The IRS has issued final regulations (TD 9746) with respect to payout requirements for non-functionally integrated Type III supporting organizations, adopting rules originally issued in temporary form in 2012. In the preamble to the final regulations, the IRS also describes new proposed regulations that it intends to issue which would modify these final regulations in part, as well as add specific rules with respect to Type III supporting organizations that support governmental supported organizations.

Background

Under Section 509(a)(3), supporting organizations attain their public charity status by supporting one or more organizations described in Section 509(a)(1) or (2) (supported organizations). All types of supporting organizations must meet an organizational test, operational test, disqualified person control test and one of three relationship tests. These three relationships are commonly referred to as Type I, Type II and Type III, based on the supporting organization's relationship with its supported organization(s). Supporting organizations that are operated in connection with one or more supported organizations are termed Type III supporting organizations.

The Pension Protection Act of 2006 (PPA) made a number of changes to the requirements for Type III supporting organizations, including directing the Secretary of the Treasury to create a new payout requirement for Type III organizations that are not "functionally integrated." In 2007, the IRS issued an advanced notice of proposed rulemaking (ANPRM) describing rules to implement the changes to the Type III supporting organization requirements made by the PPA (see Tax Alert 2007-670). In 2009, after considering the comments received on the ANPRM, the IRS issued proposed regulations on the new requirements for Type III supporting organizations (see Tax Alert 2009-1471).

In 2012, the IRS issued additional proposed, temporary and final regulations on the requirements to qualify as a Type III supporting organization (see Tax Alert 2013-39). The 2012 final regulations adopted (with some modifications) most of the 2009 proposed regulations. However, the IRS issued the 2012 rules relating to payout requirements for non-functionally integrated Type III supporting organizations as temporary and proposed regulations due to their significant differences from the 2009 proposed regulations, and reserved for future rulemaking the issue of how a Type III functionally integrated supporting organization can meet the integral part test by supporting a governmental organization. The 2012 final and temporary regulations became applicable on December 28, 2012.

In Notice 2014-4, the IRS issued interim guidance, including transitional relief, for Type III supporting organizations that qualify as functionally integrated by supporting governmental supported entities (see Tax Alert 2013-2484).

New final regulations

The new final regulations generally adopt with minimal changes the 2012 temporary and proposed regulations relating to payout requirements for non-functionally integrated Type III supporting organizations. Accordingly, the new final regulations — like the 2012 temporary and proposed regulations — stipulate that non-functionally integrated organizations must annually distribute the greater of: (1) 3.5% of the excess of the aggregate fair market value of its non-exempt-use assets over the acquisition indebtedness with respect to such non-exempt use assets, or (2) 85% of its adjusted net income, in each case for the immediately preceding tax year. Although the IRS received some comments in response to the temporary regulations suggesting changes to these rules, it declined to adopt them.

Announcement of forthcoming proposed regulations

In the preamble to the new final regulations, the IRS also announced that it plans to issue in the near future additional proposed regulations for Type III supporting organizations. The IRS explained that these new regulations will, among other things, propose a change to the new final regulations by removing the provision that reduces the distributable amount by the amount of taxes imposed under subtitle A of the Code on a supporting organization during the immediately preceding tax year.

The IRS stated that the additional proposed regulations will include rules regarding the requirements that must be met for Type III supporting organizations that support governmental supported organizations to be treated as functionally integrated Type III supporting organizations. Furthermore, the new proposed regulations would extend the transition relief beyond the period provided in Notice 2014-4. The IRS added that supporting organizations may continue to rely on the transitional rule described in Section 3.01 of Notice 2014-4 until the new proposed regulations are issued.

Implications

In light of these final regulations, non-functionally integrated Type III supporting organizations should carefully review the amounts they distribute annually to their supported organizations. The final regulations require that supported organizations receive the greater of (i) 85% of the supporting organization's adjusted net income for the immediately preceding tax year, or (ii) 3.5% of the fair market value of the supporting organization's noncharitable use assets for the immediately preceding tax year. This distribution requirement ensures that a significant amount is paid to supported organizations. Additionally, the 85% of income test makes it more likely that supported organizations will timely benefit from higher returns on investment that are received by their supporting organizations.

The IRS has indicated that it intends to issue in the near future new proposed regulations that would modify the regulations governing supporting organizations in several respects. The IRS has specified some of these, as noted above, but not others. All supporting organizations, but particularly Type III supporting organizations that are non-functionally integrated or that support governmental supported organizations, should carefully monitor any future guidance issued by the IRS on these regulations.

———————————————
RELATED RESOURCES

— For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg

———————————————