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Archives
December 2001
The Ups and Downs of Being Public, Part III: An Overview of the 509(a)(2) Support Test
Most section 501(c)(3) charities must maintain an adequate level of "public support" in order to avoid classification by the IRS as private foundations, which are subject to additional regulatory requirements and a higher tax burden. The Internal Revenue Code generally subdivides publicly supported charities into two types-organizations described in sections 509(a)(1) and 509(a)(2)-both of which calculate their level of public support differently. Earlier this year, the Navigator described the public support test used by the most common of these two types, 509(a)(1)s [NN 4/01, 5/01]. This month we turn our attention to the public support test for 509(a)(2) organizations, which is significantly more complex.
509(a)(2)s versus 509(a)(1)s
When people refer to a "public charity," they usually mean an (a)(1)-that is, an organization that receives most of its financial support in the form of gifts, grants or contributions from the general public, including individuals, private foundations, government entities, and other public charities. In contrast, (a)(2)s derive revenue primarily by providing goods or services to the public and charging fees for those goods or services. This fee-for-service work must be directly related to the organization's exempt purpose, or it will be deemed by the IRS to generate unrelated business income. Such income would be subject to the unrelated business income tax (UBIT) and, if significant, could jeopardize the organization's tax status. An example of an (a)(2) might include a nonprofit symphony orchestra that receives most of its income from the sale of tickets to its performances. Similarly, an organization that performs contract research related to its exempt purpose might qualify as an (a)(2).
In general, (a)(2)s are less common than in the late 1960s, when amendments to the Internal Revenue Code established the (a)(1) / (a)(2) distinction. This is largely due to the fact that many social service provider organizations, such as day care centers, community health clinics, and mental health centers receive a high proportion of their income from government grants rather than directly from their clients. This has led them to qualify as (a)(1)s rather than (a)(2)s. [See NN 4/01 for distinction between government grants and contracts].
The 509(a)(2) Public Support Test
As with the (a)(1) test, the (a)(2) test is generally calculated over a four-year period of time on an organization's Form 990-Schedule A, and requires knowledge of a charity's total income during this period. Unlike (a)(1)s, however, (a)(2)s are required to meet two separate standards. The first of these, which resembles the (a)(1) test, is the "more-than-one-third" support test: (public support during calculation period
total support during calculation period) If more than 1/3 (33.33%) of the organization's income comes from sources deemed "public" by the IRS, the organization satisfies this part of the test. What differentiates the one-third test for (a)(2)s from the equivalent (a)(1) test is the types of income that may be counted as public.Like (a)(1)s, (a)(2)s face restrictions on the gifts, grants, and contributions from individuals and corporations that can be counted as public. An (a)(2) must exclude as public support all contributions, membership dues, and fee-for-service income that come from "disqualified persons." Disqualified persons include "substantial contributors" (donors who contribute a total of $5,000 or more if that amount is greater than 2% of the total contributions the organization has received from its inception until the end of the final year in which the donor made contributions); directors and officers; family members of such persons; and corporations and trusts in which any of such people have 35% or more ownership interests.
Due to their reliance on fee-for-service income, (a)(2)s are permitted to count some of this income as public support when it is received from non-disqualified persons (all fee-for-service income is thrown out of the (a)(1) test). The catch is that fee-for-service income from any one source is limited in each year to 1% of the charity's total support for the year or $5,000, whichever is less. Excess fee-for-service income is excluded from public support, as is net income from unrelated business activities, interest, dividends and other related income (see below). All such non-public income is included in the denominator of the fraction as total support. The exception is capital gain income, which is totally excluded from the support fraction.
The second test for (a)(2)s is the "not-more-than-one-third" support test. A service-provider charity may not receive more than one-third of its support from a combination of interest, dividends, income received from payments on securities loans, rents, royalties, net (after tax) unrelated business taxable income, and other types of "passive" income. The support fraction for this test is calculated as follows: (investment income and net UBTI during calculation period
total support during calculation period). A charity that fails to satisfy both the "more than one-third" and the "not-more-than-one-third" tests will not qualify as a section 509(a)(2) public charity. In contrast to the (a)(1) support calculation, there is no "facts and circumstances" test available for qualifying as an (a)(2) in the event that a charity fails either of the (a)(2) tests.Disadvantages to 509(a)(2) Status
It is possible for a public charity to satisfy both the 509(a)(1) and 509(a)(2) support test, but for a number of reasons it is often preferable to qualify as an (a)(1) rather than an (a)(2). For one thing, it is usually easier-especially for relatively new charities-to meet the (a)(1) public support test. Moreover, an (a)(1) may count a grant from another (a)(1) as fully public in its own calculation of public support, regardless of its size. In contrast, a large grant from an (a)(1) to an (a)(2) might render the donor organization a "substantial contributor" to the (a)(2), with the result that the (a)(2) would have to exclude the grant from its calculation of public support. An (a)(1) may treat investment income generated by another type of public charity-section 509(a)(3) supporting organizations-as a grant, helping it to satisfy the public support test. In contrast, (a)(2) must treat such support as investment income, which makes it more difficult to satisfy the "not-more-than-one-third" support test.
