Assessing the Impact of the Pension Protection Act on Tax-Exempt Organizations

By James P. Sweeney, CPA, Cherry, Bekaert & Holland, L.L.P. (CB&H)
Email: jsweeney@cbh.com

On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006 (the Act). Sometimes referred to as HR 4, the Act contains many provisions – some friendly, some punitive – that directly impact the tax-exempt community, including the following changes of particular significance to tax-exempt organizations:

• Relaxation of the unrelated business income rules for payments from wholly owned subsidiaries to tax-exempt parent organizations
• A new reporting requirement for acquisitions in life insurance contracts
• Increase in excise taxes imposed on public charities, social welfare organizations and private foundations
• Expansion of the base of the tax on private foundation net investment income
• New notification requirements for exempt entities not currently required to file a 990
• Requirement that the unrelated business income tax returns of 501(c)(3) organizations be made publicly available
• Accountability improvement regulations for donor-advised funds and supporting organizations

Payments Received from Wholly Owned Subsidiaries

Over the past decade, tax law changes stopped the use of a two-tier subsidiary structure by tax-exempt parent corporations to avoid the unrelated business income tax (UBIT) on receipts received from an indirectly held, or second-tier, subsidiary. The concern was that if payments of interest, rent, annuity or royalty are deducted by a subsidiary (directly or indirectly owned) in computing its taxable income, then the receipt of these payments represents unrelated business income for the recipient parent organization.

The Act temporarily changes the tax treatment of these receipts for parent tax-exempts. Now, if a payment of interest, rent, annuity or royalty is paid at an arm’s-length value to a tax-exempt parent organization, the payment is not considered unrelated business income. On the other hand, if the payment (which will be deducted in determining the taxable income of the subsidiary) is not at arm’s length, and the amount is determined to be an excess amount, then only the excess payment is subject to UBIT and a 20% penalty. Therefore, previously taxed receipts are no longer subject to tax as long as the payments were determined to be at arm’s length. This two-year provision expires January 1, 2008.

In addition, a tax-exempt organization that receives interest, rent, annuity or royalty payments from a controlled entity must disclose such payments on its Form 990, as well as any loans made to any controlled entity and any transfers between the organization and a controlled entity. This reporting requirement applies to organizations with a tax return due date after August 17, 2006, the date of enactment, but not to return due dates extended until after that date.

New Reporting Requirement for Acquisitions in Life Insurance Contracts

With some exceptions, 501(c)(3) organizations (including those organized outside the United States), governments or political subdivisions of a government, and Indian tribal governments are required to report acquisitions of interests in any life insurance, annuity or endowment contract in which both the reporting organization and a person other than the reporting organization have directly or indirectly held an interest (whether or not at the same time).

Guidance has yet to be issued as of the date of this newsletter; however, the information that must be disclosed to the IRS includes the name, address and taxpayer identification number of the organization and of the issuer of the applicable insurance contract, and such other information as the Secretary of the Treasury prescribes.

Penalties: Double Your Money

Public charities and private foundations will now be penalized double for entering into or not entering into certain transactions, essentially making it more expensive to disregard the rules and regulations that apply to tax-exempt organizations. For acts of self-dealing by a private foundation to a disqualified person, the Act increases the initial tax on the amount involved from 5% to 10%, the initial tax on foundation managers from 2.5% to 5%, and the dollar limitation on the amount of initial and additional taxes on foundation managers from $10,000 to $20,000 per act. Similarly, the Act doubles the dollar limitation on organization managers of 501(c)(3)s and 501(c)(4)s for participation in excess benefit transactions from $10,000 to $20,000 per transaction.

For private foundations, the initial tax for failing to distribute income has increased from 15% to 30% of the undistributed amount, and the initial tax on the value of excess business holdings has increased from 5% to 10%. The initial tax imposed on the foundation and its managers for jeopardizing the foundation’s investments has increased from 5% of the investment amount to 10%. The dollar limitation on the initial tax on foundation managers of $5,000 per investment has increased to $10,000, and the dollar limitation on the additional tax on foundation managers has increased from $10,000 per investment to $20,000.

The initial tax on the amount of taxable expenditures has also increased from 10% to 20%, and the initial tax on the foundation manager has increased from 2.5% to 5%. The dollar limitation on the initial tax on foundation managers has increased from $5,000 to $10,000, and the dollar limitation on the additional tax on foundation managers has increased from $10,000 to $20,000.

More Tax to Pay on Private Foundation Investment Income

The Act also expands the definition of private foundation net investment income subject to tax. Case law has shaped the application of the excise tax on net investment income in the past, and Congress amended the definition of gross investment income (including for purposes of capital gain net income) to include items of income similar to the items presently enumerated in the Code.

Such similar items include income from notional principal contracts, annuities and other substantially similar income from ordinary and routine investments, as well as capital gains from appreciation, including capital gains and losses from the sale or other disposition of assets used to further an exempt purpose. However, certain gains and losses on a like-kind exchange of any property used for a purpose constituting the foundation’s exemption basis for other property to be used primarily for a similar purpose are not taken into account in determining capital gain net income. Rules similar to the rules of IRC §1031 also apply, and there are no carrybacks of losses from sales or other dispositions of property.

No Return Requirement? Now There Is Disclosure!

Under this new law, tax-exempt organizations previously excused from filing a 990 (generally for having gross receipts below $25,000) are now required to submit annually, in electronic form, the organization’s legal name and other names under which the organization operates or does business, mailing address, Web site address, and taxpayer identification number, as well as the name and address of a principal officer and evidence of the organization’s continuing basis for its exemption from the generally applicable information return filing requirements. These organizations are also now required to furnish a termination of existence should they cease operations.

