Charitable Reform
Legislation:
President Signs Pension
Protection Act of 2006
On Thursday, August 17th (the Enactment Date), President Bush signed the Pension Protection Act of 2006 (H.R. 4) (“PPA”) into law. This legislation directly impacts charities in two principal respects: it provides charitable giving incentives and implements a number of significant changes designed to effectuate charitable reform.
Helpful Sources Used for this Article
The PPA represents a fairly significant piece of legislation that impacts a number of sectors within the charitable community. While the industry is still absorbing the PPA and its impact, the remainder of this article will address the legislative provisions specifically directed towards the following issues and industries:
- Charitable Reform Measures, including the following:
Over the last several years, one of the most talked about pieces of proposed legislation was the allowance of a tax-free distribution to charity from an IRA. With the signing of the PPA, this important piece of legislation came to fruition, with several limitations. For 2006 and 2007, participants in traditional IRAs and Roth IRAs who have reached age 70 ½ at the date of distribution will be allowed to exclude from gross income up to $100,000 distributed to a public charity. The following notable exceptions exist in which the distribution will not be tax-free:
- Qualifying charitable donations from an IRA may not be made to supporting organizations (including many college and university foundations), private foundations or donor advised funds.
- A distribution from an IRA to charity is not tax-free if the donor receives goods or services in return for the contribution (for example, a foursome in a golf outing or a table at a fundraising event).
- Qualifying charitable distributions may not be made to a charitable lead trust, a charitable remainder trust, or in exchange for a charitable gift annuity.
- Only distributions from traditional and Roth IRAs are excluded from gross income. Distributions from other types of retirement plans, such as 401(k)s, 403(b) plans, defined benefit plans, and Keoghs, are not eligible for the exclusion.
A qualifying distribution to charity is counted towards the participant’s minimum distribution requirement. Thus, a participant who is required to take a distribution from the plan, but does not need the additional cash flow, could benefit from this new provision. Others who may benefit from this legislation include (i) individuals who do not itemize deductions; (ii) individuals who do itemize, but have reached the limit on charitable contributions for the year (generally, 50% of adjusted gross income); and (iii) individuals whose itemized deductions are subject to the 3% reduction because of their income levels.
Donors wishing to make contributions to charity from their IRAs should begin the process now because this is new legislation, and plan administrators may not yet have the tools in place to seamlessly make the distribution to charities. Donors should also keep in mind that they must have an acknowledgment of the gift from the charity for income tax purposes. This will likely require communication from the donor to both the IRA administrator and the charity to ensure that this requirement is met.
In addition to tax-free charitable distributions from an IRA, several other charitable giving incentives and reforms were added by the PPA. Of particular note are the following provisions:
- The charitable deduction limits for qualified conservation contributions were increased from 30% to 50%, provided that the contribution does not prevent the use of the donated land for farming or ranching purposes. The charitable deduction limit is raised to 100% for eligible farmers and ranchers.
- No deduction is allowed for charitable contributions of clothing and household goods if they are not in good used condition or better. In addition, the donor may be denied a deduction for any item with minimal monetary value, such as used socks.
- A deduction equal to the fair market value of gifts of tangible personal property to a charity will generally only be allowed if the property is used by the charity in furtherance of its tax-exempt purposes. If the charity disposes of the property within three years of contribution, a portion of the donor's original charitable deduction may be recaptured in the year the charity disposes of the property.
- A donor is now required to maintain a cancelled check, bank record or receipt from the charity showing the name of the charity, the date of contribution and the amount of contribution, regardless of the dollar amount of contribution.
- Charities receiving a fractional interest in an item of tangible personal property (for example, a painting) must take complete ownership of the item within 10 years of contribution or the death of the donor, whichever first occurs.
- The threshold for imposing accuracy-related penalties on taxpayers who donate property valued at $5,000 or greater has been lowered to 150% of the correct value for a substantial valuation misstatement and 200% of the correct value for a gross valuation misstatement.
One of the most significant charitable aspects of the PPA is undoubtedly the charitable reform provisions designed to curb perceived abuses by charities and donors. The reform initiatives are principally intended to combat risks associated with improper control by a donor or grantmaker over a gift or a grantee institution. These provisions evolved from the efforts and concerns of Senator Grassley, and include many of the proposals originally included in some form in the CARE Act. However, while the charitable community provided significant input on the CARE Act, much of this input was not reflected in the final version of the PPA. Therefore, commentators agree that the PPA may have an adverse impact on organizations (albeit, unintended) that do not present the risks giving rise to this reform legislation.
