The New Pension Reform Law Affects Every Church

Provisions go far beyond pension plans.

Provisions go far beyond pension plans.

Article summary. In August Congress enacted the most comprehensive pension reform legislation in over 30 years. While the massive Pension Protection Act of 2006 is designed primarily to provide added security to employees enrolled in pension plans, it also addresses additional issues that affect church leaders, including some that will impact charitable contributions made to churches. Church leaders need to be familiar with these provisions. This article explains the provisions in the new law that are of most importance to churches, and illustrates them with examples.

Congress enacted a massive new 900-page pension reform bill designed to strengthen pension plans and reduce the need for taxpayer-funded bailouts of failed plans. While the main focus of the ‘Pension Protection Act of 2006’ is pension reform, the Act also includes a number of unrelated provisions of direct relevance to every church. Most notably, the Act imposes new requirements on the substantiation of charitable contributions. These requirements take effect immediately, and affect contributions made to churches.

In summary, this Act affects nearly everyone, since it applies to the millions of Americans enrolled in pension or retirement plans, as well as persons who make charitable contributions to churches or charities.

This article focuses on those provisions in the new law that are of greatest relevance to church leaders. We will begin by focusing on the provisions that apply to charities and charitable contributions, and then address the retirement provisions.

Charitable Giving Incentives

The Pension Protection Act contains charitable giving incentives designed to encourage charitable donations. Here are the main provisions of interest to church leaders.

1. Tax-free distributions from IRAs for charitable purposes

The Pension Protection Act of 2006 allows tax-free ‘qualified charitable distributions’ of up to $100,000 from an IRA to a church or other charity. Note the following rules and conditions:

  • A qualified charitable distribution is any distribution from an IRA directly by the IRA trustee to a charitable organization, including a church, that are made on or after the date the IRA owner attains age 70½.
  • A distribution will be treated as a qualified charitable distribution only to the extent that it would be includible in taxable income without regard to this provision.
  • This provision applies only if a charitable contribution deduction for the entire distribution would be allowable under present law, determined without regard to the generally applicable percentage limitations. For example, if the deductible amount is reduced because the donor receives a benefit in exchange for the contribution of some or all of his or her IRA account, or if a deduction is not allowable because the donor did not have sufficient substantiation, the exclusion is not available with respect to any part of the IRA distribution.
  • If an IRA owner has any IRA that includes nondeductible contributions, a special rule applies in determining the portion of a distribution that is includible in taxable income and thus is eligible for qualified charitable distribution treatment. Under the special rule, the distribution is treated as consisting of income first, up to the amount that would be includible in taxable income if the balance of all IRAs having the same owner were distributed during the same year. In determining the amount of subsequent IRA distributions includible in income, proper adjustments are to be made to reflect the amount treated as a qualified charitable distribution under the special rule.
  • Qualified charitable distributions that are not includible in taxable income pursuant to this provision are not to be taken into account in determining a taxpayer’s allowable charitable contribution deduction for any other contributions made during the year.
  • This provision is effective for distributions made in 2006 and 2007.

Example. Ted is a 50-year-old church member who would like to make a tax-free distribution of part of his IRA account to satisfy a pledge he made to his church’s building fund. He will not be able to do so, since he is not at least 70½ years of age.

Example. Terry is 72 years old, and at the end of 2006 makes a transfer of $20,000 from her IRA account to her church. The church failed to provide her with a written acknowledgment of her contribution, as required by the tax code for any contribution of $250 or more. The distribution of $20,000 from Terry’s IRA to her church is tax-free only if it meets all of the requirements of a deductible charitable contribution (other than the percentage limitations). Since Terry’s $20,000 contribution would not be allowed due to the church’s failure to provide her with an adequate written acknowledgment, the entire $20,000 IRA distribution must be reported by Terry as taxable income.

Example. Gary is 75 years old, and at the end of 2006 makes a transfer of $50,000 from his IRA account to his church. The church provides Gary with a written acknowledgment of his contribution. His gross income for the year is $40,000. A distribution from an IRA to a church or charity is tax-free only if a charitable contribution deduction for the entire distribution would be allowable, determined without regard to the percentage limitations. Generally, individual donors cannot claim a charitable contribution deduction in excess of 50% of their adjusted gross income for contributions to a church, meaning that Gary’s $50,000 IRA contribution would not be entirely deductible if it were in the form of a cash contribution. However, the Pension Protection Act of 2006 clarifies that the percentage limitations on charitable contributions are not considered in deciding if an IRA donation is fully deductible.

Example. Jan had a traditional IRA with a balance of $100,000 in 2005, consisting solely of deductible contributions and earnings. She had no other IRA. In 2005 she had the entire IRA balance distributed to her church. The entire distribution of $100,000 was included in Jan’s income.

Example. Tom has a traditional IRA with a balance of $100,000, consisting of $20,000 of nondeductible contributions and $80,000 of deductible contributions and earnings. Tom has no other IRA. Tom distributes $80,000 of his IRA balance to his church. The distribution is treated as consisting of income first, up to the total amount that would be includible in taxable income (but for the provision) if all amounts were distributed from all IRAs otherwise taken into account in determining the amount of IRA distributions. The total amount that would be includible in income if all amounts were distributed from the IRA is $80,000. As a result, the entire $80,000 distributed to the church is treated as includible in income (before application of the provision) and is a qualified charitable distribution. Therefore, no amount is included in Tom’s income as a result of the distribution and the distribution is not taken into account in determining the amount of Tom’s charitable deduction for the year. In addition, for purposes of determining the tax treatment of other distributions from the IRA, $20,000 of the amount remaining in the IRA is treated as Tom’s nondeductible contributions (i.e., not subject to tax upon distribution).

