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Stephanie B. Casteel is a partner in tax in the Atlanta office of King & Spalding LLP, vice-chair of the Charitable Planning Committee of the Charitable Planning and Exempt Organizations Group, and an associate articles editor of Probate & Property.
The Pension Protection Act of 2006 (PPA) imposes new rules on supporting organizations, private foundations, and donor-advised funds, the primary types of charitable entities clients create to perpetually support other public charities. This article discusses these new rules and how they affect the type of grant-making charitable entity that will be most appropriate for clients, depending on their goals and desires.
Type of Entity Before Enactment of PPA
Since 1969, when supporting organizations and private foundations were recognized in the Code, and before the enactment of the Pension Protection Act of 2006, in determining whether a client should establish a supporting organization, private foundation, or donor-advised fund as the vehicle by which the client and his family would perpetually support other public charities, the choice was based primarily on the client’s desires, priorities, and goals. As discussed below, these factors should be considered along with the characteristics and requirements of the different types of giving entities to select the type most compatible with the client’s wishes.
A supporting organization, which is classified as a public charity by virtue of its relationship to the organization(s) it supports, is one of three types. Although the type relates to only one prong of a multiple part test to qualify as a supporting organization, supporting organizations are identified primarily by their type. A “Type I” supporting organization is one in which a majority of its board is appointed by the supported charity or charities. A “Type II” supporting organization is one in which a majority of its board members, officers, or managers also serve as board members, officers, or managers of the supported charity or charities. A “Type III” supporting organization is not controlled by its supported charity or charities through its board, but instead has a relationship with its supported charity or charities, established by meeting a responsiveness test and an integral part test sufficient to qualify it as a supporting organization.
A supporting organization typically would be used if a donor intended to benefit either a finite pool of charities or a single charity, but one to which the donor did not desire to give total control over a large irrevocable gift. If a donor wished to define the class of supported charities by type or geographic area, rather than by name, only a Type I or Type II supporting organization could be used. If a donor desired to maintain the maximum control allowable, a Type III supporting organization could be used. Regardless of type, the donor or a related party could provide services to, and be paid by, the supporting organization. As a public charity, the supporting organization would have no minimum payout requirement, and the donor’s contribution to it would be subject to higher income limitations for purposes of the charitable deduction.
A donor establishes a donor-advised fund under the tax umbrella of a public charity, which acts as a sponsor to many funds. The donor and his family members may recommend the charities to which annual grants are made from this established fund, but the donor has no legal control over the grants. Instead, the public charity legally controls the grants and donees. As with a supporting organization, the donor-advised fund is a public charity by virtue of its relationship with the public charity that is the sponsor.
A donor-advised fund nonetheless offers a donor great control because, although the donor does not retain legal control, most sponsor charities in fact would follow the recommendations of their donors, thereby giving them effective control. Also, because a donor-advised fund is owned by the sponsor charity and is not a separate legal entity, the donor would incur less cost to establish and maintain the fund. Because the sponsor is a public charity, contributions to a donor-advised fund would be subject to the higher charitable deduction income limitations. Finally, the donor and advisors to the fund could provide services to, and be paid by, the fund.
A private foundation offers the greatest control to a donor and for this reason is not classified as a public charity. Because a private foundation does not have a defined relationship with any particular public charity or class of charities, as do supporting organizations and donor-advised funds, no public charity is deemed a “watchdog” for the IRS over the operations of the private foundation. For this reason, a private foundation is subject to a set of rules not applicable to public charities, including
Notwithstanding these rules, “disqualified persons” of the foundation, which generally include the donor, family members, certain controlled entities, and foundation managers, could provide services to, and be paid by, the private foundation, as long as the compensation is reasonable.
A donor wishing to establish a charitable grant-making entity should consider his desired flexibility in the charities to which grants will be made, how much control the donor wishes to maintain, what level of charitable income tax deduction may be used, and the expected size of the grant-making entity in relation to the legal costs to create the entity and the ongoing maintenance costs. The determination of the appropriate type of charitable entity will depend on these factors and the limitations applicable to the various types of entities.
Type of Entity After Enactment of PPA
Since the enactment of the PPA, the questions that must be asked to determine the most appropriate type of charitable grant-making entity for a client include those described above. The PPA, however, also imposes new rules on all three types of grant-making entities to curtail some perceived abuses. Thus, it is now relevant whether a client wishes to support a foreign charity, whether a client wishes to contribute interests in an operating business or in non-income-producing property, whether the client or certain related parties may expect to receive compensation or expense reimbursement, and whether the client controls any potential donee. These new factors, and how they affect the choice of grant-making entity most appropriate for a client, also must be considered.
If one of the purposes or activities of the proposed grant-making entity is to support a foreign charity, any of a supporting organization, donor-advised fund, or private foundation could have been used before the PPA. In the case of a private foundation, grant expenditure responsibility would have been necessary, but its proper exercise would have allowed such support. Under the PPA, however, foreign charities no longer may be supported by a “non-functionally integrated” (that is, grant-making) Type III supporting organization. (For existing Type III supporting organizations, support of a foreign charity is allowed to continue only until the first day of the organization’s third taxable year beginning after August 17, 2006.) A Type I or Type II supporting organization still may be used. Although a donor-advised fund may continue to support a foreign charity after the PPA, the donor-advised fund now must exercise expenditure responsibility over such grants. Private foundations still may be used as long as expenditure responsibility is exercised.