Should an organization fail to provide the required notice for three consecutive years, its tax-exempt status will be revoked. Moreover, this rule is extended to include those organizations which should have filed Form 990, but did not. If an organization that is required to file a 990 under IRC §6033(a) fails to file for three consecutive years, that organization’s tax-exempt status is revoked.

This provision is effective for notices and returns with respect to annual periods beginning on or after January 1, 2007. Organizations that do not file Form 990 for reasons other than the gross receipts test (e.g., religious organizations or affiliates of governments) are not subject to this provision.

501(c)(3)s: Hand Over Your 990-T

The Act also extends public inspection laws, disclosure requirements and penalties applicable to Form 990 to the UBIT return (Form 990-T) of 501(c)(3) organizations. The provision provides that certain information may be withheld from public disclosure and inspection if public availability would adversely affect the organization, similar to the information that may be withheld under present law with respect to applications for tax exemption and Form 990 (e.g., information relating to a trade secret, patent, process, style of work or apparatus of the organization) if the Secretary determines that public disclosure of such information would adversely affect the organization.

The provision is effective for returns filed after the date of enactment. Therefore, if a Form 990-T is filed on August 18, 2006, only this return is subject to the disclosure and public inspection requirements. In effect, the “open statute rule” does not apply just yet to 990-Ts, and will not until this provision is three years old.

Donor Advised Funds and Supporting Organizations

The Act now defines a donor advised fund (DAF), which should clear up any current confusion. Prior NFP News articles have summarized the differences in the three types (I, II and III) of supporting organizations (SOs). If more interest in these two areas exists, we suggest that you contact your local CB&H tax-exempt organizations representative.

Contributions to a sponsoring organization for maintenance in a DAF are not eligible for a charitable deduction for income tax purposes if the sponsoring organization is a veterans’ organization, a fraternal society, a cemetery company or a Type III SO (other than a functionally integrated Type III SO).
The Act extends current substantiation requirements under IRC §170(f) to DAFs. Now a donor must obtain, with respect to each contribution made to a sponsoring organization to be maintained in a DAF, a contemporaneous written acknowledgment providing that the sponsoring organization has exclusive legal control over the assets contributed.

Under the Act, any grant, loan, compensation or other similar payment from a DAF to a person that with respect to the fund is a donor, donor advisor, or a person related to the donor is an automatic excess benefit transaction subject to excise tax under IRC §4958. Other similar payments include payments in the nature of a grant, loan or compensation, such as an expense reimbursement.

Certain distributions from a DAF are also now subject to tax. A “taxable distribution” is any distribution from a DAF to (1) any natural person, or (2) to any other person for any purpose other than one specified in IRC §170(c)(2)(B) (generally, a charitable purpose). If the distribution is for a charitable purpose, it will be considered taxable if the sponsoring organization does not exercise expenditure responsibility in accordance with IRC §4945(h).

For DAFs, the Act requires each sponsoring organization to disclose on its 990 the total number of DAFs owned, the aggregate value of assets held in those funds at the end of the organization’s taxable year, and the aggregate contributions to and grants made from those funds during the year.

These changes are generally effective for taxable years beginning after August 17, 2006, the date of enactment. The provision relating to excess benefit transactions is effective for transactions occurring after that date, and information return requirements are effective for taxable years ending after that date as well. Requirements relating to charitable contributions to DAFs are effective for contributions made after 180 days from August 17, 2006.

For SOs, the Act also considers a “substantial contributor” of any type of SO as a disqualified person for purposes of the excess benefit transaction. The Act defines a substantial contributor as any person who contributed or bequeathed an aggregate amount of more than $5,000 to an SO, if such amount is more than 2% of the total contributions and bequests received by the organization before the close of its taxable year. Any grant, loan, compensation or other similar payment to a substantial contributor (or person related to the substantial contributor) of an SO, is treated automatically as an excess benefit transaction.

Regardless of gross receipts, each SO must now file a 990 annually to indicate its SO type, identify its supported organizations and demonstrate that one or more disqualified persons do not directly or indirectly control the organization. Failure to provide this information will deem the return incomplete and subject to penalties. The intent is for SOs to certify that the majority of their governing body is comprised of individuals selected based on their special knowledge or expertise in the particular field or discipline in which the organization is operating, or because they represent the particular community that is served by the supported public charities.
The Act treats a Type I or Type III SO as a private foundation for all purposes if it accepts any gift or contribution from a person (other than a public charity, not including an SO) who: (1) controls, directly or indirectly, either alone or together (with persons described below) the governing body of a supported organization of the SO; (2) is a member of the family of such a person; or (3) is a 35% controlled entity, until the organization can demonstrate its qualifications as a public charity. Regulations that further limit Type III SOs (other than those that are functionally integrated) are still pending.

Lastly, a nonoperating private foundation may not count as a qualifying distribution under IRC §4942 any amount paid to a Type III SO that is not functionally integrated or any other SO if a disqualified person with respect to the foundation directly or indirectly controls the SO or a supported organization of such SO. Furthermore, any amount not considered as a qualifying distribution under this rule is treated as a taxable expenditure.

Conclusion

It is important to understand that this article is only a brief summary of the new rules that apply to tax-exempt organizations. In the next issue of NFP News, we will highlight the provisions of the Act that relate to donors of charitable organizations. Unfortunately, this is just the beginning of an anticipated whirlwind of change to the tax laws governing the nation’s tax-exempt community. Your CB&H tax-exempt organization professionals are paying very close attention to the suggestions in the Panel on the Nonprofit Sector reports, as they most likely provide the road map for what’s to come.