2. Charitable deduction for contributions of food inventory

A taxpayer’s deduction for charitable contributions of inventory generally is limited to the taxpayer’s basis (cost) in the inventory, or if less, the fair market value of the inventory. For certain contributions of inventory, ‘C corporations’ may claim an enhanced deduction equal to the lesser of (1) basis plus one-half of the item’s appreciation (i.e., basis plus one half of fair market value in excess of basis) or (2) two times basis. In general, a C corporation’s charitable contribution deductions for a year may not exceed 10 percent of the corporation’s taxable income.

To be eligible for the enhanced deduction, the contributed property generally must be inventory of the taxpayer, contributed to a charitable organization, and the charity must (1) use the property consistent with its exempt purpose solely for the care of the ill, the needy, or infants, (2) not transfer the property in exchange for money, other property, or services, and (3) provide the taxpayer a written statement that the charity’s use of the property will be consistent with such requirements.

Under the Katrina Emergency Tax Relief Act of 2005, any taxpayer engaged in a trade or business is eligible to claim the enhanced deduction for certain donations made after August 28, 2005 and before January 1, 2006, of food inventory. In other words, the enhanced deduction is not limited to C corporations. However, the total deduction for donations of food inventory in a given year generally may not exceed 10 percent of a taxpayer’s net income from all business entities from which contributions of ‘apparently wholesome food’ were made. ‘Apparently wholesome food’ is defined as food intended for human consumption that meets all quality and labeling standards imposed by federal, state, and local laws and regulations even though the food may not be readily marketable due to appearance, age, freshness, grade, size, surplus, or other conditions.

The Pension Protection Act extends the provision enacted as part of the Katrina Emergency Tax Relief Act of 2005. Any taxpayer, whether or not a corporation, engaged in a trade or business is eligible to claim the enhanced deduction for donations of food inventory. The total deduction for donations of food inventory in a given year generally may not exceed 10 percent of the taxpayer’s net income for such taxable year from all business entities from which contributions of apparently wholesome food are made.

This provision is effective for contributions made after December 31, 2005, and before January 1, 2008.

Charitable Reform

The Pension Protection Act of 2006 contains a charitable reform package designed to responsibly regulate exempt organizations. Here are the main provisions of interest to church leaders.

1. Modification of recordkeeping requirements for cash contributions

Caution. The Pension Protection Act of 2006 changes the way that donors substantiate cash contributions to a church or charity. Church leaders must be familiar with these new rules to ensure that members will be able to deduct their cash contributions. The new rules took effect upon enactment of the Act on August 17, 2006.

A donor who claims a deduction for a charitable contribution must maintain reliable written records regarding the contribution, regardless of the value or amount of the contribution.

Contributions of cash

Prior to enactment of the Pension Protection Act of 2006, donors could substantiate a cash contribution to a church or charity with any one of the following:

(1) a cancelled check;

(2) a receipt (or a 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

(3) 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.

As noted below, the Pension Protection Act of 2006 changes the way that cash contributions are substantiated.

Contributions of noncash property

For a contribution of property other than money, the donor generally must maintain a receipt from the donee charity showing the name of the donee, the date and location of the contribution, and a detailed description (but not the value) of the property. A donor of property other than money need not obtain a receipt, however, if circumstances make obtaining a receipt impracticable. Under such circumstances, the donor must maintain reliable written records regarding the contribution. The required content of such a record varies depending upon factors such as the type and value of property contributed.

Contributions of $250 or more

In addition to the foregoing recordkeeping requirements, substantiation requirements apply in the case of individual charitable contributions with a value of $250 or more. No charitable deduction is allowed for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgement of the contribution from the donee organization. Such acknowledgement must include the amount of cash and a description (but not value) of any property other than cash contributed, whether the donee provided any goods or services in consideration for the contribution, and a good faith estimate of the value of any such goods or services. In general, if the total charitable deduction claimed for non-cash property is more than $500, the taxpayer must attach a completed Form 8283 (Noncash Charitable Contributions) to the taxpayer’s return or the deduction is not allowed. In general, taxpayers are required to obtain a qualified appraisal for donated property with a value of more than $5,000, and to attach an appraisal summary to the tax return (Form 8283, Section B).

The Pension Protection Act

The rules for substantiating contributions of noncash property were not affected by the Pension Protection Act of 2006. However, the Act made an important change in the way that contributions of cash are substantiated. It amended the tax code to require all cash contributions, regardless of amount, to be substantiated by either a bank record (such as a cancelled check) 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. The recordkeeping requirements may not be satisfied by maintaining other written records. In the past, donors could substantiate cash contributions of less than $250 with ‘other reliable written records showing the name of the donee, the date of the contribution, and the amount of the contribution’ if no cancelled check or receipt was available. This is no longer allowed.

As noted above, additional substantiation requirements apply to individual contributions (of cash or property) of $250 or more, and these must be satisfied as well.

This change is effective for contributions made in taxable years beginning after the date of enactment.

