered to be operated in connection with one or more supported organizations if any of those supported organizations are organized outside of the United States. To meet the Type III supporting organization relationship test under the proposed regulations, an organization must satisfy three requirements: a new notice requirement, the responsiveness test, and the integral part test.

Notification to Supported Organizations

The PPA added a requirement for Type III supporting organizations that the organization provide certain information to its supported organization(s) to ensure that the organization is responsive to the supported organization’s needs. The proposed regulations confirm this requirement and require that a Type III supporting organization annually provide the following information to each of its supported organizations:

  • Written notice addressed to the principal officer of the supported organization identifying the supporting organization and describing the amount and type of support it provided in the past year.
  • A copy of the supporting organization’s most recently filed Form 990 (or other return required to be filed under federal tax law).
  • A copy of the supporting organization’s governing documents, including any amendments, if not previously provided.

The supporting organization must provide this information by the end of the fifth month after the close of its tax year (ordinarily, the month in which its tax return is due) and must retain proof of delivery of the required information, but the organization is permitted to send such information by electronic media.

Responsiveness Test

The responsiveness test for classification as a Type III supporting organization remains largely unchanged. For charitable trusts, however, the proposed regulations confirm the elimination of the alternate rule as a way to meet the responsiveness trust. Under the proposed regulations, all Type III supporting organizations (including those that are charitable trusts) are required to meet the responsiveness test under existing Treasury Regulation §1.509(a)-4(i)(2)(ii).

This responsiveness test requires that the officers, directors, or trustees of the supported organization(s) have a significant voice in the supporting organization’s investment policies, timing of grants, manner of making grants, selection of recipients, and direction of the use of the income or assets. This significant voice may occur by one of three methods:

  • One or more officers, directors, or trustees of the supporting organization are elected or appointed by the officers, directors, trustees, or membership of the supported organization;
  • One or more members of the governing bodies of the supported organization are also officers, directors, or trustees of, or hold other important offices in, the supporting organization; or
  • The officers, directors, or trustees of the supporting organization maintain a close and continuous working relationship with the officers, directors, or trustees of the supported organization.

The proposed regulations continue, however, to allow supporting organizations that were in existence before November 20, 1970, to use additional facts and circumstances, such as a historic and continuing relationship between the supporting and supported organizations, to satisfy the responsiveness test. See Treas. Reg. §1.509(a)-4(i)(1)(ii).

Integral Part Test

The proposed regulations make significant revisions to the integral part test to reflect the changes made by the PPA. The PPA created two categories of Type III supporting organizations, those that are “functionally integrated” and those that are not.

Functionally Integrated Type III Supporting Organizations. On August 2, 2007, the IRS issued an Advance Notice of Proposed Rulemaking (Advance Notice), defining a functionally integrated Type III organization as one that is not required to make payments to supported organizations because the activities of the organization are related to performing the functions, or carrying out the purposes of, such supported organizations. See 72 Fed. Reg. 42335 (Aug. 2, 2007).

Thus, under the Advance Notice, this definition encompassed organizations that met the “but for” prong of the integral part test as set forth in existing Treasury Regulation § 1.509(a)-4(i)(3)(ii) and an expenditure test and an assets test similar to those that apply for determining if an organization is a private operating foundation under Internal Revenue Code section 4942(j).

“But For” Test. The proposed regulations confirm that a Type III supporting organization may be considered “functionally integrated” by meeting the “but for” prong under existing Treasury Regulation §1.509(a)-(4)(i)(3)(ii). The “but for” test requires the organization to engage in activities substantially all of which directly further the exempt purposes of the supported organization(s) to which it is responsive by performing the functions of, or carrying out the purposes of, such supported organization(s), and, but for the involvement of the supporting organization, would normally be engaged in by the supported organization(s). The proposed regulations eliminate an expenditure or assets test as previously contemplated by the Advance Notice.

The proposed regulations also provide new guidance on what type of activities are considered to “directly further” the exempt purposes of a supported organization. Holding title to and managing exempt-use property will be considered to directly further the supported organization’s exempt purposes. Fundraising, investing and managing non-exempt-use property, and making grants (to the supported organization or to third parties) are not considered to directly further the supported organization’s exempt purposes.

