A nonprofit corporation fails to qualify as a “supporting organization” operated in connection with a public charity when it will provide only $7,900 a year in support of a public charity raising more than $7 million a year in new contributions. The Sixth Circuit Court of Appeals ruled that contributions of $7,900 to the charity receiving $7 million are not sufficient to assure the attentiveness of public charity.
The Sixth Circuit Court of Appeals has affirmed a Tax Court decision holding that the organization should be classified as a private foundation because it has failed to show that its support will be an “integral part” of the public charity’s operations. (See Nonprofit Issues, December 2002.) (Lapham Foundation v. Commissioner, No. 03-1229, 11/18/04.)
The Lapham Foundation was formed “to operate exclusively for the benefit of the American Endowment Foundation” in a manner intended to enable it to qualify as a “supporting organization” under Section 509(a)(3) of the Tax Code. AEF is a national organization that provides donor-advised funds for its donors.
The Foundation’s sole asset was a $1,554,244 note from a company controlled by family members, providing $120,454 a year in interest income. The note had been transferred to the Foundation by family members, in return for a charitable gift annuity under which the Foundation agreed to pay them $116,568 a year.
According to the application for exemption, the Foundation expected to raise about $5000 of new gifts each year, which would allow it to contribute $7,900 to AEF. The Foundation would then recommend support for charities in southeastern Michigan, particularly in Northville.
The Foundation also estimated that it would receive another gift of approximately $693,000 upon the death of the Lapham, but they had a life expectancy of more than 25 years. It might also receive $355,834 annually over 17 years from a charitable lead trust after their death. Such payments were not assured, however, because the trust could still be revoked. The Laphams had also pledged $207,733 to the Foundation if it obtained supporting organization status.
Under the Tax Code, charities are presumed to be private foundations, which are subject to tax on their gross investment income and other significant imitations, unless they convince the IRS that they should be classified as public charities, which have much wider latitude in operations. Generally, public charities receive a broad range of public support from contributions and/or fees for charitable services.
An organization can be classified as a public charity as a supporting organization, without regard to its sources of income, however, if it is organized to perform the functions of one or more public charities and is controlled by, operated under common control with, or operated in conjunction with the public charities. A supporting organization may not be controlled by “disqualified persons.” (See Ready Reference Page No. 38, October 2000.) The Foundation claimed it was operated “in conjunction with” the AEF.
Under the Treasury Regulations, an organization will be deemed operated in conjunction with a public charity only if it meets a “responsiveness test” and an “integral part test.” There was no issue that the Foundation would be responsive to AEF.
The “integral part” test is designed to ensure that the publicly supported organization will be attentive to the supporting organization. It will be met if the supporting organization “maintains significant involvement in the operations” of the supported organization and the supported organization is “dependent upon the supporting organization for the type of support which it provides.”
There are two ways to meet the integral part test, the “but for” test and the “attentiveness” test. The “but for” test requires the supported organization to do what the supporting organization would do “but for” the existence of the supporting organization. That test did not apply to this situation.
The “attentiveness test” focuses on whether the supported organization will be attentive to the supporting organization. To meet this test, the supporting organization must donate substantially all of its income to the supported organization and the amount of support must be “sufficient to ensure the attentiveness” of the supported organization. The support must be a sufficient part of the total support or must be necessary to avoid the interruption of a particular substantial function or activity of the supported organization.
The IRS determined, and the Tax Court and the Court of Appeals both agreed, that the anticipated support from the Foundation would not be sufficient to make AEF attentive to the Foundation. The Foundation argued that it would be giving nearly $7 million to AEF over the long term, but the Courts said that significant gifts were too far in the future to assure current attentiveness.
“It is difficult to believe that AEF will give the Foundation the sort of regular oversight contemplated by the test when it will not be receiving substantial support from the organization for another two decades,” the Court of Appeals wrote. In addition, since the lead trust is revocable, the AEF may never get those funds.
The Foundation argued that its support would be significant for its “particular function or activity” of making charitable grants in southeastern Michigan. But the Court of Appeals said that to be substantial, an activity must “be important enough to the supported organization that the fear of its loss will cause the supported organization to be properly attentive to the supporting organization.” Since the AEF had given just $5,500 of its total of $1,300,000
in distributions to southeastern Michigan in 1998, its gifts to the area were not a significant activity. Because the Court decided the Foundation did not meet the integral part test, it did not have to determine whether the Foundation was controlled by disqualified persons.
YOU NEED TO KNOW
Supporting organizations formed to “operate in conjunction with” a public charity were singled out for special concern in the Senate Finance Committee White paper last summer. (See Ready Reference Page No. 74, July 1, 2004). These so-called Type 3 supporting organizations (so named because they follow Type 1 organizations “controlled by” a public charity and Type 2 organizations operated under “common control” with a public charity) offer significant opportunity for abuse since they are not controlled by an organization even theoretically responsive to the public interest. Donors could accomplish the same charitable goals by giving outright to a donor-advised fund at a public charity or by giving a public charity actual control over the Board, but many apparently are not willing to give up legal control to another organization. The result is likely to be a private foundation.