Example. A church member makes cash contributions to his church of between $20 and $50 each week. He uses offering envelopes provided by the church, but the church provides no other receipt or statement substantiating the contributions. The member will not be able to claim a charitable contribution deduction for any of these payments. The Pension Protection Act of 2006 amended the tax code to require all cash contributions, regardless of amount, to be substantiated by either a bank record (such as a cancelled check) 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. The recordkeeping requirements may not be satisfied by maintaining other written records.

Example. The IRS audits a taxpayer’s 2006 federal income tax return, and questions an alleged contribution of $100 to a church that was made on October 1, 2006, and for which the taxpayer has no canceled check or church receipt. The taxpayer does maintain a daily diary. A diary entry on the alleged date of the contribution shows that a contribution of $100 was made to the church. Such diary entries, if regularly made, constitute reliable written records supporting cash contributions of under $250 under prior law. However, the Pension Protection Act of 2006 amended the tax code to require all cash contributions to be substantiated with either bank records (including cancelled checks) or a written communication from the donee charity showing the name of the donee, the date of the contribution, and the amount of the contribution. The recordkeeping requirements may not be satisfied by maintaining other written records.

Example. A church member ordinarily contributes cash (in church envelopes, and in individual amounts of less than $250) rather than checks. Since the member will have no canceled checks to support his contributions, he must rely upon the periodic receipts provided to him by his church. If the church does not issue the member a receipt, then the member will not be able to deduct any of his cash contributions.

Example. In 1989 the Tax Court ruled that notations made on a kitchen calendar were adequate substantiation for a donor’s cash contributions to her church. The church maintained no formal record of the nature or amount of contributions made by any of its members, and accordingly the taxpayer received no receipts for her contributions. She did, however, maintain a kitchen calendar on which she made notations regarding her contributions to the church. The court ruled that the taxpayer was “entitled to deduct the amounts she recorded on her church calendar.” It observed that “in addition to being documented on her calendar, [the taxpayer’s] contributions to the church are substantiated by her own testimony, the testimony of the church’s pastor, and records from another church verifying contributions of comparable amounts in subsequent years [the taxpayer changed churches in 1985].” The Court would reach the opposite conclusion for these same contributions made after the enactment of the Pension Protection Act of 2006. Burns v. Commissioner, T.C. Memo. 1988 536.

Example. A church member claimed a deduction on his tax return of $260 for cash gifts that he made to the church. The only support he had for this deduction was his claim that he attended church at least once each week and contributed $5 to $10 every Sunday. He also claimed a charitable contribution deduction of $500 for some old clothes that he donated to the Salvation Army. The Tax Court allowed a full deduction for the weekly cash contributions in a 1999 ruling, finding the church member’s testimony to be persuasive. The Court would deny any charitable contribution deduction under these circumstances as a result of the stricter substantiation requirements for cash contributions introduced by the Pension Protection Act of 2006. Fontanilla v. Commissioner, 77 TCM 1977 (1999).

Example. A member makes a contribution (by check) of $1,000 to her church’s building fund in December of 2006. For many years the tax code has disallowed a charitable contribution deduction for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgement of the contribution from the donee organization. The acknowledgement must include the amount of cash, whether the donee provided any goods or services in consideration for the contribution, and a good faith estimate of the value of any such goods or services. This requirement was not affected by the Pension Protection Act of 2006.

2. Reduction in charitable contribution deduction for appreciated tangible personal property not used for charitable purposes

‘Tangible personal property’ is any property, other than land or buildings, that can be seen or touched. It includes such items as furniture, antiques, books, jewelry, stamp or coin collections, equipment, computers, vehicles, clothing, and works of art. In most cases such property ‘depreciates’ over time, meaning that its market value is less than what the owner paid for it (the property’s ‘basis’). It is common for persons who own tangible personal property that has decreased in value to donate the property to their church or favorite charity. In such cases, the amount of the charitable contribution deduction is the fair market value of the donated property at the time of the contribution, and not the property’s cost basis.

Example. A church member owns a computer that he purchased two years ago for $4,000. The current value of the computer is $1,000. The member donates the computer to her church. The amount of her charitable contribution deduction is the donated property’s market value ($1,000), and not its cost basis ($4,000).

Some tangible personal property may increase in value over time. This is called appreciation. Generally, the amount of a charitable contribution deduction for a donation of appreciated tangible personal property to a church or charity is the property’s fair market value at the time of the contribution, and not the cost basis. In other words, the donor gets to deduct not just the cost basis of the donated property, but also the amount the property has increased in value. But, there is an important exception to this rule. The tax code specifies that the amount of a charitable contribution deduction for a donation of appreciated tangible personal property that is not used by the church or charity for a ‘purpose or function constituting the basis for its [tax] exemption … shall be reduced by the amount of gain which would have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution).’ This generally means that the amount of the charitable contribution deduction will be reduced to the property’s ‘cost basis’ (what the donor paid for it). But, so long as the church or charity uses the donated property in a way that is directly related to its exempt purposes, the donor generally may claim a charitable contribution deduction in the amount of the property’s fair market value.

Example. Jane donates an item of jewelry to her church. The jewelry was purchased in 1985 for $2,000, but has a current market value of $8,000. The church sells the jewelry shortly after the contribution, and never used it for a ‘related purpose.’ Since the church did not use the donated tangible personal property in furtherance of its exempt purposes, Jane’s charitable contribution deduction is limited to the property’s cost basis ($2,000) rather than its market value ($8,000).

