The collection of information contained in this notice of proposed rulemaking has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545-1940. The collection of information in these proposed regulations is in §301.6501(c)-1(g)(5). This information is required to provide the IRS, under penalties of perjury, with the information necessary to properly determine the taxpayer’s applicable period of limitations. The collection of information in these proposed regulations is the same as the collection of information in Revenue Procedure 2005-26, 2005-1 C.B. 965, which was previously reviewed and approved by the Office of Management and Budget under control number 1545-1940. The collection of information in §301.6501(c)-1(g)(6) is the same as the collection of information required under section 6112. See §601.601(d)(2)(ii)(b).

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. §6103.

This document contains proposed amendments to the Procedure and Administration Regulations (26 CFR Part 301) under section 6501(c) relating to exceptions to the period of limitations on assessment. Section 6501(a) provides that, except as otherwise provided, if a return is filed, tax with respect to that return must be assessed within 3 years from the later of the date the return was filed or the original due date of the return. Section 6501(c) contains several exceptions to the general three-year period of limitations on assessment.

Section 6501(c)(10) was added to the Code by section 814 of the American Jobs Creation Act of 2004, Public Law 108-357 (118 Stat. 1418, 1581 (2004)) (AJCA), enacted on October 22, 2004. Section 6501(c)(10) provides that, if a taxpayer fails to disclose a listed transaction as required under section 6011, the time to assess tax against the taxpayer with respect to that transaction will end no earlier than one year after the earlier of (1) the date on which the taxpayer furnishes the information required under section 6011, or (2) the date that a material advisor furnishes to the Secretary, upon written request, the information required under section 6112 with respect to the taxpayer related to the listed transaction. Accordingly, if neither the taxpayer nor a material advisor furnishes the requisite information, the period of limitations on assessment will remain open, and thus, the tax with respect to the listed transaction may be assessed at any time. Section 6501(c)(10) is effective for taxable years with respect to which the period of limitations on assessment did not expire prior to October 22, 2004.

As noted, section 6501(c)(10) applies when a taxpayer does not properly disclose a listed transaction (as defined in section 6707A(c)(2)) as required under section 6011. Taxpayers are required under section 6011 and the regulations under section 6011 (collectively referred to as the “section 6011 disclosure rules”) to disclose certain information regarding each reportable transaction in which the taxpayer participated. See Treas. Reg. §§1.6011-4; 20.6011-4; 25.6011-4; 31.6011-4; 53.6011-4; 54.6011-4; and 56.6011-4. Among the transactions that are reportable are “listed transactions.” See Treas. Reg. §1.6011-4(b)(2). Under the section 6011 disclosure rules, a listed transaction is a transaction that is the same as, or substantially similar to, a transaction that the IRS has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance. Treas. Reg. §1.6011-4(b)(2). Section 6707A(c)(2) incorporates the same definition of listed transaction. For a list of transactions the IRS has identified as listed transactions, see Notice 2009-59, 2009-31 I.R.B. 170. See §601.601(d)(2).

If the section 6011 disclosure rules require a taxpayer to disclose a listed transaction, the taxpayer must complete and file a disclosure statement in accordance with the section 6011 disclosure rules. The section 6011 disclosure rules currently require that Form 8886, “Reportable Transaction Disclosure Statement” (or successor form), be used as the disclosure statement and be completed in accordance with the instructions to the form. The Form 8886 (or successor form) generally must be attached to the taxpayer’s original or amended tax return for each taxable year for which a taxpayer participates in a listed transaction. Treas. Reg. §1.6011-4(e)(1). If a listed transaction results in a loss that is carried back to a prior year, Form 8886 (or successor form) must be attached to the taxpayer’s application for tentative refund or amended tax return for that prior year. The taxpayer also must send a copy of Form 8886 (or successor form) to the IRS Office of Tax Shelter Analysis (OTSA), generally at the same time that a disclosure statement pertaining to a particular listed transaction is first filed. Under the current rules, when a transaction is identified as a listed transaction after the date on which the taxpayer files a tax return (including an amended return) for a taxable year reflecting the taxpayer’s participation in the listed transaction and before the end of the period of limitations for assessment of tax for any taxable year in which the taxpayer participated in the listed transaction, then the taxpayer must file Form 8886 (or successor form) with OTSA within 90 calendar days after the date the transaction became a listed transaction.

If a taxpayer does not disclose its participation in a listed transaction in accordance with all of the requirements of the section 6011 disclosure rules and section 6501(c)(10) applies, then the time to assess tax related to the listed transaction will expire no earlier than the earlier of (1) one year after the date on which the information described in section 6501(c)(10)(A) is provided, or (2) one year after the date on which the information described in section 6501(c)(10)(B) is provided.

The IRS and Treasury Department issued Rev. Proc. 2005-26, 2005-1 C.B. 965, on April 25, 2005, to provide interim guidance on section 6501(c)(10). The revenue procedure prescribes how taxpayers and material advisors should disclose listed transactions that were not properly disclosed under section 6011 in order to start the one-year period under section 6501(c)(10). Taxpayers may continue to rely on Rev. Proc. 2005-26 until temporary or final regulations are issued under section 6501(c)(10). See §601.601(d)(2). In that revenue procedure, the IRS and Treasury Department also requested comments concerning the procedures set forth in the revenue procedure, especially their application to partners and partnerships. One comment was received but it did not address the limitations period.

These proposed regulations provide rules reflecting the enactment of section 6501(c)(10) by the AJCA. They explain how to determine whether section 6501(c)(10) applies and, if so, the applicable period of limitations on assessment. As a preliminary matter, the effective date of section 6501(c)(10) limits its application to taxable years with respect to which the period of limitations on assessment was open on or after October 22, 2004 (the date the AJCA was enacted). Thus, for taxable years for which a return was due prior to October 22, 2004, an analysis under section 6501 must be conducted to determine if the period of limitations on assessment was open under the general three-year period or an exception other than section 6501(c)(10).

The general rule for applying section 6501(c)(10) is set forth in §301.6501(c)-1(g)(1) of these proposed regulations. The first step in analyzing whether section 6501(c)(10) applies is to determine whether the taxpayer failed to comply with any disclosure obligation under the section 6011 disclosure rules with respect to a listed transaction (as defined in section 6707A(c)(2)) for any taxable year. The IRS and Treasury Department have issued several regulations under section 6011, some of which apply only to certain types of taxpayers. The disclosure requirements also vary among the regulations. Therefore, particular attention must be paid to the effective dates of the various section 6011 disclosure rules in order to determine whether there was a disclosure obligation.

If there was no obligation to disclose the listed transaction, or if the taxpayer complied with its disclosure obligations, then section 6501(c)(10) does not apply. If there was a disclosure obligation and a failure to disclose as required, then section 6501(c)(10) applies. Section 6501(c)(10) applies to all open years for which the taxpayer failed to disclose its participation in the transaction as required under the section 6011 disclosure rules, even if the disclosures required under section 6011 were not due in, or with a return for, the year of participation but were due in a later year when the transaction was subsequently identified as a listed transaction. If section 6501(c)(10) applies because a taxpayer failed to disclose a listed transaction and the transaction is later removed from the category of listed transactions, section 6501(c)(10) will continue to apply with respect to the tax years for which disclosure was required. If section 6501(c)(10) applies, then the period of limitations with respect to the listed transaction will remain open until at least the earlier of (1) one year after the date on which the taxpayer provides a disclosure to satisfy section 6501(c)(10)(A) (as provided in §301.6501(c)-1(g)(5) described elsewhere in this preamble), or (2) one year after the date on which a material advisor provides the IRS with information concerning the taxpayer’s participation in the transaction sufficient to satisfy section 6501(c)(10)(B) (as provided in §301.6501(c)-1(g)(6) described elsewhere in this preamble). If either paragraph (g)(5) or (g)(6) is satisfied, the period of limitations on assessment will end under the circumstances described in §301.6501(c)-1(g)(2) of these proposed regulations.