Community Foundations/Donor Advised Funds
The PPA provides for the first time the statutory regulation of donor advised funds. Specifically, the PPA (i) imposes rules with respect to whom distributions may be made from a donor advised fund and corresponding penalties for distributions to non-qualifying organizations and individuals; (ii) enacts new rules regarding substantiation of gifts to donor advised funds; and (iii) applies the excess benefit transaction rules and excess benefit holdings rules to donor advised funds.
What is a Donor
Advised Fund?
For purposes of these new rules, a “donor advised fund” is a fund or account that possesses all of the following characteristics:
- It must be separately identified by reference to contributions of a donor or donors.
- It must be owned and controlled by an organization described in Code Section 170(c) (other than a governmental entity), that is not a private foundation, and maintains one or more donor advised funds (a “sponsoring organization”).
- The donor (or any person appointed or designated by the donor – 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.
The following types of funds and accounts are not considered to be “donor advised funds”:
§ A fund or account that makes distributions only to a single identified organization or governmental entity, even if the donor has advisory privileges. The technical explanation to the legislation specifically provides that a donor who makes a contribution to a university for purposes of establishing a fund named after the donor that exclusively supports the activities of the university is not a donor advised fund, even if the donor has advisory privileges.
§ A fund or account with respect to which a donor or donor advisor provides advice as to which individuals receive grants for travel, study or other similar purposes if (i) the donor’s or donor advisor’s advisory privileges are performed exclusively by the donor or donor advisor in his or her capacity as a member of the committee, all of the members of which are appointed by the sponsoring organization; (ii) the donor, the donor advisor and persons related to them do not control (directly or indirectly) the committee; and (iii) all grants from the fund or account are awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the board of directors of the sponsoring organization and the procedure is designed to meet the requirements of Code Section 4945(g)(1), (2) or (3).
§ A fund or account to which several donors contribute as long as the fund is not tracked by reference to the gift of any particular donor (for example, many field-of-interest funds).
Further, the PPA gives to the Secretary the right to exempt funds or accounts from characterization as a “donor advised fund” if the fund or account (i) is advised by a committee not directly or indirectly controlled by the donor, a donor advisor or persons related to the donor or donor advisor; or (ii) benefits a single identified charitable purpose.
Deductibility of Contributions
Contributions to a donor advised fund at a sponsoring organization that is a Type III supporting organization that is not functionally integrated (see section on Type III Organizations That Are Not Functionally Integrated), a veterans’ organization, a fraternal society or a cemetery company do not qualify for a charitable deduction. In addition, with respect to contributions to a donor advised fund at other sponsoring organizations, a charitable contribution deduction will only be allowed if the donor obtains a contemporaneous written acknowledgment from the sponsoring organization providing that the sponsoring organization has exclusive legal control over the assets contributed.
Excess Business Holdings
The private foundation excess business holdings rules are now applied to donor advised funds and provide that a donor advised fund and all disqualified persons (donor, donor advisors, their family members and 35% controlled entities) may not own more than 20% of any business, including unincorporated businesses. Donor advised funds that currently own more than 20% of any business will be required to divest their holdings in accordance with a schedule based upon the percentage ownership in the entity by the donor advised fund and disqualified persons.
Application of Intermediate Sanctions
For purposes of Code Section 4958 (intermediate sanctions), donors and donor advisors with respect to a donor advised fund and investment advisors to the sponsoring organization are now considered disqualified persons. Thus, the penalty taxes imposed on excess benefit transactions would be applied to transactions between the donor advised fund and these disqualified persons.
In addition, the PPA provides that any grant, loan,
compensation or other similar payment from a donor advised fund to a person who
is a donor, donor advisor or related party is automatically treated as
an excess benefit transaction with the entire amount of the payment
considered an excess benefit. A penalty
tax of 25% is imposed and the amount paid must be repaid and may not be held in
the donor advised fund. Certain
exceptions exist for payments directly from the sponsoring organization to
donors, donor advisors and related parties.
Taxable Distributions
The PPA now provides that certain distributions from a donor advised fund are subject to tax. The following distributions are prohibited:
§ Distributions to individuals
§ Distributions for purposes that are not charitable
§ Distributions to the following organizations if expenditure responsibility is not exercised:
o Private foundations and other organizations that are not charities under Code Section 501(c)(3), if the grant is otherwise for charitable purposes.
o A Type III supporting organization that is not functionally integrated.
o A supporting organization if the organization that is being supported is controlled by either the donor or an advisor appointed by the donor.
