Friday March 29, 2024

7.1.9 Supporting Organizations vs. Private Foundations

Supporting Organizations vs. Private Foundations

SOs vs. Private Foundations:  Although supporting organizations often operate in a fashion similar to private foundations, there are important distinctions.

Deduction Rules:  Supporting organizations offer more favorable deduction treatment than private foundations because they are treated as public charities.

Distribution, Charity Designation and Control:  Supporting organizations and private foundations are subject to different rules when it comes to charitable distributions, charity designation and donor control.

Excise Taxes:  Excise taxes are levied on a variety of improper transactions involving private foundations and supporting organizations

Introduction: SOs vs. Private Foundations


One way to gain a clearer understanding of supporting organizations ("SOs") is to compare them to private foundations. An SO might seem similar to a private foundation, especially when the SO is making payments to multiple charities. However, when comparing SOs to private foundations, there are important distinctions.

In contrast to public charities, which receive a majority of their support from the public, private foundations are often formed by one individual or a family who invests funds and uses those assets to make grants to other charities. Private foundations may be attractive to high net worth individuals who want control over their gifted assets. By creating a private foundation, donors can exercise control over the management and investment of the funds and make contributions to targeted programs of public charities. However, it is often more advantageous to structure an organization as a public charity rather than a private foundation because of the restrictions and income tax deduction limitations placed on private foundations.

Although SOs often operate in a fashion similar to private foundations, they are granted public charity status because they provide support to public charities (hereinafter referred to as "supported organizations" or "supported charities"). Sec. 509(a)(3)(A). Thus, even though many (if not most) SOs are funded by one individual or family, SOs will still receive the more favorable tax treatment enjoyed by public charities. SOs enjoy the higher 60% deduction limit, do not have to pay tax on investment income and are not subject to the stringent regulatory requirements placed on private foundations. Additionally, SOs (particularly Type III SOs) offer donors substantial involvement in the use and investment of their contributions. See Chapter 7.1.6 for more information about SOs.

Deduction Rules


SOs receive more favorable contribution deduction limitations than private foundations because they are treated as public charities. When donors make cash contributions to SOs, they can deduct the value of their contribution up to 60% of their adjusted gross income. However, when donors contribute cash gifts to private foundations, they can only deduct up to 30% of their adjusted gross income. Similarly, when donors make gifts of appreciated property to SOs, they can deduct the value of the gift up to 30% of their AGI. In contrast, when donors make gifts of appreciated assets to private foundations, they may only deduct up to 20% of their adjusted gross income. Sec. 170(b).

Additionally, when appreciated property is donated to an SO, the deduction is based on the property's fair market value. However, when appreciated property is donated to a private foundation, the deduction is limited to cost basis (unless the donation is of publicly traded securities, in which case the deduction is based on fair market value). Sec. 170(e).

Minimum Distribution


Private foundations are required to annually distribute at least 5% of their assets for charitable purposes. This is known as the "minimum distribution" requirement. The 5% minimum distribution amount is calculated using the average fair market value of all foundation assets for the preceding year that are not directly used for charitable purposes (generally, this means the private foundation's investments) reduced by the amount of any debt incurred to acquire those assets and reduced by an allowable cash reserve (1.5% of assets less debt).

In contrast, SOs are not required to make annual distributions. The exception here is for Type III non-functionally integrated (NFI) SOs. An NFI Type III SO must distribute either 85% of its adjusted net income for the prior taxable year or its minimum asset amount for the preceding taxable year (3.5% of the aggregate fair market value of the organization's non-exempt use assets with certain adjustments). Reg. 1.509(a)-4(i)(5)(ii).

Charity Designation


One difference between an SO and a private foundation is that an SO must designate the charities that it will support upon formation. In contrast, private foundations are not required to choose benefiting charities and can change grant recipients year by year. Reg. 1.509(a)-4(d)

Donor Control


Donors who establish private foundations enjoy a larger degree of control than SO donors. By establishing a private foundation, donors can manage the foundation's investments, retain control over charitable donations and choose multiple charitable recipients. In addition, donors can establish and serve on the board of directors and involve family members in the operation of the private foundation.

Type I and II SOs provide less control to their donors. This is due to the fact that Type I SOs are directly controlled by their supported organizations and Type II SOs are supervised or controlled in connection with their supported organizations. Type III SOs offer a larger degree of control to donors, because they need only be operated "in connection with" one or more publicly supported organizations. However, the amount of control given to Type III SO donors is still less than the amount enjoyed by private foundations. Unlike private foundations, which can select multiple grant recipients at any given time, SOs must designate their supported charities upon formation. Additionally, substantial contributors to the SO and their family members are not permitted to constitute a majority of the SO governing body.

Excise Taxes


Excise taxes are levied on a variety of improper transactions involving private foundations and public charities. Private foundation taxes are levied on self-dealing between the private foundation and a prohibited party, failure to distribute income as required, excess business holdings, taxable expenditures and investments that jeopardize the foundation's charitable purpose.

Investment Income


In general, private foundations must pay a 2% excise tax on net investment income (or 1% if certain requirements are met). Sec. 4940(e). SOs, like other public charities, are not subject to an excise tax on investment income.