Section 301.6501(c)-1(g)(2) of these proposed regulations also provides guidance on how section 6501(c)(10) interacts with the otherwise applicable period of limitations provided in the Internal Revenue Code. The proposed regulations confirm that section 6501(c)(10) does not operate to extend a limitations period that expired before the effective date of section 6501(c)(10) or before the date on which the failure to disclose occurs. In addition, a taxpayer or material advisor cannot shorten any other applicable period of limitations on assessment by following the procedures to begin the one-year period provided under section 6501(c)(10), including, but not limited to, a limitations period that has been extended by agreement under section 6501(c)(4), or the limitations period described in section 6501(c)(1) relating to a false or fraudulent return.

The terms “listed transaction,” “material advisor,” and “taxable year(s) to which the failure to disclose relates” are defined in §301.6501(c)-1(g)(3) of these proposed regulations by cross-reference to section 6707A and the relevant regulations under sections 6011 and 6111.

Under section 6501(c)(10), the term “listed transaction” is defined by reference to section 6707A(c)(2), which defines a listed transaction as “a reportable transaction that is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011.” Although section 6707A was enacted by section 811 of the AJCA and is effective for returns and statements due after October 22, 2004, and which were not filed before that date, its definition of “listed transactions” incorporates transactions identified as listed transactions in the section 6011 disclosure rules before section 6707A was enacted. Accordingly, any transactions that were listed transactions as of October 22, 2004, under the section 6011 disclosure rules are listed transactions under section 6707A and, thus, for purposes of section 6501(c)(10). Therefore, section 6501(c)(10) applies to transactions that were identified as listed transactions prior to October 22, 2004.

The term “taxable year(s) to which the failure to disclose relates” identifies the years to which section 6501(c)(10) applies. Clarification is necessary because a taxpayer may participate in a listed transaction over multiple years, because a transaction may be identified as a listed transaction after the taxpayer enters into the transaction, and because the section 6011 disclosure rules may require disclosure in a year in which the taxpayer did not participate in the listed transaction. The term “taxable year(s) to which the failure to disclose relates” means each taxable year that the taxpayer participated (as defined by the regulations under section 6011) in a transaction that was identified as a listed transaction and for which there was no proper disclosure when required under the section 6011 disclosure rules. For these purposes, it does not matter whether the transaction was identified as a listed transaction before or after the taxpayer filed a tax return for any taxable year in which the taxpayer participated in the transaction. On occasion, the section 6011 disclosure rule may require that a disclosure be filed in a taxable year or with a tax return for a taxable year other than the taxable year in which the taxpayer participated in the listed transaction. In those circumstances, the taxable year(s) to which the failure to disclose relates is not the taxable year in which the disclosure is required to be filed, but each taxable year that the taxpayer participated in the listed transaction.

Section 301.6501(c)-1(g)(4) of these proposed regulations provides the rule for application of section 6501(c)(10) in the case of taxpayers who are partners in partnerships, shareholders in S corporations, or beneficiaries of trusts. If these taxpayers were required to disclose their participation in a listed transaction under the section 6011 disclosure rules, and failed to disclose, then the period of limitations on assessment with respect to each partner, shareholder, or beneficiary that failed to disclose will remain open under section 6501(c)(10) even if the partnership, S corporation, or trust disclosed in accordance with the section 6011 disclosure rules and even if another partner, shareholder, or beneficiary disclosed in accordance with the section 6011 disclosure rules. This rule is as adopted because the period of limitations on assessment is specific to each taxpayer. Consistent with the above rule, a failure to disclose by an entity will not cause section 6501(c)(10) to apply to all of the taxpayers who are partners, shareholders or beneficiaries of the entity.

Guidance on the events that will start the one-year period under section 6501(c)(10) is provided in §301.6501(c)-1(g)(5) and (6) of these proposed regulations.

Under section 6501(c)(10)(A), if there is a failure to disclose information related to a listed transaction as required under the section 6011 disclosure rules, the time to assess tax will end no earlier than one year after the date “the Secretary is furnished the information so required.” Section 301.6501(c)-1(g)(5)(i)(A)-(C) of these proposed regulations sets forth the general procedures for how to furnish the information to the IRS. These procedures are similar to the ones required under the section 6011 disclosure rules because failure to comply with those rules triggers the application of section 6501(c)(10). Because the rules set forth in §301.6501(c)-1(g)(5)(i) generally concern annual returns, §301.6501(c)-1(g)(5)(ii) provides that the IRS may issue published guidance that prescribes alternative procedures to address particular listed transactions, if necessary, in the case of returns other than annual returns.

Section 301.6501(c)-1(g)(5)(i)(A) of these proposed regulations provides that to begin the one-year period under section 6501(c)(10)(A) taxpayers must complete Form 8886 (or successor form) in accordance with the instructions to the form and these proposed regulations and submit the completed form with a cover letter (as described in §301.6501(c)-1(g)(5)(i)(B)) to OTSA. Under the procedures set forth in Revenue Procedure 2005-26, taxpayers were required to submit the completed form and cover letter both to OTSA and the Internal Revenue Service Center where the taxpayer filed its original return in all cases and, if applicable, to an IRS examiner or Appeals officer. These proposed regulations simplify the procedures taxpayers need to follow by only requiring them to submit the information to one IRS office instead of two, unless the taxpayer also needs to submit a copy to an IRS examiner or Appeals officer, as discussed later in this Preamble.

Taxpayers must complete the most current version of the form available at the time the taxpayer attempts to satisfy section 6501(c)(10). In other words, if the Form 8886 (or successor form) changes between the date that the taxpayer was required to disclose the listed transaction under the section 6011 disclosure rules and the date that the taxpayer discloses the listed transaction for purposes of section 6501(c)(10), then the taxpayer must follow the rules in effect on the date of the section 6501(c)(10) disclosure.

The taxpayer also must indicate on the form that the disclosure is for purposes of section 6501(c)(10) and the tax return(s) and taxable year(s) for which the taxpayer is making a section 6501(c)(10) disclosure. The section 6501(c)(10) disclosure will only be effective for the tax return(s) and taxable year(s) that the taxpayer specifies he or she is attempting to disclose for purposes of section 6501(c)(10). Thus, for example, if a taxpayer failed to disclose the taxpayer’s participation in a listed transaction in three taxable years but the taxpayer’s section 6501(c)(10) disclosure only specifies one taxable year, then the period of limitations on assessment for the other two taxable years will remain open under section 6501(c)(10). If the Form 8886 (or successor form) contains a line for that purpose, then taxpayers may use that line, so long as the line is completed in accordance with the instructions to the form. If no line is provided on the form, then the taxpayer must include on the top of Page 1 of the Form 8886, and each copy of the form, the following statement: “Section 6501(c)(10) Disclosure” followed by the tax return(s) and taxable year(s) for which the taxpayer is making a section 6501(c)(10) disclosure. This information is necessary to place the IRS on notice that the taxpayer is attempting to remedy its failure to properly disclose the listed transaction and, thus, the one-year period will start to run with respect to the tax years identified. Because the IRS may have as little as one year to determine whether to conduct an examination and, if it does conduct an examination, to determine whether any additional tax is due with respect to the listed transaction, it is important that the IRS receives proper notice that the one-year period has started.

Taxpayers must submit a separate Form 8886 (or successor form) and cover letter (discussed elsewhere in this Preamble) for each listed transaction that the taxpayer did not properly disclose under the section 6011 disclosure rules. If the taxpayer participated in one listed transaction over multiple years, then the taxpayer may submit one Form 8886 (or successor form), so long as the taxpayer indicates on the Form 8886 all of the tax returns and taxable years for which the taxpayer is making a section 6501(c)(10) disclosure. If a taxpayer participated in more than one listed transaction, then the taxpayer must submit separate Forms 8886 (or successor form) for each listed transaction, unless the listed transactions are the same or substantially similar, in which case all the listed transactions may be reported on one Form 8886.

Section 301.6501(c)-1(g)(5)(i)(B) of these proposed regulations provides the requirements for the cover letter. The cover letter must identify the tax return(s) and taxable year(s) for which the taxpayer is making a section 6501(c)(10) disclosure. In addition, the cover letter must include the statement provided in §301.6501(c)-1(g)(5)(i)(B) signed under penalties of perjury by the taxpayer and, if applicable, by the paid preparer preparing the Form 8886. The cover letter is necessary because the Form 8886 does not currently contain a penalties-of-perjury statement or place for signature.

