Public Charity v. Private Foundation Classification

Charities and private foundations have many benefits, but what is the real difference between the two and how are they classified. The difference is that one is required to exercise expenditure responsibility for the grant. This is determined by the nature of the charity or the public or governmental funding it receives.

To be classified as a public charity, rather than a private foundation, a Section 501(c)(3) organization must be described in Section 509(a). Such organizations are churches, educational organizations, hospitals, medical research organizations, endowment funds supporting colleges and universities, governmental units, and publicly supported organizations. These organizations must also meet the public support test. For example, "supporting organizations," derive their public charity status simply because they are organized and operated "exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more" public charities described in Section 509(a)(1) or 509(a)(2).

There are three types of Supporting Organizations and they must maintain that relationship with the organization they support. Type I are "operated, supervised, or controlled by one or more" supported organizations. Type II  are "supervised or controlled in connection with one or more" supported organizations. Type III are "operated in connection with" one or more supported organizations.

Due to abuses by Supporting Organizations, the rules are now being tightened. Specifically, there now exists a distinction between Type III Supporting Organizations that are "functionally integrated" with their supported organizations by virtue of their carrying out activities that directly perform the functions of the supported organizations, and those that are not. The "non-functionally integrated" Type III Supporting Organizations will now be subject to new requirements, including a payout requirement and limitations on excess business holdings. Additionally, private foundations and donor-advised funds now to have to exercise expenditure responsibility on grants given to non-functionally integrated Type III Supporting Organizations.

Here are some additional highlights of the new regulation.

Qualifying as a Type III Supporting Organization

Under the new regulations, a Type III Supporting Organization must now satisfy a a three prong test that includes 1. notification requirement, 2. a responsiveness test, and  3. an integral part test. The integral part test is used to determine whether the Type III Supporting Organization is in fact functionally integrated or non-functionally integrated.

Notification Requirement

A Type III Supporting Organization must provide provide to each of its supported organizations a written description of the type and amount of all of the support it provided to each supported organization, its most recent Form 990, and a copy of its governing documents, amongst other documents.

Responsiveness Test

The responsiveness test generally requires a connection between the boards of directors and officers of the Supporting Organization and its supported organizations giving each supported organization a significant voice in the investment policies and use of the Supported Organization's income and assets.

Integral Part Test for Functionally Integrated Type III SOs

A Type III functionally integrated Supporting Organization can meet the integral part test through one of the three following ways:

• Conducting activities that directly further the exempt purposes of the supported organizations
  • These are activities that would otherwise normally be performed or carried out by each supported organization;
• Being the parent of each supported organization; or
• Supporting a governmental supported organization.

Fundraising and Grantmaking Disfavored Activities

A Type III Supporting Organization that is established to fundraise or manage an endowment for a supported organization or to make grants (with the exception of individual grants, scholarships, and other payments made under certain circumstances) will not qualify as functionally integrated unless it is the parent of the supported organization or the supported organization is a governmental unit.

Integral Part Test for Non-Functionally Integrated Type III SOs

Under the integral part test for a non-functionally integrated Type III Supporting Organization, there are usually two components:

• The first component requires the Supporting Organization to distribute a "distributable amount" to, or for the use of, its supported organizations each year. The distributable amount must equal the greater of 85% of adjusted gross income or 3.5% of the fair market value of nonexempt use assets. Administrative expenses, excluding investment management fees, may count toward this distribution requirement, and SOs may take advantage of a set-aside provision.
• The second component requires the Supporting Organization to be "attentive" to the supported organization in one of the following ways:
  • distributing to its supported organization (other than to a donor-advised fund) at least 10% of such organization's total support.
  • Avoiding the interruption of a substantial program of the supported organization.
  • Facts and circumstances, such as the length and nature of the relationship, the SO's use of funds, and the support from the SO in comparison to the supported organization's total support.

Transition Periods

Supporting Organizations in existence prior to the effective date of the new regulations may be able to take advantage of a transition relief periods with respect to compliance with the notification requirements and the integral part test or in transitioning to a non-functionally integrated Type III SO.

Future Guidance

The IRS reserved several provisions for further guidance, including the definition of "control" for purposes of these provisions, an amendment to the responsiveness test to clarify that an Supporting Organization must be responsive to all of its supported organizations, the definition of "parent," how Supporting Organization can qualify as functionally integrated by supporting a governmental entity, and what expenditures will count toward the distribution requirement.

Call us if you have any questions or concerns! We are here to help (239)963-6043

*This article provides general information and is not intended as legal advice. It further does not create any client-attorney relationship or right to any confidentiality or privileges