In two recent, similar rulings - PLR 202412011 and PLR 202414006 - the IRS ruled that two organizations it recognized as public charities under IRC Section 501(c)(3), and as supporting organizations under IRC Section 509(a)(3), no longer qualified as supporting organizations, or as any other type of public charity, and reclassified both as non-operating private foundations.

Background

The organizations were originally recognized by the IRS as tax-exempt under IRC Section 501(c)(3) and determined not to be private foundations because they qualified as public charities under IRC Section 509(a)(3); that is, they were organized and operated exclusively for the benefit of publicly supported IRC Section 501(c)(3) entities. The organizations indicated on their respective Forms 990, Schedule A that they qualified as Type III functionally integrated supporting organizations. The IRS examined both organizations and ultimately reclassified them as non-operating private foundations, without revoking their 501(c)(3) tax-exempt status.

Law

Treas. Reg. 1.501(c)(3)-1(a)(1) requires an organization to be both organized and operated exclusively for one or more purposes specified in IRC Section 501(c)(3). Organizations are considered private foundations under IRC Section 509(a) unless they qualify as a type of public charity described in IRC Section. 509(a)(1), (2), (3) or (4).

Organizations that qualify as public charities generally receive broad public support or actively function in a supporting relationship to a publicly-supported charity or charities. To qualify as a supporting organization, rather than as a private foundation, an organization must meet all four of the following tests:

1. The organizational test — Treas. Reg. 1.509(a)-4(c) — requires the entity to be organized exclusively for the benefit of, to perform the function of, or to carry out the purposes of one of more publicly supported organizations described in IRC Section 509(a)(1) or (a)(2)). This test is generally met by reciting this "exclusively for the benefit of" purpose in the organization's organizing document (e.g., articles of incorporation) and naming the supported organization(s) in the organizing document.
2. The operational test — Treas. Reg. 1.509(a)-4(e) — requires the entity to be operated exclusively for the benefit of, to perform the function of, or to carry out the purposes of one of more publicly supported organizations described in IRC Section 509(a)(1) or (a)(2)). This test is met by engaging solely in activities that support or benefit its specified publicly supported organizations. An entity would fail a test if it makes a grant to a beneficiary other than its supported organization(s), individual beneficiaries in a charitable class, state colleges or universities, or organizations that are operated, supervised or controlled by, or in connection with, the entity's supported organization(s).
3. The control test — Treas. Reg. 1.509(a)-4(j) — prohibits the supporting organization from being controlled directly or indirectly by one or more IRC Section 4946 "disqualified persons" (e.g., substantial contributors, their family members, entities 35% owned by substantial contributors and their family members), other than officers and directors of the organization and one or more publicly supported organizations.
4. The relationship test — Treas. Reg. 1.509(a)-4(f) — requires the supporting organization to be operated, supervised, or controlled by or in connection with one or more publicly supported organizations. A Type I supporting organization is supervised or controlled by its supporting organization(s). A Type II supporting organization is supervised or controlled in connection with its supported organization(s). A Type III supporting organization is operated in connection with its supported organization(s).

Because Type III supporting organizations are not controlled by or in connection with their supported organization(s), the regulations impose tighter qualification criteria and restrictions on them. All Type III supporting organizations must meet all three of the following:

• Notification requirement: the Type III supporting organization must provide certain organizational and financial information to its supported organization(s) each year.
• Responsiveness test: the Type III supporting organization must maintain a close enough relationship with its supported organization(s) so that it is responsive to the supported organizations' needs and demands, and so that the supported organizations have a significant voice in the investment policies and grantmaking of the supporting organization.
• Integral part test": the Type III supporting organization may meet this test by being "functionally integrated" with its supported organization(s) so that it is either their parent or is engaged in certain activities substantially all of which directly further their tax-exempt purposes. If it is "non-functionally integrated," it must meet this test by making annual distributions to its supported organization(s) similar to annual distributions that private foundations must make.

Rulings

The IRS originally recognized the organizations as tax-exempt under IRC Section 501(c)(3), and as public charities under IRC Section 509(a)(3). Although the organizations still qualified as tax-exempt under IRC Section 501(c)(3), the IRS concluded on examination that they did not meet the definition of either a Type III functionally integrated or non-functionally integrated supporting organization because they did not meet the notification requirement, responsiveness test, or the integral-part test, as required by Treas. Reg. 1.509(a)(4)(i)(2)-(5).

In PLR 202412011, the IRS also analyzed how the organization didn't qualify as a Type I or Type II supporting organization, or as an IRC Section 509(a)(1) or 509(a)(2) public charity. It noted that the organization "has complete autonomy and independence" from its named supported organization, rather than being operated, supervised, or controlled by or in connection with that supported organization. Accordingly, the IRS reclassified both organizations as non-operated private foundations and indicated that they must now file Form 990-PF rather than Form 990.

Implications

These rulings highlight the need for an organization to carefully determine its foundation status under 501(c)(3), both at its inception and throughout its lifetime.

When applying for IRS recognition of tax-exempt status under IRC Section 501(c)(3), organizations should carefully consider the statutory and regulatory requirements for classification as a public charity and apply for IRS recognition of the most favorable public charity status for which they qualify. For instance, if an IRC Section 501(c)(3) organization would qualify as both a private foundation and a public charity, it is generally preferable to qualify and be classified as a public charity. If an IRC Section 501(c)(3) organization would qualify as both a publicly-supported organization under 509(a)(1)/170(b)(1)(A)(iii) and a supporting organization under IRC Section 509(a)(3), it is generally preferable to qualify and be classified under IRC Section 509(a)(1). If an IRC Section 501(c)(3) organization would qualify as both a Type I and Type III supporting organization, it is generally preferable to qualify and be classified as a Type I supporting organization.

It is also important for an organization recognized by the IRS as a public charity to review and confirm on an annual basis that it continues to meet that public charity status, or another public charity status. If an organization recognized by the IRS as a public charity fails to qualify as a public charity in a given tax year, it becomes a private foundation for that tax year and subsequent tax years by operation of law and must file a Form 990-PF for that tax year and subsequent tax years.

If an organization that is initially recognized by the IRS as a public charity fails to meet the requirements of its recognized public charity status, it can avoid being treated as a private foundation by qualifying under a different public charity status (e.g., an IRC Section 509(a)(3) supporting organization rather than an IRC Section 509(a)(2) organization). A 501(c)(3) public charity isn't constrained to classify itself, on its annual Form 990 Schedule A, as the type of public charity named in its IRS exemption determination letter or in the IRS records. Rather, it should list whatever public charity status it met that tax year. If it qualified under multiple public charity tests, it should list the most favorable public charity status. If the organization continues to check the Schedule A box for its IRS-recognized public charity status year after year but does not actually qualify for that status in a particular year, it risks being reclassified by the IRS as a private foundation, like the two organizations addressed in PLRs 202412011 and 202414006.

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