The following has been prepared for general informational purposes only and does not constitute legal or other advice to be relied upon. If legal advice or other expert assistance is required, the services of a competent professional should be sought.
NOTE: The Internal Revenue Service posted a Q&A document (pdf) on the 2006 Form 990 information return clarifying certain instructions and questions, particularly pertaining to compensation of officers, directors, and key employees. In recent months, practitioners representing tax-exempt organizations expressed confusion about changes made to the 2006 form after enactment of the Pension Protection Act of 2006 (Pub. Law No. 109-280).
The Pension Protection Act of 2006 (known by various names such as “the Pension Bill” and “H.R. 4”) tightens the rules for tax-exempt fund raising supporting organizations (“Foundations”) and certain contributions to them. These changes will affect how and to whom donors such as private foundations make grants to your hospital’s foundation, and how your foundation administers these complex relationships. The changes will not affect hospitals that raise funds internally without use of a separate foundation.
Since many health care entities entrust their fund raising activities to separate foundations, H. R. 4 raises several important questions for health care philanthropy, addressed in this article. However, each foundation must examine its own organization and operation – the basis for its tax exemption – to determine what, if anything, it needs to do to comply. This overview of the new rules in Q & A format will help you cope with the new rules.
Three simple starting points to consider:
- Gifts made directly to the public charity hospital/health care entity supported by the foundation are not impacted.
- Type I and II foundations (described in question 2) are not subject to the limitation on gifts from private foundations discussed in question 7, so the rationale behind having organized and operated as a Type III foundation should be reexamined.
- Foundations and the entities they support must pay increased attention to tax laws and reach out to potential donors – especially private foundation donors --to reassure them that gifts
are still OK.
1. What are the types of Foundations?
The universe of charitable organizations under Section 501(c)(3) divides into two major groups – public charities and private foundations. Public charities – like charitable hospitals -- receive financial support from a wide range of donors, whereas private foundations derive support from limited groups. Based on this difference, private foundations must comply with regulations not applied to public charities. These extra requirements arise from the theory that public charities receive oversight by the public; because accountability to many donors and recipients of care requires public charities to meet the needs, interests, and expectations of a broad cross-section of the community. By contrast, private foundations are not beholden to a large group of donors; so the Code imposes extra and complex rules on private foundations to ensure that their activities remain in the public’s interest. Failure to follow these guidelines can expose private foundations and their managers to excise taxes. Since private foundations are major donors, the changes made by H. R. 4 will dramatically impact the fund raising ability of many Foundations.
To qualify as a public charity, an organization must meet one of three basic tests. Two of those tests require significant public support, as well as other facts and circumstances. The third way to qualify as a public charity exempt from taxation to which contributions may be deductible is to be a Supporting Organization under 509(a)(3) of the Code, which means that the entity provides support to one or more other public charities. In essence, 509(a)(3) organizations piggy back on the public charity status of the entities they support—in this case hospitals or systems that are independently public charities. The IRS treats Foundations as public charities, not private foundations, on account of their close relationship to the public charities they support. Although a foundation may qualify as a public charity on its own, most of the fund raising foundations organized by health care entities are organized and operated as 509 (a)(3) Supporting Organizations. Those few foundations that are not Supporting Organizations are not affected by most of the changes discussed in this FAQ.
2. What are the differences in Foundations?
All Foundations must satisfy three basic tests:
- The Foundation must be “organized and at all times operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more public charities.”
- It must be “operated, supervised, or controlled by or in connection with one or more public charities.”
- It may not be controlled, directly or indirectly, by certain persons, known as “disqualified persons” (substantial donors, their family members, and organizations controlled by them).
There are three different ways that a Foundation can meet the second test, called the “relationship” test, listed above. So, there are three different types of Foundations, distinguished by the character of their relationship with the organizations they support. (Foundations must satisfy the other two tests as well; but those rules are outside this discussion.)
- Type I Foundations are operated, supervised, or controlled by the entity they support. This model parallels a parent-subsidiary relationship, where generally the supported (i.e., “beneficiary”) charity holds the power to appoint or elect a majority of the Foundation’s board of directors, officers, or trustees.
- Type II Foundations are supervised or controlled in connection with the entity they support. A Type II relationship exists in a brother-sister relationship with the supported charity; in which the same persons control or manage both entities. Common control of the two ensures that the Foundation serves the needs of the beneficiary entity.
- The relationship between a Type III Foundation and its beneficiary differs from both of the other types. The Code describes a Type III as “operated [not controlled] in connection with” its beneficiary. Treasury Regulations further outline both a “responsiveness” test and an “integral part” test that a Type III must satisfy. Type I and II Foundations and their beneficiaries share relationships of control. Type IIIs operate with looser connection to the beneficiary. This lack of control leaves Type IIIs more susceptible to abuse. Many of the Foundation provisions in H.R. 4 apply only to Type IIIs.
You will have to examine your organizational documents to determine which type of supporting organization your foundation is. The rest of this article focuses on the additional restrictions on Type III foundations, but some restrictions are placed on all types of foundations. However, the limitation of gifts from private foundation donors applies only to Type III.
3. What is a “functionally integrated” Type III Foundation?
Type III Foundations may use two alternatives to satisfy the “integral part” test. First, the Foundation may engage in activities for or on behalf of its publiclysupported beneficiary. The Type III performs the functions of, or fulfills the purposes of, the entity it supports. But for the Type III Foundation, the
beneficiary organization would perform the activities itself. Such a “functionally integrated” Type III supports its beneficiary through vital programmatic participation rather than by simply paying over its income.
