(i) 60-Month Termination Issues

A private foundation (PC) that seeks future recognition as a public charity can request a 60-month termination period to achieve that goal by filing Form 8940.[1] This change is appropriate and possible when the PC begins to receive support from a sufficient number of donors that is can satisfy the 33-13% support test for donative public charities.[2] This type of change is not an “advance ruling” described above in §11.1(f). For any year during the 60-month conversion in which the PF fails to meet the public support test, the private foundation sanctions will apply, including the §4940 excise tax on its investment income and the § 4941 sanctions on self-dealing transactions as discussed in Chapter 18.3.

(a) Churches

The first category includes a “church, convention, or association of churches.”¹⁶ Churches are narrowly defined, and not all religious organizations are eligible to be classified as churches. Chapter 3 is devoted to these distinctions. Perhaps due to the need to separate church and state, neither the Internal Revenue Code nor the IRS regulations define a church.¹⁷

(b) Schools

Although the title of the IRS category does not say “school,” the second category basically includes formal schools. A school is an “educational organization that normally maintains a regular faculty, has a regular curriculum, and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.”¹⁸ The IRS very strictly scrutinizes what are referred to as the “four regulars” in granting classification as a school. Note that the world of educational organizations for purposes of IRC §501(c)(3) is much broader.¹⁹

(c) Hospitals and Medical Research Organizations

This class of public charity includes hospitals, the principal purpose or function of which is to provide medical or hospital care, medical education, or medical research. An organization directly engaged in continuous, active medical research in conjunction with a hospital may also qualify if, during the year in which the contribution is made, the funds are committed to be spent within five years.

Medical care includes the treatment of any physical or mental disability or condition, on an inpatient or outpatient basis. A rehabilitation institution, outpatient clinic, or community mental health or drug treatment center may qualify. Convalescent homes, homes for children or the aged, handicapped vocational training centers, and medical schools are not considered to be hospitals.²⁰ An animal clinic was also found not to be a hospital.²¹ The issues involved in qualifying for tax exemption as a hospital may evolve, and close attention must be paid to the latest information.²²

Medical research is the conduct of investigations, experiments, and studies to discover, develop, or verify knowledge relating to the causes, diagnosis, treatment, prevention, or control of physical or mental diseases and impairments of human beings. Appropriate equipment and qualified personnel necessary to carry out its principal function must be regularly used. The disciplines spanning the biological, social, and behavioral sciences, such as chemistry, psychiatry, biomedical engineering, virology, immunology, biophysics, and associated medical fields, must be studied.²³ Such organizations must conduct research directly. Granting funds to other organizations, while possible, may not be a primary purpose.²⁴ The rules governing a research organization's expenditure of funds and its endowment levels are complicated, and the regulations must be studied to understand this type of public charity. A participant in a joint venture is considered to conduct the activity of the venture. Tax-exempt participants in a whole-hospital joint venture may be treated as providers of hospital care for purposes of qualification as a public charity under IRC §170(b)(1)(A)(iii).²⁵

(d) College and University Support Organizations

An entity operating to receive, hold, invest, and administer property and to make expenditures to or for the benefit of a state or municipal college or university qualifying under §170(b)(1)(A)(ii) is a public charity. Such entities must normally meet the 33⅓ percent test, which means they receive a substantial part of their support from governmental grants and contributions from the general public, rather than from exempt function and investment revenues.

(e) Governmental Units

The United States, District of Columbia, states, possessions of the United States, and their political subdivisions are classified as governmental units. They are listed as qualifying as public charities, although they are not actually tax exempt under §501(c)(3). They are, in essence, public charities because they are responsive to all citizens. The tax code, in §170(c)(1), permits a charitable contribution deduction for gifts to governmental units. The regulations contain no additional definition or explanation of the meaning of this term, but IRS rulings and procedures and the courts have provided some guidance.²⁶

(f) Donative Public Charities: §170(b)(1)(a)(vi)

Public charities in this category are called “donative public charities” because to qualify they must receive at least 33⅓ percent of their annual support in the form of donations from members of the general public (not including fees and charges for performing exempt functions).²⁷ The calculation is based on a five-year period including the current and past four years; before 2008, the test covered four years. If the organization achieves at least 33⅓ percent public support for the current year, it is treated as a public charity for that year and the following year. If it fails this test in the current year but passes it in the following year, it can continue to be treated as public. If it fails the test two years in a row, the organization is reclassified as a private foundation for the second year and must file Form 990-PF rather than Form 990. Checkboxes on lines 14 and 15 of Part II of Schedule A (shown in Exhibit 11.3) request the percentage to indicate whether the entity passed or failed. An entity with a lower than 33⅓% result can consider seeking qualification under the “facts-and-circumstances” test²⁸ or by excluding unusual grants.²⁹

To implement the five- rather than four-year public support test, effective October 9, 2008, new standards were adopted.³⁰ The mathematical tests are calculated following the organization's regular accounting method: either cash or accrual. Organizations that report on an accrual basis for tax purposes faced a major challenge that year to correctly convert cash-basis revenue reported for 2006 and 2007 to accrual.

In another significant change intended to streamline the IRS approval processes, the advance-ruling-period system under which new organizations were issued a tentative five-year period of classification as a public charity was eliminated. If the information submitted in the initial application for exemption, Form 1023, establishes to the satisfaction of the IRS that the organization can reasonably be expected to meet a public-support test, the IRS will issue a determination letter stating that the organization qualifies as publicly supported for its first five years as a §501(c)(3) organization and is classified as a public charity. This status continues for the entity's first five years, regardless of the level of public support it in fact receives during this period. The filing of Form 8734 is no longer required. Instead, information provided in Schedule A is the support information used to determine ongoing qualification as a public charity.

The organization will not owe any §4940 tax or §507 termination tax with respect to its first five years regardless of whether it eventually qualifies as publicly supported.³¹ Beginning with the organization's sixth year, a lack of adequate support or governance structure to qualify as a public charity will cause it to become a private foundation and liable for the §4940 excise tax and other Chapter 42 sanctions applicable to private foundations for that year and any future year for which it cannot establish that it is not a private foundation.³²

During an organization's first five years, a box is checked to indicate no support percentages need be reported. Filing of Form 8734 was eliminated; the last filers were those organizations with advance ruling periods ending before June 9, 2008. A new determination letter is not provided, but can be requested by calling 1-877-829-5500. The IRS admits that donors may not be willing to accept a determination letter reflecting an advance ruling period, but advises that such donors should refer to IRS Publication 78; alternatively, the FAQ section advises that donors can call the same Customer Account Services number.

Because an organization that cannot meet a public support test for the current taxable year is at risk of private foundation classification as of the first day of the subsequent taxable year (if it fails the test for that year), organizations should carefully monitor their public support calculations. The IRS and the Treasury Department recognize that an organization may not be able to compute its public support for the current taxable year until sometime in the subsequent taxable year.

Organizations that believe that the imposition of private foundation excise taxes and/or penalties against them for all or part of the first year in which they are reclassified as a private foundation would be unfair or inequitable should contact the IRS, Exempt Organizations, Rulings and Agreements, Washington, DC, at 1-202-283-4905. An organization will be required to provide to the IRS all of the relevant facts and circumstances establishing that imposition of private foundation taxes would be unfair or inequitable due to events beyond the organization's control.

Many agree that the public support test is overly complex and should be simplified. The level of noncompliance is significant, and there is often a lack of awareness of the need to maintain historic donor information. At a minimum, keeping a list of the names of and amount given by donors of more than 2 percent of the total contributions for each five-year rolling average period is necessary for a §509(a)(1)/§170(b)(1)(a)(vi) public charity. For §509(a)(2) entities, a permanently updated list should be maintained for substantial contributors and vendors.³³ This is particularly true for modest organizations that file Form 990-N, which has no display of public support to be prepared for a future year in which Form 990-EZ or 990 must be filed and support information reported.

Support. The 33⅓ percent support formula for donative public charities does not include revenue the organization receives from performing its exempt activities (student tuition or patient fees, for example), unlike the formula for §509(a)(2) service-providing organizations, which does include such revenue.³⁴ Donations of services for which a contribution deduction is not allowed³⁵ are also excluded. Grants from other donative (§509(a)(1)) public charities and governmental entities are fully included in the numerator and denominator for this test, but other types of donations are partly or fully excluded, as next explained. An organization that is primarily dependent on exempt function revenues may qualify as a donative public charity,³⁶ but only if it receives more than an insignificant amount of donations from governmental units and the general public.

Sponsorship payments that are acknowledged by the tax-exempt organization with no quantitative and qualitative information to avoid classification as advertising revenue can be treated as contributions for public support purposes.³⁷

The amount reported as a contribution of noncash property, such as an art object or real estate, is the fair market value of the property for both financial and Form 990 tax purposes.³⁸ The charitable contribution standards limit the deduction for gifts of certain property to the donor's tax basis if it is less than the value.³⁹ Gifts of inventory, intellectual property, food, and more have varying limitations. In a ruling regarding a donation of software, the IRS said that “notwithstanding that a donor's charitable contribution deduction is limited by §170(e)(3),” the full fair market value of such gifts is includible in calculating the public charity support test.⁴⁰

Two Percent Gifts. There is a 2 percent ceiling for donations treated as public support under this test. Contributions from each donor, whether an individual, corporation, trust, private foundation, or other type of entity (after combining related parties), during each five-year period are each counted only up to 2 percent of the charity's total support. For example, say an organization receives total support of $1 million during the five-year test period. In such a case, contributions from each donor (including gifts from his or her related parties) of up to $20,000 could be counted as public donations. If one person gave $20,000 each year for a total of $100,000 for five years, only $20,000 is counted as public. The organization must receive at least $333,333 in public donations of $20,000 or less from each donor to satisfy the one-third support test. It could receive $666,666 from one source and $10,000 from 33 sources or $20,000 from 17 sources, for example.

