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Focus on Not-For-Profits: The American Taxpayer Relief Act of 2012 and Beyond

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On January 2, 2013, the President signed the American Taxpayer Relief Act of 2012 (the "Act") into law. From the viewpoint of many charitable organizations, the majority of the provisions of the Act related to not-for-profit organizations target temporary extensions of various donation benefits.
January 10, 2013

On January 2, 2013, the President signed the American Taxpayer Relief Act of 2012 (the "Act") into law. From the viewpoint of many charitable organizations, the majority of the provisions of the Act related to not-for-profit organizations target temporary extensions of various donation benefits. In addition, there is a 24-month extension of an exception to unrelated business taxable income related to controlled groups of exempt organizations – both charitable and other types of tax-exempt organizations. Further, the general economic environment of taxpayers will be affected due to tax rate changes and other provisions.

TARGETED CONTRIBUTION PROVISIONS

Individual Retirement Account Distributions

Through December 31, 2013, taxpayers who have reached age 70 ½ will be able to transfer up to $100,000 per year from an Individual Retirement Account (IRA) to qualified charities. With a direct transfer, the taxpayer does not include the distribution in income (does not increase adjusted gross income ("AGI")) and receives no charitable donation deduction. This provision had expired at the end of 2011. In order to make it retroactive to 2012, the Act permits two elections. First, qualifying taxpayers who took distributions during December of 2012 may transfer cash to a qualifying organization before February 1, 2013. As long as all of the other provisions of the law are met, the cash transfer will be deemed to satisfy the direct transfer requirement and the distribution will be excludable from income. Second, a qualifying taxpayer may make a direct transfer during January 2013 and elect to treat it as a December 31, 2012 distribution. The IRS is to provide guidance on the time and manner of making these elections.

RubinBrown Observation

Due to the tax law changes effective in 2013 such as the limitation on itemized deductions and other provisions based on AGI discussed below, the rule permitting limited direct transfers of IRA assets to charities will have additional advantages compared to 2012. Use of the first or second election may allow a taxpayer to contribute $200,000 to charities on a tax-free basis ($100,000 deemed for 2012 and $100,000 for 2013). The law provides that a direct transfer may be applied to meeting required minimum distribution requirements.

Expenses of Elementary and Secondary School Teachers

The Act extends through 2013 an above-the-line deduction (for AGI) for qualifying expenses of up to $250 incurred by elementary and secondary teachers. The Act retroactively extended this provision to 2012 as it had expired at the end of 2011.

RubinBrown Observation

For expenses in excess of $250, there may be a tax deduction available for taxpayers with sufficient itemized deductions.

S Corporation Basis Rule for Contributions of Property

The Act extends through 2013 a provision that the adjusted tax basis of donated property, rather than the fair market value of donated property, is the amount by which shareholders are required to adjust their stock basis.

RubinBrown Observation

The Act is extending relief for owners of S corporation stock so that such shareholders are treated similarly to partners in a partnership. For example, assume a one-shareholder S corporation donates land with a fair market value of $500,000 and a tax basis of $100,000. Prior to this provision, the shareholder's basis in the S corporation stock would decrease by the $500,000. The provision only requires a basis reduction of $100,000 in this example. The amount of the basis reduction could affect the amount of non-taxable cash distributions or deductible operating losses in a future year as well as the gain on a sale of the stock. Without this temporary extension, S corporation shareholders could be worse off than a partner in a partnership making a similar gift. This is because the partnership rules generally only require a reduction to basis in the amount of the tax basis of the property.

Contributions of Capital Gain Real Property Made for Conservation Purposes

Individuals contributing appreciated property are generally limited in their deduction to 30% of AGI and a 5-year carryover of unused deductions. The Act extends through 2013 special rules providing for a 50% limitation (100% for qualified farmers and ranchers) and a 15-year carryover.

RubinBrown Observation

The Act does not affect the basic provisions allowing a charitable deduction by individuals or corporations for qualified conservation contributions. Qualified conservation purposes include historic preservation, open space, outdoor recreation and protection of natural habitat. The donation may be of the entire property, a remainder interest or a qualifying restriction (easement).

