Changes for Charities and Donors in the Pension Protection Act
- IRA Charitable Rollovers. During 2006-2007, the Act permits up to $100,000 per year per taxpayer to be directly transferred tax-free from a Traditional IRA or Roth IRA (but not from other forms of retirement plans, such as a 401(k) or a SIMPLE IRA) to qualified charities. Normally, a distribution from a IRA to a charity would be taxable to the plan owner.
To qualify, the distribution must be distributed directly from the IRA to a qualified charity and the plan owner (donor) must be at least 70 ½ on the date of the distribution to the charity. Not every charity is a qualified recipient. Excluded charities include donor advised funds, supporting organizations and most private foundations. It is important that the donor not receive any benefit that would otherwise reduce his or her charitable deduction as a result of the transfer, otherwise the donor is taxed on the entire amount of the distribution. This excludes, for example, distributions to charitable remainder trusts, charitable lead trusts, pooled income funds and charitable gift annuity programs. The donor must be sure to obtain a gift acknowledgement for the contribution from the charity or the distribution will be taxed.
- Contributions from S Corporations. Shareholders of S Corporations receive an added benefit for charitable contributions made during 2006 and 2007. When an S Corporation contributes money or other property to a charity, each shareholder is entitled to deduct a pro rata share of the contribution. But each shareholder must also reduce the basis of his or her stock in the S Corporation by the amount of his or her charitable deduction. A Reduced basis in S Corporation stock means more taxable income later for the shareholders.
For charitable contributions by S Corporations during 2006 and 2007, the basis reduction in the S Corporation stock is the pro rata share of the adjusted basis (not the fair market value) of the contributed property. This won’t make a difference for contributions of cash. But it may be important for contributions of other types of property. For example, if, during 2006-2007, an S Corporation contributes stock with a basis of $200 and a fair market value of $500, each shareholder receives a pro rata share of the $500 charitable contribution, but only reduces the S Corporation stock basis by a pro rata share of $200.
- Recordkeeping for Charitable Contributions of Cash. The rules for contributions of cash are fairly straight forward. A donor who claims a deduction for a charitable contribution of cash must maintain written records concerning the charitable recipient and the amount of the contribution. (There are also complex rules – made more so by the Act – for donations of property.) Most people understand the need for a written acknowledgement for contributions of $250 or more. Beginning in 2007, written records must kept for all contributions of cash. Donors should be sure to make their cash contributions by check or obtain written receipts from the charities to which they donated that include all contributions – not just those of $250 or more. Charities should be prepared for requests from donors to include all contributions in the year end acknowledgement letter.
- New IRS Notification for Small Charities. Currently, most Section 501(c)(3) organizations annually file a Form 990. The law exempts some religious organizations and small charities (those charities that are not private foundations and have annual gross receipts of less than $25,000) from this filing requirement. Small charities exempt from the requirement to file a Form 990 must now electronically file with the IRS their name, mailing address, website address (if any), taxpayer identification number, name and address of principal officer, and evidence of the continuing basis of the exemption from the Form 990 filing requirements. As with the Form 990, the electronic filings are public record. Failure to provide this notice for three consecutive years will result in a revocation of exempt status.
- Revocation for failure to File Form 990. Any tax-exempt organization – not just charities – that is required to file a Form 990 will have its exempt status revoked if it fails to file the required Form 990 for three consecutive years. There are also stiff financial penalties for failure to file a Form 990. Organizations that have their exemption revoked due to a failure to file a Form 990 may apply to the IRS for reinstatement.
- Public Disclosure of Form 990-T. Section 501(c)(3) organizations are required to make the Form 990 publicly available. But the tax return charities file to report unrelated business income (the Form 990-T) is not currently subject to public disclosure. The Act requires that a Form 990-T filed by a charity after
August 17, 2006be made available to the public following the same rules that apply to the public disclosure of the Form 990.
