Exempt Organizations Advisory - Charitable Incentives and Reforms Passed by Congress

Any day now, the President is expected to sign into law the Pension Protection Act of 2006, H.R. 4, which was passed by the House on July 28, 2006 and by the Senate on August 3, 2006 by a vote of 93 to 5. The bill includes numerous provisions affecting tax-exempt organizations, most of which were included in one form or another in the Senate version of the tax reconciliation bill but were dropped in conference. Taken together, the provisions represent a significant change to the tax rules affecting charitable organizations. Moreover, the provisions affecting donor advised funds and supporting organizations represent sweeping changes to the rules affecting those charities.

The summary below is divided into 5 sections: Charitable Giving Incentives; Reforms Affecting Charitable Giving; Donor Advised Funds; Supporting Organizations; and Miscellaneous Reforms.

CHARITABLE GIVING INCENTIVES

Tax-Free Distributions From IRAs for Charitable Purposes
H.R. 4, section 1201, permits persons who have reached the age of 70 ½ years to exclude from gross income certain distributions of up to $100,000 from a traditional individual retirement account (“IRA”) or a Roth IRA, which would otherwise be included in income. To qualify as a qualified tax-free distribution, the charitable distribution must be made to a tax-exempt organization to which deductible contributions are allowed. This provision is effective for contributions made during 2006 and 2007. The exclusion does not extend to split-interest gifts or gifts to supporting organizations, donor-advised funds, or private foundations. Under present law, if an amount withdrawn from a traditional IRA or a Roth IRA is donated to a charitable organization, the rules relating to the tax treatment of withdrawals from IRAs apply to the amount withdrawn and the charitable contribution is subject to the normally applicable limitations on deductibility of such contributions.

Charitable Deduction for Contributions of Food Inventory
H.R. 4, section 1202 extends the special rules for contributions of food inventory under Internal Revenue Code ("Code") section 170(e)(3)(C) through the end of 2007. The special rules provide an enhanced deduction for trades and businesses equal to the lesser of (i) the taxpayer’s basis plus one-half of the difference between fair market value and basis, and (ii) twice the taxpayer’s basis in the contributed inventory. The enhanced deduction is available only for food that qualifies as “apparently wholesome food,” as defined under the Katrina Emergency Tax Relief Act of 2005. The provision is effective for contributions made after December 31, 2005, and before January 1, 2008.

Charitable Deduction for Contributions of Book Inventory
H.R. 4, section 1204 extends the special rules under Code section 170(e)(3)(D) for enhances deductions for contributions of book inventory by C corporations to added public elementary and secondary schools. This provision, which was added by the Katrina Emergency Tax Relief Act of 2005, expired on December 31, 2005.

Basis Adjustment to Stock of S Corporation Contributing Property
Section 1203 of H.R. 4 provides that the amount of a shareholder’s basis reduction in the stock of an S corporation, by reason of a charitable contribution made by the corporation, will be equal to the shareholder’s pro rata share of the adjusted basis of the contributed property. Under present law, under Code sections 1366 and 1367, if an S corporation contributes money or other property to a charity, each shareholder takes into account the shareholder’s pro rata share of the contribution in determining its own income tax liability, and each shareholder reduces the basis in the stock of the S corporation by the amount of the charitable contribution that flowed through to the shareholder. For example, under the new rules, if an S corporation with one individual shareholder were to make a charitable contribution of stock with a basis of $200 and a fair market value of $500, the shareholder would be treated as having made a $500 charitable contribution (or a lesser amount if special rules under section 170(e) applied), and would reduce the basis of the S corporation stock by $200. The provision is effective for contributions made in taxable years beginning after December 31, 2005, and taxable years beginning before January 1, 2008.

