On August 3, 2006, Congress passed the Pension Protection Act of 2006. Title XII of the PPA contains 24 provisions affecting tax-exempt organizations. Some of these provisions are broadly significant; others affect only a narrow group of organizations. This memo describes some of those significant changes.
The biggest news is that the changes could have been far worse. For more than two years, Congress has considered many sweeping changes in the laws governing exempt organizations. Most of those provisions did not appear in the PPA, and thus appear to be dead for the remainder of 2006.
Section 1201 - Tax-free distributions from IRAs for Charitable Contributions
Under current law, taxpayers are encouraged to save for retirement by placing their funds in Individual Retirement Accounts where the money grows un-taxed until it is withdrawn in retirement. When the funds are finally withdrawn, they are taxable income, but presumably the tax rates are lower than during prime earning years. This amendment permits tax-free withdrawals of up to $100,000 per taxpayer, per year, from IRA funds if the funds are used for charitable contributions.
Expect marketing campaigns from major financial institutions touting these withdrawals as tax-free ways to make charitable contributions. Remember, however, that IRA funds are intended as a reserve for retirement and for emergencies, so, as with all charitable contributions, only those funds which are truly not needed for current or future expenses should be contributed to charity.
Section 1202 - The Stale Potato Chip Enhanced Tax Deduction
Ordinarily, a business can deduct only its basis (usually cost) or fair market value if it contributes excess inventory to charity. Under the Hurricane Katrina relief legislation, however, any business could get a double deduction for food donated to charity. This provision extends for another two years the deduction of up to double the basis of the donation. There is no limit on where the food can go, the donor does not have to be in the food business, and the food can be outdated or unsaleable so long as the government deems it "apparently wholesome food," as defined under the Hurricane Katrina Emergency Tax Relief Act of 2005.
Section 1203 - Favorable Rule for Stockholders in S Corp Making Charitable Contribution
Under current law, when S Corporations (generally closely-held corporations with few shareholders) make charitable contributions, their stockholders deduct their pro rata share of the Fair Market Value of the donated property. They must then reduce their cost basis in the S Corp stock by that same amount; basis reduction means bigger gains when the stock is sold, and the greater the reduction, the larger the gains in later years. Under this provision, for the next two years, an S Corp stockholder must reduce his or her stock basis by only the shareholder's pro rata share of the Adjusted Basis of property given to charity. This is normally a smaller figure than the Fair Market Value of that contributed property and the smaller basis reduction means smaller future gains (and tax) when they sell their stock .
Section 1204 - Extending Enhanced Deduction for Charitable Contributions of Books to Schools
Another Katrina relief extension, this time for contributions of books to schools by corporations. Key restriction: the charity must certify that the books fit its program and will be used in those programs.
Section 1205 - Limiting Taxes on Payments from Controlled Subsidiaries of Exempt Organizations
Many organizations put their revenue-generating activities into for-profit subsidiaries owned or controlled by the parent exempt-organization. Under current law, rent, royalties, and other income paid from the subsidiary to the parent is generally taxable unrelated business income. Under this provision, for the next two years, only "excess" income paid from the subsidiary will be taxable UBI; other income will not be taxed. This is a significant change for organizations with revenue-generating activities. There is a critical limitation in the provision: such payments must be pursuant to a contract which is negotiated at "arms-length." You may want to seek professional assistance to take advantage of the enormous opportunities presented in this provision.
Section 1206 - Encouraging Farmers and Ranchers to Donate Real Property
Contributing real property or even the use of the property can provide substantial charitable deductions. This provision, limited to farmers and ranchers (including non-public corporations engaged in those activities), provides enhanced deductibility and carry-forwards for contributions of real property which can be used for farming or ranching. The property may be used for other charitable purposes (including recreation and public education) so long as it also remains available for ranching or farming.
Section 1207 - Exempting Red Cross From Excise Taxes
The tax code has a host of excise taxes on things such as motor fuels. This provision exempts principally the Red Cross (but potentially other blood-collecting organizations as well) from a variety of excise taxes on motor fuel and other activities related to blood collections.
