The provisions of the Pension Protection Act of 2006, enacted on Aug. 17, 2006, include a package of changes related to tax-exempt entities and charitable contributions. Many of the provisions were designed to tighten perceived abuses involving tax-exempt entities and deductions for charitable contributions. A few of the new provisions, however, liberalize the charitable giving rules.
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With many of these provisions already effective for 2006, and the rest coming into play this January 1, tax practitioners will want to make sure that their clients have sufficient knowledge and procedures in place to stay in compliance with the new requirements.
Tax-free distributions to charities
First, a bit of good news.
Individuals aged 70-1/2 or older can distribute up to $100,000 of their IRA balances to charitable organizations in 2006 and again in 2007 without recognizing income on the distribution.
Although the change also applies to Roth IRA distributions, since the charitable distributions must have been otherwise taxable, the provision would appear to have relatively limited application in the Roth IRA context, and might not make much sense tax-wise even if it did apply, since Roth IRA distributions could eventually be tax-free in any event.
The law changes the distribution ordering rules for charitable distributions so that all of the charitable distribution may be considered to have come from taxable funds, rather than a portion being allocated to nondeductible contributions.
The limitation to individuals aged 70-1/2 or older appears designed to coincide with the onset of minimum distribution requirements, but advise your clients to be careful. While minimum distributions must commence by April 1 following the tax year in which the individual reached age 70-1/2, the tax-free distributions to charity must be made after the taxpayer reaches age 70-1/2. The distribution must be made directly to the charity, and certain types of charities, such as supporting organizations and donor-advised funds, may not qualify.
Another advantage to making charitable contributions from an IRA is that it can result in a lower adjusted gross income figure for the year than might have otherwise been the case. This creates the indirect benefit of perhaps increasing the taxpayer's eligibility for other tax breaks that phase out at various AGI levels.
Clothing and household items
In an apparent effort to restrict charitable contributions for clothing sold by charities for its rag content or other items sold for junk value, the Pension Act limits charitable deductions for clothing or other household items to those items in good used condition or better.
The change was effective beginning Aug. 17, 2006. It will be left to regulations to determine what "good used condition or better" means and what, if any, burdens will be placed on the charity to enforce this provision. The charity may be similarly required to state whether the item will be used by the charity, sold as an item of clothing or disposed of for its rag content. The IRS is given the authority to deny any deduction for items of minimal value.
An exception is provided for a single item worth more than $500 with a qualified appraisal attached to the return. Household items for the purpose of this provision do not include collections, paintings, antiques, jewelry or objects of art.
With the change in the law for the donation of vehicles, the burden was placed on the charity to inform the taxpayer of the price it obtained for the vehicle.
Beginning Jan. 1, 2007, taxpayers will be required to be able to document any deductions for a cash contribution with a communication from the charity or a bank record. Maintaining a contemporaneous taxpayer record will not be sufficient. Taxpayers accustomed to making cash contributions may want to shift to checks or credit card payments instead. Charities may also respond by making receipts more readily available from those collecting for their causes.
In an effort to address a perceived abuse in the donation of partial interests in property to a charity, the new law limits the valuation of all contributions of fractional interests in tangible personal property after Aug. 17, 2006, to no more than the value of the property used to determine the deduction for the initial fractional contribution.
A recapture provision, with a 10 percent penalty, is also included in the event that the entire interest in the property is not contributed within 10 years, or if the charity fails to take possession of the property or fails to use the property for its exempt purposes within 10 years of the initial fractional contribution.
One further requirement for a deduction of a contribution of a fractional interest is that the donor must own the entire interest in the property immediately before the contribution.
The Pension Act addresses both donations of conservation easements on real property and façade easements on certified historical structures. On conservation easements, the news is on the whole good. Individual donors may take charitable deductions of up to 50 percent of their contribution base for contributions of qualified conservation real property, with the limit increasing to 100 percent for farmers and ranchers contributing property suitable for farming or ranching. This change applies for all of 2006.
Contributions of façade easements are, however, tightened. The easement must preserve the entire exterior of the building, unless the building is listed in the National Register of Historic Places. Only residences listed in the National Register may qualify for a deduction for contributions of façade easements. The deduction is also reduced for the portion of the contribution attributable to the rehabilitation credit.
Filing fees and documentation requirements have also been added, including a written agreement between the donor and donee, for buildings in registered historic districts, that the donee is qualified and has the resources to protect and manage the property. The effective dates vary with the individual provisions, but all except the filing fee are effective for at least part of 2006.
Donor-advised funds have become increasingly popular in recent years, as donors have tried to achieve the benefits of a private foundation without the trouble and expense of setting up and operating their own. The new law tries to rein in perceived abuses in the operation of these funds.
The law adds a definition of donor-advised funds. A 20 percent tax is now imposed on the sponsoring organization for taxable distributions from the funds. A 5 percent tax is also imposed on any fund manager agreeing to a taxable distribution. Excise taxes are imposed on donors, donor advisors and related persons who receive a benefit from a distribution from a donor-advised fund. The excess business-holding rules applicable to private foundations have been extended to donor-advised funds. Contributions to donor-advised funds may not be deductible for funds maintained at non-charitable and Type III supporting organizations.
The provisions applicable to donor-advised funds generally apply to calendar years commencing on or after Jan. 1, 2007.
Split-interest trust reporting
Split-interest trusts, such as charitable remainder trusts, charitable remainder unity trusts and charitable gift annuities, now must file whether or not they distribute all current income to beneficiaries, and increased failure-to-file penalties are imposed. On the positive side, information on the beneficiaries of split-interest trusts, other than the charities involved, need no longer be made public. These provisions will apply to tax years beginning after Dec. 31, 2006.
Recapture of tax benefits
Under a new recapture provision, if a charity receives appreciated tangible personal property as a charitable contribution and disposes of the property within three years of receiving it, the donor may not derive any tax benefit beyond a deduction in the amount of the property's basis. An exception applies if the charity certifies that the property was intended to be used or was put to a use related to its exempt purpose.
This provision implies some ongoing responsibility for communication between the donor and the donee for years after the contribution. These provisions have various effective dates, but all are effective for the latter part of 2006.
Other charitable provisions
Also included in the legislation are provisions extending the favorable treatment of corporate contributions of food and book inventories, and a provision-preserving basis for shareholders of S corporations contributing appreciated property to charity.
On the negative side are provisions restricting deductions for donations of taxidermy property and imposing civil penalties on appraisers providing an appraisal that results in a substantial or gross valuation misstatement on a tax return or refund claim. These penalties could have a significant impact on the appraisal industry.
Although a mixture of good and bad news, the charitable provisions of the Pension Protection Act of 2006, on the whole, represent an effort to curtail abusive contribution deductions. With many of these provisions already in effect for the 2006 tax year, tax practitioners will want to alert their clients as soon as possible to these changes to forestall unanticipated problems when it comes time to prepare the 2006 tax returns.