Tax and Pension Legislative UpdateAugust 21, 2006
In the past few months there have been two major pieces of pension and tax legislation, the Tax Increase Prevention and Reconciliation Act, signed by the President on May 18, 2006 (the Tax Act), and the Pension Protection Act of 2006, signed by the President on August 17, 2006 (the Pension Act).
The Pension Act attempts to deal with some of the problems with under-funded defined benefit plans and the issues associated with the transformation of the pension system from a defined benefit to a defined contribution framework. The Pension Act identifies defined benefit plans that are at risk, requires action to fund them, and increases premiums paid to the Pension Benefit Guaranty Corporation. The Pension Act also attempts to improve the rules governing defined contribution plans in an effort to prevent the defined contribution framework from coming up short as workers increasingly shoulder the interest-rate, return and longevity risks.
The Pension Act also adopts a number of exempt organization and charitable contribution reforms, including tightening the rules for donor-advised funds, supporting organizations and certain donations of property, while at the same time encouraging conservation easements.
The highlight of the Tax Act is the extension of the 15% capital gain and dividend tax rates through 2010, but the Tax Act also makes various changes to other Internal Revenue Code sections and extends certain provisions that were due to expire.
The following summarizes the most notable provisions of each act. Because it is a summary and not comprehensive it should not be relied upon as the basis for taking specific action without further consultation. If you have any questions please contact a member of the Tax/Employee Benefits team.
Pension Protection Act of 2006
Funding Single Employer Pension Plans. If a single employer defined benefit pension plan experiences a funding shortfall any time after 2007, the shortfall must be amortized over no more than seven years. A plan must be 100% funded to avoid a shortfall in 2011, but there are lower thresholds for the three preceding years, e.g., 92% for 2008.
If a plan is categorized as being "at risk" after 2007, the law may require accelerated funding, restrict or eliminate lump sum distributions, freeze benefits, and prohibit the plan's sponsor and any affiliates from setting aside assets to fund nonqualified deferred compensation for key executives and directors. A plan generally will be at risk if its funding percentage for the preceding year was less than 80% using normal assumptions or less than 70% using specified "worst case" assumptions. However, no plan will be "at risk" if the sponsor and all of its affiliates have fewer than 500 participants covered by pension plans.
Funding Multiemployer Pension Plans. The Pension Act's changes to the funding requirements for multiemployer plans are less drastic, but it does impose temporary requirements, effective through 2014, to improve the status of plans that are seriously underfunded. For example, the new law imposes 5% and 10% surcharges on employer contributions to a plan that is in "critical" condition because it is projected to have a minimum funding violation within the next three to six years.
Hybrid Pension Plans. The Pension Act confirms the legitimacy of cash balance, pension equity and other hybrid pension plans, but only on a prospective basis. However, the conversion of a traditional pension plan to a hybrid formula is permitted only if a participant's total benefit equals the sum of the benefit he or she earned before the conversion plus his or her post-conversion benefit under the new formula.
Automatic Enrollment. Effective for plan years beginning after December 31, 2007, the Pension Act relaxes certain 401(k) and top-heavy tests for defined contribution plans which automatically enroll an eligible employee (and start salary reductions from the employee's pay) unless he or she elects not to participate. The new automatic enrollment alternative is in addition to, not in lieu of, existing safe harbors.
To qualify under the new rules, the employer must make a nonelective contribution of 3% of each eligible employee's pay or a matching contribution equal to 100% of the first 1% of pay plus 50% of the next 5% of pay. These contributions must be fully vested after two years of service. The minimum contribution rates for automatic enrollees must be at least 3% for the first year of participation, 4% during the second, 5% during the third, and 6% thereafter, but may not exceed 10% in any year. An employee who is automatically enrolled may be permitted to withdraw the automatic contributions within 90 days of his or her first contribution. The Pension Act also provides certain fiduciary protections related to default investments of automatic contributions.
Default Investments. Under ERISA, an employer receives certain fiduciary protection if its retirement plan allows participants to direct the investment of their accounts. One question which has arisen is how to invest an employee's account when the employee does not provide an affirmative investment designation. Typically, the employer chooses a default investment, such as a balance or lifestyle mutual fund. The Pension Act generally extends the general fiduciary protection to a default investment as long as a notice requirement is satisfied, and the default investments include a "mix of asset classes consistent with capital preservation or long-term capital appreciation, or a blend of both."