A special rule for taxpayers under examination or Appeals consideration by the IRS is provided in §301.6501(c)-1(g)(5)(i)(C) of these proposed regulations. If the taxpayer wants to make a section 6501(c)(10) disclosure for a taxable year or a listed transaction under examination or Appeals consideration, then, in addition to the otherwise applicable filing obligations set forth in §301.6501(c)-1(g)(5)(i)(A), the taxpayer must submit a copy of the submission made under paragraph (g)(5)(i)(A) to the IRS examiner or Appeals officer examining or considering the taxable year to which the section 6501(c)(10) disclosure relates. This rule is adopted to ensure that the IRS personnel who are considering the taxpayer’s tax year(s) at issue are made aware as soon as possible that the one-year period under section 6501(c)(10) may have started to run, so that whatever action is necessary can be taken within the one-year period.

Section 301.6501(c)-1(g)(5)(i)(D) provides guidance concerning the date on which the taxpayer is considered to have furnished the information to the IRS to satisfy section 6501(c)(10)(A) and start the running of the one-year period. The one-year period under section 6501(c)(10)(A) will begin on the date that the taxpayer satisfies all the requirements set forth in §301.6501(c)-1(g)(5)(i)(A) through (C). If the required procedures are not completed on the same date, the one-year period will begin on the date that the last procedure is satisfied. For example, if a taxpayer mails a completed Form 8886 to OTSA but not to the IRS examiner or Appeals officer who is examining or considering the taxable year to which the section 6501(c)(10) disclosure relates, the one-year period under section 6501(c)(10)(A) will not begin until both events occur.

Information provided under §301.6501(c)-1(g)(5) is deemed furnished on the date the IRS receives the information. Section 7502 does not apply to the mailing of the information detailed in §301.6501(c)-1(g)(5), because the information is not required to be filed within a prescribed period or on or before a prescribed date. Taxpayers can determine the date the IRS receives the information by using a delivery service that provides a way to track delivery, such as U.S. registered or certified mail, express or priority mail, or delivery confirmation from the U.S. post office or a private delivery service that provides tracking. Moreover, documentation from the post office or private delivery service showing the date the information was delivered to the IRS, together with evidence that the envelope was properly addressed to the office to which the information was required to be sent, generally will be sufficient proof that the IRS received the information, unless the IRS can establish that it did not in fact receive the information. Separate delivery confirmation documentation should be obtained to establish receipt by OTSA and the appropriate IRS revenue agent or Appeals officer, if applicable.

Under section 6501(c)(10)(B), if a taxpayer fails to disclose information related to a listed transaction as required under the section 6011 disclosure rules, the time to assess tax will end no earlier than one year after the date “a material advisor meets the requirements of section 6112 with respect to a request by the Secretary under section 6112(b) relating to such transaction with respect to such taxpayer.” Section 6112 requires material advisors to maintain lists of advisees and other information with respect to reportable transactions, including listed transactions, and to furnish that information to the IRS upon request. The term “material advisor” is defined in §301.6111-3(b). The IRS and Treasury Department finalized regulations under section 6112 in T.D. 9352, 2007-2 C.B. 621, (72 FR 43154) published on August 3, 2007. Section 6112 and §301.6112-1 provide guidance relating to the preparation, content, maintenance, retention, and furnishing of lists by material advisors.

Section 6501(c)(10)(B) provides that a material advisor must satisfy the requirements of section 6112 to begin the one-year period. Information provided in response to another method of inquiry, such as an Information Document Request in a section 6700 investigation, will not begin the one-year period. In addition, §301.6501(c)-1(g)(6)(i) provides that the material advisor must furnish the information described in §301.6112-1(e) with respect to the taxpayer that failed to properly disclose the listed transaction. Thus, if the material advisor furnishes the information described in §301.6112-1(e) for some, or even most, of its clients but not for a particular taxpayer that failed to properly disclose the listed transaction, then the assessment period for that taxpayer will remain open under section 6501(c)(10).

Section 301.6501(c)-1(g)(6)(ii) of these proposed regulations clarifies that the one-year period will begin once the material advisor furnishes the information in response to an IRS request under section 6112, regardless of whether the material advisor provides the information within 20 business days of the IRS’s request as required by section 6708. If the material advisor furnishes the required information over the course of multiple days, the requirements of paragraph (g)(6) of this section will be deemed satisfied and the one-year period will begin on the date that the IRS is furnished the information that, together with prior information, satisfies the requirements of section 6112 and §301.6112-1 with respect to the taxpayer. The information is deemed furnished for purposes of section 6501(c)(10) on the date the material advisor is treated as satisfying the requirements of section 6112 under the rules applicable to that section.

Section 6501(c)(10) allows the IRS to assess any tax with respect to a listed transaction for the taxable year(s) to which the failure to disclose relates. Section 301.6501(c)-1(g)(7) of these proposed regulations provides that taxes with respect to the listed transaction include, but are not limited to, (1) adjustments made to the tax consequences claimed on the return, (2) adjustments to any item to the extent the item is affected by the listed transaction even if it is unrelated to the listed transaction, and (3) interest and penalties that are related to the listed transaction or the adjustments made to the tax consequences (see I.R.C. §§6601(e)(1) and 6665(a)(2)). An example of an item affected by the listed transaction but not related to the listed transaction is the threshold for the medical expense deduction under section 213 that varies if there is a change in an individual’s adjusted gross income. Examples of a penalty related to the adjustments made to the tax consequences are the accuracy-related penalties under sections 6662 and 6662A. An example of a penalty related to the listed transaction is the penalty under section 6707A for failure to file the disclosure statement reporting the taxpayer’s participation in the listed transaction.

Section 301.6501(c)-1(g)(8) of these proposed regulations contains examples of the application of section 6501(c)(10) to various types of taxpayers participating in listed transactions. Additional examples illustrate the application of the one-year period under section 6501(c)(10), the coordination of section 6501(c)(10) with other limitations periods provided by the Internal Revenue Code, and tax that can be assessed with respect to a listed transaction.

When adopted as final regulations, these rules will apply to taxable years with respect to which the period of limitations on assessment did not expire before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. However, taxpayers may rely on these proposed regulations for taxable years with respect to which the period of limitations on assessment expired before the publication of the Treasury decision. Otherwise, Rev. Proc. 2005-26 continues to apply for taxable years to which these regulations do not apply and for which the period of limitations on assessment did not expire before April 8, 2005 — the effective date of Rev. Proc. 2005-26.

Upon the publication of final regulations under section 6501(c)(10) in the Federal Register, Rev. Proc. 2005-26, 2005-1 C.B. 965, will be superseded for taxable years with respect to which the period of limitations on assessment did not expire before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations.

It is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6). Section 6501(c)(10) applies when taxpayers fail to comply with the reporting requirements set forth in section 6011. The Treasury Department and the IRS do not know the exact number and types of taxpayers that fail to comply with those requirements. However, although the Treasury Department and the IRS are aware that many tax avoidance transactions involve pass-through entities, when pass-through entities are utilized, the entities are not ultimately liable for the tax; rather, the taxpayers subject to section 6501(c)(10) will be the individuals and corporations owning, directly or indirectly, the interests in the pass-though entities. Therefore, the Treasury Department and the IRS have determined that these proposed regulations will not affect a substantial number of small entities.

In addition, the Treasury Department and the IRS have determined that any impact on small entities resulting from these proposed regulations will not be significant. Most of the information required under these proposed regulations is already required by other regulations or forms, namely §1.6011-4, §301.6112-1, and Form 8886, “Reportable Transaction Disclosure Statement.” The only new information required to be submitted to the IRS is a cover letter, which must contain a reference to the tax returns and taxable year(s) at issue and a statement signed under penalty of perjury. The cover letter should take minimal time and expense to prepare. Therefore, the additional requirement of the cover letter should not significantly increase the burden on taxpayers. Based on these facts, the Treasury Department and the IRS have determined that these proposed regulations will not have a significant economic impact on a substantial number of small entities. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the substance of the proposed regulations, as well as on the clarity of the proposed rules and how they can be made easier to understand. All comments submitted by the public will be made available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register.

