Recent Tax Law Changes Affect Charities, Donors and IRA Accounts
October 23, 2006
Richard Sills - Washington
Recent changes in the tax law, including those made by the Pension Protection Act of 2006, may affect your planning. Some of these planning opportunities are available only if certain conditions are met, and some are in effect only for a limited period of time. Additionally, the Pension Protection Act contains many provisions directly impacting charitable organizations. This article will provide a brief overview of some of the most significant changes introduced by this legislation but for more information, or to discuss how these changes may affect your particular situation or the situation of a particular charitable organization with which you are involved, contact your attorney.
Qualified retirement plan accounts may be “rolled over” income tax-free at death to inherited IRAs by non-spousal beneficiaries. Under prior law, only a surviving spouse qualified for a tax-free rollover to an inherited IRA account. For distributions made after 2006, this tax advantage will be available to any other beneficiary of a qualified retirement plan who inherits benefits upon the participant’s death, such as a child, or a trust for a child’s benefit.
An IRA owner may make “qualified charitable deductions” directly from his or her IRA account without causing the distributions to be included in income. This change applies only to IRA owners at least 70-1/2 years old, and permits transfers up to $100,000 per year in 2006 and 2007. Amounts transferred from the IRA to charity will count in satisfying the minimum required distribution for that year. Under prior law, if an IRA owner wanted to contribute IRA distributions to charity, he or she would have to include the distributed amount in income, and then would be entitled to a charitable contribution deduction for the gift to charity. But, due to various limitations on the use of itemized deductions, there was no assurance that the charitable deduction would offset the income. Increasing adjusted gross income by withdrawing funds from an IRA may: (1) cause social security benefits to become taxable, if the increased income causes certain thresholds to be reached; (2) reduce the deductibility of medical expenses and miscellaneous itemized deductions; and (3) accelerate the loss of itemized deductions for higher-income taxpayers. The new provision can help avoid those adverse effects, in addition to benefiting donors who use the standard deduction and those who live in states that restrict or prohibit state income tax deductions for charitable contributions. “Qualified charitable deductions” include distributions to most public charities and private operating foundations, but do not include distributions to a supporting organization, a private non-operating foundation, or a donor-advised fund.
Starting in 2006, the net unearned income of a child under 18 will generally be taxed at the parents’ highest marginal tax rate. Previously, this rule applied only to children under age 14. This change reduces the effectiveness, for income tax purposes, of intra-family transfers of income-producing property from high-bracket parents to their minor children. In 2006, the first $1,700 of a minor’s income is generally exempt from this rule.
Exempt organizations (other than private foundations) must file an annual notice containing basic financial information with the IRS even if gross receipts are less than $25,000. Previously, some organizations with gross receipts under $25,000 were generally exempt from annual reporting requirements. Failure to file an annual return or notice three consecutive years may result in revocation of the organization’s tax-exempt status.
Tax benefits arising from a gift of a partial interest in tangible personal property (such as a gift of artwork to a museum) are now subject to new time limits. Charities receiving a fractional interest in an item of tangible personal property must take complete ownership of the item within 10 years or upon the death of the donor, whichever is first. Also, the charity must have (i) taken “substantial” physical possession of the item at some point during the 10-year period as long as the donor remains alive; and (ii) used the item for the organization’s exempt purpose. If these requirements are not met, all tax benefits are recaptured, plus interest and a 10 percent penalty.
Liberalized charitable deduction rules apply to the following: (1) businesses that donate food inventory to a charity; (2) corporations that contribute book inventory to public schools; and (3) qualified conservation contributions of land. For the first two items, the change consists of extending through 2007 a tax benefit that was to have expired. For certain qualified conservation contributions, deductions are allowed up to 50 percent of the donor’s contribution base (rather than 30 percent) and carryovers are allowed for up to 15 years.
If a taxpayer deducts the fair market value of contributed property based on the representation that the donee will use it for exempt purposes, that tax benefit will be subject to recovery if the donee sells it within three years of the contribution and fails to certify the “exempt purpose” use.