Key point. Churches frequently receive donations of tangible personal property. But in most cases the donated property has depreciated rather than appreciated, in value. Examples include donations of vehicles, bicycles, equipment, computers, clothing, books, and furniture.

Key point. Given the nature of most items of appreciated tangible personal property, it is rare for a church to be able to use a donation of such property for exempt purposes. This means that donors ordinarily will be able to claim a charitable contribution deduction in the amount of their cost basis in the donated property, and not the property’s fair market value.

Under prior law, if a charity sold or otherwise disposed of donated property (including tangible personal property) with a claimed value of more than $5,000 (other than publicly traded securities) within two years of the contribution, it was required to file an information return (Form 8282) with the IRS and furnish a copy to the donor showing the name, address, and taxpayer identification number of the donor, a description of the property, the date of the contribution, the amount received on the disposition, and the date of the disposition.

The Pension Protection Act of 2006 made the following changes to these rules:

• The Act ‘recovers’ the ‘tax benefit’ for charitable contributions of appreciated tangible personal property for which a fair market value deduction was claimed and which was not used for exempt purposes. However, this provision only applies to appreciated tangible personal property that is identified by the donee charity, for example on Form 8283, for a use related to the charity’s tax-exempt purposes, and for which a deduction of more than $5,000 is claimed (‘applicable property’).

• If a donee charity disposes of applicable property within three years of the contribution of the property, the donor is subject to an adjustment of the tax benefit. If the disposition occurs in the tax year of the donor in which the contribution is made, the donor’s deduction generally is his or her cost basis rather than the donated property’s fair market value. If the disposition occurs in a subsequent year the donor must include as ordinary income for the taxable year in which the disposition occurs an amount equal to the excess (if any) of (i) the amount of the deduction previously claimed by the donor as a charitable contribution with respect to such property, over (ii) the donor’s basis in such property at the time of the contribution.

• There is no adjustment of the tax benefit if the donee charity makes a certification to the IRS by written statement signed under penalties of perjury by an officer of the charity. The statement must either (1) certify that the use of the property by the charity was related to the purpose or function constituting the basis for its exemption, and describe how the property was used and how such use furthered such purpose or function; or (2) state the intended use of the property by the charity at the time of the contribution and certify that such use became impossible or infeasible to implement. The charity must furnish a copy of the certification to the donor (for example, as an attachment to Form 8282, a copy of which is supplied to the donor).

• A penalty of $10,000 applies to a person that identifies applicable property as having a use that is related to a purpose or function constituting the basis for the donee’s exemption knowing that it is not intended for such a use.

• The Act modifies the information return requirements that apply upon the disposition of donated property by a charitable organization (Form 8282). The return requirement is extended to dispositions made within three years after receipt (up from two years under prior law). The donee charity also must provide, in addition to the information already required on the return, a description of the donee’s use of the property, a statement of whether its use of the property was related to the purpose or function constituting the basis for the donee’s exemption, and, if applicable, a certification of any such use.

• This provision is effective for contributions made and returns filed after September 1, 2006, and with respect to the penalty, for identifications made after August 17, 2006.

Changes in Form 8282

Prior to enactment of the Pension Protection Act of 2006, churches and other charities were required to file Form 8282 with the IRS if they disposed of certain donated noncash property within two years of the date of contribution. This requirement applied to donated property (other than money or certain publicly traded securities) for which the donee charity signed, or was asked to sign, the Appraisal Summary (Form 8283, Section B) pertaining to donated noncash property valued at more than $5,000. IRS Form 8282 will have to be modified in the following three ways:

• The charitable contribution deduction available to donors who contribute tangible personal property to a charity is not reduced (from market value to cost basis) if the donee charity makes a certification to the IRS by written statement signed under penalties of perjury by an officer of the charity that either (1) certifies that the use of the property by the charity was related to the purpose or function constituting the basis for its exemption, and describes how the property was used and how such use furthered such purpose or function; or (2) states the intended use of the property by the charity at the time of the contribution and certifies that such use became impossible or infeasible to implement. The charity must furnish a copy of the certification to the donor (for example, as an attachment to Form 8282, a copy of which is supplied to the donor).

• The Form 8282 reporting requirement is extended to dispositions of donated property made within three years after receipt (up from two years under prior law).

• Form 8282 must include, in addition to the information already required on the return, a description of the donee charity’s use of the property, a statement of whether use of the property was related to the purpose or function constituting the basis for the donee’s exemption, and, if applicable, a certification of any such use.

Example. A church member purchased a coin collection in 1990 for $3,000 that is worth $10,000 today. He donates the collection to his church in December of 2006. The church sells the collection shortly after the contribution, and never used it for a ‘related purpose.’ Since the church did not use the donated appreciated tangible personal property in furtherance of its exempt purposes, the member’s charitable contribution deduction is limited to the property’s cost basis ($3,000) rather than its market value ($10,000). Since the contribution deduction does not exceed $5,000, the donor is not required to obtain a qualified appraisal or complete a qualified appraisal summary (Form 8283, Section B), and the church is not required to file Form 8282 with the IRS upon its sale of the collection.

