In the Tax Reform Act of 1969, Congress separated tax exempt charitable organizations which could receive tax deductible contributions (“entities”) into three classifications, 1) public foundations, 2) private foundations and 3) supporting organizations. Later, Congress passed the Pension Protection Act of 2006 which further tightened the requirements for entities to qualify as supporting organizations. This article will explain what private foundations and supporting organizations are and why supporting organization status is no longer a good alternative for a private foundation.
According to Section 509 of the Internal Revenue Code (“IRC”), a private foundation is an entity which receives less than two-thirds of its annual income from public donations. The private foundations with which this article deals are started by individuals who wish to make systematic charitable donations annually, but not necessarily grants in the same amount and to the same entities annually. These types of private foundations are often called family private foundations. A supporting organization is an entity that supports another entity—usually one or more public foundations referred to in IRC Section 509 as a “supported organization.”
Supporting organization status is preferred for an entity because it can remove the entity from private foundation status (and taxation). For donors to the entity, the advantage is a higher percentage of allowable income tax charitable deductions. For cash contributions, donors can take up to 50 percent versus 30 percent with private foundations, and for non-cash contributions, donors can take up to 30 percent versus 20 percent with private foundations.
According to IRC Section 509, there are three types of supporting organizations, Type I, Type II, and Type III. Type I supporting organizations are organized and at all times operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of a supported organization. Type II’s are operated, supervised by, or controlled by a supported organization. Type III’s are operated in connection with a supported organization. Treas. Reg. 1.509(a)-4 states the requirements for being a supporting organization described in IRC Section 509. All supporting organizations must pass each of four tests: an organizational test, an operational test, a control test, and a relationship test to determine whether they can qualify for preferential tax treatment.
The organizational test asks whether the supporting organization is created “exclusively for the benefit of, to perform the functions of, or to carry out the purposes of” the supported organization. This means that the supporting organization can only operate for the benefit of its supported organization—it cannot exist to support other organizations.
The control test asks which individuals control the supporting organization. “Disqualified persons,” as defined by the IRC, are ineligible to control a supporting organization either directly or indirectly. Such individuals can include, among others: (1) substantial contributors to the foundation; (2) foundation managers who have other disqualifying characteristics; (3) an individual owning more than 20 percent of the total combined voting power of a corporation, the profits interest of a partnership, or the beneficial interest of a trust or unincorporated enterprise which is a substantial contributor; (4) a family member of any of the individuals described in (1), (2), or (3); or (5) a trust, estate, or unincorporated enterprise where an individual described in (1), (2), (3), or (4) owns more than 35 percent of its beneficial interest. The purpose of the control test is to ensure that the individuals running the supporting organization do not have too much of an interest or financial stake in the supported organization’s operations.
The relationship test further clarifies what is a Type I, Type II, or Type III supporting organization. This test is made up of two additional tests: a responsiveness and an integral part test which define the type of supporting organization at issue. While all types of supporting organizations must respond to the needs of their supported organizations and constitute an integral part therein, a Type III supporting organization is subject to a more stringent level of control by its supported organization as Type I or II organizations. Therefore, Type III supporting organizations are not deemed to meet the responsiveness or integral part requirements by default as Type I and II supporting organizations are. Thus, Type III supporting organizations are subject to an additional notification requirement, plus an explicit responsiveness and integral part test to qualify as supporting organizations.
These additional requirements mandate that a Type III supporting organization provide its supported organization with (1) a written notice describing the type and amount of support provided by the supporting organization for the preceding year; (2) a copy of the supporting organization’s most recently filed Form 990 or 990-EZ; and (3) a copy of the supporting organization’s most updated governing documents.
A Type III supporting organization is deemed responsive to the needs of the supported organization if the supported organization has adequate representation in the supporting organization’s governing body. This ensures that the supported organization has a significant voice in how the supporting organization manages and uses assets.
In terms of integration, a Type III supporting organization can be either functionally integrated (FISO) or non-functionally integrated (non-FISO). FISOs are subject to fewer restrictions and requirements than non-FISOs, making them more appealing for administration purposes. FISO status can be achieved a few different ways. First, it can be achieved via an activities test which asks whether the supporting organization carries out a function that directly furthers the supported organization’s purpose that it would otherwise be carrying out on its own if the supporting organization were not. Second, it can be achieved by the supporting organization serving as a parent of a supported organization where the supporting organization has the majority rule over the supported organization’s officers, directors, or trustees and its policies and activities. Third, it can be achieved by the supporting organization benefitting a governmental entity which would carry out similar functions as the supported organization.
In contrast, non-FISO status includes distribution and attentiveness requirements which show that the supporting organization serves as a significant enough contributor of funds or services that the supported organization has an interest in the supporting organization’s role in its operations. Both the distribution and the attentiveness determinations require a more fact-intensive inquiry that could be avoided under FISO status.
When the supporting organization concept was first placed in IRC Section 509, Type III supporting organizations were an attractive alternative for a family private foundation with loose relationships with entities to which it made grants. However, the amendments to IRC Section 509, and the subsequent Treasury Regulations under it, made supporting organizations more and more effectively supervised by the supported organization. These developments effectively ended the attraction of Type III supporting organization status as an alternative to private foundation status for family private foundations.
This article was written with contribution from Sarah Rothermel, 3rd year law student at Widener Law Commonwealth.