TAX EXEMPT ENTITIES PARTICIPATING IN TAX SHELTER TRANSACTIONS

The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), enacted on May 17, 2006, includes new excise taxes and disclosure rules under Code Sections 4965 and 6033 that target certain potentially abusive tax shelter transactions to which a tax-exempt entity is a party. The managers of these entities, and in some cases the entities themselves, can be subject to excise taxes if the entity is a party to a prohibited tax shelter transaction. In Notice 2006-65, the IRS issued guidance as to the applicability of these new rules. Some of the key aspects include:

-Entities that may be affected by the new provisions include, but are not limited to, charities, churches, state and local governments, Indian tribal governments, qualified pension plans, individual retirement accounts, and similar tax-favored savings arrangements.

-Prohibited tax shelter transactions include (a) transactions that are identified by the IRS as potentially abusive “listed” tax avoidance transactions pursuant to Code Sections 6707A(c)(2) and 6011, and (b) reportable transactions that are (i) within the meaning of § 1.6011-4(b)(3) of the Income Tax Regulations, and (ii) transactions with contractual protection within the meaning of § 1.6011-4(b)(4) of the Income Tax Regulations.

-A tax-exempt entity, if subject to these rules and if a party to a prohibited tax shelter transaction, must disclose to the IRS (a) that such entity is a party to the prohibited tax shelter transaction; and (b) the identity of any other party to the transaction which is known to such tax-exempt entity.

Managers and trustees of tax-exempt entities conducting any activities that are more than plain vanilla activities should review these requirements to avoid penalties under these rules.

CAUTION NEEDED WITH POST-DEATH IRA ROLLOVERS TO A SURVIVING SPOUSE

Charlotte Gee’s husband died in 1998. He was the owner of an IRA. Charlotte then had the IRA, with a balance of $1,010,998, transferred to her own separate IRA. Charlotte was age 51 at the time.

In 2002, Charlotte directed that a $977,887.79 distribution be made to her from her IRA. She was under age 59 ½ at the time.

APPLICABLE RULE 1: Section 72(t) imposes a 10-percent penalty tax on distributions on IRAs received by beneficiaries under the age of 59 ½.

APPLICABLE RULE 2: Section 72(t)(2)(A)(ii) provides an exception to the 10-percent penalty tax for distributions "made to a beneficiary (or to the estate of the employee) on or after the death of the employee."

THE ISSUE: Can Charlotte use APPLICABLE RULE 2 to avoid a 10% penalty tax under APPLICABLE RULE 1 for her distribution? In a recent Tax Court case, Charlotte argued that the funds from her deceased husband's IRA did not lose their character as funds from her deceased husband's IRA, even though she rolled them over to her own IRA - thus, she should be able to use the APPLICABLE RULE 2 exception.

THE RESULT: The 10-percent penalty tax (here, $97,789) will apply. Once the funds were put in her IRA, they became part of her IRA and thus distributions later made to her were not distributions to a beneficiary after the death of the IRA employee.

The only good news for Charlotte in the Tax Court opinion was that the Court found reasonable cause for Charlotte’s erroneous reporting. Thus, the 20% accuracy related penalty will not apply to her.

Charlotte T. Gee, et vir. v. Commissioner, 127 T.C. No. 1 (2006).

CHARITABLE CONTRIBUTIONS OF REMAINDER INTERESTS IN RESIDENCES AND FARMS

Generally, when someone gives property to charity, to get an income tax deduction for the contribution they have to give their entire interest in the property, not just a partial interest. However, there is an important, but often overlooked, exception to this partial interest limitation that allows contributors to transfer a remainder interest in a residence or farm to a charity. A remainder interest in property means that someone is allowed the use of the property for their lifetime or for a term of years, and at the expiration of that term, the "remainder interest" then passes to the person or entity designated to receive the remainder interest.

Certain tax advantages accrue to the contributor in the circumstances. First, the contributor gets a current income tax deduction, even though he or she can continue to use the property and the property doesn't pass to the charity for many years. Second, the contributor can gift a life interest in the property to a third party along with a remainder interest to charity - this reduces the value of the taxable gift to the recipient of the life interest. Lastly, the charity gets immediate title to what is hopefully an appreciating asset - while the charity will not get possession of the property immediately, it is guaranteed to receive the remainder interest even if the contributor later changes his or her mind.

In regard to what residences may be transferred, the only requirement is that the property be a residence of the contributor. Thus, a second home or vacation home can qualify as a personal residence for this purpose. Even a yacht can qualify if it is used by the contributor as a residence.

There are some tricky aspects to these contributions. First, the transfer of the remainder interest must be by deed, and not by a trust. Second, there cannot be any restrictions on the remainder interest. For example, the contributor cannot require the remainderman to consent to any sale of the underlying property. Lastly, in determining the amount of the charitable contribution for deduction purposes, straight-line depreciation is calculated into the valuation, making estimates of future value, and allocations between depreciable and non-depreciable property important.