Tax Treatment of Certain Payments to Controlling Exempt Organizations
Under present law, Code section 512(b)(13) provides that
rent, royalty, annuity, and interest income paid to a tax-exempt organization by a controlled subsidiary generally is treated as unrelated business income and is taxable to the exempt parent organization. More specifically, section 512(b)(13) includes interest, rent, annuity, or royalty payments made by a controlled entity to the controlling tax-exempt organization in the controlling organization’s unrelated business income, to the extent the payment reduces the net unrelated income (or increases any net unrelated loss) of the controlled entity. H.R. 4, section 1205 amends Code section 512 to apply this rule only to the portion of payments received or accrued in a taxable year that exceeds the amount of the specified payment that would have been paid or accrued if such payment had been determined under the principles of Code section 482 (allocation of income and deductions among taxpayers) i.e., fair market value. Thus, for example, under the new rules if a payment of rent by a controlled subsidiary to its tax-exempt parent organization exceeds fair market value, the excess amount of such payment over fair market value is included in the parent organization’s unrelated business income, to the extent that such excess reduces the net unrelated income (or increases any net unrelated loss) of the controlled entity (determined as if the entity were tax exempt). Exempt organizations are required to report certain amounts received from controlled organizations. The provision is effective for two years through 2007.

Qualified Conservation Contributions
H.R. 4, section 1206 raises the charitable deduction limit from 30 percent of adjusted gross income to 50 percent of adjusted gross income for qualified conservation contributions, provided the contribution does not prevent the use of the donated land for farming or ranching purposes. The charitable deduction limit is raised to 100 percent of adjusted gross income for eligible farmers and ranchers. The provision allows a taxpayer to carryforward the deduction for 15 years, provided that the taxpayer is a farmer or rancher in the year of the carryforward. The provision is effective for two years through 2007.

Excise Tax Exemption for Blood Collector Organizations
H.R. 4, section 1207 provides that certain blood collector organizations are exempt from certain excise taxes—the special fuels tax under section 4041, the manufacturers excise tax under section 4221, and the tax on heavy vehicles imposed by section 4481—with respect to activities related to blood collection.

REFORMS AFFECTING CHARITABLE CONTRIBUTIONS

Charitable Contributions of Façade Easements
H.R. 4, section 1213 provides special rules for charitable deductions for contributions of façade easements with respect to buildings located in a registered historic district. To qualify for a charitable contribution deduction, the easement must provide that no portion of the exterior of the building may be changed or altered in a manner inconsistent with the historical character of the exterior. H.R. 4 also clarifies that the charitable deduction is reduced if a rehabilitation tax credit has been claimed with respect to the donated property.

Recapture of Tax Benefit for Charitable Contributions of Exempt Use Property Not Used for an Exempt Use
Section 1215 of H.R. 4 provides for the recovery of the tax benefit derived from the contribution of tangible personal property with respect to which a fair market value deduction was claimed if the property is not used for an exempt purpose of the organization.

Clothing and Household Items
H.R. 4, section 1216 amends Code section 170 to disallow deductions for charitable contributions of clothing and household items if the donated items are not in good used condition or better. The provision also allows Treasury to deny a deduction for any item with minimal monetary value.

Modification of Recordkeeping Requirements for Certain Charitable Contributions
H.R. 4, section 1217 requires donors making charitable contributions of money, regardless of the amount, to maintain a cancelled check, bank record or receipt from the organization showing the name of the organization, the date of the contribution, and the amount of the contribution.

Fractional Interest in Donated Property
Section 1218 of H.R. 4 provides for recapture of the donor's charitable deduction for a contribution of a fractional interest in an item of tangible personal property if (1) the donor does not contribute the donor's remaining interest in the property within 10 years or the death of the donor, whichever is first or (2) the charity does not take possession of the item at least once during the 10-year period as long as the donor remains alive and use the item for the organization’s exempt purpose. Failure to comply with these requirements results not only in the recapture of all tax benefits but also payment of interest and a 10 percent penalty.

Appraisal Reform
H.R. 4, section 1219 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. The provision also applies for purposes of estate tax appraisals and provides definitions of a qualified appraiser and qualified appraisals.

Taxidermy and Substantiation of Exempt Use Property
Section 1214 of H.R. 4 limits the basis for donated taxidermy property to the cost of preparing, stuffing and mounting an animal. The value of the deduction is equal to the lesser of basis or fair market value.

DONOR ADVISED FUNDS

Study on Donor Advised Funds and Supporting Organizations
H.R. 4, section 1226 directs Treasury to conduct a one-year study to determine whether charitable contributions deductions are “appropriate” for gifts to donor-advised funds and supporting organizations in consideration of the use of the contributed assets or the use of the assets of the organization to benefit the person making the gift or a related person; whether donor advised funds should be subject to minimum distribution requirements; whether retention of advisory rights by donors is consistent with the treatment of the transfers as completed gifts; and whether these issues are of concern with other forms of charities or charitable donations.

