Winter 2007 Newsletter
CONGRESS GIVETH AND CONGRESS TAKETH AWAY:
Charitable Giving Provisions of the Pension Protection Act of 2006
by Katherine E. Ramsey
Hunton & Williams LLP
“Real charity doesn’t care if it’s tax-deductible or not.” – Dan Bennett
Mr. Bennett may be right, but it is of course essential for professionals to be able to advise their clients properly regarding the deductibility of a charitable gift for income and transfer tax purposes. On August 17, 2006, President Bush signed the Pension Protection Act of 2006 (“PPA”), P.L. 109-280, into law. Among its many provisions are new rules pertaining to the deductibility of certain charitable gifts. This article describes the most significant of these changes. Although many of them are applicable only to gifts made in 2006 or 2007, others are not. Practitioners should be familiar with all of them if they hope to help their clients avoid an unpleasant surprise.
Tax-Free IRA Distributions
A taxpayer who has attained age 70½ (at the time of the gift) may give up to $100,000 per year from his or her individual retirement account (“IRA”) to charity in 2006 or 2007 without having to include the distributed amount in his or her gross income for tax purposes. The distribution counts toward the minimum distribution requirements.
Because the distribution is excluded from income rather than deducted, it does not affect the donor’s ability to make other, deductible charitable gifts subject to the usual percentage limitations. It also does not increase the donor’s income for social security purposes or for applying the itemized deduction floors for medical and miscellaneous expenses. Even donors who do not itemize deductions or whose deductions are subject to phase-out can benefit.
It is important to note that a distribution from a donor’s Roth IRA, SEP, SIMPLE IRA or 401(k) plan is not eligible for the special treatment, nor is one made to a private foundation, supporting organization or donor-advised fund. Furthermore, the donor must be the individual for whose benefit the IRA is maintained (that is, the owner or the owner’s spouse, if he or she has rolled the IRA over into his or her own IRA or elected to treat the deceased spouse’s IRA as his or her own), and the gift must pass directly from the IRA administrator to the charity. Gifts to a split-interest trust or gifts of funds distributed to the taxpayer do not qualify.
Also, the entire distribution must be otherwise includible in gross income and deductible under Section 170 of the Internal Revenue Code (the “I.R.C.”), determined without regard to applicable percentage limitations. When applying this requirement in cases where only part of the distribution would normally be included in income under I.R.C. Section 72 (for example, if the donor has previously made non-deductible contributions to the IRA), the entire distribution is generally treated as coming first from the taxable portion.
Lastly, the donor may not receive anything from the charity in exchange for the gift. This restriction prevents a taxpayer from using an excluded distribution to satisfy a binding pledge.
Generally, an individual may deduct charitable gifts of long-term capital gain property (including real estate) to a public charity up to 30% of his or her adjusted gross income (“AGI”), with a five-year carryover period. In the case of corporations, the charitable contribution deduction for all charitable gifts is limited to 10% of the corporation’s taxable income, with a five-year carryover period.
However, for qualified conservation easements made in 2006 or 2007, the PPA allows individuals to deduct the value of the easement up to 50% of AGI. For individuals who are also “qualified farmers or ranchers” for the tax year in which the easement is placed (that is, he or she receives more than one half of his or her gross income for the year from the trade or business of farming), the AGI limit is increased to 100%. If the easement is placed on property that is used in (or available for) agriculture or livestock production, then the 100% AGI limit applies only if the easement requires that it remain available for such use. If the property is used in (or available for) agriculture or livestock production, but the easement does not ensure that it will remain available for that use, then the 50% AGI cap is applied to that donation before the 100% AGI is applied to any other donation. An individual taxpayer may carry forward any unused deduction for up to 15 years.
For example, assume an individual qualified farmer has AGI of $200,000. In 2006, he grants a $150,000 easement on non-agricultural, beachfront property and a $150,000 easement on his farm. Unfortunately, he does not preserve the right to continue farming in the latter case. The $150,000 non-qualifying farm easement is subject to the 50% AGI cap, so only $100,000 of that contribution is deductible for 2006 (the remaining $50,000 carries forward). This allowed $100,000 deduction reduces the total amount deductible under the 100% AGI cap for 2006. Consequently, only $100,000 of the beachfront easement is deductible in 2006 under that provision.