The Act increases the severity of a number of penalties that already apply to charities and private foundations. It is useful to remember that all Section 501(c)(3) organizations are either public charities or private foundations. Public charities typically receive broad public support. Private foundations receive funding from only a few sources (such as a family or a company). Donors to public charities receive better tax treatment and private foundations face more regulation than public charities.
- Doubling of the Initial Intermediate Sanctions Penalties. Public charities and Section 501(c)(4) social welfare organizations are subject the Intermediate Sanctions Rules of Section 4958. These rules impose steep penalties on disqualified persons who engage in excess benefit transactions with a public charity (or social welfare organization). In some circumstances, a penalty is also imposed on the managers who approve the transaction giving rise to the excess benefit. The Act doubles the dollar limitation (from $10,000 to $20,000) for penalties imposed on managers.
- Doubling of First-Tier Excise Tax Penalties. Private foundations are subject to a series of restrictive excise tax provisions that are (generally) not applicable to public charities. The provisions cover failure to distribute income, self-dealing, excess business holdings, jeopardizing investments and taxable expenditures. Violations of any of these provisions trigger stiff penalties. The initial penalties range from 5% to 15% of the amount involved. Lesser penalties – subject to specific dollar limitations – are imposed on foundation managers who knowingly approve of a transaction that violates an excise tax provision. The Act generally doubles the initial penalties and the dollar limits for managers.
Much of the Act involves new restrictions placed on donor advised funds. Traditionally, donor advised funds were offered by community foundations and allowed a donor to provide non-binding advice concerning the distribution of his or her contributions by the community foundation. The popularity of donor advised funds has dramatically increased over the past several years. Donor advised funds are now sponsored by many types of charities, including those affiliated with investment managers.
- Donor Advised Funds Defined. Until the Act, there was no definition of what constituted a donor advised fund. The Act 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 public charity (the sponsoring charity); and (3) with respect to which a donor (or any person appointed or designated by a donor – called a donor advisor) has or reasonably expects to have advisory privileges with respect to the distribution or investment of amounts held in the fund or account by reason of the donor’s status as a donor. All three prongs of the test have to be met in order for the fund or account to be treated as a donor advised fund.
Exceptions to the definition of a donor advised fund includes a fund that makes distributions only to a single identified public charity or governmental unit – such as a fund established for the sole benefit of a university. Also excluded are certain independent scholarship funds.
- Contributions to Donor Advised Funds. Contributions to a donor advised fund are not deductible if the sponsoring charity is a veterans organization, fraternal society, cemetery or certain support organizations. This provision applies to contributions beginning 180 days after enactment, approximately mid-February, 2007.
- Substantiation Requirements. In addition to satisfying other substantiation requirements for charitable contributions, to deduct a contribution to a donor advised fund, a donor must obtain a contemporaneous written acknowledgement from the sponsoring charity stating that the sponsoring charity has exclusive legal control over the assets contributed. The acknowledgment can be added to the gift substantiation letters already provided to donors. This provision applies to contributions beginning 180 days after enactment, approximately mid-February, 2007.
- Taxable Distributions. Donor advised funds may not make distributions to individuals or for non-charitable purposes. Distributions to non-charities (for a charitable purpose), non-operating private foundations and certain support organizations require the exercise of expenditure responsibility. Donor advised funds may make distributions (without exercising expenditure responsibility) to other public charities (except certain support organizations), the sponsoring charity, governmental units and to another donor advised fund. Sponsoring charities that make disqualified distributions from donor advised fund are subject to a 20% excise tax. In some circumstances, a 5% penalty (not to exceed $10,000 per act) is levied on those who approve the disqualified distribution.
- Intermediate Sanctions Rules. The Intermediate Sanctions Rules apply to transactions between a donor advised fund and disqualified persons. The Act adds donors, donor advisors, the donor advised fund’s investment managers and related persons (such as family members and 35% or more controlled entities) to the list of disqualified persons. This provision applies to transactions after
August 17, 2006.
