IRS Final and Temporary Regulations for Type III Supporting Organizations: The Integral Part Test for Functionally Integrated Type III Supporting Organizations
Tax-Exempt Organizations Law Update 05/06/13 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 (although other parts of the revised integral part test are contained in the Temporary Regulations).
This client update discusses the integral part test's "functionally integrated" definition and requirements. A client update discussing the notification requirement and the responsiveness test is available here. A separate client update discussing the integral part test's "non-functionally integrated" definition and requirements is available here.
Three "Functionally Integrated" Alternatives
The Final Regulations require a Type III supporting organization to fulfill one of three requirements in order to meet the "functionally integrated" definition. In particular, in order to be considered functionally integrated, a Type III supporting organization must:
- engage in activities "substantially all" of which "directly further" the tax-exempt purposes of one or more supported organizations to which the supporting organization is "responsive";
- be the parent of each of its supported organizations; or
- satisfy certain requirements related to supporting a governmental organization.
Substantially All Activities Directly Further Certain Tax-Exempt Purposes
For purposes of alternative (1), a facts and circumstances analysis will be used to determine whether "substantially all" of a supporting organization's activities satisfy the requirements. Activities that "directly further" exempt purposes are activities that perform the functions of, or carry out the exempt purposes of, the supported organization(s), and that, but for the involvement of the supporting organization, would normally be engaged in by the supported organization(s). By way of illustration, while holding title to and managing exempt-use assets are activities that directly further the exempt purposes of a supported organization, fundraising, grantmaking (whether to a supported organization or to third parties), and investing and managing non-exempt-use assets are not activities that directly further the exempt purposes of a supported organization.
This rule is subject to a limited exception for scholarship payments made to individual beneficiaries who are members of the charitable class benefitted by a supported organization. Making such payments will be treated as directly furthering tax-exempt purposes, but only if (a) the beneficiaries are selected on an objective and nondiscriminatory basis; (b) the officers, directors, or trustees of the supported organization have a significant voice in the timing and manner of payments and selection of recipients; and (c) the making or awarding of the payments is part of an active program of the supporting organization that directly furthers the exempt purposes of the supported organization and in which the supporting organization is significantly involved.
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.
Parent of Supported Organization(s)
For purposes of alternative (2), a supporting organization is the parent of a supported organization if the supporting organization exercises a substantial degree of direction over the policies, programs, and activities of the supported organization and a majority of the supported organization's officers, directors, or trustees are appointed or elected by the supporting organization or by members of its governing body.
Supporting a Governmental Entity
The Treasury Department and the Service are continuing to consider the comments received with regard to what it means to support a governmental entity and have expressed their intent to issue proposed regulations in the near future that will provide guidance as to how supporting organizations can satisfy the integral part test and qualify as functionally integrated by supporting a governmental entity.
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. As a result, a Type III supporting organization in existence on December 28, 2012, that met and continues to meet the requirements of the "but for" test under prior Regulations Section 1.509(a)-4(i)(3)(ii) will be treated as meeting the requirements of a functionally integrated Type III supporting organization until the first day of its second taxable year beginning after December 28, 2012. (Additional transitional rules apply to a supporting organization that met the requirements of the "but for" test under the prior Regulations but that does not meet them in its first taxable year beginning after December 28, 2012.) The "but for" test under prior Regulations Section 1.509(a)-4(i)(3)(ii) is satisfied if the activities engaged in by the supporting organization for or on behalf of the supported organizations are activities to perform the functions of, or to carry out the purposes of, such supported organizations, and which, but for the involvement of the supporting organization, would normally be engaged in by the supported organizations themselves. The prior Regulations do not provide any examples of activities that satisfy the "but for" test and do not include the additional requirements of alternative (1), as described above.
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 "but for" test under prior Regulations Section 1.509(a)-4(i)(3)(ii) will be treated as meeting the requirements of a functionally integrated Type III supporting organization under the Final Regulations until January 1, 2014, at which time the supporting organization will become subject to the new requirements described in this update.
The Final Regulations became effective when published on December 28, 2012. All Type III supporting organizations wishing to qualify as functionally integrated should take steps to ensure that they meet the new requirements set forth in the Final Regulations. 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 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 / [email protected], Amanda K. Blaising at (312) 715-5112 / [email protected] or your Quarles & Brady LLP attorney.