United States: New IRS Notice: Interim Guidance Regarding Supporting Organizations And Donor Advised Funds

On December 4, 2006, the Internal Revenue Service issued Notice 2006-109 with interim guidance for supporting organizations and donor advised funds, in light of the new legislation enacted as part of the Pension Protection Act of 2006 ("PPA").1

In part, these temporary guidelines provide safe harbors for private foundations with regard to grants to certain types of public charities classified as supporting organizations. These guidelines also provide transitional relief for those organizations with pre-existing agreements impacted by the new provisions in the PPA.

The provisions enacted by the PPA impose certain excise taxes on transactions in which a private foundation makes a grant to a recipient who is ultimately controlled by the private foundation donor. These interim guidelines provide relatively "bright-line" tests for determining when a donee will be considered to be "controlled" by the donor.

While the Notice also provides guidance with relation to the new provisions impacting donor advised funds, those donor advised guidelines will not be dealt with herein.

The PPA amendments to Sections 4942 and 4945 affect private foundations that make grants or similar payments to supporting organizations, and impose an additional excise tax in certain situations. These interim guidelines establish more definitively when the excise taxes will be applicable.

If a non-operating private foundation makes a grant to a Type III supporting organization of one of the following types, the grant will not be a qualifying distribution under section 4942. Additionally, the grant will be a taxable expenditure under section 4945 if the private foundation does not exercise expenditure responsibility as to that grant. The Type III supporting organizations that are, as a result, essentially precluded from grants from private foundations are the following:

• A Type III supporting organization that is not functionally integrated with its supported organization

• A Type I, Type II, or functionally integrated Type III supporting organization when one or more disqualified persons of the donor private foundation directly or indirectly controls the supporting organization (or one of its supported organizations)

In order to avoid these taxable events, a private foundation may rely upon the IRS Business Master File or the grantee’s current IRS letter in which the grantee’s public charity classification is specified, to determine whether the organization falls within one of the supporting organization definitions above. In addition, a private foundation grantor, acting in good faith, may rely upon a written representation from a grantee in determining whether the grantee is a Type I, Type II, or functionally integrated Type III supporting organization and thus not within these new PPA excise taxes, if it also obtains copies of, and reviews, the grantee’s governing documents. The written representation must be consistent with the underlying documents. Or, the private foundation may rely on a written representation signed by an officer, director or trustee of the grantee that the grantee is a functionally integrated Type III supporting organization, as long as the written representation contains certain specified information. In all of these scenarios, the grantor must verify that the grantee is listed in IRS Publication 78, or must obtain a copy of the current IRS letter recognizing the grantee as exempt from federal income tax.

Additionally, as an alternative to relying on a written representation from a grantee with the underlying documentation, a private foundation grantor may rely on a reasoned written opinion of counsel of either the grantor or the grantee in concluding that the grantee is a Type I, Type II, or functionally integrated Type III supporting organization, and thus will not cause the private foundation to be subject to excise taxes.

In determining whether a grantee supporting organization is ultimately controlled by disqualified persons of the private foundation and thus would subject the private foundation to excise taxes, the definition of control that will be utilized until further guidance is issued is found in Treas. Reg. Section 53.4942(a)-3(a)(3). Under this definition, a supporting organization is controlled by one or more DP’s as to the private foundation, if any of the DP’s may, by aggregating their votes or position of authority, require the supporting or supported organization to make an expenditure, regardless of the method by which the control is exercised.

Additionally, solely for purposes of an opinion of counsel on which the grantor may rely, an organization will be considered a functionally integrated Type III supporting organization, if it meets the test set forth in Treas. Reg. section 1.509(a)-4(i)(3)(ii). This test is the "integral part test" under the supporting organization definitional regulations, and thus the supporting organization must be an integral part of its supported organization(s).

Under section 4958(c), any payment by a supporting organization to a substantial contributor or related individual, and any loan provided by a supporting organization to certain disqualified persons, is treated automatically as an excess benefit transaction subject to excise tax. Under the PPA, these rules are applicable for transactions occurring after July 25, 2006. However, since the statute was not enacted until August 17, 2006, the IRS has moved the effective date, and section 4958(c) will only apply to transactions entered into after August 17, 2006. The IRS will not consider payment made pursuant to a written contract that was binding on August 17, 2006 as an excess benefit transaction under new section 4958(c)(3), provided that the contract was binding at all times between August 17, 2006 and when payment is made, the contract is not modified, and the payment is made on or before August 17, 2007. The same transitional relief is afforded those legally enforceable arrangements that are not governed by a written contract, but by some other legal obligation, e.g., employment relationship.

^{1. Pub.L. No. 109-208, 120 Stat. 780 (2006)}

This Client Alert is prepared by the Tax Practice of Powell Goldstein LLP as a client service. The information discussed is general in nature and may not apply to your specific situation. Legal advice should be sought before taking action based on information discussed.