Robert P. Goldman Goulston & Storrs, P.C., Boston

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1 Pension Protection Act of 2006 (the Act ) Provisions Affecting Certain IRA and Qualified Plan Provisions, Charitable Giving and Tax Exempt Organizations Robert P. Goldman Goulston & Storrs, P.C., Boston The Act was signed by the President on August 17, Various provisions of the Act have different effective dates as described below. 1. Certain IRA and Qualified Plan Provisions IRA Rollovers Direct to Charities. Section 408(d) now excludes from certain taxpayers income distributions directly from a traditional IRA or Roth IRA to certain public charities, up to $100,000 per year, for tax years 2006 and 2007 only. Only taxpayers who have reached age 70 ½ are eligible for the exclusion. The age 70 ½ requirement applies to the individual for whose benefit the plan is maintained, presumably referring not just to an original owner of an IRA but also to a beneficiary of an inherited IRA. The charitable distribution will count toward satisfaction of the owner/beneficiary s required minimum distribution under Section 401(a)(9). Qualifying charities are those described in Section 170(b)(1)(A), namely religious organizations, schools, hospitals, and any other organization qualifying as a public charity because it normally receives a substantial amount of its support from government grants or from the general public. Specifically excluded from the class of charities are Section 509(a)(3) supporting organizations and donor advised funds. The exclusion only applies to the extent the IRA distribution would have been included in the taxpayer s gross income; however, in applying this provision, there is a special override of normal Section 72 rules that allows the charitable distribution to represent taxable income to the maximum extent that there would be taxable income if the entire IRA had been distributed to its owner/beneficiary. Charitable distributions excluded from the taxpayer s income are not deductible by the taxpayer and are not counted when applying limitations on the taxpayer s charitable deduction. However, the quid pro quo and substantiation rules of Section 170 do apply, reducing the exclusion to the extent that the IRA owner/beneficiary receives value in return for the contribution, and requiring that the owner/beneficiary obtain a tax receipt from the charity. Goulston & Storrs, A Professional Corporation Boston DC London* New York 400 Atlantic Avenue, Boston, Massachusetts (617) Tel (617) Fax *A Subsidiary of Goulston & Storrs, PC

2 Page 2 IRA Trustees are not required to permit direct charitable distributions, and given the short duration of the new law and the liability the Trustee faces if it fails to withhold taxes on a distribution that turns out not to be to a qualified charity, implementation of this opportunity may be limited. In any event, the opportunity seems attractive mostly to donors whose charitable deductions are hitting up against various limitations, or for donors looking for relief from state income taxes. IRA Rollovers for Non-Spouses. New Section 402(c)(11) permits non-spouse beneficiaries of qualified plans to rollover plan assets to an IRA. This does not give non-spouses all of the same rights as with a spousal rollover (such as rolling to the spouse s own IRA where required minimum distributions don t begin until the spouse is 70 ½, and where the spouse can designate another beneficiary and further extend the timing of minimum distributions). Rather, the provision is intended to assist a non-spouse beneficiary who, following the death of an employee/owner, might otherwise be required to take a lump sum subject to immediate income tax where the employer s plan does not permit a non-spouse beneficiary to elect to receive distributions under the minimum distribution rules. Under the new law, the non-spouse may request a direct trustee-to-trustee rollover to an IRA which will be treated as an inherited IRA and enjoy deferral of income taxes, subject to the usual minimum distribution rules of Section 401(a)(9). This provision, effective for distributions beginning January 1, 2007, may be especially attractive to same-sex couples married in Massachusetts, who are treated as non-spouses under federal law. Direct Deposit of Tax Refunds to IRAs. The IRS will now be required to offer direct deposit of any income tax refund to the taxpayer s IRA. Presumably the usual rules will apply regarding the year in which an IRA contribution is deducted and any limitations on the deduction. 2. Charitable Contribution Reforms. No More de minimus Exception from Substantiation Requirements. The substantiation requirements of Section 170(f)(8) remain in place: to deduct gifts above $250, the taxpayer must be able to substantiate the contribution with a contemporaneous written acknowledgement from the charity that describes the amount of cash or describes the property donated, and states whether the charity has provided any goods or services in exchange for the contribution. Now new Section 170(f)(13) provides that regarding all contributions by cash or check, the donor must maintain either a bank record (cancelled check or credit card statement) or a written communication from the charity confirming the gift. Prior to this new statute, regulations had provided that small charitable gifts could be substantiated by other reliable written records such as the donor s checkbook register. Contributions of Used Clothing and Household Items. New Section 170(f)(16) denies a charitable deduction for contributions of clothing and household items unless they are in good used condition or better, and the IRS has been authorized to issue regulations denying a deduction for a contribution of clothing or a household item that has minimal monetary