Type of Asset Contributed—Interest in an Operating Business
A client may be planning to contribute closely held stock, limited partnership or limited liability company interests, interests in a real estate development, or some other interest in a business enterprise. Before the PPA, any type of entity could have been used, with the possible exception of a private foundation. As mentioned above, private foundations are subject to the excess business holding rule, which mandates that the combined holdings of a private foundation and its disqualified persons, in a business enterprise, may not exceed 20%. Private foundations also are subject to a requirement to annually spend or pay out for charitable purposes at least 5% of the average fair market value of their investment assets for the preceding year. Depending on the liquidity of the business interest or whether an income yield is attached to it, a business interest may not be suitable to be held by a private foundation.
Under the PPA, the excess business holdings rule, previously applicable only to private foundations, now applies to (1) a Type III supporting organization, (2) a Type II supporting organization if it accepts contributions from a person (other than a public charity that is not a supporting organization) who controls, either alone or with family members and/or certain controlled entities, the governing body of a supported organization, or (3) a donor-advised fund. Thus, if a client plans to contribute an interest in a business enterprise that would implicate the excess business holdings rule, his only option would be a Type I supporting organization or a Type II supporting organization that does not accept contributions from certain control parties. Note that under the PPA, a tailored fund dedicated to a single specific charity is not defined as a donor-advised fund, and thus the excess business holdings rules are not applicable to it.
Type of Asset Contributed—Non-Income Producing Property
A client may plan to contribute property that produces little or no income. Before the PPA, any type of entity may have been used, again with the possible exception of a private foundation. As mentioned above, a private foundation is required to make annual minimum distributions equal to 5% of its fair market value. The PPA now imposes a payout requirement on Type III supporting organizations. An Advance Notice of Proposed Rulemaking, issued by the Treasury and the IRS in 2007, proposed that the payout requirement be the same as that applicable to a private foundation. Comments were requested, and the Treasury was expected to issue Proposed Regulations some time this past summer. Although the minimum annual distribution requirement for a Type III supporting organization under Proposed and Final Regulations ultimately may not be as high as 5%, commentators believe that this percentage is likely.
In addition, the IRS has announced that it is studying whether a minimum payout requirement also would be appropriate for a donor-advised fund. Because of this scrutiny, some sponsors may be hesitant to accept non-income producing property if they prepare consolidated Forms 990. So even though the PPA does not impose a distribution requirement on donor-advised funds, their use may be impractical for some sponsoring public charities.
A Type I or Type II supporting organization may continue to be used for non-income producing property, but this option also may be impractical (as it likely was before) simply because the supported organizations will want liquidity. And because a majority of its board will be either appointed by or overlap with the supporting organization’s board, the supported organization’s board may not agree to continue to hold non-income producing property. A gift to a public charity, either directly or through a charitable remainder trust, likely would be the best option for non-income producing property.
Provision of Services
Another new factor to consider is whether the client intends or expects himself or certain related parties to receive compensation for services provided to the grant-making entity. Before the PPA, any type of entity could pay compensation for services provided by any person, as long as the compensation was reasonable. Ironically, under the PPA, only a private foundation may continue to compensate “disqualified persons,” as an exception to the rule prohibiting certain transactions between a private foundation and its disqualified persons.
Under the PPA, any payment by a supporting organization to a substantial contributor or a family member or controlled business of a substantial contributor is prohibited. A payment is defined by the PPA as a grant, loan, or “similar payment,” and the Joint Committee staff explanation states that “similar payment” includes the reimbursement of expenses. This prohibition is also applicable to a donor-advised fund for a donor, advisor, or business in which a donor or advisor has a substantial interest. Thus, if compensation, loans, reimbursements of expenses, or other payments to certain related persons are important to a client, a private foundation may be the only option.
Control of Donees
Finally, a new factor that must be considered is the identity of the charities that the client may want to support and the identity of those who control these potential donees. This consideration never mattered before the PPA, but now it does.
A private foundation may support a Type III supporting organization, but, if a grant is made to a nonfunctionally integrated Type III supporting organization, such grant will not be considered a qualifying distribution for purpose of the minimum distribution requirement. A private foundation also may support a Type I or Type II supporting organization, but a grant will not be a qualifying distribution if a disqualified person controls the supporting organization or any public charity supported by the supporting organization. (It is still allowable for a private foundation to make a grant directly to a public charity controlled by a donor, as long as the public charity is not a supporting organization.)
A Type I or Type III supporting organization will not qualify as a public charity (or will lose its public charity status) if a donor controls, directly or indirectly, a supported organization or is a relative of a person who controls, directly or indirectly, a supported organization. Although a donor-advised fund may make grants to charities controlled by a donor or advisor, the PPA requires the exercise of grant expenditure responsibility for any grant made to a supporting organization that supports a charity controlled by a donor or advisor. Therefore, if a client wishes to support, through an entity, a charity he controls, he may use a Type II supporting organization, a private foundation (as long as a grantee is not a supporting organization), or a donor-advised fund (as long as a grantee is not a supporting organization.)
In recommending the most appropriate type of entity to a client wishing to establish a grant-making charity, factors to consider include the desired flexibility of potential donees, the desired level of control, the optimal charitable income tax deduction, and the anticipated size and scope of the entity. Additional factors are now relevant in light of the enactment of the PPA. These additional factors include the type of asset the donor wishes to contribute, in particular whether it produces income or is an interest in a business enterprise, whether the donor desires himself or certain related parties to perform services for the entity and to be entitled to compensation or expense reimbursement, whether the donor wishes to make grants to a foreign charity, and whether the donor controls any of the charities he wishes to support. The new restrictions the PPA imposes are not difficult to address, but they must be considered in light of the client’s wishes in order to select the most appropriate type of charitable grant-making entity.Return To Issue Index