Final regulations for Type I and Type III supporting organizations became effective on October 16, 2023. The document published in the Federal Register with the regulations provides a helpful summary and background of the laws regarding Type I and Type III supporting organizations. In this post, we’ll focus on the more complex Type III supporting organizations, and more specifically functionally integrated Type III supporting organizations. In this post, we quote liberally from the published document (with some edits for clarification and brevity). References below to the “Code” are to the Internal Revenue Code.
Overview
An organization described in section 501(c)(3) of the Code is classified as either a private foundation or a public charity. To be classified as a public charity, an organization must be described in section 509(a)(1), (2), or (3). Organizations described in section 509(a)(3) are known as “supporting organizations” (SOs). SOs achieve their public charity status by providing support to one or more organizations described in section 509(a)(1) or (2), which, in this context, are referred to as “supported organizations.”
To be described in section 509(a)(3), an organization must satisfy (1) an organizational test, (2) an operational test, (3) a relationship test, and (4) a disqualified person control test. The organizational and operational tests require that an SO be organized, and at all times thereafter operated, exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more supported organizations. The relationship test requires a SO to establish one of three types of relationships with one or more supported organizations. An SO that is operated in connection with one or more supported organizations is known as a “Type III” SO . The disqualified person control test requires that an SO not be controlled directly or indirectly by certain disqualified persons.
PPA Changes to Type III Supporting Organizations
The Pension Protection Act of 2006 (PPA) made the following five changes to the requirements an organization must satisfy to qualify as a Type III SO:
(1) Section 1241(c) of the PPA removed the ability of a charitable trust to rely on the special rule under § 1.509(a)–4(i)(2)(iii) as then in effect, which allowed a trust to satisfy the attentiveness requirement of the integral part test for non-functionally integrated Type III SO if the SO was a beneficiary of the trust and state law allowed the beneficiary to enforce the trust and compel an accounting of the trust;
(2) Section 1241(d) of the PPA directed the Secretary of the Treasury or her delegate (Secretary) to promulgate regulations under section 509 that establish a new distribution requirement for Type III SOs that are not “functionally integrated” (a non-functionally integrated (NFI) Type III SO) to ensure that a “significant amount” is paid to supported organizations; for this purpose, the term “functionally integrated” means a Type III SO that is not required under regulations to make payments to supported organizations, because the SO engages in activities that relate to performing the functions of, or carrying out the purposes of, its supported organization(s);
(3) Section 1241(b) of the PPA required a Type III SO to provide annually to each of its supported organizations the information required by the Treasury Department and the IRS (referred to in § 1.509(a)–4(i)(2) as the notification requirement) to ensure that the SO is responsive to the needs or demands of its supported organization(s);
(4) Section 1241(b) of the PPA also prohibited a Type III SO from supporting any supported organization not organized in the United States; and
(5) Section 1241(b) of the PPA additionally prohibited a Type I or Type III SO from accepting any gift or contribution from a person who, alone or together with certain related persons, directly or indirectly controls the governing body of a supported organization of the Type I or Type III SO.
Type III Supporting Organization Relationship Test
Section 1.509(a)–4(i)(1) provides that, for each taxable year, a Type III SO must satisfy (i) a notification requirement, (ii) a responsiveness test, and (iii) an integral part test provided in the regulations. The 2016 proposed regulations proposed additional rules regarding each of these requirements. These final regulations adopt the 2016 proposed rules with certain described modifications.
A. Notification Requirement
Section 509(f)(1)(A) provides that an organization will not be considered a Type III SO unless the SO provides to each supported organization, for each taxable year, such information as the Secretary may require to ensure that the SO is responsive to the needs or demands of the supported organizations. To satisfy this notification requirement, § 1.509(a)–4(i)(2) requires a Type III SO to provide to each of its supported organizations for each taxable year:
(1) A written notice addressed to a principal officer of the supported organization describing the type and amount of all of the support it provided to the supported organization during the SO’s preceding taxable year;
(2) a copy of the SO’s most recently filed Form 990 (or other annual information return required to be filed); and
(3) a copy of the SO’s governing documents, including any amendments (unless previously provided and not subsequently amended).
The description of support in the written notice must include all of the distributions that count toward the distribution requirement to the supported organization.
Section 1.509(a)–4(i)(2)(iii) requires that the notification be transmitted by the last day of the fifth month of the SO’s taxable year after the taxable year in which it provided the support it is reporting.
The annual written notice may summarize all the programs and services an SO performs for its supported organization so long as it summarizes its activities directly furthering the exempt purpose of the supported organization and that summary provides sufficient notice to the supported organization on the character of the activity and its related costs. The report must include a brief narrative description of the support provided and sufficient financial detail for the recipient to identify the types and amounts of support being reported.
B. Responsiveness Test
Section 1.509(a)–4(i)(3)(i) provides that an SO meets the responsiveness test if it is “responsive to the needs or demands of a supported organization.” To meet this responsiveness test, an SO must satisfy two elements—the “relationship requirement” and the “significant voice requirement.”
Under the relationship requirement, the officers, directors, or trustees of the SO must have one of three specified relationships with the officers, directors, or trustees (and in some cases the members) of the supported organization.
Under the significant voice requirement, the officers, directors, or trustees of the supported organization, by reason of their relationships described in § 1.509(a)–4(i)(3)(ii), must have a significant voice in the investment policies of the SO, the timing of grants, the manner of making grants, and the selection of grant recipients by the SO, and in otherwise directing the use of the income or assets of the SO.
