Statement of Chapman Trusts

The Chapman Trusts are a group of 12 trusts supporting 18 charitable, medical and educational organizations in Oklahoma, Arkansas and Texas.' The trusts are managed by independent fiduciaries and have provided consistent and responsive support to their charitable beneficiaries since 1949. Because each of the twelve trusts is a type III supporting organization, the following comments are confined to those provisions of the Pension Protection Act² (the "PPA") affecting type III supporting organizations.³

Introduction

Unlike type I and type II supporting organizations, whose governing boards are controlled by or overlapping with those of the supported organizations, type III supporting organizations have governing boards that are independent of those of their supported public charities. In order to demonstrate that a type III nevertheless has a sufficiently close relationship with its supported organizations to justify its public charity status, existing Treasury Regulations have required such organizations to meet two tests: a "responsiveness test" and an "integral part test." The responsiveness test requires that the supporting organization be responsive to the needs and desires of its supported organizations, while the integral part test requires that the support actually provided by the supporting organization is substantial and needed by the supported organizations to conduct their charitable programs. Together, these two tests ensure that, despite having

^I See attached schedule of Chapman Trust beneficiaries.

² Pub. L. No. 109-280, 120 Stat. 780 (2006).

Each Chapman Trust is a state law charitable trust, exempt from taxation under IRC §501(c)(3) and qualifying as public charity under I.R.C. § 509(a)(3)(iii).

independent management, the supporting organization is operating closely with the supported public charities in much the same way as a controlled subsidiary would.

We agree with the distinguished panelists at the Subcommittee's hearing on July 24, including Steven T. Miller, Commissioner of the Tax Exempt and Government Entities Division of the Internal Revenue Service, and Steve Gundersen, President and Chief Executive Officer of the Council on Foundations, that in general the charitable sector is very compliant with the tax laws. We also acknowledge that there are those in every sector, including our own, that will use whatever means are available to enrich themselves, and that in recent years some have used type III supporting organizations for improper personal gain. However, as was pointed out numerous times during the Subcommittee's hearing, the charitable sector is a vital part of American society, and charitable organizations—including type III supporting organizations—play an important role in healing the sick, educating our young, caring for the aged and at-risk youth, and countless other important tasks that the government alone cannot accomplish.

Several provisions of the PPA were aimed at supporting organizations generally and type III supporting organizations specifically. It is no secret that some on the Hill would solve the problem of abuse within the type III community by eliminating all type III supporting organizations,⁴ and many of the PPA provisions appear to reflect this radical approach. For example, without attempting to delineate between abusive and essential supporting organizations, the PPA jeopardized the private foundation funding for all type III supporting organizations (and in some cases all supporting organizations) by placing harsh penalties on private foundations that fund certain type III supporting organizations. Similarly, without any evidence of the extent or nature of the abuse of supporting organizations save a few anecdotal media reports, the PPA included sweeping prohibitions on compensation of substantial contributors to all supporting organizations, as well as reimbursement of expenses they incur, that extend far beyond the restrictions placed even on private foundations. Other provisions appear to have been hastily inserted, without much idea as to how they would apply in practice, leading potentially to many unintended consequences. And yet other provisions delegate to Treasury vast discretion to subject all type III supporting organizations to restrictive operating and payout requirements that would inhibit the ability of good organizations to provide support tailored to the needs and desires of their supported public charities.

We submit that this is no way to strengthen and improve the charitable sector. Instead, Congress should undo the misguided PPA supporting organization provisions and direct the IRS to embark on a comprehensive program of enforcement of the current regulatory standards. This would eliminate abusive supporting organizations that are indirectly controlled by or providing private benefits to their donors as well as organizations that do not have a close relationship of responsiveness and dependence with their supported organizations. In addition to weeding out abusive entities without uprooting effective organizations, such a targeted effort would provide Congress with

⁴ See Charity Oversight and Reform: Keeping Bad Things from Happening to Good Charities: Hearing Before the Senate Committee on Finance, 108th Cong., Staff Discussion Draft at 2, at http://finance.senate.gov/hearings/testimony/2004test/062204stfdis.pdf

information about the nature and extent of actual supporting organization abuses so that, with input from compliant and constructive type Ills and their supported public charities, Congress could enact an effective package of legislative reforms that would not eliminate good organizations along with the bad.

Although piecemeal amendment of the PPA's supporting organization provisions cannot make up for the lack of information or absence of collaboration in the lead up to their passage, it would nonetheless alleviate some of the difficulties these provisions have caused or may cause for numerous supporting organizations that daily contribute to the education, health and welfare of our communities. Following are specific comments on some supporting organization provisions of the PPA offered in response to your request for information regarding how the PPA's new rules affect charitable organizations and the difficulties arising in implementing PPA provisions.