Paragraph 1. The authority citation for part 301 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 301.6501(c)-1 is amended by adding paragraph (g) to read as follows:

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by November 23, 2009. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the Internal Revenue Service, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information;

How the quality, utility, and clarity of the information to be collected may be enhanced;

How the burden of complying with the proposed collection of information may be minimized, including through forms of information technology; and

Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.

The collection of information in this proposed regulation is in Prop. Reg. §1.509(a)-4(i)(2). The collection of information flows from section 509(f)(1)(A), which requires a Type III supporting organization to provide to each of its supported organizations such information as the Secretary may require to ensure that the Type III supporting organization is responsive to the needs or demands of its supported organization(s). The likely recordkeepers are Type III supporting organizations.

Estimated total annual reporting burden: 8,400 hours.

Estimated average annual burden hours per recordkeeper: Two hours.

Estimated number of recordkeepers: 4,200.

Estimated frequency of collection of such information: Annual.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget. Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and return information are confidential, as required by 26 U.S.C. 6103.

An organization described in section 501(c)(3) of the Internal Revenue Code (Code) is classified as either a private foundation or a public charity. To be classified as a public charity, an organization must meet the requirements of section 509(a)(1), (2), (3), or (4). Organizations described in section 509(a)(3) are known as supporting organizations. Such organizations achieve their status by providing support to one or more organizations described in section 509(a)(1) or (2), which in this context are referred to as supported organizations.

To meet the requirements of section 509(a)(3), an organization must satisfy an organizational test, an operational test, a relationship test, and a disqualified person control test. The organizational and operational tests require that the supporting organization be organized and at all times thereafter operated exclusively for the benefit of, to perform the functions of, or to conduct the purposes of one or more supported organizations. The relationship test requires the supporting organization to establish one of three types of relationships with one or more supported organizations. Finally, the disqualified person control test requires that the supporting organization not be controlled directly or indirectly by certain disqualified persons. Although each of these tests is a necessary requirement for an organization to establish that it qualifies as a supporting organization, this notice of proposed rulemaking (NPRM) focuses primarily on the relationship test.

Treas. Reg. §1.509(a)-4(f)(2) provides that a supporting organization must maintain one of three types of structural or operational relationships with its supported organization(s). A supporting organization that is operated, supervised or controlled by one or more supported organizations is commonly known as a Type I supporting organization. The relationship of a Type I supporting organization with its supported organization(s) is comparable to that of a corporate parent-subsidiary relationship. A supporting organization that is supervised or controlled in connection with one or more supported organizations is commonly known as a Type II supporting organization. The relationship of a Type II supporting organization with its supported organization(s) is comparable to a corporate brother-sister relationship. A supporting organization that is operated in connection with one or more supported organizations is commonly known as a Type III supporting organization. This NPRM focuses primarily on Type III supporting organizations.

Prior to the enactment of the PPA, the regulations under section 509(a)(3) generally provided that an organization is “operated in connection with” one or more supported organizations if it meets a “responsiveness test” and an “integral part test.”

Treas. Reg. §1.509(a)-4(i)(2)(i) provides that an organization meets the responsiveness test if the organization is responsive to the needs or demands of its supported organizations. Treas. Reg. §1.509(a)-4(i)(2)(ii) provides three ways that a supporting organization may demonstrate responsiveness to a supported organization: (1) the supported organization appoints or elects one or more of the officers, directors, or trustees of the supporting organization; (2) one or more members of the governing body of the supported organization serve as officers, directors, or trustees of, or hold other important offices in, the supporting organization; or (3) the officers, directors, or trustees of the supporting organization maintain a close continuous working relationship with the officers, directors, or trustees of the supported organization. In all three cases, the relationship must result in the supported organization having a significant voice in the investment policies of the supporting organization, the timing and the manner of making grants, the selection of the grant recipients of the supporting organization, and direction over the use of the income or assets of the supporting organization.

The existing regulations also provide an alternative means for charitable trusts to satisfy the responsiveness test. Under Treas. Reg. §1.509(a)-4(i)(2)(iii), a supporting organization is responsive if: (1) it is a charitable trust under State law, (2) each specified supported organization is a named beneficiary under the charitable trust’s governing instrument, and (3) each beneficiary organization has the power to enforce the trust and compel an accounting under State law.

In the case of an organization that was supporting one or more supported organizations before November 20, 1970, Treas. Reg. §1.509(a)-4(i)(1)(ii) provides that additional facts and circumstances, such as a historic and continuing relationship between the supporting organization and its supported organization(s), also may be taken into account to establish compliance with the responsiveness test.

Treas. Reg. §1.509(a)-4(i)(3)(i) provides that a supporting organization meets the integral part test by maintaining a significant involvement in the operations of one or more supported organizations that are dependent upon the supporting organization for the type of support which it provides. Under the existing regulations, there are two alternative ways to meet the integral part test: (1) the “but for” test under Treas. Reg. §1.509(a)-4(i)(3)(ii); or (2) the “attentiveness” test under Treas. Reg. §1.509(a)-4(i)(3)(iii).

Treas. Reg. §1.509(a)-4(i)(3)(ii) states that the “but for” test is satisfied if “the activities engaged in [by the supporting organization] for or on behalf of the supported organizations are activities to perform the functions of, or to carry out the purposes of, such organizations, and, but for the involvement of the supporting organization, would normally be engaged in by the supported organizations themselves.”

The “attentiveness” test under Treas. Reg. §1.509(a)-4(i)(3)(iii) requires a supporting organization to: (1) make payments of substantially all of its income to or for the use of one or more supported organizations, (2) provide enough support to one or more supported organizations to ensure the attentiveness of such organization(s) to the operations of the supporting organization; and (3) pay a substantial amount of the total support of the supporting organization to those supported organizations that meet the attentiveness requirement. Rev. Rul. 76-208, 1976-1 C.B. 161 (see §601.601(d)(2)(ii)(b)), provides that the phrase “substantially all of its income” in Treas. Reg. §1.509(a)-4(i)(3)(iii) means at least 85 percent of adjusted net income.

The PPA made five changes to the requirements an organization must meet to qualify as a Type III supporting organization:

(1) It removed the alternative test for charitable trusts as a means of meeting the responsiveness test;

(2) It required the Secretary of the Treasury to set a new payout requirement for organizations that are not functionally integrated (generally, those organizations that met the integral part test by satisfying the attentiveness test under the existing regulations) to ensure that such organizations pay a “significant amount” to their supported organizations;

(3) It provided that a Type III supporting organization must annually provide to each of its supported organizations such information as the Secretary may require to ensure that the supporting organization is responsive to the needs or demands of its supported organization(s);

(4) It prohibited a Type III supporting organization from supporting any supported organization not organized in the United States; and

(5) It prohibited a Type I or Type III supporting organization from accepting a gift or contribution from a person who, together with certain related persons, directly or indirectly controls the governing body of a supported organization of the Type I or Type III supporting organization.

On December 18, 2006, the Treasury Department and the IRS released Notice 2006-109, 2006-2 C.B. 1121, (see §601.601(d)(2)(ii)(b)), which alerted taxpayers to the new supporting organization rules enacted by the PPA; provided interim guidance, including reliance standards for private foundations making grants to supporting organizations; and solicited comments regarding the new supporting organization requirements. Fifteen comments and numerous phone calls were received in response to the request for comments contained in Notice 2006-109.

On August 2, 2007, the Treasury Department and the IRS issued an ANPRM titled “Payout Requirements for Type III Supporting Organizations that Are Not Functionally Integrated” (Reg-155929-06, 72 FR 148). The ANPRM described proposed rules to implement the PPA changes to the Type III supporting organization requirements, and solicited comments regarding those proposed rules.

In the ANPRM, the Treasury Department and the IRS proposed that all Type III supporting organizations would be required to meet the responsiveness test under Treas. Reg. §1.509(a)-4(i)(2)(ii). In addition, the Treasury Department and the IRS proposed that Type III supporting organizations that are functionally integrated would be required to meet: (A) the “but for” test in existing Treas. Reg. §1.509(a)-4(i)(3)(ii); (B) an expenditure test resembling the section 4942(j)(3)(A) qualifying distributions test for private operating foundations; and (C) an assets test resembling the section 4942(j)(3)(B) alternative assets test for private operating foundations. However, the Treasury Department and the IRS indicated that an exception would be provided for certain Type III supporting organizations that oversee or facilitate the operation of an integrated system, such as certain hospital systems. The ANPRM stated that such organizations would be classified as functionally integrated as long as they satisfied the responsiveness and “but for” tests under the existing regulations.