A corporate taxpayer does not benefit from the higher 50% AGI limit, but it may deduct the value of an easement given in 2006 or 2007 up to 100% AGI if (1) its stock is not publicly traded; (2) it is a qualified farmer or rancher; (3) the easement is placed upon property used in (or available for) agriculture or livestock production; and (4) the easement requires that the property remain available for such use. The deduction is limited by the corporation’s taxable income, reduced by the amount of any other deductible charitable contributions (that is, those subject to the usual 10% taxable income limit) made during the year. Like an individual, a corporate donor may carry forward any unused deduction related to a farm conservation easement for up to 15 years.
Advisors should also be aware of important related changes to the Virginia Land Preservation Tax Credit program. Effective for conservation easements granted on or after January 1, 2007, the Virginia tax benefits associated with conservation easements will become less generous. Among other provisions:
• The 50% Virginia tax credit for conservation easements is reduced to 40% of the fair market value of the easement. Va. Code Section 58.1-512.A.
• The total amount of credits that may be issued to all taxpayers for 2007 is $100,000,000 (to be adjusted for inflation in future years). Credits will be issued in the order that each complete application is received, until the cap is reached. Va. Code Section 58.1-512.D.4.a.
• Claimed tax credits of over $1,000,000 (including the value of credits allowed in the past 11 years to the same or related taxpayers with respect to the same parcel) will be subject to “verification” by the Department of Conservation and Recreation, based on criteria adopted by the Virginia Land Conservation Foundation. Va. Code Section 58.1-512.D.3.
- A sale or distribution of tax credits will incur a fee of 2% of the easement value or $10,000, whichever is less. Va. Code Section 58.1-513.C.2.
- Non-profit land conservation organizations holding one or more conservation easements will no longer be permitted to obtain credits. Va. Code Section 58.1-512.C.5.
- However, the five-year carry-forward period is extended to 10 years. Va. Code Section 58.1-512.C.1.
Gifts of Undivided Fractional Interests in Tangible Property
Perhaps in response to taxpayers who claimed charitable deductions for gifts of undivided fractional interests in artwork or other tangible property in situations that did not require the donor to give up any actual enjoyment of the property, The PPA severely restricts the deductibility of any such gifts made after August 17, 2006 in several ways.
First, in order to qualify for an income or gift tax deduction, the tangible property must be owned entirely by the donor (or the donor and the charitable donee). Future Treasury regulations or IRS guidance may extend the donation to gifts of tangible property owned by multiple individuals (for example, a donor and his or her spouse), provided all owners contribute a pro rata share of their interests.
Second, any income or gift tax deduction previously allowed will be subject to recapture (plus interest and a 10% penalty) if the donor does not contribute the remainder to the same charity (or if it is no longer existing, to another charity) before the earlier of (i) 10 years after the initial gift and (ii) the donor’s death. As drafted, the PPA creates a potential trap for the unwary if the donor dies unexpectedly within 10 years of making the gift. Even if the donor’s will bequeaths the remainder of the property to the correct charity, the recapture provisions presumably apply because the gift was not completed “before” the donor’s death.
Third, any income or gift tax deduction previously allowed will be recaptured (together with interest and a 10% penalty) if the charity does not retain “substantial” physical possession of the property and use it in a manner related to its exempt purposes during the period beginning on the date of the contribution and ending on the earlier of 10 years after the initial gift or the donor’s death.
Lastly, the PPA makes gifts of appreciating property much less attractive. If a taxpayer makes a deductible gift of an undivided fractional interest in tangible property and then later donates part or all of the remainder, the tax deduction for the second gift is limited to the lesser of (i) the value used for determining the deduction for the initial gift and (ii) the property’s fair market value at the time of the additional contribution. Presumably, then, in the case of a partial interest gift where the donor dies before the gift can be completed, not only will the income tax deduction be recaptured (together with interest and a 10% penalty), but the donor’s retained interest will also be included in his or her gross estate at its full fair market value. However, assuming that the donor leaves the remainder of the property to the charity under his or her will, the estate tax deduction associated with the bequest will be limited to the value of the property at the time of the initial gift.
