On August 5, 1997, President Clinton signed into law the Taxpayer Relief Act of 1997, prompting intense debate over the merits of capital gains tax cuts and the $500-per-child tax credit. In addition to the better-publicized provisions, the Act also contains a number of sections of interest to foundations, individual donors, and other exempt organizations. This insert on the Taxpayer Relief Act, based on analysis provided to The Philanthropy Roundtable by KPMG Peat Marwick LLP, inaugurates an occasional series on information of practical use to foundations and donors alike.
The information contained herein reflects KPMG’s initial interpretation of the statutory language of the new law and the relevant legislative history. This analysis is subject to change as KPMG gains experience with applying the provisions to actual factual situations and as the Internal Revenue Service issues guidance on those provisions. Applicability to specific situations is to be determined through consultation with your tax advisor.
For more information on the contents of this insert or the services KPMG provides to private foundations, contact Richard A. Speizman, Partner, Exempt Organizations Tax Practice, at (202) 467-3814. For information on KPMG’s legislative monitoring service, call Evan Liddiard at (202) 530-6499. For regular updates and additional information on the Taxpayer Relief Act of 1997, visit the KPMG web site (http://www.us.kpmg.com/taxact).
Charitable Remainder Trusts
Two new restrictions have been imposed in connection with charitable remainder trusts. First, for transfers in trust after June 18, 1997, the trust will not qualify as a charitable remainder trust if the required annual payout to the income beneficiary is greater than 50 percent of the initial fair market value of the trust assets, in the case of a charitable remainder annuity trust, or 50 percent of the annual value of the trust assets, in the case of a charitable remainder unitrust.
Observation: This provision is designed to eliminate a planning technique that used a short-term, high payout charitable remainder trust to eliminate most of the capital gains tax on the sale of an appreciated asset.
The second restriction is a requirement that the value of the remainder interest of a charitable remainder trust must be at least 10 percent of the value of the property transferred to the trust. This requirement is effective for transfers made after July 28, 1997.
Observation: This provision was added to the legislation at the last minute. Many large charities depend heavily on charitable remainder trusts to raise funds. This provision may cause this source of funds to dry up because charitable remainder trusts will be less attractive to potential donors.
Contributions of Stock to Private Foundations
An expired provision that allowed donors of qualified appreciated stock to private foundations to deduct the fair market value of the contributed stock is reinstated retroactively, for contributions made from June 1, 1997, through June 30, 1998. Qualified appreciated stock is generally publicly traded corporate stock. The deduction applies only to the extent that total family contributions to private foundations do not exceed 10 percent of a corporation’s outstanding stock.
Example: On September 16, 1997, Taxpayer contributes to his family private foundation 100 shares of XYZ stock that is listed on the NYSE and that was purchased in 1995 before the great bull market for $1,000. The stock is now worth $35,000. Absent this reinstated provision, Taxpayer would only be able to deduct his basis in the stock, $1,000. The reinstated provision raises Taxpayer’s maximum charitable contribution deduction to the fair market value of the stock, $35,000.
Observation: Consider contributing appreciated shares of stock rather than cash to a private foundation and using the cash to buy new shares of the contributed stock. The result will be a full fair market value charitable deduction for the shares of stock subject to certain percentage limitations, with no capital gains liability. In addition, the donor effectively receives a tax-free stepped-up basis in identical property through the purchase of the new shares.
Estate and Gift Tax Relief
The new law makes the most comprehensive changes to estate and gift taxes since the Economic Recovery Tax Act of 1981, when the unified credit was last increased. The 1981 legislation phased in the amount exempt from estate and gift taxes from $175,625 to $600,000, for years following 1986, and reduced the maximum tax rate from 70 percent to 50 percent (currently 55 percent). The 1997 Act does not reduce rates but does contain several specially targeted relief provisions, particularly in the area of family businesses and family farms.
Increase in Estate and Gift Tax
The current $192,800 unified credit is raised so that by the year 2006 every taxpayer may transfer assets during their lifetime and at death valued in the aggregate at $1 million free from estate and gift tax. The phase-in is as follows:
For Decedents Dying and Gifts During Applicable Credit Amount Applicable Exclusion Amount 1997 (current law) $192,800 $600,000 1998 $202,050 $625,000 1999 $211,300 $650,000 2000 $220,550 $675,000 2001 $220,550 $675,000 2002 $229,800 $700,000 2003 $229,800 $700,000 2004 $287,300 $850,000 2005 $326,300 $950,000 2006 (and thereafter) $345,800 $1,000,000
The new law makes conforming adjustments to an estate’s requirement to file an estate tax return (i.e., an estate valued at less than the applicable exclusion amount will not need to file). The provision is effective for decedents dying and gifts made after 1997.
Observation: The unified credit available for estates of nonresident, non-citizen decedents who do not benefit from a treaty provision remains at $13,000, sufficient to exempt assets valued at $60,000 from estate tax.