Accelerated Vesting. The Pension Act requires all defined contribution plans to subject employer profit-sharing contributions to a vesting schedule that is no more stringent than the 3-year cliff or 6-year graded schedule, effective for contributions made for plan years beginning after December 31, 2006. Plans can apply more rapid vesting schedules. Under prior law, plans could apply a 5-year cliff or 7-year graded vesting schedule to these contributions.
Employer Stock. Under the Pension Act, a defined contribution plan which holds publicly traded employer stock must satisfy new diversification requirements, effective for plan years beginning after December 31, 2006. For example, a plan must offer at least three alternative investment options (other than employer stock) which are diversified and have materially different risk and return characteristics. Further, participants must have the right at all times to invest their own contributions in investments other than employer stock. (The same rights apply with respect to employer contributions after three years of service.) Plans also must provide certain notices which describe participants' rights to diversify. The new employer stock rules do not apply to ESOPs to which no 401(k) or matching contributions are made.
Investment Advice. The Pension Act amends ERISA to permit certain fiduciaries (e.g., banks, mutual funds, registered broker-dealers) to furnish investment advice to plan participants, subject to rules intended to protect against abuse, effective for advice provided after December 31, 2006. The Pension Act generally relieves plan sponsors of fiduciary responsibility for investment advice provided by third-party advisers.
EGTRRA Permanency. The Pension Act makes permanent a multitude of rules affecting qualified plans and IRAs that were enacted in 2001 as a part of the Economic Growth and Tax Relief Reconciliation Act. These provisions, which include Roth 401(k) plans, "catch-up" contributions for participants age 50 or older, and increased limits on employer and employee contributions, were previously scheduled to expire at the end of 2010.
Nonspousal Rollovers. The Pension Act permits a nonspousal beneficiary to roll over to an IRA or other plan any amount he or she inherits as a designated beneficiary, effective for distributions occurring after December 31, 2006. Under prior law, only spouses could roll death benefits over to IRAs or other employer plans.
Charitable Giving Incentives and Reforms
Conservation Easements. The Pension Act introduces new rules for conservation easement deductions. Generally, donations of partial interests in property are not deductible as charitable contributions. There is an exception, however, for qualified conservation contributions. Such contributions generally include the transfer of a remainder interest or the establishment of a restriction so that the property is used exclusively for conservation purposes. Generally, conservation purposes include the preservation of land areas for outdoor recreation by the general public, the protection of a relatively natural habitat or ecosystems, the preservation of open space where such preservation will yield a significant public benefit, and the preservation of historically important land or a certified historic structure.
The Pension Act makes three significant changes to the rules for qualified conservation contributions. First, for contributions made in tax years beginning after December 31, 2005 and before January 1, 2008, individuals are now allowed to deduct the fair market value of any qualified conservation contribution up to 50% (in the case of farmers or ranchers, 100%) of the donor's contribution base (i.e., adjusted gross income less net operating losses) and carry forward any excess deduction for up to 15 years.
Second, effective for contributions made after August 17, 2006, the Pension Act narrows the definition of certified historic structure for this purpose to exclude structures and land that are not certified as historic but instead merely located in a registered historic district, precluding deductions for contributions of such properties.
Third, effective for contributions made after August 17, 2006, the Pension Act reduces the charitable deduction for a qualified conservation contribution of historic structures by the amount of recent rehabilitation credits allowed to the taxpayer for a building that is part of the contribution.
Charitable Contributions of Fractional Interests in Property. The Pension Act adds new rigor to the rules relating to deductions for fractional interests in tangible personal property, effective for contributions made after August 17, 2006. As in the past, a donor will be able to obtain a deduction for the donation of a fraction or percentage interest in tangible personal property if the interest extends over the entire term of the donor's ownership of the property and the donee is given the right as a tenant in common with the donor. The Pension Act provides additional requirements for contributions of fractional or percentage interests. First, the donor will generally need to own the entire interest in the property prior to donation. Second, the fair market value of the property at the time the first percentage or fractional interest is donated will control the value of any future donations. Third, the donee must receive full title to the property within ten years of the initial gift or by the time of the death of the donor, whichever occurs first, and the donee must have gained substantial possession of the property for charitable use in the time between receipt of the initial gift and obtaining full title. If the donee does not receive substantial use and full title as required, there will be recapture of the donation deduction for the fractional interest plus a penalty.