3 Page 3 value. However, a taxpayer will nevertheless be able to deduct any such single item worth $500 or more by attaching to the return a qualified appraisal of the item. Taxpayers will likely begin asking for charity receipts that describe donated items as in good used condition. Contributions of Tangible Personal Property Followed by Premature Disposition. The general rule of Section 170(e)(1)(B) is that a deduction for the contribution of tangible personal property is limited to the donor s basis in the property if the use of the property by the donee charity is unrelated to the charity s exempt purposes. That Section has now been amended to also limit the deduction to the donor s basis if the charity disposes of the property in the same tax year in which the contribution was made. New Section 170(e)(7) provides for recapture of any portion of the deduction that exceeded the donor s basis where the charity disposes of the tangible personal property after the year in which the contribution was made and within three years of the date of the contribution (such recaptured portion to be included in the donor s income in the year of such disposition). But such limitation on the deduction and such recapture of a portion of the deduction can be avoided if the charity provides a certification that either (i) the property s use was in fact related to the charity s exempt purposes (the certification must describe how the property was used and how such use furthered the charity s exempt purpose) or (ii) that the property s intended use (described in the certification) would have been related to the charity s exempt purposes but such intended use became impossible or infeasible to implement. These new provisions are applicable for contributions after September 1, 2006, and apply only where the deduction claimed exceeds $5,000. Note that in Silverman, TC Memo , where a donor placed a condition on a charitable gift of artwork that the donee charity not sell the art for three years, the court reduced the value of the contributed property to reflect the restriction. There is a new $10,000 tax penalty on any person who knowingly and falsely identifies donated property as having a use related to the charitable donee s exempt purposes (presumably such person could be the donor or the donee). Gifts of Fractional Interests in Tangible Personal Property. Generally a donor can only deduct gifts of undivided interests in property, meaning a gift of a fractional interest in property is deductible but a gift of use of property for a stated time period is not. The gift must consist of a fraction of each and every substantial right that the donor has in the property, and for fractional interests of less than 100% the charitable donee must be given the right as a tenant in common with the donor to possession and control of the property for a portion of each year appropriate to its interest in the property. Class of owners limited to donor and charitable donee. New Section 170(o) provides that no deduction is available for a contribution of an undivided fractional interest in tangible personal property unless immediately before the contribution all interests in the property are held either by the donor or by the donor and the donee charity. So a taxpayer will be

4 Page 4 permitted to deduct an initial contribution of an undivided fractional interest in an item of tangible personal property ( initial contribution ), and to deduct gifts of further undivided fractional interests in the same item in future years ( additional contributions ), but only so long as the charity still retains the interests it has received. The IRS is authorized to issue regulations that will permit separate donors who own undivided interests in the same item to simultaneously make proportional contributions of such interests to the same charity. Valuation. In addition, new Section 170(o) requires that if a deduction is claimed for an initial contribution of an undivided fractional interest in tangible personal property and later a deduction is claimed for an additional contribution of an undivided fractional interest in such property, the donor may not value the item of property at the time of an additional contribution any higher than its value at the time of the initial contribution. Therefore, the donor s aggregate deductions for a series of gifts of interests in the same item can no longer be greater than the deduction would have been if a gift of the entire item had been made initially. Similar new rules now apply under the gift and estate tax, so that if a donor makes a lifetime charitable gift of a fractional interest in an item of tangible personal property, and subsequently at death leaves the balance of the interest in the item to the same charity, the value of the item for purposes of the estate tax charitable deduction can not exceed the value of such item at the time of the initial contribution. This rule would appear to result in increased estate tax if the value of the item has increased at the donor s death and the retained fractional interest must be included in the donor s estate using the higher value but can be deducted only using the lower value, a trap that will likely end the use of fractional interest charitable gifts. Recapture. To further discourage making gifts of undivided fractional interests in an item of tangible personal property, new Section 170(o) provides for the recapture of a charitable deduction claimed by the donor for all contributions of such interests if the donor has not completely donated all of his interests in the property to the charitable donee (or if the initial charitable donee is no longer in existence, to any other charitable donee) by the earlier of 10 years after the initial contribution and the donor s death. There is also recapture if during such period the charitable donee has not had substantial possession of the property and has not used such property in a manner related to its exempt purposes. Similarly, there is now recapture of the gift tax charitable deduction where charitable gifts of an item are not completed in the specified time period. The recapture takes the form of taxing the amount of recaptured deductions in the year in which the recapture is triggered, and paying interest on any additional tax due running from the due date of the tax that would have earlier been paid had the deduction not been claimed. Further, with any recapture there is an added tax penalty of 10% of the amount recaptured. The recapture rules will apply to gifts made after August 17, 2006, and any initial contributions or additional contributions made before that time will not be recognized in