In addition to the obvious advantages, several more obscure pluses exist. For instance, a private foundation seeking to terminate its operations may transfer all of its net assets to an (a)(1) but is restricted from doing so to an (a)(2). Finally, unlike (a)(1)s, (a)(2)s are prohibited from operating a particular kind of estate planning vehicle known as a pooled income fund.
As a result of these potential disadvantages, a charity that meets both tests will likely prefer to seek (a)(1) status. In fact, in such an instance the IRS usually presumes (a)(1) status unless "almost all" of the organization's support comes from fee-for-service revenue and only an insignificant amount from contributions. Unfortunately, the IRS has not provided much guidance on the exact percentage of fee-for-service income that will prevent a charity from qualifying as an (a)(1). An example in the IRS regulations illustrating "almost all" describes an organization whose fee-for-service income amounted to 99% of its total support. In other contexts, however, the IRS has interpreted the similar phrase "substantially all" to mean 85%. While these percentages are not definitive, it is reasonable to expect that a very high percentage of an organization's total support would have to come from related fee-for-service activities to require it to satisfy the (a)(2) support test if it would otherwise qualify as an (a)(1).
The often misunderstood, often confusing 509(a)(2) public support test is useful for service-provider charities that rely heavily on gross receipts from the public and other fee-for-service income. Otherwise, public charities that satisfy both the 509(a)(1) and (a)(2) public support tests will probably want to seek (a)(1) public charity status.
By Mark Sawchuk and Paul J. Murphy
IRS Modifies its Position on 9/11 Disaster Relief Aid
Citing the unique circumstances of the September 11th terrorist attacks, the IRS recently gave charitable organizations working with those victims and their families more leeway in determining who could receive assistance. The IRS decision revises its longstanding position that charitable funds should be distributed based on an objective determination of the victims' needs at the time the grant is made. The policy shift came as a reaction to complaints from numerous organizations facing difficulties distributing the millions of dollars in relief funds while trying to comply with the IRS regulations.
The need-based guidance for distributing disaster relief funds is described in the publication "Disaster Relief: Providing Assistance Through Charitable Organizations," which the IRS made available through its web site just days after the September 11th disaster [see NN 10/01]. This publication offers basic forms, rules and limitations for determining who is eligible for funds, as well as recordkeeping and objective standards that organizations are required to follow. It points out that charitable funds for disaster relief must be distributed based on the evaluation of the victim's financial needs at the time of the grant, noting that "charitable funds cannot be distributed to persons merely because they are victims of a disaster."
This need-based position regarding distribution of relief funds was reinforced as recently as November 8, in testimony by the IRS Exempt Organization Division Director to the House Ways and Means Committee. At the same time, organizations were raising concerns about problems with compliance with the regulations while trying to honor the intentions of donors, many of whom earmarked their donations to reward the heroic sacrifices of police and firefighters rather than their families' financial need. A number of organizations complained to the IRS that regulations were preventing the distribution of these funds to the families, particularly since many of them would receive considerable pensions and death benefits. Other organizations argued that objectively demonstrating the need of victims and their families would delay the distribution of the relief payments.
As a result of the complaints from organizations, the IRS announced on November 15th that it would be revising its disaster relief policy for the September 11th victims. In its announcement, the IRS stated that it recognizes the problems with the application of the current guidelines in the unique circumstances of this disaster has raised. The IRS will treat payments to victims as related to a charity's exempt purpose provided that the payments are made in good faith using objective standards. This policy change will apply only to 9/ll charities from now until the end of 2002, or until Congress passes legislation that addresses this issue in a comprehensive manner.
The IRS statement addresses many of the concerns of 9/11 charities and allows for more leeway when determining the recipients and the amount of aid they receive. However, organizations should continue to establish internal guidelines for who is eligible for assistance. By carefully documenting this criteria and information, organizations can prevent future questions from the IRS that might arise regarding the standards used to distribute relief.
By Anne Cornelison
IRS Issues Notice on Leave-Based Donations
Employees participating in leave-based donation programs will have an added incentive from the IRS to donate through these programs. In the wake of the September 11th tragedy, the IRS has issued interim guidance stating that it will not treat donations made through these programs as part of the employee's gross income.