Example. Esther purchased a religious painting in 1995 for $4,000 that is worth $8,000 today. She donates the painting to her church in December of 2006. The church displays the painting in a prominent location as a means of facilitating prayer and worship. Since she assumed the painting would be used indefinitely for exempt purposes, Esther claimed a charitable contribution deduction on her 2006 tax return in the amount of the painting’s market value ($8,000). In 2008, the church sells the painting for $10,000. As a result of a provision in the Pension Protection Act of 2006, if a donee charity disposes of donated appreciated tangible personal property within three years of the date of the contribution, the donor is subject to an ‘adjustment’ in the charitable contribution deduction. If the disposition occurs in the year the contribution is made, the donor’s deduction generally is his or her cost basis rather than the donated property’s fair market value. If the disposition occurs after the year of the contribution the donor ‘must include as ordinary income for the taxable year in which the disposition occurs an amount equal to the excess (if any) of (i) the amount of the deduction previously claimed by the donor as a charitable contribution with respect to such property, over (ii) the donor’s basis in such property at the time of the contribution.’ This means that Esther must report $4,000 as additional income on her 2008 tax return (the excess of the deduction claimed in 2006 over the property’s cost basis).

Example. Same facts as the previous example, except that the church attaches to the Form 8282 that it files with the IRS upon disposing of the painting a written statement signed by a church officer under penalties of perjury certifying that the use of the property by the church was related to the purpose or function constituting the basis for its exemption, and describes how the property was used and how such use furthered the church’s exempt purpose or function. The church also provides Esther a copy of the Form 8282 and the attachment. Under these circumstances Esther is not required to report the difference between her charitable contribution deduction and the property’s cost basis on her 2008 tax return.

Example. Jon purchased a religious sculpture in 1987 for $3,000 that is worth $7,000 today. He donates the sculpture to his church in December of 2006. Assuming that the church will use the sculpture for religious purposes, Jon claims a charitable contribution deduction in the amount of the sculpture’s fair market value. The church puts the sculpture in a storeroom until it sells it in 2007. Not wanting to report additional income, Jon persuades the church treasurer to attach a signed statement to the Form 8282 the church submits to the IRS following the sale certifying that the property was used for exempt purposes. There are two consequences to note. First, Jon must report additional income of $4,000 on his 2007 tax return corresponding to the difference between the deduction he claimed in 2006 and the property’s cost basis. Second, the church treasurer may be assessed a penalty of $10,000 for certifying that the donated property was used by the church for exempt purposes when he knew that it was not so used.

Example. Sarah purchased a musical instrument in 1999 for $4,000 that is worth $6,000 when she donates it to her church in December of 2006. The church uses the instrument in worship services on several occasions over the next three years. In 2010 it sells the instrument. Since the church’s disposition of the instrument occurred more than three years after the date of Sarah’s contribution, she is not required to report any additional income on her 2010 tax return. Further, the church is not required to file a Form 8282 with the IRS since it disposed of the property more than three years after the date of the contribution.

3. Fines and penalties applicable to charitable organizations

Under prior law, the IRS could assess a penalty against ‘managers’ of a church or other charity who approve an ‘excess benefit transaction’ unless a manager can demonstrate that his or her approval was ‘not willful and due to reasonable cause.’ This penalty was in the form of an excise tax of up to 10% of the amount of the excess benefit, with a maximum of $10,000 per manager (but the total tax on all directors cannot exceed $10,000).

The Pension Protection Act of 2006 increases the 10% amount to 20%. It also doubles the dollar limitation on managers for participation in excess benefit transactions from $10,000 per transaction to $20,000 per transaction.

Example. A church pays its senior pastor an annual salary of $45,000 in 2007. In addition, it reimburses expenses the pastor incurs for the use of his car, out of town travel, entertainment, and cell phone use, but does not require substantiation of the amount, date, location, or business purpose of reimbursed expenses. Instead, the pastor provides the church treasurer with a written statement each month that lists the total expenses incurred for the previous month without any detail. The treasurer then issues a check to the pastor for this amount. This is an example of a nonaccountable reimbursement arrangement. Assume that the church reimburses $5,000 under this arrangement this year, and that the amount is not reported as taxable income by the church on the pastor’s Form W-2. The church treasurer assumed that the pastor had “at least” $5,000 in business expenses, and so there was no need to report the nonaccountable reimbursements as taxable income. This is an erroneous assumption that converts the nonaccountable reimbursements into an “automatic” excess benefit and exposes the pastor to intermediate sanctions. An “excess benefit” is defined by section 4958 of the tax code as any compensation or benefit provided to a disqualified person in excess of the reasonable value of his or her services. It includes nonaccountable reimbursements of business and personal expenses-unless the reimbursements are reported as taxable compensation by the church or pastor in the year they are paid. Since the church did not “clearly indicate its intent to treat the benefit as compensation for services when the benefit was paid” (i.e., the benefit was not reported on the pastor’s W-2 or Form 1040), the benefit constitutes an “automatic” excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit. So, even though the total amount would not have constituted an excess benefit had the church reported it as taxable income, the fact that it did not do so makes the transaction an ‘automatic’ excess benefit. This may result in (1) the assessment of penalties against the pastor, and (2) an excise tax of up to 20% of the amount of the excess benefit ($1,000) against each member of the church board who approved the transaction, up to a maximum of $20,000.

