Pension Protection Act Glossary
On Aug. 17, 2006, President Bush signed into law a bill that will impact grantmakers and donors.
The new charitable provisions, part of the Pension Protection Act of 2006 (H.R. 4), include the
first comprehensive regulation of donor-advised funds, as well as reforms or incentives that will
affect private foundations, supporting organizations and individual donors.
Legal Disclaimer: The following information was gleaned from a variety of sources. None of this information should be construed as offering legal advice. The specific advice of tax counsel is recommended before acting on any matter discussed here.
Date of Enactment
The Pension Protection Act of 2006 was signed by the President on August 17, 2006, which is the date of enactment. Most provisions of the law require compliance with tax returns filed after that date. Some provisions are effective after six months of enactment, February 13, 2007, or on the date the legislation was approved by the two houses of Congress, July 25, 2006.
Donor Acknowledgments
Donors may claim tax deduction for contributions to a donor-advised fund only if they receive a written acknowledgment from the community foundation stating that the foundation has exclusive legal control over the contributed assets. Community foundations need to add appropriate language to their standard written acknowledgment letters, such as "As required by federal tax laws, the Foundation has exclusive legal control over the entire contribution." This requirement becomes effective on February 13, 2007.
Donor-Advised Funds (new definitions)
The Pension Protection Act of 2006 defines a donor-advised fund as a fund that possesses the three following characteristics:
- Is separately identified with reference to the contribution of one donor or more donors, e.g., the fund is named after a donor or persons related to the donor, or the organization's books track contributions to the fund with respect to the specific donor(s).
- Is owned and controlled by a community foundation or other sponsoring charitable organization.
- Affords advisory rights to the donor or his or her appointee with respect to investments or distributions.
The definition does not include funds that benefit only one charity or governmental unit or making grants for scholarships and similar purposes if the fund is advised by a committee wholly appointed by the community foundation and grants are made according to an "objective and nondiscriminatory" process that tracks the rules applicable to private foundations that make scholarship grants.
Donor-Advised Funds Grant Restrictions
Community foundations with advised scholarship funds must take steps to bring those funds into compliance with the law's new requirements (i.e., makes grants for scholarships and similar purposes if the fund is advised by a committee wholly appointed by the community foundation and grants are made according to an "objective and nondiscriminatory" process that tracks the rules applicable to private foundations that make scholarship grants).
Subject to the exception for scholarship funds, donor-advised funds may not make grants to individuals, nor may donor-advised funds make grants to organizations for any noncharitable purpose. Grants may not be made to 1) private non-operating foundations, 2) most Type III supporting organizations and other supporting organizations in which the donor or advisor controls the supported organization(s) and 3) foreign organizations, unless the community foundation exercises "expenditure responsibility" to ensure that the grant is used appropriately for charitable purposes.
Excessive Business Holdings
The Pension Protection Act applies the "excessive business holdings" rules previously applicable only to private foundations to donor-advised funds. In general, they prevent a donor-advised fund from holding more than a 20 percent ownership interest in an active trade or business. The excess business holdings rules apply only to interest in a so-called "business enterprise," i.e., a business that derives more than 5 percent of its gross income from an active trade or business. The excess business holdings rules do not apply to 1) holdings in a trade or business which obtains at least 95 percent of its gross income from passive sources (e.g., an investment partnership that derives its income from interest, dividends, rents or royalties), or 2) program-related investments. These provisions become effective, subject to transition rules, in tax years beginning after the date of enactment.
Excise Taxes
Private foundations are subject to an excise tax of 2 percent, or in some cases 1 percent, on their net investment income (dividends, interest, rents, royalties and capital gains from the sale of stocks, bonds and other investment assets). The Pension Protection Act makes several important changes in how taxable net investment income is defined, effective August 17, 2006:
- Other less traditional forms of income such as annuity payments, securities loans and notional principal contracts (e.g., interest rate swaps) are included in the tax base.
- Gains from the sale of property that is held for appreciation but may not produce income (e.g., raw land) is also included in the base.
- Gains from the sale of assets held for exempt purposes or as a program-related investment are no longer excluded from the tax base, e.g., the sale of appreciated property used as a foundation office or rented to other nonprofits below cost are not subject to the excise tax.
Expenditure Responsibility
Under the Pension Protection Act, grants will not count as qualifying distributions and will be treated as a taxable expenditure, if they are made by a private foundation to 1) a Type III supporting organization that is not "functionally integrated" (i.e., the supporting organization does not directly carry out a function or activity of the supported charity or charities), or 2) any type of supporting organization if a disqualified person with respect to the private foundation directly or indirectly controls the supporting organization or a public charity that the supporting organizations support.
Foundations will now need to conduct appropriate due diligence to determine whether any of its grantees is a Type III supporting organization and whether any disqualified persons control the supporting or supported organization. Generally, a grantee's IRS determination letter will indicate whether it is a 509(a)(5) supporting organization; if the letter indicates that it is a supporting organization, then additional due diligence is required to determine if it is a Type III organization.
IRA Charitable Rollover
The Pension Protection Act permits individuals older than 70½ to contribute, in 2006 and 2007, up to $100,000 per year from an IRA directly to a charitable organization and to exclude the contributed amount from their gross income for tax purposes. The exclusion is not available for contributions to private foundations or to donor-advised funds.
Penalty Taxes for Private Foundations
Private foundations are subject to special limitations and restrictions on their activities and operations. Violations of these rules can result in the imposition of penalty taxes on the foundation, its directors and officers and certain disqualified persons, e.g. substantial contributors and their relatives and entities in which they have a substantial interest. The Pension Protection Act significantly increases many of these penalties, in most cases doubling them, effective for tax years beginning after August 17, 2006.
Reporting Requirements for Community Foundations
Effective for tax years beginning after August 17, 2006, community foundations will be required to disclose:
- The total number of donor-advised funds they own.
- The aggregate values of assets held by those funds at the end of the foundation's tax year.
- The aggregate contributions to and grants made from those funds during the tax year.
Supporting Organizations
The Pension Protection Act of 2006 prohibits private foundations (other than operating foundations) from making grants to certain types of supporting organizations. A supporting organization is a special type of 501(c)(3) organization that qualifies as a public charity because it has a special relationship with one or more public charities and uses its resources to support those charities.
- Type I: A Type I supporting organization is "controlled" by the charity or charities it supports. The supported charity or charities usually exercise this control through their authority to appoint at least a majority of the trustees or directors of the Type I supporting organization. The relationship between a Type I supporting organization and its supported charity or charities is analogous to a parent-subsidiary relationship. Most supporting organizations fall into this group.
- Type II: A Type II supporting organization stands in a brother-sister relationship with the charity or charities it supports. To qualify as a Type II supporting organization, there must be common supervision or control of both the supporting organization and the supported charity or charities. Control of the supporting organization must be vested in the same people that control or manage the supported charity or charities.
- Type III: Type III supporting organizations off the greatest planning potential but also the greatest possibility of abuse because of the tenuous nature of the required relationship between a Type III supporting organization and the charity or charities it supports. To qualify as a Type III, a supporting organization must satisfy a number of complicated requirements designed to ensure that the supporting organization is responsive to and significantly involved in the operations of the supported charity or charities.
Supporting Organizations Disclosures on Form 990
Every supporting organization must disclose on its annual information return Form 990 whether it is a Type, I, II or II supporting organization. It must also identify the public charities that it supports. In addition, it mush also certify that it is not controlled by disqualified persons. This requirement is applicable to all returns filed after August 17, 2006.
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