New limits imposed on charitable contribution deductions for contributions of clothing and household items. A charitable deduction will be denied if the clothing and household items are not in good used condition or better. The Secretary of the Treasury may by regulation deny a deduction for any item with “minimal monetary value.” These new rules do not apply to contributions of a single item for which a deduction of greater than $500 is claimed, provided the taxpayer files a qualified appraisal of the item.
For private foundations, the definition of “net investment income” subject to excise tax has been expanded to include income from “sources similar” to those enumerated in the Tax Code (as opposed to only those items enumerated in Section 4940 of the Code), and will now include capital gains, annuities and other similar investment income. However, pending the adoption of implementing regulations from the IRS, private foundations may be able to exclude from the calculation of “net investment income” capital gains and losses with respect to like-kind exchanges of property used for exempt purposes for at least one year.
Penalties increase for various charity-related misdeeds. The amount of penalty excise taxes applicable to certain activities by public charities, social welfare organizations, private foundations and exempt organization managers, including, among other things, self-dealing, a failure to distribute income, investments that jeopardize charitable purposes and knowingly engaging in “excess benefit transactions” will double. Also, it lowers the thresholds for imposing accuracy-related penalties on a taxpayer who claims a deduction for donated property for which a qualified appraisal is required. In essence, penalties will be imposed for a lesser deviation between the appraised value and the “correct” value (as finally determined) than would have been true under prior law. Appraisers will also be subject to civil penalties if their appraisals result in a substantial or “gross” valuation misstatement.
Grants made by non-operating private foundations to certain types of supporting organizations (including Type III supporting organizations that are not “functionally integrated” and Types I and II supporting organizations where a disqualified person with respect to the grantor private foundation directly or indirectly controls either the supporting organization or a supported organization of the supporting organization) no longer constitute qualifying distributions for purposes of the annual payout requirement. Additionally, all private foundations must exercise “expenditure responsibility” (fulfill certain prescribed oversight requirements) with respect to grants made to these types of supporting organizations in order to avoid taxable expenditure treatment of such payments. These rules are effective for all distributions and expenditures made by private foundations after August 17, 2006.
Donors must now maintain records even for small charitable contributions. When money is given to charity, regardless of the amount, the donor must maintain a cancelled check, bank record, or receipt from the donee organization showing the name of the donee organization, the date of contribution and the amount of the contribution. Previously, only monetary contributions of $250 or more needed to be substantiated in this manner.
The IRS is focusing on donor-advised funds, sponsoring organizations (such as community foundations) and supporting organizations. The IRS will undertake a one-year study of donor-advised funds and of supporting organizations, to determine whether they are operating in a manner consistent with the purposes or functions constituting the basis for their tax-exempt status. Distributions from donor-advised funds to any individual, or to any entity if the payment is not for a charitable purpose will be deemed taxable distributions. Penalties will apply if the donor, donor advisor or related parties of the donor or donor advisor receive more than incidental benefits from a donor-advised grant. Also, an “excess benefits” tax will apply to a grant, loan, compensation or similar payment from a donor-advised fund to a donor, donor advisor or their related parties (as defined), or from a supporting organization to a substantial contributor or a related person of the substantial contributor. New excess business holdings rules apply to donor-advised funds and certain types of supporting organizations, including Type IIIs that are not “functionally integrated” with the supported charity. Both Form 1023 and Form 990 will require more disclosure by sponsoring organizations with regard to their donor-advised funds.
Charities must report to IRS acquisitions of interests in certain insurance contracts for a two-year period. During that period, IRS will study the issue to determine whether acquisition of insurance contracts is consistent with the charities’ tax-exempt purposes.
For more information, e-mail Richard P. Sills or Allison N. Abbott at
richard.sills@hklaw.com or
allison.abbott@hklaw.com, respectively, or call toll free, 1-888-688-8500.
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