The ANPRM proposal provided that a non-functionally integrated Type III supporting organization would be required to make an annual payout equal to the annual payout required from a private non-operating foundation (generally, five percent of the fair market value of non-exempt-use assets). The Treasury Department and the IRS also proposed a limitation on the number of supported organizations a non-functionally integrated Type III supporting organization could support.

The IRS received over 40 comments and numerous phone calls in response to the ANPRM. After consideration of all comments received, the Treasury Department and the IRS are issuing this NPRM regarding the new qualification requirements for Type III supporting organizations. The major areas of comment in response to the ANPRM are discussed in the preamble under Explanation of Provisions.

The proposed regulations provide that every Type III supporting organization must: (1) satisfy the notification requirement set forth under Prop. Reg. §1.509(a)-4(i)(2); (2) meet the responsiveness test set forth under Prop. Reg. §1.509(a)-4(i)(3); and (3) demonstrate that it is an integral part of one or more supported organizations. A Type III supporting organization demonstrates that it is an integral part of a supported organization by satisfying either the requirements for functionally integrated Type III supporting organizations set forth in Prop. Reg. §1.509(a)-4(i)(4), or the requirements for non-functionally integrated Type III supporting organizations set forth in Prop. Reg. §1.509(a)-4(i)(5). Further, as set forth in Prop. Reg. §1.509(a)-4(i)(10), a Type III supporting organization may not support a supported organization that is organized outside of the United States. Finally, as set forth in Prop. Reg. §1.509(a)-4(f)(5), Type I and Type III supporting organizations are prohibited from accepting a gift or contribution from a person who, together with certain related persons, directly or indirectly controls the governing body of a supported organization of the Type I or Type III supporting organization.

Prop. Reg. §1.509(a)-4(i)(2) implements section 509(f)(1)(A) of the Code, which provides that a Type III supporting organization must provide to each of its supported organizations such information as the Secretary may require to ensure that the supporting organization is responsive to the needs or demands of the supported organization.

The Treasury Department and the IRS requested comments in the ANPRM on the type of information a Type III supporting organization should be required to provide to its supported organizations. One commentator recommended that the proposed regulations adopt a recommendation of the Panel on the Nonprofit Sector, which suggested requiring Type III supporting organizations to provide annually to their supported organizations: (1) a copy of governing documents, including those filed with Form 1023, “Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code,” and any updates; (2) a copy of Form 990, “Return of Organization Exempt From Income Tax;” and (3) an annual report of activities, including a narrative, financial detail, and a description of the support provided (including how it was calculated or determined) and a projection of support to be provided in the subsequent year. Panel on the Nonprofit Sector, Strengthening Transparency, Governance, Accountability of Charitable Organizations (June 2005), at 45.

Another commentator recommended that the proposed regulations require only that the Form 990 be distributed to the “lead” supported organization. This commentator argued that any additional requirement would impose too much additional administrative burden and cost on the charitable sector. The comment also suggested allowing the notification to be provided electronically.

The proposed regulations require that each taxable year, a Type III supporting organization must provide to each of its supported organizations: (A) a written notice addressed to a principal officer of the supported organization identifying the supporting organization and describing the amount and type of support it provided to the supported organization in the past year; (B) a copy of the supporting organization’s most recently filed Form 990; and (C) a copy of the supporting organization’s governing documents, including any amendments. Copies of governing documents need only be provided once. The proposed regulations provide that the required notice and documents may be delivered by electronic media. Organizations must satisfy the notification requirement to qualify as a Type III supporting organization and should retain proof of delivery in their records.

The proposed regulations provide that all Type III supporting organizations, including those organized as charitable trusts, must meet the responsiveness test under existing Treas. Reg. §1.509(a)-4(i)(2)(ii).

The ANPRM proposed to apply the responsiveness test to all Type III supporting organizations and to remove the special rule for charitable trusts. In response to the ANPRM, commentators argued that the PPA did not require imposition of the general responsiveness test on charitable trusts, and that the test could be difficult to satisfy because of state-law fiduciary requirements on trusts. Thus, a commentator recommended the development of an alternate charitable trust test based on facts and circumstances.

One commentator recommended exempting trusts managed by institutional trustees from the responsiveness test. The commentator stated that institutional trustees employ strict rules to manage trusts, thereby making abuse of these trusts highly unlikely. Another commentator recommended transition relief for trusts in existence on the date the PPA was enacted similar to that provided in Treas. Reg. §1.509(a)-4(i)(4) for trusts established before November 20, 1970, which would apply to a trust with a lengthy and continuous history of distributions, and no discretion to vary the beneficiaries or the amount of distributions.

The proposed regulations require that all Type III supporting organizations demonstrate the necessary relationship between its officers, directors or trustees and those of the supported organization, and show that this relationship results in the officers, directors or trustees of the supported organization having a significant voice in the operations of the supporting organization. The proposed regulations do not adopt a special rule for trusts.

The Treasury Department and the IRS believe that requiring charitable trusts to meet the responsiveness test set forth in these proposed regulations is consistent with Congress’ intent in the PPA. The Treasury Department and the IRS expect that some charitable trusts will be able to demonstrate that they meet the requirements of the responsiveness test. The proposed regulations provide examples that illustrate factors that could lead to a conclusion that a supporting organization organized as a trust is responsive to the needs of a supported organization. Additionally, the Treasury Department and the IRS request comments regarding a specific responsiveness rule for trusts that would be consistent with the existing responsiveness test and the Congressional intent behind section 1241 of the PPA, which removed the alternative trust test in the regulations.

The proposed regulations provide that a Type III supporting organization is functionally integrated if it either: (1) engages in activities substantially all of which directly further the exempt purposes of the supported organization(s) to which it is responsive by performing the functions of, or carrying out the purposes of, such supported organization(s) and that, but for the involvement of the supporting organization, would normally be engaged in by the supported organization(s); or (2) is the parent of each of its supported organizations.

The ANPRM proposed requiring an organization to meet not only the “but for” test under existing Treas. Reg. §1.509(a)-4(i)(3)(ii), but also two additional tests — an expenditure test and an assets test — in order to qualify as a functionally integrated Type III supporting organization. In general, commentators said that the additional tests were unduly restrictive and more burdensome than those proposed for non-functionally integrated Type III supporting organizations. These commentators argued that the ANPRM’s expenditure test was arbitrary and that Congress did not authorize the Secretary to impose a payout requirement on functionally integrated organizations. Many commentators highlighted differences between a Type III supporting organization and a private operating foundation that warrant treating these types of organizations differently, including the fact that a supporting organization is dedicated to specific organizations and that those specified organizations rely on the supporting organization for consistent support.

Many commentators recommended exempting certain types of organizations from the proposed requirements for functionally integrated Type III supporting organizations, such as long-standing supporting organizations and supporting organizations that support governmental agencies, religious organizations, and grant-making organizations. Several commentators recommended that the proposed regulations take into account the historic and continuing relationship of “long-standing” organizations with their supported organizations. Additionally, many commentators requested an exemption for supporting organizations of governmental entities, contending that these organizations are not subject to abuse because of their connection to a governmental entity. These commentators argued that supporting organizations choose a Type III structure to ensure that funds are dedicated long-term to a specific purpose, and removed from the appropriation process of the government.

In formulating the criteria in the proposed regulations, the Treasury Department and the IRS also noted the suggestion in the Joint Committee on Taxation’s Technical Explanation of the PPA that “substantially all of the activities of [a functionally integrated Type III supporting organization] should be activities in direct furtherance of the functions or purposes of supported organizations.” Staff of the Joint Committee on Taxation, Technical Explanation of H.R. 4, The “Pension Protection Act of 2006” (Aug. 3, 2006), at 360 n.571 (Technical Explanation). In the Technical Explanation, the Joint Committee on Taxation also expressed concern that “the current regulatory standards for satisfying the integral part test not by reason of a payout are not sufficiently stringent to ensure that there is a sufficient nexus between the supporting and supported organizations.” Technical Explanation at 360 n.571.