A question arises when the charity receives a donation from a partnership. Is the donor the partnership or the partnership's individual partners? There is no explicit guidance in the code regulations under IRC §509. The partnership rules⁴¹ do not allow the partnership to take a charitable contribution deduction, so, logically, a distributive share of the gift should be allocable to each partner.

All contributions made by a donor and by any person or persons standing in relationship to the donor, including businesses, that are described in the code definition of disqualified persons⁴² must be combined and treated as if made by a single person.⁴³ Under §4946(a)(1)(E), IRC § 4946 stipulates combination of “a corporation of which persons described in subparagraph (A), (B), (C), or (D) own more than 35 percent of the total combined voting power.” An unanswered question in this regard is whether a donation from a private foundation must be combined with donations of that foundation's disqualified persons for this purpose. The regulations don't follow the same alpha labels but indicate:

§ 53.4946–1(a)(5) For purposes of subparagraph (1)(iii)(a) and (v) of this paragraph, the term “combined voting power” includes voting power represented by holdings of voting stock, actual or constructive (under § 4946(a)(3)),but does not include voting rights held only as a director or trustee.

IRC §4946(a)(1)(H) says “only for purposes of § 4943, a private foundation which is (i) effectively controlled directly or indirectly by the same person or persons … or (ii) substantially all of the contributions to which were made by the same person, or members of their families.” The authors expect that a gift by the donor and her PF should be combined for the IRC §509(a)(1) 2 percent limitation purposes, as has been our practice in the past, but do not find guidance on the matter.

For IRC §509(a)(2) purposes, there is no 2 percent test; instead, support from all disqualified persons (DPs) is excluded entirely. There is no requirement that all DPs be combined; rather, the family member of a substantial contributor is also deemed to be a disqualified person.

Grants from Other Charities. Voluntary grants and donations received by a donative public charity from other charities listed in §170(b)(1)(A)(i)–(vi) and from governmental units, not including foreign governments,⁴⁴ are not subject to the 2 percent limit and instead are fully counted as donations from the general public,⁴⁵ unless the gift was passed through as a donor-designated grant over which the donor has control.⁴⁶

It is important to note that the 2 percent limitation on inclusion in the public support test does not apply to grants from organizations described in IRC §170(b)(1)(A)(vi): in other words, such grants are fully counted.⁴⁷ A grant from those organizations described in §170(b)(1)(A)(i)–(iv) that have sufficient public support to also qualify as donative public charities under §170(b)(1)(A)(vi) is likewise fully counted as public support.⁴⁸ It is sometimes the case that a service-providing organization classified as a §509(a)(2) public charity is also eligible for classification as a public charity under §170(b)(1)(A)(vi). If this fine distinction makes or breaks an organization's qualification as a publicly supported one, the Forms 990 (or for a church not required to file one, a financial statement) of grantors can be evaluated to ascertain their dual qualification as a donative charity.

A grant from a service-providing entity⁴⁹ and a grant from a supporting organization are subject to the 2 percent inclusion limitation.⁵⁰

(g) Facts-and-Circumstances Test

When the percentage of an organization's public donations falls below the precise 33⅓ percent test, it may be able to sustain public charity status by applying the facts-and-circumstances test. The history of the organization's fund-raising efforts and other factors are considered as an alternative method to the strict mathematical formula for qualifying for public support under (a)(1). This test is not available for charities qualifying as public under §509(a)(2). An organization can seek to apply this test to prove it qualifies for public status by submitting the information in the following lists when originally filing Form 1023 or subsequently in submitting the Form 990.

The revised public support test displayed in Schedule A contains a box to check if the organization's public support percentage falls below 33⅓ percent, but is more than 10 percent and the organization can otherwise qualify under the facts-and-circumstances test. Detailed information demonstrating qualification under the facts-and-circumstances exception must provided. To measure ongoing qualification as a public charity, the percentage for the preceding year is shown. The applicant should spare no details evidencing that it meets the test. Brochures, board lists, program descriptions, and fund solicitations can be furnished.

When reviewing Form 1023, the IRS will scrutinize the facts and issue its approval or disapproval. When an organization needs to apply the test later in its life because its support has fallen below the 33⅓ percent level, it submits the calculation and information required by Schedule A of its annual Form 990. It can also choose to file a formal request with the IRS to acknowledge qualification. The problem with only submitting information with Schedule A is that the IRS does not customarily respond to such a filing. Though prior IRS approval is not required, an organization might choose to seek overt approval by submitting the information to the Cincinnati office responsible for determinations, particularly if support has fallen below 33⅓% and the facts- and-circumstances or unusual grant exceptions are used.⁵¹

For the facts-and-circumstances test to apply, the following series of factors must be evidenced.⁵² The first two factors in the following list must be present, and a sufficient number of the other favorable factors must indicate that the organization is responsive to public interests. In the author's experience, control of the board by major contributors or their family members is a major flaw. The factors that are considered are fully explained in the regulations, which should be carefully studied during preparation of information evidencing satisfaction of the test.

• Public support must be at least 10 percent of the total support, and the higher the better.
• The organization must have an active “continuous and bona fide” fund-raising program designed to attract new and additional public and governmental support. Consideration can be given to the fact that, in its early years of existence, the charity limits the scope of its solicitations to those persons deemed most likely to provide seed money in an amount sufficient to enable it to commence its charitable activities and to expand its solicitation program.
• The composition of the board is representative of broad public interests (rather than those of major contributors).
• Some support comes from governmental and other sources representative of the public (rather than a few major contributors).
• Facilities and programs are made available to the public, such as those presented by a museum or symphony society.
• Programs appeal to a broadly based public (and, in fact, the public participates).
• An organization is an educational or research institution that regularly publishes scholarly studies that are widely used by colleges and universities and the public.
• Members of the public having special knowledge or expertise, public officials, or civic or community leaders participate in or sponsor the programs of the organization.
• For a membership organization, the solicitations for dues-paying members are designed to enroll a substantial number of persons in the community or area and the dues amount makes membership available to a broad cross-section of the interested public.

In the author's experience, the IRS seldom questions a claim that fact and circumstances exist to allow a public support percentage of less than 33⅓ percent to qualify for continued qualification as a public charity. Facts to support the position (listed earlier) are submitted with Form 990. No advance approval is required.

A factor not contained in the preceding listed, which appeared in a private letter ruling about application of the facts-and-circumstances test, may cause some confusion. The ruling stated, “You have previously met the one-third support test without the exclusion of any unusual grants. You have never benefited from the use of the exclusion of unusual grants to meet the one-third support test.”⁵³ The regulations clearly permit exclusion of unusual grants from both the numerator and denominator for purposes of making this calculation. This statement may indicate that ongoing claims for different donors will be questioned.⁵⁴

(h) Unusual Grants

When inclusion of a substantial donation(s) causes an organization to fail the 33⅓ percent public support test, public charity status may still be sustained by excluding such gift(s) for both (a)(1) and (a)(2) purposes. A grant is unusual if it is an unexpected and substantial gift attracted by the public nature of the organization and received from a disinterested party. Factors evidencing “unusualness” follow. No single factor is determinative, and not all factors need be present. The eight positive factors are shown in the following list, along with their opposites in parentheses:⁵⁵

1. The contribution is received from a party with no connection to the organization. (The gift is received from a person who is a substantial contributor, board member, or manager, or is related to one.)
2. The gift is in the form of cash, marketable securities, or property that furthers the organization's exempt purposes. (The property is illiquid, difficult to dispose of, and not used or to be used for mission activities.) A gift of a painting to a museum or a gift of wetlands to a nature preservation society would be useful and appropriate property.⁵⁶
3. No material restrictions are placed on the gift. (Strings are attached.)
4. The organization attracts a significant amount of support to pay its operating expenses on a regular basis, and the unusual gift adds to an endowment or pays for capital items. (The gift pays for operating expenses and is not added to an endowment.)
5. The gift is a bequest. (The gift is an inter vivos transfer.)
6. An active fund-raising program exists and attracts significant public support. (Fund solicitation programs are unsuccessful or nonexistent.)
7. A representative and broadly based governing body controls the organization. (Related parties control the organization.)
8. Prior to the receipt of the unusual grant, the organization qualified as publicly supported. (The unusual grant exclusion was relied on in the past to satisfy the test.)

If the grant is payable over a period of years, it can be excluded each year, but any income earned on the sums would be included.⁵⁷ The IRS has provided a set of “safe harbor” reliance factors to identify unusual grants. If the first four factors just listed are present, unusual grant status can automatically be claimed and relied on. As to item 4, the terms of the grant cannot provide for more than one year's operating expense.⁵⁸

A proposed substantial grant by a new donor (Factor #1) to an IRC §509(a)(1) publicly supported organization to enrich lives of at-risk youth and foster children by providing programs that restore and increase self-esteem, self-worth, self-sufficiency, and opportunity for long-term success constituted an “unusual grant” under Reg. §1.170A-9(f)(6)(ii) and related provisions.⁵⁹

A bequest from an estate (Factor #5), the size of which was unusual compared with the foundation's support levels, would have adversely affected the foundation's status as a public charity. The decedent had not previously contributed a substantial part of the foundation's support (Factors #1 and #8 on the preceding list). The bequest was not burdened with any material restrictions other than the establishment of a fund to benefit public charities (Factor #3).⁶⁰

A grantor in another ruling did not exercise control over the grantee and was not a disqualified person with respect to it (Factor #1); the prospective grantee had a public solicitation program and a representative governing body (Factors #6 and #7).⁶¹

A private foundation operating a sculpture garden, park, and museum had previously used the unusual grant exception (Factor #8). Nonetheless, its request for unusual treatment again (meant not counted in calculation) was approved for a significant donation amount of artwork. It was a public charity (Factor #8) and had an active fund-raising program (Factor #4) and a representative governing body (Factor #7).⁶²

An unusual grant occurred when it was higher than the typical level of support from a new donor (Factor #1) not in a position of authority and in the form of a bequest (Factor #5) without any material restrictions other than that the funds were to benefit specific designated charities (Factor #3). The contribution was in the form of securities, cash, and properties, which were to be sold and the earnings used to benefit the designated charities. The board of directors consisted of 18 community leaders, and the organization had previously met the public support tests (Factors #7 and #8).⁶³

In one last example, the ruling concerned an expected endowment fund bequest in the form of cash or investments. The grant was to be used to benefit community residents at the discretion of the board of directors. One small grant from the testator had been received several years ago. The testator was the organization's creator and did not stand in a position of authority in the organization. The entity had a successful public solicitation program to attract public support and consistently met the public support test. Last, the entity had a large board that included an elected county official, an elected member from the local board of education, and an officer/employee of a local bank from the community, as well as three directors elected at large.

