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Ways and Means Chairman Dave Camp (R-MI), on Feb. 26, 2014, released (but didn’t introduce) a nearly 1,000 page bill (Discussion Draft, The Tax Reform Act of 2014), a major overhaul of the Internal Revenue Code. Effective. Generally, 2015.
You, no doubt, have heard the pundits echo that the bill is Dead on Arrival—too many interest groups would be adversely affected, it doesn’t have bipartisan support, the Administration isn’t interested, it’s an election year, etc.
So why be concerned about this now? Tax reform, it's been said, is always dead until 15 minutes before it is enacted.
Bits and pieces—and even large chunks—of the Discussion Draft could be seriously considered after the 2014 election. Without making predictions, suppose the Republicans control both the House and the Senate after the 2014 election. The Dead on Arrival Discussion Draft could be quickly resuscitated. If you believe that the provisions in the Discussion Draft would adversely affect the people served by American charities, now's the time to muster your arguments and communicate them to your legislators.
Highlights of Discussion Draft dealing with charities
• The invisible elephant in the W&M Committee Room. Only 5 percent (instead of the current approximately 35 percent) of taxpayers would itemize their deductions. This results from elimination or reduction of currently allowable itemized deductions and increased standard deductions.
However, for the 5 percent of itemizers still standing, a charitable deduction would, at the taxpayer’s election, be deductible on the prior year’s tax return if made by the April 15 filing due date.
• 2 percent floor on charitable deductions.
• No fair market value deduction for appreciated real estate and non-publicly traded securities, but FMV still allowable for appreciated publicly traded securities and related-use tangible personal property.
• Special benefits retained for conservation easements and land gifts by farmers and ranchers.
• Nix on tix-deduction for college athletic events.
• Required distributions by Donor Advised Funds and excise tax on salaries of highly compensated executives of charities. Some would say good, others bad.
Current law followed by Discussion Draft changes
• Adjusted gross income deductibility ceilings and carryovers. A charitable deduction is limited to a percentage of the individual's adjusted gross income (AGI). The AGI limitation varies depending on the type of gift and the type of exempt organization receiving it. Cash gifts to public charities, private operating foundations, and conduit (passthrough) private foundations are deductible up to 50 percent of the donor's AGI. Contributions that do not qualify for the 50-percent limitation (for example, contributions to private foundations) are generally deductible up to 30 percent of AGI.
• Long-term appreciated property (capital gain property) contributed to public charities, private operating and conduit foundations are deductible up to 30 percent of AGI. That property contributed to non-operating private foundations is generally deductible up to 20 percent of AGI.
• Qualified conservation easements are generally deductible up to 30 percent of AGI. Under a temporary provision, however, qualified conservation contributions made in tax years beginning before 2014 were deductible up to 50 percent of AGI or up to 100 percent of AGI (that’s not a typo) for property used in agriculture or livestock production.
If an individual contributes more than the applicable AGI limits, the excess contribution, generally, may be carried over and deducted in the following five tax years or 15 years for qualified conservation contributions (that too isn’t a typo).
• Gifts of long-term appreciated securities, real estate and related-use tangible personal property (capital gain property) to public charities are deductible at fair market value. That property contributed to non-operating private foundations is deductible at cost-basis. But, if the property is “qualified appreciated” marketable securities, a fair market valuation is allowable.
• A charitable deduction is generally disallowed to the extent a taxpayer receives a benefit in return. A special rule, however, permits taxpayers to deduct as a charitable contribution 80 percent of the value of a contribution made to an educational institution to secure the right to purchase tickets for seating at an athletic event in a stadium at that institution.
• The value of a deduction for contributed intellectual property is generally limited to the property's adjusted basis. Under current law, however, the donor is allowed an additional deduction equal to a percentage of the income generated by the intellectual property over the 12 years following the contribution, even though that income is likely earned by a tax-exempt entity.