The second way to satisfy the “integral part” test requires the Foundation to pay substantially all its income to or for the use of one or more supported organizations, as well as other quantitative tests. H.R. 4 exempts “functionally integrated” Type III Foundations from some of the new rules it applies to other Type III Foundations.
4. Does H.R. 4 impose any new rules that apply to all Foundations?
Yes. H.R. 4 says that any grant, loan, compensation, or other similar payment from any Foundation to one or more “substantial contributors,” family members of substantial contributors, or business entities controlled by substantial contributors, will be an “automatic excess benefit transaction.” Excise taxes on the excess benefit transaction will fall on both the recipient and on any director, officer, or trustee who knowingly allowed the transaction.
A “substantial contributor” is anyone who donates at least $5,000 to the Foundation, so long as the donation amount exceeds two percent of the total contributions received in the taxable year of contribution. Public charities are not treated as “substantial contributors;” but private foundations may be deemed substantial contributors. “Family members” of substantial contributors include spouses, ancestors, lineal descendants, siblings, and the spouses of those individuals. All loans by any type to “disqualified persons” (those in position to control the organization – directors, officers, or trustees) are excess benefit transactions.
All Foundations now must file annual Form 990, regardless of the income of the Foundation. (By contrast, other public charities with gross receipts less than $25,000 generally are exempt from Form 990 filing requirements.) Also, when filing Form 990, the Foundations must identify itself as Type I, II, or III. It must disclose the public charities supported and must certify absence of control by disqualified persons.
H.R. 4 deems a disqualified person of any Foundation also to be disqualified with respect to the
public charity beneficiaries of that Foundation. So, if the beneficiary organization engaged in an excess benefit transaction with such persons, they and the managers of the public charity would incur excise tax.
5. What additional requirements and restrictions does H.R. 4 place on Type III
Foundations?
H.R. 4 directs the Secretary of the Treasury to issue new regulations requiring minimum distributions by non-functionally integrated Type III Foundations, in order to ensure that the Foundation pays a significant amount of its income or assets to the publicly-supported beneficiaries.
Under H.R. 4, the “excess business holdings” rules that apply to private foundations now apply to Type III Foundations other than those that are functionally integrated. In a nutshell, this means that a Type III Foundation may not hold, either alone or when aggregated with the business holdings of its disqualified persons, significant ownership interests in other business entities. These excess business holdings rules generally also will apply to Type II Foundations if they accept any gift or contribution from 1) persons who control, either directly or indirectly, and either alone or together with others, the governing body of the public charity that the Type II Foundation supports; 2) family members of persons described in the previous clause; or 3) business entities of which at least 35% is controlled by such persons.
H.R. 4 also precludes Type IIIs from supporting publicly-supported beneficiaries not organized in the United States. Finally, H.R. 4 requires a Type III to provide its publicly-supported beneficiary with information (e.g., its Form 990) necessary to establish that the Foundation is responsive to the needs of the beneficiary.
6. Are there any other provisions of H.R. 4 that pertain to or otherwise concern Foundations?
Yes. If a Type I or Type III Foundation accepts any gift or contribution from a person (including business entities, but not including public charities) who controls (either directly or indirectly, and either alone or together) the board of directors of one of its beneficiary organizations, the Foundation automatically will become a private foundation. The same rule applies to contributions received from family members of, or entities controlled by, such persons.
7. What is the limitation on contributions from private foundations to Foundations?
If a private foundation makes a contribution to a Type III foundation that is not “functionally integrated,” the private foundation may not count the amount as a qualifying distribution. The contribution becomes a taxable expenditure. Until the new 990s are released (see Question 8 below), the private foundation will generally have no way to determine whether any Foundation to which is wishes to make a grant is a Type III, much less whether it is a functionally integrated Type III.
Similarly, if a private foundation makes a contribution to a Foundation of any type, and that Foundation is controlled by a person who is deemed to be a “disqualified person” with respect to the contributor, the grant will not count as a qualifying distribution and will instead constitute a taxable expenditure. The private foundation will generally be in a position to determine and guard against the existence of this type of relationship.
8. You are contacted by a private foundation which had planned to make a contribution to your Foundation. How do you inform them what Type of foundation you are, and if a type III, whether you are “functionally integrated”?
From now on, all Foundations must file annual Form 990 and must certify whether they are a Type I, II, or III Foundation. Any member of the public may request from a charity a copy of its filed Form 990. But this is a new requirement, so you will not have a Form 990 that demonstrates that at this point.
Until Foundations file their first Form 990 under the new rules of H.R. 4 and publicly disclose their Type, you should reach out to grantors that are private foundations with written disclosures identifying the basis of your tax exemption and describing what type of supporting organization your Foundation is. Expect donors to seek certification as to the Type of Foundation of the recipient. Also, in any grant agreement, private foundations may ask Foundations to represent and warrant that they are Type I, Type II, or functionally integrated Type III Foundations, and that they will not at any time during the term of the grant change their status or accept any contributions that would cause them to be treated as a private foundation.
You should seek advice of counsel to determine the basis of your foundation’s tax exemption. Correspondence to and from the IRS, and your foundation’s organizational documents, should describe the type of 509(a)(3) organization you are, but you may need a letter from counsel or your accountants to satisfy others. This will entail an additional step if your foundation is a Type III, because you will then have to substantiate that the foundation is functionally integrated. It is advisable to do your review as soon as possible to enable a prompt response to inquiries, and an explanatory letter to existing and prospective private foundation donors.
________________
Remember, the IRS is not finished with Foundations. It continues to study them as H.R. 4 mandates, and will be issuing regulations. Legal developments in this area merit continued vigilance.
Posted 11/30/2006