Charitable Contributions of Money. The Pension Act revises the record keeping requirements for charitable contributions of money, effective for contributions made in tax years beginning after August 17, 2006. Prior to the enactment of the Pension Act, in order to receive a deduction a donor had to maintain either a cancelled check, a receipt (or letter or other written communication) from the donee showing the name of the donee organization, the date of the contribution, and the amount of the contribution, or in the absence of a cancelled check or a receipt, other reliable written records showing the name of the donee, the date of the contribution, and the amount of the contribution. For tax years beginning after August 17, 2006, the donor must maintain a bank record or a written communication from the donee showing the name of the donee organization, the date of the contribution, and the amount of the contribution. Cash contributions without an acknowledgment will not be sufficient, making it advisable to use a check in circumstances such as a collection box in which a receipt will not be available.
IRAs and Charitable Contributions. Under the Pension Act, certain taxpayers can exclude from taxable income distributions from an IRA to a charity. To qualify for the tax-free distribution, the distribution must be made directly by the IRA trustee to a qualifying organization after the IRA owner attains age 70½. If any other applicable limitation to the charitable contribution applies, with the exception of the overall percentage limitations, the distribution is not excludable in its entirety. For instance, if the taxpayer receives a benefit in exchange for the donation or if the contribution is not adequately substantiated, the entire distribution is subject to the general rules for distributions and charitable deductions. The maximum yearly exclusion from income is $100,000. This provision is effective for distributions made in taxable years beginning after December 31, 2005, and before January 1, 2008.
Charitable Contributions for Household Goods. The Pension Act makes a few small changes to the contribution of household goods and clothing effective for contributions made after August 17, 2006. Under the new provision deductions are disallowed unless the donated items are in good or better condition. However, a deduction will be allowed for a charitable contribution of $500 or more even if the item is not in good or better condition, provided the taxpayer includes a qualified appraisal with respect to the property. The Pension Act also gives the IRS the authority to deny a deduction for donated items of little value.
Charitable Contributions by S Corporations. The Pension Act alters the basis adjustment for a shareholder of an S corporation that contributes property to a charity. Under prior law, the basis of an S corporation shareholder was decreased by the amount of charitable contributions that flowed through to the shareholder from the S corporation. Under the Pension Act, the basis is only decreased by the taxpayer's pro rata share of the S corporation's basis in the donated property, similar to the treatment for partnerships. For example, if an S corporation with one shareholder contributed property with a basis of $1,000 and a fair market value of $2,000, that shareholder would have a $2,000 charitable deduction but would only reduce basis by $1,000. This provision applies to contributions made in taxable years beginning after December 31, 2005, and before January 1, 2008.
Recapture for Donations of Tangible Personal Property. Generally, a taxpayer may deduct the fair market value of tangible personal property donated to an exempt organization provided that the organization uses the property in manner related to the organization's exempt status. Under the Pension Act, donations of appreciated personal tangible property to an exempt organization are subject to recapture if (1) the deduction claimed exceeds $5,000, (2) the property is identified by the donee organization for use related to the purpose or function that serves as the basis for the donee's tax exemption, and (3) the property is subsequently resold within the first three years following the donation. If the donated property is resold within the same tax year of the donation, the charitable deduction for the year will be equal to the donor's basis. If the resale occurs after the first year, but before three years has expired, the donee will include as ordinary income the amount that the claimed charitable deduction exceeded the basis at the time of the donation. Recapture of the tax benefit can be avoided if the organization makes a certification that either the use of the property by the organization was related to the purpose or function constituting the basis for the organization's exemption and describes how such use furthered that purpose or function, or the intended use of the property at the time of the donation became impossible or infeasible to implement.
