2006 Charities Reform Legislation: How Will It Affect Your Nonprofit Organization?
After more than two years of heated debate and controversial discussion drafts, Congress in August 2006 enacted charities legislation as part of the Pension Protection Act of 2006. The new law, which amends the Internal Revenue Code, will have a significant impact on many tax-exempt organizations.
The legislation doubles the penalties on private foundations, related parties and foundation managers who violate the private foundation rules regarding annual pay-out requirements, self-dealing, improper grants (taxable expenditures), excess business holdings and jeopardizing investments. It also expands the types of income to which the foundation excise tax on investment income applies.
Unrelated Business Income
On the bright side, the new law temporarily solves a problem that has long plagued groups of related organizations that include both tax-exempt and taxable entities, such as hospital systems. The tax law has classified payments of rents, royalties, and interest received from controlled taxable (and some tax-exempt) organizations as unrelated business income ("UBI"), even though such payments are not UBI if received from an unrelated party. The new law changes that result for payments made in 2005-2007, and treats such payments as UBI only to the extent that they exceed fair market value.
At the same time, the new law requires exempt organizations to make the tax return on which they report UBI, Form 990T, publicly available. Until now, the information return, Form 990, has been subject to public disclosure, but the Form 990T has not been a public document.
New Reporting Requirements for Small Organizations
Exempt organizations that are not required to file an annual Form 990 with the IRS, because their annual gross receipts do not normally exceed $25,000, will be required to file an annual notice with the IRS containing basic contact and financial information. An organization that fails to file the notice for three consecutive years will have its tax exemption revoked, and will have to reapply to the IRS in order to regain exemption. The new provision is effective for tax years beginning after 2006, and will likely lead to loss of exemption for many unsuspecting small organizations.
Donor Advised Funds
The legislation includes an array of complex new restrictions on organizations that hold donor advised funds ("DAFs"), such as community foundations. The new law prohibits grants to individuals from DAFs and restricts the types of organizations to which DAFs may make grants. Grants, loans, compensation and “similar payments” to donors, advisors and related parties are also prohibited. The new law applies the private foundation excess business holdings rules to DAFs. Those rules will severely limit the percentage interest that a DAF may own in a business enterprise, such as a corporation or partnership, that is not operated for charitable purposes. All organizations that hold DAFs should have their procedures and policies reviewed for compliance with the new law.
Prior drafts of the legislation prohibited grants from DAFs to foreign organizations. The final version permits such grants, so long as the grantmaking organization follows specific due diligence and documentation procedures.
The legislation in particular targets supporting organizations ("SOs"), i.e., charities that draw their “public charity” status from a relationship with one or more charities or certain other nonprofit organizations. The new law makes the rules for qualification as an SO even more complex than under prior law. Among other changes, the new law applies the private foundation excess business holdings rules to certain types of SOs, prohibits a variety of transactions involving SOs, and prohibits private foundations from making grants to some types of SOs. The law also makes qualification as an SO more difficult for organizations formed as charitable trusts. All SOs should have their structures, as well as their procedures and policies, reviewed for compliance with the new law.
The new law makes a number of technical changes to the rules concerning charitable contributions. On the positive side, it allows tax-free distributions from IRAs for charitable purposes. It also tightens rules concerning gifts of partial interests in tangible personal property (such as works of art) and requires donors to maintain a cancelled check, bank record, or receipt from the charity for charitable contributions of any amount.
While these changes are significant, the 2006 legislation is as noteworthy for what is not in the package as for what is. Many of the most controversial proposals that had been floated over the past two years did not make the final cut. Proposals to impose federal restrictions on board size, to restrict who may serve on nonprofit boards and to expand the ability of plaintiffs to sue charities under federal law were not included in the final bill. Also not included were proposals to apply the private foundation self-dealing rules to all charities and to limit compensation paid to foundation executives to the federal employee pay scale.
But some lawmakers continue to push for a further charities “reform” package. The national debate over how to prevent tax abuses involving exempt organizations while allowing legitimate charities to operate without undue constraints seems likely to continue.