Discussion Draft proposed changes
• The AGI limitations on deductible contributions would be “substantially simplified.” The 50 percent limitation for cash contributions and the 30 percent limitation for contributions of capital gain property to public charities and certain private foundations would be “harmonized” at a single limit of 40 percent. The 30 percent contribution limit for cash contributions and the 20 percent limitation for contributions of capital gain property that apply to organizations not covered by the current 50 percent limitation rule would be “harmonized” at a single limit of 25 percent. Thus, contributions to this latter group of organizations would be allowed to the extent they don’t exceed the lesser of: (1) 25 percent of AGI; or (2) the excess of 40 percent of AGI for the tax year over the amount of charitable contributions subject to the 25 percent limitation.
My take: A better way to “simplify” and “harmonize” the Code—and a way that would increase charitable gifts—would be to have one deductibility ceiling of 50 percent of AGI. The “harmony” ceilings retain complexity and still wouldn’t simplify the carryover computations. And, if there's to be a 2 percent floor under the charitable deduction, the ceiling on deductibility for all types of gifts should be raised to 50 percent of AGI.
• Two percent floor mechanics. An individual's charitable contributions could be deducted, as noted earlier, only to the extent they exceed 2 percent of the individual's AGI. The reduction would apply to charitable contributions in the following order: first, to contributions subject to the 25 percent of AGI limitation; second, to qualified conservation contributions; and third, to contributions subject to the 40 percent limitation. Simplification?
Value of deduction generally limited to adjusted basis. Appreciated long-term real property and closely held (not publicly traded) stock would be deductible at cost basis. However, contributions of long-term appreciated publicly traded stock and related use gifts of long-term tangible personal property (for example, artworks) would continue to be deductible at fair market value (but remember the 2 percent of AGI floor).
• Gifts of qualified conservation easements would generally continue to be deductible at fair market value (but remember the 2 percent AGI floor).
• The special, temporary rules for conservation easements, including the rules for farmers and ranchers, would be made permanent. The general rule would provide that deductions for conservation easements would be limited to 40 percent of AGI. Farmers and ranchers would still be allowed a charitable deduction up to 100 percent of AGI for property used in agricultural or livestock production. The discussion draft “clarifies” that no deduction is permitted for land reasonably expected to be used as a golf course. Fore! This would be effective starting after 2013.
• Nothing to cheer about—college athletic-event seating rights. The special rule that provides a charitable deduction of 80 percent of the amount paid for the right to purchase tickets for athletic events would be repealed.
• Income from intellectual property contributed to a charitable organization would no longer be allowed as an additional contribution by the donor. The deduction for the contribution of the intellectual property would be retained.
Discussion Draft “Considerations” (Rationale)
In so many words, not to worry.
• This bill would be good for charity. Because a taxpayer must itemize to claim a charitable deduction, only about 25 (actually about 35) percent of Americans benefit from the current charitable contribution rules.
My take: It's the people served by the charities who benefit. The donor is out of pocket by making a charitable gift.
Back to the Discussion Draft. While other changes in the discussion draft would result in fewer taxpayers choosing to itemize overall—as the remaining 95 percent would take advantage of the larger, simpler standard deduction instead—the changes to the charitable contribution rules would continue to provide significant tax incentives for those who continue to itemize.
My take: Yeah, sure! 2 percent of AGI floor and cost basis limitation.
• The provision recognizes that Americans typically contribute to churches, community organizations and other public charities out of generosity, not for a tax benefit, which only higher income individuals generally claim under current law. The provision would continue to provide a tax incentive for individuals who want to make large contributions to public charities.
• Moreover, historical data show that the total amount of charitable giving is tied more closely to the health of the overall economy than to any specific tax policies that may be in place. The best way to promote charitable giving to the organizations doing so much good in communities across the country is to improve the overall economy, which is precisely what comprehensive tax reform is designed to achieve.
As noted below, several aspects of the provision would encourage charitable giving in important ways, and by creating a stronger economy, the discussion draft as a whole is estimated—based on calculations using data provided by the independent, non-partisan Joint Committee on Taxation—to increase charitable giving by up to $2.2 billion per year.