Reforming Exempt Organizations
Increases in Penalties. Under current law, certain transactions engaged in by private foundations are subject to excise taxes designed to prohibit such transactions. Prohibited transactions include self-dealing transactions between private foundations and certain disqualified persons, failure to meet required annual charitable distribution requirements, retention of excess business holdings, the making of jeopardizing investments and the making of certain taxable expenditures. Effective for tax years beginning after August 17, 2006, the Pension Act doubles the amounts and percentages of the taxes.
Under current law, if disqualified persons (generally foundation managers and persons in a position to exercise substantial influence) with respect to public charities receive "excess benefits" (such as excessive compensation or excessive profit from transactions with the organization) the foundation managers who authorized or participated in the transaction are subject to a tax of $10,000. Effective for tax years beginning after August 17, 2006, the Pension Act doubles the penalty to $20,000.
Expansion of the Base for the Private Foundation Tax on Investment Income. Private foundations are subject to a 2% (subject to possible reduction to 1% based on the amount of annual charitable distributions) excise tax on investment income, including capital gains. Current law generally excludes from the excise tax gains on the sale of property used to further a private foundation's exempt purposes, such as the real estate where its office is located, or items constituting the collection of a private museum. The Pension Act expands the number of items which are subject to the excise tax and no longer exempts capital gains on dispositions of exempt use property. However, exempt use property held for at least one year may be exchanged for like kind property in a Section 1031 transaction. The change is effective for tax years beginning after August 17, 2006.
Donor-Advised Funds. Many charitable organizations administer funds established by donors who reserve the right to advise the charity concerning distributions from or investments to be made by the fund. Under current law, such funds have generally not been subject to any regulation apart from the tax provisions applying to charitable organizations generally. The Pension Act imposes a number of regulations and restrictions on the operation and administration of donor-advised funds.
Substantiation. Effective for gifts made after February 13, 2007, the donor must receive a contemporaneous written acknowledgement from the organization that the organization has exclusive legal control over the contributed assets.
Prohibited Distributions. Effective for tax years beginning after August 17, 2006, distributions to an entity if the distribution is not for a charitable purpose and distributions to an individual are prohibited and will subject the recipients and persons approving the distributions to excise taxes. Also, grants for charitable purposes to organizations not described in Section 170(b)(1)(A) are permitted only if "expenditure responsibility" is exercised. This generally requires a pre-grant investigation, a grant agreement with the recipient, measures to verify that the grant is used for the intended purpose and post-grant reporting.
Prohibited Benefits. Effective for tax years beginning after August 17, 2006, penalties apply if the donor, advisor or related parties receive more than "incidental benefits" from a donor-advised grant. The committee reports indicate that a more than incidental benefit exists if a donor receives a benefit that would have reduced (or eliminated) a charitable contribution deduction if the benefit was received as part of the contribution. Examples might be admission to special events, which are commonly stated in donor acknowledgement letters as reducing the amount of charitable contributions.
Automatic Excess Benefits Transactions. The Pension Act bars grants, loans, compensation and similar payments (including expense reimbursement) from donor-advised funds to donors, advisors and related parties. Receipt of such payments is automatically treated as an excess benefit transaction subject to penalty and correction. This provision is effective for transactions occurring after August 17, 2006.
Investment Advisors. Under the Pension Act, investment advisors are regarded as "disqualified persons" for purposes of the excess benefits rule. Accordingly, investment advisors will be subject to penalties if they receive excessive compensation. This provision is effective for transactions occurring after August 17, 2006.
Excess Business Holdings Rule. Effective for tax years beginning after August 17, 2006, the Pension Act makes the private foundation excess business holdings rules applicable to donor-advised funds. These rules are complex, but generally provide that an advised fund and disqualified persons with respect to the fund together cannot own more than 20% of the voting stock of a business.
Supporting Organizations. Many charitable organizations have "friends" organizations or other affiliates known as supporting organizations that provide financial support to another (supported) organization or carry out one or more functions of the supported organization. Under prior law, supporting organizations were recognized as "public" charities and were not subject to the restrictions placed on private foundations. The Pension Act increases the regulation of supporting organizations, by providing for the following:
Excess Benefit Transactions. Effective for transactions occurring after July 25, 2006, the Pension Act provides that grants, loans, compensation or similar payments (including expense reimbursement) to the supporting organization's substantial contributors, members of the substantial contributor's family, or businesses they control are automatically considered to be prohibited excess benefit transactions.