Contributions of Food Inventory

The Act extends the enhanced deduction for food inventory for the care of the ill, needy or infants for 2012 and 2013. The contribution must be from the trade or business of the taxpayer and the food must be "apparently wholesome".

RubinBrown Observation

The deduction continues to be available to individuals as well as C corporations. However, for individuals, it is subject to a limit of 10% of the net income of the taxpayer's trade or business that is making the contribution.

NOTE: The Act did NOT extend enhanced contribution provisions related to "book inventory" donated to public schools and certain computer equipment donated to qualifying schools or public libraries.

UNRELATED BUSINESS INCOME TAX

Certain Payments Made to Controlling Exempt Organizations

The Act extends from January 1, 2012 through December 31, 2013 a provision that modifies the definition of unrelated business income. Interest, rents, annuities or royalties paid by a controlled entity to a controlling exempt organization are generally taxable as unrelated business income. The extended provision exempts such payments from tax to the extent they are comparable to an arm's length transaction and meet certain other qualifications.

RubinBrown Observation

The Act does not appear to change the limited scope of payments to which this rule applies. The payment may only qualify if it is pursuant to a binding written contract in effect on August 17, 2006 or a renewal, under substantially similar term

s, of a binding written contract in effect on August 17, 2006. For contracts that are up for renegotiation, the controlling organization may want to consider the potential tax advantage of renewal of a pre-August 18, 2006 contract. Generally, there is no benefit of this provision for new organizations or new agreements.

Increased Tax Rates on Trusts

Unrelated Business Taxable Income tax rates depend on whether the organization is taxable as a corporation or a trust. While the Act does not affect corporate rates, unincorporated organizations taxable as trusts are subject to the new 39.6% tax rate. The top tax rate is expected to apply to trust taxable income in excess of $11,950.

On December 5, 2012, proposed regulations were issued on the 3.8% tax on net investment income pursuant to the Health Care and Reconciliation Act of 2010. The 3.8% tax will apply to some trusts; however, the background discussion accompanying the proposed regulations indicates that tax-exempt trusts should not be subject to the 3.8% tax even if they have unrelated business taxable income comprised of net investment income.

RubinBrown Observation

Changing to an incorporated form of organization may not be practical. Aside from any legal or operational issues, incorporation of a charitable organization currently operating as a tax-exempt trust would require reapplying to the IRS (via Form 1023 and paying applicable fees) for charitable tax-exempt status. Investments such as partnerships that generate unrelated business income may need to be re-evaluated with regard to potential after-tax returns given that unrelated ordinary income may be taxed an additional 4.6% and unrelated capital gains or dividends may be taxed an additional 5%.

GENERAL ECONOMIC ENVIRONMENT

Increased tax rates on Individual Income and Gains

A 39.6% rate will apply for Taxable Income above certain thresholds.

  • The thresholds are $450,000 for married filing jointly and surviving spouse filers, $425,000 for head of household filers, $400,000 for single filers and $225,000 for married filing separately filers.
  • These thresholds will be adjusted for inflation after 2013.

For tax years beginning after December 31, 2012, the top income tax rate for long-term capital gains and qualified dividends will rise to 20% (up from 15%) for taxpayers with Taxable Income above certain thresholds.

  • The thresholds are $450,000 for married filing jointly and surviving spouse filers, $425,000 for head of household filers, $400,000 for single filers and $225,000 for married filing separately filers.

In addition to income taxes, the new 3.8% tax on Net Investment Income enacted in the Health Care and Reconciliation Act of 2010 will apply to Net Investment Income for certain taxpayers with modified AGI over $250,000 married filing jointly or over $200,000 single. Net Investment Income in general terms is taxable interest, dividends, and gains plus passive income from partnerships and S corporations minus expenses such as investment interest expense and broker fees. It is not reduced by itemized deductions unrelated to the production of investment income.