My take: This is based on “dynamic,” rather than “static,” scoring. And that’s a topic for another day. The bottom line, however, is that you wouldn’t run your own economic life on “dynamic” scoring.
• Enabling individuals to take charitable deductions in a particular tax year through the due date for that return (typically April 15 of the following year) is expected to increase charitable giving since many taxpayers will decide to give more generously at the time they are actually preparing and finalizing their returns.
Head-in-the-sand department: How can this be if only 5 percent of taxpayers itemize. And, oh yes, there’s a 2 percent AGI floor and cost basis limitation for many gifts.
• The provision also would continue to provide an incentive for contributions of conservation easements for the benefit of our communities and the environment.
• The provision would simplify the complex rules and limitations with respect to charitable contributions to make the tax law easier to understand and to help taxpayers better comply with the rules.
My take: I have several bridges over the Potomac for sale.
Donor Advised Funds: distribution requirements
• Public charities, including community foundations, exempt from tax under IRC Section 501(c)(3) are permitted to establish accounts to which donors may contribute and, thereafter, provide non-binding advice regarding distributions from the fund or the investment of the fund’s assets. Those accounts are commonly referred to as “donor advised funds.”
• Donors who make contributions to charities sponsoring those funds generally may claim a charitable deduction at the time of the contribution even though the contributed funds may be held in the account without distribution for significant periods. While the sponsoring charities generally must have legal ownership and control over the funds held in a donor advised fund, there's no requirement that the funds be distributed to other charitable organizations within any period of time. Donor advised funds also aren’t subject to the private foundation net investment excise tax.
Discussion Draft change
• Donor advised funds would be required to distribute contributions within five years of receipt. An eligible distribution would be a distribution made to a public charity. Failure to make distributions would subject the sponsoring charitable organization to an annual excise tax equal to 20 percent of the undistributed funds. Effective. Contributions made after 2014. For contributions made before 2015 and remaining in the fund on Jan. 1, 2015, the five-year distribution period would begin on Jan. 1, 2015.
Investment income of private colleges and universities.
Current law. Private foundations and certain charitable trusts are subject to a 2 percent excise tax on their net investment income. That tax doesn’t apply to public charities, including colleges and universities, even though some of those organizations may have substantial investment income similar to private foundations.
Discussion Draft change
• Certain private colleges and universities would be subject to a 1 percent excise tax on net investment income. The excise tax would only apply to those institutions with assets (other than those used directly in carrying out their educational purposes) valued at the close of the preceding tax year of at least $100,000 per full-time student. State colleges and universities wouldn’t be subject to the tax. Effective. Tax years beginning after 2014.
“Excess” executive compensation
Current law. The deduction allowed to publicly traded C corporations for compensation paid to chief executive officers and certain highly paid officers is limited to no more than $1 million per year. Similarly, current law limits the deductibility of certain severance-pay
arrangements ("parachute payments"). No parallel limitation applies to tax-exempt organizations for executive compensation and severance payments.
Discussion Draft change
• A tax-exempt organization would be subject to a 25 percent excise tax on compensation in excess of $ 1 million paid to any of its five highest paid employees for the tax year. The excise tax would apply to all remuneration paid to a covered person for services, including cash and the cash value of all remuneration (including benefits) paid in a medium other than cash, except for payments to a tax-qualified retirement plan, and amounts that are excludable from the executive's gross income.
Once an employee qualifies as a covered person, the excise tax would apply to compensation in excess of $1 million paid to that person, so long as the organization pays him remuneration. The excise tax also would apply to excess parachute payments paid by the organization to those individuals. An excess parachute payment generally would be a payment contingent on the employee's separation from employment with an aggregate present value of three times the employee's base compensation or more. Effective. Tax years beginning after 2014.
Discussion Draft “considerations”
No limit is placed currently on “excessive” compensation paid by a tax-exempt organization to its senior management other than the limitation on private inurement, the consequence of which can be revocation of the organization's exemption.
