Firm Thanks Treasury for Agreeing to Discuss Type III Supporting Organization Proposals

Firm Thanks Treasury for Agreeing to Discuss Type III Supporting Organization Proposals

News story posted in Foundations on 22 February 2011| comments
audience: National Publication | last updated: 18 May 2011
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Writing on behalf of Caplan & Drysdale, Michael Durham has thanked the Treasury for agreeing to meet with the Wisconsin Alumni Research Foundation for the purpose of discussing the contours of the currently proposed "Government Entity Exception" allowing some type III supporting organizations of government entities to include investment and grantmaking activities among the activities qualifying them for functionally integrated status, and your willingness to consider our further proposals growing out of that discussion.

Full Text:

February 9, 2011

Alexandra Minkovich, Esq.
Attorney Advisor, Office of Tax Policy
Department of Treasury
1500 Pennsylvania Avenue
Room 1313-AMT
Washington, D.C. 20220

RE: "Government Entity" Exception for Functionally Integrated Type IIIs

Dear Ms. Minkovich:

Thank you again for your willingness to meet with WARF in December to discuss the contours of the currently proposed "Government Entity Exception" allowing some type III supporting organizations of government entities to include investment and grantmaking activities among the activities qualifying them for functionally integrated status, and your willingness to consider our further proposals growing out of that discussion. This letter aims to discuss alternative options for broadening that exception that may be acceptable to Treasury.

Please note that although it is not discussed in detail in this letter, we continue to believe that the final regulations should make clear that a supporting organization "may use any reasonable method to determine the amount of its activities directly furthering the exempt purposes of its supported organization(s), as long as such method is consistently used," as we have previously proposed.

    I. WARF's Previous Proposal and Treasury's Concerns
We continue to believe that the Government Entity exception should be extended to apply even if the supporting organization, besides supporting its primary government entity, also supports other affiliated public charities or governmental entities that are closely connected to that institution. However, in our meeting, you expressed concern that our proposed modifications to the proposed regulations might be too broad. The key language to which you objected was as follows:
    (iii) Governmental Entity Exception. A supporting organization may treat the investment and management of non-exempt-use assets and the making of grants directly to a supported organization as activities that directly further the exempt purposes of a supported organization if:

    (A) Such activities are conducted on behalf of a supported organization

      (1) whose assets are subject to the appropriation process of a federal, state, local or Indian tribal government for purposes or programs unrelated to the exempt purposes of the supported organization, or

      (2) that is responsive to, and has a substantial operational connection with, a supported organization described in paragraph (i)(4)(iii)(A)(1);

    (B) The supporting organization supports only supported organizations described in paragraph (i)(4)(iii)(A); and

    (C) A substantial part of the supporting organization's total activities directly furthers the exempt purpose(s) of its supported organization(s) and are activities other than fundraising, grantmaking, and investing and managing non exempt-use assets.1

Treasury's chief concern. As we understood it, Treasury's principal concern expressed at our meeting was that the above language not only allows the supporting organization to support closely related institutions, but could also be read to allow an organization to qualify as functionally integrated even if it supported a large number of unrelated government institutions. Even though our language referenced "a" supported organization subject to the appropriations process, its test could be applied separately to activities supporting any number of different institutions, so that investment and grantmaking on behalf of each institution would count as "directly furthering" activities because each such activity would be on behalf of a government supported organization or a supported organization with a substantial operational connection to such an entity.

Our original proposal already provides some practical limits on how many unrelated organizations an entity could support. We believe that our original proposal does provide some limits on the ability for an organization to spread its support among many unrelated institutions. Specifically, the proposal leaves in place the requirement that "substantially all" of the supporting organization's activities must directly further the purposes of those supported organizations to which it is responsive. Thus, a supporting organization would have to be responsive to each institution whose support it wished to count as functionally integrated, which would create a natural limit on the number of such organizations it could support. This responsiveness requirement is the same practical limitation that prevents other functionally integrated type IIIs from dividing their support among a large number of supported organizations, and it seems like it could serve the same function for type IIIs supporting governmental entities. (A type III would have to assure each such institution a significant voice in its affairs, typically by having a representative from each supported institution on its board.)

    II. Options for Further Restriction
We recognize that Treasury may determine that the responsiveness requirement alone does not limit its proposed Government Entity Exception tightly enough to ensure the desired closeness between a functionally integrated organization and each of its supported organizations. We also recognize that, as it considers whether and how far to broaden the currently proposed Government Entity Exception, Treasury must balance the needs of administrative enforcement against the need to accommodate a variety of legitimate type III supporting organizations. Accordingly, we have tried to propose a few alternative approaches that would each solve the core problem raised by WARF (the need to accommodate support for closely related institutions on a public university's campus), while imposing varying degrees of restriction on how many institutions a government entity could support.
    A. Reinstate the limit to a single government supported organization, but allow support for close affiliates of that institution.
The simplest change is to leave in force the currently proposed regulations' limit to a single core government supported organization, while making it clear that a type III primarily supporting such an institution can also support closely related institutions:
    (iii) Governmental Entity Exception. A supporting organization may treat the investment and management of non-exempt-use assets on behalf of a supported organization and the making of grants directly to a supported organization as activities that directly further the exempt purposes of that supported organization if:

    (A) The supporting organization primarily supports an organization whose assets are subject to the appropriation process of a federal, state, local or Indian tribal government for purposes or programs unrelated to the exempt purposes of the supported organization;

    (B) The supporting organization's other supported organizations (if any) are responsive to, and have a substantial operational connection with, the supported organization described in paragraph (i)(4)(iii)(A)(1); and

    (C) A substantial part of the supporting organization's total activities directly furthers the exempt purpose(s) of its supported organization(s) and are activities other than fundraising, grantmaking, and investing and managing non exempt-use assets.

    A supported organization described in paragraph (i)(4)(iii)(B) is responsive to the supported organization described in paragraph (i)(4)(iii)(A) if it would meet the requirements of paragraphs (i)(3)(ii) and (i)(3)(iii) with respect to that supported organization, read by substituting "supported organization described in paragraph (i)(4)(iii)(B)" for "supporting organization" and by substituting "supported organization described in paragraph (i)(4)(iii)(A)" for "supported organization" wherever such terms appear. Whether a supported organization described in paragraph (i)(4)(iii)(B) has a substantial operational connection with the supported organization described in paragraph (i)(4)(iii)(A) shall be determined based on all the facts and circumstances. The following factors shall ordinarily be considered evidence of a substantial operational connection between organizations: commonality of purpose as evidenced in the two organizations' governing documents and operations; common staff or facilities; the activities of the supported organization described in paragraph (i)(4)(iii)(B) serving as part of a larger complex of activities conducted by the supported organization described in paragraph (i)(4)(iii)(A), or complementing or enhancing those activities; and the supported organization described in paragraph (i)(4)(iii)(B) having a historic and continuing relationship with the supported organization described in paragraph (i)(4)(iii)(A).

Note that this language deletes the clause requiring the qualifying investment and grantmaking activities to be conducted "on behalf of" the permitted supported organizations, but there should be no loss in meaning, because that clause has been added to the paragraph before clause (A).

Under the proposed language, a type III could only qualify for the Government Entity exception if it provided support primarily to a single entity subject to a government appropriation process. It could support additional governmental or nongovernmental entities, but only if they each were "responsive to" and had "a substantial operational connection with" the primary supported organization (keeping those terms materially the same as defined in our previous proposal). This proposal thus leaves intact the currently proposed regulations' refusal to extend the exception to organizations that support multiple unrelated government institutions. Of course, there is no requirement that the type III have any additional supported organizations besides a single government entity. And the number of such secondary supported organizations receiving any substantial support would be naturally limited, because the type III would have to devote substantially all of its activity to supported organizations to which it is responsive.

    B. Narrow option (A) by adding a numerical limit on the number of secondary supported organizations.
The foregoing option could be further modified to specify a numerical limit on the number of related institutions that an organization could support in addition to its primary governmental supported organization.
    (B) the supporting organization has at most one other supported organization, which (if it exists) is's other supported organizations (if any) are responsive to, and havehas a substantial operational connection with, the supported orgnization described in paragraph (i)(4)(iii)(A); and
OR:
    (B) the supporting organization's has at most [X] other supported organizations, each of which (if any) areis responsive to, and havehas a substantial operational connection with, the supported orgnization described in paragraph (i)(4)(iii)(A); and
The core language defining a government supported organization, and the language defining responsiveness and "substantial operational connection" would remain unchanged. We understand that this narrower approach may be attractive, although even without this kind of narrowing language, the number of "close affiliate" supported organizations would be naturally limited by the type Ill's need to meet the responsiveness test with respect to each such entity.
    C. Broaden option (A) to allow additional supported organizations.
We understand that some other organizations that have raised concerns about the special needs of type IIIs supporting government entities in the past may support a few unrelated government entities (for example, a public school or university and a nearby county or city). If Treasury wished to make its Government Entity exception accommodate a broader range of such organizations, it could do so by making one or more of the additional changes mentioned below:
  • Allow up to a fixed number unrelated government supported organizations, along with close affiliates of each such entity. This is perhaps the simplest alternative to draft and to administer, although it may be difficult to determine what the exact numerical limit should be.
  • Allow multiple unrelated government supported organizations and their closely related affiliates, but count investment or grantmaking activities in support of each such entity as "directly furthering" its purposes only if the type III supporting organization also spends a substantial part of its activities on other functionally integrated activities on behalf of that entity. This approach would set a practical limit rather than (or potentially in addition to) a strict numerical limit on the number of government entities whose support would count toward functionally integrated status. Note that we would not recommend changing the Government Entity exception to require a substantial part of a type Ill's activities to be devoted separately to each closely related affiliate of a government entity. In many cases, such organizations are quite tiny relative to their associated public institutions, and we believe a type III supporting the government institution should be able to support these affiliates as an incidental part of supporting the overall program of the government institution. Thus, so long as the "substantial part" requirement is met with respect to a government supported organization and its closely related affiliates as a group, we do not believe it should have to be met separately with respect to each close affiliate in that group.
  • Allow other supported organizations, but do not count investment management or grantmaking to them as "directly furthering" their purposes. Under the current Proposed Regulations and our suggested revisions, the existence of any supported organization beyond those allowed would disqualify the type III from taking advantage of the Government Entity exception -- even if substantially all support went to qualifying supported organizations. An alternative approach would be to allow such additional supported organizations so long as support for such organizations remained small enough that substantially all of the organization's activities would still be on behalf of organizations meeting the criteria of the Government Entity exception.
Because these suggestions go beyond the discussion we had in December, we are not proposing text implementing these suggestions at this time. However, we have spent some time drafting language along these lines, which we would be happy to share with Treasury upon request.
    III. Conclusion
We believe any of the above proposals, like our original proposal, would adequately address WARF's primary concern, which is to ensure that a supporting organization to a public institution may also support other entities integrally connected to that institution without losing the benefits of the Government Entity exception. Treasury has a range of ways in which it can cabin that exception without precluding support for closely integrated institutions such as WARF's support for the Morgridge Institute alongside its support for the University of Wisconsin itself.

Please do not hesitate to call me at 202-862-5031 if you have any questions about these comments on the scope of the Government Entity exception.

                Sincerely,

                Michael W. Durham
                Caplin & Drysdale
                Washington, DC
Attachment

cc:
Andew Cohn, Wisconsin Alumni Research Foundation
* * * * *

Wisconsin Alumni Research Foundation

February 9, 2011

Exhibit A

Previous WARF Suggestions
Regarding Proposed Treasury Regulations § 1.509(a)-4(i)(4)

(4) Integral part test -- functionally integrated Type III supporting organization --

(i) General rule.

A supporting organization meets the integral part test as a functionally integrated Type III supporting organization if it satisfies either paragraph (i)(4)(i)(A) or paragraph (i)(4)(i)(B) of this section.

(A) The supporting organization engages in activities:

(1) Substantially all of which directly further the exempt purposes of the supported organization(s) to which the supporting organization is responsive, by performing the functions of, or carrying out the purposes of, such supported organization(s); and

(2) That, but for the involvement of the supporting organization, would normally be engaged in by the supported organization(s).

(B) The supporting organization is the parent of each of its supported organizations. For purposes of the integral part test, 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 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 capacity) of the supporting organization.

(C) For purposes of this paragraph, a supporting organization may use any reasonable method to determine the amount of its activities directly furthering the exempt purposes of its supported organization(s), as long as such method is consistently used.

(ii) "Directly further." Holding title to exempt-use property and managing exempt-use property are activities that directly further the exempt purposes of the supported organization within the meaning of paragraph (i)(4)(i)(A) of this section. Except as provided in paragraph (i)(4)(iii) of this section, fundraising, investing and managing non-exempt-use property, and making grants (whether to the supported organization or to third parties) are not activities that directly further the exempt purposes of the supported organization within the meaning of paragraph (i)(4)(i)(A) of this section.

(iii) Governmental Entity Exception. A supporting organization may treat the investment and management of non-exempt-use assets and the making of grants directly to a supported organization as activities that directly further the exempt purposes of a supported organization if:

(A) Such activities are conducted on behalf of a supported organization

    (1) whose assets are subject to the appropriation process of a federal, state, local or Indian tribal government for purposes or programs unrelated to the exempt purposes of the supported organization, or

    (2) that is responsive to, and has a substantial operational connection with, a supported organization described in paragraph (i)(4)(iii)(A)(1);

(B) The supporting organization supports only one-supported organization organizations described in paragraph (i)(4)(iii)(A); and

(C) A substantial part of the supporting organization's total activities directly furthers the exempt purpose(s) of its supported organization(s) and are activities other than fundraising, grantmaking, and investing and managing non exempt-use assets.

A supported organization described in paragraph (i)(4)(iii)(A)(2) is responsive to a government supported organization described in paragraph (i)(4)(iii)(A)(1) if it would meet the requirements of paragraphs (i)(3)(ii) and (i)(3)(iii), read by substituting "organization described in paragraph (i)(4)(iii)(A)(2)" for "supporting, organization" and by substituting "organization described in paragraph (i)(4)(iii)(A)(1)" for "supported organization" wherever such terms appear. Whether a supported organization described in paragraph (i)(4)(iii)(A)(2) has a substantial operational connection with a government supported organization described in paragraph (i)(4)(iii)(A)(1) shall be determined based on all the facts and circumstances. The following factors shall ordinarily be considered evidence of a substantial operational connection between organizations: commonality of purpose as evidenced in the supported organization's governing documents and operations; common staff or facilities; whether the activities of a supported organization are part of a larger complex of activities conducted with a government supported organization; whether the activities of a supported organization support, complement or enhance the activities of a government supported organization; whether a supported organization has a historic and continuing relationship with a government supported organization.

(iv) Examples. The provisions of this paragraph (i)(4) may be illustrated by the following examples. In each example, the supporting organization meets the requirements of paragraphs (i)(2) and (i)(3) of this section.

. . . .

Example 6. W, an organization described in section 501(c)(3), is organized as a supporting organization to Z, a public university in state D described in section 509(a)(1). Z is, and Y, a charitable medical research organization described in section 509(a)(1). Y was created to engage in medical research in conjunction with Z's medical school and the Z hospital and to promote, conduct and enhance scientific research at and in conjunction with Z. Z designates one member of Y's governing board and has a significant voice in Y's activities. Y conducts its primary research activities in facilities on the Z campus and several Z professors serve as researchers for Y. Y also conducts additional research on scientific processes developed at Y and Z and makes the results of this research available to the public. Y and Z are the sole named supported organization organizations in W's articles of incorporation. Under the laws of state D, assets under Z's control are subject to the appropriation process for any state D purpose by an action of the state D legislature. Z transfers Y and Z transfer the intellectual property developed by Y and by Z's science department to W for patenting and licensing, including making the property available to the public. The royalties generated by the licenses are shared among Z Y or Z, as the case may be, the original researcher, and W. W invests and manages its share, and at Z's request, Z's share, of the royalties and other income generated by the patenting and licensing of the intellectual property to build an endowment to support Z. Y and Z. W also conducts further research on scientific processes developed at Z and makes the results of this research available to the public. W's research W's patent and licensing activities make up a substantial part of W's total activities. But for the activities of W, Y and Z would normally conduct the research patent and licensing activities engaged in by W and manage the royalties from the intellectual property generated at Z Y and Z, respectively. W's activities of investing and managing its share of royalties and other income are not considered activities that directly further the exempt purposes of Y or Z under paragraph (i)(4)(ii) of this section. However, because Z's assets are subject to the appropriation process of state D for purposes unrelated to Z's exempt purposes, Z is W's sole supported organization, and Y is responsive to, and has a substantial operational connection with, Z; because Y and Z are W's only supported organizations; and because a substantial part of W's activities directly further Y and Z's exempt purposes, W qualifies for the exception in paragraph (i)(4)(iii) of this section. Accordingly, based on these facts, W qualifies as a functionally integrated Type III supporting organization under paragraph (4)(i)(A) of this section.


FOOTNOTE

1 A complete copy of our original proposal, showing its changes to the currently proposed regulations, is attached as Exhibit A.
END OF FOOTNOTE

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