February 23, 2016 Proposed rules clarify requirements for Type III supporting organizations In REG-118867-10, the IRS and Treasury issued proposed regulations revising and clarifying the rules on how Type III supporting organizations may satisfy the relationship test, as well as defining "control" for purposes of the prohibition on Type I and Type III supporting organizations accepting contributions from controlling donors. 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 (supporting organization is operated, supervised or controlled by the supported organization(s)), Type II (supporting organization is supervised or controlled in connection with the supported organization(s)) and Type III (supporting organization is operated in connection with the supported organization(s)), based on the supporting organization's relationship with its supported organization(s). 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 supporting organizations that are not "functionally integrated" with their supported organizations. 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. 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 entities (see Tax Alert 2013-2484). In December 2015, the IRS issued final regulations on payout requirements for non-functionally integrated Type III supporting organizations, adopting the rules originally issued in temporary form in 2012 (see Tax Alert 2016-20). In the preamble to the final regulations, the IRS also described new proposed regulations that it intended to issue, which would modify these final regulations in part, as well as add specific rules on Type III supporting organizations that support governmental supported organizations. New proposed regulations The new 2016 proposed regulations take into consideration comments received on both the 2012 regulations and Notice 2014-4. The new rules are proposed to generally be effective on the date that final or temporary regulations adopting them are published. The preamble to the proposed regulations, however, states that taxpayers may rely on the proposed rules until such final or temporary regulations are issued. Gifts from "controlling" donor The new proposed regulations define "control" for purposes of the prohibitions on Type I and Type III supporting organizations as accepting contributions from persons who exercise direct or indirect control over the governing body of their supported organizations. Specifically, the proposed regulations define the term "control" consistently with the regulations relating to control by disqualified persons for purposes of the disqualified person control test; that is, in general, a person exercises "control" over the governing body of a supported organization if that person's voting power, either alone or with certain related persons, is 50% or more of the total voting power, or if such persons have veto power. Type III supporting organization relationship test The new proposed regulations would expand guidance on the requirement for Type III supporting organizations to annually satisfy: (1) a notification requirement; (2) a responsiveness test; and (3) an integral part test. Notification requirement Under the notification requirement, a Type III supporting organization must provide certain information to supported organizations annually to ensure that the organization is responsive to the needs or demands of the supported organizations. The proposed regulations would clarify the due date that supporting organizations must deliver the required documents to each of their supported organizations: the last day of the fifth month of the tax year after the tax year in which the supporting organization provided the support with respect to which it is reporting. Responsiveness test The responsiveness test, in general, requires supporting organizations to demonstrate that they are responsive to the needs of the supported organization by satisfying a "relationship test" and a "significant voice test." The proposed regulations specify that, to satisfy the responsiveness test, a supporting organization must be responsive to the needs and demands of each of its supported organizations (not just a subset of supported organizations, as some commenters suggested). The proposed regulations include a new example aimed at demonstrating how supporting organizations may cost-effectively deal with the potential administrative burden of satisfying this requirement. This example also illustrates how a Type III supporting organization could ensure that its supported organization has a "significant voice" in the supporting organization's investment policies, timing of grants, manner of making grants, selection of grant recipients and in directing the use of the supporting organization's income and assets. Integral part test — functionally integrated Type III supporting organizations The integral part test generally requires Type III supporting organizations to maintain significant involvement in the operations of their supported organizations and provide support on which such organizations depend. The requirements to satisfy the test differ for functionally integrated and non-functionally integrated Type III supporting organizations. In general, Type III supporting organizations are considered "functionally integrated" if they: (1) engage in activities substantially all of which directly further the exempt purposes of their supported organizations by performing the functions of, or carrying out the purposes of, such supported organizations that would otherwise normally be engaged in by the supported organizations; (2) are the parent of each of their supported organizations; or (3) support a "governmental supported organization." The new proposed regulations provide guidance on the second and third ways of meeting the functionally integrated test. For a supporting organization to qualify as the parent of each of its supported organizations, the supporting organization and its supported organizations must be part of an integrated system, and the supporting organization must engage in activities typical of the parent of an integrated system. The proposed regulations mention hospital systems as an example of an integrated system. While the proposed regulations provide some examples of such activities (i.e., planning, budgeting and policy development), the IRS requests comments on other "typical" activities in an integrated system and whether such activities should be explicitly listed as examples. The proposed regulations retain the requirement that the governing body, members of the governing body or officers of the supported organization must appoint or elect a majority of the officers, directors or trustees for the supported organizations. The proposed regulations would clarify that this power to appoint or elect a majority of the officers, directors or trustees of each supported organization includes the power to remove and replace such officers, directors or trustees, or otherwise to have an ongoing power to appoint or elect with reasonable frequency. The proposed regulations also define "governmental supported organization" as a governmental unit described in Section 170(c)(1) or an instrumentality of a governmental unit that is described in Section 170(c)(2) and (b)(1)(A) and that is not a private foundation or a supporting organization. The proposed regulations allow a supporting organization that supports more than one governmental organization to be considered functionally integrated if all of its governmental supported organizations either: (1) operate within the same geographic region (defined as a city, county or metropolitan area); or (2) work in close coordination or collaboration with one another to conduct a service, program or activity that the supporting organization supports. To satisfy the close cooperation or coordination requirement, the proposed regulations would require a supporting organization to maintain on file a letter from each of its governmental supported organizations (or a joint letter from all of them) describing their collaborative or cooperative efforts with respect to the particular service, program or activity. In addition, the proposed regulations would require that a "substantial part" of the supporting organization's total activities must directly further the exempt purposes of its governmental supported organization(s), which differs from the more restrictive "substantially all" test for supporting organizations of non-government organizations. The proposed regulations also include certain transitional relief for existing supporting organizations that support governmental organizations. Integral part test — non-functionally integrated Type III supporting organizations Non-functionally integrated Type III supporting organizations meet the integral part test by satisfying distribution and attentiveness requirements. For the distribution requirement, the proposed regulations remove a regulatory provision treating taxes paid on unrelated business income as distributable amounts. The proposed regulations would also revise the list of what expenditures count toward the distribution requirement. In addition, the proposed regulations would clarify the treatment of fundraising expenses with respect to the distribution requirement. The proposed regulations specify that reasonable and necessary administrative expenses paid to accomplish the exempt purposes of supported organizations generally do not include fundraising expenses of the supporting organization. Under the proposed regulations, however, reasonable and necessary expenses incurred by a supporting organization to solicit contributions that a supported organization receives directly from donors would count toward the distribution requirement, to the extent that amount is not greater than the amount of contributions actually received by the supported organization as a result of the supporting organization's solicitation efforts. The proposed regulations would require the supporting organization to obtain written substantiation from the supported organization of the amount of contributions the supported organization actually received as a result of the supporting organization's solicitations. This requirement would ensure that the supporting organization has the information needed to calculate the allowable expenses. Implications The proposed regulations would loosen the requirements for Type III supporting organizations of governmental organizations, but tighten them for other Type III supporting organizations. For example, they provide that the responsiveness test would only be met by Type III supporting organizations when they are responsive to, and significantly involved in, the operations of each of their supported organizations. According to the IRS, this requirement would work to ensure that a supported organization exercises the requisite level of oversight and accountability over the operations and activities of its supporting organization at all times. The proposed regulations also provide an exclusive list of payments that count towards satisfying the distribution requirement. Additionally, in adopting a definition of "control" with regard to contributions from certain individuals involved in the governance of a supported organization, the proposed regulations would provide Type I and Type III supporting organizations with an objective measure for determining whether proposed contributions and gifts from such individuals to a supporting organization are problematic. This clearer definition would enable supporting organizations to identify with greater certainty prohibitive contributions that could result in the loss of the organization's public charity status. Type I and Type III supporting organizations in particular should review closely the proposed regulations to determine the implications for their current operations, compliance obligations and tax-exempt status. If these proposed regulations are finalized, such organizations will be required to comply with the requirements to be treated as public charities, rather than as private foundations. Prior to the proposed regulations being adopted as final, the IRS and Treasury will give consideration to any written comments that are timely submitted. Exempt organizations that will be subject to the new rules should consider submitting comments on their viewpoint by May 19, 2016. Please contact your EY professional for additional details. ——————————————— — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg. ———————————————
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