5 Page 5 applying the new rules. Taxidermy Property. Knocking the stuffing out of inflated values of hunting trophies, new Section 170(e)(1)(B)(iv) provides that the deduction for a gift of taxidermy property can not be greater than the donor s basis in the property even where the charity might use such property in a manner related to its exempt purposes (the lobbyists for the Institute of Contemporary Elk Horn Art were completely asleep at the switch on this one). Further, for a donor who prepared, stuffed or mounted his own taxidermy property (or who paid for such costs), only the direct costs of such preparation, stuffing and mounting may be included in basis, and basis may not include the indirect costs of hunting, killing, and transporting the animal carcass. The NRA plans a constitutional challenge. Deduction for Qualified Conservation Contributions Expanded. One exception to the general rule that a donor can only deduct gifts of undivided interests in property is a qualified conservation contribution, which includes an easement contributed to certain charitable organizations for conservation purposes such as preservation of land for recreation, education or scenic enjoyment of the public, protection of natural wildlife habitat, and preservation of certain historic land and structures. The Act encourages qualified conservation contributions of long term capital gain property by increasing the donor s Section 170(b) percentage limitation from 30% of the donor s contribution base to 50% for such contributions, and by allowing the donor whose qualified conservation contributions in any year exceed such limitation (after first deducting all other allowable charitable contributions) a 15-year carry-forward of such excess contributions (rather than the 5-year carry-forward allowed for other charitable contributions). In addition, deductions for qualified conservation contributions of certain farmers and ranchers will have a percentage limitation of 100% of the donor s contribution base plus a 15-year carry-forward of excess contributions. The expanded deduction for such farmers and ranchers applies even if they do business in corporate form and would otherwise be subject to the usual 10% percentage limitation applicable to corporations. These rules are effective only for qualified conservation contributions in 2006 and In a related provision, after August 17, 2006, the Act no longer permits a qualified conservation contribution deduction for the preservation of a non-depreciable structure such as a private residence, unless such structure is listed in the National Register (prior to the Act, it was sufficient if such structure was located in an historic district). In addition, these deductions must now be reduced by rehabilitation credits claimed by the taxpayer under Section 47 for the same building that is being contributed for preservation purposes. Deduction for Facade Easement Placed on Historic Structure. Amendments to Section 170(h)(4)(B) continue to permit a qualified conservation contribution deduction for an historic facade easement, but now only if the easements protects the entire exterior of the

