Thursday April 25, 2024
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7.3.1 Charitable Corporate Formation and Management Issues
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I. Introduction
Charities can accomplish certain charitable objectives or minimize certain risks with proposed gifts through the creation of separate, but affiliated, legal entities. These entities must comply with state law when it comes to their formation. To qualify for federal tax-exemption, these organizations must also meet federal requirements. Therefore, their governing documents must contain restrictions related to exempt purposes, private inurement, dissolution, limitations on lobbying and campaigns and private foundation restrictions.
Charitable Trust
A trust provides control to a donor, allowing him or her to select the trustee and the purpose of the trust. A charitable trust can be easily and privately created. A trust results when a grantor transfers property to a trustee to hold in trust for the grantor or other individuals pursuant to a trust agreement. A trust agreement does not need to be filed with any governmental agency. Depending on the nature of the trust, modifications to the trust agreement may require a court order.
Unincorporated Association
Similar to a partnership, an unincorporated association is where two or more persons agree to carry out a specific purpose. Nothing needs to be filed for an association to be formed, although in some instances an assumed name certificate may need to be filed for the association to operate. Like a partnership, the members of the association are personally liable for the obligations of the association.
Stock and Nonstock Corporations
Corporations limit the personal liability of officers, directors, shareholders and other individuals associated with the corporation. However, to maintain corporate status, the corporation must submit annual filings, at a minimum, with the state of incorporation and comply with other operational restrictions.
A corporation is created by filing Articles of Incorporation with a state's corporation commission or Secretary of State. The articles must include the corporation's name, the corporation's address and the name of the corporation's registered agent. If a stock corporation is created, it will only have tax-exempt status if the articles require shares to be held only by exempt entities.
Limited Liability Companies
In Notice 2012-52, 2012-35 I.R.B., the Service announced that a charity could create a wholly-owned subsidiary limited liability company ("LLC"), making the charity the sole member of a single-member LLC. As a result, the LLC is disregarded for federal tax purposes.
Contributions to a wholly-owned, charitable LLC subsidiary are treated the same as contributions to the charity - they are tax deductible - and the member charity is responsible for providing a receipt to the donor. The receipt should indicate the LLC is wholly-owned by the charity and is disregarded for federal income tax purposes.
A charity can create an LLC by filing Articles of Organization with the appropriate state agency. Generally, the articles must contain the LLC's name, address and registered agent for service of process.
Much like a corporation, the personal liability of an LLC's members is limited. If a tax-exempt organization creates a wholly-owned, single-member LLC then the LLC does not need to submit an application for exempt status. The LLC will not be eligible for tax-exempt status, however, unless its Articles of Organization require 100% of its membership interest to be owned solely by an entity exempt under the same Sec. 501(c)(3) subsection as the LLC's original member.
Low-Profit Limited Liability Company
Some states have adopted legislation permitting the formation of low-profit limited liability companies ("L3Cs"). L3Cs are organized for both a profit and a charitable purpose, which must be stated in the Articles of Organization. The primary goal of an L3C must be charitable and not the maximization of profit, although some profit can be distributed to members.
Benefit Corporation
Some states allow a stock corporation to designate itself as a "benefit corporation" that provides a general public benefit to society. Generally, this public benefit must provide a material positive impact on society and the environment as measured by a third-party standard. A benefit corporation can be formed by filing Articles of Incorporation creating the corporation or by amending the Articles of Incorporation of an existing corporation. Whereas a traditional corporation is accountable to shareholders for producing a profit, a benefit corporation is accountable to its shareholders with regard to the benefit it imparts on society. Other requirements for benefit corporations may vary according to state law.
Fiscal Sponsorships
A fiscal sponsorship allows an existing tax-exempt organization to receive tax-deductible donations that can be used to fund the activities of an organization that is not yet tax exempt. The activity of the non-exempt entity must be something that is within the charitable mission or goals of the sponsoring organization. The sponsoring organization cannot act only as a conduit to channel funds to the sponsored organization. Instead, the two organizations must agree that gifts to the sponsoring organization are the property of the sponsoring organization and that it may direct the funds as it sees fit.
