IRS Final and Temporary Regulations for Type III Supporting Organizations: The Integral Part Test for Non-Functionally Integrated Type III Supporting Organizations
Tax-Exempt Organizations Law Update 05/07/13 Norah L. Jones, Amanda K. Blaising
The Internal Revenue Service (the "Service") has issued final and temporary regulations (the "Final Regulations" and "Temporary Regulations") regarding the requirements to qualify (or continue to qualify) as a Type III supporting organization. The regulations, which reflect changes made to the law by the Pension Protection Act of 2006 (the "PPA"), can be read in their entirety here and went into effect on December 28, 2012.
Type III Supporting Organizations
The PPA statutorily defined Type I, Type II, and Type III supporting organizations for the first time. It also created two subcategories of Type III supporting organizations: "functionally integrated" and "non-functionally integrated." The distinction is important because "functionally integrated" Type III supporting organizations are not subject to an annual distribution requirement and generally are favored as recipients of grants and distributions from private foundations and donor advised funds. "Non-functionally integrated" Type III supporting organizations, in contrast, are subject to an annual distribution requirement and are not favored as recipients of grants and distributions from private foundations and donor advised funds.
Under the Final Regulations, all supporting organizations must continue to meet an organizational test, an operational test, a disqualified person control test, and a relationship test. The Final Regulations revise the relationship test for Type III supporting organizations by requiring each Type III supporting organization to satisfy three criteria as part of that test: (1) a notification requirement; (2) a responsiveness test; and (3) an integral part test. The Final Regulations also create specific definitions of "functionally integrated" and "non-functionally integrated" Type III supporting organizations as part of the revised integral part test. Other key parts of the revised integral part test are contained in the Temporary Regulations.
This client update discusses the integral part test for organizations wishing to qualify as Type III supporting organizations, but that are not functionally integrated. A separate client update discussing the notification requirement and the responsiveness test applicable to all Type III supporting organizations is available here, and a client update discussing the integral part test's "functionally integrated" definition and requirements is available here.
A non-functionally integrated Type III supporting organization will satisfy the integral part test if it meets a distribution requirement and an attentiveness requirement.
The Distribution Requirement
Proposed regulations issued in 2007 in response to the PPA (the "Proposed Regulations") had suggested a mandatory annual payout of five percent of the value of an organization's non-exempt-use assets. The Final Regulations instead provide that a non-functionally integrated Type III supporting organization must distribute annually an amount equal to or exceeding its "distributable amount." The Final Regulations reserve the provision defining the distributable amount and instead refer to the Temporary Regulations, which define the distributable amount generally as the greater of (1) 85 percent of the supporting organization's adjusted net income (as defined in Code Section 4942(f)) for the immediately preceding tax year; or (2) three and a half percent of the fair market value of all of the supporting organization's non-exempt-use assets for the immediately preceding tax year.
Distributions That Count
In meeting its distribution requirement, a supporting organization must follow new rules about the types of distributions that will and will not count. Specifically, the Final Regulations provide that distributions that count toward a non-functionally integrated Type III supporting organization's distribution requirement include, but are not limited to, the following:
- any amount paid to a supported organization to accomplish the supported organization's tax-exempt purposes;
- any amount paid by the supporting organization to perform an activity that directly furthers the tax-exempt purposes of one or more supported organizations to which the supporting organization is responsive, but only to the extent such amount exceeds any income derived by the supporting organization from the activity and further provided that investment activities do not count;
- any reasonable and necessary administrative expenses paid to accomplish the tax-exempt purposes of the supported organization(s), which do not include expenses incurred in the production of investment income;
- any amount paid to acquire an exempt-use asset as further described in the Temporary Regulations; and
- any amount paid for certain set-asides, provided that appropriate approval from the Service is obtained.
Distributions to third-party organizations other than the supporting organization's own supported organization(s) are not included in the list of distributions that count toward reaching the distributable amount. In fact, the preamble to the Final Regulations makes clear that the Service and the Treasury did not agree with commenters who suggested that distributions to organizations other than supported organization(s) should count toward the distribution requirement. As a result, non-functionally integrated Type III supporting organizations should consider the impact that not being able to count such distributions may have on meeting their distribution requirements, including whether they will need to make additional distributions of the character described above in order to satisfy their respective distributable amounts.
The Attentiveness Requirement
The attentiveness requirement generally requires a supporting organization to distribute one-third or more of its distributable amount to supported organizations that are attentive to its operations and to which it is responsive. A supported organization is "attentive" to a supporting organization if at least one of the following three requirements is satisfied:
- the supporting organization provides ten percent or more of the supported organization's total support (or, in the case of a particular department or school of a university, hospital, or church, the total support of the department or school) received during the supported organization's last tax year ending before the beginning of the supporting organization's tax year;
- the amount of support received is necessary to avoid interruption of a particular function or activity of the supported organization. The support is necessary if either organization earmarks the support for a particular program or activity of the supported organization, even if such program or activity is not the supported organization's primary program or activity so long as it is a substantial one; or
- based on all pertinent factors, including the number of supported organizations, the length and nature of the relationship between the supported and supporting organizations, and the purpose to which the funds are put, the amount of support received from the supporting organization is a sufficient part of a supported organization's total support (or, in the case of a particular department or school of a university, hospital, or church, the total support of the department or school) to ensure attentiveness. The more substantial the amount involved in terms of a percentage of the supported organization's total support, the greater the likelihood that the required degree of attentiveness is present. Evidence of actual attentiveness by the supported organization, however, is of almost equal importance to the amount paid. A supported organization is not considered to be attentive solely because it has enforceable rights against the supporting organization under state law.
Distributions by the supporting organization to a donor advised fund held by the supported organization are disregarded in determining whether the supported organization is attentive. Finally, the preamble to the Final Regulations makes clear that grants to organizations other than the supported organization will not ensure the attentiveness of the supported organization. Consequently, Type III supporting organizations may not satisfy the attentiveness test by making distributions to third-party organizations.
As discussed further here, being "responsive" to a supported organization generally means that (1) the supported organization must be represented on the supporting organization's governing body or otherwise maintain a close and continuous working relationship with the supporting organization; and (2) the supported organization must have a significant voice in the supporting organization's investment policies, grantmaking, and use of assets.
Valuation of Assets
The Temporary Regulations specify rules for valuing non-exempt-use assets for purposes of the distribution requirement. These rules provide that their values are to be determined under the detailed private foundation rules of Code Section 4942, which generally require monthly valuations of marketable securities and annual valuations of most other assets. The value of the non-exempt-use assets may not be reduced by the amount of any set-aside that has not yet been distributed. Non-exempt-use assets are all assets of a supporting organization other than the following:
- any future interest of the supporting organization in the income or corpus of any real or personal property, other than a future interest created after August 17, 2006;
- the assets of an estate until such time as such assets are distributed to the supporting organization;
- any present interest of the supporting organization in any trust created by or funded by another person;
- any pledge to the supporting organization of money or property (whether or not the pledge may be legally enforced); and
- exempt-use assets, which are assets that are used (or held for use) directly to carry out the tax-exempt purposes of the supporting organization's supported organization(s), generally determined by applying principles described in the private foundation Regulations.
The Department of the Treasury and the Service recognized the need for transitional rules with respect to the integral part test for Type III supporting organizations in existence on the December 28, 2012, effective date of the Final and Temporary Regulations. As a result, a Type III supporting organization in existence on December 28, 2012, that met and continues to meet the "payout" test of prior Regulations Section 1.509(a)-4(i)(3)(iii) will be treated as satisfying the integral part test of a non-functionally integrated Type III supporting organization until the first day of its second taxable year beginning after December 28, 2012. That "payout" test is satisfied if a supporting organization makes payments of substantially all (i.e., 85 percent) of its adjusted net income to or for the use of its supported organization(s). In determining whether an excess amount is created under the carryover rules, however, the distributable amount is the greater of 85 percent of adjusted net income or three and a half percent of the value of assets in the immediately preceding taxable year, as described in the Temporary Regulations.
Quarles & Brady Comments
Pursuant to the transitional rules described above, a calendar-year supporting organization that has met and continues to meet the requirements of the "payout" test under prior Regulations Section 1.509(a)-4(i)(3)(iii) will be treated as satisfying the integral part test of a non-functionally integrated Type III supporting organization under the Final Regulations until January 1, 2014. Beginning on January 1, 2014, the supporting organization will be required, pursuant to the integral part test described in this update, to distribute an amount equal to its distributable amount on or before the last day of the 2014 calendar year. The determination of the supporting organization's distributable amount will be based on its adjusted net income and asset values from the 2013 calendar year. One-third or more of this amount must be distributed to supported organizations that are attentive to the supporting organization and to which the supporting organization is responsive, as described above.
The Final Regulations became effective when published on December 28, 2012. All non-functionally integrated Type III supporting organizations should begin to take steps to ensure they will meet the distribution requirement following the period of transitional relief. Because neither expenses incurred in the production of investment income nor distributions made to third parties will count toward satisfying their distribution requirements, non-functionally integrated Type III supporting organizations will need to consider the impact this may have, including whether they will need to make additional distributions that count in order to satisfy their distributable amounts.
Finally, to the extent a supporting organization is unsure of its Type I, Type II, or Type III classification or its "functionally integrated" qualification, or unsure whether it will meet the requirements of the Final Regulations, we recommend that it consult with qualified counsel to help make these determinations.
This update is intended as a general summary of legal matters and not as specific advice to any particular client. If you have any questions concerning the subject matter of this update, please contact Norah L. Jones, at (312) 715-5052 / firstname.lastname@example.org, Amanda K. Blaising, at (312) 715-5112 / email@example.com, or your Quarles & Brady LLP attorney.