6 Page 6 building (front, sides, rear, and the space above the building) and prohibits any change in the exterior that is inconsistent with the exterior s historical character. The charitable donee of the easement must certify that its purposes include conservation and preservation and that it has the resources to enforce the restriction and the commitment to do so. These changes are effective for contributions of easements after July 25, In addition, for contributions after August 17, 2006, the taxpayer s return must be accompanied by a qualified appraisal of the donated easement, photographs of the building exterior, and a description of all legal restrictions (public and private) on the development of the building. In addition, a deduction of $10,000 or more for the donation of an historic facade easement will require payment of a $500 fee at the time of filing the return, effective for contributions made after February 13, Reporting Requirement on Charity that Sells Donated Property. Current law provides that if a charity sells donated property within two years of the donation, where the donor has deducted such gift claiming a value (in combination with all similar items of property donated by that donor to the charity or other charities) in excess of $5,000, the charity must report such sale to the IRS and to the donor. This rule has been expanded to cover sales within three years of a contribution. Further, such report must now include a description of the donee charity s use of such property and whether such use is related to the charity s exempt purposes, and in the event that the use is related to such exempt purposes, the report must include the certification described above regarding the new limitation and recapture rules under Section 170(e)(1)(B) if the donor is claiming an exception to such rules. S Corporation Charitable Contribution. When an S corporation donates property to a charity, each shareholder takes into account a pro rata portion of the contribution and each shareholder is required to reduce his or her basis in the stock by such share of the charitable contribution. Prior to the Act, such reduction in stock basis was for an amount equal to the shareholder s pro rata portion of the fair market value of the donated property, which caused the shareholder to recognize more gain when the stock was subsequently sold. New Section 1367(a)(2) provides that the decrease in the shareholder s stock basis equals the shareholder s pro rata portion of the corporation s adjusted basis in the donated property. This provision is effective only for S corporation gifts to charity made in tax years beginning in 2006 or Qualified Appraisers. Charitable deductions for donations of property in excess of $5,000 continue to require that the taxpayer have a qualified appraisal prepared by a qualified appraiser. Prior to the Act, the definition of a qualified appraiser was found in regulations, and generally required that the appraiser either hold himself out to the public as an appraiser or otherwise perform appraisals on a regular basis; have qualifications to make an appraisal of the type of property being valued; and not be related to the donor or donee. Under new Section 170(f)(11)(E), a qualified appraiser must also have earned an appraisal designation from a recognized professional organization or otherwise have met minimum education and experience requirements and must regularly perform appraisals for

7 Page 7 compensation. Gifts and Bequests to Donor Advised Funds. Under new Section 170(f)(18), no deduction will be allowed for a contribution to a DAF that is sponsored by veterans organizations, fraternal lodges or cemetery organizations--so we are now safe from the abuse that might have been wreaked by these pariahs of society. In addition, no deduction is allowed for contributions to a DAF sponsored by a Type III supporting organization unless the organization is a functionally integrated Type III supporting organization. See below for a discussion of these defined terms. New Section 170(f)(18) is a substantiation requirement providing that, in order to claim a deduction for federal income, gift and estate tax purposes, a donor must obtain a contemporaneous written acknowledgement from the DAF s sponsoring organization that the sponsoring organization has exclusive control over the assets contributed. Accordingly, for the first time an estate must obtain and retain a tax receipt if funds pass to a DAF. 3. Donor Advised Funds. New Definition of Donor Advised Fund. For the first time, the term donor advised fund is defined in the Code, in new Section 4966(d), as a fund or account (1) that is separately identified by reference to contributions of a donor or donors, (2) that is owned and controlled by a sponsoring organization, and (3) for which a donor or any other person appointed or designated by the donor has, or reasonably expects to have, advisory privileges with respect to investments or distributions by reason of the donor s status as a donor. New Tax on Taxable Distributions from DAFs. Effective after August 17, 2006, new Section 4966 provides for a tax on a taxable distribution from a DAF. The tax is 20% of the taxable distribution and must be paid by the DAF s sponsoring organization; in addition, any fund manager who agreed to the distribution knowing it was a taxable distribution must pay a tax of 5% of the distribution (to a maximum of $10,000). A taxable distribution is any distribution from a DAF to (1) an individual or (2) any other organization or entity if the distribution is for any purpose other than the charitable purposes listed in Section 170(c)(2)(B) (except that if the organization or entity is not so described, a taxable distribution can still be avoided if the DAF exercises expenditure responsibility). However, a distribution from a DAF is explicitly not a taxable distribution if it is made to (1) a publicly supported organization, excluding certain supporting organizations that might otherwise be publicly supported, (2) the DAF s sponsoring organization, or (3) another DAF. Bottom line: DAFs will now go beyond checking to see that an intended grantee is exempt under Section 501(c)(3) and will need some form of assurance either that the grant will be used for charitable purposes or that the grantee is a publicly supported organization.

