Type III Supporting Organizations ("SO"), which are those "operating in connection with" one or more supported organizations, are treated as public charities because they support one or more public charities. ("SO" herein refers exclusively to "Type III Supporting Organizations," there are also Type 1 and Type II supporting organizations, which are outside the scope of this discussion.) As public charities, they enjoy advantages not applicable to private foundations. Because of these advantages, and real and perceived tax abuse, SO's have been subject to much scrutiny over the last 10 or so years.
In the Pension Protection Act of 2006, Congress added restrictions designed to eliminate abuse in utilizing SO's. Effective December 28, 2012, the IRS issued regulations that add additional restrictions and clarifications. The new provisions are particularly relevant for "non-functionally integrated" SO's - SO's that do not carry out activities that directly perform the functions of the supported organizations.
To qualify, SO's must satisfy several provisions, including 1) a notification requirement, 2) a responsiveness test, 3) an integral part test, and 4) a control analysis.
1) The notification requires that the SO provide documents to each of its supported organizations, including a written description of the type and amount of all of the support it provided to each supported organization, its most recent Annual Return (Form 990), and a copy of its governing documents.
Recommendation: The SO should support only one supported public charity.
2) The responsiveness test requires a connection between the boards of directors and officers of the SO and its supported organizations that gives each supported organization a significant voice in the investment policies and use of the SO's income and assets.
Recommendation: The SO Board should include one or more members who are Board members or officers of the supported charity.
3) A non-functionally integrated SO has the following two components to satisfy the integral part test:
A. The first component requires that the SO distribute an amount to, or for the use of, its supported organizations each year. The "distributable amount" must equal the greater of 85% of the SO's adjusted gross income or 3.5% of the fair market value of its nonexempt use assets. Administrative expenses, excluding investment management fees, count toward this distribution requirement.
Observation: This distribution provision is a major change from prior law, which required only the 85% adjusted gross income distribution. Now, one prong of the test is similar to distributions required for private foundations, but with a 3.5% minimum distribution rather than a 5% minimum distribution.
B. The second component requires that the SO be "attentive" to the supported organization. Although there are different ways to satisfy this test, the most common will require that the SO provide support that is necessary to avoid the interruption of a substantial program of the supported organization.
Recommendation: The So should support a program that is either new or at risk of elimination due to budget cuts, that is identified and designed with the direction of the supported organization.
4) SO's may not receive contributions from a person who directly or indirectly "controls" the SO. There is more guidance expected from the IRS regarding the definition of control.
Finally, some issues may still arise. For example, prior to 2006 and the IRS's evolving position, the SO donor could appoint "independent" trustees to serve with him or her. Now, the question of who is "independent" is becoming more restrictive in the IRS' eyes to include not only family members, but perhaps any trustee appointed by the donor.
Recommendation: If there is a three member board of trustees, including the SO donor, at least one trustee should be from the supported organization, and perhaps the third should be appointed by the supported organization.
Also, since the 2006 Act, the excess benefit transaction rules apply to SO's, meaning neither the founder nor his family can benefit from grants, loans, compensation or "similar payment." Thus, unlike private foundations, where reasonable compensation can be paid to family members, SO's should not pay compensation to the donor or his family members, nor to substantial contributors.
When all is said and done, SO's remain viable planning tools for donors and charities to enhance charitable giving.
Read more discussion of estate planning topics affecting Virginia residents and U.S. citizens at Dedon on Estate Planning.
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