IRS Provides Interim Guidance for Supporting Organizations and Grantors to Supporting Organizations

IRS Provides Interim Guidance for Supporting Organizations and Grantors to Supporting Organizations

News story posted in IRS Notices on 10 January 2014| comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 27 April 2017
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by Richard L. Fox, Esq.

On December 23, 2013, the IRS issued Notice 2014-4, 2014-2 IRB, providing interim guidance for Type III supporting organizations (SOs) seeking to qualify as functionally integrated by supporting a governmental supported organization.  The notice also provides interim guidance to grantors (private foundations and donor-advised funds) in determining whether a potential grantee is a Type I, Type II, or functionally integrated Type III SO for purposes of the Chapter 42 excise taxes imposed under IRC § 4942, 4945 and 4966.   

Functionally Integrated Type III SO Supporting a Governmental Organization

The Pension Protection Act of 2006 (PPA) made a vast array of statutory changes to the tax regime applicable to Type III SOs, including introducing two newly-created categories of Type III SOs: the “functionally integrated Type III SO” and the “non-functionally integrated Type III SO.”  The functionally integrated Type III SO performs the functions of, or carries out the purposes of, its supported organizations. The non-functionally integrated Type III SO distributes funds to its supported organizations so that its activities tend to focus on grant-making, similar to a private foundation. Whether a Type III SO is "functionally integrated" or "non-functionally integrated" is a very important distinction because many of the limitations and restrictions imposed on Type III SOs under the PPA only apply if the organization is a non-functionally integrated Type III SO. Hence, the functionally integrated Type III SO is more attractive from a tax standpoint. 

On December 28, 2012, the Department of the Treasury (the Treasury Department) and the Internal Revenue Service (IRS) published a Treasury Decision in the Federal Register (TD 9605, 2013-11 I.R.B. 587 [77 FR 76382]) containing final and temporary regulations (the “2012 regulations”) that, among other things, set forth the requirements to qualify as a functionally integrated Type III supporting organization. To qualify as functionally integrated, the 2012 regulations provide that a Type III SO must meet one of following three tests:

  1. Engage in activities substantially all of which directly further the exempt purposes of one or more of the supported organizations to which the supporting organization is responsive by performing the functions of, or carrying out the purposes of, such supported organization(s) and that, but for the involvement of the supporting organization, would normally be engaged in by the supported organization(s);
  2. Be the parent of each of its supported organizations; or
  3. Support a governmental supported organization.

No guidance was provided in the 2012 regulations regarding a functionally integrated Type III that supports a “governmental supported organization,” as the Treasury Department reserved Reg. 1.509(a)-4(i)(4)(i)(C) for subsequent guidance on this issue. The 2009 proposed regulations provided a governmental entity exception under which a Type III SO that supports one (and only one) supported governmental organization. Several commenters requested that this governmental entity exception be expanded to allow SOs to support more than one supported organization.   The preamble to the 2012 regulations state that the “Treasury Department and the IRS are continuing to consider these comments regarding the governmental entity exception and intend to issue proposed regulations in the near future that will provide guidance on how supporting organizations can qualify as functionally integrated by supporting a governmental entity.”

Section 3.01 of Notice 2014-4 provides a transitional rule for qualifying as a functionally integrated Type III SO by supporting a governmental supported organization.  Under this interim guidance, until the earlier of the date final regulations are published or the first day of the organization's third taxable year beginning after December 31, 2013, a Type III SO will be treated as functionally integrated, if it: (1) supports “at least one” supported organization that is a governmental entity to which the SO is responsive and (2) engages in activities for or on behalf of the governmental supported organization that perform the functions of, or carry out the purposes of, that governmental supported organization and that, but for the involvement of the SO, would normally be engaged in by the governmental supported organization itself.  The use of the phrase “at least one” in this notice indicates that, contrary to the 2009 proposed regulations, more than one governmental entity can be supported by a Type III SO.  The notice specifically states, however, that this “transitional rule is not intended to signal what future proposed regulations will require with respect to qualifying as functionally integrated by supporting a governmental entity and that “No Type III supporting organization will qualify as functionally integrated by reason of satisfying this transitional rule once final regulations … are published.”