Gifts of Exempt-use Tangible Property
Generally, the allowable charitable deduction for a gift of a donor’s entire interest in tangible personal property that is to be used by the donee charity in a manner related to its exempt purpose is its fair market value. If the charity will not put the property to a related use, the deduction is limited to the donor’s adjusted basis. I.R.C. Section 170(e)(1)(B)(i).
However, applicable to returns filed after September 1, 2006 (which could include donations made in 2005, if the donor’s income tax return was put on extension), if a donor gives a charity “exempt use” tangible property worth more than $5,000, but the charity either (i) sells or disposes of such property in the year of contribution or (ii) fails to certify under oath how the property will be used to further its exempt purposes, the donor’s deduction is limited to his or her adjusted basis. (The charity is subject to a $10,000 penalty if it certifies property as exempt use, if it knows that it is not.)
If the charity provides the donor with the required certification, but then sells or disposes of the claimed “exempt use” property after the last day of the year in which the gift was made but before the last day of the three-year period beginning on the date of contribution, the donor must recapture the difference between the claimed fair market value and the donor’s basis in the property.
So, if the donor makes a gift on December 31, 2006, a three-year recapture period runs from January 1, 2007 through December 31, 2009. On the other hand, if the donor makes the gift on January 1, 2007, there is a two-year recapture period from January 1, 2008 through December 31, 2009; any sale or disposition of the property during 2007 would simply limit the initial claimed deduction to basis.
Fortunately, the taxpayer may avoid recapture if the charity certifies under oath to the IRS that it intended to use the donation for its exempt purposes at the time of the contribution (and presumably, its earlier certification of such use), but that it later became impossible or infeasible actually to use it as such.
Record keeping and Substantiation Requirements
Donors have always been required to keep reliable written records of their charitable contributions in order to support their claimed deductions. For contributions of $250 or more, the donor must obtain contemporaneous written acknowledgment of the gift from the charity. I.R.C. Section 170(f)(8). Additional requirements regarding appraisals, etc. apply for contributions of high-value property. I.R.C. Section 170(f)(11).
However, for tax years beginning after August 17, 2006, any donor wishing to claim a deduction for any donation by cash, check or other monetary instrument, regardless of amount, must maintain a bank record or written communication from the charity showing the charity’s name, the date of the contribution and the amount.
Charitable Gifts by S Corporations
Effective for contributions made by S corporations in taxable years beginning in 2006 or 2007, a shareholder’s basis in his or her stock is reduced only by his or her pro rata share of the corporation’s adjusted basis in the donated property. Prior to the enactment of the PPA, the shareholder’s basis would have been reduced by the donated property’s fair market value.
Gifts of Clothing and Household Items
Although enforcement of existing valuation rules would disallow any deduction for worthless property, Congress seemed to find it necessary to address donations of used clothing or household items of questionable value specifically. Referenced by some practitioners as the “used underwear” provision, the PPA requires all items of clothing or household goods donated after August 17, 2006 to be in “good condition.” If an item is not in good condition and the claimed deduction is more than $500, the donor must attach a qualified appraisal to his or her tax return. In addition, Congress has authorized the Secretary to issue regulations denying any deduction for items of “minimal” value. Of course, it remains to be seen what will be considered “good condition” or “minimal” value.
Katherine E. Ramsey, an associate at Hunton & Williams LLP, in Richmond, Virginia, practices primarily in the areas of estate planning and administration and exempt organizations. After earning her B.A. in International Studies from Virginia Tech and an M.S. in Management from Boston University, she received her J.D. from the University of Virginia Law School in 1998. In addition to many writing projects, Ms. Ramsey has presented Virginia continuing legal education seminars on various estate planning topics and guest-lectured at the T.C. Williams School of Law at the University of Richmond. Ms. Ramsey is a member of the Virginia Gift Planning Council, the Richmond Estate Planning Council and the Richmond Trust Administrators’ Council, as well as the Legislative Committee of the Virginia Bar Association’s Section on Wills, Trusts and Estates and the Virginia Museum of Fine Arts Planned Giving Advisory Committee.