An excise tax equal to 20% of the amount of the distribution is imposed against the sponsoring organization, and an excise tax of 5% is imposed on any officer, director or trustee of the sponsoring organization who agreed to make the distribution knowing that is was a prohibited distribution.
In addition, if a distribution is made from the donor advised fund on the advice of a donor, a donor advisor or a person related to a donor or donor advisor and such distribution results in any of those persons receiving more than an incidental benefit as a result of the distribution, an excise tax equal to 125% of the benefit is imposed against any person who advised as to the distribution or the recipient of the benefit. The technical explanation to the legislation provides that in determining whether more than an incidental benefit exists, the rules applicable to charitable contribution deductions can be used for guidance.
A number of the PPA provisions are intended to improve accountability of supporting organizations. The primary intent of these new provisions is to identify organizations with substantial donor control and apply or mirror the private foundation excise taxes for these organizations.
The PPA imposes a number of restrictions and conditions upon supporting organizations and their funders, dependent upon their status as a Type I, Type II or Type III supporting organization. The heightened attention to this status was most recently visible when organizations were first required to disclose their status (as Type I, II or III) on their 2005 Form 990. While many supporting organizations may not have focused on this classification in the past, it will have significant importance as the PPA is implemented.
Type I Supporting Organizations
As a summary, a Type I supporting organization is operated, supervised or controlled by one or more publicly supported organizations. The relationship between a Type I and its supported organization is generally comparable to that of a parent and subsidiary. In this context, the parent exercises a substantial degree of direction over the Type I's policies, programs and activities. This control is typically established by the fact that the parent appoints or elects a majority of the Type I's officers, directors or trustees.
Type II Supporting Organizations
A Type II supporting organization is supervised or controlled in connection with one or more publicly supported organizations. The relationship between a Type II and its supported organization is generally comparable to that of a brother and sister corporation. In order to satisfy this relationship requirement, the Type II and its supported organization must demonstrate common supervision or control. In other words, the same pool of individuals must demonstrate control over both organizations (as compared to a Type I relationship where the parent exerts control over the Type I).
Type III Supporting Organizations
A Type III supporting organization is operated in connection with one or more publicly supported organizations. In order to satisfy this relationship requirement, the Type III must demonstrate that it is responsive to, and significantly involved in the operations of, its supported organization in two material respects.
First, the Type III must be responsive to the needs or demands of its supported organization by demonstrating that (i.e., the Responsiveness Test):
One Of The Following Conditions Must Be Met
§
One or more of its officers, directors, or
trustees are elected or appointed by the officers, directors, trustees, or
membership of the supported organization;
§
One or more members of the governing bodies of
the supported organization are also officers, directors, or trustees of the
Type III; or
§
The officers, directors, or trustees of the Type
III maintain a close continuous working relationship with the officers,
directors or trustees of the supported organization.
And
§
Due to this overlap, the supported organization
has a significant voice in the Type III's investment policies, the timing and
manner of making grants, the selection of grant recipients, and the use of its
income and assets.
Second, the Type III must demonstrate that it is integral to the supported organization (i.e., the Integral Part Test). To satisfy this test, the Type III must maintain significant involvement in the operations of its supported organization and the supported organization must be dependent upon the Type III for the type of support that it provides. There are two ways to satisfy the Integral Part Test, and the distinction is important for purposes of applying the PPA:
Functionally Integrated Type III Organizations
A functionally integrated Type III must establish two facts:
§ The activities the Type III engages in are activities to perform the functions of, or to carry out the purposes of, its supported organization; and
§ But for the involvement of the Type III, the supported organization would engage in these activities directly.
In sum, a functionally integrated Type III supporting organization directly conducts activities for, or on behalf of, its supported organization.
Type III Organizations That Are Not Functionally Integrated
In contrast, a Type III supporting organization that is not functionally integrated establishes its integration with its supported organization based upon the financial relationship between the two institutions. Towards this end, it must establish three facts:
- The Type III must pay substantially all of its income to or for the use of its supported organization;
- The supported organization must receive support sufficient enough to insure its attentiveness to the Type III’s operations; and
- A significant amount of the Type III’s total support must go to the supported organization.
