Interactive Legal Systems

President Bush signed the Pension Protection Act of 2006 (“Pension Act”) into law on August 17. Although most of the legislation deals with complicated and technical pension plan issues, some provisions will be of more direct concern to many estate planners.

New Rules for Charitable Gifts of Fractional Interests in Tangibles Interest too?

Although the Code permits a taxpayer an income and gift or an estate tax deduction for a gift of a percentage or fractional share of an interest in items of tangible person property (such as a work of art) given to charity, the Pension Protection Act imposes new conditions on the deduction. In fact, the rules are so onerous that it is unlikely that any informed taxpayer will ever make such a gift again. (The rules do not apply to fractional or percentage interest gifts in real estate or intangibles.)

First, new section 170(o) of the Code permits a deduction only if the sole owner of the item of tangible personal property is the taxpayer or the only owners are the taxpayer and the charitable donee. The Act authorizes the Secretary of the Treasury to issue regulations that would permit the deduction if other also owns an interest in the item and if they all give a proportionate interest of their interests to charity at the same time. Hence, if a sister and brother own a painting and the sister gives one-half of her half interest to charity but her brother does not give one-half of his half, no income tax deduction will be allowed to the sister, apparently even if the regulations are issued.

Second, the Act forces a taxpayer to recapture the amount of the deduction for a contribution of a fractional interest in property if the taxpayer has not transferred his or her remaining balance in the property upon the earlier of ten years of the contribution or the taxpayer’s death. As a practical matter, this recapture rule will compel taxpayers to transfer his or her remaining interest in the item of tangible personal property to the charity within the foregoing timeframe.

Recapture also occurs if charity does not take “substantial physical possession” of the item or does not use it in its exempt function within the ten year/by death period mentioned above.

There seems to be no minimum time exception for these recapture rules. For example, the taxpayer gives a fractional interest in a painting of which she owns 100% in September 2006 and dies in October 2006, without the charity taken possession of the painting. It seems that recapture of the charitable deduction for both income and gift tax purposes occurs even if the balance of the taxpayer’s interest in the painting is bequeathed at her death to the charity. Perhaps regulations will provide a reasonable time exception, but there is none in the statute. Therefore, any taxpayer who plans to make contribution of a fractional share of his or her interest in tangible personal property should arrange for the immediately possession and exempt use of the property.

Second, the amount the taxpayer may deduction for the subsequent gift or gifts to charity of additional interests are limited to the lower of the value of the interest later transferred or the value based on the value at the time of the initial gift. For example, the painting given to charity on January 15, 2007, is worth $1 million, entitling the taxpayer to a deduction of $250,000 for the 25% fractional interest then given. The taxpayer gives the balance (75%) interest to the museum on August 1, 2012, when the painting is worth $2 million. The taxpayer’s deduction is limited to $750,000, or 75% of the lesser of (1) $1 million, which is what the painting was worth when the first fractional interest was given away, and (2) $3 million, which is what the painting is worth the second fractional interest is given.

The limitation of the income tax deduction for the essentially “forced” subsequent donation (“forced” because of the threat of recapture) is not the worst tax effect the taxpayer faces. When the subsequent donation is made, the limitation based upon the fair market value of the item at the time of the initial fractional share gift or the time of the subsequent gift applies for gift and estate tax charitable deduction purposes as well. That means that, if the item has appreciated in value from the time of the initial donation and the subsequent one, the excess “actual” value of the subsequent gift over the limited amount deducted will be subject to gift or estate tax without a corresponding charitable deduction.

The bottom line is that no informed taxpayer likely will ever make a fractional interest transfer during lifetime again.

Tax Appraisals Changes

Taxpayers are compelled in certain cases to have property appraised and to attach copies of the appraisals to a tax return. In some situations, failure to obtain the appraisal results in denial of a tax benefit.

Even prior to Act, a taxpayer faced penalty equal to 20% of the tax underpaid was attributable to a substantial value misstatement. A substantial misstatement of value was deemed to occur for income tax purpose if the value used for income tax purposes (e.g., the value claimed for a painting donated to charity) was two times or more of the correct value. The penalty also was imposed with respect to estate or gift tax if the value used to determine the amount of such tax were 50% of less of correct value. And the taxpayer faced a penalty equal to 40% of the tax underpaid that was gross valuation misstatement. A gross misstatement of value was deemed to occur for income tax purpose if the value used for income tax purposes was four times or more of the correct value. A gross misstatement of value was deemed to occur for gift or estate tax purpose if the value used (e.g., the value claimed for a donation to charity) was 25% or less of the correct value.

