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Supporting Organizations: Creation, Operation, and Use
In this edition of Gift Planner's Digest, New York attorney Patrick Martin discusses the technical requirements, operation, and uses of supporting organizations as described under Section 509(a)(3).
Charitable organizations described in Section 501(c)(3) of the Internal Revenue Code are both exempt from federal income tax and eligible to receive tax deductible contributions. But not all charitable organizations are accorded equal status. Since the adoption of the Tax Reform Act of 1969, charitable organizations are broadly classified under the tests of Section 509 as either public charities or private foundations.
The topic of this article is the creation, operation, and use of supporting organizations as defined in Section 509(a)(3) of the Internal Revenue Code of 1986 (Code). A supporting organization is a special type of charitable organization that, based on its relationship to a public charity, is itself classified as a public charity rather than a private foundation. These unique organizations offer some of the operational advantages of private foundations as well as the tax advantages of the public charities they support.
The operational and funding advantages of a public charity can be traced to the belief of Congress that if the public was involved in either the financial support or operation of a charitable organization, it was less likely that the intended public good would be secondary to the potential private advantage of those in control. While not expected to be subjected to the same direct public scrutiny that supporting organizations are, by their required relationship to publicly supported/controlled organizations, they are expected to be equally supervised.
The major operational advantages of a public charity, including a supporting organization, are:
- No tax on net investment income [IRC §4940].
- No self-dealing prohibition [IRC §4941].
- No minimum distribution requirements [IRC §4942].
- No excess business holding limitations [IRC §4943].
- No jeopardizing investment limitations [IRC §4944].
- No taxable expenditure rule [IRC §4945].
- No termination tax [IRC §507].
The funding advantages of a public charity, which apply also to a supporting organization, include a higher percentage limitation on allowable income tax charitable deductions [IRC §170(b)(I)]: a) 50% versus 30% for cash contributions; and b) 30% versus 20% for non-cash contributions.
Under Section 509, a charitable organization is presumed to be a private foundation. There are three tests that govern reclassification as a public charity:
- Activities Test [IRC §509(a)(1)]. Under this test, organizations described in Section 170(b)(l)(A) other than clause (vii) and (viii) are given public charity status. These include charities, schools, hospitals, and governmental units.
- Publicly Supported Organizations [IRC §509(a)(2)]. Under this test, organizations that receive a substantial part of their financial support from the general public are given public charity status. There are actually two alternative tests to determine public support that are set forth in Section 509(a)(2) and Section 170(b)(l)(A)(vii).
Supporting Organizations [IRC §509(a)(3)]. Under this test, which is the subject of the following discussion, charitable organizations that would otherwise be classified as private foundations can be classified as public charities if they meet the three-pronged test of:
- relationship; and
Neither activities nor the source of financial support are relevant with this test.
Supporting organizations must, in the first instance, meet the requirements of a charitable organization as set forth in Section 50l(c)(3). Generally, Section 501(c)(3) includes:
"Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation, (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office."
Supporting organizations can generally be created as either a corporation or a trust under state law. There are a number of factors that go into the selection of a structure including intended duration, formality of operation, liability for activities, and state oversight.
A supporting organization must be structured to meet the following four requirements of Section 509(a)(3):
- Operated, supervised, or controlled by or in connection with one or more public charities (relationship test).
- Organized, and at all times thereafter, is operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified public charities (organizational test).
- Operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified public charities (operational test).
- Not controlled directly or indirectly by one or more disqualified persons (as defined in Section 4946) other than foundation managers and other than one or more public charities (limitation on control by disqualified person).
Relationship Test [Treas. Reg. §l.509(a)-4(f)]
In order to meet the requirements of a supporting organization, three different types of relationships are possible:
- operated, supervised, or controlled by;
- supervised or controlled in connection with; or
- operated in connection with.
No matter which test applies, the relationship established between the supporting organization and specified public charity must ensure that the supporting organization will be responsive to the needs or demands, and constitute an integral part of, or maintain a significant involvement in, the public charity's operations.
Operated, Supervised, or Controlled By [Treas. Reg. §1.509(a)-4(g)]
The distinguishing feature of this relationship is a substantial degree of direction by the supported public charity over the policies, programs, and activities of the supporting organization. The relationship, comparable to that of a parent and subsidiary, is established when a majority of the officers, directors, or trustees of the supporting organization are appointed or elected by the governing body or officers of the supported public charity acting in their official capacity. Following are examples from the Regulations:
X is a college press that is organized and operated as a nonstock, educational corporation to perform the publishing and printing for M University, a publicly supported organization. Control of X is vested in a Board of Governors appointed by the Board of Trustees of M University upon the recommendation of the president of the university. X is considered to be operated, supervised, or controlled by M University within the meaning of Section 509(a)(3)(B).