Responsiveness

Two of the new provisions in the PPA are aimed at strengthening the responsiveness test in existing Treasury Regulations in order to ensure that an appropriately close relationship exists between the supporting and supported organizations. In current Treasury regulations, there are two alternative methods to satisfy the responsiveness test. The first alternative generally requires either that at least one officer or board member of the supporting organization be appointed by or be one of the supported public charity's officers or governing board or that the officers or board members of the supporting organization maintain a "close and continuous" relationship with the officers or board members of the supported organizations. In addition, by reason of the relationship between the supporting and supported organizations' leaders, the supported organization must have a "significant voice" in the investment policies of the supporting organization, the timing and manner of making grants, the selection of grant recipients of the supporting organization, and otherwise directing the use of the income or assets of the supporting organization.⁵ The second alternative, sometimes known as the "trust option," allows type III supporting organizations that are state law charitable trusts to meet the responsiveness test if (i) the trust is a charitable trust under state law; (ii) each beneficiary is named specifically in its governing instrument; and (iii) each beneficiary has the power to enforce the trust and compel an accounting under state law.⁶ Many type III supporting organizations have been created as state law charitable trusts in conformity with this regulation.

The first of modification of the responsiveness test was the addition of new Code section 509(0(1)(A), which requires supporting organizations to provide certain information specified by the Treasury Secretary to each supported organization, such as

5 Treas. Reg. § 1.509(a)-4(i)(2)(ii).

⁶ Treas. Reg. § 1.509(a)-4(i)(2)(iii). State trust law varies by state. However, in Oklahoma, trustees have a duty of loyalty to invest and manage the trust assets solely in the interest of the beneficiaries, and a duty of impartiality to invest and manage the trust assets of multiple beneficiaries impartially. Okla. Stat. tit. 60, §§ 175.65,175.66. In addition, private inurement to employees, officers, directors and members of the governing board is prohibited. Okla. Stat. tit. 60, § 301.8.

the supporting organization's governing documents, its annual Forms 990 and 990-T, and an annual report detailing the support provided to its supported organizations as well as a projection of support to be provided in the next year.⁷ The provision of additional information about the supporting organization's finances and activities will enable the supported organizations to better monitor and supervise the supporting organization and increase the ability of supported organizations to make meaningful recommendations and requests of the supporting organization, and we fully support this new requirement. In fact, since inception the Chapman Trusts have provided the named beneficiaries annually with copies of the Trusts' Forms 990 and statements of trust activity, including all trust income and disbursements (trustee fees, consulting fees, etc.) and current trust asset values. Failure to provide such information would be a factor in determining whether the supporting organization meets the responsiveness test, allowing the IRS to deny type III supporting organization status to abusive organizations that do not maintain the intended close and responsive relationship with their supported organizations.

The second attempted modification of the responsiveness test fails for lack of clarity and attention to the application of the rules to type Ills organized as trusts. Section 1241(c) of the PPA provides that for purposes of satisfying the requirements for type III supporting organization status a trust shall not be considered to be operated in connection with a supported organization "solely because (1) it is a charitable trust under state law, (2) the supported organization . . . is a named beneficiary of such trust, and (3) the supported organization . . . has the power to enforce the trust and compel an accounting."⁸ The meaning of this provision is far from clear. Standing alone it appears to be merely an accurate statement of the existing regulations: solely meeting the trust option of the responsiveness test has never been sufficient to establish an "operated in connection with" relationship with a supported organization, because the integral part test must also be met. In its technical explanation, the Joint Committee on Taxation indicates that this provision of the PPA means that type III supporting organizations organized as trusts "must, in addition to present law requirements, establish to the satisfaction of the Secretary that it has a close and continuous relationship with the supported organization such that the trust is responsive to the needs or demands of the supported organization."⁹ We certainly affirm the value of a close relationship between the trustees of a supporting organization and the leadership of its supported organizations. We have long maintained very close working relationships with the board and officers of each of our supported public charities, and we believe this to be necessary in order for us to fulfill our fiduciary duties under state trust law to these beneficiary organizations.

We have heard that in some instances a type III trust has claimed it met the responsiveness test under the trust option while failing to ever inform its supported organizations of its existence. This is clearly improper, and it is difficult to see how such

PPA, § 1241(b), 120 Stat. at 1102; Staff of the Joint Committee on Taxation, 109th Cong., Technical Explanation of H.R. 4, the "Pension Protection Act of 2006," As passed by the House on July 28, 2006 and as Considered by the Senate on August 3, 2006, at 362 (JCX-38-06, 2006) (hereinafter, "JCT Technical Explanation").

⁸ PPA, § 1241(c), 120 Stat. at 1103.

⁹ JCT Technical Explanation, supra note 7, at 362.