An exception is made for a supporting organization if it supports only one government entity whose assets are subject to a governmental appropriation process for purposes unrelated to its exempt purposes. In that case, the investment and management of non-exempt-use property and making grants directly to the supported organization are considered to directly further exempt purposes, as long as a substantial part of the supporting organization’s total activities that further the supported organization’s exempt purposes are activities other than fundraising, grant-making, and investing and managing non-exempt-use property.

Finally, the proposed regulations also add to the “but for” test a requirement that a functionally integrated Type III supporting organization’s activities must directly further the exempt purposes of the supported organizations to which it is responsive under the responsiveness test.

Parent Test. The proposed regulations provide a new second test under which a Type III supporting organization may be found to be functionally integrated, by being the parent of each of its supported organizations. If a Type III supporting organization is the parent of its supported organizations, that is, it oversees or facilitates the operation of an integrated system, such as a hospital system, the organization will qualify as a functionally integrated Type III supporting organization.

To be considered a parent of a supported organization, the supporting organization must exercise a substantial degree of direction over the policies, programs, and activities of the supported organization, and the majority of the officers, directors, or trustees of the supported organization must be appointed or elected, directly or indirectly, by the officers, governing body, or members of the governing body of the supporting organization.

Non-Functionally Integrated Type III Supporting Organizations. The PPA eliminated the method of meeting the integral part test known as the “substantially all income” prong as set forth in existing Treasury Regulation §1.509(a)-(4)(i)(3)(iii). In its place, Type III supporting organizations that previously met this prong would now be considered non-functionally integrated Type III supporting organizations. The PPA directed the Treasury to issue regulations imposing a minimum distribution requirement on these organizations and requiring them to meet an attentiveness requirement.

In its Advance Notice in 2007, the IRS proposed an additional requirement limiting the number of organizations that a non-functionally integrated Type III supporting organization could support. The proposed regulations eliminate this limitation.

Minimum Distribution Requirement. The proposed regulations require that, for each taxable year, a non-functionally integrated Type III supporting organization must distribute, on or before the last day of such taxable year, to or for the use of its supported organization(s), amounts equaling or exceeding 5 percent of the aggregate fair market value of its non-exempt-use assets as measured by the asset values over the preceding taxable year.

The proposed regulations generally adopt the same rules for valuation, timing, and carryovers that are used for private foundations under Internal Revenue Code section 4942, with two small changes in determining the amounts distributed in a taxable year.

First, the proposed regulations would not allow set-asides to be used to satisfy the minimum distribution requirement. Second, in determining the use of carried-over excess distributions, any amount carried over from a previous year would be used first to reduce the distributable amount, and then actual amounts paid in the current year would be used, rather than in the reverse order, as applicable to private foundations.

The proposed regulations also include a reasonable cause exception. If a failure to meet the minimum distribution requirement was due solely to an incorrect valuation of assets, ministerial error, or unforeseen events or circumstances beyond the supporting organization’s control, and was not due to willful neglect, then the supporting organization may meet the distribution requirement by making such distributions within 180 days of the date when it found or should have found the error relating to the distributions, or within 180 days of the date when, notwithstanding the unforeseen events or circumstances, it is able to make the required distributions.

A new provision in the proposed regulations allows the Secretary to provide for an emergency temporary reduction in the required distribution amount for a non-functionally integrated Type III supporting organization in the case of a disaster or emergency.

Attentiveness Test. The proposed regulations also require that a non-functionally integrated Type III supporting organization distribute one-third or more of its distributable amount to organizations that are attentive to the supporting organization’s activities and to which the supporting organization is responsive. A supported organization is considered to be attentive to the supporting organization in the following circumstances:

  • The supporting organization provides 10 percent or more of the supported organization’s total support;
  • The supporting organization is providing support that is necessary to avoid the interruption of a particular function or activity (i.e., the support is earmarked for a specific function or activity); or
  • The supporting organization is providing an amount of support that, based on the facts and circumstances, is a sufficient part of the supported organization’s total support (thus, taking into account actual attentiveness).

The proposed regulations specifically state that distributions to a donor-advised fund in and of itself will not cause the sponsoring organization of the donor-advised fund to be attentive to the supporting organization.

