Effective December 28, 2012, the Internal Revenue Service (IRS) issued final and temporary regulations regarding "Type III supporting organizations" under Internal Revenue Code §509(a)(3)(B)(iii). "Supporting organizations" are entities that are not themselves publicly supported but rather have public charity status by virtue of supporting a public charity. Supporting organizations are further classified into "Types" (I, II or III) depending on the relationship between the supporting organization and its supported public charity. The Pension Protection Act of 2006 added provisions to the Internal Revenue Code intended to more tightly regulate supporting organizations because of actual and perceived abuses in the operation of Type III supporting organizations, those that have the loosest connection with their publicly supported charities (are operated "in connection with" a supported public charity).
In order to qualify as a supporting organization, an entity must meet an organizational test, an operational test, a disqualified person control test and a relationship test. The newly issued regulations focus mainly on the relationship test and clarify that Type III supporting organizations must meet (i) a notification requirement -- requiring it to annually provide particular documents to its supported public charity; and (ii) a responsiveness test -- requiring the supported public charity to have a significant voice in its operations. Type III supporting organizations are further classified into those that are functionally integrated (FI) and those that are non-functionally integrated (NFI) with their supported public charity.
To further determine whether a Type III supporting organization is FI or NFI, the entity must meet an integral part test, which is satisfied if substantially all of the entity's activities are "direct furtherance activities" (i.e., those that directly further the exempt purposes of the supported public charity and would be undertaken by it if not for the entity). Merely controlling the assets of a supported public charity, such as managing its endowment fund or fundraising, is not a direct furtherance activity (unless the entity is the parent of its supported public charity). Rather, running specific charitable programs on behalf of the supported public charity is a direct furtherance activity.
A Type III supporting organization that does not meet the integral part test is classified as NFI. NFI Type III supporting organizations are subject to a mandatory payout requirement (not unlike that required for private foundations), and they must annually distribute the greater of 85 percent of adjusted net income from the prior tax year or 3.5 percent of the fair market value of nonexempt-use assets. At least one-third of this distribution must be to one or more supported public charities that are "attentive" to the supporting organization, defined with respect to the amount of support received by them from the supporting organization.
The new regulations are complex, and the above is only a broad overview of some of the changes imposed. If you have any questions about how these regulations affect your organization, you should contact your tax advisor.