For a variety of complex tax, business, and operational purposes, tax-exempt entities may create complex organizational systems similar to their taxable counterparts that contain a variety of related entities: parents, subsidiaries, brothers, and sisters. These systems can contain both tax-exempt and taxable entities with a "parent" entity that coordinates the overall mission and activities of the whole system.
All Sec. 501(c)(3) organizations default to private foundation status unless described in Secs. 509(a)(1)-(4) (i.e., per se charities, publicly supported organizations, supporting organizations, and organizations that test for public safety). Therefore, complications may arise when the parent of a large, multientity system applies for recognition of tax-exempt status as a Sec. 501(c)(3) public charity. Through "derivative exemption" (i.e., carrying out the activities that a related organization could perform directly), the parent generally meets the requirements to be described in Sec. 501(c)(3); however, it must also rely on supporting organization status to qualify as a public charity.
The detailed rules applicable to supporting organizations have grown in complexity in recent years as a result of a stricter regulatory regime introduced by the Pension Protection Act of 2006, P.L. 109-280: statutory changes in 2006, final regulations in 2012 and 2015, and a revised Form 990, Return of Organization Exempt From Income Tax, Schedule A, Public Charity Status and Public Support. Failure to meet the detailed requirements could jeopardize the supporting organization's status as a public charity, cause it to default to private foundation status, and subject it to possible excise taxes under Chapter 42 and other penalties.
Introduction to Supporting Organizations
One type of tax-exempt entity often found in complex, related systems is the supporting organization. Supporting organizations come in a handful of varieties, defined by the relationship with their supported organizations: Type I (supervised or controlled by); Type II (supervised or controlled in connection with); and Type III (operated in connection with). Each supporting organization must meet an organizational test, operational test, relationship test, and control test. This item attempts to clarify the rules governing supporting organizations, with a particular focus on satisfying the Type II relationship test.
The Organizational Test
A Type II supporting organization must be organized exclusively for the benefit of, to perform the functions of, or to carry out the purposes of (to support or benefit) one or more supported organizations. Specifically, a supporting organization's organizing documents generally must designate by class, purpose, or name the supported organizations for whose benefit the supporting organization will operate, limit the supporting organization's purposes to supporting or benefitting those supported organizations, and not empower the supporting organization to engage in activities that are not in furtherance of the aforementioned activities or to operate to support or benefit any organization other than its designated supported organizations (Regs. Sec. 1.509(a)-4(c)).
The Operational Test
In addition, a Type II supporting organization must operate exclusively to support the supported organizations designated in its articles by engaging solely in activities that support or benefit those supported organizations. This support may include making payments directly to the individual members of the charitable class benefited by the supported organizations, or carrying on an independent activity or program that supports or benefits the specified supported organizations (Regs. Sec. 1.509(a)-4(e)).
The Control Test
A Type II supporting organization cannot be controlled directly or indirectly by one or more disqualified persons, other than foundation managers and supported organizations (Regs. Sec. 1.509(a)-4(j)). Disqualified persons generally include persons who have contributed more than 2% of the organization's total support, their family members, and certain related organizations (Sec. 4946).
The Relationship Test
The crux of the analysis, however, is the relationship a Type II supporting organization must have with its designated supported organization, specifically being "supervised or controlled in connection with" it (Sec. 509(a)(3)(B)(ii)). Generally, a Type II supporting organization meets this requirement through a provision in its governing documents providing that the same persons who control the supporting organization also control the designated supported organizations, for example, by requiring that a majority of the supporting organization's board members also represent a majority of the supported organizations' governing bodies (see, e.g.,General Counsel Memorandum 39508; see also Sec. 6110(k)).
Example: P, a Sec. 501(c)(3) supporting organization, is the parent of an integrated health care delivery system, formed to support SD1, a Sec. 501(c)(3) hospital. P's governing documents provide that a majority of its board members must represent a majority of SD1's governing body. P should meet the Type II relationship test.
A supporting organization may have a Type II relationship with its supported organizations if fewer than a majority of the persons have the requisite commonality required to meet the rule of thumb if the facts and circumstances indicate that the supporting organization can and is responsive to each of the supported organizations and maintains involvement in each of the supported organization's operations. In undertaking this analysis, it may be appropriate to evaluate various factors, including the extent to which there is commonality between the two organizations; the stated purpose of forming a system of related supported organizations; the number of related supported organizations; agreements between the supported organizations to cooperate for their mutual benefit; and the nature of the supporting organization's activities. However, as the number of supported organizations grows, the influence each supported organization has over the control or management of the supporting organization can wane. Therefore, it may become difficult for the supporting organization to demonstrate the requisite responsiveness to and involvement with each of its supported organizations.
Another common problem with the Type II relationship test arises when the governing bodies of the supported organizations are significantly larger than the governing body of the supporting organization. For example, if the supporting organization has a five-member board of directors and two supported organizations have 15- and 17-member boards, respectively, it is mathematically impossible for a majority of the supported organization board members to also be a majority of the supporting organization's governing body. In this situation, it may be appropriate to afford the board overlap less weight. Instead, it would be critical to evaluate other facts and circumstances to determine whether the supporting organization is responsive to and involved in the operations of its supported organizations.
The Type III Supporting Organization Alternative
In multientity structures, the Type II relationship test may prove problematic. However, as a system parent, an alternative classification may be available: a functionally integrated Type III (Type III-FI) supporting organization. Because a Type III supporting organization is operated in connection with its supported organization, the governance relationship is not as strong as compared to a Type I or Type II relationship. Therefore, Type III supporting organizations must meet additional requirements, including a notification requirement, a responsiveness test, and an integral-part test.
The notification requirement necessitates that the Type III supporting organization provide a written notice to each supported organization describing the type and amount of support provided during the previous tax year, a copy of its most recently filed Form 990, and a copy of its organizing documents, as most recently amended, to the extent not previously provided.
The responsiveness test requires governing body or management overlap or the existence of a close and continuous working relationship among the governing body or management of the supporting organization and supported organization. As a result of this relationship, the supported organization must have a significant voice in the supporting organization's investment policies and grant-making procedures.
Finally, the integral-part test establishes whether the Type III supporting organization is functionally integrated (FI) or non-functionally integrated (NFI). If the supporting organization is the parent of its supported organizations, directly furthers the exempt purposes of its supported organizations, or supports a governmental unit, it is a Type III-FI supporting organization. Otherwise, it is a Type III-NFI supporting organization, which is required to make annual distributions to its supported organizations.
Conclusion
A Type II supporting organization supporting numerous supported organizations is a common structure in the exempt sector (e.g., health care organizations) if the supporting organization delivers strategy, planning, coordination, fundraising, and administrative services to its supported organizations. When the supporting organization acts as a parent of a large, integrated system, the presence of many supported organizations may strain the supporting organization's ability to be responsive to and involved in the activities of each of its supported organizations. In these cases, minority board overlap may not be fatal, but it is critical to review the facts and circumstances supporting Type II classification to ensure that there is an adequate nexus to establish that the supported organizations effectively supervise the supporting organization. Alternatively, these organizations may consider Type III classification, taking into account the additional requirements associated with that status.
EditorNotes
Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2016 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
