Supporting Organizations As a I, Tool for Effective Fundraising

.. = ~{ Supporting Organizations as a I, Tool for Effective Fundraising

by Patrick D. Martin, Esq. & Michael J. Cooney, Esq. ! i i

In today's highly competitive world of charitable fundraising, development professionals are faced with the twin demands of meeting both institutional and donor needs. Increasingly, major donors are seeking a higher level of involvement in the organizations they support. The delicate negotiation of a I~ ~ major gift requires familiarity with both the institution and the donor, coupled with a broad knowledge of gift planning techniques. The supporting organization, an independent public charity under Internal

Revenue Code (IRC) ~ 501(c)(3), has been the subject of increasing interest and use in the past few years. l No development professional is well equipped to deal with the demands of the marketplace without a

. keen understanding of how supporting organizations work and when they are appropriate. i i The purpose of this article is to familiarize the reader with the creation, operation and use of supporting organizations as defined in IRC ~ 509(a)(3). These unique organizations have many applications in fundraising because they offer some of the operational advantages of private foundations as well as the tax , advantages of the public charities they support. il

THE SITUATION The development professional has scheduled a meeting with major supporter and businessman 1 Phillip N. Thropist. The file on Mr. Thropist indicates that he is a self-made man, turning his small, family-owned business into a publicly traded company. He is as generous as he is opinionated, and believes fervently in your cause. The meeting is short on small talk. Mr. Thropist has a series of expectations and sets them forth for your consideration. 1) He wants to make an endowment gift of $20 million. 2) He will give his own company's stock. 3) He wishes the charity to hold the stock for as long as he deems appropriate. 4) He wants to be involved in the specific uses of the income, and upon his death wishes his children or i I other family members so designated by him to serve as advisors, as well. The chief executive of the charity is a wonderful advocate for the development program, but has a striking tendency to vanish when he thinks a donor is being demanding. The new head of the finance committee is an investment banker who prides herself on her ability to maintain high levels of earnings through a properly managed and monitored, diversified portfolio. Fortunately, the charity's legal counsel is an expert in charitable giving and has taught you the proper use of the supporting organization.

PUBLIC CHARITIES The IRC divides the universe of charitable organizations into basically two spheres, the public charity

and the private foundation. 1 xs I Generally speaking, public charities fare better than private foundations under the tax laws. The oper- i ational and funding advantages of a public charity can be traced to the belief on the part of Congress that if the public was involved in either the financial support or operation of a charitable organization, it was less likely that the intended public good would be secondary to the potential private advantage of those in control of the organization. Supporting organizations are not subject to the same direct public scrutiny, and yet their required relationship to one or more publicly supported/controlled organizations provides a level of supervision sufficient to avoid private foundation status.