Relief for Family Businesses and Farms
Estate Tax Exclusion for Qualified
For deaths occurring after 1997, “qualified family-owned business interests” are excluded from a taxable estate to the extent such interests plus the applicable exclusion do not exceed $1.3 million. The interests must make up more than 50 percent of the estate and certain other requirements must be met. The qualified family business interests include a sole proprietor’s interest in a trade or business, as well as an interest in an entity carrying on a trade or business that is held at least 50 percent by one family, 70 percent by two families, or 90 percent by three families of which the decedent’s family owns at least 30 percent. The principal place of business must be located in the United States, and the entity’s stock must not have been publicly traded within three years of death. The value of the family business interest is reduced to the extent the business holds passive assets (e.g., stock in a publicly traded corporation), excess cash, or marketable securities.
To qualify, the decedent must have been a U.S. citizen or resident and the qualified business interests must meet a liquidity test. The liquidity test requires the value of all transfers of qualified business interests made to qualified heirs at death, plus certain lifetime transactions to family members, to exceed 50 percent of the value of the adjusted gross estate. For this purpose, qualified heirs include members of the decedent’s family as well as any individual who has been actively employed by the trade or business for at least ten years prior to the date of death.
Furthermore, the decedent or a family member must have owned and materially participated in the trade or business for at least five of the eight years prior to the date of death, and, after death, each qualified heir (or a family member of that qualified heir) must materially participate in the trade or business for at least five years in an eight-year period during the ten years following the date of death.
Observation: Material participation is generally determined by reference to all the facts and circumstances of the particular business. For instance, a person who works on less than a full-time basis but has the ultimate responsibility for management decisions could be considered to be materially participating in the business. If a qualified heir rents qualifying property to a member of his or her family on a net cash basis, and that family member materially participates in the business, the material participation requirement will be met.
If, within ten years of death, a qualified heir fails the material participation requirement, or the property is disposed of (other than to a family member or through a conservation contribution), a recapture tax applies. The recapture tax is equal to the reduction in estate taxes attributable to the disqualified family-owned business interest; however, if the recapture event occurs more than six years after the date of death, the recapture tax is reduced by 20 percent, with a further 20 percent reduction for each year thereafter.
Observation: A sale or disposition of inventory or equipment in the ordinary course of business will not result in the imposition of this recapture tax.
Indexing of Certain Other Estate and Gift Tax Provisions
Several estate and gift tax provisions are indexed for inflation, in the case of decedents dying and gifts made after 1998:
The annual $10,000 exclusion from gift tax for each donee ($20,000 if gift splitting is elected).
The $750,000 maximum reduction in value allowed for certain property held in a decedent’s estate as real property used in farming or a trade or business (an alternative to valuing the property at its highest and best use).
The $1 million exemption allowed each taxpayer for transfers that are otherwise subject to the generation-skipping transfer tax (e.g., transfers to grandchildren).
The $1 million limitation on the special 2 percent interest rate applied against estate taxes paid in installments attributable to the value of a closely held business included in a decedent’s estate.
Observation: The potential increase in the $10,000 annual exclusion could prove highly beneficial to taxpayers who start an annual gifting program early in life.
Other Estate, Gift, and Trust Provisions
Distributions During First 65 Days of Taxable Year of Estate
An election is provided to allow an executor to treat distributions paid within sixty-five days after the close of an estate’s tax year as having been made on the last day of that tax year. This rule previously was available only to trusts. The election is available for tax years beginning after August 5, 1997.
Observation: The 65 day rule election will simplify the administration of an estate.
Certain Revocable Trusts Treated as Part of Estate
An election is now available to treat certain revocable trusts established by a decedent as part of the decedent’s estate for income tax purposes. If no estate tax return is required, the election is effective for the two years from the date of the decedent’s death. If an estate tax return is required, the election is effective until six months after the final determination of estate tax liability. The election is available for estates of decedents dying after August 5, 1997.
Repeal of Throwback Rules
The “throwback rules” applicable to amounts of accumulated income distributed by a trust are eliminated for domestic trusts for distributions in tax years beginning after August 5, 1997. Under the throwback rules, a trust beneficiary who receives a distribution from a trust that includes income the trust earned in an earlier year must perform a complex calculation to determine his or her income tax. The throwback rules continue to apply to foreign trusts, trusts that were foreign but became domestic, and certain domestic trusts created before March 1, 1984, that would be treated as “multiple trusts” under the tax laws.
Observation: The throwback rules were enacted when it was possible for taxpayers to reduce their overall tax burden by shifting income to trusts, where the trust had a lower tax rate than the beneficiaries. For a number of reasons, including the compressed income tax brackets applying to trusts (for the 1997 tax year, the 39.6 percent tax rate applies to trust income above $8,100), the original purpose for the throwback rules no longer exists.