8 Page 8 New Tax on Benefits Received by a DAF Donor, a DAF Donor Advisor, and Related Persons. Effective August 17, 2006, new Code Section 4967 taxes any incidence where a DAF distribution provides more than incidental benefit to a donor of the DAF or others with advisory privileges and others related to them. A tax of 125% of the excess benefit must be paid by the donor or donor advisor, and also a tax of 10% of the excess benefit is imposed on a DAF manager that knows that such a distribution will provide such a benefit. The committee reports indicate that more than incidental benefit will mean any benefit beyond those incidental benefits that current law says can be received by a donor from a charity and not reduce such donor s charitable deduction. Rev. Proc , for example, provides guidelines to charities on this topic that includes safe harbors for (1) benefits that don t exceed in value the lesser of 2 percent of the contribution or $50 (adjusted for inflation); or (2) low cost items such as book marks, calendars and key chains; or (3) newsletters and non-commercial quality publications. Likely target of this new rule: donors using a DAF to satisfy a personal pledge to a charity, or a donor accepting tickets to an event where payment was via a DAF. Intermediate Sanctions Rules Applied to DAFs. DAFs have always been subject to the socalled intermediate sanctions rules that apply to all public charities--generally penalizing excess benefit transactions between public charities and certain insiders labeled disqualified persons (persons in a position to exercise substantial influence over the affairs of the charity, including substantial contributors, board members, and certain employees) where the benefits paid to the disqualified person are in excess of the value of the goods or services provided by such person to the charity. The most common potential excess benefit transaction is compensation by the charity paid to a disqualified person for services provided, and the regulations provide a safe harbor for how a charity can determine that such compensation is not excessive. Under new Section 4958(f), all donors, donor advisors and related parties are considered disqualified persons with respect the application of intermediate sanctions rules to a DAF. This rule will place more scrutiny on transactions we have seen in the past, where a donor gives closely-held securities to a DAF and then the donor or an affiliate of the donor purchases the securities from the DAF. In addition, investment advisors to DAFs or their sponsoring organization will be treated as a disqualified person. Thus, compensation arrangements between a commerciallysponsored DAF and the sponsor s for-profit investment management company that manages the DAF funds will come under closer scrutiny. Further, with respect to DAFs, the term excess benefit transaction includes any grant, loan, compensation or similar payment to a donor, donor-advisor or related person, regardless of whether the payment is reasonable and not in excess of the value of the services provided by such persons.

9 Page 9 DAFs Now Subject to Private Foundation Rule Against Excess Business Holdings. Section 4942 of the Code, which prohibits a private foundation from owning too much of any one business, now applies to DAFs. Typically, a foundation will be considered to have excess business holdings if it and any of its contributors, directors or trustees (and related parties) together own more than 20% of the voting stock or more than 20% of the profits interest in a business enterprise. The permissible percentage rises to 35% if it can be demonstrated that none of these disqualified persons effectively controls the business. An initial tax of 5% of the excess business holdings applies following any available disposition periods, and thereafter an additional tax of 200% of the excess business holdings applies if the foundation does not dispose of the excess business holdings by the end of a defined period of time. The disposition periods range from 90 days where the foundation purchased the excess business holdings, to 5 years where it was obtained by gift or bequest (and an additional 5 years may be granted under certain circumstances). For tax years beginning after August 17, 2006, a DAF will be subject to these same rules, with more lenient transition rules to apply to assets owned by the DAF on the effective date. Other DAF Rules. Organizations applying for tax exempt status that intend to sponsor a DAF must now disclose information about the DAF on Form 1023, or if the organization is already tax exempt, by other written notice to the IRS. In addition, charitable organizations that sponsor DAFs will now have to disclose information about the DAF on Form Supporting Organizations. New Definitions of Type I, II, and III Supporting Organizations, and Tighter Control on Type III Supporting Organizations. Section 509(a) defines a private foundation to include all 501(c)(3) organizations other than the exceptions described therein. Two of the exceptions describe organizations that receive substantial support from the public (so-called publicly supported organizations ), and a third exception describes organizations that are organized and operated exclusively for the support of one or more publicly supported organizations (so-called supporting organizations ). The statute has always vaguely described (and regulations have clarified) three alternative requirements for a supporting organization, one of which must be met, and now the statute has been modified to make more clear what the three choices are: the supporting organization must be operated, supervised or controlled by the supported organization (commonly known as a Type I supporting organization ); regulations provide the requirement is satisfied if the supporting organization has a majority of its directors appointed by the supported organization; or the supporting organization must be supervised or controlled in connection with the supported organization (commonly known as a Type II supporting organization ); regulations provide the requirement is satisfied if a majority of the supporting organization s directors are appointed by the same individuals who control the supported organization; or