Tax-exempt organizations enjoy a tax subsidy from the federal government as a result of the requirement that they use their resources for specific purposes. Some may question whether excessive executive compensation diverts resources from those particular purposes.
The provision is consistent with the limitation on the deductibility of executive compensation by taxable publicly traded corporations.
Given that exemption from federal income tax constitutes a significant benefit conferred upon tax-exempt organizations, the case for discouraging excess compensation paid out to the organizations' executives may be even stronger than it is for publicly traded companies.
Private Foundations—discussion draft changes
• An excise tax of 2.5 percent would be imposed on a private foundation when the self-dealing tax is imposed on a disqualified person. The tax rate would be 10 percent for cases in which the self-dealing involves the payment of compensation.
• Foundation managers would no longer be able to rely on the professional advice safe harbor. Thus, a manager’s reliance on professional advice, by itself, would not preclude the manager from being subject to the excise tax for participating in a self-dealing transaction. Effective. Tax years beginning after 2014.
• Simplification of excise tax on private foundation investment income.
Excise tax on private foundation investment income—current law. Private foundations and certain charitable trusts are subject to a 2 percent excise tax on their net investment income. However, an organization may reduce the excise tax rate to 1 percent by meeting certain requirements regarding distributions to qualifying tax-exempt organizations during a tax year.
A special rule excludes “exempt operating foundations” from the excise tax. To be an exempt operating foundation, an organization must: (1) be an operating foundation, which is an organization that spends at least 85 percent of its adjusted net income or its minimum investment return, whichever is less, directly for the active conduct of its exempt activities, (2) be publicly supported for at least ten tax years, (3) have a governing body no more than 25 percent of whom are disqualified persons and that is broadly representative of the general public, and (4) have no officers who are disqualified persons.
A disqualified person, generally, is any person in a position to exercise substantial influence over the affairs of the organization (for example, officers, directors or trustees).
Discussion Draft changes—the excise tax rate on net investment income would be reduced to 1 percent. The rules providing for a reduction in the excise tax rate from 2 percent to 1 percent would be repealed. The exception from the excise tax for exempt operating foundations would also be repealed. Effective. Tax years beginning after 2014.
Repeal of exception for private operating foundation failure to distribute income—current law. Private foundations, generally, are required to pay out a minimum amount each year in distributions to accomplish one or more of the organization’s exempt purposes, including reasonable and necessary administrative expenses. Failure to pay out the minimum amount results in an initial excise tax on the foundation of 30 percent of the undistributed amount. An additional tax of 100 percent of the undistributed amount applies if an initial tax is imposed and the required distributions generally have not been made within the following year. Private operating foundations are not subject to the payout requirements. To qualify as a private operating foundation, the organization must spend at least 85 percent of its adjusted net income or its minimum investment return, whichever is less, directly for the active conduct of its exempt activities.
Discussion Draft changes—the special exclusion for private operating foundations would be repealed. Thus, the foundations would be subject to the excise tax for failure to distribute income—just like private foundations. Effective. Tax years beginning after 2014.
Other “Discussion Draft” provisions
• Expansion and modification of intermediate sanctions. The excise tax on excess-benefit transactions would be expanded to apply not only to public charities, but also to labor, agricultural, and horticultural organizations under IRC Section 501(c)(5); also business leagues, chambers of commerce, real-estate boards and boards of trade under IRC Section 501(c)(6).
An excise tax of 10 percent would be imposed on the tax-exempt organization when the excess-benefit excise tax is imposed on a disqualified person. The entity-level tax would be avoidable if the organization follows minimum standards of due diligence or other procedures to ensure that no excess benefit is provided by the organization to a disqualified person. The minimum standards of due diligence would be satisfied if the transaction was approved by an independent body of the organization that relied on comparability data prior to approval and documented the basis for approving the transaction. The Treasury regulations would be overruled by providing that no presumption of reasonableness is created by the organization satisfying the minimum standards of due diligence for purposes of imposing the excise tax on disqualified persons and managers.