Benefits to Disqualified Persons-Self-Dealing (Private Foundations)


Private foundations will face excise taxes for acts of self-dealing. These acts include direct or indirect sale, lease, loan, payments or provision of goods or services by a private foundation to a disqualified person (including substantial donors, foundation directors, managers, certain entities and family members of disqualified persons). Sec. 4941(d)(1); Sec. 4946. An initial tax of 10% of the amount involved with respect to an act of self-dealing is imposed on a disqualified person involved in self-dealing. If a self-dealing tax is imposed, a 5% tax (up to $20,000) may be levied on a foundation manager who knowingly participated in the act of self-dealing. Sec. 4941(c)(2). Further taxes will be imposed for failure to correct the act of self-dealing.

Benefits to Disqualified Persons-Excess Benefit Transactions (SOs)


SOs are not subject to the same self-dealing rules; however, Type I and Type III supporting organizations are subject to the excess benefit transaction rules that apply to public charities exempt under Sec. 501(c)(3) and social welfare organizations exempt under Sec. 501(c)(4). As such, SOs may not directly, or indirectly, transfer an economic benefit to a disqualified person where the value of the economic benefit provided exceeds the value of consideration (including the performance of services) received for providing the benefit. The term "disqualified person" includes substantial contributors and related persons. The recipient of the excess benefit is required to pay an initial tax equal to 25% of the entire transaction amount (rather than the excess value). However, there are exceptions for bona fide sales or leases of property. See Chapter 7.1.6 for further discussion.

Excess Business Holdings


Private foundations are subject to the excess business holdings rules under Sec. 4943. Gifts by disqualified persons who, together with attributed family and entities, hold 20% (or 35% with outside control) of an entity will trigger application of Sec. 4943. The initial tax is equal to 10% of the value of the excess business holding and will increase to 200% if the property is not sold within five years.

Type III SOs that are not functionally integrated are also subject to Sec. 4943 excess business holdings rules. In addition, if a Type I or Type II SO is effectively controlled by the donor, then the excess business holdings rules will apply. Private foundations and supporting organizations are both given five years to sell the business interest (or 10 years in limited circumstances).

Jeopardizing Investments


Private foundations are subject to tax on investments that jeopardize the foundations' charitable purposes. Sec. 4944. This includes investments that show a lack of reasonable business care and prudence in providing for the long and short-term financial needs of the foundation. It does not include investments that are made primarily to fulfill the foundation's charitable purposes. Sec. 4944(c). The initial tax is 10% of the amount involved, but if the investment is not sold within the taxable period, then an additional tax of 25% will apply. In addition, foundation managers will also be subject to the tax if they knowingly made the jeopardizing investment.

SOs are not subject to the jeopardizing investment rules.

Taxable Expenditures


Money spent by a private foundation for purposes outside of the permissible charitable purposes specified in IRC 170(c)(2)(B) (i.e., religious, charitable, scientific, literary, or educational purposes, to foster certain amateur sports or competitions, or for the prevention of cruelty to children or animals) is called a "taxable expenditure." This includes expenses for lobbying, certain voter registration drives, student study or travel grants (unless following Treasury procedures), private grants (unless following expenditure responsibility procedures) and payments for non-charitable purposes. The foundation will face an excise tax equal to 20% of the amount of each taxable expenditure, and an additional tax of 100% is imposed if the expenditure is not corrected. Sec. 4945. A manager who knowingly makes a taxable expenditure could face excise tax liability as well.

While SOs are not subject to the same taxable expenditure rules imposed on private foundations, they still must adhere to the same operating rules that govern public charities. Thus, they cannot engage or participate in political campaigns. Treas. Reg. Sec.1.501(c)(3)-1(c)(3)(i) - (iii). Again, an SO must engage in activities that support or benefit its supported organization. Thus, any money spent that is not consistent with its supported charity's exempt purpose could threaten its status as an SO.

 Supporting OrganizationPrivate Foundation
Cash Deduction Limit Up to 60% of AGI Up to 30% of AGI
Appreciated Property Deduction Limit Up to 30% of AGI Up to 20% of AGI
Value of Appreciated Property for Deduction Appreciated property deduction based on fair market value Appreciated property deduction limited to cost basis. Exception for publicly traded securities
Excise Tax on Investment Income Not required to pay excise tax on net investment income Must pay an excise tax on net investment income
Minimum Distribution Not required, except Type III non-functionally integrated SOs, which must distribute greater of 85% of income or 3.5% of the value of their non-charitable assets Must make minimum distributions annually. Generally 5% of assets, with expenses included as part of minimum distribution
Self-Dealing Not subject to private foundation self-dealing rules but subject to rules involving excess benefit transactions Excise Taxes are imposed on acts of self-dealing
Excess Benefit Transactions SOs are subject to the public charity excess benefit rules and may not provide excess benefits to disqualified persons Not subject to excess benefit rules, but subject to excise taxes for self-dealing
Excess Business Holdings Type III non-functionally integrated SOs are subject to Sec. 4943 excess business holdings rules (Type I, II are only subject to rules if donor effectively controls the SO) Must follow Sec. 4943 excess business holdings rules which restrict the percentage of for-profit businesses that private foundations (and their insiders) may own
Charity Designation Must designate supported public charity upon formation Not required to designate public charity upon formation
Donor Control Donor must, at a minimum, operate the SO in connection with its supported organizations and must designate charitable recipients upon formation Donor retains control over charitable donations, can manage investments and can choose multiple charitable recipients
Jeopardizing Investments Not subject to jeopardizing investment rules under Sec. 4944 Board members are prohibited from putting foundations assets at risk
Taxable Expenditures Must follow the same expenditure rules placed upon public charities Must pay 20% excise tax on taxable expenditures (i.e. money spent for a purpose other than the foundation?s charitable purpose).


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