A number of employers have begun offering leave-based donation programs to employees who want to make a donation to charity but may not have the means to donate cash. These programs allow employees to forego their vacation or sick leave in exchange for a monetary contribution from the employer to a specific charity.
Leave-based donations have increased in popularity recently as employees are looking for ways to contribute to various September 11th relief funds. This has prompted the IRS to offer guidance to concerned donors regarding the possible tax consequences of such donations. The Notice provides information on the application of income and employment taxes to, and the proper reporting of, payments by employers under these programs.
The IRS maintains that donations made by an employer before January 1, 2003, will not constitute gross income or wages, therefore they are not subject to income or employment taxes. Normally, such donations would be considered income to the taxpayer under the "assignment of income" doctrine. The IRS statement adds that an employee may not claim a charitable contribution deduction for the value of the donated leave. The IRS and the Treasury Department will consider modifying the regulations under section 61 to address certain leave-based donation programs during the period covered by the interim guidance.
The IRS is accepting comments on leave-based donation programs from now until February 1, 2002. Specifically, the Service is looking for comments on the types of leave-based programs currently being offered, as well as whether they should be excepted from the assignment-of-income doctrine and the application of constructive receipt principles to the programs. Comments should be sent to the Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20224, Attn: CC:ITA:RU (Notice 2001-64), Room 5226. The Service is also accepting comments at the following e-mail address: notice.comments@m1.irscounsel.treas.gov.
By Anne Cornelison
Schedule B of Form 990 Misleads Many
The IRS has begun making portions of the new Form 990-Schedule B publicly available despite a printed statement that the attachment is not open to public disclosure.
For years, Form 990 has required exempt organizations to prepare a schedule to Part I, Question 1a listing the name, address, and amount donated by contributors whose contributions totaled $5,000 or more during a fiscal year. The 990 instructions required substantial detail on each contribution, including whether the contributions were cash, payroll contributions, or noncash. This is essentially the same information now required to be presented on Schedule B, which was created for the 2000 version of Form 990 to standardize the method of reporting this information.
Until the appearance of Schedule B, the IRS did not release contributor lists. The 990 instructions even cautioned charities against including the schedule when filing a copy of the 990 with state authorities unless it was specifically required by the state, in order to prevent unintended public disclosure. Nonprofits assumed that the IRS would follow the same policy with Schedule B, particularly because the form includes a note in italics across the top announcing that "this form is generally not open to public inspection except for section 527 organizations." The form's instructions give a similar warning about filing at the state level, and the 990 instructions explicitly state that Schedule B "is not open for public inspection when filed by a non-527 organization."
Nevertheless, the IRS is now releasing copies of Schedule B to the public, redacting only clearly identifying information such as contributors' names and addresses. Other information, such as amounts and types of contributions, has been left in, leading many to wonder whether it might now be possible to deduce the identities of donors. For example, in the case of a stock donation, the IRS redacts the corporation's name but leaves in the number of shares donated, an estimation of the stock's fair market value, and the date of the gift. Thus, a nonprofit that receives a stock gift totaling $1 million on a particular day might deduce that the same donor also gave money to other charities if it sees that another nonprofit got a similar gift at the same time.
These redacted schedules have also begun appearing on GuideStar, a web site that posts past Forms 990 of thousands of charities. An IRS official revealed that the Service had already finalized and printed Schedule B before it decided that only the identities of contributors could be considered protected tax return information. The official noted that the IRS will amend the disclosure language on the 2001 version of Form 990, but the note on Schedule B itself will remain unchanged.
Some nonprofit organizations and their counsel have strongly criticized the IRS for its misleading language and for reversing its longstanding position on this issue. Some wondered whether nonprofits will be required to include redacted Schedule Bs when they make their Forms 990 available for public inspection, while others have argued that donors will be hesitant to make large contributions if they believe that the IRS is releasing imprecisely or insufficiently redacted Schedule Bs. Many agree that the information made available on the redacted forms may vary depending on the skill of the redactor, and that a sloppy redactor may not successfully delete sensitive information.
Nonprofits will want to follow this debate, keeping in mind that Schedule B will be made publicly available until the Service indicates otherwise. Organizations that are especially worried may want to have a legal professional review their Schedule B to determine whether donors' identities could be determined from information other than names and addresses.
By Mark Sawchuk
This publication is designed to provide accurate and authoritative information about the subject matter covered. It is not distributed with the intent to render legal, accounting, or other professional advice. The services of a competent professional should be sought if legal advice or other expert assistance is required.
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