/-a,7~ j" THE IOURNAL OF GIFT PLANNING The potential donor in our example makes precisely the capital gains; private foundations enjoy full deductibility type of demands that a supporting organization can accommo- only for gifts of cash or qualified appreciated stock. 12 date: continued donor control over grants and investments com- bined with public charity status linked to a public institution. PUBLIC CHARITY STATUS "Well then," Mr. Thropist might ask, "why do I have this OPERATIONAL ADVANTAGES private foundation when a public charity is what I really need?" A public charity has some major operational advantages Yet, attaining and maintaining public charity status is not neces- over a private foundation. A supporting organization avoids sarily a simple task. Under IRC ~ 509, a charitable organization the following. is presumed to be a private foundation unless it meets one of 1) Tax on net investment income. 2 three tests that govern redassification as a public charity. 2) Self-dealing prohibition) 1) Donations test. 13 Under this test, certain organizations 3) Minimum distribution requirements. 4 described in IRC ~ 170(b)(1)(A) are given public charity 4) Excess business holding limitations.5 status. These indude churches, schools, hospitals and enti- 5) Jeopardizing investment limitations. 6 ties with broad public donation support. 6) Taxable expenditure rule.7 2) Donations and gross receipts test. 14 Under this test, orga- 7) Termination tax.8 nizations that receive a substantial part of their financial support from the general public in the form of gifts, grants Your conversation with the potential donor has gone well or membership fees and gross receipts from exempt activi- thus far. Mr. Thropist already has a private foundation, but dis- ties are granted public charity status. There is a limit on the likes the restrictions it entails. He especially finds the 2% tax on amount of investment income (i.e., from endowment) that investment income to be abhorrent, asking why any charity is allowed. Nursing homes and social service agencies often should pay any tax on its income. You explain that there are meet this test. proposals before Congress that would eliminate the investment 3) Supporting organizations. 15 Under this test, charitable tax imposed by IRC ~ 4940. Mr. Thropist is apparently organizations that Would otherwise be classified as private unaware of the debt-financing rules of IRC ~ 511 et. seq., foundations can be classified as public charities if they meet which would convert some or all of the income earned by his the three-pronged test off private foundation to fully taxable unrelated business income to • purpose; the extent of the debt financing involved. • relationship; and Mr. Thropist's donor advised fund at the local community • control. foundation works well enough, but does not provide him with the investment control he seeks. The foundation's development Under this test, neither activities nor the source of financial director told him that retention of investment control would support are relevant. The relationship to one or more public result in a gift of something less than all his rights in the given charities is paramount. property; a partial-interest gift, which would result in no deduction at all.9 SUPPORTING ORGANIZATIONS It is important to remember that a supporting organiza- Mr. Thropist is not that generous. He expects a full fair- tion, in the first instance, is a charitable organization, described market value deduction for his gift. 1° He also mentions some in IRC ~ 501(c)(3). Supporting organization status is thus a other relevant facts. He has already made substantial gifts to his subset within the world of charitable organizations. 16 private foundation, and is also interested in the possibility of A supporting organization is a separate entity from the using some other dosely held stock in his most recent start-up charity it supports, created as either a corporation or a trust in order to make a gift to your institution. under state law. A number of factors go into the selection of a structure, including: FUNDING ADVANTAGES As a public charity; a supporting organization also possesses 1) intended duration; 2) formality of operation; certain funding advantages over a private foundation. 1) Higher percentage limitation on allowable income tax 3) liability for activities; and charitable deductions: 4) state oversight. • 50% versus 30% for cash contributions; and This choice is not inconsequential. For example, if the • 30% versus 20% for non-cash contributions. 11 donor wishes to maintain a relatively high concentration of a 2) Fair-market value deduction for all gifts of intangible per- specific stock in his or her supporting organization, a strict state sonal property; the sale of which would result in long-term law requirement to diversify for charitable trusts may mean that