Transitional Rule for pre-1970 Trusts. The proposed regulations continue to allow certain trusts created before November 20, 1970, to meet the integral part test by meeting certain requirements as set forth in existing Treasury Regulation §1.509(a)-(4)(i)(4). This test allows such trusts to bypass the distribution and attentiveness requirements, but classifies them as non-functionally integrated Type III supporting organizations for all other purposes.

Excess Business Holdings Rules

For the purpose of the excess business holdings rules, the PPA applied the private foundation excess business holdings rules to non-functionally integrated Type III supporting organizations. The PPA also established a transitional rule to allow such non-functionally integrated supporting organizations additional time to comply with the excess business holdings rules.

The proposed regulations close a gap in the rules by applying the same transitional rule to organizations that were previously classified as Type III supporting organizations but were re-classified as private foundations as a result of the PPA. The proposed regulations also provide that charitable trusts that meet the exception from the integral part test for trusts established before November 20, 1970, are exempt from the application of the excess business holdings rules.

Effective Date & Transition Rules

The proposed regulations will become effective on the first day of an organization’s taxable year that begins after the date when the rules are published in the Federal Register as final or temporary regulations.

Organizations previously classified as Type III supporting organizations under the “but for” test in existing Treasury Regulation §1.509(a)-4(i)(3)(ii) will be treated as functionally integrated Type III supporting organizations until these proposed regulations become effective. Such organizations must meet the new requirements by the first day of their first taxable year beginning after the date when the final or temporary regulations are published.

Organizations previously classified as Type III supporting organizations under the “substantially all income” test in existing Treasury Regulation §1.509(a)-4(i)(3)(iii) will be treated as non-functionally integrated supporting organizations until these proposed regulations become effective. Such organizations must meet the new requirements by the first day of their second taxable year beginning after the date when the final or temporary regulations are published; provided that the first year after the final or temporary regulations are published must be used to value the organization’s assets and the mandatory distributions must commence in the second year based on those values. The distributable amount for the first tax year after publication of final or temporary regulations will be zero.

After the proposed regulations are published as final or temporary regulations, an organization that was previously classified as a Type III supporting organization but fails to meet the requirements of the proposed regulations will be classified as a private foundation for the taxable year in which it fails such requirements and all subsequent taxable years.

Comments Requested

The IRS and the Treasury Department request comments on certain provisions of these proposed regulations and related issues, including those specific items noted below. Comments must be received by December 23, 2009.

  • A specific responsiveness test for charitable trusts that would be consistent with the existing responsiveness test and the Congressional intent of removing the alternate trust test.
  • Guidance on how to apply the “substantially all” requirement of a functionally integrated organization where substantially all of its activities must further the exempt purposes of the supported organization.
  • The requirement that a functionally integrated organization’s activities directly further the exempt purposes of the supported organizations to which the supporting organization is responsive.
  • Whether amounts set-aside under Internal Revenue Code section 4942(g)(2) by non-functionally integrated Type III supporting organizations should count toward its annual 5 percent distribution requirement.
  • The reasonable cause exception for the distribution amount.
  • Whether a transitional rule is needed for a non-functionally integrated Type III supporting organization, where more than one-half of the assets of such organization are not readily marketable.
  • Whether exceptions or special rules are needed for terminating private foundation status under Internal Revenue Code section 507 for organizations previously classified as Type III supporting organizations and reclassified as private foundations as a result of the PPA changes.
  • Whether additional transitional relief is needed on meeting the integral part test.

McGuireWoods LLP routinely represents tax-exempt organizations in a variety of legal matters. If you have any questions, please do not hesitate to contact us.

McGuireWoods Nonprofit & Charitable Advisory Services

Nonprofit and Charitable Advisory Services provides advice and guidance that enables charities and other nonprofits to operate in the increasingly complicated, regulated, and competitive environment facing nonprofits today.

McGuireWoods Fiduciary Advisory Services

Fiduciary Advisory Services assists financial institutions in a wide array of areas in which questions or concerns may arise. This includes advising corporate trustees on how to avoid litigation before it arises, and how to address litigation when it does arise.

Subscribe
Back to top