The Pension Protection Act reduces the percentage by which the claimed value is incorrect. A substantial misstatement of value now is deemed to occur for income tax purpose if the value used for income tax purposes is 150% (one and a half times or more) of the correct value. It now is imposed with respect to estate or gift tax if the value used to determine the amount of such tax is 65% of less of correct value. A gross misstatement of value is deemed to occur for income tax purpose if the value used for income tax purposes is two times (the old gross valuation level) or more of the correct value. A gross misstatement of value now is deemed to occur for gift or estate tax purpose if the value used (e.g., the value claimed for a donation to charity) is 40% or less of the correct value.

Before the Act, taxpayers could avoid, under section 6664(c), the misvaluation (and other) penalties imposed by section 6662 if the taxpayer acted in good faith and had a reasonable basis to use the value reported. The Act has eliminated that good faith/reasonable basis exception for a gross valuation misevaluation with respect to an income charitable deduction. But the good faith/reasonable basis defense seems to continue with respect to estate and gift tax misevaluations.

In addition, the Pension Protection Act also imposes a nearly automatic penalty on appraisers. In the case of a substantial income tax valuation misstatement or a gross estate or gift tax valuation misstatement contained in an appraisal that the appraiser knows or has reason to know that the appraiser will be used “in connection” with an income tax return or income tax claim for refund, a penalty, under new section 6695A of the Code, equal to the greater of $1,000 or 10% of the amount of tax underpaid by reason of the misevaluation (but in no event more than 125% of the fee paid to the appraiser). For example, an appraiser hired for a valuation for estate tax purposes and who values stock included in the decedent’s gross estate at $400,000 will be subject to the penalty if the correct value is $1 million or more. The only exception to the imposition of the penalty is if the appraiser proves, to the satisfaction of the Treasury Department, that the appraised value was more likely than not the correct value.

There is another hammer given in the Act to the Treasury with which to bludgeon appraisers: threat of blacklisting. Circular 230 permits the Treasury, in essence, to blacklist appraisers—that is to rule that the determinations of value of the appraiser have no probative value for IRS administrative purposes. However, before the Act, the Treasury could blacklist only if the penalty under section 6701 of the Code had been imposed on the appraiser. That section permits the penalty to be imposed only if, among other conditions, the appraiser knew the appraisal would result in an underpayment of tax. But the Act eliminates the requirement of a section 6700 penalty. Now, after notice and hearing as specified in the Circular, an appraiser may, among other things, be suspended or barred from presenting valuations before the Treasury (including the IRS). It is uncertain what conduct would cause the Treasury to commence such a blacklisting proceeding against an appraiser under the Circular. The Act does not direct the Treasury to adopt regulations (by amendment to the Circular or otherwise) to specify a course of conduct that could result in such discipline. It seems that being subjected to the new appraiser penalty under section 6695A may serve as a basis for blacklisting.

As indicated above, an appraiser cannot avoid the new section 6695A penalty by limiting appraisals to claims for refund. It applies where the appraisal is prepared “in connection with” a return or a refund.

It seems nearly certain that the appraiser penalty and threat of blacklisting, even if the appraiser honestly and reasonably believed the appraised value was correct, will cause appraiser to be much more cautious in determining the value of property for tax purposes. Taxpayers may not be as well served under these new regimes.

The effective date of section 6695A also seems harsh. It applies to any appraisal that supports a tax position with respect to a return or submissions after August 17, 2006. For example, an estate tax return is due to be filed on December 1, 2006. The executor obtained appraisals to value property in the taxable estate in May of 2006. Because the estate tax return will be filed after August 17, the appraiser could be penalized under the section even though the appraiser had no reason to belief the appraisal was not correct. Similarly, the new blacklisting rules (no longer requiring the imposition of a penalty under section 6700) apply with respect to returns and submissions after August 17.

New Reporting Requirements for Charities Owning Life Policies

Arrangements involving tax exempt entities (such as charitable organizations) acquiring policies on the lives of individuals under which others (such as an investor group) provide funding to pay or all or part of the premiums have been proposed. The Pension Protection Act, in enacting new section 6050V, mandates reporting rules with respect to certain of these arrangements. No tax or loss of exemption of an income tax exempt entity is imposed by the Act, although penalties may be imposed if the reports are not made. The Treasury is directed to study the information received and to report the results of its study to the Senate Finance Committee and the House Ways & Means Committee within 30 months of August 17, 2006, including, according to the Staff Report, whether such arrangements are consistent with the tax exemption granted to the organizations involved, whether the arrangements are used to improperly shelter income from tax and whether these arrangement should be reportable transactions under Regulations issued under Code Sec. 6011.

