Editor: Mary Van Leuven, J.D., LL.M.
All organizations that are tax-exempt under Sec. 501(c)(3) are classified as private foundations and are thereby subject to a host of burdensome rules and restrictions, unless they qualify as public charities. Most organizations that qualify as public charities do so by raising a certain amount of support from the general public or by falling into one of a few specified categories such as churches, hospitals, and schools.
However, organizations may also qualify as public charities by supporting or benefiting one or more churches, hospitals, schools, or other publicly supported charities. These organizations are called "supporting organizations" and are subject to a "fantastically intricate and detailed" set of requirements, including general rules requiring the public charities they support or benefit (their "supported organizations") to be specifically designated in the governing instruments of the supporting organizations and requiring certain specified types of relationships with the supported organizations (Windsor Foundation, No. 76-0441-R (E.D. Va. 10/4/77)).
Of all these requirements, the one that perhaps raises the most questions among supporting organizations is the "operational test" — the requirement that a supporting organization be operated "exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more" supported organizations (Sec. 509(a)(3)(A)). Specifically, supporting organizations routinely struggle with the question: Can we support and benefit supported organizations by making grants to other public charities that are not our supported organizations? Unfortunately, the formal guidance on supporting organizations does not clearly answer this question. This item reviews how the regulations, case law, and IRS guidance address the issue and explores potential arguments for and against making these grants.
The operational test regulations
A supporting organization meets the operational test "only if it engages solely in activities which support or benefit the specified . . . supported organizations" (Regs. Sec. 1.509(a)-4(e)(1)). This general language does not make clear whether a supporting organization may support or benefit a supported organization by making grants to another public charity on its behalf. The regulations allow a supporting organization to support and benefit a supported organization by "making payments to or for the use of, or providing services or facilities for, individual members of the charitable class benefited by" the supported organization. The regulations specify that these payments could be made "indirectly through another unrelated organization to a member of a charitable class benefited by the . . . supported organization, but only if such a payment constitutes a grant to an individual rather than a grant to an organization."
Although the meaning of "unrelated organization" is undefined, the italicized language in the last sentence could suggest that grants to organizations other than supported organizations are per se prohibited. However, if Treasury and the IRS intended to establish a blanket prohibition as important and central as this, one would think they would do so directly and clearly rather than bury it in a description of how supporting organizations may support the charitable classes of their supported organizations.
The regulations clearly allow a supporting organization to support or benefit: (1) other Sec. 501(c)(3) organizations (other than private foundations) that have supporting organization-type relationships with its supported organizations; and (2) state universities. Generally, the supported organization must be specified in the articles of the supporting organization. However, a supporting organization can support a publicly supported charity even if it is not specified in the supporting organization's articles if there has been a "historic and continuing relationship" between the supporting organization and the publicly supported charity (Regs. Sec. 1.509(a)-4(d)(2)(iv)). For ease of reference, this discussion refers to all these permissible beneficiaries as "supported organizations."
Adding to the confusion is another paragraph in the regulations that permits a supporting organization to satisfy the operational test by "using its income to carry on an independent activity or program [that] supports or benefits" the supported organization (Regs. Sec. 1.509(a)-4(e)(2)). Arguably, a supporting organization's independent grant-making program, under which the supporting organization makes grants to public charities that the supported organization would otherwise make grants to could be an "independent activity or program" that supports or benefits a supported organization — especially if that supported organization were itself a grant-maker (such as a community foundation). Indeed, the IRS expressly concluded that the grant-making activities of a supporting organization may be "activities to perform the functions of or carry out the purposes of" a grant-making supported organization (General Counsel Memorandum 38417 (June 20, 1980)).
However, the same regulation requires that all support provided through an independent activity or program "be limited to" supported organizations. Taken to its extreme, this limitation could be read to mean that no organization other than a supported organization may benefit from a supporting organization's independent activity or program; such a strict interpretation would clearly rule out making grants to organizations other than supported organizations.
Finally, an example in the regulations provides that a supporting organization fails the operational test by making a small annual grant to a private foundation that performs a particular function that assists in the overall aid program carried on by the grantor's supported organization (Regs. Sec. 1.509(a)-4(e)(3), Example (3)). This example (Example 3) is the clearest expression in the regulations of a grant-making prohibition to organizations other than supported organizations.
Case law
The precise meaning of the operational test regulations summarized above received its first and only detailed scrutiny by a court in Change-All Souls Housing Corp., 671 F.2d 463 (Ct. Cl. 1982). In Change-All Souls, a public charity and a private foundation (both focused on economic development and low-income housing) formed a supporting organization to provide low-income housing, implement operation and management policies for a housing project, and provide certain services to tenants. Relying heavily on Example 3, the government took a relatively aggressive position in arguing that the regulations made "clear that if the supporting organization supports, even to a minor extent, an organization which is not publicly supported," the supporting organization would fail the operational test.
The court disagreed, stating that Example 3 was too ambiguous to support the government's interpretation. Because of the common purposes of the public charity and the private foundation, the court determined that when the supporting organization "benefits one, it necessarily benefits the other equally." The court held that the regulation "merely requires that the supporting organization refrain from engaging in any activity that does not directly support or benefit" its supported organizations, and that a supporting organization may meet the operational test even if it "simultaneously benefits, directly or indirectly," other organizations.
The court also noted, however, that if the supporting organization were to provide financial support (e.g., grants) to the private foundation, "the government's argument might be convincing because the grants to [the foundation] would not benefit [the supported organization] directly." However, because the supporting organization did not make grants to either the foundation or the supported organization, this statement in the opinion is merely dicta.
The IRS's position after Change-All Souls
The IRS did not acquiesce in the Change-All Souls decision (seeAction on Decision 1984-15). Change-All Souls arguably involved a fact pattern that was particularly offensive to the IRS — a situation in which a private foundation (which never can qualify as a supported organization) not only benefited from a supporting organization's activities but was also instrumental in its founding. Under more favorable circumstances, it is not entirely clear that the IRS would take as firm a position — that is, benefiting a non-supported organization is always prohibited.
In addition, the IRS determined in reclassifications of foundation status (e.g., IRS Letter Ruling 200949056) and revocations of tax-exempt status (e.g., IRS Letter Ruling 201004046) that the operational test was not met when a supporting organization distributed funds to charities other than its supported organizations. However, the supporting organizations in these determinations did not appear to claim that they were operating grant-making programs on behalf of their supported organizations and failed other requirements in addition to the operational test.
Moreover, the IRS has not been consistent in its application of the operational test. For example, in IRS Letter Ruling 9725035, the IRS recognized a supporting organization that would support and benefit its supported organization by, among other things, providing services and financial assistance to governmental organizations and Sec. 501(c)(3) organizations for purposes related to the provision of health, medical, or related social services to community residents. Nothing in the ruling suggests that the governmental organizations and Sec. 501(c)(3) organizations were supported organizations or otherwise permissible beneficiaries.
An anomaly
In addition to supporting publicly supported charities, the Code and regulations permit a Sec. 501(c)(3) organization to qualify as a supporting organization by supporting or benefiting organizations described in Secs. 501(c)(4), (5), and (6). And the IRS has ruled that these supporting organizations may support their supported organizations by making grants to non-supported Sec. 501(c)(3) organizations (see, e.g., Rev. Rul. 76-401; IRS Letter Ruling 200149045). This exception makes some sense, as an organization that only supported or benefited one or more Sec. 501(c)(4), (5), or (6) organizations might otherwise have difficulty qualifying for tax-exempt status under Sec. 501(c)(3). However, it still raises the question of why supporting organizations of Sec. 501(c)(4), (5), or (6) organizations may support their supported organizations by making grants to any public charities, while supporting organizations of Sec. 501(c)(3) organizations may not. The exception also provides a relatively easy way for a Sec. 501(c)(3) grant-making organization to avoid the private foundation rules without having to restrict its grantees to publicly supported organizations: establish a supporting organization relationship with a Sec. 501(c)(4), (5), or (6) organization rather than a Sec. 501(c)(3) organization.
Difficulties with the operational test
Compliance is difficult enough for supporting organizations due to the complexity of the tests they must meet on an ongoing basis, but the operational test is especially precarious for all but the simplest supporting organizations. The regulations offer no relief for foot faults, and a supporting organization that fails the operational test faces the specter of private foundation status. For supporting organizations that engage in grant-making, the permissibility of grants to non-supported organizations remains unclear as a result of ambiguous regulations, inconsistent written determinations, and a lack of clear guidance. The safest course for supporting organizations is to make grants only to their supported organizations, leaving to the supported organizations the final decision as to whether to re-grant the funds to other public charities (though the supporting organization could make recommendations as to the ultimate recipients).
Another option for a supporting organization that wants to make grants directly to a broader range of organizations than its current supported organizations is to consider amending its articles of organization to include the prospective grantees as supported organizations (while abiding by certain regulatory provisions relating to the substitution of supported organizations) (see Regs. Secs. 1.509(a)-4(d)(3) and -4(d)(4)(i)). If a supporting organization takes these steps, it may be able to make grants to the public charities it wants to support without fear of violating an ambiguous rule.
EditorNotes
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com..
Contributors are members of or associated with KPMG LLP. These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice 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.