10 Page 10 the supporting organization must be operated in connection with the supported organization (commonly known and now defined in the Code as a Type III supporting organization ); regulations provide the requirement is satisfied by satisfying each of two further tests: 1. Type III Responsiveness Test. Prior to the Act, regulations provided that this test could be satisfied by either of the following conditions: one of the following three relationships must result in the supported organization having a significant voice in the supporting organization s investment policies and the use of the supporting organization s income and assets: (i) the supported organization has the right to appoint at least one director of the supporting organization; or (ii) at least one director of the supporting organization is in fact a member of the governing body of the supported organization; or (iii) the directors and officers of the supporting organization maintain a close and continuous relationship with the directors and officers of the supported organization; or the supporting organization is a charitable trust under state law and the supported organization is a named beneficiary of the trust with the power under law to enforce the trust and compel an accounting. As discussed below, the creating a Type III supporting organization as a charitable trust under state law is no longer sufficient to satisfy the Type III Responsiveness Test. 2. Type III Integral Part Test. A supporting organization must show it has significant involvement in the operations of the supported organization and that the supported organization is dependent upon the supporting organization for support. Prior to the Act, regulations provided that this requirement could be met in one of two ways: either (i) the supporting organization must show that it sends substantially all of its income to the supported organization and the amount of support is sufficient to ensure the attentiveness of the supported organization to the supporting organization s operations (see changes from the Act discussed below); or (ii) the supporting organization must show that it performs an important function of the supported organization and that, but for its activities, the supported organization would have to conduct those activities itself. Under the Act, there are now additional requirements for a Type III supporting organization: new Section 509(f) authorizes the IRS to issue regulations under the Type III Responsiveness Test requiring that the supporting organization report information to the supported organization, such as any changes to its governing instruments and to its tax status, and providing copies of financial and tax reports; Act Section 1241(c) (there is no change to the Code) provides that the Type III Responsiveness Test can no longer be met solely by creating a charitable trust under state

11 Page 11 law, naming the supported organization as a beneficiary, and providing that the supported organization may compel an accounting of the trust. This change is effective on August 17, Act Section 1241(d) directs that new regulations be issued under the Type III Integral Part Test directing a Type III supporting organization that is not a functionally integrated Type III supporting organization to distribute a percentage of either income or assets to the supported organization, because the current regulation s reference to substantially all income did not ensure that a significant amount of income is in fact paid to the supported organization. The term functionally integrated Type III supporting organization is defined in new Section 4943(f)(5) and generally describes a Type III supporting organization that satisfies the Type III Integral Part Test by performing an important function of the supported organization that, but for such performance by the supporting organization, the supported organization would have to conduct such function itself. Section 509(f) also provides that the supported organization must be organized in the United States (for Type III organizations that currently support a foreign organization, this provision is not effective until the start of the third tax year following August 17, 2006). Control of Supported Organization by Supporting Organization Donor. Section 509(a) has always had an additional requirement that the supporting organization cannot be controlled, directly or indirectly, by certain disqualified persons such as substantial contributors (or related parties) to the supporting organization. Under new Section 509(f), Type I and Type III supporting organizations will lose their status as a supporting organization if they accept any gift or contribution from a person who controls (alone or in conjunction with related parties) the supported organization. Apparently, in an effort to make supporting organizations increasingly responsive to the supported organization, there was concern that oversight by the supported organization might be compromised if persons who control the supported organization are also donors to the supporting organization. Private Foundation Grants to Supporting Organizations. Under new Section 4942(g)(4), a private foundation s requirement to distribute a minimum amount to public charities each year (the so-called 5% minimum distribution requirement ) can no longer be satisfied with grants to certain supporting organizations: Grants to a Type III supporting organization will not count toward the private foundation s 5% minimum distribution requirement unless the grantee is a functionally integrated Type III supporting organization. This term, which new Section 4943(f)(5) defines primarily by cross-reference to regulations not yet written, will generally describe a Type III supporting organization that satisfies the Type III Integral Part Test by performing an important function of the supported organization that, but for such performance by the supporting organization, the supported organization would have to