Reduction in Estate Tax for Certain Land Subject to Permanent Conservation Easement
An election is available to exclude from a taxable estate 40 percent of the value of any land subject to a qualified conservation easement. The maximum exclusion will be $100,000 in 1998, $200,000 in 1999, $300,000 in 2000, $400,000 in 2001, and $500,000 in 2002 and beyond. No step-up in basis is allowed to the extent the property is subject to this exclusion. The exclusion does not extend to the value of any development rights retained by the decedent or donor, although estate tax payments attributable to retained development rights can be deferred for up to two years (or until the disposition of the property, if earlier).
Also, a charitable deduction is allowed, for both income tax and estate tax purposes, for contributions of permanent conservation easement property where mineral interests have been retained, if the probability of surface mining on the property is negligible. The rules apply to deaths after and easements granted after 1997.
Exempt Organizations and Tax-Exempt Bonds
Expansion of Look-Through Rule for Income from Subsidiaries
The Act modifies the rules governing when a tax-exempt organization must include interest, rents, royalties, and annuities from related parties in unrelated business taxable income (UBTI). Under prior law, such income was generally exempt from tax, unless derived directly from an 80 percent controlled subsidiary. The Act modifies the control requirement to apply where the parent owns more than 50 percent of the stock of the subsidiary, measured by vote or value, or in the case of a partnership (or other entity), where the parent owns more than 50 percent of the profits, capital, or beneficial interests. In addition, constructive ownership rules are applied, so that the rule will apply to a parent organization indirectly owning more than 50 percent of the voting power or value of the other entity (such as through a second-tier subsidiary). The Act provides that a parent entity’s income from a controlled subsidiary is subject to tax, in general, to the extent it reduces the net taxable income (or increases any net taxable loss) of the controlled entity. Treasury is instructed to prescribe regulations to prevent avoidance of these rules through the use of related persons.
The new provision is effective generally for tax years beginning after August 5, 1997, with a delayed effective date for payments made during the first two tax years beginning on or after August 5, 1997, made pursuant to a binding contract in effect on June 8, 1997.
Exclusion from UBTI for Certain Corporate Sponsorship Payments
“Qualified sponsorship payments” are now specifically excluded from taxation as UBTI. These are defined as payments made with no expectation of return benefit other than the use or acknowledgement of the sponsor’s name or logo (or product lines) in connection with the activities of the donee exempt organization. The content of the acknowledgement and the form of the payment are restricted. The new rules apply to payments solicited or received after 1997.
Observation:The Act puts to rest an ongoing controversy over whether “corporate sponsorship” income received by a section 501(c) entity is subject to tax. In a controversial 1991 ruling, the IRS held that corporate sponsorship income received by the Cotton Bowl, a section 501(c)(3) entity, was subject to tax as unrelated business income. In 1993, the IRS issued proposed regulations adopting a much more liberal position. In essence, the Act codifies the position taken in the proposed regulations.
Estimated Tax Payments by Private Foundations. The Act extends the due date for the first quarter estimated tax payments by private foundations from April 15 to May 15, to coincide with the due date for private foundation tax returns.
Tax Exemption for Hospitals Participating in Provider-Sponsored Organizations. A provision in the Balanced Budget Act of 1997 assures section 501(c)(3) hospitals that they will not jeopardize their tax status by participating in “provider-sponsored organizations” as defined under the Medicare laws. However, any person with a material financial interest in such an organization will be treated as a private shareholder or individual with respect to the hospital, requiring an evaluation of the facts and circumstances of each arrangement to determine whether the relationship results in impermissible private inurement or private benefit.
Purchasing Receivables by Tax-Exempt Hospital Cooperative Service Organizations. The Act clarifies the services that exempt cooperative hospital service organizations may provide by specifying that such services include the purchase of patron accounts receivable on a recourse basis.
Pension business of TIAA-CREF and Mutual of America. For tax years beginning after 1997, the Act repeals special exceptions for the pension business of Mutual of America and TIAA-CREF to the rule that generally denies tax-exempt status under 501(c)(3) or (4) to organizations which, as a “substantial part” of their activities, provide “commercial-type insurance.”
The IRS is authorized to abate the first-tier “intermediate sanctions” excise taxes imposed on disqualified persons and organization managers when section 501(c)(3) or 501(c)(4) organizations engage in “excess benefit transactions,” if the taxable event was due to reasonable cause and not to willful neglect and the event was timely corrected. The amendment is effective retroactively.
Exempt organizations now must report excise taxes on political and lobbying expenditures paid by an organization’s managers, and reimbursement paid by the organization to its managers for such taxes. The organization is not required to report the excise taxes imposed on it or on its managers, or excise tax reimbursements paid to its managers, if the taxes are abated. In addition, exempt organizations must report intermediate sanctions excise taxes paid by the organization’s managers and reimbursements paid by the organization to any manager or disqualified person for such taxes, unless the taxes are abated. The change is effective for returns filed for tax years beginning after July 30, 1996.