Section 1211 - Reporting on and Study of Insurance Interests Held by Exempt Organizations
Some taxpayers take charitable deductions for the cost of life insurance policies which provide some benefits to a charity. This provision requires the Treasury Secretary to issue a report in two years concerning whether the acquisition of interests in insurance policies are consistent with charities' tax-exempt purposes. Charities must report certain acquisitions of interests in some insurance policies.
Section 1212 - Doubling Penalties for Intermediate Sanctions and Private Foundation Violations
Private foundations and, since 1995, 501(c)(3) and (c)(4) organizations, are subject to strict conflict-of-interest rules on investments and transactions with "disqualified persons" and other insiders. This provision doubles the penalty taxes which can be imposed for violations of intermediate sanctions under Section 4958 (applicable to charities and social welfare organizations) and for private foundation penalty provisions (such as self-dealing or jeopardizing investments). For example, the tax on private foundation managers for acts of self-dealing rises from $10,000 to $20,000.
Section 1213 - Limiting Deductions for Historic Building Easements
Under current law, charitable contributions were allowed for preserving historic buildings and property, but there were abuses by those who would contribute only easements on a portion of the building. This provision limits those deductions to certain buildings, and requires that the easement prohibit changing the historical character of the exterior. If a rehabilitation tax credit has been taken on the building, the charitable deduction is commensurately reduced.
Section 1214 - Limiting Charitable Contributions of Stuffed Animals
Under current law, donors were deducting the cost of safaris and hunting expeditions if they contributed the taxidermy property to a charity. In addition, some appraisers were setting unreasonably high values on mounted trophies which were simply warehoused in obscure locations. This provision limits the deduction to the lower of (1) the cost of preparing, stuffing and mounting an animal or (2) the fair market value.
Section 1215 - Recapturing the Tax Benefit for Exempt Use Property Donations Not Actually Used for the Exempt Use
Under current law, donors may get a tax deduction for contributing property which a tax-exempt organization uses in its charitable activities, but must have an appraisal and file certain forms (Form 8283) for property worth more than $5,000. Under this provision, if a donee organization disposes of the donated property within three years of its contribution, the donor's deduction may be reduced. No reduction is required if the donee organization certifies that the property was, in fact, used for the exempt purpose. This provision will make an already complicated process for contributions of valuable property even more complex. You will likely want to involve professional assistance for any gift of valuable property.
Section 1216 - Limiting Deductions for Contributions of Clothing or Household Items
Taxpayers claimed $9 billion a year in deductions for contributions of used clothing and household items. Consumer software programs tied to databases run by E-Bay and other on-line auction services made such deductions not only easier but much more valuable to the consumer. As a reaction, this provision limits charitable deductions for clothing and household items to those in good or better condition, and to those with a more than minimal value (in other words, not including used underwear). The value of larger used items can still be deducted if an appraisal is offered justifying the fair market value.
Section 1217 - Requiring Documentation of Deductions
Generally, a person claiming a charitable deduction must keep reliable and accurate records substantiating the gift and the value claimed. Substantiation rules for gifts of property are both more detailed and more often followed than those for gifts of money; usually donors don't keep separate receipts or records for money donations, even though current law generally requires them. This provision clarifies that money donations must also be amply documented through checks or receipts. Expect to see more checks in the collection plate.
Section 1218 - Recapture of Tax Benefits for Gifts of Partial Interests in Property Which Isn't Used by the Charity
Rules governing deductions for gifts of partial interests in property are complex, and donors sometimes attempt to retain possession or use of property ostensibly donated to charity. This provisions strengthens the rules on charities' use and possession of property in which they have a donated interest, and requires recapture of claimed tax benefits if the charity does not take ownership or possession and actually use the property for its exempt purposes. In addition to recapture of tax benefits, the donor may have to pay a ten per cent penalty for violations.
Section 1219 - Appraisal Reform
Gifts of valuable property must be accompanied by an appraisal, but sometimes appraisals may differ from the IRS's valuation of donated property. This provision describes who can be a qualified appraiser and what constitutes a qualifying appraisal. The provision also boosts the penalties for over-stated appraisals, and reduces the threshold for applying special penalties for substantial and gross over-valuations. The provision will create a new group of qualified appraisers and you should be sure that any appraiser is certified by the Treasury Department as qualified before using an appraisal for tax purposes.
Section 1220 - Limiting Credit Counseling Agencies
Credit counseling agencies help consumers cope with financial difficulties, the vast majority of which are caused by medical expense crises. After reports of profiteering and abuses, this provision vastly limits the permissible activities of credit counseling agencies. If you are involved in this area, you should seek professional assistance to discuss the new rules and possible options for future activities.
Section 1221 - Reversing Court Decision on Private Foundation Income
In 1982, the IRS lost a court case, which said that the only items which a private foundation had to take into income were those specifically mentioned in the tax laws. This provision reverses that court decision, by adding items "similar to" those in the listing of the income items. The effect is to broaden substantially the items which will be subject to private foundation net investment income tax.
Section 1222 - Expanding Definition of Church
Under present law, a "convention or association of churches" does not have to file tax returns and gets other benefits accorded to churches. This provision expands the definition of "convention or association of churches" to include those with individual members.
Section 1223 - Notification Requirement for Entities Not Required to File Annual Returns
Under current law, small organizations (budgets under $25,000), churches and several other categories of exempt organizations are not required to file annual information returns (Form 990). This provision requires all such organizations, in annual periods beginning after 2006, to file electronically each year with the IRS. The filing must include identifying information, such as name, address, web site, name of officer to contact, and "evidence of the organization's continuing exemption" from the Form 990 filing requirement. An organization that does not file will lose tax-exemption. The filed forms are publicly-discloseable.
Section 1224 - Information Sharing Between IRS and State Officials
Under current law, the IRS is barred from sharing confidential tax return information with state officials. This provision shatters that barrier by allowing the IRS to provide confidential information to state officials who claim to need it to investigate violations of state law or "fraud." The IRS may also provide such information on its own whenever it thinks that state law may be violated. Individuals may still sue the IRS for disclosing confidential information wrongfully, so this provision will likely lead to years of litigation, in addition to substantial new waves of cooperative state and IRS investigations.
Section 1225 - Public Disclosure of Form 990-T
Under current law, while regular annual information returns (Form 990) are required to be made available to any member of the public upon request, until now, tax returns related to unrelated business income were not discloseable. The idea was that competitors could use the tax information to get an unfair business advantage. This provision makes such UBI returns filed after the date of enactment publicly available on the same terms as the Form 990. Organizations which wish to protect their UBI returns could ask the IRS for permission to refuse or limit disclosure, but there are no guidelines indicating what the IRS would require to grant permission.
Section 1226 - Treasury Study on Donor-Advised Funds and Supporting Organizations
Donor-advised funds and supporting organizations are public charities which do not have to comply with the restrictive rules governing private foundations, even though they are similar to private foundations in many ways. In recent years, there have been increasing reports of abuses of these organizations by individuals who use them for private gain. This provision requires the Treasury Department to undertake a study of these organizations to see if they are operating in a charitable fashion.
Sections 1231 through 1245 - New Excise Taxes and Limitations on Donor-Advised Funds and Supporting Organizations
Donor-advised funds are charities which gather tax-deductible contributions and listen to donor advice about which charities to pass on the funds to. As noted above, there have been many reports of abuses of donor-advised funds. For example, donors have obtained charitable deductions for contributions to donor-advised funds, and then directed the funds to their own use, as in fulfilling charitable gift pledges. This provision adds a variety of new excise taxes and penalties on such transactions. This provision defines "donor-advised fund" and "supporting organization" in a very broad manner, including where a donor "could reasonably expect to" have their advice considered by an organization sponsoring a fund on a decision about where to re-grant the donor's funds. The provision applies the Section 4943 excess business holdings limitations, the Section 4958 intermediate sanctions excess benefit transaction tax, and other rules on donor-advised funds, supporting organizations, their donors and their managers. These rules are complex and you should obtain professional assistance if you are contemplating involvement with a donor-advised fund or a supporting organization.