II. Lobbying Restrictions for IRC Sec. 501(c)(3) Entities
An organization cannot qualify for Sec. 501(c)(3) status if a substantial part of its activities is the influencing of legislation or the carrying on of propaganda. The definition of "substantial" is not clear from the tax code, regulations or court decisions. Because of the uncertainty surrounding what constitutes "substantial," many organizations elect under Sec. 501(h) to have their lobbying activities judged under an expenditure test. The test sets dollar limits on an organization's lobbying expenditures. Lobbying expenditures in any given year in excess of the limit are subject to a 25% excise tax, but repeated violations can jeopardize the organization's exempt status.
Note: Churches and private foundations cannot make a Sec. 501(h) election.
Lobbying Prohibited by Private Foundations
Private foundations are prohibited from lobbying. Any lobbying expenditure by a private foundation is subject to a 20% excise tax. In addition, the foundation must recover the expended funds and take other corrective actions. See Sec. 4945(d)(1).
III. Management Issues
When creating a charitable affiliate, there are a number of management issues that must be considered, such as being familiar with the applicable fiduciary standards or selecting the state in which to form the entity.
Fiduciary Standards
Individuals operating not-for-profit entities must abide by state-law fiduciary standards when it comes to the operation and management of the particular type of entity involved. Applicable fiduciary duties are derived from organizational documents and state statutes. In addition, many states have adopted statutes that apply to all entities depending on the types of actions or situations involved. For example, the Uniform Prudent Management of Institutional Funds Act ("UPMIFA") provides standards for the investment, expenditure and modification of charitable endowments. See Chapter 7.3.2 of GiftLaw Pro.
Corporations. The actions of corporate directors will be evaluated according to whether they exercise good faith business judgment in the best interests of the corporation. This standard focuses on the process the directors used to reach a decision as opposed to the ultimate result.
Trusts. Under the Uniform Trust Code, trustees are required to act as a prudent person would, exercising a reasonable standard of care, skill and caution. This standard focuses more on the actual decision the trustee made as opposed to the process the trustee used to reach the decision.
LLCs and L3Cs. Depending on state law, limited liability company managers may be required to exercise duties in accordance with a corporate standard or a trustee standard.
Unincorporated Associations. Most states do not have statutory fiduciary standards for unincorporated associations. As a result, the decisions of unincorporated association managers are judged using standards derived from tort, contract or agency law.
Single Manager v. Multiple Managers
When creating a charitable entity, decisions must be made with regard to how the entity will be managed and operated. Corporations or LLCs are entities best suited to situations where management responsibilities are spread among several individuals or groups. Trusts, on the other hand, are traditionally managed by a single trustee or a small group of trustees. Consequently, they are best suited to situations where the charitable entity is to be managed by a single person or a small group of individuals.
Choosing the Governing Law
Although LLCs, corporations and other entities can be created in most states, the law applicable to those entities can differ. When a charity is looking to create a charitable affiliate, it is often desirable to form that entity within the same state as the charity. However, there may be aspects of one state's laws that may lead the charity to form the affiliate in that other state. For example, some states provide stronger limitations on personal liability for the officers and directors of corporations or LLCs that may better suit the needs of the charity creating the affiliate.
Protecting the Charitable Purpose
A donor may be interested in ensuring that their gift is used to fully accomplish their original charitable purpose. In that instance, such a donor may prefer to establish a trust, which can generally only be modified by court order or the attorney general. In other instances, a donor may prefer flexibility when it comes to the charitable purpose. In that case, an LLC or corporation may be preferred.
Other State Issues
Charitable immunity is a concept that protects some charitable organizations from liability for simple negligence in their dealings with intended beneficiaries. In most states, the concept has been eliminated or substantially weakened.
Finally, the creation of a charitable affiliate may conflict with the receipt of state income tax credits or the ability of a corporation to make distributions to trusts or other public entities.
IV. Special Operational Restrictions on Private Foundations
All Sec. 501(c)(3) charities are classified as either private foundations or public charities. Private foundations are subject to operational restrictions, deduction limits and other requirements that do not apply to other Sec. 501(c)(3) entities. Further information about these differences can be found in Chapter 7.2.1 of GiftLaw Pro.
