The IRS published final regulations on the rules for supporting organizations under IRC Section 509(a)(3) that generally are effective for tax years beginning on or after Oct. 16, 2023. The regulations implement changes made by the Pension Protection Act of 2006 and include additional changes to the rules for Type III supporting organizations. The final regulations generally adopt the proposed regulations published in February 2016, with some modifications and clarifications.
Crowe observation
The changes made by the Pension Protection Act of 2006 and the final regulations aim to make sure that supporting organizations operate in a manner that directly furthers the exempt purposes of their supported organizations, thereby strengthening the integrity and effectiveness of the not-for-profit sector.
Background
Under IRC Section 509(a)(3), an organization is classified as either a private foundation or a public charity. An organization classified as a public charity must be further described in IRC Section 509(a)(1), (2), or (3). Supporting organizations, as described in IRC Section 509(a)(3), achieve their public charity status by providing support to one or more organizations described in IRC Section 509(a)(1) or (2).
To qualify as a supporting organization, an entity must satisfy an organizational test, an operational test, a control test, and a relationship test. Supporting organizations further are classified into Type I, Type II, and Type III, each with different relationships with their supported organizations.
Highlights of changes in the final regulations
The final regulations make a number of changes to the rules for organizations to qualify as a Type I or Type III supporting organization. IRC Section 509(f)(2) prohibits Type I and Type III supporting organizations from accepting gifts from any person who controls the governing body of the supported organization, other than a public charity or an entity that is organized and operated exclusively for testing for public safety. The final regulations define “control” as one or more persons described in Section 1.509(a)-4(f)(5)(i)(A), (B), or (C) holding 50% or more of the total voting power of the governing body or having the right to exercise veto power over the actions of the governing body. The final regulations further clarify that all the pertinent facts and circumstances will be taken into consideration when determining whether one or more person directly or indirectly controls the governing body, even if such persons do not have 50% or more of the voting power or a veto power.
The final regulations also modify the rules regarding the nature of the relationship required between a qualifying Type III supporting organization and the supported organization. To meet the relationship requirement, the supporting organization must send certain notifications to the organization it supports, including a narrative description of the support provided as well as sufficient financial detail for the recipient to identify the types and amounts of support being reported. The final regulations clarify that they must be delivered by the last day of the fifth month of the supporting organization's taxable year after the taxable year in which it provided the support it is reporting.
The final regulations also provide rules regarding the supporting organization’s responsiveness to its supported organizations and include an example to illustrate how Type III supporting organizations that support multiple organizations can satisfy this requirement. Type III supporting organizations must maintain significant involvement in the operations of one or more supported organizations and provide support on which the supported organizations are dependent. Whether a supporting organization meets this requirement depends on whether it is functionally or nonfunctionally integrated.
The final regulations define a functionally integrated Type III supporting organization as one that engages in activities substantially all of which directly further the exempt purposes of one or more supported organizations based on all pertinent facts and circumstances. A parent organization of an integrated system of supported organizations will be functionally integrated if it directs the overall policies, programs, and activities of the supported organizations, including coordinating activities and engaging in overall planning, policy development, budgeting, and resource allocation or the provision of systemwide administrative services.
The final regulations also provide that a Type III supporting organization supporting a governmental entity will be treated as functionally integrated if it is responsive and engages in activities that perform the functions of, or carry out the purposes of, that governmental entity, and if a substantial part of its total activities directly furthers the exempt purposes of its governmental supported organizations. The final regulations also provide an exception to these requirements in the case of certain preexisting organizations supporting governmental entities.
To qualify as a nonfunctionally integrated Type III supporting organization, an organization must meet, among other things, certain distribution requirements to or for the use of its supported organizations. Under the final regulations, amounts paid to a supported organization to accomplish its exempt purposes and amounts paid for any reasonable and necessary administrative expenses paid to accomplish the exempt purposes of the supported organization are taken into account to determine if the distribution requirements are satisfied. However, fundraising expenses are not considered for these purposes.
The final regulations are applicable to taxable years beginning on or after Oct. 16, 2023. However, taxpayers can apply the final regulations to taxable years beginning on or after Feb. 19, 2016, and before Oct. 16, 2023, so long as the taxpayer applies the provisions of these final regulations in their entirety and consistently.
Looking ahead
While the final regulations generally adopt the proposed regulations, there are some important changes. The effective date also provides the opportunity to apply the final regulations retroactively. Supporting organizations should consult with their tax advisers to understand how these rules affect them and evaluate whether changes to their operations are needed.