Example. In 2007 a church sends its pastor and his wife on an all-expense-paid trip to Hawaii in honor of their 25th wedding anniversary. The total cost of the trip is $8,000. The church treasurer assumes that this amount is a nontaxable fringe benefit, and so she does not report any of the $8,000 on the pastor’s W-2. The pastor likewise assumes that the cost of the trip is a nontaxable benefit. The church’s payment of these travel expenses constitutes an automatic excess benefit resulting in intermediate sanctions since it was not reported as taxable income by either the church or pastor in the year the benefit was provided. This is so even though the amount of the benefit by itself, or when added to the pastor’s other church compensation, is reasonable in amount, This may result in (1) the assessment of penalties against the pastor, and (2) an excise tax of up to 20% of the amount of the excess benefit ($1,600) against each member of the church board who approved the transaction, up to a maximum of $20,000.

4. Clothing and household items

Americans love to donate used clothing and household items to charity. The IRS reports that the amount claimed as deductions in a recent year for clothing and household items was more than $9 billion! These items are notoriously difficult for the IRS to value, and the attempt to do so wastes valuable time and resources that could better be directed on other matters.

The Pension Protection Act of 2006 responds to these concerns by amending the tax code to deny a charitable contribution deduction for a contribution of clothing or household items unless the clothing or household items are in ‘good used condition or better.’ The Treasury Department is authorized to deny (by regulation) a deduction for any contribution of clothing or a household item that has minimal monetary value, such as used socks and used undergarments.

Under the new provision, a deduction may be allowed for a charitable contribution of an item of clothing or a household item not in good used condition or better only if the amount claimed for the item is more than $500 and the taxpayer includes with his or her tax return a qualified appraisal with respect to the property. Household items include furniture, furnishings, electronics, appliances, linens, and other similar items. Food, paintings, antiques, and other objects of art, jewelry and gems, and collections are excluded from the provision.

This provision is effective for contributions made after August 17, 2006.

5. Appraisal reform

Taxpayer penalties

Prior to the Pension Protection Act of 2006, the tax code imposed ‘accuracy-related penalties’ on taxpayers in cases involving a ‘substantial valuation misstatement’ or ‘gross valuation misstatement’ relating to an underpayment of income tax. A substantial valuation misstatement generally meant a value claimed that was at least twice (200 percent or more) the amount determined to be the correct value, and a gross valuation misstatement generally means a value claimed that is at least four times (400 percent or more) the amount determined to be the correct value.

The penalty was 20 percent of the underpayment of tax resulting from a substantial valuation misstatement and rose to 40 percent for a gross valuation misstatement. No penalty was imposed unless the portion of the underpayment attributable to the valuation misstatement exceeded $5,000 ($10,000 in the case of a corporation). In addition, no penalty was imposed with respect to any portion of the understatement attributable to any item if (1) the treatment of the item on the return is or was supported by substantial authority, or (2) facts relevant to the tax treatment of the item were adequately disclosed on the return or on a statement attached to the return and there is a reasonable basis for the tax treatment. In addition, the accuracy-related penalties did not apply if a taxpayer could demonstrate that there was reasonable cause for an underpayment and the taxpayer acted in good faith.

The Pension Protection Act of 2006 lowers the thresholds for imposing accuracy-related penalties on a taxpayer. A substantial valuation misstatement exists when the claimed value of any property is 150 percent or more of the amount determined to be the correct value. A gross valuation misstatement occurs when the claimed value of any property is 200 percent or more of the amount determined to be the correct value. And, the ‘reasonable cause’ exception to the accuracy-related penalty does not apply in the case of gross valuation misstatements.

Qualified appraisals

Taxpayers are required to obtain a qualified appraisal for donated property with a value of more than $5,000, and to attach an appraisal summary to their tax return. Treasury Regulations define a qualified appraisal as an appraisal document that, among other things: (1) relates to an appraisal that is made not earlier than 60 days prior to the date of contribution of the appraised property and not later than the due date (including extensions) of the return on which a deduction is first claimed; (2) is prepared, signed, and dated by a qualified appraiser; (3) includes (a) a description of the property appraised; (b) the fair market value of the property on the date of contribution and the specific basis for the valuation; (c) a statement that the appraisal was prepared for income tax purposes; (d) the qualifications of the qualified appraiser; and (e) the signature and taxpayer identification number of the appraiser; and (4) does not involve an appraisal fee that violates certain prescribed rules.

Treasury Regulations define a qualified appraiser as a person holding himself or herself out to the public as an appraiser or who performed appraisals on a regular basis, is qualified to make appraisals of the type of property being valued (as determined by the appraiser’s background, experience, education and membership, if any, in professional appraisal associations), is independent, and understands that an intentionally false or fraudulent overstatement of the value of the appraised property may subject the appraiser to civil penalties.

The Pension Protection Act of 2006 makes the following changes in the qualified appraisal requirement:

• Qualified appraiser. It amends the tax code to define a qualified appraiser as an individual who (1) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements to be determined by the IRS in regulations; (2) regularly performs appraisals for which he or she receives compensation; (3) can demonstrate verifiable education and experience in valuing the type of property for which the appraisal is being performed; (4) has not been prohibited from practicing before the IRS by the Secretary at any time during the three years preceding the conduct of the appraisal; and (5) is not excluded from being a qualified appraiser under applicable Treasury regulations.

• Qualified appraisal. It amends the tax code to define a qualified appraisal as an appraisal of property prepared by a qualified appraiser (as defined by the provision) in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed by the Secretary.