Excise Taxes Relating to Donor Advised Funds
H.R. 4, Section 1231 added two new Code sections, 4966 and 4967, defining “donor advised fund” and imposing excise taxes on taxable distributions and on prohibited transactions of donor advised funds. Previously, the tax code did not contain a definition of a “donor advised fund” or otherwise deal with donor advised funds directly.

Definition of Donor Advised Fund. New section 4966 defines a “donor advised fund” as a fund or account that is: (1) separately identified by reference to contributions of a donor or donors; (2) owned and controlled by a sponsoring organization; and (3) with respect to which a donor (or any person appointed or designated by such donor (a “donor advisor”) has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of amounts held in the separately identified fund or account by reason of the donor’s status as a donor. All three prongs of the definition must be met for a fund or account to be treated as a donor advised fund.

Exceptions to Definition. The term donor-advised fund does not include any fund or account that makes distributions only to a single identified organization or governmental entity. The definition also does not apply to a fund or account that makes grants to individuals for travel, study, or other similar purposes if the fund is advised by a committee, all of the members of which are appointed by the sponsoring organization, and the committee is not controlled by the donor or persons appointed by the donor, and if the grants are awarded using an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the sponsor’s board and that meets the requirements for similar grants by private foundations. Finally, the Secretary of the Treasury is authorized to exempt a fund or account from the definition, provided the fund is either advised by a committee not controlled by the donor or is a fund benefiting a single charitable purpose.

Prohibited Distributions (Grants). Donor advised funds are prohibited from making grants to individuals; to nonoperating private foundations; to any entity if the payment is not for a charitable purpose; to Type III supporting organizations (except for those that are “functionally integrated”); and grants to Type I or II supporting organizations if the donor or advisor controls a supported organization or the Secretary determines by rule that a distribution is inappropriate; and to organizations not described in Code section 170(b)(1)(A) without the exercise of expenditure responsibility.

Excise Tax on Prohibited (Taxable) Distributions. New Code section 4966 imposes two separate excise taxes on prohibited distributions -- one on the sponsoring organization equal to 20 percent of the amount of the distribution and another tax on a fund manager who agrees to make the distribution, knowing that it is a taxable transaction, equal to 5 percent of the distribution, with a maximum amount of $10,000.

Prohibited Benefits. New Code section 4966 also imposes excise taxes if the donor, advisor or related parties receive more than incidental benefits from a donor-advised distribution from the fund or account. The excise tax equals 125 percent of the amount of the benefit, and can be imposed on the person who recommends the grant or the person who receives the benefit. Fund managers who approve the distribution are subject to a penalty of 10 percent if they knew the distribution would result in an impermissible benefit.

Excess Benefit Transactions Involving Donor Advised Funds and Sponsoring Organizations
H.R. 4, section 1232 amends the excess benefit transaction rules under Code section 4958 to include special rules for donor advised funds. The special rules prohibit grants, loans, compensation and similar payments from donor-advised funds to donors, advisors and related parties, and any receipt of such payments is automatically an excess benefit transaction subject to penalty taxes under Code section 4958. Code section 4958 imposes an initial (first-tier) excise tax of 25 percent of the amount involved and requires that the amount involved be repaid. Under the new rules, the amount repaid may not be held in any donor-advised fund.

Excess Business Holdings of Donor Advised Funds
H.R. 4, section 1233 applies the excess business holdings rules applicable to private foundations under Code section 4943 to donor advised funds. In applying these rules to donor advised funds, the term “disqualified person” is defined to mean, with respect to the donor advised fund, a donor, donor advisor, a member of the family of a donor or donor advisor, or a 35 percent controlled entity of any such person.