Y Council was organized under the joint sponsorship of seven independent publicly supported organizations, each of which is dedicated to the advancement of knowledge in a particular field of social science. The sponsoring organizations organized Y Council as a means of pooling their ideas and resources for the attainment of common objectives including the conducting of scholarly studies and formal discussions in various fields of social science. Under Y Council's bylaws, each of the seven sponsoring organizations elects three members to Y's board of trustees for three-year terms. Y's board also includes the president of Y Council and eight other individuals elected at large by the board. Pursuant to policies established or approved by the board, Y Council engages in research, planning, and evaluation in the social sciences, and sponsors or arranges conferences, seminars, and similar programs for scholars and social scientists. It carries out these activities through its own full time professional staff, through a part time committee of scholars, and through grant recipients. Under the above circumstances, Y Council is subject to a substantial degree of direction by the sponsoring publicly supported organizations. It is therefore considered to be operated, supervised, or controlled by such sponsoring organizations within the meaning of Section 509(a)(3)(B).
Z is a charitable trust created by A in 1972. It has three trustees, all of whom are appointed by M University, a publicly supported organization. The trust was organized and is operated to pay over all of its net income for medical research to N, O, and P, each of which is specified in the trust, is a hospital described in Section 509(a)(1), and is located in the same city as M. Members of M's biology department are permitted to use the research facilities of N, O, and P. Under subparagraph (1)(ii) of this paragraph, Z is considered to be operated, supervised, or controlled by M within the meaning of Section 509(a)(3)(B), even though it is operated for the benefit of N, O, and P within the meaning of Section 509(a)(3)(A) [Treas. Reg. §1.509(a)-4(g)(2)].
Supervised or Controlled in Connection With [Treas. Reg. §1.509(a)-4(h)]
The distinguishing feature of this relationship is that the control or management of both the supporting and supported organization is vested in the same persons. This type of relationship is established when a charitable organization needs to create a new parallel entity rather than to facilitate the charitable giving goals of an individual donor. Following are examples from the Regulations:
A, a philanthropist, founded X school for orphan boys (a publicly supported organization). At the same time A founded X school, he also established Y trust into which he transferred all of the operating assets of the school, together with a substantial endowment for it. Under the provisions of the trust instrument, the same persons who contribute and manage the school also control and manage the trust. The sole function of Y trust is to hold legal title to X school's operating and endowment assets, to invest the endowment assets, and to apply the income from the endowment to the benefit of the school in accordance with direction from the school's governing body. Under these circumstances, Y trust is organized and operated "for the benefit of" X school and is "supervised or controlled in connection with" such organization within the meaning of Section 509(a)(3). The fact that the same persons control both X and Y ensures Y's responsiveness to X's needs.
In 1972, B, a philanthropist, created P, a charitable trust for the benefit of Z, a symphony orchestra described in Section 509(a)(2). B transferred 100 shares of common stock to P. Under the terms of the trust instrument, the trustees (none of whom are under the control of B) were required to pay over all of the income produced by the trust assets to Z. The governing instrument of P contains certain provisions whose effect is described in Section 508(e)(l)(A) and (B). Under applicable state law, Z can enforce the provisions of the trust instrument and compel payment to Z in a court of equity. There is no relationship between the trustees of P and the governing body of Z. Under these circumstances, P is not supervised or controlled in connection with a publicly supported organization. Because of the lack of common supervision or control by the trustees of P and the governing body of Z, P is not supervised or controlled in connection with Z within the meaning of Section 509(a)(3)(B).
T is a charitable trust described in Section 501(c)(3) and created under the will of D. Prior to his death, D was a leader and very active in C Church, a publicly supported organization. D created T to perpetuate his interest in, and assistance to, C. The sole purpose of T was to provide financial support for C and its related institutions. All of the original named trustees of T are members of C, are leaders in C, and hold important offices in one or more of C's related institutions. Successor trustees of T are by the terms of the charitable trust instrument to be chosen by the remaining trustees and are also to be members of C. All of the original trustees have represented that any successor trustee will be a leader in C, and will hold an important office in one or more of C's related institutions. By reason of the foregoing relationship, T and its trustees are responsive to the needs and requirements of C and its related institutions. Under these circumstances, T trust is organized and operated "for the benefit of" C and is "supervised or controlled in connection" with C and its related institutions within the meaning of Section 509(a)(3)(B). [Treas. Reg. §1.509(a)-(4)(h)(3)].
Operated in Connection with [Treas. Reg. § 1.509(a)-4(i)]
This type of relationship exists when the supporting organization meets the requirements of two additional tests: the "responsiveness" test and the "integral part" test.