• Civil penalty. It amends the tax code to create a civil penalty that the IRS can assess against any person who prepares an appraisal that is to be used to support a tax position if the appraisal results in a substantial or gross valuation misstatement. The penalty is equal to the greater of $1,000 or 10 percent of the understatement of tax resulting from a substantial or gross valuation misstatement, up to a maximum of 125 percent of the gross income derived from the appraisal. The penalty does not apply if the appraiser establishes that it was ‘more likely than not’ that the appraisal was correct.

These changes generally apply after August 17, 2006.

6. Convention or association of churches

An organization that qualifies as a ‘convention or association of churches’ is not required to file an annual return (IRS Form 990), is subject to the church tax inquiry and church tax examination protections, and is subject to certain other provisions that generally apply to churches. The tax code does not define the term ‘convention or association of churches.’

The Pension Protection Act of 2006 amends the tax code to provide that an organization that otherwise is a convention or association of churches does not fail to so qualify merely because the membership of the organization includes individuals as well as churches, or because individuals have voting rights in the organization.

7. Public disclosure of information relating to unrelated business income tax returns

The Pension Protection Act of 2006 amends the tax code to make the annual unrelated business income tax return (Form 990-T) subject to public inspection. Such forms ‘shall be made available by such organization for inspection during regular business hours by any individual at the principal office of such organization and, if such organization regularly maintains one or more regional or district offices having three or more employees at each such regional or district office, and upon request of an individual made at such principal office or such a regional or district office, a copy of such return … shall be provided to such individual without charge other than a reasonable fee for any reproduction and mailing costs. The request … must be made in person or in writing. If such request is made in person, such copy shall be provided immediately and, if made in writing, shall be provided within 30 days.’

The new law specifies that certain information may be withheld by the organization from public disclosure and inspection if public availability would ‘adversely affect’ the organization.

Example. A church allows a telecommunications company to install an antenna on its property in exchange for an annual ‘rental fee’ of $20,000. The church pays the unrelated business income tax on this income, using Form 990-T. This form is now subject to public inspection. This means that the church must make the form available for inspection during regular business hours to any person who asks to see it, without charge other than a reasonable fee for any reproduction or mailing costs. The request to inspect may be made in person or in writing. If made in person, the copy must be provided immediately and, if made in writing, it must be provided within 30 days.

Example. A church operates a bookstore on its premises that is open to the general public. Net earnings from the bookstore are $15,000 in 2007. The church pays the unrelated business income tax on this income, using Form 990-T. This form is now subject to public inspection. This means that the church must make the form available under the same conditions listed in the previous example.

Elimination of ‘Sunset’ Retirement Provisions

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made a number of changes to the tax code pertaining to pension plans and IRAs. However, EGTRRA included a ‘sunset’ provision under which all of these provisions expired at the end of 2010. The Pension Protection Act of 2006 makes these provisions permanent. Here are the main provisions that were scheduled to expire after 2010, and that were made permanent by the Pension Protection Act:

1. Increases in the IRA contribution limits, including the ability to make catch-up contributions

EGTRRA increased the maximum annual dollar contribution limit for IRA contributions from $2,000 to $3,000 for 2002 through 2004, to $4,000 for 2005 through 2007, and to $5,000 for 2008. After 2008, the limit is adjusted annually for inflation in $500 increments. In addition, individuals who have attained age 50 may make additional “catch-up” IRA contributions. The maximum contribution limit (before application of the ‘phase-out limits’ that apply to taxpayers with adjusted gross income above a specified amount) for an individual who has attained age 50 before the end of the taxable year is increased by $500 for 2002 through 2005, and $1,000 for 2006 and thereafter. Both the increased annual contribution limits and the special ‘catch up’ contribution option were scheduled to expire at the end of 2010. The Pension Protection Act makes both of these provisions permanent.

Example. Pastor Tim receives a salary of $45,000 from his church in 2011, and would like to make the maximum contribution to his IRA. Under EGGTRA, he could contribute only $2,000—the annual contribution limit that applied prior to the enactment of EGGTRA. However, because of the passage of the Pension Protection Act, Pastor Tim can contribute $5,000 (plus any inflation adjustments).

Example. Same facts as the previous example. Can Pastor Tim make an additional ‘catch up’ contribution to his IRA? In 2010 he can make an additional $1,000 ‘catch up’ contribution to his IRA if he is 50 years of age or older, meaning that Pastor Tim will be able to contribute an additional $1,000 to his IRA in 2011 (for a total contribution of $6,000). Note that the $5,000 contribution limit is adjusted for inflation in $500 increments.

2. ‘Deemed’ IRAs

EGGTRA introduced the concept of ‘deemed IRAs.’ A qualified employer plan (including a 403(b) plan) may permit employees to make voluntary employee contributions to a separate account or annuity established under the plan. If the requirements of section 408(q) are met, such an account or annuity is treated in the same manner as an IRA, and contributions to such an account or annuity are treated as contributions to an IRA and not to the qualified employer plan. The account or annuity is referred to as a deemed IRA.

Deemed IRAs were scheduled to expire at the end of 2010, but the Pension Protection Act of 2006 makes them permanent.

3. Increase in allowable contributions to a 403(b) plan

EGGTRA substantially increased the amount that could be contributed to an employee’s 403(b) account. It amended the tax code to allow employees to contribute up to the lesser of (1) the limit on annual additions, or (2) the limit on elective deferrals.

The limit on annual additions is the lesser of 100% of includible compensation, or $40,000. The $40,000 amount is indexed for inflation, and in 2006 increased to $44,000.