The Treasury Department and the IRS believe that a sufficient nexus exists between a supporting organization and its supported organization(s) where the supporting organization engages in activities that directly further the exempt purposes of the supported organization(s) and that would otherwise be conducted by the supported organization itself. Accordingly, the proposed regulations provide that a Type III supporting organization is functionally integrated if it either: (1) engages in activities (a) substantially all of which directly further the exempt purposes of the supported organization(s) to which it is responsive by performing the functions of, or carrying out the purposes of, such supported organization(s) and (b) that, but for the involvement of the supporting organization, would normally be engaged in by the supported organization(s); or (2) is the parent of each of its supported organizations. The Treasury Department and the IRS request comments on how guidance might clarify the application of the “substantially all” test in this context. The proposed regulations do not adopt the expenditure test and the assets test described in the ANPRM.

The proposed regulations provide that a supporting organization directly furthers the exempt purposes of its supported organization by holding or managing exempt-use assets but does not directly further such exempt purposes by fundraising, grantmaking, or investing and managing non-exempt-use assets. The Treasury Department and the IRS believe that fundraising, grantmaking, and investing and managing non-exempt-use assets do not alone establish a sufficient nexus between a supporting organization and its supported organization. Further, the Treasury Department and the IRS believe that an organization that does not engage in activities that directly further a exempt purpose will achieve a sufficient nexus with its supported organization(s) only if it distributes a significant amount to its supported organizations, as Congress directed in the PPA.

The Treasury Department and the IRS recognize the unique circumstances of a governmental entity whose assets are subject to the appropriations process of a federal, state, local or Indian tribal government and that therefore organizes a Type III supporting organization to remove assets from the appropriations process of the government. The proposed regulations therefore provide an exception under which a supporting organization that supports a single governmental entity may treat investing and managing non-exempt-use assets as activities that directly further an exempt purpose, so long as a substantial part of the supporting organization’s total activities directly furthers the exempt purposes of such governmental entity.

The proposed regulations specifically require that a functionally integrated Type III supporting organization’s activities directly further the exempt purposes of those supported organizations with respect to which the supporting organization meets the responsiveness test under Prop. Reg. §1.509(a)-4(i)(3). The Treasury Department and the IRS request comments on this requirement.

The proposed regulations provide that a supporting organization will be treated as the parent of a supported organization if the supporting organization exercises a substantial degree of direction over the policies, programs, and activities of the supported organization, and the majority of the officers, directors, or trustees of the supported organization is appointed or elected, directly or indirectly, by the governing body, members of the governing body, or officers of the supporting organization acting in their official capacity. Thus, the supporting organization could qualify as a parent of a second-tier (or lower) subsidiary. The classification of a parent supporting organization as functionally integrated is intended to apply to supporting organizations that oversee or facilitate the operation of an integrated system, such as hospital systems.

The proposed regulations provide examples that illustrate the requirements for functionally integrated Type III supporting organizations.

The proposed regulations provide that a Type III supporting organization is non-functionally integrated if it satisfies a distribution requirement equal to five percent of the fair market value of non-exempt-use assets and an attentiveness requirement.

Section 1241(d)(1) of the PPA directed the Secretary of the Treasury to promulgate new regulations on a payout requirement for non-functionally integrated Type III supporting organizations, based on income or assets, in order to ensure that these supporting organizations pay a significant amount to their supported organizations. The ANPRM proposal required an annual payout of five percent of the fair market value of non-exempt-use assets. Many commentators said that this payout rate was too high and would erode an organization’s assets over time. The commentators said that a Type III supporting organization provides long-term consistent support to specific organizations, while private foundations may pay out to whomever they choose. Further, a supporting organization maintains a governance relationship with its supported organization(s) in a way that a private foundation does not. Commentators argued that because of these differences, the private foundation payout requirement should not be imposed on a supporting organization. Imposing a five percent payout, these commentators contend, would jeopardize the ability of supporting organizations to provide the kind of consistent, reliable, long-term support supported organizations have come to expect.

Commentators suggested a number of alternative payout rates. Many of them also recommended allowing an averaging of assets over a period of years for purposes of calculating the payout amount.

The ANPRM proposed to limit the number of organizations a non-functionally integrated Type III supporting organization can support to no more than five. The ANPRM further provided that Type III supporting organizations in existence before the date regulations are proposed may support more than five organizations, as long as the supporting organization pays 85 percent of its support to organizations to which the supporting organization is responsive.

Many commentators asked that the proposed regulations not include the limitation on the number of supported organizations a non-functionally integrated Type III supporting organization can support, arguing that such a rule is arbitrary. In particular, commentators pointed out that the original Senate bill associated with supporting organizations, contained in the Tax Increase Prevention and Reconciliation Act of 2005, Public Law 109-222 (120 Stat. 345 (2005)), limited the number of organizations a supporting organization could support to five, but that Congress ultimately did not enact such a limitation.

One commentator suggested that the proposed regulations adopt a rule that one-third of a non-functionally integrated Type III supporting organization’s required distribution must go to a supported organization that is attentive to the supporting organization and to which the supporting organization is responsive.

Commentators recommended providing a transition period for the payout requirement to allow organizations sufficient time either to modify governing instruments or to sell assets.

A number of commentators suggested that the proposed regulations exempt Type III supporting organizations that (1) have no continuing involvement of donors or their family in the governance of the organization; and (2) before the date of enactment of PPA, had distributed to or for the benefit of its supported organizations an amount equal to or greater than the amounts transferred to the organization for which charitable deductions were allowed.

Under the proposed regulations, to qualify as a non-functionally integrated Type III supporting organization, an organization must meet a distribution requirement and an attentiveness requirement. The proposed regulations set the distribution requirement for non-functionally integrated Type III supporting organizations at five percent of non-exempt-use assets, and retain the concept of attentiveness that is in the current regulations. The proposed regulations do not adopt the five organization limit described in the ANPRM.

To satisfy the distribution requirement of Prop. Reg. §1.509(a)-4(i)(5)(ii), a Type III supporting organization that is not functionally integrated must distribute, with respect to each taxable year, to or for the use of its supported organizations, amounts equaling or exceeding five percent of the aggregate fair market value of its non-exempt-use assets (the annual distributable amount), on or before the last day of such taxable year. The annual distributable amount is determined based on asset values measured over the preceding taxable year. Thus, for example, a Type III supporting organization that is not functionally integrated would determine its annual distributable amount for its 2012 taxable year, which must be distributed on or before the last day of the organization’s 2012 taxable year, based on asset values measured over its 2011 taxable year. A Type III supporting organization that is not functionally integrated is not required to distribute any amount in its first year of existence.

The proposed regulations generally draw from the regulations under section 4942 for principles on valuation, timing, and carryovers. However, the proposed regulations do not permit set-asides, which count towards a private foundation’s distribution requirement under section 4942(g)(2). While Congress statutorily provided that set-asides constitute qualifying distributions for private foundations, Congress made no such statutory provision for supporting organizations. Rather, in the PPA, it directed that a payout requirement be implemented for non-functionally integrated Type III supporting organizations that would result in a prompt, robust flow of support to supported organizations. The Treasury Department and the IRS request comments on whether set-asides are necessary and consistent with Congressional intent in determining whether Type III supporting organizations that are not functionally integrated have distributed their annual distributable amount.

The proposed regulations also provide a slightly different rule regarding the carryover of excess distributions than is applicable to private foundations. Under section 4942(i), a private foundation that distributes more than its distributable amount may carry forward that excess amount for five years. However, when calculating qualifying distributions in a future year under section 4942, amounts paid out in the future year count first towards the required distributable amount, and any amount carried forward is not “used” in the future year to the extent that the organization made qualifying distributions in that future year. These proposed regulations reverse the ordering rule and first count any excess amount carried forward toward the non-functionally integrated Type III supporting organization’s annual distributable amount, followed by amounts paid out in the later year.