12 Page 12 conduct such function itself (so it is insufficient that the Type III supporting organization merely sends all of its income to the supported organization). Grants to Type I supporting organizations, Type II supporting organizations, and to functionally integrated Type III supporting organizations will still not count toward the private foundation s 5% minimum distribution requirement if a disqualified person with respect to the private foundation controls such supporting organization or if such a disqualified person controls any supported organization supported by such supporting organization. And just to be sure that the Code provides the maximum deterrence against private foundations granting to supporting organizations, new Section 4942(g)(4)(A) authorizes regulations to describe additional circumstances under which a grant of a private foundation to a supporting organization is inappropriate and therefore will not satisfy the 5% minimum distribution requirement. Further, grants by a private foundation to the above-described supporting organizations will constitute taxable expenditures under Section 4945, but the usual relief from a grant to another organization being a taxable expenditure is available: the private foundation making the grant must conduct expenditure responsibility (involving some important but not onerous obligations to monitor the grantee s use of the granted funds). Intermediate Sanctions Rules Applied to Supporting Organizations. The intermediate sanction rules have always applied to excess benefit transactions between a supporting organization and a disqualified person. Under new Section 4958(c)(3), the term excess benefit transaction includes any grant, loan, compensation or similar payment to a substantial contributor (or related person) to the supporting organization, regardless of whether the payment is reasonable and not in excess of the value of the services provided by such person; similarly, there is an automatic excess benefit transaction regarding any loan to other disqualified persons (anyone in a position to exercise substantial influence over the supporting organization). This new rule is applicable to any transaction occurring after July 25, Further, effective after August 17, 2006, new Section 4958(f)(1)(D) adds to the list of disqualified persons with respect to a supported organization anyone who is otherwise a disqualified person with respect to the supporting organization Supporting Organizations Now Subject to Private Foundation Rule Against Excess Business Holdings. Section 4942 of the Code, which prohibits a private foundation from owning too much of any one business, applies to the following supporting organizations for tax years beginning after August 17, 2006: a Type III supporting organization other than a functionally integrated Type III supporting organization; and

13 Page 13 a Type II supporting organization that accepts any gift or contribution from a person who controls (alone or in conjunction with related parties) the supported organization. As with the new application of the rule against excess business holdings to donor advised funds, there are lenient transition rules that apply to assets owned by such supporting organizations on the effective date. Supporting Organization Reporting Requirements. The Form 990 of a supporting organization must now include a list of its supported organizations, identify whether the supporting organization is a Type I, Type II or Type III, and contain a certification that it complies with the requirement that it is not controlled by certain disqualified persons. 5. Other Private Foundation Provisions. Tax on Private Foundation s Net Investment Income. The 2% (reduced to 1% under certain circumstances) excise tax on a private foundation s net investment income has always applied to realized capital gains, but there have been inconsistencies between the Code and the regulations regarding whether the tax applies upon the sale of an asset used by the foundation directly to accomplish its tax exempt purpose (such as gain from the sale of a building that had been used as a soup kitchen operated by the private foundation); and there have been further inconsistencies as to whether the tax applies to gain from the sale of an asset not held for the production of interest, dividends, rents or royalties, such as a work of art. Revised Section 4940(c)(4)(A) and committee reports clarify that the tax applies to gain on any asset used for the production of gross investment income (which would include the art, and which would include art even if the charity sold the art immediately upon receipt of the art from a donor and so had not in fact used the art to produce the appreciation, and which would include even the sale of building housing the soup kitchen even though the charity had not in fact used the building for its appreciation). Section 4940 now includes rules similar to the like-kind exchange rules for a foundation that has held the exchanged asset for at least one year and the asset was used for a purpose constituting the basis for the foundation s exemption. Pursuant to IRS Circular 230, please be advised that, to the extent this communication contains any federal tax advice, it is not intended to be, was not written to be and cannot be used by any taxpayer for the purpose of (i) avoiding penalties under U.S. federal tax law or (ii) promoting, marketing or recommending to another taxpayer any transaction or matter addressed herein.