Loans Prohibited. Effective for transactions occurring after July 25, 2006, supporting organizations may not make loans to any disqualified persons (includes foundation managers).
Supported Organization Disqualified Status. Effective as of August 17, 2006, persons who are disqualified persons with respect to a supporting organization will also be disqualified with respect to the supported organization. Accordingly, transactions between a supported organization and a disqualified person with respect to a supporting organization will be subject to the excess benefit rules.
Excess Business Holdings Rule. The Pension Act makes the private foundation excess business holdings rule applicable to certain supporting organizations.
Grants by Private Foundations to Certain Supporting Organizations. Effective for distributions and expenditures after August 17, 2006, private foundations must now exercise expenditure responsibility in making grants to certain supporting organizations if a disqualified person of the private foundation directly or indirectly controls the supported organization.
Filing Requirements for Exempt Organizations. The Pension Act requires certain exempt organizations to provide the IRS with more information than was required in the past. Generally, exempt organizations are required to file an annual information return (Form 990). Under prior law, exempt organizations (other than private foundations) were not required to file an annual return if gross receipts of the organization do not normally exceed $25,000. Effective for tax years beginning after December 31, 2006, exempt organizations that are not required to file an annual information return because its gross receipts do not normally exceed $25,000 must provide annually information such as the legal name of the business, the organization's taxpayer ID, and the basis for the organization's exemption from requiring the annul information return.
Public Inspection of Exempt Organization Tax Returns. The Pension Act requires that private foundations and Section 501(c)(3) public charities make available for public inspection their unrelated business income tax returns (Form 990-T). As in the past, organizations described in Section 501(c) are required to make available for public inspection their information returns (Form 990). If the organization does not provide the information for three consecutive years, the organization's tax-exempt status is revoked. The Pension Act also provides that organizations that are required to file an annual information return and fail to do so for three consecutive years will lose their tax-exempt status. This provision is effective for notices and returns with respect to tax years beginning after December 31, 2006.
Tax Treatment of Company-Owned Life Insurance.
The Pension Act provides generally that, in the case of an employer-owned life insurance contract, the amount excluded from the policyholder's income as a death benefit cannot exceed the premiums and other amounts paid by such policyholder for the contract. The excess death benefit is included in income. The new provision is effective life insurance contracts issued after August 17, 2006.
Exceptions to this income inclusion rule are provided. In the case of a life insurance contract with respect to which certain notice and insured consent requirements are met, the income inclusion rule does not apply (1) to amounts received by reason of the death of an insured who, with respect to the policyholder, was an employee at any time during the 12-month period before the insured's death, or who, at the time the contract was issued, was a director or highly compensated employee or highly compensated individual, and (2) to amounts received by reason of the death of an insured, to the extent the amount is (a) paid to a member of the family of the insured, to an individual who is the designated beneficiary of the insured, to a trust established for the benefit of any such member of the family or designated beneficiary, or to the estate of the insured; or (b) used to purchase an equity (or partnership capital or profits) interest in the policyholder from such a family member, beneficiary, trust or estate.
Tax Increase and Reconciliation Act
Long-term Capital Gains and Dividends. The Tax Act extends for an additional two years, the lower rates for dividends and capital gains that were scheduled to expire on December 31, 2008. Under these rules, the tax rate on most long-term capital gains and dividends are 5% or 15%. A taxpayer pays 5% (which is reduced to 0% for years beginning after 2007) on the amount of the dividends that would be taxed at the 10% or 15% marginal tax bracket if the income were ordinary income. Most other long-term capital gains and dividends are taxed at 15% (there are still the special categories of gain that are taxed at 25% or 28%).
Conversion of IRAs to Roth IRAs. The Tax Act removes the modified adjusted gross income ("AGI") limitations for taxpayers who convert traditional IRAs to Roth IRAs after December 31, 2009. Previously, only taxpayers with a modified AGI of $100,000 or less could convert a traditional IRA into a Roth IRA without the 10% early withdrawal penalty. Under the Tax Act, for all years except 2010, the taxpayer includes in taxable income the amount converted during the year of conversion. For conversions in 2010, half of the amount converted in 2010 will be taxed in 2011 and half will be taxed in 2012, unless the taxpayer elects otherwise.