The proposed regulations provide a reasonable cause exception for failure to meet the distribution requirement applicable to non-functionally integrated Type III supporting organizations. Under the exception, an organization that fails to meet the distribution requirement will not be classified as a private foundation in the taxable year for which it fails to meet such distribution requirement, if the organization establishes to the satisfaction of the Secretary that: (1) the failure was due solely to an incorrect valuation of assets, a ministerial error, or unforeseen events or circumstances that are beyond the organization’s control; (2) the failure was due to reasonable cause and not to willful neglect; and (3) the distribution requirement is met within 180 days after the date the incorrect valuation or ministerial error was or should have been discovered, or 180 days after the organization is first able to make its required payout notwithstanding the unforeseen event or circumstances. The reasonable cause exception applies only to the distribution requirement of Prop. Reg. §1.509(a)-4(i)(5)(ii), and not to the attentiveness requirement of Prop. Reg. §1.509(a)-4(i)(5)(iii). The Treasury Department and the IRS request comments regarding the reasonable cause exception for the distribution requirement.

The proposed regulations also provide for an emergency temporary reduction in the annual distributable amount. Under Prop. Reg. §1.509(a)-4(i)(5)(ii)(D), the Secretary may provide by publication in the Internal Revenue Bulletin for a temporary reduction in the annual distributable amount in the case of a disaster or emergency.

The Treasury Department and the IRS are aware that some supporting organizations impacted by the distribution requirement contained in these proposed regulations may be heavily invested in assets that are not readily marketable. The Treasury Department and the IRS request comments regarding the need for a transition rule for non-functionally integrated Type III supporting organizations whose assets, as of the effective date of these regulations, consist predominantly (in any event more than one-half) of assets that are not readily marketable.

These proposed regulations modify the attentiveness requirement in existing Treas. Reg. §1.509(a)-4(i)(3)(iii) to provide that an organization must distribute one-third or more of its annual distributable amount to one or more supported organizations that are attentive to the supporting organization and with respect to which the supporting organization meets the responsiveness test under Prop. Reg. §1.509(a)-4(i)(3).

The proposed regulations provide that to demonstrate that a supported organization is attentive, a supporting organization must either: (1) provide 10 percent or more of the supported organization’s total support; (2) provide support that is necessary to avoid the interruption of the carrying on of a particular function or activity of the supported organization; or (3) provide an amount of support that based on all the facts and circumstances is a sufficient part of a supported organization’s total support.

A Type III supporting organization that fails to meet the requirements of these proposed regulations, once they are published as final or temporary regulations, will be classified as a private foundation. Once classified as a private foundation, the section 507 rules regarding termination of private foundation status apply. The Treasury Department and the IRS request comments on whether exceptions or special rules under section 507 are needed for Type III supporting organizations that are reclassified as private foundations as a result of the changes in the PPA.

The proposed regulations continue to provide that additional facts and circumstances, such as a historic and continuing relationship with a supported organization, may be taken into account in establishing compliance with the responsiveness test for organizations that were operating prior to November 20, 1970.

The proposed regulations provide a transition rule for Type III supporting organizations in existence on the date these regulations are published in the Federal Register as final or temporary regulations. Under the transition rule, such organizations that met and continue to meet the requirements of existing Treas. Reg. §1.509(a)-4(i)(3)(ii) (i.e., an organization that meets the integral part test by satisfying the “but for” test) will be treated as meeting the requirements of a functionally integrated Type III supporting organization set forth in Prop. Reg. §1.509(a)-4(i)(4) until the first day of the organization’s first taxable year beginning after the date these proposed regulations are published as final or temporary regulations.

The proposed regulations also provide that Type III supporting organizations in existence on the date these regulations are published in the Federal Register as final or temporary regulations that met and continue to meet the requirements of existing Treas. Reg. §1.509(a)-4(i)(3)(iii) will be treated as meeting the requirements of a non-functionally integrated Type III supporting organization set forth in Prop. Reg. §1.509(a)-4(i)(5) until the first day of the organization’s second taxable year beginning after the date these proposed regulations are published as final or temporary regulations. Such organizations will be required to value their assets in accordance with Prop. Reg. §1.509(a)-4(i)(8) in the first taxable year beginning after final or temporary regulations are published, and to meet all of the requirements of Prop. Reg. §1.509(a)-4(i)(5)(i) in the second taxable year beginning after the publication of these regulations as final or temporary regulations and for all succeeding taxable years.

For example, if the Treasury Department and the IRS publish these regulations as final or temporary regulations any time in 2010, a calendar-year non-functionally integrated Type III supporting organization must: (1) in 2010, meet all of the requirements of existing Treas. Reg. §1.509(a)-4(i)(3)(iii) (i.e., distribute to its supported organizations substantially all of its income in accord with the existing regulations); (2) in 2011, meet all of the requirements of current Treas. Reg. §1.509(a)-4(i)(3)(iii) and value its assets according to Prop. Reg. §1.509(a)-4(i)(8); and (3) in 2012, meet all of the requirements of Prop. Reg. §1.509(a)-4(i)(5)(i), including the distribution requirement.

The proposed regulations also retain the exception from the integral part test for pre-November 20, 1970 trusts that meet certain other requirements found in current Treas. Reg. §1.509(a)-4(i)(4).

The Treasury Department and the IRS request comments on whether additional transition relief is needed.

The proposed regulations eliminate current Treas. Reg. §1.509(a)-4(i)(1)(iii), which provides an exception from the integral part test if an organization can establish that: (1) it met the payout requirement under current Treas. Reg. §1.509(a)-4(i)(3)(iii)(a) for any five-year period; (2) it cannot meet such payout requirement for its current taxable year solely because the amount received by one or more of the supported organizations is no longer sufficient to satisfy the attentiveness requirement; and (3) there has been a historic and continuing relationship of support between such organizations between the end of the five-year period and the taxable year in question. The Treasury Department and the IRS believe that the breadth of this exception is inconsistent with Congress’ intent in mandating a payout requirement in the PPA.

This NPRM also includes proposed regulations under section 4943 that provide two transition rules to address excess business holdings for Type III supporting organizations affected by the PPA. The PPA applied the section 4943 excess business holdings excise tax to non-functionally integrated Type III supporting organizations. However, it provided that in calculating the “present holdings” of Type III supporting organizations in existence on August 17, 2006 (the date of enactment of the PPA), the transition rules that applied to private foundations in 1969, when section 4943 was first enacted, would apply. These transition rules effectively allow affected organizations additional time to dispose of certain business holdings.

The proposed regulations provide transition relief to a private foundation that qualified as a Type III supporting organization under section 509(a)(3) immediately before August 17, 2006, and that was reclassified as a private foundation under section 509(a) on or after August 17, 2006, solely as a result of the rules enacted by Section 1241 of the PPA. Thus, under the proposed regulations, the present holdings of such private foundations will be determined using the same rules that apply to Type III supporting organizations under section 4943(f)(7).

In addition, the Treasury Department and the IRS believe that pre-November 20, 1970 trusts that are exempted from the integral part test under current regulations and these proposed regulations should not be subject to the excess business holdings excise tax that applies to non-functionally integrated Type III supporting organizations. Therefore, the proposed regulations under section 4943 provide that a Type III supporting organization created as a trust before November 20, 1970, that meets the requirements of current Treas. Reg. §1.509(a)-4(i)(4) and Prop. Reg. §1.509(a)-4(i)(9), will be treated as a “functionally integrated Type III supporting organization” for purposes of section 4943(f)(3)(A).

In Notice 2006-109, the Treasury Department and the IRS provided guidance to private foundations regarding determinations of the public charity status of a section 501(c)(3) organization when making grants. In particular, because a grant to a non-functionally integrated Type III supporting organization is not considered a qualifying distribution under section 4942, and is considered a taxable expenditure unless expenditure responsibility is exercised under section 4945, the notice provided criteria for determining whether a Type III supporting organization is functionally integrated and allowed private foundations to rely on those criteria for purposes of sections 4942 and 4945. Commentators to the ANPRM requested that the Treasury Department and the IRS permit private foundations to continue to rely on the guidance in Notice 2006-109 on private foundation grantmaking until the IRS issues determination letters addressing functionally integrated status.

Private foundations can continue to rely on the grantor reliance standards of section 3.0 of Notice 2006-109 until these proposed regulations are published as final or temporary regulations.

