Attorney Issues Call to Action Re: Proposed 5% Distribution Requirement for Certain Supporting Organizations
Attorney Issues Call to Action Re: Proposed 5% Distribution Requirement for Certain Supporting Organizations
Summary
By Bruce Givner
Background. Following is a small
portion of the history that resulted in the enactment of the charitable
provisions of the Pension Protection Act of 2006.
2004 Hearing. On June
22, 2004, the United States Senate Finance Committee held a hearing entitled “Charity Oversight and Reform: Keeping Bad Things from
Happening to Good Charities.” The featured witnesses included the Commissioner of the Internal Revenue
Service (“IRS”) and the President Emeritus of Harvard University. Failings in the enforcement of the
existing charitable laws were discussed and recommendations for the future,
e.g., changes in IRS Form 990, were made. At that point, supporting organizations were not yet in the
cross-hairs.
2005 Letter. On February
3, 2005, Senators Max Baucus and Charles Grassley, the Chairman and Ranking
Member of the Senate Finance Committee, respectively, wrote a letter to
Secretary of the Treasury John Snow in which they expressed concern “about
section 501(c)(3) charitable organizations avoiding private foundation rules by
claiming public charity status as a Type III supporting organization (SO) under
section 509(a)(3) of the Code and section 1.509(a)-4(i) of the Treasury
regulations.” They cited one supporting
organization which only made a “payout of approximately .3%.” They noted that “In contrast, a private
foundation is generally required to payout 5% of the value of its noncharitable
use assets annually….” They
concluded by “strongly encourag[ing] the Department of Treasury to revisit the
regulations that have created the Type III supporting organizations.”
2005 Article. On April
25, 2005, a New York Times article
entitled “A Tax Benefit for Big Donors Often Bypasses Idea of Charity” described
how “George B. Kaiser, a publicity-shy oilman who built a fortune estimated at
$4 billion by snapping up busted petroleum businesses in Oklahoma, set aside
roughly $1 billion for charitable endeavors from 2000 to the end of last
year.” However, “only $3.4 million
of the money he set aside has gone to charities. The rest is sitting in an obscure philanthropic entity called
a supporting organization, so named because it is created to support a specific
charity or charities.” The article
went on to quote Senate Finance Committee Chairman Senate Grassley: “I'm deeply
disturbed that with a good number of supporting organizations, people are
taking multimillion-dollar tax deductions for what they claim are contributions
to charity, yet too often the result is a thimbleful of benefit to charity."
The Statute.
Distribution Requirement. On August 17, 2006, the President signed Public Law 109-280, the massive
Pension Protection Act of 2006. Section
1421(d), entitled “Payout Requirements For Type III Supporting Organizations,“ provided,
in relevant part, as follows:
“(1) In General. The Secretary of the Treasury shall
promulgate new regulations under Section 509 of the Internal Revenue Code…on
payments required by type III supporting organizations which are not
functionally integrated type III supporting organizations. Such regulations shall require such
organizations to make distributions of a percentage of either income or assets to
supported organizations…to ensure that a significant amount is paid to such
organizations.”
Definition. A new
subparagraph was added to the Internal Revenue Code (“IRS”) to supply the key
definition:
“Section 4943(f)(5)(B) Functionally Integrated Type III Supporting
Organization. The term `functionally
integrated type III supporting organization’ means a type III supporting
organization which is not required under regulations established by the
Secretary to make payments to supported organizations (as defined under section
509(f)(3)) due to the activities of the organization related to performing the
functions of, or carrying out the purposes of, such supported organizations.”
The ANPRM. On August 2, 2007, the Treasury and the
IRS issued an Advanced Notice of Proposed Rulemaking (ANPRM). Reg-155929-06, 72 FR 148. Among other interesting points, the
ANPRM proposed a distribution requirement for all Type III supporting
organizations. For functionally
integrated type III supporting organizations it was to be an expenditure
requirement similar to that in Section 4942(j)(3)(A) for private operating
foundations: substantially all of the lesser of (a) its adjusted net income or
(b) five percent of the aggregate fair market value of all its assets (other
than assets that are used, or held for use, 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. For
non-functionally integrated type III supporting organizations it was to be five
percent of the fair market value of its assets (other than assets that are
used, or held for use, directly in supporting the charitable programs of its
supported organizations).
The Proposed Regulations. On September 24, 2009, the IRS issued proposed
regulations regarding the requirements to qualify as a Type III supporting
organization. REG-155929-06, 74 FR
184.
Functionally Integrated Type III Supporting Organizations. In the Background discussion of the Integral
Part Test, the IRS described how several “commentators argued that the ANPRM’s
expenditure test [for functionally integrated type III supporting
organizations] was arbitrary and that Congress did not authorize the Secretary
to impose a payout requirement on functionally integrated organizations.” Those comments and others apparently
had an impact because the Treasury Department and the IRS did not incorporate
the expenditure test for functionally integrated type III supporting
organizations in the proposed regulations.
Nonfunctionally Integrated Type III Supporting Organizations. Similarly, in the Background discussion
of the Integral Part Test, the IRS described how “Many commentators said that
[the proposed 5%] payout rate was too high and would erode an organization’s
assets over time.” Despite those
and similar comments, the Treasury Department and the IRS incorporated the five
percent payout rate in the proposed regulations.
Deadline. The September 24, 2009, Notice of
Proposed Rulemaking indicates that “Written or electronic comments and requests
for a public hearing must be received by December
23, 2009.” [italics in
original].
