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New Regulations for Type III SOs

New Regulations for Type III SOs

Long-awaited guidance has arrived on the requirements to qualify as these types of supporting organizations
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On Dec. 28, 2012, the Internal Revenue Service published final regulations regarding Type III supporting organizations (SOs), along with temporary regulations.1 A Type III SO is one that’s operated in connection with one or more SOs. These regs constitute a culmination of sorts of the IRS’ interest in curbing what it perceived as abusive practices involving SOs, which led to new restrictions on SOs under the Pension Protection Act of 2006 and to proposed regulations issued in 2009.  While the new regs adopt many of the provisions in the 2009 proposed regs, they introduce their full share of novelties and nuances as well.

 

Gifts From Donors in Control of SOs

Under a provision in the new regs affecting Type I as well as Type III SOs, an organization loses its SO status for any taxable year in which it accepts a contribution from a person directly or indirectly in control of an SO.2  Internal Revenue Code Section 4958 applies to determine “control” for these purposes. 

 

Requirements

A Type III SO must now meet the following requirements:

·      Notification.  For each of its taxable years, a Type III SO must provide the following documents to each of its SOs (including those that may have received little or no support over the years):  (1) a written notice describing the type and amount of all support provided by the SO to its SO during the previous taxable year; (2) a copy of the SO’s Form 990 (or equivalent return) most recently filed as of the date of the notification; and (3) a copy of the SO’s governing documents in effect on the date of the notification.3  The notification must be postmarked or electronically transmitted by the last day of the fifth calendar month following the close of the SO’s taxable year (May 31 in the case of calendar-year SOs).4  The notification packet is to be provided to “the principal officer” of the SO.5 

 

·      “Responsiveness” test.  Under the new regs, this test consists of two subtests:  the “relationship” test and the “significant voice” test.  A Type III SO meets the relationship test only if one of the following elements is met:  (1) one or more officers, directors or trustees of the SO are elected or appointed by its SO’s officers, directors, trustees, or membership; or (2) one or more members of the SO’s governing body are also officers, directors, or trustees of, or hold important offices in, its SO; or (3) the SO’s officers, directors, or trustees maintain a close and continuous working relationship with its SO’s officers, directors, or trustees.6  The significant voice test is met if, by reason of satisfying the relationship test, the SO’s officers, directors, or trustees have a significant voice in: (1) its SO’s investment policies; (2) the timing of the SO’s grants; (3) the manner of the SO’s making of grants; (4) the selection of grant recipients; and (5) otherwise directing the use of the SO’s income or assets.7  An example of satisfying the “responsiveness” test is when an SO’s trustee and an officer of its SO conduct quarterly face-to-face or telephonic meetings in which they discuss the SO’s projected needs and how the SO would like its SO to use its income and invest its assets, in addition to regular communication regarding the SO’s investments and distribution plans.  The SO’s trustee also provides the SO’s officer with quarterly investment statements and an annual accounting statement.8

 

·      Integral part” test.  By far, the most complicated provisions of the new regs relate to the integral part test. This test is divided into a different set of requirements for functionally integrated (“but for”) Type III SOs and non-functionally integrated (“grantmaking”) Type III SOs, dubbed “NFIs” in the “Explanation” section accompanying the new regs. 

Functionally Integrated vs. NFI

A functionally integrated Type III SO meets the integral part test if it satisfies any of the following three elements: (1) it engages in activities, substantially all of which directly further the exempt purposes of one or more SOs; or (2) it’s the parent of each of its SOs; or (3) it supports a governmental organization.9  A functionally integrated Type III satisfies the “directly further” element if it engages in activities, substantially all of which: (1) directly further the exempt purposes of one or more SOs to which the SO is responsive, by performing the functions of, or carrying out the purposes of, these; and (2) but for the SO’s involvement, would normally be engaged in by such SOs.10  An SO is deemed to be the “parent” of an SO if the SO exercises a substantial degree of direction over its SO’s policies, programs and activities, and a majority of the SO’s officers, directors, or trustees is appointed or elected (directly or indirectly) by the SO’s governing body, members of such body or officers (acting in their official capacity).11  

As to NFIs, the integral part test includes a distribution or payout requirement.12  On or before the end of each taxable year, an NFI must distribute to, or for the use of, one or more of its SOs, an amount at least equal to the NFI’s distributable amount for the taxable year.13  Under a new temporary regulation, the distributable amount is ordinarily an amount equal to the greater of: (1) 85 percent of the SO’s adjustable net income for the immediately preceding taxable year, or (2) the SO’s minimum asset amount for such year.14  An SO’s minimum asset amount is defined under a new temporary regulation as 3.5 percent of the excess of: (1) the aggregate fair market value of the SO’s non-exempt-use assets for the immediately preceding taxable year, over: (2) the acquisition indebtedness as to such “non-exempt-use” assets as determined under IRC Section 514(c)(1);  increased by: (1) amounts received or accrued during the immediately preceding taxable year as repayments of amounts taken into account by the SO to meet its distribution requirement for any taxable year, plus: (2) amounts received or accrued during the immediately preceding taxable year from the sale or disposition of property to the extent the SO took into account the acquisition of such property to meet its “distribution” requirement for any taxable year, plus: (3) any amount set aside under Temporary Regulations Section 1.509(a)-4(i)(6)(v) to the extent it’s determined during the immediately preceding taxable year that this amount is unnecessary for the original set-aside purposes, and such amount was taken into account by the SO to meet the distribution requirement for any taxable year.15