No grant, loan, compensation or other similar payment (such as expense reimbursement) may be paid from a donor advised fund to its donor, donor advisor or a related person. Such payments will trigger an automatic penalty under the Intermediate Sanctions Rules. The penalty is based on the entire amount of the payment. In some circumstances, a penalty may also be imposed on those persons who approve the payment. This provision applies to transactions after August 17, 2006.
- Prohibited Benefits from Donor Advised Funds. The Act imposes a 125% penalty on a donor, donor advisor or related person who gives advice to a sponsoring charity to make a grant from the donor advised fund that results in more than an incidental benefit to a donor, donor advisor or related person. In some circumstances, a manager of the sponsoring charity approving the grant could be subject to a penalty equal to 10% of the amount of the benefit.
Unlike the Intermediate Sanctions Rules, a transaction with a donor, donor advisor or related person is not required to trigger these penalties. Under the prohibited benefit rules, the transaction involves a grant to a charity. An incidental benefit should not result, for example, from a grant to the Girl Scouts of America if a donor’s daughter is a member of the local girl scouts. Certain token gifts (following detailed IRS rules) are also permitted. But a grant to a charity from a donor advised fund that satisfies a binding pledge of the donor would be a prohibited benefit.
- Excess Business Holding Rules. The excess business holdings rules apply to donor advised funds. As a result, extra care will need to be taken prior to any contribution of a closely held business to a donor advised fund.
Support organizations are Section 501(c)(3) charities that are treated as public charities – even though they do not receive broad public support. Support organizations receive public charity status because they support one or more public charities. (A public charity supported by a support organization is called a supported charity.) Support organizations may not support private foundations.
There are three types of support organizations. The first type (called a Type I support organization) is a subsidiary of the supported charity. The second type of support organization (a Type II) has a brother-sister relationship with the supported charity – there is generally common supervision or control over both organizations by the same persons. The third type of support organization (a Type III) has the loosest relationship with the supported charity. The test for Type III status is extremely complex, but generally requires that the Type III support organization be responsive to, and significantly involved in the operations of, the supported charity. Support organizations – especially Type III – are subject to a series of new rules that reflect those imposed on donor advised funds.
- Prohibited Payments. As public charities, support organizations are subject to the Intermediate Sanctions Rules. A support organization (Type I, II or III) may not make any grant, loan, payment of compensation or similar payment (including expense reimbursement) to a substantial contributor or a related person (such as a family member or 35% or more controlled entity). Such payments will trigger an automatic penalty under the Intermediate Sanctions Rules. The penalty is based on the entire amount of the payment. Similar rules apply for loans by a support organization to a disqualified person. In some circumstances, an organization manager approving the payment is also penalized. This provision applies to transactions occurring after July 25, 2006.
- Prohibited Contributions. A Type I or Type III support organization will be treated as a private foundation if it accepts a contribution from a person (other than another public charity that is not a support organization) that directly or indirectly controls the governing body of the supported charity. This provision applies to contributions received after August 17, 2006.
- Distributions from Private Foundations. Qualifying distribution for purposes of the 5% distribution requirement do not include distributions by a non-operating private foundation to a Type III support organization (unless it is functionally integrated – in other words, it performs the functions or carries out the purposes of its supported charity) or to a Type I or II support organization controlled by a disqualified person with respect to the private foundation. This provision applies to distributions after August 17, 2006.
- Type III – Excess Business Holding Rules. The Act applies the excess business holding rules to Type III support organizations (other than those that are functionally integrated) and to Type II support organizations that accept contributions from persons who control the supported charity.
Due to the complexity of the Act, the need for IRS guidance, and because the Act introduces many new concepts to the tax law, this information is subject to change. This information is general in nature and is not a substitute for professional legal advice. You should contact your professional advisor to determine the impact of the Act on your particular situation.