Reliance for Grantors to Type III SOs

Prior to the PPA, a distribution by a grant-making private foundation to any IRC § 509(a)(3) SO constituted a “qualifying distribution” under IRC § 4942(g) and was not considered a “taxable expenditure” under IRC § 4945(d).  This was the case because SOs, whether classified as Type I, II or III SOs, were treated the same as any other public charity for purposes of determining the tax treatment of distributions by private foundations to a SO.  Similarly, distributions by sponsoring organizations of donor-advised funds to SO were not subject to any special rules, regardless of the type of SO to which a distribution would be made.  After the PPA, however, it became extremely important for a private foundation and donor-advised fund to know the classification of a prospective donee SO because of special rules that the PPA put in place for distributions by these organizations to non-functionally integrated Type III SOs, as follows:

  1. The PPA amended IRC § 4942(g) to provide that distributions by a private nonoperating foundation to Type III SOs that are not functionally integrated are not considered “qualifying distributions,” and unless the private foundation exercises “expenditure responsibility” in accordance with IRC § 4945(h), the distribution is considered to be a taxable expenditure.  Thus, after the PPA, a grant by a private foundation to a non-functionally integrated Type III SO does not count against the foundation’s 5% annual distribution requirement and will be subject to taxable expenditure penalties unless the foundation exercises expenditure responsibility with respect to the grant.
  2. Similarly, the PPA provided under IRC § 4966 that unless expenditure responsibility is exercised, a “taxable distribution” will result where a distribution is made from a donor-advised fund to a Type III supporting organization that is not a functionally integrated Type III SO.  Thus, unless the sponsoring organization of a donor-advised fund exercises expenditure responsibility with respect to a distribution to a non-functionally integrated Type III SO, the sponsoring organization will be subject to excise tax under IRC § 4966.

These rules make it imperative for a private foundation and donor-advised fund to know whether or not a prospective grantee organization is a SO and, if it is, the specific type of SO. And, if the prospective grantee is a Type III SO, it is imperative to know whether it is a functionally integrated Type III SO or a non-functionally integrated Type III SO.  Because of the potential negative tax implications introduced under the PPA for grants by private foundations and donor advised funds to non-functionally integrated Type III SOs organizations, the IRS previously issued interim guidance (on December 4, 2006), in the form of Notice 2006-109, which addressed grantor reliance issues for private foundations and donor-advised funds making grants to SOs, including determining whether a Type III SO is “functionally integrated.”  Notice 2006-109 provides procedures under which these grantors, acting in good faith, may rely on written representations and/or reasoned written opinions of counsel in determining whether a prospective grantee is a Type I, Type II, or functionally integrated Type III SO for purposes of  IRC §§ 4942, 4945 and  4966.

Now, Section 3.02 of recently issued Notice 2014-4 provides that “[u]ntil further guidance is issued addressing the reliance standards of  Notice 2006-109, private foundations and sponsoring organizations that maintain donor-advised funds may continue to rely on the grantor reliance standards of section 3 of Notice 2006-109, as modified by Rev. Proc. 2011-33 and this notice.”  Notice 2014-4 further provides that for grants made after December 28, 2012, a Type III SO must meet the functionally integrated requirements described in the December 28, 2012 final regulations (specifically Reg. § 1.509(a)-4(i)(4)), or the functionally integrated requirements of Section 3.01 of Notice 2014-4 for a Type III SO that supports a governmental organization, in order to be considered “functionally integrated” for purposes of a representation or opinion of counsel on which a grantor may rely.  Accordingly, in order to determine that a Type III SO is functionally integrated based on a written representation, a grantor must collect and review a written representation and documents that demonstrate the grantee meets the functionally integrated requirements described in current Reg. § 1.509(a)-4(i)(4) (issued under the December 28, 2012 final regulations) or Section 3.01 of Notice 2014-4 in the case of a Type III SO supporting a governmental organization.

            Comment:  Given the potential negative tax implications and compliance requirements associated with grants by private foundations and donor-advised funds to Type III SOs that are not functionally integrated, and the attendant need to determine the status of a prospective SO at a Type I, Type II or functionally integrated Type III SO, many private foundations and donor-advised funds simply avoid making grants to SOs.  One alternative available to a SO is to request an IRS determination regarding its SO status by filing Form 8940, Request for Miscellaneous Determination, so that there is an IRS determination of whether a SO is a Type I, Type II, or functionally integrated Type III SO that may be given to potential funders.

Copyright © Richard L. Fox 2014.


About the Author

Richard L. Fox, Esq. is a partner in the Philadelphia-based law firm of Buchanan Ingersoll & Rooney. He concentrates his practice in the areas of charitable giving, private foundations, tax-exempt organizations, estate planning, trusts and estates, and family planning. Mr. Fox is the author of the treatise, Charitable Giving; Taxation, Planning and Strategies, a Warren, Gorham and Lamont publication, writes a national bulletin charitable giving, and writes and speaks frequently on issues pertaining to nonprofit organizations, estate planning and philanthropy. See More

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