Everything You Ever Wanted to Know About Type 3 Supporting Organizations

Everything You Ever Wanted to Know About Type 3 Supporting Organizations

Article posted in Foundations on 26 June 2000| comments
audience: National Publication | last updated: 18 May 2011
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Summary

This may seem like an all-encompassing title, but according to Los Angeles attorney Jeffrey Davine, his firm received so many inquiries from clients and their advisors regarding type 3 supporting organizations, they decided to draft an explanation for advisors and laypersons alike (in 2,618 words or less)!

By: Jeffrey D. Davine
Mitchell, Silberberg & Knupp LLP

For over 30 years, the government has divided charities into two broad categories: public charities and private foundations. As a general rule, it is much more advantageous to an entity and its contributors if it can be classified as a public charity rather than as a private foundation. This is because private foundations are subject to a myriad of rules that not only dictate how these entities must be managed but also restrict the amount that contributors may deduct when transferring cash or property to the foundation.

For these reasons, the use of supporting organizations (SO) by donors and advisors as an alternative to the traditional private foundation has increased in popularity over the last several years. The principal reason is that, pursuant to Internal Revenue Code Section 509(a)(3), SOs are treated as public charities. This means that neither the SO nor its contributors are subject to the rules and restrictions that are applicable to private foundations.

Types of Supporting Organizations. There are three different types of SOs. These three types are, conveniently, known as "type 1," "type 2," and "type 3." Although our goal is to provide readers with a general overview of SOs, we will focus on the organization and operation of a type 3 SO.

Type 3 Supporting Organizations-In General. Most type 3 SOs are established as trusts. This is because most SOs that choose to be a type 3 find it easiest to meet the applicable requirements when organized as a trust as opposed to a corporation. The trust agreement governing the SO identifies the specific charities the SO will support. Typically, a trust agreement for a type 3 SO contains between 10 and 20 charities that are eligible to receive support from the SO.

Overview of Supporting Organizations. One way to understand SOs and the benefits they offer is to compare them with the more traditional private foundations. There is no disputing the fact that private foundations do offer some substantial advantages to philanthropically minded individuals with the wealth to support a certain level of philanthropy. These advantages are generally grouped in three areas: (i) timing of tax benefits; (ii) control of assets; and (iii) name recognition. The timing of tax benefits refers to the ability to "bank" several years of charitable giving in a single contribution to the private foundation. Thus, highly appreciated stock in a company that is about to be sold may fund several years worth of charitable gifts an individual plans to make - or even a lifetime of philanthropy. By contributing the stock to a private foundation, the tax benefits can be achieved in the year of the anticipated transaction while the contributions are banked for future distribution from the private foundation to public charities.

Control of assets refers to the fact that many wealthy individuals, especially entrepreneurs who have created wealth by maintaining control over assets, may be uncomfortable in turning a large block of those assets over to a certain charity. For example, in the view of the philanthropist, some smaller or relatively new organizations may simply lack the staff and volunteer resources to manage the money as effectively as he or she would have. More importantly, the philanthropist may wish to support more than one organization and do so in varying amounts. The private foundation allows the philanthropist to maintain control over assets through the money management and investment process and to target distributions to programs of public charities where they will be put to the best use from the perspective of that philanthropist.

Name recognition simply refers to the fact that by creating an ongoing philanthropic entity bearing the name of a philanthropist's family, that name will be identified with the good works of that family in the community, perhaps for generations to come.

Tax Disadvantages of a Private Foundation. The advantages of a private foundation come at a significant price. As stated above, federal tax law has long distinguished between public charities and private foundations and has imposed, what some people would consider to be, draconian rules on private foundations and their donors. From a donor's perspective, contributions to a private foundation are much less attractive, in terms of tax benefits, than the same contributions to a public charity. Contributions of cash to a public charity may be deducted up to 50% of the donor's adjusted gross income (with certain modifications), while contributions of cash to a private foundation may only be deducted up to 30%. Contributions of appreciated property, such as real estate or securities, to a public charity may be deducted up to 30% of adjusted gross income, but if the same property is given to a private foundation, it may be deducted only up to 20%. Moreover, the deduction of appreciated property to a public charity is calculated at its full fair market value - including the untaxed appreciation - while the contribution to a private foundation must be reduced by this untaxed appreciation, down to the donor's tax basis in the contributed property. This can effectively eliminate the tax deduction for contributions to a private foundation of highly appreciated stock, since the cost basis of the donor may be very low. There is a limited exception for contributions of publicly traded securities to a private foundation. Contributions of these assets can be deducted at their fair market value as well (subject to the 20% AGI limitation).

