On October 13, 2023, the Department of Treasury and the IRS issued the last round of final regulations implementing changes to the rules for supporting organizations ("SOs") under section 509(a)(3) of the Internal Revenue Code, as enacted by the Pension Protection Act of 2006. These final regulations largely adopt proposed regulations released in February 2016, and among other things contain technical rules for supporting organizations of governmental entities, clarify distribution requirements for non-functionally integrated Type III SOs, and provide the definition of "control" for purposes of the prohibition on Type I and Type III SOs receiving contributions from persons who control the governing body of a supported organization of that SO.
Of particular note, the final regulations set a potentially high bar for parent organizations of health systems (or other integrated systems) organized as Type III SOs. Parent organizations of such integrated systems often lack their own source of revenue, making qualification as a publicly supported organization under sections 509(a)(1) or 509(a)(2) difficult. Qualification as a Type I SO of the subsidiaries in the system, which generally requires that the supported organizations appoint a majority of the SO's board, is counter to the structure of the SO serving as the parent. Qualification as a Type II SO is feasible if the parent is able to have a mirror board with each of its subsidiary supported organizations. For small systems, this may be achievable, but for large systems with many supported organizations, implementing mirror boards throughout the entire system may be practically difficult and may not suit the operational needs of each organization. Under an earlier set of final regulations implementing the new SO rules, Treasury and the IRS opened a pathway for parents of integrated systems to qualify as Type III functionally integrated SOs, as long as the SO exercises a substantial degree of direction over the policies, programs, and activities of the supported organizations, and a majority of the officers, directors, or trustees of the supported organizations are appointed by the SO (through its officers or governing body). Many parent corporations of integrated systems, particularly hospital and health systems, are structured as Type III functionally integrated SOs, consistent with these existing rules.
The final regulations largely leave in place the ability of an integrated system's parent to qualify as a Type III SO, albeit with some tightening of the requirements. Most notably, the final regulations require that the parent "direct the overall policies, programs, and activities" of its supported organizations and that it not only have the ability to appoint or elect, but also to remove and replace or otherwise appoint with reasonable frequency, a majority of the boards of the supported organizations. Helpfully, the final regulations indicate that a parent may meet this requirement indirectly with respect to lower-tier subsidiaries, such as if the parent has majority board appointment and removal authority over a supported organization that in turn has board appointment and removal authority over a lower-tier supported organization.
Type III SOs must satisfy, among other conditions, a responsiveness test that requires the officers, directors or trustees of the supported organization(s), by reason of their relationships with the SO, to have a "significant voice" in the investment policies, the timing of grants, the manner of making grants, and the selection of grant recipients by the SO, and in otherwise directing the use of the income or assets of the SO. Following the approach of the 2016 proposed regulations, the final regulations amend the existing regulations to provide that an SO only meets the responsiveness test if it is responsive to the needs ofeachof its supported organizations.
The final regulations include a new example demonstrating how an organization with multiple supported organizations can satisfy the significant voice requirement, where not all supported organizations have a governance role with the parent (such as through board or officer overlap or appointment). Under the example, officers and representatives of the SO hold regular meetings with representatives of the supported organizations and make available to the supported organizations information about the SO's activities, assets, liabilities, receipts, distributions, and investment policies and returns, and during the meetings the supported organizations have the opportunity to ask about the SO's investment and grantmaking policies and practices. Moreover, the SO provides the supported organizations with the contact information of one of its officers and encourages the supported organizations to contact that individual with any questions or if additional meetings are desired.
While the preamble notes that this example is just one way an SO may meet the revised responsiveness test, the facts of the example may be challenging to satisfy for a large integrated system with top-down management, where numerous subsidiaries are unlikely to be solicited for their input into the operations of the system or given the opportunity to weigh in on investment and grantmaking decisions of the parent. For an integrated system with a Type III functionally integrated SO system parent in which all the supported charities do not have a formal governance role at the parent level, the final regulations may invite uncertainty as to whether the parent needs to implement the types of meetings and information sharing described in the new example in order to maintain its status as a Type III functionally integrated SO.
The final regulations are applicable to taxable years beginning on or after October 16, 2023.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