V. Restrictions on Supporting Organizations
Prior to the passage of the Pension Protection Act of 2006 ("PPA"), supporting organizations ("SOs") qualified as nonprivate foundations and enjoyed a status almost identical to publicly supported charities under Secs. 509(a)(1) and (a)(2). The PPA created new requirements and restrictions for SOs, including applying different rules to SO's if they are a Type III SO.
Restrictions on Functionally Integrated Type III SOs
If a Type III SO is functionally integrated with the charity it supports, its activities must meet two important requirements. First, its activities must substantially further the supported organization's exempt purposes through the performance of functions of the supported organization. Second, the SO's activities must be those the supported organization would perform if the SO were not involved. Regulations outlined in T.D. 9605 indicate that activities that would not meet these requirements include fundraising, grantmaking and investing and managing non-exempt-use assets.
Distribution Requirements for Non-Functionally Integrated Type III SOs
Prior proposed regulations for non-functionally integrated Type III SOs required such SOs to make annual distributions similar to those required of private foundations. Temporary regulations contained within T.D. 9605, however, modified this requirement. The new temporary requirement proposes that the distribution be equal to 85% of the SO's adjusted net income or 3.5% of the value of its non-exempt-use assets, whichever is greater. SOs must follow private foundation rules in determining net asset value and adjusted gross income.
Additional Restrictions on Non-Functionally Integrated SOs
Contributions to donor advised funds maintained by a non-functionally integrated SO cannot be deducted. In addition, the excess business holdings rules of Sec. 4943 are applicable to non-functionally integrated SOs.
Further information about SOs and the rules applicable to them can be found in Chapter 7.1.6 of GiftLaw Pro.
VI. Program-Related Investments
Under Sec. 4940, private foundations are required to distribute at least 5% of their assets each year for charitable purposes. Many foundations do so through grants to public charities, but others satisfy the obligation through what are known as program-related investments ("PRIs"). Besides counting towards a foundation's distribution requirement, PRIs are also exempt from taxes on jeopardy investments and the excess business holdings rules.
History of PRIs
PRIs must be conducted primarily to achieve exempt purposes and the production of income or appreciation of property may not be a significant purpose of the investment. Sec. 4944(c). When regulations for PRIs were first issued in 1972, the Service provided ten examples of permissible investments. Those examples focused on aid to impoverished populations and blighted urban areas. In addition, many of the PRIs the Service approved involved loans or common stock investments. Fortunately, in 2012, the Treasury issued proposed regulations that contained nine new examples that expand the modern day understanding of permissible PRIs.
Uses of PRIs
The new examples provide private foundations with a greater understanding of what kinds of PRIs will be permissible. Among others, the new examples include PRIs directed toward promoting the arts, combating environmental deterioration, educating poor farmers in developing countries, helping commercial employers in disaster areas and developing drugs to combat diseases that primarily affect the poor in third-world countries. See Prop. Treas. Reg. Sec. 53.4944-3(c).
Permissible PRI Participants
The new examples in the proposed regulations illustrate PRIs through 501(c)(3) charities, 501(c)(4) social welfare organizations, businesses and individuals. Thus, PRIs can be conducted not only through tax-exempt organizations but also through non-exempt entities or individuals.
PRI Return Success
With PRIs, the potential exists for a high rate of return on the investment. This will not disqualify the investment, however, so long as the potential income or appreciation is not a substantial factor in the investment. Some foundations, however, may be concerned that a PRI may transform into a regular investment. As such, these foundations may want to explore ways to free themselves of the investment and use the invested funds for other charitable purposes. Potential options for doing so include repayment of loans, puts, calls, forced liquidation and demand or piggyback registration rights.
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Private Letter Rulings
PLR
200436019 Charity Exempt from Filing Form 990:
Charity, a Sec. 501(c)(3) organization, is a state-created entity. Charity operates Hospital, which is also a Sec. 501(c)(3) organization. Charity's primary mission is to provide medical and hospital care to residents of City. Its primary source of revenue is generated from patient services.
PLR
200513030 PF Converts to Community Foundation:
Donors Alfred and Bertha created a private foundation. The private foundation was primarily designed to enhance the "physical, cultural and spiritual environment of the people of the State of M and the United States of America, and primarily of N and the area comprising O."
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