Estate Planning & Administration

This legislation makes significant changes in federal tax laws affecting charities and pensions Some of these changes are discussed in further detail in our "Focus on Foundations" section appearing on page 7, and "New Hurdles for Employers Who Obtain New Corporate Owned Life Insurance" on page 4, but other major changes are set forth below:

One of the most noteworthy changes is the ability of taxpayers to exclude up to $100,000 per year from their income when they make a "qualified charitable distribution" from their IRA or Roth IRA. You must have attained age 70 1/2 on the date of the distribution and the distribution must occur in tax years 2006 and/or 2007. A "qualified charitable distribution" is a direct distribution from an IRA or Roth IRA to a public charity or a "conduit private foundation" that would otherwise be subject to income tax. Donor advised funds, supporting organizations, and most private foundations are specifically excluded from the definition of "qualified charitable distribution."

Taxpayers who take advantage of this rule are not entitled to a deduction for the contribution, but income exclusion generally results in an even more favorable outcome for the taxpayer (especially for taxpayers in states like New Jersey that do not allow a charitable income tax deduction). Furthermore, the law favorably provides that, for taxpayers who have made both deductible and non-deductible contributions to their IRA, the qualified charitable distribution ("QCD") will withdraw the taxable portion of the IRA before the non-taxable portion. This is a substantial change from current law which requires each distribution to carry out an allocable portion of both the taxable and non-taxable funds.

Example: 72 year-old Mr. Smith's IRA is comprised of $80,000 attributable to deductible contributions and $120,000 attributable to non-deductible contributions. In 2006, when Mr. Smith directs a $100,000 distribution from his IRA to the American Red Cross, $80,000 of the distribution will be a QCD and will be excluded from Mr. Smith's 2006 federal and New Jersey taxable income. The remaining $20,000 does not qualify for the QCD income exclusion because it is not otherwise subject to income tax upon its withdrawal from the IRA, but Mr. Smith may include the $20,000 as an itemized charitable deduction on his Form 1040 Schedule A.

Distributions from qualified tuition plans (which are more commonly known as "529 plans") are not subject to tax if used to pay qualified higher education expenses of the designated beneficiary such as tuition, fees, books and (in most instances) room and board. If a distribution is not used to pay qualified higher education expenses, the earnings distributed from 529 plans are subject to tax. In addition, a 10% excise tax is generally imposed.

Most of the benefits associated with 529 plans were set to expire at the end of 2010. The Act has now permanently extended those benefits.

Effective for distributions made after 2007, distributions from qualified retirement plans, tax-sheltered annuities and governmental 457 plans may be directly rolled over to a Roth IRA (subject to the rules that apply to transfers from traditional IRAs to Roth IRAs). The rollover would be included in income (except to the extent that it represents a return of after-tax contributions).

Individuals with adjusted gross income of $100,000 or more cannot presently roll over amounts from tax-qualified retirement plans directly to Roth IRAs. But, for tax years beginning after 2009, individuals will be able to make rollovers from qualified retirement plans, tax-sheltered annuities and governmental 457 plans to Roth IRAs even if their adjusted gross income is $100,000 or more, since the $100,000 adjusted gross income limit for rollovers from traditional IRAs to Roth IRAs will be repealed beginning that year.

Distributions to a surviving spouse from qualified retirements plans, tax-sheltered annuities and governmental 457 plans may generally be rolled over to an IRA tax-free within 60 days of receipt. Under prior law, nonspouse beneficiaries were not allowed to roll over distributions.

The Act amended the rollover rules to provide that benefits of a beneficiary other than a surviving spouse under a qualified retirement plan, tax-sheltered annuity or governmental 457 plan may be transferred directly to an IRA. The IRA is treated as an inherited IRA of the nonspouse beneficiary. Distributions from the inherited IRA are subject to the required minimum distribution rules applicable to nonspouse beneficiaries (i.e., distributions from the IRA must be taken annually based upon the nonspouse beneficiary's life expectancy).

The new Act provides new recordkeeping rules for charitable contributions. Under the new law, no deduction will be allowed for the donation of clothing or household items unless the property is in good used condition and has more than minimal monetary value. Furthermore, for any donation of cash, regardless of value, the taxpayer must be able to substantiate the donation with a bank record or written communication from the donee organization showing the name of the donee organization, the date of the contribution, and the amount of the contribution.