• Managers would no longer be able to rely on the professional advice safe harbor under Treasury regulations. Thus, a manager’s reliance on professional advice, by itself, would not preclude the manager from being subject to the excise tax for participating in an excess-benefit transaction.
• The definition of disqualified persons would be expanded to include athletic coaches and investment advisors regardless of whether the investment advisor provides services to a supporting organization. Effective. Tax years beginning after 2014.
• Repeal of tax-exempt status for professional sports leagues.
Current law. A professional football league is specifically granted tax-exempt status as a 501(c)(6) organization, an exemption that generally applies to trade or professional associations. The IRS has interpreted the exemption for “professional football leagues” to include all professional sports leagues.
Discussion Draft. Professional sports leagues wouldn’t be eligible for tax-exempt status as a trade or professional association under IRC Section 501(c)(6). The provision wouldn’t apply to amateur sports leagues. They would continue to qualify as tax-exempt entities. Effective. Tax years beginning after 2014.
Brackets—income tax, not college basketball (April, not March, madness).
Current law. There are seven regular individual income tax brackets of 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent and 39.6 percent. In addition, there are five categories of filing status: single, head of household, married filing jointly (and surviving spouses), married filing separately, and estates and trusts. For married individuals filing jointly, the upper bounds of the 10 percent and 15 percent brackets are exactly double the upper bounds that apply to single individuals, to prevent a marriage penalty from applying at these income levels. The income levels for each bracket threshold are indexed annually based on increases in the Consumer Price Index (CPI).
A separate rate schedule applies to adjusted net capital gain and qualified dividends, with rates of 0 percent, 15 percent and 20 percent. Additional rates of 25 percent and 28 percent apply to unrecaptured Section 1250 gain and 28 percent rate gain (collectibles gain and section 1202 gain), respectively. Special rules (for example, the so-called "kiddie tax") apply to certain unearned income of children, taxing a portion of such income at the parents' tax bracket.
Discussion Draft changes. The current seven tax brackets would be consolidated and simplified into three brackets: 10 percent, 25 percent and 35 percent.
Certain “tax preferences” could only be taken against the 25 percent bracket, but not the 35 percent bracket. These tax preferences would include: the standard deduction; all itemized deductions except the deduction for charitable contributions (but remember the 2 percent AGI floor); the foreign earned income exclusion (including the exclusions for income from Puerto Rico and U.S. possessions); tax-exempt interest; employer contributions to health, accident and defined contribution retirement plans to the extent excluded from gross income; the deduction for health premiums of the self-employed; the deduction for contributions to health savings accounts; and the portion of Social Security benefits excluded from gross income.
The special rate structure for net capital gain would be repealed. Instead, non-corporate taxpayers could claim an above-the-line deduction equal to 40 percent of adjusted net capital gain. Adjusted net capital gain would equal the sum of net capital gain and qualified dividends, reduced by net collectibles gain. Effective. Tax years beginning after 2014.
The modified tax preference for long-term capital gains and dividends would result in that income being taxed at 60 percent of the taxpayer's marginal rate. Thus, for example, taxpayers in the 35 percent bracket would pay an effective rate of 21 percent on adjusted net capital gain. Combining this with the additional 3.8 percent tax imposed on that income by Section 1411 yields a top effective rate of 24.8 percent, slightly lower than the top effective rate under current law, which is 25 percent.
Why this is good according to the Discussion Draft. The 40 percent deduction for adjusted net capital gain would greatly simplify the calculation of the tax preference for that income relative to current law, and is similar to how the tax preference was structured prior to enactment of the Tax Reform Act of 1986.
My overall take on the almost 1,000 page discussion draft: Call me a simpleton, but this ain’t simplification.
© Conrad Teitell 2014. This is not intended as legal, tax, financial or other advice. So, check with your adviser on how the rules apply to you.