Congress Passes Sweeping Charitable Incentive And Reform Package: Considerations For Nonprofit Organizations

The pension reform bill, H.R. 4, recently passed by Congress and soon to be signed into law by President Bush, contains a sweeping package of incentives and reforms related to charities and charitable contributions. While these measures are directly applicable mainly to Section 501(c)(3) organizations, the reforms will affect many, if not most, nonprofit organizations, and numerous for-profit companies. Nonprofit organizations need to understand these changes in order to take advantage of the new charitable giving incentives and ensure compliance with heightened restrictions on certain activities.

For several years, Congress and the IRS have scrutinized nonprofit organizations and considered tightening the laws governing such organizations to reduce perceived abuses and close loopholes. Senator Charles Grassley, Chairman of the Senate Finance Committee, has been the main catalyst driving the push for reforms. The measure ultimately passed by Congress is considered to be a moderated version of the package originally proposed in the Senate Finance Committee. While the provisions of this bill are not likely to come as a shock to the nonprofit community, there are some notable inclusions and absences in both the incentive and reform packages.

On the incentives side, this measure contains some, but not all, of the measures endorsed by much of the nonprofit community. The package includes several incentives that are expected to encourage increased contributions to charities. For example, there is a $100,000 exclusion from gross income for certain contributions made from an individual retirement account (IRA) or Roth IRA (if the donor is at least 701/2 years old). There is a reduction in the unrelated business income tax ("UBIT") calculation for certain payments received by controlling organizations and an improved tax basis calculation for donations made by S corporations. The incentives also extend the enhanced charitable deductions for donations of food and book inventory originally passed as part of a Hurricane Katrina relief package.

While there are additional incentives, the vast majority of the new legislation is dedicated to reforms aimed at preventing abuses by charities, private foundations, and individuals who seek "to enrich themselves rather than serve the public," in the words of Senator Grassley. Foremost among the omitted incentives is a deduction for non-itemizers who make charitable contributions.

The reforms in H.R. 4 are not only more numerous, but are larger in scope than the incentives. The reforms, like the incentives, are milder than the version originally considered by the Finance Committee. For example, there is no provision mandating the permissible size of a tax exempt organization’s board, unlike the initial Finance Committee version, and the scope of reforms with respect to supporting organizations has been narrowed. The following are merely the highlights of the reforms that Congress passed in H.R. 4.

The reform package contains a doubling of penalties for charities, private foundations, and other exempt organizations that commit certain prohibited actions, such as excess benefit transactions, etc. For example, foundation and organization managers who participate in excess benefit transactions will now be penalized $20,000 per transaction, twice the current fine.

An entirely new provision created by H.R. 4 will require tax exempt entities with less than $25,000 in gross annual receipts, which are currently exempt from filing, to file electronic informational returns with various information, including evidence that the organization continues to qualify for its tax exemption. While there is no monetary penalty associated with this provision, the IRS may revoke an entity’s tax exemption if it fails to file a return for three consecutive years. This provision is expected to allow the IRS to keep better track of small charities and to track down organizations with more than $25,000 in gross receipts who have not been filing their Form 990s.

Another major reform is a requirement that all Section 501(c)(3) organizations’ Form 990T filings, related to disclosure of unrelated business income, be made available to the public. While there is a narrow exception to this requirement, this provision has the potential to adversely affect many organizations.

Among other notable reforms, donors, and organizations that receive charitable contributions, should be aware that the substantiation and record keeping requirements related to cash contributions will change. Specifically, donors of cash must maintain a bank record or written communication from the donee for each donation they make, regardless of the amount.

For donors of property, there is a provision that permits the IRS to "recapture" the donor’s tax benefit if the donated gift is not used by the charity for exempt purposes. Moreover, the laws with regard to overstatement of donated property value will be tightened, reducing the margin for error and increasing related penalties.

Additional major reforms, among others, include a new set of standards for credit counseling organizations, an expansion on the base of tax on private foundation net investment income, and an increase in the types of information the IRS can provide to state officials regarding IRS dealings with organizations that have applied for federal tax exemption.

Given the widespread criticism of donor advised funds by Members of Congress, most publicly represented by attacks on Health and Human Services Secretary Mike Leavitt’s charitable family fund, which is known more for benefiting the Leavitt family than charities, it is not surprising that H.R. 4 includes several reforms directed at closing legal loopholes in the law with respect to donor advised funds.

The reforms, inter alia, apply excess business holdings and excess benefit transaction prohibitions to such funds, remove the deductibility of certain related payments, increase reporting and disclosure requirements, and direct the Secretary of the Treasury to conduct a study on the organization and operation of donor advised funds to be submitted to Congress within a year of the bill’s enactment.

The bill also specifically targets Section 509(a)(3) "supporting organizations," many of which are donor advised funds. Some reforms apply to all three types of supporting organizations, such as increased disclosure requirements and application of "automatic" excess benefit rules for certain payments to "substantial contributors."

Other reforms single out "Type III" supporting organizations, those operated only "in connection with," as opposed to controlled or operated by, one or more publicly supported tax exempt organizations. Such reforms include a requirement to distribute a certain percentage of the organization’s assets to its sponsoring organization each year and a modification to the deductibility of payments to and from Type III supporting organizations.

In sum, the package of charitable incentives and reforms in H.R. 4 will impact all Section 501(c)(3) entities, most nonprofit organizations, many for-profit companies, and anyone who makes charitable contributions. The modifications to the law discussed above are by no means exhaustive and it is imperative that affected entities and persons understand these changes. We routinely assist hundreds of organizations with their legal and tax compliance efforts and would welcome the opportunity to provide our services to your organization.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.