Form 8940, reproduced in §18.4 and issued June 2011, can be submitted to seek approval for claiming that a major grant is an unusual grant. This application requires a fee that readers should verify on instructions to the form. Previously, this recognition required a costly letter ruling. Responses to this form usually come in a month or two, which is also helpful. An organization may not realize it wishes to make a claim that a grant is unusual until it tallies up its finances after year-end and finds that its public support ratio is below 33⅓ percent. Nonetheless, there is potential that the request will not be approved prior to the return filing deadline. This possibility should be anticipated as soon as the gift (cash or pledge) is received.

(a) Single-Entity Test

All legally separate entities operating under the aegis of the community foundation and meeting the criteria outlined here are treated as part of a single entity, rather than as separate funds. The individual funds associated with a CF—whether trusts, not-for-profit corporations, unincorporated associations, or a combination thereof—are not treated as separate legal entities for tax purposes. Essentially, they are considered as part of a consolidated group and do not separately apply for recognition or exemption.⁷⁴

• Name The organization must be commonly known as a community trust, fund, foundation, or other similar name conveying the concept of a capital or endowment fund to support charitable activities in the community or area it serves.
• Common Instrument All funds of the organization must be subject to a common governing instrument or a master trust or agency agreement, which may be embodied in a single or several documents containing common language. Making the component fund subject to the CF's governing instrument in the transfer documents is acceptable.
• Common Governing Body A single or common governing body or distribution committee must control all components. Any restricted funds dedicated to a particular purpose or organization must be monitored by the governing body.
• Power to Modify or Remove The CF's governing body must generally have the power—in the governing instrument, instrument of transfer, bylaws, or other controlling documents—to modify any restriction or condition on the distribution of funds. Particularly when a restriction or condition becomes, in effect, unnecessary, incapable of fulfillment, or inconsistent with the charitable needs of the community or area served, the CF must be able to prevail in disbursing the funds or income therefrom.
• Exercise of Powers There must be a written resolution to replace any participating trustee, custodian, or agent for breach of fiduciary duty under state law. A breach would result when the charitable purposes are jeopardized due to improper disbursements of funds or a failure to produce a reasonable return on assets, for example.
• Common Reports The periodic financial reports must be presented in a consolidated manner treating all funds as CF funds.

The variety of funds cited by the IRS as acceptable examples of component funds that can be offered or maintained within a CF include the following:⁷⁵

• Unrestricted Funds The CF has unfettered use of these funds—both the income and the principal. No restrictions or conditions on the management or distribution of the moneys can exist. The CF, not the donor, is expected to identify community needs and distribute funds according to those needs.
• Memorial Funds Funds can be named after a particular person, family, private foundation, or historic event or catastrophe.
• Field-of-Interest Funds These funds can be dedicated to a particular charitable need or concern: the arts, the poor, the homeless, higher education, religion, or similar charitable and social concerns. The types of interests for which funds are made available may be broad or narrow and can be designated or requested by the donors. The manner in which the interest is pursued, however, is up to the CF itself (whether to directly conduct a program or re-grant the funds to another organization serving the interest).
• Advised Funds The donor is given the right to make nonbinding suggestions as to the specific organization or projects to receive funding. The CF retains final authority to determine use of its income. See further discussion later in this section regarding limitations on donor designations.
• Designated Funds The donor may specify the charitable purpose(s) or organization(s) to be supported with his or her funds.
• Agency Endowments A designated fund supporting a particular local charity may be established within the CF. The charity solicits donations made payable into the fund for its benefit. Such an agency arrangement may be advantageous to the local charity from an investment management standpoint.
• Pooled-Income Funds The income is paid to the donors during their lives, and upon the donors' death the principal and income are distributed to the CF.

(b) Component-Part Test

Each qualifying component must be created by a gift, bequest, legacy, device, or other transfer to a community trust treated as a single entity, and the gifts may not be directly subjected by the transferor to any material restriction or condition.⁷⁶ Even if the donor is not a private foundation, the rules applicable to private foundations that make transfers to CFs upon termination apply. A donor may not encumber a fund with a restriction that prevents the CF from “freely and effectively employing the transferred assets, or the income derived therefrom, in furtherance of its exempt purposes.”⁷⁷ Essentially, the regulations are intended to prevent the creation of pseudo-private foundations under an umbrella CF. The following donor-imposed restrictions are not considered material and are therefore allowed:

• Name The fund may take the name of a private foundation, the fund's creator, or the creator's family.
• Purpose The donor may designate that the income and principal be used for specified charitable purposes or one or more §509(a)(1), (2), or (3) organizations. The CF's governing body must be given the power to stop distributions and recover any funds that were not used for the CF's exempt purposes.
• Administration A separate or identifiable fund may be required by the donor. Distribution of some or all of the principal can be delayed in time.
• Required Retention of Gift A donor may require the CF to keep the property if, because of the property's peculiar features (such as a historic property or wildlife preserve), its retention is important to accomplishing the exempt purposes of the community.

(c) Donor Designations versus Donor Directions

Donors may designate the purposes for which their funds are to be expended before or at the time the gift is made—not later. Reservation of the right to choose grantees or programs (donor direction) is not permitted once the fund is established. Recognizing that moral suasion can be imposed by philanthropists even without written direction, the regulations provide a list of factors indicating that donors have not reserved a right to designate:⁷⁸

• The CF investigates the donor's advice and its investigation shows that the advice is consistent with specific charitable needs most deserving of support in the community.
• The CF has published guidelines listing the specific charitable needs of the community and the donor's advice is consistent with those guidelines.
• The CF has begun an educational program advising donors and other persons of its guidelines that list the specific charitable needs most deserving of support. These needs must be consistent with its charitable purposes.
• The CF disburses other funds to the same or similar organizations or charitable needs as those recommended by the donor. Other funds are from sources other than, and in excess of, those distributed from the donor's fund.
• The CF's solicitation for funds specifically states that it will not be bound by any advice the donor offers.

Impermissible donor retention of control is evidenced, according to the regulations, by the presence of two or more of the following factors:⁷⁹

• The only criterion considered by the CF in making a distribution of income or principal from the donor's fund is the donor's advice.
• Solicitations of funds by the CF state or imply that the donor's advice will be followed. Also considered is a pattern of conduct by the CF that creates an expectation that the donor's advice will be followed.
• The donor's advice is limited to distributions of amounts from his or her fund and the CF has not (1) done an independent investigation to evaluate whether the donor's advice is consistent with the charitable needs most deserving of support in the community, or (2) established guidelines that list the specific charitable needs of the community.
• The CF solicits advice regarding distributions from the donor's fund only from the donor, and no procedure is provided for considering advice from others.
• The CF follows the advice of all donors concerning their funds substantially all the time.

A bequest to a community foundation to establish a designated fund to support public charities following the CF's customary procedures was found to be an unusual grant excludable from the calculation of its public support test.⁸⁰ Of the eight factors listed on this page, the ruling particularly noted that the exclusion was generally intended to apply to the following type of substantial contributions or bequests from disinterested parties:

• Bequest was attracted by reason of the publicly supported nature of the CF.
• Size of the contribution is unusual compared to CF's typical level of support.
• Contribution may, by reason of its size, adversely affect CF's status as normally being publicly supported.

The particular factor noted in the ruling that would have brought a negative ruling was a donor's prior relationship to the organization, evidenced by one of the following facts:

• Donor created the organization,
• Donor had previously contributed substantial support or an endowment,
• Donor stood in position of authority with respect to the organization,
• Donor directly or indirectly exercised control over the organization, or
• Related party of donor possessed the aforementioned characteristics.

Additionally, the ruling noted that the gift was a bequest without any material restrictions other than that the funds were to benefit specific designated charities, that the gift was in the form of marketable securities, that the CF's board of directors consisted of 18 community leaders, and that the CR had previously met the public support tests. In other words, most of the factors on the list were positive.

This ruling is of interest because the regulations refer to the list as a “set of safe-harbor reliance factors” to identify unusual grants without the need for a private ruling.⁸¹ See §11.2(h) for discussion of such grants.

(d) Public Support Test

A community foundation must submit each year, on Form 990, complete financial information to calculate its percentage of public support. Part I of Schedule A contains a separate box to identify an organization as a “community trust.” The regulations specifically say that a CF must meet the 33⅓ percent public support test or, if not, the facts-and-circumstances test.⁸²

(e) Impact of Pension Protection Act of 2006

The Pension Protection Act of 2006 (PPA) essentially imposes private foundation–type constraints on advised funds, referred to in the legislation as “donor-advised funds (DAFs).” A DAF is defined, for the first time in the tax code, as a fund or account that:⁸³

1. Is separately identified by reference to contributions of a donor or donors.
2. Is owned and controlled by a sponsoring organization.
3. Is one with respect to which a donor (or any person appointed or designated by such donor) has, or reasonably expects to have, advisory privileges with respect to the distribution or investment amounts held in such fund or account by reason of the donor's status as donor.