However, simply applying the other current alternative, the "close and continuous relationship" option, to all type III charitable trusts, as the IRS seems poised to do,¹° will not be appropriate in many type III trust situations. For example where an independent institutional trustee holds the assets of the supporting organization, it may be quite responsive to the needs and desires of the supported organization with respect to the timing and manner of distributions even without a relationship at the board level. Similarly, large institutional trustees typically neither seek nor accept advice from supported organizations regarding their investment policies and practices, but in other respects are very responsive to the needs and desires of the type III trust's supported organizations. Even the Panel on the Nonprofit Sector, a group which lacked sufficient representation of type III supporting organizations, recognized (and twice specifically noted) the need to adapt any application of the existing close and continuous relationship option to type III trusts.¹¹

Section 1241(c) of the PPA, as drafted, is ambiguous and does not give type III supporting organizations or the Treasury sufficient direction. We suggest that Congress repeal section 1241(c) of the PPA and instead direct Treasury to require that the trust option of the responsiveness test in current Treasury Regulations be amended to require the supporting organization's trustees or, in the case of independent institutional trustees, appropriate trustee employees or representatives to maintain a close and continuous relationship with the officers, directors or trustees of each supported organization and that, subject to state law fiduciary duties, the trustees of the supporting organization give each supported organization the opportunity to have a significant voice in determining the recipients of, timing of, and manner of making the organization's grants.

Minimum Payout

Section 1241(d) of the PPA directs Treasury to promulgate new regulations requiring non-functionally integrated type III supporting organizations to pay out annually a percentage of assets or income for the use of the supported organization to ensure a significant amount is paid to such organization.¹² Although it may be easiest for

See Advanced Notice of Proposed Rulemaking, Payout Requirements for Type III Supporting Organizations That Are Not Functionally Integrated, 72 Fed. Reg. 42,335, at 42,339 (Aug. 2, 2007).

^{I I} Panel on the Nonprofit Sector, Strengthening Transparency Governance Accountability of Charitable Organizations: A Final Report to Congress and the Nonprofit Sector 45-46 (2005).

¹² PPA, § 1241(d), 120 Stat. at 1103; JCT Technical Explanation, supra note 7, at 360. A non-functionally integrated type III supporting organizations is defined as a "type III supporting organization which is not required under regulations established by the Secretary to make payments to supported organizations due to the activities of the organization related to performing the functions of, or carrying out the purposes of, such supported organization." I.R.C. § 4943(f)(5)(B).

Supporting organizations, by contrast, are intended to be charity-focused entities, whether they are created by the supported charities themselves or by interested benefactors. A large measure of donor discretion is forfeited when the supporting organization relationship is created, binding the supporting organization to its designated supported public charities, often in perpetuity and excluding the donor from even an indirect control relationship.'³ In the case of type III supporting organizations, the supported public charities must be specifically named in their organizing documents—thus ensuring an ongoin relationship between a supporting organization and specific supported organizations.' Although, the type III relationship has been identified as the "loosest" of the three supporting organization relationships, it is still much closer than the typical relationship between a private foundation (or even a donor advised fund) and its grantees. Unlike the typical private foundation, a supporting organization acts as an integral part of its designated supported organizations, consistently providing functional or financial support over the long term.

This consistent, long-term support provided by a supporting organization is a significant advantage to its supported public charities. When beneficiaries have a reliable, sustainable source of support they are able to focus more time and energy on fulfilling their charitable mission instead of constant fundraising. In addition, a long-term relationship of support with a supporting organization, like having a permanent endowment, allows beneficiaries to conduct long-term research and initiate programs on which their service populations can rely without fear of interruption. Many public charities prefer predictable, sustainable and increasing distributions from a dedicated supporting organization rather than short-lived—even if large—distributions from private foundations and the uncertainty of hand-to-mouth fundraising.

Because type III supporting organizations are relied upon by their supported organizations as a source of long-term support for their charitable programs—much as an endowment would be—any fixed payout requirement should be set so as to preserve the

13 Treas. Reg. § 1.509(a)-4(d).

¹⁴ Treas. Reg. § 1.509(a)-4(d)(4).

supporting organization's ability to continue to provide comparable levels of support in the future. The benefits of a permanent endowment are not a novel discovery; they are age-old and well-documented. Like a permanent endowment, a supporting organization can provide beneficiaries with a reliable source of support that ensures financial stability and security even in fluctuating market conditions. Historically, inflation has averaged approximately 3 percent per annum. For a permanent endowment to maintain its inflation-adjusted value, the principal must be permitted to grow by that much each year. At least one empirical study has demonstrated that a 5 percent annual distribution rate exposes the portfolio to a high probability of failing to meet that objective.^I5