THE JOURNAL OF GIFT PLANNING ~~ the corporate form works better.17 The distinguishing feature of the "supervised or controlled in A supporting organization must be structured to meet the connection with" relationship is that the control or management following four requirements. of both the supporting and supported organization is vested in 1) Operated, supervised or controlled by or in connection the same persons. 22 With this type of brother/sister relationship, with one or more public charities (relationship test). an example from the Regulations may be helpful. 2) Organized, and at all times thereafter operated exclusively A, a philanthropist, founded X school for orphan boys (a for the benefit of, to perform the functions of, or to carry publicly supported organization). At the same time A out the purposes of one or more specified public charities founded X school, he also established Y trust into which he (organizational test). transferred all of the operating assets of the school, together 3) Operated exclusively for the benefit of, to perform the with a substantial endowment for it. Under the provisions functions of, or to carry out the purposes of one or more of the trust instrument, the same persons who control and specified public charities (operational test). manage the school also control and manage the trust. The 4) Not controlled directly or indirectly by one or more dis- sole function of Y trust is to hold legal title to X school's qualified persons (as defined in IRC ~ 4946) other than operating and endowment assets, to invest the endowment foundation managers, and other than one or more public assets and to apply the income from the endowment to the charities (limitation on control by disqualified person).18 benefit of the school in accordance with direction from the school's governing body. Under these circumstances, Y trust RELATIONSHIP "rEST is organized and operated for the benefit of X school and is In order to meet the requirements of a supporting organiza- "supervised or controlled in connection with" such organi- tion, three different types of relationships are possible: zation within the meaning of Section 509(a)(3). The fact 1) operated, supervised or controlled by, that the same persons control both X and Y ensures Y's 2) supervised or controlled in connection with; or responsiveness to X's needs. 23 3) operated in connection with. 19 In contrast, the organization below fails the test for lack of These relationships might be thought of as a continuum, control in the supported charity, despite the existence of other from a greater to a lesser degree of control by the supported state law rights. public charity. No matter which test applies, the relationship In 1972, B, a philanthropist, created P, a charitable trust established between the supporting organization and the speci- for the benefit of Z, a symphony orchestra described in fied public charity must ensure that the supporting organization Section 509(a)(2). B transferred 100 shares of common will be responsive to the needs or demands, and constitute an stock to P. Under the terms of the trust instrument, the integral part of, or maintain a significant involvement in, the trustees (none of whom is under the control of B) were public charity's operations. required to pay over all of the income produced by the The distinguishing feature of the "operated, supervised or trust assets to Z. The governing instrument of P contains controlled by" relationship is a substantial degree of direction certain provisions whose effect is described in by the supported public charity over the policies, programs and Section 508(e)(1)(A) and (B). Under applicable state law, activities of the supporting organization.20 The relationship, Z can enforce the provisions of the trust instrument and comparable to that of a parent and subsidiar> is established compel payment to Z in a court of equity. There is no rela- when a majority of the officers, directors or trustees of the sup- tionship between the trustees of P and the governing body porting organization are appointed or elected by the governing of Z. Under these circumstances P is not supervised or body or officers of the supported public charity acting in their controlled in connection with a publicly supported organi- official capacity. The Regulations provide an illustrative example. zation. Because of the lack of common supervision or X is a university press that is organized and operated as a control by the trustees of P and the governing body of Z, P nonstock educational corporation to perform the publish- is not supervised or controlled in connection with Z within ing and printing for M University, a publicly supported the meaning of Section 509(a)(3)(B).24 organization. Control of X is vested in a Board of The "operated in connection with" relationship exists when Governors appointed by the Board of Trustees of M the supporting organization meets the requirements of two University upon the recommendation of the president of additional tests~the "responsiveness" test and the "integral the university. X is considered to be operated, supervised part" test. 25 This relationship does not reflect the broad control or controlledby M University within the meaning of relationship of the other two tests, but relies instead on control IRC ~ 509(a)(3)(B).2~ in a review based largely on facts and circumstances. " ([ continued on page 35 ,7. THE JOURNAL OF GIFT PLANNING Martin, Cooney, continuedfrom page 7 , ,, ..... Under the responsiveness test, the supporting organization from X for their continuation. Under these circumstances, must be responsive to the needs or demands of the supported X will be treated as providing Y with a sufficient portion of public charity. The Regulationsrequire that one of two alternative Y's total support to assure Y's attentiveness to X's opera- tests be met. Under the first test: tions, even though the chamber music series is not the pri- 1) one or more officers, directors or trustees of the supporting mary part of Y's activities. 