Responsiveness test: The supporting organization must be responsive to the needs or demands of the supported public charity. The Regulations require that one of two alternative tests be met. Under the first test:
- one or more officers, directors, or trustees of the supporting organization must be elected or appointed by the officers or trustees of the supported public charity; or
- one or more members of the governing body of the supported public charity must also be officers or trustees of, or hold other important offices in, the supporting organization; or
- the officers, directors, or trustees of the supported public charity must maintain a close and continuous working relationship with the officers or trustees of the supporting organization; and
- by reason of 1, 2, or 3 above, the officers or trustees of the supported public charity must have a "significant voice" in the investment policies of the supporting organization, the timing and manner of making grants, the selection of grant recipients, and otherwise directing the use of the income or assets of the supporting organization.
Under the alternative test:
- the supporting organization is a charitable trust under state law;
- each specified publicly supported organization is a named beneficiary under such charitable trust's governing instrument, and until the benefiting organization has the power to enforce the trust and compel an accounting under state law.
Where the supporting organization is a charitable trust under state law, however, the responsiveness test may be met as long as the supported public charity is the named beneficiary in the trust instrument, and it has the power to enforce the trust and compel an accounting under state law.
Integral part test: The integral part test can be satisfied in one of two ways. First, the supporting organization must maintain a "significant involvement" in the operations of the supported public charity, which must then also be dependent on the supporting organization for the type of support that it provides. To meet this test, the supporting organization's activities must perform the functions of, or carry out the purposes of, the supported public charity. These are activities that, in the absence of the supporting organization, normally would be carried out by the supported public charity [Treas. Reg. §1.509(a)-4(i)(3)(ii)]. In the alternative, the supporting organization needs to demonstrate its "attentiveness" to the supported public charity by payment of substantially all (i.e., 85%) of its income to, or for the use of, the supported public charity. Following are examples from the Regulations:
X, an organization described in Section 501(c)(3), pays over all of its annual net income to Y, a museum described in Section 509(a)(2). X meets the responsiveness test described in Treas. Reg. §1.509(a)-4(i)(2). In recent years, Y has earmarked the income received from X to underwrite the cost of carrying on a free chamber music series consisting of 12 performances a year that are performed at its premises for the general public free of charge. Because of the expense involved in carrying on these recitals, Y is dependent upon the income from X for their continuation. Under these circumstances, X will be treated as providing Y with a sufficient portion of Y's total support to assure Y's attentiveness to X's operations, even though the chamber music series is not the primary part of Y's activities. [Treas. Reg. §1.509(a)-4(i)(3)(iii)(c), Ex. 1]
M, an organization described in Section 50l(c)(3), pays all of its annual net income to the Law School of N University, a publicly supported organization. M meets the responsiveness test described in Regs. §1.509(a)-4(i)(2). M has earmarked the income paid over to N's Law School to endow a chair in its Department of International Law. Without M's continued support, N might not continue to maintain this chair. Under these circumstances, M will be treated as providing N with a sufficient portion of N's total support to ensure N's attentiveness to M's operations. [Treas. Reg. §1.509(a)(4)(i)(3)(iii)(c), Ex. 2]
N is a nonprofit publishing organization described in Section 501(c)(3). It does all of the publishing and printing for the churches of a particular denomination (publicly supported organizations). Control of the organization is vested in a five-member Board of Directors, which includes one church official and four lay members of the congregations of that denomination. N does no other printing or publishing. It publishes all of the churches' religious, as well as secular, tracts and materials. Under these circumstances, N is considered as being "operated in connection with" a number of publicly supported organizations. Publishing religious literature is an integral part of the churches' activities-N carries on the publishing on behalf of the churches, and there is sufficient direction of N's activities by the churches to ensure responsiveness by N to their needs. [Treas. Regs. §1.509(a)-4(i)(5), Ex. 1]
O, an alumni association described in Section 501(c)(3), was formed to promote a spirit of loyalty among graduates of Y University, a publicly supported organization, and to affect united action in promoting the general welfare of the university. A special committee of Y's governing board meets with O and makes recommendations as to the allocation of O's program of gifts and scholarships to the University and its students. O also provides certain functions that would otherwise be part of Y's functions, such as maintaining records of alumni. O publishes a bulletin to keep alumni aware of the activities of the University. Under these circumstances O is considered to be operated in connection with Y within the meaning of Section 509(a)(3)(B). [Treas. Regs. § 1.509(a)-4(i)(5), Ex. 2]
P is a trust created under the will of A for the purpose of furthering musical education. As a means of accomplishing its purposes, P founded X, a school of music described in Section 509(a)(l). The trust instrument is thereafter amended to name X specifically as the beneficiary of the trust. X can enforce its equitable rights as trust beneficiary under state law. Members of the governing body of X form a minority of the foundation managers of P. For many years, the organizations have been operated in close association with each other. P provides the principal endowment fund for the operation of X. In addition, while the governing body of X concerns itself with artistic policies, the foundation managers of P handle the budgetary concerns of X. X's annual budget is prepared with the assistance of P's foundation managers and is approved by P. Under these circumstances, P is considered to be operated in connection with X within the meaning of Section 509(a)(3)(B). [Treas. Regs. § l.509(a)-4(i)(5), Ex. 3.]
Q is a charitable trust described in Section 501(c)(3) and created under the will of C. Prior to his death, C built H Hospital and deeded it to I University for use as a training and clinical facility for I's Medical School. Both H and I are publicly supported organizations. C created Q to perpetuate his interest in, and assistance to, H Hospital. The sole purpose of Q was to provide financial support for H, the beneficiary organization named in C's will. H can enforce its equitable rights as trust beneficiary under state law. After the death of C, Q continued to provide substantial support for H. It was primarily responsible for erecting a new hospital building as well as constructing other facilities for the hospital. In addition, each medical department of H makes financial requests for new equipment. Once these requests are approved by the medical director of the University's Medical School, they are presented to Q, and subject to the amount of Q's income (all of which is applied to H). These requests are honored and the new equipment is supplied through Q's funds. The governing body of Q and those of H and I are completely independent. However, based on the above facts, Q is responsive to the needs of H; Q maintains a substantial involvement in the conduct of H; and H is substantially dependent upon the receipt of support from Q. Accordingly, Q is operated in connection with one or more Section 50l(a)(l) organizations within the meaning of Section 509(a)(3)(B). [Treas. Regs. § 1.509(a)4(i)(5), Ex. 4]
Organizational Test [Treas. Reg. § 1.509(a)-4(c)]
The supporting organization's governing instrument must:
- limit the purposes of such organization to one or more of the purposes set forth in Section 509(a)(3)(A);
- not expressly empower the organization to engage in activities that are not in furtherance of the purposes referred to in subdivision (i) of this subparagraph;
- state the specified publicly supported organizations on whose behalf such organization is to be operated; and
- not expressly empower the organization to operate to support or benefit any organization other than the specified publicly supported organizations.
There is no specific required language to meet this test. This requirement is, however, best met by a specific reference to the support of one or more specific publicly supported organizations. In addition, the purpose of the supporting organization may be as broad as or more specific than the purposes set forth in Section 509(a)(3)(A). Examples include an organization formed "for the benefit of" one or more specified publicly supported organizations; or an organization found "to perform the publishing function of" a specific university. [Treas. Reg. §1.509(a)-4(c)(2)]
Operational Test [Treas. Reg. § 1.509(a)-4(e)]
The third test that a supporting organization must satisfy is demonstrating that it is operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of the specified publicly supported organization. This test has two components. First, the supporting organization must "operate exclusively" for the benefit of the specified public charity; and second, it must only engage in activities that support or benefit the specified public charity. The actual scope of activity is very broad. (See PLR 9347032-performing management and administrative services; GCM 36043 (10/9/74)-scholarships; and TAM 8536001-financial aid.)
Limitations On Control By Disqualified Persons [Treas. Reg. § 1.509(a)-4(j)]
The last test that a supporting organization must satisfy is that it may not be controlled by one or more "disqualified persons." Disqualified persons, for purposes of Section 509(a)(3), include the following, other than publicly supported organizations:
- persons (i.e., individuals, corporations, foundations, and trusts) that are substantial contributors to the supporting organization. A substantial contributor means any person who has contributed more than $5,000 or 2% of the total contributions received by the supporting organization since its inception, whichever is greater;
- persons with more than a 20% interest in a corporation, partnership, trust, or unincorporated enterprise that is a substantial contributor to the supporting organization;
- family members of any individual described in 1 or 2 above; and
- corporations, partnerships, trusts, or estates in which persons described in 1, 2, or 3 above have more than a 35% interest.
Control is demonstrated where the disqualified persons, by aggregating their votes or positions of authority, may require the organization to take, or not to take, a particular action.
The decision of whether to make a gift to a public charity, a supporting organization, or a private foundation by a donor must take into consideration a number of factors. These include:
- Public recognition
- Family involvement
- Tax advantage
- Scope of interest
From the perspective of the supported public charity, there is often a need for it to determine if it will participate in the management of a supporting organization. In addition, public charities need to decide if they wish to be proactive in suggesting the use of supporting organizations to their potential donors. The use of a supporting organization involves consideration of the following factors:
- Unique investments
- Compliance issues
- Available endowment alternatives
In spite of the technical requirements of qualification, supporting organizations can provide a superior alternative to private nonoperating foundations and play an integral role in helping families perpetuate the spirit of philanthropy to future generations.