A related foundation must use the funds it raises for educational, charitable, or scientific purposes. Nevertheless, very often the parent association is already carrying on significant educational, charitable, or scientific activities which can be shifted to the related foundation.

Qualifying for Public Charity Status

Qualification for tax exemption as a 501(c)(3) organization is primarily contingent upon the activities of the related foundation being educational, charitable, or scientific in nature.

The exemption application process has a second component, however: qualifying as a public charity in order to avoid private foundation status. Although qualifying as a public charity can be done in three ways, most related foundations qualify as “supporting organizations” under IRC section 509(a)(3). A supporting organization is an entity that is—

A section 501(c)(4), (c)(5), or (c)(6) organization, which would qualify as a “publicly supported charity” under section 509(a)(1) or (a)(2) if it were also a section 501(c)(3) organization, is permitted to establish a supporting organization. This means that a related foundation will qualify as a supporting organization if its parent association “normally” receives 1) at least one-third of its total annual revenue from government grants or contributions made directly or indirectly from the general public, or 2) more than one-third of its total annual revenue from government grants, contributions, membership fees, and program service revenue (i.e., from activities related to its tax-exempt functions) and no more than one-third of its total annual revenue from gross investment income, rents, royalties, and unrelated business taxable income. Most associations satisfy the second test.

Related Foundation Activities

A related foundation may engage in many activities either previously undertaken by the association, initiated by the related foundation, or both: publishing, seminars and conferences, research, grants, scholarships, fellowships, and awards. The related foundation’s activities can be funded by gifts, grants, and program service revenue (e.g., publication sales, conference registration fees), leaving the association’s revenues (e.g., membership dues) to support the remaining association programs and activities.

Educational activities may be intended only for a special segment of the public, such as members of a particular trade or profession; however, they cannot be limited to members of the parent association. If nonmembers attend educational seminars or conferences sponsored by the related foundation, the association may consider it an opportunity to solicit new members.

Association–Foundation Operational Relationships

As with any relationship an association maintains with an affiliated entity, an association and its related foundation must maintain strict financial, managerial, and operational separation at all times. The IRS and the courts will disregard the separate corporate existence of the related foundation—with tremendous adverse consequences for the association, the foundation, and foundation donors—if the parent association controls its affairs so pervasively that the foundation becomes a “mere instrumentality” of the parent. This finding will occur if “the facts provide clear and convincing evidence that the [foundation] is in reality an arm, agent, or integral part of the parent [association].”

The IRS and the courts will consider several different factors when determining whether an affiliated entity is separate, including whether a valid purpose exists for forming the affiliated entity; whether the parent is involved in the day-to-day management of the affiliate’s affairs; the extent to which the two entities share directors, officers, or employees; and the extent to which the two entities share facilities or services.

Unlike an association’s relationship with a taxable subsidiary or other types of affiliated entities, however, when the related foundation is a section 509(a)(3) supporting organization, more control by the parent association is not only permitted but required. In practical terms, while this requirement does not obviate the need to maintain strict financial and operational separation, more overlap is permitted (e.g., between directors and officers). Because section 509(a)(3) requires that the related foundation be “operated, supervised, or controlled by or in connection with” the parent association, the IRS cannot contest the presence of some common directors and officers. However, associations and their related foundations must negotiate this narrow and often ambiguous line with care.

Association Contributions to the Related Foundation

As a general rule, a parent association may make virtually unlimited contributions—without consideration—of cash, assets, services, and other items of value to its related foundation without jeopardizing its tax-exempt status or that of the foundation (although this might increase the risk that the separate corporate existence of the foundation will be disregarded). This is because, in most cases, the activities of the related foundation are also in furtherance of the tax-exempt purposes of the association.

Consequently, while associations must carefully track and record the nature and amount of all cash, assets, and securities they provide to their related foundations, it is not necessary for the related foundation to reimburse the association for the full fair market value of such items, or to reimburse the association at all. It is permissible to do so—as long as the reimbursements do not exceed fair market value—but not required. The foundation should record all such nonreimbursed items as in-kind contributions.

Foundation Contributions to the Parent Association

In contrast, because the terms and conditions of tax exemption of 501(c)(3) organizations are more stringent and limited than those of 501(c)(6) organizations, items of value can flow from related foundations to parent associations only if certain guidelines are followed.

A related foundation clearly may transfer items of value to its parent association in exchange for consideration at fair market value (assuming the transaction is at arm’s length). For example, if a foundation owns an office building and leases space in the building to its parent association at the fair market rent, there is no problem.

But a problem arises when the foundation seeks to transfer items of value to its parent association without receiving anything in return, or with receiving consideration at less than fair market value. In addition, IRS officials have indicated informally that the “intermediate sanctions” law might be applied to transfers of items of value from related foundations to their parent associations for less than fair market consideration (with the resulting penalty taxes levied on the associations).

A related foundation may properly make grants, make contributions in the form of educational seminars and publications, and otherwise transfer its assets to its parent association without adequate consideration only if the foundation can clearly demonstrate that such transfers are strictly for one or more qualifying educational, charitable, or scientific purposes and the foundation retains ultimate control and discretion over use of the items. The association may not use the items to defray general operating costs.

A related foundation thus may carry out its educational purposes in conjunction with the activities of its parent association. For example, the foundation and association may jointly sponsor educational programs, or the foundation may sponsor educational programs in conjunction with the professional activities of the association (such as educational seminars at the association’s annual meeting). The foundation bears the burden, however, of proving that its funds and resources were used solely for the educational programs, not for professional or business activities. Furthermore, it is critical that the educational programs be promoted and open to all members of the relevant trade or profession (not merely association members). Likewise, the foundation’s name should be clearly and conspicuously used in conjunction with the promotion and staging of the educational programs (not merely the name of the association). Furthermore, if the foundation’s nonprofit postal permit is being used to mail promotional materia

ls for the educational programs, the foundation must ensure that the postal permit is not being used to promote the professional or business activities of the association.

The joint sponsorship of educational programs and publications by foundations and their parent associations can be accomplished either by having the foundation pay its share of the costs directly (such as room rental, publishing costs, and speaker fees) or by having the association pay the costs up front and seek reimbursement from the foundation, as long as the foundation maintains a strict accounting of the educational use of its funds at all times.

When a related foundation offers educational programs or materials and promotes them to, among others, members of the parent association, the foundation will often seek to offer discounts to the association’s members on those programs and materials. As a general rule, such a discount would be seen as a transfer of assets from the foundation to the association without consideration, and thus prohibited. Most organizations avoid this result by having the association provide something of comparable value to the foundation in return for the discounts. For example, many associations permit their related foundations to use their membership mailing list to promote educational programs and materials in return for the discounts. Where this approach is impractical, the association may consider donating other goods or services, such as the use of trademarks and logos, staff services, or even cash. However, note that if the association chooses to perform administrative services for the foundation in exchange for member discounts, the IRS could maintain that the value of the member discounts received by the association for its administrative services represents unrelated business income. (In general, fees received by an association for performing administrative services for another tax-exempt organization are taxable, even if the other organization shares a related purpose or mission.) In all cases, the fair market value of the goods, services, or other consideration provided by the association must approximate the value of the member discounts offered by the related foundation.

Editor:
Thomas W. Morris
The CPA Journal

©2009 The New York State Society of CPAs. Legal Notices