Kiddie Tax. The Tax Act increases the age at which a child can be subject to "kiddie tax" from less than 14 years of age to less than 18 years, effective for tax years beginning after December 31, 2005. Under the "kiddie tax" rules, a child's unearned income (i.e. interest, dividends and capital gains) that exceeds an annual inflation-adjusted amount are taxed at the parent's marginal tax bracket. In 2006, a child that has no other earned income will be taxed at his/her parent's highest marginal tax bracket for all amounts that exceeded $1,700. Absent adequate financial planning, the increase in age for the application of the "kiddie tax" will likely affect many college bound students as their college savings accounts grow in preparation for college. One method to avoid application of the "kiddie tax" on college savings accounts is to invest college savings in a Section 529 plan.
AMT Exemption. The Tax Act increases the 2006 Alternative Minimum Tax ("AMT") exemption to $62,550 for married taxpayers and $42,500 for unmarried taxpayers. While this will provide AMT protection for millions of taxpayers in 2006, the increased exemption only applies to the 2006 tax year. Absent additional legislative action, the exemption amounts will return to the 2000 levels of $45,000 for married taxpayers and $33,750 for individuals.
Section 179 Expensing. The Tax Act extended the enhanced Section 179 expensing deduction for two years through 2009. In 2006, taxpayers other than a trust or an estate may expense $108,000 of tangible personal property that is placed into service in a trade or business during the year. The maximum deduction is reduced for every dollar that qualified purchases exceed $430,000 during 2006. The maximum deduction and the phase-out ceiling are adjusted each year through 2009. Additionally, off-the-shelf software is an approved property for Section 179 expensing. After 2009, the maximum deduction allowed is expected to decline to $25,000 per year, the phase-out will begin at $200,000 of purchases, and off-the-shelf software will no longer qualify as "Section 179 property."
Tax-free Spinoffs. The Tax Act makes certain changes to tax-free corporate divisions under Section 355. In general, if the requirements of Section 355 are met, a corporation may transfer a part of its assets to a controlled corporation, followed by a distribution of the controlled corporation's stock in a spin-off, split-off or split-up without recognizing taxable income.
The Tax Act places a fixed limit on the amount of passive investments a company may hold while still qualifying for tax-free treatment under Section 355. Before the Tax Act, it was unclear how much of a company could be comprised of passive investments before the presence of such assets would disqualify the use of Section 355. Investment assets are defined to include cash, any stock or securities in a corporation, any interest in a partnership, and any debt instrument or other evidence of indebtedness. Under the Tax Act, the amount of investment assets of the controlled corporation or the distributing corporation may not exceed 2/3 or more of the fair market value of all assets of the corporation. The maximum amount is increased to 3/4 of the fair market value for the one year period that immediately preceded the enactment of the Tax Act. By expressly placing a limitation on the amount of allowable investment assets, the Tax Act is signaling that a substantial amount of cash may change hands without being taxed.
Self-created Musical Works and Copyrights. The Tax Act provides capital gains treatment for sales of self-created musical work in tax years beginning after May 17, 2006 and before January 1, 2011. This includes the sale or exchange of musical compositions or copyrights in musical works. Previously, the gain was treated as ordinary income.
Extenders Not Included. There are a number of items that were expected to be extended but were left out of the Tax Act. There continues to be talk of including these in a subsequent bill, but they have been held up in the debate over estate tax reform. Some of the items that are expected to be included in a subsequent extender are the research credit, 15-year straight-line write-offs for qualified leasehold improvements and qualified restaurant improvements, the work opportunity and welfare-to-work credits, the choice to deduct state and local general sales taxes, and the above-the-line deductions for qualified tuition and teacher classroom expenses. Many of these expired January 1, 2006, and it was originally expected that the extension would be retroactive to January 1, 2006, but with the passage of time it is becoming less likely.
* * * * * * Pursuant to Circular 230 promulgated by the Internal Revenue Service, if this correspondence, or any attachment hereto, contains advice concerning any federal tax issue or submission, please be advised that it was not intended or written to be used, and that it cannot be used, for the purpose of avoiding federal tax penalties unless otherwise expressly indicated.