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Regs set distribution amount for non-functionally integrated Type III supporting organizations

T.D. 9746, 12/21/2015, Reg. § 1.509(a)-4

IRS has issued final regs that set out the amount that a non-functionally integrated (NFI) Type III supporting organization must annually distribute to its supported organizations. The regs reflect changes to the law made by the Pension Protection Act of 2006 (PPA).

Background. Tax-exempt charitable organizations that are private foundations are subject to a number of specialized rules depending on whether they are operating or non-operating private foundations. An organization can avoid being treated as a private foundation — and by avoiding this status be treated as a public charity — if it falls within one of several categories, one of which is supporting organizations under Code Sec. 509(a)(3).

Organizations described in Code Sec. 509(a)(3) are known as “supporting organizations” because their non-private foundation status is based on their provision of support to one or more organizations described in Code Sec. 509(a)(1) or Code Sec. 509(a)(2), which in this context are referred to as “supported organizations.” Supporting organizations that are “operated in connection with” their supported organization(s) are called “Type III supporting organizations”.

The Pension Protection Act of 2006 (PPA, P.L. 109-280) divided Type III supporting organizations into two categories–those that are “functionally integrated” and those that are not. A functionally integrated Type III supporting organization is one that is not required under IRS regs to make payments to supported organizations because the supporting organization engages in activities that relate to performing the functions of, or carrying out the purposes of, its supported organization(s). The PPA directed IRS to promulgate regs under Code Sec. 509 that establish a new distribution requirement for Type III supporting organizations that are not “functionally integrated” to ensure that a “significant amount” is paid to supported organizations.

Late in 2012, IRS issued final, temporary and proposed regs on Type III supporting organizations that addressed the amount that a Type III supporting organization that is not functionally integrated (a non-functionally integrated (NFI) Type III supporting organization) must annually distribute to its supported organizations.

Under the 2012 regs, an NFI Type III supporting organization must annually distribute to or for the use of one or more supported organizations an amount equaling or exceeding the supporting organization’s “distributable amount” for the tax year. The temporary regs defined an NFI Type III supporting organization’s “distributable amount” as equal to the greater of:

  1. 85% of the supporting organization’s adjusted net income; or
  2. Its “minimum asset amount,” in each case for the immediately preceding tax year. The “minimum asset amount” is defined as 3.5% of the excess of the aggregate fair market value of the supporting organization’s non-exempt-use assets over the acquisition indebtedness with respect to such non-exempt use assets.

The 2012 proposed regs provide that, for purposes of the calculation of the annual distributable amount, a supporting organization’s adjusted net income would be determined using the principles of Code Sec. 4942(f) and Reg. § 53.4942(a)-2(d). These provisions apply the principles of subtitle A of the Code. Under the proposed regs, adjusted net income would be determined by applying the principles that apply in calculating the adjusted net income of private operating foundations under Code Sec. 4942(d) and Code Sec. 4942(j)(3) that are generally based on long-standing principles under subtitle A of the Code.

In determining the distributable amount for a tax year under the proposed regs, non-exempt-use assets would be valued using the principles generally applicable to private foundations under Reg. § 53.4942(a)-2(c), which applies the principles of regs under Code Sec. 2031 (which generally apply for estate tax purposes to the valuation of real property).Reg. § 20.2031-1(b) provides that the value at which property is assessed for local tax purposes may be considered only if that value represents the fair market value as of the valuation date. Reg. § 20.2031-3 further provides that if real property is leased or otherwise used in a business, special valuation rules may apply.

The temporary regs provide that the determination of the aggregate fair market value of an NFI Type III supporting organization’s non-exempt-use assets would be made using the valuation methods generally applicable to private foundations under Reg. § 53.4942(a)-2(c). The temporary regs also provide that, consistent with the private foundation rules, the “non-exempt use” assets of a supporting organization do not include certain investment assets described in Reg. § 53.4942(a)-2(c)(2) or assets used (or held for use) to carry out the exempt purposes of the supported organizations (as determined by applying the principles described in Reg. § 53.4942(a)-2(c)(3)).

Final regs. Other than a change conforming the provision in the final regs on the valuation of non-exempt-use assets to the provision in the Code Sec. 4942 regs, the final regs are the same as the temporary regs that have been applicable to Type III supporting organizations since Dec. 28, 2012. The final regs also adopt the 2012 proposed regs without change, except to (a) conform the provision on the valuation of non-exempt-use assets to the Code Sec. 4942 reg provision that it cross-references (Reg. § 53.4942(a)-2(c)(2)); and (b) replace references in Reg. § 1.509(a)-4 to the temporary regs, with references to the final regs. The final regs also remove the temporary regs.

The final regs adopt the annual distributable amount rule of the 2012 proposed regs without changes. IRS believes that a distribution requirement equal to the greater of 85% of adjusted net income or 3.5% of the net fair market value of an organization’s non-exempt-use assets strikes an appropriate balance.

IRS believes that this distribution requirement ensures that NFI Type III supporting organizations distribute significant amounts to their supported organizations, as Congress directed in the PPA. Further, the 85% of income test will make it more likely that supported organizations will timely benefit from higher returns received by their supporting organizations. Conversely, in years with lower returns or for organizations that invest in assets that largely produce appreciation rather than income, a 3.5% of assets distribution requirement will apply, which is less than the 5% of assets distribution requirement that applies to private non-operating foundations.

Proposed regs to be issued. IRS states that, in the near future, it intends to publish proposed regs for Type III supporting organizations that would make a change to the final regs. Specifically, the proposed regs would remove the provision in the final regs that reduces the distributable amount by the amount of taxes that subtitle A of the Code imposes on a supporting organization during the immediately preceding tax year.

In addition, the proposed regs would provide specific rules on the requirements for Type III supporting organizations that support governmental supported organizations being treated as functionally integrated Type III supporting organizations.

The proposed regs would also provide transition relief beyond the period provided in Notice 2014-4, 2014-2 IRB 274. Supporting organizations may continue to rely on the transitional rule described in Notice 2014-4, Sec. 3.01 until the date that the proposed regs under Reg. § 1.509(a)-4(i)(4)(iv) are finalized.

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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