In addition, the IRS stated in a September 24, 2007 memorandum from the Director of Exempt Organizations Rulings and Agreements that it would issue functionally integrated Type III supporting organization determinations to organizations that meet the requirements for functionally integrated organizations set forth in the ANPRM. As of the date of the publication in the Federal Register of this notice of proposed rulemaking, the IRS will issue a functionally integrated Type III supporting organization determination only to organizations that meet the requirements of Prop. Reg. §1.509(a)-4(i)(4). An organization that received a determination that it qualified as a functionally integrated Type III supporting organization under the ANPRM can continue to rely on such determination letter until final or temporary regulations are published in the Federal Register, so long as the organization continues to meet the requirements of either the ANPRM or Prop. Reg. §1.509(a)-4(i)(4). An organization that receives a determination that it is a functionally integrated Type III supporting organization under either the ANPRM or these proposed regulations will be required to meet the requirements established in final or temporary regulations as of the first taxable year beginning after final or temporary regulations are published in the Federal Register.

The proposed regulations will apply to taxable years beginning after the date these rules are published in the Federal Register as final or temporary regulations.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It is hereby certified that this regulation will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that this regulation will not impact a substantial number of small entities. Based on IRS Statistics of Income data for 2005, there are over 1.4 million organizations that qualify as exempt from federal income tax under section 501(c)(3). Approximately 13,000 of the 1.4 million exempt organizations reported as supporting organizations; approximately 4,200 supporting organizations reported as Type III supporting organizations; and it is expected that some fraction of the 4,200 Type III supporting organizations may be classified as non-functionally integrated Type III supporting organizations. Thus, the number of organizations affected by this regulation will not be substantial. The collection of information in this regulation that is subject to the Regulatory Flexibility Act will impose a minimal burden upon the affected organizations. All of the information required to be delivered is information that the organization is already required to maintain. Further, the distribution requirement in Prop. Reg. §1.509(a)-4(i)(5)(ii) for non-functionally integrated Type III supporting organizations does not have a significant economic impact. A non-functionally integrated Type III supporting organization that fails to satisfy the distribution requirement of Prop. Reg. §1.509(a)-4(i)(5)(ii) would be reclassified as a private non-operating foundation and as such, would be required under section 4942 to distribute amounts equal to five percent of the aggregate fair market value of non-exempt-use assets. In addition, as a private non-operating foundation, the organization would be subject to additional regulatory requirements and excise taxes that do not apply to non-functionally integrated Type III supporting organizations. Accordingly, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Before these proposed regulations are adopted as final or temporary regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The Treasury Department and the IRS request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register.

Par. 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.509(a)-4 is amended by:

1. The term “publicly supported organization” is removed and replaced by the term “supported organization” wherever it appears.

2. Paragraphs (a)(5) and (i) are revised.

3. New paragraphs (a)(6) and (f)(5) are added.

The revisions and additions read as follows:

Par. 3. The authority citation for part 53 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 4. In §53.4943-11, section heading is revised and paragraphs (f) and (g) are added to read as follows:

Section 1563(a) defines four types of controlled groups of corporations. This definition is relevant for purposes of allocating certain tax benefits under section 1561, as well as other provisions of the Internal Revenue Code that incorporate the concept of a controlled group of corporations. In order for a corporation to be included in one of these controlled groups under section 1563(a), it must satisfy the stock ownership test for that type of group. In addition, other rules in section 1563 may also apply in order to determine whether a corporation satisfies the applicable stock ownership test. For example, section 1563(c) excludes certain stock of a corporation (for example, nonvoting stock that is limited and preferred as to dividends) from the definition of stock, section 1563(d) determines when to take into account the stock owned by a corporation, and section 1563(e) determines when stock of a corporation is constructively owned.

Section 1563(b) describes which corporations are “component members” of a section 1563(a) controlled group of corporations for purposes of section 1561 and section 1563, in part by excluding certain corporations under section 1563(b)(2). For example, certain special purpose corporations, such as tax-exempt corporations, are treated as excluded members and not as component members. See sections 1563(b)(2)(B) through 1563(b)(2)(E). Notwithstanding that a corporation is not a “component member,” however, the IRS has consistently taken the position that the determination of whether a corporation is included in a controlled group under section 1563(a) is determined without applying section 1563(b).

The Treasury Department and the IRS propose to amend §1.1563-1 to clarify that an excluded member of a controlled group, such as a corporation described in sections 1563(b)(2)(B) through 1563(b)(2)(E), is nevertheless a member of the group. Specifically, the proposal will add paragraph (a)(1)(ii) to §1.1563-1 and an Example to §1.1563-1(b)(4).

Section 1563 was originally promulgated to limit the use of the tax benefit items described in section 1561 by the component members of a controlled group as defined in section 1563. S. Rep. No. 88-830 at 150 (1964), 1964-1 (Part 2) CB 502, 654. However, since then, certain other statutory and regulatory provisions have referenced the controlled group rules of section 1563 for other purposes. Some of these provisions adjust the definition of a controlled group to state that certain provisions of section 1563 do not apply.

For example, section 41(f)(1)(A)(i) provides that, in determining the amount of the credit for increasing research activities under section 41, all members of the same controlled group shall be treated as a single taxpayer. Section 41(f)(5)(B) provides that the term “controlled group of corporations” has the same meaning given to such term by section 1563(a), except that the determination shall be made without regard to subsections (a)(4) and (e)(3)(C) of section 1563. The effect of not applying section 1563(a)(4) is to treat two or more life insurance companies, which would otherwise be treated as members of a separate life insurance controlled group, each as a member of a controlled group described in section 1563(a)(1)-(3) (Section 1563(e)(3)(B) deals with an application of the constructive ownership rules; however, because that application is not relevant to the issue being addressed in this preamble, it will not be further discussed.). However, section 41(f)(5) and similar provisions make no reference to subsection (b) of section 1563. Section 1563(b), among other things, defines which corporations are “component members” and “excluded members” for purposes of section 1561 and section 1563. Nevertheless, some taxpayers have argued that a corporation that is an “excluded member” within the meaning of section 1563(b)(2) cannot, as a consequence, be a “member” of a section 1563(a) controlled group generally. This line of argument tends to equate a corporation’s membership generally with such corporation’s status as a component member.

The Treasury Department and the IRS disagree with such arguments and believe that an excluded member under section 1563(b)(2), while not a component member of a controlled group under section 1563(b)(1), is nevertheless a member of a controlled group under section 1563(a). See also §1.414(b)-1(a).

This position is supported by the clear language of the statute. Section 1563(b)(2) provides, in the introductory text, that a “corporation which is a member of a controlled group of corporations . . . shall be treated as an excluded member of such group . . .”. Moreover, this position is also supported by the legislative history for sections 1561 and 1563, which states that “the determination of the corporations included within a parent-subsidiary controlled group, or a brother-sister controlled group, is made without regard to the type of corporation involved.” S. Rep. No. 88-830 at 152 (1964), 1964-1 (Part 2) CB 505, 656; see also H.R. Rep. 88-749 at A201-202 (1963), 1964-1 (Part 2) CB 248, 449-450 (providing examples where an “excluded member” is treated as a member of a controlled group of corporations). Compare section 1504(a)(1)(A) (affiliated group comprised of includible corporations only). Therefore, this proposed regulation clarifies that a corporation identified in section 1563(b)(2) as an excluded member of a controlled group is nevertheless a member of such group for purposes of section 1563(a). Accordingly, a corporation whose stock is held by such an excluded member may be treated as a component member of the controlled group of corporations.

Finally, this proposed regulation further illustrates that an excluded member of a controlled group is treated as a member of such group by adding an example demonstrating that a controlled group can consist solely of excluded members.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation and because this regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Before this proposed regulation is adopted as a final regulation, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and the Treasury Department request comments on the clarity of the proposed regulation and how it can be made easier to understand. All comments will be available for public inspection and copying. A public hearing may be scheduled if requested in writing by any person that timely submits written or electronic comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register.

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.1563-1 is amended by:

1. Redesignating paragraph (a)(1)(ii) as paragraph (a)(1)(iii) and adding paragraph (a)(1)(ii).

2. Adding Example 4 to paragraph (b)(4).

3. Adding a sentence at the end of paragraph (e).

The additions to read as follows: