October 24, 2023
Final regulations on supporting organizations modify proposed regulations
The Treasury Department and IRS have released final regulations (TD 9981) on gifts or contributions to Type I and Type III supporting organizations from donors that control their supported organizations. The final regulations also address certain other requirements for Type III organizations, such as (1) meeting the Type III responsiveness test, (2) qualifying as a functionally integrated Type III supporting organization (including a definition of a governmental supported organization), and (3) the required annual distributions by non-functionally integrated Type III supporting organizations.
The final regulations adopt the proposed regulations (REG-118867-10) with some modifications (see Tax Alert 2016-0366). The final regulations apply to tax years beginning on or after October 16, 2023, but taxpayers may choose to apply them to tax years beginning on or after February 19, 2016, so long as they apply them in their entirety and in a consistent manner.
Under IRC Section 509(a)(3), supporting organizations attain their public charity status by supporting one or more organizations described in IRC 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 known 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 some 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 2009, the IRS issued proposed regulations on the new requirements for Type III supporting organizations. In 2012, the IRS issued additional proposed, temporary and final regulations on the requirements to qualify as a Type III supporting organization. The 2012 final regulations adopted (with some modifications) most of the 2009 proposed regulations. The IRS issued the 2012 regulations on payout requirements for non-functionally integrated Type III supporting organizations as temporary and 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.
In December 2015, the IRS issued final regulations on payout requirements for non-functionally integrated Type III supporting organizations, adopting the regulations originally issued in temporary form in 2012 (see Tax Alert 2016-0020).
2016 proposed regulations
In February 2016, the IRS issued proposed regulations revising and clarifying the regulations 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 (see Tax Alert 2016-0366). The IRS said taxpayers could rely on the proposed regulations until final regulations were issued.
Definition of "controlling" donor
The final regulations clarify the definition of "control," for purposes of the prohibition on a Type I or Type III supporting organization receiving any gift or contribution from any person exercising direct or indirect control over the governing body of those supporting organizations' supported organizations (unless that person is a publicly supported organization described in IRC Sections 509(a)(1) or 509(a)(2) or public safety testing organizations described in IRC Section 509(a)(4)). The final regulations clarify that a person exercises "control" over the governing body of a supported organization if (1) that person's voting power, either alone or with certain related persons, is 50% or more of the total voting power of the governing body, or (2) those persons have veto power over the governing body's actions. If those persons do not have 50% or more of the voting or a veto power, whether they directly or indirectly control the governing body of the supported organization depends on "all pertinent facts and circumstances."
Type III supporting organization relationship test
The final regulations adopt the proposed regulations' guidance, with some modifications, on the requirement for Type III supporting organizations to annually satisfy: (1) the notification requirement, (2) the responsiveness test and (3) the integral part test of IRC Section 509(a)(3).
Under the notification requirement, a Type III supporting organization must provide certain information to its supported organization(s) annually to make certain that the organization responds to the needs or demands of the supported organization(s), including a written notice to each supported organization's principal officer describing the type and amount of support the supporting organization provided in the preceding tax year. The final regulations clarify that the due date by which supporting organizations must deliver the required documents to each of their supported organizations is the last day of the fifth month of the supporting organization's tax year after the tax year in which it provided the reported support.
The Type III supporting organization responsiveness test, in general, requires supporting organizations to demonstrate that they respond to the needs of their supported organization by satisfying a "relationship test" and a "significant voice test."
The final regulations adopt the proposed regulations on the responsiveness test without change. Thus, to satisfy the responsiveness test, a supporting organization must respond to the needs and demands of each of its supported organizations (not just a subset of those supported organizations). The final regulations also adopt Example 3 of the proposed regulations, which demonstrates how supporting organizations may cost-effectively deal with the potential administrative burden of satisfying this requirement, as well as illustrating how a Type III supporting organization could make sure that its supported organization has a "significant voice" in the supporting organization's investment policies, timing of grants, manner of making grants, and 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 the support on which their supported organizations depend. The test requirements differ for functionally integrated and non-functionally integrated Type III supporting organizations. In general, a Type III supporting organization is considered "functionally integrated" if it (1) engages in activities substantially all of which directly further the exempt purposes of its supported organizations; (2) is the parent of each of its supported organizations; or (3) supports a "governmental supported organization."
To qualify as the parent of each of its supported organizations for purposes of the functionally integrated Type III supporting organization test in the proposed regulations, the supporting organization had to:
The proposed regulations mentioned hospital systems as an example of an integrated system. The final regulations clarified that this is only one example and not exclusive. "The test is whether the structure is that of an integrated system and whether the requirements of [Treas. Reg. Section] 1.509(a)-4(i)(4)(iii) are satisfied, not whether the system is in a particular industry." The final regulations also remove the requirement for a supporting organization parent to engage in "activities typical of a parent."
While the proposed regulations provided some examples of typical activities (i.e., planning, budgeting and policy development), the final regulations state that the absence of an activity from that list does not mean it is excluded. The final regulations clarify that a parent of an integrated system of supported organizations must direct the overall policies, programs and activities of its supported organizations. Examples include coordinating the activities of the supported organizations and engaging in overall planning, policy development, budgeting and resource allocation.
The final regulations adopt the proposed regulations' requirement that the governing body, members of the governing body or officers of the parent supporting organization must have the power to appoint or elect a majority of the officers, directors or trustees of each of its supported organizations. The final regulations clarify that the parent supporting organization must also have the power to remove and replace the officers, directors or trustees, or otherwise have the ongoing power to appoint or elect them with reasonable frequency.
Governmental supported organizations
The final regulations adopt the proposed regulations' definition of "governmental supported organization" using the existing IRC definition of "government unit," with some modifications. A governmental unit is defined as one described in IRC Section 170(c)(1) or an instrumentality of a governmental unit that (1) is described in IRC Section 170(c)(2) and (b)(1)(A), and (2) is not a private foundation or a supporting organization. Under the final regulations, a supporting organization that supports more than one governmental organization is considered functionally integrated if all of its governmental supported organizations work in close coordination or collaboration with one another to conduct a service, program or activity that the supporting organization supports. The final regulations remove the requirement in the proposed regulations that an organization qualified as a governmental supported organization only if it operated within the same geographic region as all other governmental supported organizations of the supporting organization. To satisfy the close cooperation or coordination requirement, the final regulations confirm that a supporting organization must 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 around the particular service, program or activity.
In addition, the final regulations adopt the proposed regulations' requirement that a "substantial part" of the supporting organization's total activities must directly further the exempt purposes of its governmental supported organization. The final regulations add a new example to clarify that a supporting organization can meet this requirement and still make grants to one of its governmental supported organizations as a substantial part of its activities.
Integral part test — non-functionally integrated Type III supporting organizations
Non-functionally integrated Type III supporting organizations meet the Type III integral part test by satisfying distribution and attentiveness requirements. For each tax year, a non-functionally integrated Type III supporting organization must distribute to or for the use of one or more supported organizations an amount equaling or exceeding its "distributable amount." The final regulations adopt the proposed regulations' description of what distributions count toward satisfying the distribution requirement, including that the distributable amount is not reduced by unrelated business income tax paid by the supporting organization during the immediately preceding tax year.
The final regulations also adopt, with some modifications, the proposed regulations regarding which distributions count toward meeting the non-functionally integrated Type III distribution requirement. Under the final regulations, fundraising expenses incurred by a supporting organization to solicit contributions count towards the distribution requirement when the resulting contributions are either:
In addition, the supporting organization must substantiate that those contributions were received as a result of the supporting organization's solicitation activities. This limitation applies on a solicitation-by-solicitation basis.
Like the proposed regulations, the final regulations require the non-functionally integrated Type III 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. The final regulations also clarified that the supported organization may provide this written substantiation by electronic media.
The final regulations for Type I and Type III supporting organizations are generally consistent with the proposed regulations released in 2016. As with the proposed regulations, the requirements are generally loosened for Type III supporting organizations of governmental supported organizations but generally tightened for other Type III supporting organizations.
Type I and Type III supporting organizations should note the final regulations' definition of "control," for purposes of the prohibition on a Type I or Type III supporting organization accepting gifts or contributions from a donor that controls the supported organization(s). As supporting organization/public charity status could be jeopardized by such gifts, the IRS's added clarification of what constitutes control should help organizations navigate potentially risky gift transactions. For instance, the IRS and Treasury noted in the Preamble to the final regulations that a supporting organization may not accept donations from another supporting organization that controls those supporting organizations' supported organization(s). Thus, if a Type I or Type III supporting organization (SO) is controlled by a tax-exempt health system parent (Parent) that is a supporting organization under IRC Section 509(a)(3), and if Parent controls SO’s supported organization(s), SO would cease to qualify as a supporting organization if it accepted a gift or contribution from Parent. Type I and Type III supporting organizations and their supported organizations should determine which of the final regulations apply to their operations, so they can continue to meet the requirements of IRC Section 509(a)(3).
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor