So many tax provisions these days are effective so far out into the future, practitioners can't quite figure out how to address them. File them away on a long-term calendar? Start preparing for them immediately? Ignore them?In dealing with the recently passed Pension Protection Act of 2006, where the majority of provisions are not effective until either 2008 or 2011, the answer varies considerably. This article offers some first-off-the-bat timelines to consider.
Pension provisions
The brand-new law addresses several areas: defined-benefit plans, defined-contribution savings, charitable deductions and "miscellaneous." Among those, the defined-benefit plan provisions are the largest in terms of volume. To give companies time to prepare for stricter funding requirements, most full funding requirements under the Pension Protection Act do not kick in until 2008, and then there are transition rules to create a still softer landing for many companies. Several provisions, however, are effective immediately or starting in 2007.
* Higher (and more volatile) funding liability. Effective for plan years beginning after 2007 - but having such an impact that employer-sponsors are looking immediately at the consequences - employers maintaining single-employer DB plans will be subject to new funding rules that will require them to make a minimum contribution to their plans based on the plans' assets (reduced by credit balances), funding target and target normal cost.
The higher funding liability requirements have many experts predicting that the new law marks the beginning of the end for DB plans. As a result, many companies are evaluating now whether to cut their losses and freeze or terminate existing plans sooner rather than later.
* Higher contribution deductions. In the world of DB plans, even a 10-year period is relatively short. From that perspective, the new rules for 2008 will be here tomorrow. Increasing funding balances now is one way to avoid having the characteristics of an "at risk" plan starting in 2008.
One significant benefit that began immediately upon enactment of the Pension Protection Act is a higher allowable level of annual contribution.
For years beginning in 2006 and 2007, the maximum deduction limitation for contributions to single-employer defined-benefit plans cannot be any less than the unfunded current liability determined under Code Sec. 412(l)(8)(A) as in effect in 2006 and 2007.
However, when calculating that unfunded current liability, a single-employer plan subtracts the value of the plan's assets from 150 percent of the current liability of the plan.
* Deferred comp. Starting immediately after Aug. 17, 2006, the new law strictly prohibits setting aside deferred comp when a pension plan is in trouble. While an "at risk" plan that triggers this prohibition is not defined as rigorously now as it will be for post-2007 years, most plans that are in trouble or that try to get out of trouble by termination will no longer be able to fund nonqualified deferred comp for executives.
Assets that are set aside in a rabbi trust or otherwise during any "restricted period" for the payment of deferred comp to covered employees and while a defined-benefit plan is at risk will be taxed to the "covered employee" as income for services under Code Section 83.
"Covered employees" include the chief executive, the four highest paid officers for the tax year and individuals subject to Section 16(a) of the Securities Exchange Act of 1934.
* Compensation limit on benefits. Starting for years beginning after Dec. 31, 2005, the new law allows a more favorable computation of average-three-year compensation for determining benefits.
Annual benefits payable to a participant under a defined-benefit plan generally may not exceed the lesser of 100 percent of the average compensation for the employee's high three years, or $175,000 (for 2006), with proportionate reduction for employees with fewer than 10 years of service.
The high three years under the new law is the period of not more than three consecutive calendar years during which the participant had the greatest aggregate compensation from the employer.
* Automatic enrollment in 401(k) plans. For plan years beginning after Dec. 31, 2007, additional automatic enrollment protections will be available. While automatic enrollment features have actually been around for a while, many employers have remained fearful of adopting them and leaving themselves open to charges of plan discrimination.
The Pension Protection Act encourages employers to adopt such a feature by providing nondiscrimination safe harbors for elective deferrals and matching contributions under plans that include an automatic enrollment feature, as well as allowing erroneous contributions to be distributed. Ironically, this presumption for periods after 2007 may have the effect of persuading more employers to wait until then to switch to automatic enrollment.
Giving opportunities
* Tax-free IRA distributions to charities. Individuals age 70-1/2 or older can distribute up to $100,000 of their IRA balance to charitable organizations in 2006 and in 2007 without recognizing income. Although the individual cannot double up and also take a charitable deduction (unless it is from a Roth IRA), the distribution counts towards the required minimum distribution. Distributions from a Roth IRA, however, would be unwise in most situations, since future earnings would be tax-free and no RMD would be required.
* Conservation property. Effective for contributions made in tax years beginning after Dec. 31, 2005, and before Jan. 1, 2008, individual donors are allowed to take charitable deductions of up to 50 percent of their contribution base for contributions of qualified conservation real property; this limit is raised to 100 percent of the contribution base for individual farmers and ranchers.
* S contributions. Applicable to contributions made in tax years beginning after Dec. 31, 2005, and before Jan. 1, 2008, 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 equals the shareholder's pro rata share of the adjusted basis of the contributed property. The prior rule and, therefore, the rule once again after 2007, requires a reduction in the stock basis by the fair market value of the contributed property.
Giving restrictions
* Clothing and household items. Effective for donations made after Aug. 17, 2006, deductions for charitable contributions of clothing or household items are limited to items in good used condition or better. In addition, in the future the Internal Revenue Service by regulation may deny charitable deductions for clothing or household items of minimal value. An exception exists for single items if the claimed deduction exceeds $500 in value and a qualified appraisal is included with the tax return.
While the new law requires that the donations meet the "good or better condition" standard, there is no guidance on what value should be placed on those permitted contributions. While organizations may accept clothing that they turn around and sell for its rag content, however, they will be hard-pressed to document to the donor, and indirectly to the IRS, that the condition is "good."
* Cash. Starting in tax years beginning after Aug. 17, 2006 (which is 2007 for calendar-year taxpayers), small cash donations will absolutely need some paperwork behind them, or no charitable deduction is allowed.
Specifically, donors of charitable contributions of cash, checks or other monetary gifts must maintain either a bank record or a receipt, letter or other written communication from the donee indicating the name of the donee organization, the date that the contribution was made and the amount of the contribution.
Since these are basically the same rules contained in Reg. §1.170A-13(a), they codify what has been a burden-of-proof requirement and bring it forward to a requirement for taking the deduction.
* Fractional interests. For gifts and bequests made after Aug. 17, 2006, the amount of a charitable deduction for additional contributions of fractional interests in tangible personal property is restricted to the value of the initial fractional contribution or the value on the additional contribution date, whichever is less.
Any deduction will be recaptured and an additional tax imposed if the property is not entirely contributed to the donee, substantial physical possession is not taken by the donee, or the property is not used by the donee for exempt purposes, within a certain timeframe.
Contributions made before Aug. 18, 2006, will not be treated as initial fractional contributions. Rather, the first contribution after Aug. 17, 2006, is considered the initial fractional contribution, regardless of whether the donor made earlier contributions in the same item of tangible personal property.
* Facade easements. Effective for contributions made after July 25, 2006, the requirements for claiming a charitable deduction for the contribution of a facade easement for a building in a registered historic district are tightened. Deductions are disallowed completely for personal residences, unless the residence is listed individually in the National Register of Historic Places. The deduction is reduced to take account of the rehabilitation credit.
* Recapture for non-use. Applicable to contributions after Sept. 1, 2006, a donor must recapture the tax benefit of donating appreciated tangible personal property as property that the charity will use if, within three years of receiving it, it ceases a qualified use. This rule will not apply if the donee provides a certification that the property was intended to be used, or was put to a use related to the donee's exempt purpose.
EGTRRA extenders
The Pension Protection Act extends many taxpayer-friendly changes to the Tax Code's retirement plan rules that were introduced by the Economic Growth and Tax Relief Reconciliation Act of 2001. It authorized catch-up contributions for older workers, increased contribution limits and benefits, made some retirement arrangements more attractive for small businesses, expanded rollover options for taxpayers with 457 and 403(b) plans, targeted relief to certain groups, and provided many other incentives.
Like many of EGTRRA's provisions, the enhanced retirement savings incentives were temporary, and would have ended after Dec. 31, 2010. The new law repeals the sunset provisions in EGTRRA that apply to retirement savings.
Long-range retirement planning is enhanced by making these provisions permanent. This is especially the case with respect to allowing the Roth 401(k) option for employee-share contributions. Employers had been holding back on amending plans to offer this option, concerned that administration expenses would be indefinite, while the option itself would cease after 2010. With that concern out of the way, many employers plan to amend their plans to offer Roth 401(k)s as an option starting next year.
Conclusion
Like many other pieces of tax legislation, the Pension Protection Act grew from a group of provisions focused exclusively on one issue - pension funding reform - into a final bill that included much more. Like other recent pieces of tax legislation, it contained a myriad of effective dates - some to provide time for taxpayers to prepare, some to balance the bill's overall budget numbers, and some to stop certain behavior immediately dead in its tracks.
As a result, sorting out tax provisions by effective date has once again become critically important in the case of the Pension Protection Act of 2006.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a WoltersKluwer business.