The possibility (or, perhaps, foreshadowing) that the acquisition of an interest in such a policy could be a reportable transaction may inhibit the acquisition of such interests. The Treasury has required that reportable transactions be disclosed to the IRS even if the transaction was entered into before it was labeled as reportable.

Changes with respect to Charitable Easements

Although, as a general rule, a taxpayer may not deduct in any one year more than 30% of his or her adjusted gross income (as specially computed) for donations to charity of appreciated property, the Pension Protection Act allows taxpayers to deduct a charitable donation of a qualified conservation contribution, made before 2008, of up to 50% of such income. Any excess above the deductibility threshold may be carried forward, as a general rule, and be deducted over the succeeding five tax years. But the Pension Protection Act allows any excess of a donation of a qualified conservation contribution, made before 2008, to be carried over for use in the 15 succeeding tax years.

The Act is even more generous to what are called “qualified” ranchers and farmers. Such taxpayers (including corporations that qualify) may deduct up to 100% of the taxpayer’s adjusted gross income (as specially computed) for a donation, made before 2008, of a qualified conservation contribution (and carry over any excess for use of the succeeding 15 years). However, if the property is being used for agricultural or livestock production, the donation must contain a restriction providing for the property to remain available for such production in order for the contribution to be eligible for the 100% of income threshold. A qualified rancher or farmer is a taxpayer 50% or more of whose income consists of income from the trade or business of farming.

Charitable Distributions from IRAs

As a general rule, distributions from an individual retirement account (“IRA”) must be made to the owner (or, upon death, to beneficiaries who succeed to the ownership of the IRA). The Katrina Tax Relief Act of 2005 permitted taxpayers who had reached the age of 70 ½ years to distribute assets from an IRA directly to certain so-called “publicly supported” charities without having to take the distributions into gross income (but also without any charitable income tax deduction for the distribution). Although some taxpayers could have achieved similar tax treatment by taking the distribution into income and then donating that same amount to charity, many taxpayers could not: limitations on the amount deductible for income tax purposes on account of charitable contributions and the “cutback” in itemized deductions essentially means that at least a portion of the distribution would be subject to income tax. That provision expired at the end of 2005.

The Pension Protection Act of 2006 allows a more limited type of IRA distribution to certain public charities (excluding donor advised funds). For 2006 and 2007, the owner of an IRA may direct up to $100,000 each year directly to charity without, as under the Katrina Act, having to take the distribution into gross income and without any income tax charitable deduction. As under the Katrina Act, the IRA owner must be at least 70 ½ years of age.

This distribution-to-charity option may be of interest to taxpayers who do not need the distribution, face limitations on the amount deductible, a partial or total disallowance of charitable deductions under section 68, or special state or local tax systems that do not permit the full benefit of a charitable contribution.

Expansion of Inherited IRAs

The Pension Protection Act also adds some flexibility for certain persons who become entitled to amounts in qualified retirement plans (including 401(k) plans and IRAs), government section 457 plans and tax shelter annuities. A non-spouse designated beneficiary who becomes entitled to distributions from one of those plans at the participant's death may now rollover the entire plan or account balance into what is known as an "inherited IRA". Although the designated beneficiary may exercise investment control over the IRA, it is treated essentially as an IRA of the decedent. Hence, the beneficiary must take distributions in accordance with the required minimum distribution rules with respect to designated beneficiaries of plans and IRAs. In addition to giving the designated beneficiary more investment control, rolling into an inherited IRA may provide for a payout under the required minimum distribution rules. Some plans do not permit anything but a single payout when the plan participant dies.

Conclusion

Revenue Ruling 2006-26 clarifies the application of §§104(c), §409(c) and 409(d) of the UPIA, giving comfort as to the issues of determination of income and principal. It reaffirms and extends the requirements of Rev. Rul. 2000-2, providing that the UPIA provisions will not take the place of proper drafting Will or Trust Agreement creating the QTIP trust. Prudent estate planners are well advised to study the ruling and carefully apply it to their drafting.

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