Limitations on Deductibility of Contributions to Donor Advised Funds
H.R. 4, section 1234 provides that certain contributions to a sponsoring organization for maintenance in a donor advised fund are not deductible as a charitable contribution. Contributions are not deductible if the sponsoring organization is a veterans’ organization described in Code section 170(c)(3), a fraternal society described in Code section 170(c)(4), or a cemetery company described in Code section 170(c)(5) (this rule also applies to gift and estate tax purposes). In addition, contributions to a sponsoring organization for maintenance in a donor advised fund are not eligible for a charitable deduction for income, gift, or estate tax purposes if the sponsoring organization is a “Type III” supporting organization (an organization that is operated “in connection with” a publicly supported organization, as defined in Treas. Reg. sec. 1.509(a)-4(f)(2)), other than a functionally integrated Type III supporting organization). A functionally integrated Type III supporting organization is a Type III supporting organization that is not required under regulations to make payments to supported organizations due to the activities of the organization related to performing the functions of, or carrying out the purposes of, such supported organizations.

Returns of, and Applications for Recognition of Exemption By, Sponsoring Organizations
H.R. 4, section 1235 requires each sponsoring organization to disclose on its information return: (1) the total number of donor advised funds it owns; (2) the aggregate value of assets held in those funds at the end of the organization’s taxable year; and (3) the aggregate contributions to and grants made from those funds during the year. Additionally, when applying for recognition of tax-exempt status, an organization must disclose to the IRS whether it intends to maintain donor advised funds.

Supporting Organizations

Treasury Study
See description above under DONOR ADVISED FUNDS.

Requirements for Supporting Organizations
H.R. 4, section 1241 imposes additional requirements that must be met for certain supporting organizations to qualify for public charity status. The provision requires Type III supporting organizations to provide such information as Treasury requires to each supported organization to ensure that the supporting organization is responsive to the needs or demands of the supported organization. The provision also prohibits Type III supporting organizations from supporting a foreign organization, with a three-year transition rule for existing organizations. These provisions became effective on the date of enactment.

Type I and III supporting organizations will fail to qualify as supporting organizations if they accept a gift from a person who directly or indirectly controls a supported organization. With respect to charitable trusts that are Type III supporting organizations, the charitable trust will not be considered to be operated “in connection with” the supported organization(s) (i.e., meet the “responsiveness test”) solely because it is a charitable trust under state law, the supported organization is a beneficiary of the trust, or because the supported organization has the power to enforce the trust and compel an accounting. This provision becomes effective one year after the date of enactment for trusts in existence on the date of enactment; otherwise, it is effective on the date of enactment.

Excess Benefit Transactions Involving Supporting Organizations
H.R. 4, section 1242 provides that if a supporting organization (Type I, Type II, or Type III) makes a grant, loan, payment of compensation, or other similar payment to a substantial contributor (or person related to the substantial contributor) of the supporting organization, for purposes of the excess benefit transaction rules under Code section 4958, the substantial contributor is treated as a disqualified person and the payment is treated automatically as an excess benefit transaction, with the entire amount of the payment treated as the excess benefit. Thus, the substantial contributor is subject to an initial tax of 25 percent of the amount of the payment under Code section 4958(a)(1) and an organization manager that participated in the making of the payment, knowing that the payment was a grant, loan, payment of compensation, or other similar payment to a substantial contributor, is subject to a tax of 10 percent of the amount of the payment under section Code 4958(a)(2). The second tier taxes and other rules of section 4958 also apply to such payments.

The provision applies to payments by a supporting organization to a substantial contributor but not to payments by a substantial contributor to a supporting organization.

A “substantial contributor” means any person (or a relative or controlled entity of any person) who contributed or bequeathed an aggregate amount of more than $5,000 to the organization, if the contributed amount is more than two percent of the total contributions and bequests received by the organization before the close of the taxable year of the organization in which the contribution or bequest is received by the organization from such person. In the case of a trust, a substantial contributor also includes the creator of the trust. A substantial contributor does not include a public charity (other than a supporting organization).

Loans by any supporting organization (Type I, Type II, or Type III) to a disqualified person (as defined in Code section 4958) of the supporting organization are also treated as an excess benefit transaction under Code section 4958 and the entire amount of the loan is treated as an excess benefit. A disqualified person does not include a public charity (other than a supporting organization).

