The Pension Protection Act of 2006 (the “PPA”) established a classification system for supporting organizations (“SOs”). This system divides SOs into three types on the basis of how the organization satisfies the relationship test – Type I, Type II and Type III. The requirements applicable to Type III SOs were the subject of a recent Advance Notice of proposed rulemaking issued by the IRS and the Department of the Treasury. Type III SOs are “operated in connection with” the supported organization, which is a more tenuous relationship than is the case with Type I and Type II SOs.

To be classified as a Type III SO, an organization must satisfy, among other things, two tests which have been amended by the PPA and the Advance Notice:

(1) “responsiveness”: responds to the needs of its publicly supported organizations; and

(2) “integral part”: maintenance of a significant involvement in the operations of one or more publicly supported organizations.

With regard to the “responsiveness test,” Type III SOs will be required to provide each of their supported organizations with information the IRS requires to ensure that such an organization is responsive to the needs of the supported organization. The proposed regulations will provide rules for the form, content and timing of such information.

Under the revised integral part test, Type III SOs are further divided into two categories: functionally integrated and non-functionally integrated. A functionally integrated Type III SO is one that is not required under regulations established by the IRS to make payments to supported organizations due to the activities of the organization related to performing the functions of such supported organizations. Non-functionally integrated Type III SOs include all others.

A functionally integrated Type III SO will be required to satisfy the following three tests:

  • The “But For” Test. This test is satisfied if the activities engaged in for the publicly supported organizations are “activities to perform the functions of, or to carry out the purposes of, such organizations, and, but for the involvement ofthe supporting organization, would normally be engaged in by the publicly supported organizations themselves.” 
  • The Expenditure Test. This test will require a functionally integrated Type III SO to use substantially all of the lesser of (a) its adjusted net income or (b) 5 percent of the aggregate fair market value of all its assets (other than assets that are used directly in supporting the charitable programs of the supported organizations) directly for the active conduct of activities that directly further the exempt purposes of the organizations it supports. This test is based on the test for private operating foundations.
  • The Assets Test. The assets test will require the organization to devote at least 65 percent of the aggregate fair market value of all its assets directly for the active conduct of activities that directly further the exempt purposes of the organizations it supports. This test is based on the test for private operating foundations.

The Advance Notice indicates that the IRS will propose an exception for certain Type III SOs that facilitate the operation of an integrated system that includes one or more charities and that may be unable to satisfy the “direct active conduct” and “directly further” requirements of the expenditure and assets tests, such as certain hospital systems. Such organizations will be classified as functionally integrated if they satisfy the existing “but for” test.

Non-functionally integrated Type III SOs are subject to two requirements:

  • The Payout Requirement. A non-functionally integrated Type III SO must distribute annually to its supported organizations an amount equal to at least 5 percent of the aggregate fair market value of all its assets (other than assets that are used directly in supporting the charitable programs of its supported organizations).
  • The Supported Organization Limitation. Except for organizations in existence on the date the regulations will be proposed, non-functionally integrated Type III SOs will be limited to supporting no more than five publicly supported organizations. An organization in existence on or prior to the date such regulations are proposed may support more than five supported organizations only if it distributes at least 85 percent of its total required payout amount to publicly supported organizations to which the SO is responsive.

It should be noted that the PPA made the excess business holding excise tax for private foundations applicable to non-functionally related Type III SOs, which imposes an excise tax where such an SO owns more than 20 percent of any for-profit enterprise.

The IRS is requesting comments to help establish transition rules for SOs in existence as of the date of enactment of the PPA so that such organizations will have a reasonable opportunity to amend their governing instruments or make other changes to comply with the law as amended by the PPA.