RubinBrown Observation

The effective top rate for long-term capital gains and qualified dividends will be 23.8% when the new tax on Net Investment Income is included. Similarly, the effective top rate for other investment income will be 43.4%. Therefore, in comparison to 2012, contributions of either long-term capital gain property or cash may actually have a slightly higher tax benefit in 2013. However, charitable contributions will not be a deduction in calculating Net Investment Income subject to the 3.8% tax, because this tax is not based on Taxable Income. For those individuals for whom charitable gift annuities are appropriate, part of the 3.8% tax may be deferred or avoided. This is because when the donor receives a current annuity after making the donation, part of the annuity payments for the first few years are generally considered a return of capital rather than income.

Limitation on Itemized Deductions

For tax years beginning after December 31, 2012, itemized deductions will be limited for taxpayers with AGI above certain thresholds.

  • The thresholds are $300,000 for married filing jointly and surviving spouse filers, $275,000 for head of household filers, $250,000 for single filers and $150,000 for married filing separately filers.
  • These thresholds will be adjusted for inflation after 2013.

For taxpayers subject to this "Pease" limitation, the total amount of itemized deductions is reduced by 3% of the amount by which the taxpayer's AGI exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions.

RubinBrown Observation

This limitation would decrease charitable deductions of a couple filing a joint return with AGI of $400,000 by $3,000 (3% of the AGI exceeding $300,000.) It does not specifically target charitable donation deductions.

The "Pease" limitation was in effect most of the 1990's and through 2009 but was suspended for qualifying contributions for part of 2005 and part of 2008 due to natural disasters. The limitation was not in effect for 2010 and 2011. So, charities should have some experience on how the itemized deduction limits have affected their organizations in the past. However, this is but one of many factors that might influence donors.

The "Pease" limitation does not apply in the calculation of Alternative Minimum Tax. Therefore, donors subject to Alternative Minimum tax (or would be but for the full amount of charitable deductions) still may receive a tax benefit, but it may be in the vicinity of the 28%. The actual tax benefit will vary due to various phase outs and credits.

ESTATE, GIFT & GENERATION SKIPPING TRANSFER TAXES

For individuals dying and gifts made after 2012, the Act contains the following:

  • Exemption level (by means of the unified credit) permanently set at $5,000,000 (to be indexed for inflation after 2013)
  • Top estate and gift tax rate of 40% (up from 35%)
  • Continuation of the portability feature that allows the estate of the first spouse to die to transfer his or her unused exemption to the surviving spouse

RubinBrown Observation

For the most part, this may bring a measure of stability to estate planning. To the extent taxpayers are reviewing their estate plans, this may be an additional opportunity to consider planned giving to charity.

CONCLUSION

The Act continues a pattern of short-term extensions of various donation incentives. The temporary nature of the provisions probably reflects budgetary constraints more than a rational policy. On the other hand, various tax rates that affect individuals have been made "permanent". The conventional wisdom is that this will tend to free individuals to take a more long-term view and this may make them more comfortable in undertaking major transactions.

And for the moment, charities have avoided any dramatic change in the way individual donors may benefit from gifts to charities. There have been several concepts discussed that could have had a much greater effect. This includes capping itemized deductions at a set dollar amount or capping the tax rate at which wealthy donors could benefit from their itemized deductions. There was no change in the treatment of tax-exempt bonds, a financing tool utilized by some not-for-profit organizations. The problem is that once changes in the rules become part of the discussion, there is always the possibility that the next tax bill (or the one after) will contain less favorable provisions. For long-term strategy, charities will likely need to rely (even) less on donations that have a primary motive based on current levels of income tax benefits.

There continues to be an undercurrent that significant tax reform is needed. This means that it is possible that future legislation will be introduced in the name of "tax reform" with wide-ranging changes to deductions and benefits. While in the realm of national politics there may be more differences than similarities to the mid 1980's, it is interesting to note that the Tax Reform Act of 1986, which resulted in the revamped Internal Revenue Code of 1986, was enacted during a President's second term when different political parties controlled the House of Representatives and the Senate.

 

Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.

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