Excess Business Holdings of Supporting Organizations
H.R. 4, section 1243 extends the excess business holdings rules applicable to private foundations under Code section 4943 to Type III supporting organizations (other than functionally integrated Type III supporting organizations). In applying these rules to Type III supporting organizations, the term “disqualified person” has the meaning provided in Code section 4958, and also includes substantial contributors and related persons and any organization that is effectively controlled by the same person or persons who control the supporting organization or any organization substantially all of the contributions to which were made by the same person or persons who made substantially all of the contributions to the supporting organization. The excess business holdings rules do not apply if, as of November 18, 2005, the holdings were held (and at all times thereafter, are held) for the benefit of the community pursuant to the direction (made as of such date) of a State attorney general or a State official with jurisdiction over the Type III supporting organization.

Treatment of Amounts Paid to Supporting Organizations by Private Foundations
H.R. 4, section 1244 amends the private foundation provisions of the Code to prohibit a nonoperating private foundation from counting as a qualifying distribution (under Code section 4942) any amount paid to (1) a Type III supporting organization that is not a functionally integrated Type III supporting organization or (2) any other supporting organization if a disqualified person with respect to the foundation directly or indirectly controls the supporting organization or a supported organization of such supporting organization. Any amount that does not count as a qualifying distribution under this rule is treated as a taxable expenditure under Code section 4945.

Returns of Supporting Organizations
H.R. 4, section 1245 amends Code section 6033 (relating to returns by exempt organizations) to require all supporting organizations to list their supported organizations and to indicate whether the organization meets certain requirements under Code section 509(a)(3).

MISCELLANEOUS REFORMS

Increased Fines and Penalties Applicable to Charitable Organizations
Section 1212 of H.R. 4 doubles the excise taxes applicable to charities, social welfare organizations, private foundations and exempt organization managers, relating to acts of self-dealing (Code section 4941), excess benefit transactions (Code section 4958), failure to distribute income (Code section 4942), excess business holdings (Code section 4943), investments which jeopardize charitable purposes (Code section 4944), and taxable expenditures (Code section 4945).

Treasury Report on Certain Life Insurance Contracts
H.R. 4, section 1211 requires charitable organizations to report certain acquisitions of interests in certain insurance contracts for two years beginning on the date of enactment. Treasury is required to issue a report within 30 months after the date of enactment examining whether acquisitions of applicable insurance contracts are consistent with the tax-exempt purposes of those charitable organizations that acquire the contracts. The provision is intended to address concerns regarding an increase in transactions involving the acquisition of life insurance contracts using arrangements in which both exempt organizations, primarily charities, and private investors have an interest in the contract.

Private Foundation Net Investment Income Excise Tax
H.R. 4, section 1221 amends the definition of gross investment income to include capital gains, notional principal contracts, annuities, and other substantially similar investment income.

Encourage IRS Information-Sharing with State Charity Officials
Section 1224 of H.R. 4 provides that, upon written request by an appropriate state official, the Secretary may disclose information regarding organizations for which the IRS has denied or revoked tax-exempt status, certain other actions the IRS may have taken, and returns filed by tax-exempt organizations.

Public Disclosure of Information Relating to Unrelated Business Income Tax Returns
H.R. 4, section 1225 extends the present-law public disclosure requirements applicable to Form 990 to the unrelated business income tax returns (Form 990-T) of section 501(c)(3) organizations.

Credit Counseling
H.R. 4, section 1220 imposes additional rules on credit counseling organizations, including setting guidelines on the services offered; establishing restrictions on governing boards; limiting the activities of the organization; setting a limit on the amount of debt management plan income the organization may receive; and imposing restrictions with respect to loans, fees, and solicitation of contributions from consumers receiving counseling.

Notification Requirement for Exempt Organizations
Section 1223 of H.R. 4 amends section 6033 (relating to returns by exempt organizations) to require certain organizations to file an annual notice with the IRS containing basic contact and financial information. The new rule applies to organizations that currently are not required to file an annual return because their gross receipts are less than $25,000.

Convention or Association of Churches
Section 1222 of H.R. 4 clarifies the definition of a convention or association of churches.

The Exempt Organization Advisory is a general summary of the law and is not intended as specific legal advice for any organization.

Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

For more information on this topic, please contact the authors or the attorneys with whom you usually work at Steptoe.

Questions and comments about the Exempt Organizations Advisory are always welcome and should be sent to bstone@steptoe.com.