The distribution requirement for the first year an SO is treated as an NFI is, mercifully, zero.16  Treasury may provide for a temporary reduction in the distribution amount in case of a disaster or emergency.17  The new regs also provide for “reasonable cause” relief.18  

In addition, to meet the “integral part” test, the NFI must distribute one-third or more of its distributable amount to one or more of the SOs that are “attentive” to the operations of the SO and to which the SO is “responsive.”19  An SO is deemed to be attentive to the SO’s operations during a taxable year if, within that taxable year, at least one of the following elements is satisfied: (1) the SO distributes amounts equal to at least 10 percent of its SO’s total support received during the SO’s last taxable year ending before the beginning of the SO’s taxable year;  or (2) the amount of support received from the SO is necessary to avoid the interruption of the carrying on of a particular function or activity of the SO, including a “substantial” (though not necessarily primary) program or activity of the SO;  or (3) based on all pertinent facts–including the number of SOs, the length and nature of the relationship between the SO and its own SO and the purpose to which the funds are directed–the amount of support received from the SO constitutes a sufficient part of the SO’s total support as to ensure “attentiveness.”20  The greater the amount of support received, the more likely the SO will be deemed attentive to the SO.21  Evidence of actual attentiveness is said to be of “almost equal importance.”22  An SO’s distributions to a donor advised fund are disregarded for these purposes.23

 

Additional Provisions

Other provisions of the new regs relate to types of distributions that count toward the distribution requirement,24 the five-year carryover for an SO’s excess distributions25 and the valuation of non-exempt-use assets26 as well as transition rules.27

 

Bottom Line

Many Type III SOs will find these new regs daunting, particularly in light of the consequences for a Type III SO’s failure to satisfy them–the potential reclassification as a private foundation.28  The new regs may well spur a new wave of Type III bailouts, in the form of conversion to Type I or II, or outright dissolution and termination.

For a more in-depth review of these new regs for Type III SOs, please see my upcoming article in the April 2013 issue of Trusts & Estates.

Endnotes

1. Treasury Decision 9605, http://www.gpo.gov/fdsys/pkg/FR-2012-12-28/pdf/2012-31050.pdf.

2. Treasury Regulations Section 1.509(a)-4(f)(5).

3. Treas. Regs. Section 1.509(a)-4(i)(2)(i)(A)-(C).

4. Treas. Regs. Section 1.509(a)-4(i)(2)(iii).

5. Treas. Regs. Section 1.509(a)-4(i)(2)(iv).

6. Treas. Regs. Section 1.509(a)-4(i)(3)(ii)(A)-(C).

7. Treas. Regs. Section 1.509(a)-4(i)(3)(iii),

8. Treas. Regs. Section 1.509(a)-4(i)(3)(iv), Example 1.

9. Treas. Regs. Section 1.509(a)-4(i)(4)(i).

10. Treas. Regs. Section 1.509(a)-4(i)(4)(ii).

11. Treas. Regs. Section 1.509(a)-4(i)(4)(iii).

12. Treas. Regs. Section 1.509(a)-4(i)(5).

13. Treas. Regs. Section 1.509(a)-4(i)(5)(ii)(A).

14. Temporary Regulations Section 1.509(a)-4T(i)(5)(ii)(B).

15. Temp. Regs. Section 1.509(a)-4T(i)(5)(ii)(C).

16. Treas. Regs. Section 1.509(a)-4(i)(5)(ii)(D).

17. Treas. Regs. Section 1.509(a)-4(i)(5)(ii)(E).

18. Treas. Regs. Section 1.509(a)-4(i)(5)(ii)(F).

19. Treas. Regs. Section 1.509(a)-4(i)(5)(iii)(A).

20. Treas. Regs. Section 1.509(a)-4(i)(5)(iii)(B)(1)-(3).

21. Treas. Regs. Section 1.509(a)-4(i)(5)(iii)(B)(3).

22. Ibid.

23. Treas. Regs. Section 1.509(a)-4(i)(5)(iii)(C).

24. Treas. Reg. Section 1.509(a)-4(i)(6).

25. Treas. Regs. Section 1.509(a)-4(i)(7).

26. Temp. Regs. Section 1.509(a)-4T(i)(8)).

27. Treas. Regs. Section 1.509(a)-4(i)(11).

28. See “Explanation, 7, Consequences of Failure to Meet Requirements,” supra note 1.

 

 

 

TAGS: Philanthropy
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