A charitable deduction for a contribution of tangible personal property exceeding $5,000 will now be reduced or recaptured if the donee organization sells the property within 3 years of the contribution unless the donee organization certifies in writing: (1) that the property was related to the tax-exempt purpose of the organization and how the property furthered that purpose; and (2) why the organization's use of the property became impossible or infeasible to implement.

The Act also impacts charitable giving by providing tighter restrictions on donations of fractional interests in tangible property. Prior to the enactment of the law, donors could make deductible contributions of partial interests in tangible personal property (such as artwork) as long as the donor transferred an undivided fraction or percentage of all of the donor's rights and interest in the property and the donee's use of the property furthered its exempt purposes. Taxpayers were also entitled to make additional gifts in subsequent years of fractional interests in the same property. The value of the contribution, including additional contributions of the same property in subsequent years, was based upon the fair market value of the property at the time of the contribution. If the use of the property did not further the exempt purposes of the donee organization, or if the donee organization was a private non-operating foundation, the value of the contribution was based upon the taxpayer's basis in the property.

The new rules do not change current law for the initial contribution of a partial interest in property, but do require a different calculation of the value of the contribution for subsequent gifts of an interest in the same property. Now, the value of the subsequent contribution is the lesser of: (1) the value used for purposes of determining the charitable deduction for the initial fractional contribution; or (2) the fair market value of the item at the time of the subsequent contribution. Furthermore, if a donor makes an initial fractional contribution and then fails to contribute the donor's remaining interest in the property within 10 years of the initial contribution, the value of the donor's deduction will be recaptured, with interest and a 10% penalty. A recapture of the deduction (plus interest and the 10% penalty) will also occur if the donee fails to take substantial physical possession of the property in a way that furthers the organization's exempt purposes within 10 years. The new rules will deny the charitable deduction altogether unless all of the ownership interests in the property are held either by: (1) the donor, or (2) the donor and the donee immediately prior to the contribution. However, the IRS is authorized to make an exception to this rule if all persons who hold an interest in the property agree to make contributions of their partial interests to the donee organization.

Example: Ms. Jones is an avid collector of contemporary sculpture. In 2006, she donates an undivided 25% interest in a sculpture worth $4,000,000 to a local museum. As part of the contribution agreement, the museum is entitled and does take possession of the sculpture for 3 months every year. Ms. Jones is entitled to a $1,000,000 deduction on her 2006 income tax return. In 2009, she donates another 25% interest in the sculpture, but because the artist has died in the interim, the piece is now worth $8,000,000. Ms. Jones's 2009 deduction will be limited to the lesser 2006 value of the sculpture ($1,000,000). Furthermore, if Ms. Jones does not donate 100% of the sculpture to the museum by 2016, the IRS will recapture all of the deductions taken on Ms. Jones's income tax returns attributable to the donation of the sculpture with interest and also assess 10% of the amount recaptured as a penalty. Also, if Ms. Jones had died in 2009 and bequeathed her remaining interest in the sculpture to the museum, the charitable deduction for estate tax purposes would be limited to the 2006 value, or $3,000,000 (75% of $4,000,000), thus triggering an estate tax since the date of death value of the property includible in her estate is $6,000,000.

If an S corporation makes a charitable contribution, the deduction for that charitable contribution is passed through to its shareholders and the basis of the shareholders' stock in the S corporation is reduced. The Act added a provision addressing the amount by which the shareholder will reduce the basis of his or her stock where the S corporation makes a charitable contribution. The new provision provides that, for charitable contributions made by an S corporation in taxable years beginning in 2006 or 2007, the amount of the shareholder's basis reduction will be the shareholder's pro rata share of the basis of the contributed property (as opposed to the shareholder's share of the fair market value of the contributed property).

This provision can be beneficial to a shareholder in cases where the S corporation makes a charitable contribution of appreciated property and the shareholder is able (under the general charitable contribution rules) to take a deduction for his or her share of the fair market value of the contributed property. Although the shareholder will deduct his or her share of the fair market value of the contributed property, the shareholder will only have to reduce the basis of the stock by his or her share of the basis of the contributed property. Since any basis reduction will result in a larger gain when the stock is later sold by the shareholder, the shareholder benefits by having that reduction based on the (lower) basis of the property rather than the (higher) fair market value.