The distinguishing characteristic of Type III SOs, and the basis for their public charity classification, is that they are responsive to and significantly involved in the operations of their publicly supported organizations. Unless a Type III SO is responsive to each of its supported organizations, the supported organizations cannot exercise the requisite level of oversight of and engagement with the SO. Limiting the responsiveness requirement to fewer than all of the supported organizations may result in the necessary oversight and accountability being present for less than all of an SO’s operations. Consequently, an SO must be responsive to the needs or demands of each of its supported organizations to meet the responsiveness test.
Example 3 in § 1.509(a)–4(i)(3)(iv) demonstrates one way in which a Type III SO that supports multiple organizations may satisfy the responsiveness test in a manner that can be cost-effective. An example in the regulations shows that an SO can meet the relationship requirement in § 1.509(a)–4(i)(3)(ii) in different ways with respect to each of its supported organizations. The Example also shows how an SO can organize and hold regular meetings, provide information, and encourage communication to help ensure that its supported organizations have a significant voice in the operations of the SO.
Type III SOs may be able to demonstrate that they satisfy the responsiveness test in a variety of ways, and that the determination will be based on all the facts and circumstances.
C. Integral Part Test—Functionally Integrated Type III Supporting Organizations
Section 1.509(a)–4(i)(1)(iii) provides that, for each taxable year, a Type III SO must satisfy the integral part test. The integral part test is satisfied by maintaining significant involvement in the operations of one or more supported organizations and providing support on which the supported organizations are dependent. To satisfy this test, a Type III SO must meet the requirements either for a functionally integrated Type III SO or for a nonfunctionally integrated (NFI) Type III SO, as set forth in § 1.509(a)–4(i)(4) or (5), respectively.
A Type III SO is functionally integrated under § 1.509(a)–4(i)(4) if it:
(1) engages in activities substantially all of which directly further the exempt purposes of one or more supported organizations and otherwise meets the requirements described in paragraph (i)(4)(ii) of that section,
(2) is the parent of each of its supported organizations as described in paragraph (i)(4)(iii) of that section, or
(3) supports a governmental supported organization and otherwise meets the requirements of paragraph (i)(4)(iv) of that section.
Only one of the above three requirements must be met.
1. “Substantially All” Test
Section 1.509(a)–4(i)(4)(ii)(B) provides that all pertinent facts and circumstances will be taken into consideration in determining whether substantially all of an SO’s activities directly further the exempt purposes of its supported organization(s). The facts and circumstances test allows for some consideration of year-to-year changes in activities.
2. Parent of Each Supported Organization
This reverses the role of the typical Type I SO relationship of parent supported organization and subsidiary SO, which must be operated, supervised or controlled by its supported organization(s).
Under § 1.509(a)–4(i)(4)(iii), an SO is the parent of a supported organization, and thus is deemed to be functionally integrated, if (1) the SO exercises a substantial degree of direction over the policies, programs, and activities of the supported organization and (2) a majority of the officers, directors, or trustees of the supported organization is appointed or elected, directly or indirectly, by the governing body, members of the governing body, or officers (acting in their official capacities) of the SO.
The classification of a parent organization as functionally integrated applies to SOs that oversee or facilitate the operation of an integrated system, such as hospital systems. Additionally, the SO must engage in activities typical of the parent of an integrated system. Examples of these activities include (but are not limited to) coordinating the activities of the supported organizations and engaging in overall planning, policy development, budgeting, and resource allocation for the supported organizations.
A parent of an integrated system of supported organizations must direct the overall policies, programs, and activities of the supported organizations (e.g., coordinating the activities of the supported organizations and engaging in overall planning, policy development, budgeting, and resource allocation). A parent of an integrated system may also perform system-wide administrative services (e.g., financial planning and forecasting, legal services, human resources, information management, billing and collection services, marketing, and community outreach and education) in conjunction with directing the overall policies, programs, and activities of the supported organizations. The governing body, members of the governing body, or officers of a parent SO must appoint or elect a majority of the officers, directors, or trustees of the supported organization, directly or indirectly if the SO could qualify as a parent of a second-tier (or lower) subsidiary..
The parent organization must not only have the power to appoint or elect a majority of the officers, directors, or trustees of each supported organization, but also must have the power to remove and replace such officers, directors, or trustees, or otherwise have an ongoing power to appoint or elect with reasonable frequency.
3. Supporting a Governmental Supported Organization
A substantial part of the SO’s total activities must directly further the exempt purposes of its governmental supported organizations. An SO can meet this requirement and still make grants to one of its governmental supported organizations as a substantial part of its activities.
In any case in which the SO supports more than one governmental supported organization, all of the governmental supported organizations must either (1) operate within the same city, county, or metropolitan area; or (2) work in close coordination or collaboration with one another to conduct a service, program, or activity that the SO supports.
An SO that supports more than one governmental supported organization as described in § 1.509(a)–4(i)(4)(iv)(A) satisfies the substantial part test if a substantial part of its activities directly furthers the exempt purpose of at least one of its governmental supported organizations. In determining whether a substantial part of an SO’s total activities directly further the exempt purposes of its governmental supported organization(s), all pertinent facts and circumstances will be taken into consideration.
To satisfy the close coordination or collaboration requirement of paragraph (i)(4)(iv)(A)( 2) of the regulation, the supporting organization must maintain on file a letter from each of the governmental supported organizations (or a joint letter from all of them) describing their coordination or collaboration efforts with respect to the particular service, program, or activity.
The regulations also provide for exceptions and include transition provisions.