The revised code contains rules to prohibit transactions between the DAF and its donors. The fact that the donor did not technically control the advised-fund sponsor previously shielded private benefit transactions between the fund creator and his or her designated fund from intermediate sanction penalties.⁸⁴ Those rules now provide that an automatic excess benefit occurs as a result of “any grant, loan, compensation, or other similar payment from such fund to a donor and his or her related parties and controlled companies.”⁸⁵ Note that an automatic excess benefit does not occur with a “payment pursuant to bona fide sale or lease of property.”⁸⁶ The transaction would, however, have to occur for no more than fair market value to avoid the normal excess benefit penalties.⁸⁷

A donor-advised fund now makes a “taxable distribution” if it makes a payment to a “natural person,” for a noncharitable purpose, or to a Type III non-functionally integrated supporting organization, private foundation, or other organization that is not a permitted public charity without exercising expenditure responsibility.⁸⁸ In addition to imposing automatic excess benefit penalties on transactions with donors, the code also prohibits a distribution that provides a more-than-incidental benefit as a result of such distribution to the DAF's donors and imposes a 125 percent tax on such a transaction.⁸⁹

A benefit is more than incidental if, as a result of a distribution from a DAF, such person receives a benefit that would have reduced or eliminated a charitable contribution deduction if the benefit was received as part of the transaction.⁹⁰ The private foundation rules on self-dealing provide some clues.⁹¹ The tax does not apply if a tax has already been imposed with respect to such distribution under IRC §4958. In addition, a 10 percent excise tax applies to a fund manager who makes a taxable distribution knowing that it is a taxable distribution.

Excess business holding rules also apply to donor-advised funds.⁹²

A payout requirement has not yet been imposed on donor-advised funds. Based on a congressional mandate, the IRS in late 2007 conducted a compliance study of organizations holding DAFs. Statistical information, including number of funds, grants paid out, total assets, type of investments held, nature of policies indicating the organization has dominion and control of the funds, and other operational details were requested and are being compiled. Readers should watch for proposals for new rules based on the results of the study. The questions the IRS must answer are:

• Whether the values of charitable income, estate, and gift tax deductions allowed are appropriate in view of the charitable use of those assets compared to use of assets for the benefit of the donor.
• Whether a minimum distribution requirement is needed for DAFs.
• Whether gifts to DAFs should be treated as “completed gifts” eligible for charitable deduction.

A Guide Sheet was issued August 19, 2008 (exactly two years after the effective date of the Pension Protection Act of 2006) that contained new IRM 7.20.8 on donor-advised funds, which should be carefully studied by persons managing such funds. Issues the IRS will consider in granting exemption to a DAF are addressed. Exhibit 11.4 compares the attributes of donor-advised funds, supporting organizations, and private foundations. Readers should be alert for new developments on proposed regulations issued in Notice 2017-73.

Notice 2017-73 outlines IRS proposals regarding three important aspects of activity for a donor-advised fund under §4958(f)(7), with a view to defining “incidental benefit” similar to concepts and rules for private foundations,⁹³ also referring to §4958(f)(7) which imposes a tax on excess benefit transactions. Comments included in the notice look at both sides of the issue of “incidental benefit.”

Gala Tickets. Distributions from a DAF that pay for the purchase of tickets that enable a donor, donor advisor, or related person to attend or participate in a charity-sponsored event do result in a more-than-incidental benefit to such person. The Treasury and IRS view of such purchases deems that such payments should be prohibited.

Donor Advisor or Related Person Pledges. Somewhat surprisingly, distributions from a DAF that the distributee charity treats as fulfilling a pledge made by a donor, donor advisor, or related person do not result in a more-than-incidental benefit under §4967. This result was based on a commentator's⁹⁴ suggestion that determining whether a pledge is legally binding “may unduly complicate charitable giving.” Also, some said that determining whether a pledge is enforceable under state law is inherently difficult with different results in different states. Others noted that determining whether a pledge is enforceable is impractical and imposes an undue administrative burden on the IRS. Thus, in this notice, the Treasury and IRS state their view that, in the context of DAFs, it is best left to the distributee charity which has knowledge of the facts surrounding the pledge.⁹⁵

Distributions. The Treasury Department and the IRS are “considering developing proposed regulations that would change the public support computation for organizations described in § 170(b)(1)(A)(vi)/§ 509(a)(1) and in § 509(a)(2) to prevent the use of DAFs to circumvent the excise tax rules applicable to private foundations.” DAF-holding organizations, customarily referred to as “community foundations,” receive a broad base of support from many sources, enabling them to meet the mechanical 33⅓ percent public support test.⁹⁶ A 2 percent test limits inclusion of an individual and his or her related and controlled parties⁹⁷ in the calculation of public support. Due to the public charity status of the DAF-holding entity, grants from DAFs are treated as unlimited public gifts. The suggestion is whether DAF grants should be attributed to their creators and not treated as a public donation. The suggestion is to combine DAF gifts with those of individual substantial contributors, which would deprive the ultimate recipient of the funds of the ability to qualify as a public charity.

The notice stated that the Treasury Department and the IRS continue to develop proposed regulations that would, if finalized, comprehensively address donor-advised funds. The notice is intended to provide interim guidance on the three specific issues and to solicit additional comments in anticipation of issuance of further guidance.

(a) Definition of Support

The items of gross income included in the requisite “support” are different for each category and do not necessarily equal total revenue under either class. Calculations for both categories are made on a five-year moving aggregate basis using the organization's normal method of accounting.

For (a)(1) purposes, certain revenues are not counted as support and are not included in the numerator or the denominator:¹¹⁰

• Exempt function revenue, or that amount earned through charges for the exercise or performance of exempt activities, such as admission tickets, patient fees, tuition, and similar fees.
• Capital gains or losses.
• Unusual grants.
• Donations of in-kind services and facilities (do count facility and service donations from governmental units).

For (a)(2) purposes, total revenue, including exempt function revenue, less capital gains or losses, unusual grants, and in-kind service and facility donations equals total support. An increase or decrease in the equity value of an organization's for-profit subsidiary is recognized as revenue for financial statement purposes. Such revenue is essentially capital in nature. The author finds no guidance on the subject and suggests that such revenue is excluded from total support for both §509(a)(1) and §509(a)(2) organizations, but she invites comments.

Schedule A creates two separate five-year calculations for §509(a)(1) and (2) that should eliminate mistakes in the future. Accrual-reporting organizations may be delighted that the calculation no longer requires revenues reported on a cash basis.¹¹¹ A box to be checked during the advance ruling period instructs the filer to stop short of making the “Public Support Percentage.” For (a)(1) filers, the form also provides a box for the facts-and-circumstances test.

(b) Donations/Grants Not Counted

Contributions received are counted as public support differently for each category. For planning purposes, these rules are extremely important to consider. Under the (a)(1) category, a particular giver's donations are counted only up to an amount equal to 2 percent of the total “support” for the five-year period.¹¹² Gifts from §170(b)(1)(A)(vi) public charities and governmental entities are not subject to this 2 percent floor; some say grants from those classified as public under §170(b) (1)(A)(i)–(v) are to be counted only up to 2 percent.¹¹³

For (a)(2) purposes, all gifts, grants, and contributions are counted as public support, except those received from disqualified persons.¹¹⁴ Such a person may be a substantial contributor or current board member and the close relatives of such persons. A substantial contributor is one who has given more than $5,000, if such amount is more than 2 percent of the aggregate contributions received by the organization throughout its life.¹¹⁵ For (a)(2) purposes, gifts from these insiders are not public support. Subject to the 2 percent ceiling, their gifts are counted for (a)(1) purposes. Grants from other public charities classified under §509(a)(1) are fully counted. Although they are excluded from the definition of substantial contributors under IRC §507, another §509(a)(2), a §509(a)(3), or other category of §501(c) organization is treated as a disqualified person and its grants are subject to limitations on their inclusion in public support for this purpose.¹¹⁶

(c) Types of Support

New accounting standards effective in 2018 may significantly impact the public support test for some nonprofits. Readers should study new subsection (g) for a report on the changes.

Not all revenue is counted as support. The basic definition of support for both categories excludes capital gains from the sale or exchange of capital assets, but other types of gross revenue are counted differently under the two categories.

1. Individual contributions Volunteer payments motivated by the desire to help finance the exempt activities of both types of public charities are treated as contributions.¹¹⁷ Such payments are made with the intention of making a gift with no expectation of return or consideration other than intangible recognition, such as inclusion of a name on a sponsor list or on a church pew.
2. Business donation Grants from corporations or other businesses are similarly reported as direct public support by both types. Proceeds of a cause-related marketing campaign, also referred to by the IRS as commercial co-ventures, are treated as contributions.¹¹⁸ No value is assigned to the fact that purchase of business products is encouraged by use of the charity's name in such a sales promotion. Sponsorship payments that are acknowledged by the tax-exempt organization without quantitative and qualitative information and are not classified as advertising revenue can be treated as contributions for public support purposes by both categories.¹¹⁹

Membership fees for both categories may represent a charitable donation or fee for services depending on “commensurate rights and privileges” provided to members. A pure donation exists when the benefit is merely the personal satisfaction of being of service to others and furthering the charitable cause in which the members have a common interest.¹²⁰ When the payment purchases admission, merchandise, services, or the use of facilities, an exchange transaction occurs and service revenue is realized. In some cases, a combined gift and payment for services may be present. The facts in each circumstance must be examined to properly classify the revenue. Under the enhanced scrutiny of the IRS's Special Emphasis Program on deductibility of charitable gifts, some organizations realized that their members are not necessarily making contributions.¹²¹ In such cases, the donor disclosure rules must be studied.¹²² Particularly for (a)(1) purposes, this distinction is very important, because exempt function fees are not included in the public-support calculations.

Government grant awards that represent support for the recipient organization to carry on programs or activities that further its exempt purposes are treated as contributions.¹²³ Such grants are said to give a direct benefit primarily to the general public rather than an economic or physical benefit to the payor of the grant. Instead, some grants are payments in exchange for services to serve the needs of the government agency.¹²⁴ Government support for an organization that produces a television program aired on government and local access channels; that conducts forums for educating citizens and communities on issues of local interest; that produces and coordinates training programs for city officials and local government employees, businesspeople, and interested citizens; that promotes city government month; and that encourages local governments to develop new ways to improve services and operations was found to be a contribution.¹²⁵ The language used in the ruling expands the regulation description of the condition under which a government grant is treated as a donation as follows:

A grant is normally made to encourage the grantee organization to carry on certain programs or activities in furtherance of its exempt purposes. It may contain certain terms and conditions imposed by the grantor to insure the grantee's programs or activities are conducted in a manner compatible with the grantor's own programs and policies and beneficial to the public. The grantee may also perform a service or produce a work product which incidentally benefits the grantor. Because of the imposition of terms and conditions, the frequent similarities of public purposes of grantor and grantee, and the possibility of benefit resulting to the grantor, amounts received as grants for the carrying on of exempt activities are sometimes difficult to distinguish from amounts received as gross receipts from the carrying on of exempt activities. The fact that the agreement, pursuant to which payment is made, is designated a contract or a grant is not controlling for the purposes of classifying the payment under §509(a)(2).

When a sale of goods, performance of a service, or admission to or use of a facility must be delivered or provided specifically to the grantor, exempt function revenue is received. Money a health-care provider collects from the state for treatment of indigent patients is referred to under generally accepted accounting principles (GAAP) as exchange transactions. The terms of the grant agreement indicating gross receipts from a service contract, as contrasted to those terms identifying a contribution, might include the following:

• Specific delivery of services is required within a specific timeframe (time for performance at discretion of grantee).
• Penalties beyond the amount of the grant can be imposed for failure to perform (the only penalty is return of the grant for not conducting a specific program or some other restriction).
• Goods or services are furnished or delivered only to the grantor (program recipients are other than the grantor).

Under both categories, this distinction is important to determine amounts qualifying as contributions. For (a)(2) status, the distinction has yet another dimension. The amount of service fees included as public support from a particular person or organization is limited to 1 percent of gross revenue or $5,000, whichever is higher.¹²⁶ This limitation on inclusion of service fees means that an organization performing services for a small number of contractors cannot reach the required 33⅓ percent support level under §509(a)(2). Say, for example, that an organization that studies child abuse cases receives most of its revenue from two state agencies. Because only 1 percent of each agency's support can be counted, the organization may have as little as 2 percent qualifying support. Such an organization, dependent primarily on gross receipts from related activities, is precluded from qualifying instead as a §509(a)(1) organization if “it receives an insignificant amount of its support from governmental units and contributions made directly or indirectly by the general public.”¹²⁷ Moneys received from a third-party payor, such as Medicare or Medicaid patient receipts¹²⁸ or charges collected by a hospital as agent for a blood bank,¹²⁹ are considered as gross receipts from the individual patients for services rendered.

In-kind gifts are counted differently for each category. For (a)(1) purposes, the regulation specifically says that support does not include “contributions of services for which a deduction is not allowable.”¹³⁰ For (a)(2) purposes, the regulation says that support includes the fair market or rental value of gifts, grants, or contributions of property or use of such property on the date of the gift.¹³¹ Under (a)(1), the regulations and the IRS instructions to Form 990 are silent about gifts of property that are deductible. It is not stated whether the full fair market value of property whose deductibility is limited to the donor's tax basis,¹³² such as a gift of clothing to a charity resale shop, is counted at full value or at basis. For accounting purposes, the organization would count such gifts at their full value.

Supporting organization grants and split-interest trust gifts to an (a)(1) public charity are subject to the 2 percent limit. Importantly for (a)(2) entities, such gifts also retain their character as investment income for purposes of limiting the amount of investment income it is allowed to receive.¹³³

(d) Funds Received as Agent

Grants received from another public charity are counted totally toward public support unless the gift represents an indirect grant expressly or implicitly earmarked by a donor to be paid to a subgrantee organization. In that case, the donor for public support purposes is the individual.¹³⁴ Donor-designated grants therefore require careful scrutiny. The basic question is whether the intermediary organization received the gift as an agent or whether it can freely choose to re-grant the funds. Donations received by donor-advised funds and community foundations qualify as public support to the initial recipient organization (and again to the ultimate recipient) if the fund retains ultimate authority to approve the re-grants.¹³⁵

What constitutes a variance power over a grant received by a fund-raising organization has been the subject of a lot of discussion and concern since the Financial Accounting Standards Board issued its FASB #136 in June 1999. The standard says that “when acting as an agent, trustee, or intermediary,” the reporting entity does not recognize revenue. A fund-raising organization is an agent when it receives gifts designated for specified beneficiaries unless the donor specifically grants “variance power” in the instrument conveying the gift. Such a power is defined as a “unilateral power to redirect the use of the transferred assets away from the specified third-party beneficiary.” The United Way of America vigorously objected to the issuance of this standard. With a significant decline in its reportable revenues, the United Way's ratio of organizational costs to revenues would be unacceptably high. After losing the FASB battle, the United Way of Southeastern Pennsylvania (UWSP) asked the IRS for its opinion on the matter.¹³⁶ Based on the facts and circumstances, the IRS determined that donations to UWSP's Donor Choice/Specific Care Program were reportable as revenue. Facts indicated to the IRS that the UWSP exercises a significant degree of control and discretion over the designated funds. UWSP receives payment of the pledges and is entitled to income from investing the money until it is paid out on one of five annual distribution dates. UWSP has the discretion to approve, or fail to approve, the application of any organization that is suggested as a designated recipient. UWSP as a policy withholds distributions from charities in legal or other troubling situations that leave doubt as to the charities' ability to use the funds for charitable purposes. Additionally, UWSP recovers its fund-raising costs from pledged gifts through a charge against such pledges. Because UWSP controls the amount of its costs, it “virtually controls the gift to the designated charity.” The IRS ruled that UWSP had sufficient interest in the pledges it received to be considered as possessing all right, title, and interest in and to the pledges of designated gifts.¹³⁷ Therefore, the designated gifts could be counted as public support by UWSP because they were not “earmarked.” The ruling also noted that UWSP's Form 990 would reflect a reconciling item adding designated gifts to revenues reported for financial statement purposes.

(e) Change of Public Charity Category

Sometimes the sources of a public charity's support change, causing it to fail to qualify under one category or another. When the change indicated is reclassification from (a)(1) to (a)(2) or vice versa, the factors discussed in §18.3(e) should be considered. Simply reporting the financial information on Schedule A may be sufficient to allow an organization to continue its public status; the issue is whether to seek overt IRS approval and a new determination letter.

Many charities classified as §509(a)(3) supporting organizations (SOs) receive revenues that also qualify them as a §509(a)(1) or (2) public charity. Faced with restraints placed on SOs discussed in §11.5(f), the IRS fortunately designed a process in 2006 to facilitate receipt of new classification for those that could qualify.¹³⁸ This process, intended solely for supporting organizations seeking reclassification as §509(a)(1) or §509(a)(2) organizations, has now been superseded by a general process for recognition of various changes in public support status.¹³⁹ A request for recognition of a change in status to §170(b)(1)(A)(vi) or §509(a)(2) must include the following:

• Either the organization's most recent signed Form 990 with a completed Schedule A that shows the organization qualifies for the requested public charity status or the organization's support information for the past five completed tax years.
• A list showing the names and amounts received from donors exceeding 2 percent (for §170(b)(1)(A)(vi) requests) or names and amounts received from substantial contributors (for §509(a)(2) requests). Also for §509(a)(2) requests, a list showing the name and amount received for earned revenue that exceeds the greater of $5,000 or 1 percent of total support for the year must be provided.
• Appropriate user fee.

(f) Loss of Public Status

A more serious situation arises when the changes in support cause the organization to lose its public charity status. Importantly, the loss of status is not immediate: if the financial tally submitted with the organization's 2010 return reflects that support for the years 2006–2010 was less than the requisite one-third, public status is still maintained for that year, assuming the organization qualified as public for 2009. If the support ratio was below 33⅓ percent in 2009, however, the entity becomes a private foundation for 2010.

Special rules also apply for new organizations.¹⁴⁰ Until a change of status is announced in the Internal Revenue Bulletin, contributors are entitled to rely on the latest IRS letter. A donor who is responsible for or otherwise aware of the changes is not necessarily entitled to such reliance.¹⁴¹ This issue is particularly troublesome for private foundations.¹⁴²

Consequence of Loss. When the former public charity becomes a private foundation, it is subject to the special sanctions imposed by IRC §§4940-4945 (discussed in Chapter 12). The contribution deduction level for its donors falls, it becomes subject to an excise tax on its investment income, it must meet an annual charitable expenditure test, and it becomes subject to restrictions on transactions with its governing officials. Exhibit 11.1 visually reflects the differences. Regulations finalized in 2011 provide that for the first year of reclassification as a private foundation, a former publicly supported charity will only be subject to §4940 (excise tax on net investment income) and §507(c) (termination tax).¹⁴³ For succeeding taxable years, it will be a private foundation for all purposes.

Avoiding Loss. A charitable organization classified as a public charity for reasons of its revenue sources should monitor its ongoing qualification with projections of future support. Development department targets should be set with a view both to the annual spending needs of the organization and also to meeting the 33⅓ percent test. The test is based on a five-year moving aggregate, and the results can vary significantly from year to year. Say, for example, a new organization was successful in soliciting donations for an endowment fund from a significant number of supporters in its first year of existence. Or, for a different but similar situation, assume a new organization was created to receive the assets of a nonprofit hospital (meeting the §170(b)(1)(A)(vi) tests) that sold its health-care operations to another entity. The funds are to be invested to raise funds to support public health programs. In both cases, the support in its first year of existence results in a very high public support level of 80 percent. The donations in the first year affect (and improve) the ratio for five years. It is in the sixth year, when they are not counted, that the ratio could fall to below 33⅓ percent (when most of the funding comes from investment income).

An organization that expects its support level to fall below 33⅓ percent can take a number of steps. First, the accounting classification of its revenues and the category of public support should be evaluated to be sure they are correct. It is often the case that an organization can qualify as both a §509(a)(1) and a §509(a)(2) organization; thus, the calculations should be made under both categories. Accounting standards treat some government grants as fee-for-service revenue that, under tax standards, can be treated as donations.¹⁴⁴ Next, past donations can be reviewed to determine if any major grants can be excluded from the calculation because they possess most of the eight criteria for an “unusual grant.”¹⁴⁵ The organization would also review its satisfaction of the nine criteria for meeting the facts-and-circumstances test.¹⁴⁶

Both of these tests involve some amount of subjective judgment as to qualification. In the latter test, however, there are facts that an organization can seek to achieve with advance planning. The board can be expanded to prove it represents broad public interests. Programs can be designed that involve public institutions and government and community leaders. The scope and participation in programs could be targeted for expansion. New solicitation techniques could be attempted. The point of the facts-and-circumstances test is to show that, despite its receipt of large donations from a few sources, the organization is responsive to and designed to benefit a broad public constituency and is not controlled by private individuals. Lastly, if the projects indicate that the organization will not be able to meet any of the public-support tests, the organization might initiate its merger with or acquisition by another public charity.

(g) Review of New FASB Standards Impact Revenue Recognition for Grants

The August 2018 newsletter of the accounting firm BDO provided this good summary of the new standards.

Nonprofits received long-awaited clarification on a key accounting question from the Financial Accounting Standards Board (FASB) today. The FASB released a final accounting standards update (ASU), Not-for-Profit Entities (Topic 958): Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made. The ASU aims to standardize how grants and other contracts are classified across the sector, as either an exchange transaction or a contribution.

What does this new guidance change for nonprofit organizations, stakeholders, and donors? The latest guidance from the FASB arrives at a time when nonprofit chief financial officers (CFOs), controllers, and other key financial players are facing a fast-approaching deadline to implement new revenue recognition requirements (Topic 606). The revenue standard aims to improve accounting for contracts with customers, but it also introduces a layer of complexity and challenge to nonprofits of every size. The newly released second edition of Nonprofit Standards, BDO's benchmarking survey, offers a glimpse of the administrative burden regulatory changes place on nonprofits: 45 percent of organizations say the time and effort required to deal with regulatory and legislative changes pose a moderate- or high-level challenge.

Revenue recognition brought to light a diversity of practice in the way that nonprofit organizations and funders classified grants and contracts from federal, state and local governments, and other funding sources such as foundations in the financial statements, with some categorizing them as contributions and some as exchange transactions.

What makes standardizing practices so important now? Contributions, defined as an unconditional transfer of cash or assets in a voluntary nonreciprocal transfer, are scoped out of revenue recognition. Exchange transactions—a reciprocal transaction in which two parties exchange something of commensurate value—are within the scope and need to be accounted for following the new revenue recognition requirements.

In a recent BDO webinar, my colleagues and I discuss that classifying grants as either a contribution or exchange transaction is the first step in implementing revenue recognition. The clarified guidance aims to help nonprofits complete that first step in a consistent way across the sector.

Practical Example: How to Evaluate a Grant under the New Guidance

• Description of Nonprofit A: A large research association that specializes in space exploration. Their mission is advancing scientific discoveries and supporting the advancement of new technology. The organization receives funding from various individuals, corporations, and governments to support its efforts.
• Description of the grant: Nonprofit A received a $15 million grant from the federal government to finance the costs of a research initiative to test the effectiveness of newly developed technology.
• How should Nonprofit A classify the $15 million grant? This grant could be classified as either an exchange transaction or a contribution, depending on the exact parameters of the funding. Let's examine both scenarios:

Disclaimer: These examples are for illustrative purposes only. Changing even one fact in the example could significantly change the accounting treatment.

What types of organizations need to take action?

• Grantees: All nonprofits that receive grants from foundations, governments, or other funding entities will need to assess how they are accounting for contributions. College, universities, research institutions, and social services organizations that rely heavily on grants and contracts could see the greatest impact.
• Grantors: Non-governmental organizations like public and private foundations, as well as for-profit entities that issue grants to nonprofits, will need to think about how they write their grants and contracts.

What organizations will not experience a significant impact?

• Public charities: As organizations that derive the bulk of their funding from individual contributions, they will be less impacted by this guidance.
• Local, state, and federal governments: Nonprofits will still need to assess how they classify federal and state funding, but governmental bodies are not within the FASB's scope and do not need to comply with this guidance. Governments are subject to standards issued by the Governmental Accounting Standards Board (GASB).

What's next for nonprofits?

Accounting changes are like a relay race. Today, the FASB handed off clarified guidance on accounting for contributions and answered a longstanding question for the sector. And now it's up to nonprofits to apply it to their own books, run the rest of the race to implement revenue recognition, and finish strong.

(a) Purpose Clause

A supporting organization must be organized and, at all times thereafter, be operated exclusively:

• For the benefit of,
• To perform the functions of, or
• To carry out the purposes of one or more specified IRC §509(a)(1) or (2) organizations—a “public charity.”¹⁵²

The articles of organization must limit the purposes to those previously listed, in addition to the regular constraints on operations imposed on §501(c)(3) organizations.¹⁵³ The categories of purpose—whether charitable, religious, or educational—may be very broad. Classic examples of suitable SO purposes would be to raise money for the publicly supported hospitals in an urban medical center, to fund the medical library of the center, or to build and maintain a chapel for the center.

(b) Specified Public Charities

Supporting organizations most commonly operate to benefit one or more specified public charities, as literally required by the code and regulations. Nonetheless, a complex labyrinth of terms allows nondesignation to occur. When the Type I or II relationship exists (“operated, supervised, or controlled by, or in connection with”), a class of organizations dedicated to a specific purpose can be named as the supported organizations rather than the specific organizations themselves.¹⁵⁴ A class of beneficiary organizations, such as “Catholic churches in Milwaukee” or “institutions of higher learning in California” may be named (rather than naming individual churches or schools) if the public charities are in control. The SO's charter can have the following latitude:¹⁵⁵

• It may permit the substitution of public charities.
• It may permit new or additional beneficiaries of the same class.
• It may permit the SO to vary the amount of support among different public organizations within the class.

Slightly different rules exist for Type III SOs, or entities “operated in connection with.” First and foremost, specific beneficiaries must be named in the charter. However, the articles may permit certain changes.¹⁵⁶ Particularly when one of the benefited organizations loses its tax exemption, fails, or abandons operations, substitution is permitted. However, it is not permissible to change merely because the purposes of the supported organization become “unnecessary, undesirable, impractical, impossible, or no longer adapted to the needs of the public.”¹⁵⁷

(c) Operational Control Relationship Tests

The supporting organization must have one of three special types of relationships with its supported public charity(ies).¹⁵⁸ Simply turning over all of the SO's income to a specifically named charity in accordance with the SO's articles of incorporation is not sufficient. An entity may not meet this relationship test even though it satisfies the §501(c)(3) operational tests. The three types of relationships are as follows:¹⁵⁹

• Type I: Operated, Supervised, or Controlled By An SO is operated, supervised, or controlled by its beneficiary organization(s) when it essentially functions in a parent–subsidiary relationship. A substantial degree of direction is exercised by the parent over programs, policies, and activities. The SO, or subsidiary, is accountable and responsible to the parent, or supported organization. This type is found when a majority of the controlling officials of the SO are appointed by the supportees, although any one of a group of beneficiaries need not control if all are represented.
• Type II: Supervised or Controlled in Connection With This type of relationship exists when the same persons control both the supporting and the supported organization; in other words, there is common control or supervision. The mere fact that the overlap exists currently is insufficient to establish the relationship because there is no guarantee that the relationship will continue. Therefore, the organization's governing documents must require the overlap between the organizations now and in the future.
• Type III: Operated in Connection With This type of SO is the most independent of its supportee(s), as it may have a totally independent board with specific named beneficiary organization(s). Because of its relative freedom, it must meet two additional tests to qualify: the responsiveness and the integral-part tests. This category of SO is affected the most by the changes brought about by the Pension Protection Act of 2006 as discussed herein.

Responsiveness. To meet the responsiveness test, the supported organization (SO) must have a significant voice in the SO's investment policies, operations and grant-making activities.¹⁶⁰ This voice is gained only in the following circumstances: (1) when one or more officers or directors of the SO are appointed or elected by the SO's officers, directors, trustees, or membership; (2) when one or more members of the governing body of the SO are also officers, directors, or trustees of, or hold other important offices in, the supported organization; or (3) the officers, directors, or trustees of the SO maintain a close and continuous working relationship with the officers, directors, or trustees of the supported organization.¹⁶¹ Whether a supported organization has a close and continuous relationship with, or a significant voice in directing the use of the income or assets of, its SO will be determined based on all of the relevant facts and circumstances. The Treasury Department and the IRS intend to issue proposed regulations in the near future that amend the responsiveness test by clarifying that Type III SOs must be responsive to all of their supported organizations.

In the case of a charitable trust (prior to the PPA), an alternative responsiveness test could be met when the supportee was named, and the named supportee had the power to enforce the trust and to compel an accounting under state law. A charitable trust can no longer meet this test based on the fact that the terms of the trust are enforceable under local law.¹⁶² Trustees must actually have a close, continuous working relationship with the directors, trustees, or officers of the supported organization.¹⁶³ Charitable trusts that did not reform their provisions to conform with §509(a)(3) before August 18, 2007, became private foundations required to meet applicable requirements and to file Form 990-PF effective on that date.¹⁶⁴ IRS Notice 2008-6 provided transitional relief that allowed such trusts that were reclassified as private foundations to delay filing Form 990-PF until their first taxable year beginning on or after January 1, 2008.

In one particular case, the Lapham Foundation's promise to provide about $8,000 in annual support to a community foundation donor-advised account out of its some $7 million of expected revenue was found not to be responsive. The courts agreed with the IRS determination that the amount was inconsequential and the foundation did not qualify for SO status.¹⁶⁵

Integral Part—In General. There are two alternative prongs of the integral part test, one of which must be satisfied. These alternative tests result in a Type III SO being further classified as either “functionally integrated” or “non-functionally integrated.”

Integral Part—Functionally Integrated. The first method of meeting the integral part test is to qualify as a functionally integrated Type III SO. The essence of the word functional is active conduct of direct programs by the SO and not simply holding investment assets to produce income to fund operations conducted by the supported organization. Regulations finalized on December 28, 2012, define a functionally integrated organization as one that meets one of the following criteria:¹⁶⁶

1. Engages in activities substantially all of which directly further the exempt purposes of one or more supported organizations.
2. Is the parent of each of its supported organization.
3. Supports a governmental supported organization.

For purposes of prong #1, the required activities must directly further the exempt purposes of one or more supported organizations by either performing the functions of or carrying out the purposes of such supported organization(s) and but for the involvement of the SO would normally be engaged in by the supported organization(s).¹⁶⁷ Holding title to and managing exempt-use assets are considered to be such activities. Alternatively, fund-raising, making grants, and investing and managing non-exempt-use assets are not considered to be activities that directly further the exempt purposes of the supported organization. However, the making of grants, scholarships, and similar payments to individual beneficiaries will be treated as a direct activity if the individuals are selected on an objective and nondiscriminatory basis; the officers, directors, or trustees of the supported organization have a significant voice in the timing of the payments, the manner of making them, and the selection of the recipients; and the making of such payments is part of an active program of the SO that directly furthers the exempt purposes of the supported organization(s) and in which the SO maintains significant involvement (within the meaning of Reg. §53.4942(b)-1(b)(2)(ii)), which pertains to private operating foundations that must conduct direct charitable activities).¹⁶⁸ Examples provided in the regulations of conducting direct activities include operating a food pantry and maintaining local parks on behalf of the SO's supported organization.

Prong #2 provides that a “functionally integrated” SO is one that, in addition to meeting the other requirements for SOs, is the parent of its supported organization. An SO is considered to be the parent of its supported organization if the SO exercises a substantial degree of direction over the policies, programs, and activities of the supported organization and a majority of the officers, directors, or trustees of the supported organization is appointed or elected, directly or indirectly, by the governing body, members of the governing body, or officers of the SO.¹⁶⁹ The final regulations repeat this definition, which was present in the proposed version. However, the Treasury Department and the IRS have determined that this definition of parent is insufficiently specific. Consequently, they intend to issue proposed regulations in the near future that will provide a new definition of parent that specifically addresses the power to remove and replace officers, directors, or trustees of the supported organization.

Unlike the first two prongs, the last option, supporting a governmental organization, is not further explained in the final regulations. The Treasury Department and the IRS are continuing to consider comments received regarding this option—such as the ability to support multiple governmental organizations and the entire governmental system, including parents and subsidiaries. The Treasury Department and the IRS intend to issue proposed regulations in the near future that will provide further guidance on how SOs can qualify by supporting a governmental entity. Such regulations should be released in sufficient time for such SOs to determine their eligibility prior to the expiration of transition rules discussed later in this chapter.

Integral Part—Non-Functionally Integrated. The second method of meeting the integral part test is to qualify as a non-functionally integrated (NFI) Type III SO by virtue of the amount of financial support provided to the supported organization(s). The proposed regulations suggested a distributable amount equal to 5 percent of the fair market value of the SO's non-exempt-use assets (similar to the private nonoperating foundation payout requirement). Based on comments received, the Treasury Department and the IRS determined that an asset-based payout percentage lower than the payout percentage for private nonoperating foundations was justified for NFI Type III SOs, and the final regulations reflect that adjustment, as described more fully in this section. Because the calculation in the final regulations changed significantly from that described in the proposed regulations, temporary regulations regarding this calculation were also issued simultaneously with the final regulations to provide an opportunity to make comments.

With respect to each taxable year, to qualify as an NFI Type III SO, the organization must distribute to, or for the use of, one or more supported organizations an amount equaling or exceeding the greater of:¹⁷⁰

1. 85 percent of the SO's adjusted net income (calculated based on the principles of IRC §4942¹⁷¹); or
2. The SO's minimum asset amount for the immediately preceding tax year. The minimum asset amount is calculated similarly to a private foundation's minimum investment return: the average of the fair market value (FMV) of the organization's non-exempt-use assets reduced by the average acquisition indebtedness related to such assets, multiplied by 3.5 percent (foundations multiply by 5 percent) plus recoveries of amounts taken into account in a prior year to meet the distribution requirement, plus amounts received from the sale or distribution of property to the extent the acquisition of such property was taken into account to meet the distribution requirement, plus any amount set aside that was not ultimately deemed necessary for the purpose for which it was set aside and that was taken into account to meet the distribution requirement.

For the purpose of valuing the assets used in the minimum asset calculation, the rules set forth in §4942 for private foundations are to be followed. Exempt-use assets (excluded from the calculation) include those assets that are used or held for use in carrying out the exempt purposes of either the SO itself or for its supported organization (only if such assets are made available to the supported organization at no cost or nominal cost).¹⁷²

The distributable amount for the first taxable year an organization is treated as an NFI Type III SO is zero.¹⁷³ However, for purposes of determining whether an excess amount is created, the distributable amount for the first year is considered to be equivalent to the amount that would apply in the absence of this exception. If with respect to any taxable year, an excess amount is created, it may be used to reduce the distributable amount in any of the five taxable years immediately following the taxable year in which the excess amount is created.¹⁷⁴ An excess amount is created if the total distributions made in that taxable year that count toward the distribution requirement exceed the distributable amount for that taxable year. The distributable amount is first reduced by any excess amounts carried over (the oldest excess amounts applied first) and then by any distributions made in that taxable year. This order is significantly different from the order followed by private nonoperating foundations that must first apply current-year distributions before excess distributions from the past. The result is advantageous because it causes, in a sense, excess distributions from the past to be given an additional year of life, as illustrated by this example:

• 2019 distributable amount: $100,000
• Excess amount from 2018: $25,000
• 2019 distributions made: $130,000

Following the regulations for SOs, the distributable amount of $100,000 is first reduced by the excess amount of $25,000, resulting in an adjusted distributable amount of $75,000. After applying the current distributions of $130,000, the organization has an excess amount of $55,000 attributable to 2019, which can be carried forward for five years. Following the rules for PFs, the distributable amount of $100,000 would first be reduced by current distributions of $130,000 and the PF would have a total excess amount of $55,000, of which $25,000 would be attributable to 2018 and $30,000 would be attributable to 2019. In this example, the preferential ordering rules provided by these new regulations essentially extend the life of the excess amounts attributable to 2018.

Distributions that count toward the distribution requirement shall include the following:¹⁷⁵

1. Any amount paid to a supported organization to accomplish the supported organization's exempt purposes.
2. Any amount paid by the SO to perform an activity that furthers the exempt purpose of the supported organization, but only to the extent such amount exceeds any income derived by the SO from the activity.
3. Any reasonable and necessary administrative expenses paid to accomplish the exempt purposes of the supported organization (does not include expenses incurred in the production of investment income).
4. Any amount paid to acquire an exempt-use asset that would be excluded from the payout requirement calculations.
5. Any amount set aside for a specific project that accomplishes the exempt purposes of a supported organization to which the SO is responsive following the suitability set-aside rules for private foundations.¹⁷⁶ (The cash distribution set-aside is not available for SOs.)

Further, the amount of a distribution shall be determined solely on the cash receipts and disbursement method of accounting. If an item other than cash is distributed, the amount of the distribution shall be the fair market value of the property distributed as of the date the distribution is made. An NFI Type III SO that fails to meet the distribution requirement will not be classified as a private foundation for the taxable year in which it fails to meet the requirement if the organization can prove reasonable cause (as opposed to willful neglect) for the failure and meets the distribution requirement within 180 days of the time it discovers the deficiency or becomes able to distribute following unforeseen events.¹⁷⁷ Reasonable cause is demonstrated if the failure was due solely to unforeseen events beyond the organization's control, a clerical error, or an incorrect valuation of assets.

Attentiveness. A subset of the integral part test for an NFI Type III SOs is called “attentiveness” and says the SO's support must be sufficient in amount to assure that the supported organization will be attentive to its operations. Under the new regulations, an NFI Type III SO must distribute one-third or more of its distributable amount to one or more supported organizations that are attentive to the operations of the SO and to which the supported organization is responsive.¹⁷⁸ (The responsiveness criteria were described earlier in this section.) A supported organization is attentive¹⁷⁹ during the taxable year if at least one of the following requirements is satisfied:¹⁸⁰

1. The SO distributes to the supported organization an amount equal to 10 percent or more of the supported organization's total support received during the supported organization's last taxable year ending before the beginning of the supporting organization's taxable year. The calculation can be based on the figures for a department or school rather than the entire university, hospital, or church. Example: SO distributes $50,000 to its supported organization (which is considered to be responsive) during its taxable year of January 1 through December 31, 2012. The supported organization's total support received during its taxable year ending December 31, 2011, was $400,000. Because the SO's support represented 12.5 percent of the supported organization's total support, the SO has satisfied the attentiveness requirement.
2. The amount of support received from the SO is necessary to avoid the interruption of the carrying-on of a function or activity of the supported organization. The activity does not have to be the supported organization's primary activity if it is a substantial one and the SO or the supported organization has earmarked the funds for such activity. Example: SO is responsive and annually distributes an amount exceeding its distributable amount to its single supported organization. The supported organization has earmarked the use of the funds received from its SO to underwrite the cost of carrying on a chamber music series consisting of 12 performances per year that are performed for the public free of charge. The series is not the supported organization's primary activity, but it is a substantial activity that the organization could not continue without the support from its SO. In this case, the SO has met the attentiveness requirement.
3. Based on the consideration of all pertinent factors, including the number of supported organizations, the length and nature of the relationship between the SO and its supporting organization(s), and the purpose to which the funds are put, the amount of support received from the SO is a sufficient part of a supporting organization's total support to ensure attentiveness. The more substantial the amount of support (as a percentage of the supported organization's total support), the greater the likelihood that the required degree of attentiveness will be present. Evidence of actual attentiveness by the supported organization(s) will be of equal importance. A supported organization is not considered to be attentive merely because it has enforceable rights against the SO under state law. Example: SO annually distributes an amount exceeding its distributable amount equally to its three supported organizations. Such payments equal less than 1 percent of the total support that each supported organization received in its most recently completed tax year. There is no additional evidence to suggest that the supported organizations are actually attentive to the SO. Based on these facts, the SO has not met the attentiveness requirement.

It is important to note that any amount received from an SO that is held by the supported organization in a donor-advised fund will be disregarded for purposes of determining whether the SO meets the attentiveness requirement.¹⁸¹

Alternate Test for Certain Trusts. An NFI Type III SO formed as a trust on or before November 20, 1970, does not have to satisfy the integral part requirements described previously (distribution requirement plus attentiveness) if it meets the following alternative requirements:¹⁸²

1. For taxable years beginning after October 16, 1972, the trustee of such trust annually makes written reports to all of the trust's supported organizations, setting forth a description of the trust's assets, including a detailed list of the assets and the income produced by such assets.
2. All of the unexpired interests in the trust are devoted to charitable purposes and a deduction (under certain enumerated code sections) was allowed with respect to such interests.
3. The trust has not received any grants, contributions, bequests, or other transfers since November 20, 1970.
4. The trust is required by its governing instrument to distribute its net income currently to a designated beneficiary supported organization. If there is more than one beneficiary, net income must be distributable in fixed amounts to each beneficiary.
5. The trustee of the trust does not have discretion to vary either the beneficiary supported organizations or the amounts payable to the supported organizations. The ability to cease making payments to a supported organization in the event of certain occurrences, such as the supported organization's loss of exemption or failure to operate for charitable purposes, is not impermissible discretion for this purpose.
6. None of the trustees would be disqualified persons within the meaning of §4946(a) with respect to the trust if it were a private foundation. For this purpose, the definition of disqualified persons does not include foundation managers.

Additional Requirements for Type III SOs. In addition to the aforementioned requirements, all Type III SOs:

• Must satisfy the notification requirement (effective for taxable years including December 28, 2012, and later—see transition rules described later).
• May not support a supported organization that is organized outside of the United States.¹⁸³

The notification requirement mandates that a Type III supporting organization provide annually, to each of its supported organizations, information to help ensure that the SO is responsive to the needs of the supported organization. The required information includes:¹⁸⁴

• A written notice addressed to a principal officer¹⁸⁵ of the supported organization describing the amount and type of support it provided to the supported organization during the SO's taxable year, immediately preceding the taxable year in which the notice is provided and during any other taxable year of the SO ending after December 18, 2012, for which such support information has not previously been provided.
• A copy of the SO's Form 990 (contributor information in Schedule B may be redacted) or other annual information return that was most recently filed as of the date the notification is provided and any such return for any other taxable years of the SO ending after December 28, 2012, that has not been previously provided to the supported organization.
• A copy of the SO's governing documents in effect on the date the notification is provided, including its articles of organization and bylaws (if any) and any amendments to such documents, unless such documents have been previously provided and not subsequently amended.

The notification documents for any taxable year may be provided electronically¹⁸⁶ and are due by the last day of the fifth calendar month following the close of that taxable year.¹⁸⁷ For example, an SO reporting on calendar year 2012 must satisfy its notification requirement by May 31, 2013.

An NFI Type III SO that is undergoing a judicial proceeding in order to modify its governing instrument will not have to comply with the distribution requirements in any taxable year in which all of the following criteria are met:¹⁸⁸

1. Compliance with the distribution requirements specified in the regulations is inconsistent with the organization's governing instrument that prohibits the distribution of capital.
2. The organization was formed prior to September 24, 2009.
3. The judicial proceeding must be necessary to reform a governing instrument or to excuse the SO from compliance with the governing instrument.
4. The judicial proceeding must have commenced prior to December 28, 2012.
5. The judicial proceeding must not be subject to any unreasonable delay for which the SO is responsible.

Beginning with the first taxable year following the taxable year in which such judicial proceeding is terminated, the SO will be required to satisfy the distribution requirement regardless of the outcome of the proceeding. If it does not satisfy such requirement, the organization will not qualify as an NFI Type III SO even if the failure to comply was a result of the organization operating in accordance with its governing instrument.

Impact of Changes on SOs that Receive Gifts from Private Foundations. The new rules seek to eliminate grants by nonoperating private foundations to Type III SOs that are not functionally integrated by providing that such grants no longer count as qualifying distributions.¹⁸⁹ For example, a private foundation could previously satisfy its annual 5 percent of asset value payout requirement with a distribution to an SO that itself lacked specific payout requirements.

Grant payments by private foundations to non-functionally integrated Type III SOs can be paid if expenditure responsibility steps are taken, but those payments do not count as qualifying distributions.¹⁹⁰

Payment of a grant, loan, compensation, or other similar payment to a substantial contributor, member of such person's family, or 35 percent controlled entity is an excess benefit transaction subject to a 25 percent penalty and return of the funds for all types of SOs and donor-advised funds.¹⁹¹ The new rule essentially makes such transactions “automatic” excess benefits subject to penalty without regard to the relative value of consideration and property transferred.¹⁹²

Modest supporting organizations are not eligible to file Form 990-N (the electronic postcard) and must file Form 990-EZ even if their gross receipts are normally less than $50,000. New information is requested on Schedule A of Form 990, including the name, employer identification number, type, and amount of support paid, as well as questions designed to determine compliance with certain SO requirements such as the lack of control by disqualified persons. Finally, SOs are now subject to the excess business holdings rules with which private foundations must comply.¹⁹³

(d) Control by Disqualified Persons

An SO cannot be controlled by disqualified persons other than its own managers or the public charities that it benefits.¹⁹⁴ Indirect control is also not allowed; a funder's employees, for example, cannot substitute for the funder. An organization will be considered controlled by disqualified persons if, by aggregating their votes or positions of authority in the organization, they can require the organization to perform any act that significantly affects its operations. Lack of control is evidenced when the disqualified persons have less than 50 percent of the voting power or lack the right to veto actions of the board.

(e) Conversion to Private Foundation

If the circumstances of the benefited organization or the funders change, it is possible for an SO to cease to operate solely to benefit the current public charity(ies) and convert itself into a private foundation (or a public charity if requisite support is received). Two important questions arise in such a conversion:

1. The supported organization should agree to no longer be supported. As a practical matter, since it normally controls the SO, this factor is almost always present. There may be a price for agreement. In one situation, a retiring public charity supportee was given about half of the foundation's assets upon the SO's conversion^.195
2. The conversion must not be part of a plan arranged when the SO was created, to enable the creators or donors to circumvent a tax limitation or private foundation sanction.

A supporting organization is often formed (as an alternative to a private foundation) when the property to be given is closely held corporate stock. A private foundation cannot hold more than 2 percent of the shares of a company that is owned more than 20 percent by the PF and the persons who control or created it, and such “excess business holdings” must be sold by the PF within five years of their receipt. Thus, in the case of conversion of an eight-year-old SO to a private foundation in the same year that its stock holdings were purchased in a public offering, it might well be asked if such a conversion was originally intended. Without question, a conversion within a few years of original creation would be suspect, when the SO's public status afforded the donors a contribution carryover or higher percentage limitation on deductions than that allowed to a private foundation. Effective January 1, 2007, the excess business holdings rules apply to a non-functionally integrated Type III supporting organization. Such a plan would require creation of a Type I or Type 2 SO that the donor cannot control.¹⁹⁶

(f) Noncharitable Beneficiaries

Business leagues, chambers of commerce, civic leagues, social welfare organizations, labor unions, and agricultural and horticultural organizations normally receive funding from many members and could qualify as publicly supported under the IRC §509(a)(2) test. For that reason, they may also be a beneficiary organization of an SO. Because the SO qualifies for receipt of deductible contributions, an SO formed with such a beneficiary must, of course, meet the organizational and operational tests of §501(c)(3).¹⁹⁷ In other words, an organization performing the charitable or other IRC §170(c)(2) purpose activities for an IRC §501(c)(4), (5), or (6) organization and meeting the IRC §509(a)(3)(B) control tests may qualify as a supporting organization. Such charitable arms are typically created to perform educational programs, often required continuing education for a profession. Scholarship funds and disaster relief programs may also be the mission of such a supporting organization.

(g) Intermediate Sanctions Apply

An automatic excess benefit, subject to return of the funds and imposition of penalties by the person receiving the benefit, is imposed if an SO pays any grant, loan, compensation, or other similar payment to its substantial contributor(s), a member of their family, or a 35 percent controlled entity.¹⁹⁸ Transactions that were in effect and subject to a binding contract on August 17, 2006, were not subject to penalty if (1) such contract was binding at all times after August 17 and before payment was made, (2) the contract was not modified during such period, and (3) the payment under the contract was made on or before August 17, 2007.¹⁹⁹

(h) Procedural Issues

Until mid-2006, the determination letters issued by the IRS Cincinnati Service Center did not designate the category, or type, by which a supporting organization was qualified.²⁰⁰ Additionally, IRS Publication 78 simply lists public charities without identifying the §509(a)(1), (2), or (3) category. The IRS Business Master File identifies supporting organizations with Code 17, but is not necessarily updated for subsequent changes submitted with Form 990 or requests for new determination letters. It was only on the 2005 Form 990 that the IRS began to ask SOs to check a box indicating their type.

Beginning August 18, 2006, a private foundation is required to identify those SOs to whom its grants are not counted as qualifying distributions; the only formal IRS source listing SOs is the IRS Master File. Unfortunately, that list has not been regularly updated for changes in status and does not list SOs by type. Thus, foundations considering grants to an SO have two choices:

1. Suspend grants to §509(a)(3) organizations.
2. Review the SO's organizational documents and activities and obtain its declaration of its type and functional integration.²⁰¹