PPA Provisions Impacting Supporting Organizations
Following are brief summaries of the principal portions of the PPA impacting supporting organizations:
- Tax-free IRA distributions may not be made to supporting organizations.
- A private foundation is not entitled to a qualifying distribution for amounts paid to (a) a Type III supporting organization that is not functionally integrated; or (b) any other supporting organization if it (or its supported organization) is directly or indirectly controlled by a disqualified person of the private foundation. In addition, payments that do not qualify as a qualifying distribution may constitute a taxable expenditure to the private foundation.
- A Type I or Type III can lose its public charity status (and become a private foundation) if it accepts any gift or contribution from a person (together with related parties) who directly or indirectly control the supported organization.
- If a supporting organization (Type I, II or III) makes a grant, loan, payment of compensation or other similar payment (e.g., expense reimbursement) to a substantial contributor (or related person or entity), the substantial contributor will be treated as a “disqualified person” for purposes of the intermediate sanctions penalties of Code Section 4958. In addition, the entire amount of the payment will constitute an “excess benefit” for which penalties apply.
- For purposes of intermediate sanctions, a “disqualified person” in relation to a supporting organization will be considered a “disqualified person” of the supported organization as well. This will require that each supported organization review and monitor these relationships to ensure that the supported organization does not inadvertently engage in an excess benefit transaction with a disqualified person.
- A supporting organization must include the following information on its Form 990 each year: (a) identify its supported organization(s); (b) indicate which type of entity it is (Type I, II or III); and (c) certify that it is not controlled directly or indirectly by disqualified persons.
- Type III organizations may not be “operated in connection with” foreign entities. Impacted organizations must fully comply with this prohibition by the first day of the third year following the Enactment Date.
- With respect to Type III organizations that are not functionally integrated, the excess business holdings rules applicable to private foundations (i.e., Code Section 4943) may apply in certain circumstances.
The following provisions of the PPA directly impact private foundations:
§ The private foundation excise taxes have doubled as a result of the PPA.
§ A private foundation is not entitled to a qualifying distribution for amounts paid to (a) a Type III supporting organization that is not functionally integrated; or (b) any other supporting organization if it (or its supported organization) is directly or indirectly controlled by a disqualified person of the private foundation. In addition, payments that do not qualify as a qualifying distribution may constitute a taxable expenditure to the private foundation.
As a result of these provisions, a private foundation should enhance its due diligence prior to making a grant to confirm whether its grantee is a supporting organization, and if so, whether it is a Type III supporting organization that is not functionally integrated.
There are a number of provisions in the PPA that will uniquely impact colleges and universities, including the following:
- As discussed above in the Charitable Giving Incentives section, the PPA authorizes tax-free distributions from an IRA to a qualified charitable organization. However, distributions may not be made to supporting organizations within the meaning of Code Section 509(a)(3). Therefore, while donors can make IRA distributions directly to a college or university, they cannot make tax-free distributions to an institution’s supporting organization.
- Forms 990-T will now be subject to public disclosure. Sensitive information, however, may be redacted before publication.
- For purposes of Code Section 4958 and the application of intermediate sanctions, a “disqualified person” of a supporting organization is also a “disqualified person” of the supported organization. In the context of a college or university, the institution must implement procedures to gather this data from its supporting organizations and implement safeguards so that the institution does not inadvertently engage in an automatic excess benefit transaction with a disqualified person (e.g., by virtue of paying compensation for personal services, expense reimbursements, etc.).
- The PPA dramatically tightens the rules regarding supporting organizations. If your institution has a supporting organization, it will be important to understand the impact of these new rules, as described above in the Supporting Organizations section. In addition, there are several planning opportunities that may allow you to avoid some of the restrictions present in the PPA.
- The PPA permanently extends the protections afforded § 529 college savings plans that were scheduled to expire at the end of 2010.
If you have questions regarding the PPA or its impact upon your institution, we encourage you to contact Gina M. Giacone or Marilee J. Springer.
This information is based on our continuing analysis of the PPA. Every effort has been made to ensure the
accuracy of this information. However,
due to the complexity of the PPA and the fact that many of these provisions
introduce issues that are new to the Internal Revenue Code, please understand
that this information is subject to change.
This publication is intended for general information purposes only and
does not and is not intended to constitute legal advice. The reader must
consult with legal counsel to determine how laws or decisions discussed herein
apply to the reader's specific circumstances.
©2006 Ice Miller LLP