The key to preserving a supporting organization's ability to provide consistent support for its supported organizations and their charitable activities is to select a minimum percentage payout rate that is sustainable—thus assuring undiminished purchasing power of the long-term support to the supported organizations. Some have suggested that a rate of between 4 to 4.25 percent would strike an appropriate balance between Congress's stated goal of "ensuring that a significant amount is paid" out annually and the desire of many non-functionally integrated supporting organizations and their supported organizations to maintain undiminished support in perpetuity. Indeed, where there are payout requirements in the Code supporting the operation of charitable programs, they are set at rates lower than the 5 percent minimum payout rate for private foundations. For example, some medical research organizations are required to pay out 3.5 percent annually, and even this requirement applies only if less than half of their assets are used directly and continuously in their medical research activities.¹⁶ Similarly, private operating foundations are required to pay out a maximum of 4.25 percent annually, and even less in any year in which their adjusted net income falls below 5 percent." These payout rates allow the organizations to support their current operations at a level commensurate with their assets without precluding increases in principal sufficient to support future operations in the face of inflation. Payout rates for supporting organizations should similarly enable them to provide funding for the charitable programs of the supported organizations both now and in the future.

In addition, because most public charity beneficiaries of supporting organizations prefer predictable, sustainable, and increasing distributions rather than distributions that may vary widely from year to year, the regulations creating a new annual minimum distribution amount should allow for the value of the supporting organization's assets to

15 Cambridge Associates, Inc., Sustainable Payout for Foundations: A Study Commissioned by the Council of Michigan Foundations, available at <http://www.cmiforg/documents/payout.pdf> (last updated April, 2004).

¹⁶ Treas. Reg. § 1.170A-9(c)(2)(v)(b).

¹⁷ The regulations require a private operating foundation to spend "substantially all" (defined as 85%) of the lesser of its adjusted net income or the general private foundation 5% payout requirements; 85% of 5% is 4.25%. Treas. Reg. § 53.4942(b)-1(a)(1)(ii), -1(c). A private operating foundation must also meet an endowment test, a support test, or an asset test. If it opts to qualify under the "endowment test," it must normally spend at least two-thirds of the normal private foundation 5% payout (i.e., 3¹/₃%) on the direct conduct of its charitable activities, regardless of its adjusted net income. Treas. Reg. § 53.4942(b)-2(b)(1). However, if it instead meets the support test or the asset test, it need never spend more than 85% of its adjusted net income for the year.

This could be accomplished by providing two different methods for calculating the annual minimum distribution amount. The first method could simply multiply the applicable percentage by the fair market value of assets at the immediately preceding fiscal year-end. The second method could multiply the applicable percentage by the average fair market value of assets over the immediately preceding twelve or twenty quarters. The first method provides a simple straightforward calculation formula that would lessen the burden of compliance and enforcement. Although a bit more difficult to calculate, the second method creates an important hedge for the supported beneficiaries against sudden downward shifts in the market. A smoothing mechanism similar to the one proposed would protect similarly situated beneficiaries, their employees, and the persons and communities they serve from large drops in annual funding due to a plunge in financial markets. For example, if there were a large drop in the value of the supporting organization's assets in one year, and the asset values recovered during the following year or two, the required distributions to supported organizations would remain relatively stable, decreasing only moderately, if at all, after the downturn and increasing moderately during the upswing. Using an average asset value over 3 to 5 years to calculate the minimum distribution amount thus makes it easier for the beneficiaries to project future distributions and plan accordingly—thereby increasing financial stability for the beneficiary organizations.^I8

Although some have questioned the wisdom of perpetual existence of supporting organizations, perpetual support from a supporting organization can provide a transformative base from which the supported beneficiaries can advance their charitable purposes. With the assurance of annual distributions to sustain vital programs and operations, a supported beneficiary can gradually evolve from a paycheck-to-paycheck operation with a good idea to become a regional or national leader in its philanthropic endeavors because it has the economic wherewithal to implement its vision. Often private foundations will provide seed money for an innovative philanthropic project but do not want to provide ongoing grants to carry on operations. Instead, private foundation funders will move on after a few years, funding the next organization with the next good idea. A supporting organization, however, is designed to operate hand-in-hand with the supported charities, providing sustaining support while protecting the corpus so that the charitable operations of the supported organizations can continue indefinitely.

Thank you for providing exempt organizations with an opportunity to comment on the hardships and uncertainties created by the PPA. It is unfortunate that the

18 The Tax Code and Treasury Regulations employ similar smoothing mechanisms in a variety of exempt organization contexts. Perhaps most relevantly, Treasury Regulation § 53.4942(b)-3(a) allows private operating foundations to meet their payout requirements based on total expenditures and income over a four-year period ending in the year in question.

provisions were never discussed in a bipartisan manner nor made the subject of committee hearings where they could be debated and commented on by those within the sector. If you should have any questions regarding the above, please feel free to contact me at (918) 582-5201.

CHAPMAN CHARITABLE TRUSTS

2005 & 2006 DISTRIBUTIONS