For a philanthropic entity which is supposedly exempt from federal tax, the private foundation itself is subject to fairly harsh tax treatment. First, its investment income is subject to an excise tax of 2%. This means that while the private foundation is exempt from income tax it still must pay a tax on its income! Second, the private foundation is subject to a complex set of rules designed to regulate certain behavior by the private foundation and its donors, including self?dealing transactions and certain types of investment activity. Third, the private foundation must make minimum distributions each year, equal to 5% of the value of its assets. Finally, to enforce all these rules, tax compliance for private foundations is far more complex than tax compliance for public charities, which increases the operating expenses for private foundation.

Supporting Organization Treated as a Public Charity. An entity qualifying under federal tax law as an SO avoids all of the tax disadvantages of a private foundation. Even though the typical SO is privately funded by a single individual or family, it is treated as a public charity for federal tax purposes. This means that contributions may be deducted based on the more generous rules applicable to contributions to public charities, and the SO does not pay tax on its investment income and will not be encumbered by the complex regulatory rules that apply to private foundations. To achieve this very beneficial treatment, the only requirement is that the SO be set up to provide funding for one or more specific public charities identified in the SO's organizational documents.

Not only does an SO avoid the tax disadvantages of a private foundation, but it also delivers the three benefits described above. As noted, the tax benefits are even greater for an SO and it can be given a name making it indistinguishable to the outside world from a private foundation. In the area of control, while the near total control of a private foundation (within the constraints of the regulatory overlay of IRS rules) may not be duplicated with the SO, the SO can leave the donor and his or her family with a surprising degree of autonomy. Even though the trust agreement for a type 3 SO will contain a list of supported public charities, there is no requirement that even a single representative of the supported public charities serve on the board of trustees of the SO. Many philanthropists will do so, however, to establish a nexus with the supported organizations.

Operation of a Supporting Organization. Once a type 3 SO is funded, distributions must be made each year to one or more of the public charities named in the trust instrument. Distributions do not have to be equal, and distributions do not have to be made each year to every charity on the list. In fact, distributions can be made to only one of the listed charities, so long as the support provided to a charity is sufficient to ensure its "attentiveness" to the operations of the SO. Unlike a private foundation, the minimum amount to be distributed each year by a SO is based on its income - not on its assets. A "typical" type 3 SO must distribute at least 85% of its net income (excluding capital gains) realized each year. Thus, if the SO holds a portfolio of stocks with a dividend yield of 2%, the SO might be required to distribute a minimum of 85% of this amount, or effectively 1.7% of its assets compared with 5% of a private foundations assets. Of course, an SO may also distribute more than this minimum figure.

Distributions to Community Foundations. One of the few drawbacks of a SO is the need to identify in advance the public charities that will be supported. Many donors would like to maintain the flexibility (available with a private foundation) to change their minds about which philanthropic endeavors to support. Moreover, the founders' children or grandchildren may take different paths in choosing organizations they would like to support. A very useful way to build flexibility into the seemingly rigid structure of public charities designated in SO documents is to name one or more community foundations as supported public charities. Distributions from the SO to the community foundation can be handled in a manner similar to a donor advised fund (DAF), with the SO retaining the right to advise the community foundation on how distributions from its fund should be distributed to a variety of other charities which can be changed from year to year to reflect evolving philanthropic objectives. This allows one of the few advantages of a private foundation over a SO to be replicated, since the community foundation DAF effectively serves as a window on the world of philanthropy beyond the public charities named in the SO trust agreement.

Operation of an SO. The trustees of a type 3 SO need to make distributions each year to one or more of the public charities named in its trust document. Distributions do not have to be made equally to each charity nor do distributions have to be made each year to every charity named in the trust. In fact, distributions may be made to only one of the listed charities, so long as the support that it receives is sufficient to ensure its "attentiveness" to the SO's operations.

The "attentiveness" requirement can be met each year if the SO distributes to one or more of the supported organizations an amount equal to at least 10% of the total support received by the supported organization from all sources. If an entity listed in the trust agreement is a charity that receives a relatively large amount of public support, it will normally be difficult to meet this standard. As a result, the Treasury Regulations governing type 3 SOs provide an alternative manner in which the attentiveness requirement can be met. If the SO distributes to one or more of the supported organizations an amount necessary to fund a significant project or program of the supported organization that would not otherwise receive sufficient funding the attentiveness test will be satisfied. For distributions to larger charities, a typical SO will have to rely on this alternative. The SO and the supported charity will need to earmark the contributions to be used only for the supported project or program.

Distribution Requirements. To maintain its public charity status, an SO must meet certain distribution requirements. To begin with, at least 33 1/3% of its annual support must be distributed to, or set aside for the benefit of, the supported charities which meet one of the two attentiveness tests described above. In addition, the SO must also distribute at least 85% of its annual income to the supported charities. With regard to this 85% requirement, it is important to remember two things: (i) in this context, "income" is limited to dividend and interest income and does not include capital gain and (ii) the distribution of this income is not limited to those charities which meet the attentiveness requirements discussed above.

To illustrate the distribution requirements imposed upon a SO, an example might be helpful: Assume an SO's total income for tax year 2000 is $100,000. The SO must, therefore, distribute a total of $85,000 ($100,000 x 85%). In addition, of the $85,000 being distributed, $28,333 ($85,000 x 33 1/3%) must be paid to one or more of the supported charities that meet the attentiveness test. In other words, $28,333 must be paid to an organization(s) which receives at least 10% of its total support from the SO or to an organization(s) for an important project or program that would not otherwise receive adequate funding. In addition, the SO must distribute an additional $56,667 (($100,000 x 85%) - $28,333) to one or more of the other charities listed on its governing documents. This amount, however, can be distributed in any manner in which the SO's governing board sees fit. For example, the board may give the entire $56,667 to a single supported charity which meets (or doesn't meet) the attentiveness requirement.

The IRS will generally deem that an SO meets the distribution requirements for each tax year if it distributes the appropriate amounts not later than the end of the following tax year. For example, for an SO that operates on a calendar year, it should meet its distribution requirements if it makes its required distributions based upon its tax year 2000 income at any time prior to January 1, 2002.

Once an SO's income for a particular year is determined, it should be able to maintain its status as a SO by making the necessary distributions (using the percentages in the example illustrated above) not later than the end of the year following the year in which the income is earned.

Government Filing Requirements. To claim a deduction for making contributions to an SO, donors will need to obtain an appraisal for any non-cash assets transferred to the SO. Donors will also need to attach a summary of this appraisal to their income tax return for the year in which the deduction is claimed. Meeting the appraisal requirement should be fairly simple and inexpensive. For example, many accountants are qualified to provide an appraisal that will satisfy the IRS. Donors may complete the requisite appraisal summary by completing and filing IRS Form 8283 with their income tax return. The SO will also need to issue an acknowledgment to donors for their contribution.

State reporting requirements vary. For example, an SO based in California will need to annually file federal Form 990 with the IRS, FTB Form 199 with the California Franchise Tax Board, and Form RRF-1 with the California Attorney General's Registry of Charitable Trusts. Additionally, the SO will need to file Form CT-1 with the California Attorney General's Registry of Charitable Trusts (this document need only be filed once). Check local law.

Forms 990 and 199 are each due no later than the 15th day of the fifth month after the end of the SO's tax year. For example, for an SO that has an accounting period that operates on a calendar year, these documents must be filed no later than May 15th for the SO's preceding tax year. Penalties may be imposed for the untimely filing of any of these forms. Extensions of time in which to file these documents, however, can usually be obtained.

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