The Senate Finance Committee has been considering for over a year now certain "reforms" thought to be needed in the nonprofit sector. As part of that process, the Committee asked Independent Sector, an umbrella group of some 500 national charities, foundations, and other philanthropic entities, to provide guidance on certain legislative proposals under consideration.

To that end, Independent Sector convened the Panel on the Nonprofit Sector (the Panel), composed of representatives from hundreds of nonprofit organizations (as well as other prominent individuals) to prepare recommendations. The Panel's Report, Strengthening Transparency, Governance, Accountability of Charitable Organizations, released in June 2005 (the Report), contains a wide range of suggestions, calls for targeted legislative changes and IRS actions, and recommends numerous "best practices" for nonprofit corporate governance. One focus of the Report aimed at "Type III Supporting Organizations" has potentially material and unintended adverse consequences for parent organizations in multi-corporate health care systems.

What is a supporting organization? Simply put, it is an entity exempt under § 501(c)(3) that qualifies as a "public charity" under arcane tax law principles and, as a public charity, avoids otherwise mandatory private foundation status with the additional taxes and operating restrictions which private foundation status entails. Supporting organizations (described in § 509(a)(3) of the Internal Revenue Code) qualify for public charity status because of a defined governance relationship with an exempt hospital (or certain other types of exempt entities), as opposed to being publicly supported though broad-based fundraising (under § 509(a)(1)) or through revenue raised from charitable activities (under § 509(a)(2)).

There are three types of supporting organizations that derive their public charity status through prescribed governance relationships: those where the supported exempt entity controls the supporting organization (Type I); those where a majority of the supporting entity's directors also control the supported organization (Type II); and finally, the Type III Supporting Organization, where the relationship to the supported organization is the most attenuated (and thus, where the planning flexibility is the greatest). Type IIIs need only to have one common director (or officer) between the supporting organization and each supported organization. They also must perform activities for the benefit of the supported organization, which, if not performed by the supporting organization, would have to be performed by the supported organization itself. Many health care system parents are Type III's and meet this latter test through their strategic planning, budget oversight, and other reserved powers exercised on behalf of their subsidiaries. Accordingly, legislative changes in this area could impact parent organizations structured as Type III supporting organizations.

The Panel perceived abuse in this area, claiming that "donor[s] may inappropriately maintain de facto control over a Type III supporting organization and then cause it improperly to provide private benefits." Report at 45. That symptom is generally not present in the health care arena. Unfortunately the Panel's report did not appreciate that fact, and its recommendations for Type III entities extend far beyond those situations where abuse was perceived.

Two proposed remedies are especially problematic for Type III parents: the limit on the number of exempt entities that can be supported, and a mandatory payout requirement.

The first proposed reform would limit Type III parents to supporting only five or fewer exempt entities. In many large systems, with "flat" organizational structures, the parent may support well more than five subsidiaries. The Panel, although not specifically addressing health industry concerns, suggested that this limitation should not be imposed initially on existing entities, but only on new entities. In making this recommendation, the Panel noted, however, that if "increased reporting and enforcement efforts reveal . . . problems in existing organizations ., this limitation could later be extended to existing organizations." Report at 48, n. 8. Thus, any reprieve may be only temporary.

This proposal also may be problematic in the case of affiliations and complicate their planning. Many affiliations, for political or other reasons, utilize a newly created parent (or, in some cases, "super parent") entity structured as a Type III supporting organization. To the extent the new entity directly or indirectly supports more than five subsidiaries (more likely because of the fact that health care entities are being combined through the affiliation), the new rule may be triggered. Parties contemplating affiliations may wish to adjust their transaction structures accordingly.

The second reform would also require each Type III supporting organization to expend, annually, five percent of its assets for the benefit of its supported organizations. In calculating this requirement, assets used directly for the benefit of a supported organization (e.g., a building) would not be counted; likewise the operating expenses of the parent could be counted towards meeting this requirement.

This second proposed reform essentially imposes the mandatory pay-out requirement applicable to private foundations on public charities (which were structured as such in the first place to avoid this private foundation burden). This requirement will adversely affect those parent entities that receive "upstreamed" funds from their operating subsidiaries, both to shelter such funds from judgment creditors as well as to create investment capital for system expansion. Now, such funds will need to be paid out at the prescribed rate for the benefit of the currently supported entities, as opposed to invested in other ventures.

Both of these suggested reforms were likely conceived without thinking through their potential application to the health care sector. Health care systems may want to monitor development of any legislation in this area and, through their relevant associations, attempt to educate Congress on the impacts of this particular proposal. Alternatively, if such legislation passes, Type III parents may wish to explore alternative public charity structures.

The Panel on the Nonprofit Sector's final report to Congress, Strengthening Transparency, Governance, Accountability of Charitable Organizations, is available through the Panel's website at: www.nonprofitpanel.org/final/Panel_Final_Report.pdf.