29 organization must be elected or appointed by the officers or Note how this test provides the supporting organization trustees of the supported public charity; or with the ability to highlight a segment of the supported organi- 2) one or more members of the governing body of the support- zation's operations, such as a program or a department, and ed public charity must also be officers or trustees of, or hold support solely that portion. other important offices in, the supporting organization; or 3) the officers, directors or trustees of the supported public ORGANIZATIONAL TEST charity must maintain a close and continuous working The supporting organization's governing instrument must: relationship with the officers or trustees of the supporting limit the purposes of such organization to one or more of the organization; and purposes set forth in IRC ~ 509(a)(3)(A); not expressly empower 4) by reason of 1, 2 or 3 above, the officers or trustees of the the organization to engage in activities that are not in furtherance supported public charity must have a "significant voice" in of the purposes referred to above; state the specified publicly sup- the investment policies of the supporting organization, the ported organization on whose behalf such organization is to be timing and manner of making grants and the selection of operated; and not expressly empower the organization to operate grant recipients, and otherwise directing the use of the to support or benefit any organization other than the specified income or assets of the supporting organization. 26 publicly supported organizations.30 Where the supporting organization is a charitable trust under There is no specific required language to meet this test. This state law, however, the responsiveness test may be met as long as requirement is, however, best met by a specific reference to the the supported public charity is the named beneficiary in the trust support of one or more specific publicly supported organiza- instrument, and it has the power to enforce the trust and compel tions. In addition, the purpose of the supporting organization an accounting under state law.27 Note the absence of officer or may be as broad as, or more specific than, the purposes set forth director overlap in this trust format. in IRC ~ 509(a)(3)(A). Examples include: The integral part test can be satisfied in one of two ways. 1) an organization formed "for the benefit of" one or more First, the supporting organization must maintain a "significant specified publicly supported organizations; or 2) an organization formed "to perform the publishing function involvement" in the operations of the supported public charity; of" a specific university.31 which must then also tbe dependent on the supporting organization for the type of sui~port that it provides. To meet this test, the Some flexibility is allowed in the specification of the supported supporting organization's activities must perform the functions of, public charity.32 or carry out the purposes of, the supported public charity. These are activities that, in the absence of the supporting organization, OPERATIONAL TEST normally would be carried out by the supported public charity. 28 The third test that a supporting organization must satisfy In the alternative, the supporting organization needs to involves demonstrating that it actually is operated exclusively for demonstrate its "attentiveness" to the supported public charity by the benefit of, to perform the functions of, or to carry out the purposes of, the specified publicly supported organization.33 payment of substantially all (i.e., 85%) of its income to, or for the use of, the supported public charity. This test has two components. First, the supporting organization must "operate exclusively" for the benefit of the specified An example from the Regulations demonstrates how public charity and second, it must engage only in activities that this works. support or benefit the specified public charity. The actual scope X, an organization described in Section 501(c)(3), pays over of activity is very broad.34 all of its annual net income to Y, a museum described in Section 509(a)(2). X meets the responsiveness test described LIMITATIONS ON CONTROL BY in Treas. Regs. ~ 1.509(a)-4(i)(2). In recent years, Y has ear- DISQUALIFIED PERSONS marked the income received from X to underwrite the cost of The last test that a supporting organization must satisfy carrying on a free chamber music series consisting of 12 per- is that it may not be controlled by one or more "disqualified formances a year that are performed for the general public persons."35 Disqualified persons, for purposes of IRC free of charge at its premises. Because of the expense involved 509(a)(3), include the following, other than publicly support- in carrying on these recitals, Y is dependent upon the income ed organizations.