Internal Revenue Service
Outreach. One of the two IRS officials
listed in the Notice is a skilled public speaker and has been repeatedly
available to the professional community to explain the government’s thought
process behind the Proposed Regulations. Both during the November 10, 2009, American Bar Association Section of Taxation
Exempt Organizations Committee CLE Teleconference, and on November 19, 2009, at
the 13th Annual Western Conference on Tax Exempt Organizations, he
emphasized that the IRS welcomes comments on all aspects of the Proposed
Regulations. (For your convenience,
his business card reads: Philip T. Hackney, Senior Technician Reviewer, Office
of the Chief Counsel of the Internal Revenue Service (Philip.t.hackney@irscounsel.treas.gov).) However, his responses to numerous
questions make it plain that the five percent payout requirement for
nonfunctionally integrated type III supporting organizations will remain.
Damage From the Five Percent
Payout Requirement For Nonfunctionally Integrated Type III Supporting
Organizations. The most
obvious damage from the payout requirement for type III nonfunctionally
integrated type III supporting organizations is the one voiced by “Many
commentators” and quoted above: that it “would erode an organization’s assets
over time.” Assume a supporting
organization has $1,000,000 of assets and earns 4%, but pays out 5% and has a
1.5% expense factor. Its endowment
will be reduced by approximately 25% in a decade. The less obvious damage from the payout requirement is that donors
are likely to form fewer type III supporting organizations: why should donors
subject themselves to a five percent payout requirement on top of the lack of
control and other type III supporting organization restrictions? Why not establish a private foundation
and, at least, have dictatorial control over the organization and the ability,
each year, to spread the distributions among many, and different, donees? That result will be the damage forecast
by commentators quoted in the Notice: supported organizations will not receive “the
kind of consistent, reliable, long-term support [they] have come to expect.”
The Action By The Internal
Revenue Service Is Illogical And Unwarranted. The IRC imposes a five percent payout requirement on private
foundations. IRC Section
4242. Had Congress wanted to
impose that five percent payout requirement on nonfunctionally integrated type
III supporting organizations, Congress could have amended the IRC to impose
that requirement. After all, the
Pension Protection Act of 2006 had about one hundred pages concerning
non-pension issues. In fact, that
Act made numerous changes in Section 4942 itself. So why would Congress leave such a major change to the IRS? The answer is that Congress did not
and, to the extent that the IRS has taken it upon itself to do so, its action
is unwarranted. However, as we
know all too well, logic and the tax laws are not a happily married
couple.
Also, despite this author’s strong feelings, the Proposed
Regulations would almost certainly prevail over a taxpayer’s challenge in court. To apply what former IRS Commissioner
Donald Korb has written to these facts, Congress directed the IRS to issue a
payout percentage, and when the IRS fills a gap reasonably, the Supreme Court
has consistently ruled that courts must defer to and uphold its interpretation. “The
Four R's Revisited: Regulations, Rulings, Reliance, And Retroactivity In The
21st Century: A View From Within,” Donald L. Korb, 46 Duq. L. Rev. 323 (Spring, 2008).
Policy Reason To Distinguish
Between Nonfunctionally Integrated Type III Supporting Organizations And
Nonoperating Private Foundations. The Background to the Proposed Regulations cited commentators who noted that
supporting organizations are designed to provide “long-term consistent support
to specific organizations, while private foundations may pay out to whomever
they choose.” Also, some
commentators noted that “a supporting organization maintains a governance
relationship with its supported organization(s) in a way that a private
foundation does not.” Those are
policy reasons to impose the higher distribution requirement on nonoperating
private foundations and, of course, those policy reasons are embodied in the
statute, insofar as Section 4942 does not apply to supporting organizations.
Recommended Revision To The
Proposed Regulations. Congress
charged the IRS to come up with a solution to a problem. The IRS came up with the wrong solution
by applying an IRC section, a solution available only to Congress itself. However, several decades ago the IRS came
up with a solution for a similar situation, and Congress is aware of and has
obviously acquiesced in that solution. As we know, operating public charities generally are not subject to a minimum activity level requirement. However, one category of public charity
effectively has an expenditure requirement: a medical research organization
described in §170(b)(1)(A)(iii). The IRS requires a medical research
organization to either spend 3.5% of its endowment or devote more than one-half
of its assets to further its research activities to meet the safe harbor
requirement of Regs. §1.170A-9(d)(2). That 3.5% distribution requirement
would be – for nonfunctionally integrated type III supporting organizations -
the “Goldilocks” solution.
Related Problems With The
Proposed Regulations. Although
the five percent distribution requirement is the most obvious problem with the
Proposed Regulations, there are related problems. These related problems are primarily caused by the fact that
the IRS decided not to incorporate IRC Section 4942 by reference, but to invent
another series of rules. Therefore, the new rules lack some important features needed for any
distribution requirement, e.g., set-asides. See Internal Revenue Code Section 4942(g)(2).
Call To Action. It seems unlikely that the IRS will
drop the five percent distribution requirement from the Proposed Regulations solely
due to an appeal based on (i) logic, i.e., the structure of the IRC, and (ii)
what is in the best interests of public charities and their supporting
organizations. Therefore, charities
must now contact their elected public representatives, and demand that they
send letters to the IRS clarifying that it was not Congress’ intent to apply
Section 4942 to public charities.
Conclusion. The five percent distribution requirement
for nonfunctionally integrated type III supporting organizations in the
Proposed Regulations is (i) an incorrect reading of the intent of Congress and (ii)
bad policy. The charitable
community must act now through its representatives in Congress, before the
Proposed Regulations become final. Although the official comment period ends on December 23, 2009, the IRS has
unofficially, graciously indicated that it will welcome comments into the
Spring.
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