/'aea~ o°O"" THE JOURNAL OF GIFT PLANNING 1) Persons (i.e., individuals, corporations, foundations and 5IRC $ 4943. 6IRC $ 4944. trusts) that are substantial contributors to the supporting 7IRC $ 4945. organization. A substantial contributor means any person 8IRC ~ 507. 9IRC ~ 170(f)(3)(A); Treas. Reg. ~ 1.507-2(a)(8). who has contributed more than $5,000 or 2% of the total 10Note that if Mr. Thropist could overcome his aversion to the private foundation rules, his gift of contributions received by the supporting organization since qualified appreciated stock would yield a full fair-market value deduction, assuming the requirements oflRC ~ 170(e)(5) were met. its inception, whichever is greater. lllRC $170(b)(1). 2) Persons with more than a 20% interest in a corporation, 12We would be remiss for not mentioning that the ability to achieve conduit foundation status under IRC ~ 170(b)(1)(E)(ii) for the potential donor's private foundation could also yield such a partnership, trust or unincorporated enterprise that is a sub- deduction, but requires the private foundation to act as a conduit to a public charity. The perceptive development officer would review the accumulated excess distribution carryforwards of the founda- stantial contributor to the supporting organization. tion to see if his or her charity might act as the recipient of the pass-through payment. 3) Family members of any individual described in 1 or 2 above. 13IRC ~ 509(a)(1). 14IRC $ 509(a)(2). 4) Corporations, partnerships, trusts or estates in which persons 15IRC ~ 509(a)(3) described in 1, 2 or 3 above have more than a 35% interest. 16IRC ~ 501(c)(3) includes: "Corporations, and any community chest, fund or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or Control is demonstrated where the disqualified persons, by educational purposes, or to foster national or international amateur sports competition (but only if aggregating their votes or positions of authority; may require the no part of its activities involve the provision of athletic facilities or equipment), or for the preven- tion of cruelty to children or animals, no part of the net earnings of which inures to the benefit of organization to take, or not to take, a particular action. any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation, except as otherwise provided in sub- section (h), and which does not participate in, or intervene in (including the publishing or distrib- THE SOLUTION uting of statements), any political campaign on behalf of (or in opposition to) any candidate for public office." The development professional, properly educated on the use 17Consider the importance of public charity status on this single issue. A private foundation with a of supporting organizations, provides Mr. Thropist with a simple required minimum distribution requirement of roughly 5% of its total assets could be severely affect- ed by a downturn in the value of a non-diversified portfolio. A supporting organization is not subject list of considerations for both him and the charity. In deciding to this requirement under IRC $ 4942. whether to make a gift, Mr. Thropist must take into account the 18IRC $ 509(a)(3). 19Treas. Reg. $1.509(a)-4(f). following factors: 20Treas. Reg. ~ 1.509(a)-4(g). 1) control (both investment and grants); 21Treas. Reg. $1.509(a)-4(g)(2). 22Treas. Reg. $1.509(a)-4(h). 2) public recognition; 23Treas. Reg. $1.509(a)-(4)(h)(3). Example (i). 24Treas. Reg. ~ 1.509(a)-(4)(h)(3). Example (2). 3) family involvement; 25Treas. Reg. $1.509(a)-4(i). 4) tax advantage; 26Treas. Reg. $1.509(a)-4(i)(2)(ii). 27Treas. Reg. $ 1.509(a)-4(i)(2)(iii). 5) scope of interest; and 28Treas. Reg. $1.509(a)-4(i)(3)(ii). 6) cost. 29Treas. Reg. ~ 1.509(a)-4(i)(3)(iii)(c). Example (i). 30Treas. Reg. $1.509(a)-4(c). As the development professional, you have already done the 31Treas. Reg. $1.509(a)-4(c)(2). homework as to what your charity can and will support, and 32Treas. Reg. $1.509(a)-4(d). 33Treas. Reg. $1.509(a)-4(e). present these considerations to Mr. Thropist as well: 34For example, see Rev. Rul. 75-436, 1975-2 C.B. 217 and Rev. Rul. 76-401, 1976-2 C.B. 175 (scholarships); PLR 9347032 (performing management and administrative services). 1) liability; 35Treas. Reg. ~ 1.509(a)-4(j). 2) benefit; 3) unique investments; Patrick D. Martin, Esq. is the principal of Ashford 4) financial reporting; Advisors LLC, an investment advisory and financial 5) compliance issues; and consultingfirm based in Pittsford, New York. Ashford provides a broad range of services to families and 6) available endowment alternatives. philanthropic entities. Formerly, Martin was a part- Mr. Thropist is intrigued by the ability to use a charitable ner with Nixon Peabody LLP in the personal practice and tax areas. Martin writes and speaks extensively trust under the "operated in connection with" test, but ultimately on issues relating to charitable, tax and investment decides that a doser relationship involving the appointment of a planning. He # currently a trustee of St. Lawrence majority of the supporting organization governing board by the University and a member of the Western New York public charity is acceptable. He completes the gift with some Board oft he Nature Conservancy. stock in his company; and hopes to contribute some stock in a MichaelJ. Cooney, Esq. is a partner with the law closely held company next year. ~_~ firm of Nixon Peabody, LLP. His practice concentrates on matters related to nonprofit and educational orga- Endnotes: 1There is something known as a private operating foundation, a hybrid of the two categories. nizations, their corporate governance, fundraising, IRC ~ 49420) (3). An explanation of these organizations is beyond the scope of this article, but they state regulation and taxation. He is general counsel to exist primarily as operations of single purpose foundations, like a museum, funded by a massive a number of educational institutions, foundations endowment from a limited number of donors. Because they raise funds from the public, most devel- and other charities, and is currently a director of the opment professionals have the benefit of working for public charities. 2IRC ~ 49'40. World Childhood Foundation, founded by Her 3IRC ~ 4941. Majesty, Queen Silvia of Sweden. 4IRC $ 4942.

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