The limit on elective deferrals specifies the maximum amount that an employee can contribute to his or her 403(b) account through salary reduction. Once again, EGGTRA substantially increased this amount from $10,000 to $11,000 in 2002. In 2003 and thereafter, the limit is increased in $1,000 annual increments until the limit reaches $15,000 in 2006, with indexing in $500 increments thereafter.

These two limits allow employees to contribute far more to their 403(b) account than was possible prior to the enactment of EGGTRA. They were scheduled to expire at the end of 2010, but were made permanent by the Pension Protection Act of 2006.

Example. Barb is a church employee who participates in a 403(b) plan. All contributions to her account are made through salary reductions. Assume that her annual salary in 2010 will be $50,000, that she will be 48 years old that year, and that she would like to contribute as much as possible into her account. In 2010 she can contribute up to the lesser of the limit on annual additions, or the limit on elective deferrals. These limits are (1) the lesser of includible compensation or $44,000, and (2) $15,000. She will be able to contribute the lesser of these two amounts, or $15,000. What will her maximum contribution be in 2011? The more generous contribution limits provided by EGGTRA were scheduled to expire at the end of 2010, which would have resulted in a much lower contribution for 2011. However, the Pension Protection Act of 2006 made the EGGTRA limits permanent, and so Barb’s contribution limit in 2011 should be at least as much as in 2010.

4. 403(b) plan ‘catch up’ contributions

EGGTRA substantially increased the limit on elective deferrals under a 403(b) annuity for individuals who have attained age 50 by the end of the year by allowing them to make additional ‘catch up’ contributions to their account so long as no other elective deferrals may otherwise be made because of the application of any limitation of the tax code (e.g., the annual limit on elective deferrals) or of the plan itself. The additional amount of elective contributions that may be made by an eligible individual is the lesser of (1) the applicable dollar amount, or (2) the participant’s compensation for the year reduced by any other elective deferrals of the participant for the year. EGGTRA defined the applicable dollar amount under a 403(b) annuity as $1,000 in 2002, and increased it by $1,000 each year until it reached $5,000 in 2006. It is adjusted for inflation in future years. Catch-up contributions are not subject to any other contribution limits and are not taken into account in applying other contribution limits. In addition, such contributions are not subject to applicable nondiscrimination rules.

The generous catch up contribution limits introduced by EGGTRA were to expire at the end of 2010. However, they were made permanent by the Pension Protection Act of 2010.

Example. Pastor Joel is 51 years of age in 2010, and would like to make the maximum contribution to his 403(b) account to provide for his retirement. All contributions to his account are made through salary reductions. Assume that his annual salary in 2010 is $50,000. In 2010 he can contribute up to the lesser of the limit on annual additions, or the limit on elective deferrals. These limits are (1) the lesser of includible compensation or $44,000, and (2) $15,000. He will be able to contribute the lesser of these two amounts, or $15,000. In addition, he can make a catch up contribution of $5,000, meaning that his total allowable contribution will be $20,000. This does not take into account inflation adjustments that may occur. What will his maximum contribution be in 2011? The more generous contribution limits provided by EGGTRA were scheduled to expire at the end of 2010, which would have resulted in a much lower contribution for 2011. However, the Pension Protection Act of 2006 made the EGGTRA limits permanent, and so Pastor Joel’s contribution limit in 2011 should be at least as much as in 2010.

5. ‘Roth’ contributions by 403(b) participants

EGGTRA allows a 403(b) plan to include a “Roth contribution program” that permits a participant to elect to have all or a portion of his or her elective deferrals treated as Roth contributions. Roth contributions are elective deferrals that the participant designates (at such time and in such manner as the IRS may prescribe) as not excludable from the participant’s gross income. The annual dollar limitation on a participant’s Roth contributions is the annual limitation on elective deferrals, reduced by the participant’s elective deferrals that the participant does not designate as Roth contributions. The plan is required to establish a separate account, and maintain separate recordkeeping, for a participant’s Roth contributions (and earnings).

A qualified distribution from a participant’s Roth contribution account is not includible in the participant’s gross income. A qualified distribution is a distribution that is made after the end of a specified nonexclusion period and that is (1) made on or after the date on which the participant attains age 59, (2) made to a beneficiary (or to the estate of the participant) on or after the death of the participant, or (3) attributable to the participant being disabled. The nonexclusion period is the 5-year taxable period beginning with the earlier of (1) the first taxable year for which the participant made a Roth contribution to any Roth contribution account established for the participant under the plan, or (2) if the participant has made a rollover contribution to the Roth contribution account that is the source of the distribution from a Roth contribution account established for the participant under another plan, the first taxable year for which the participant made a Roth contribution to the previously established account. A participant is permitted to roll over a distribution from a Roth contribution account only to another Roth contribution account or a Roth IRA of the participant.

This provision was enacted in 2001 but did not take effect until 2006, and was scheduled to expire at the end of 2010. The Pension Protection Act of 2006 makes it permanent.

6. Rollovers of after-tax contributions to a 403(b) account

EGGTRA allows employees to roll over after-tax contributions from one qualified retirement plan to another if the rollover is a direct rollover, and the plan to which the rollover is made provides for separate accounting for such contributions (and earnings). For purposes of this provision, a qualified retirement plan includes a 403(b) annuity.

After-tax contributions may also be rolled over to an IRA. If the rollover is to an IRA, the rollover need not be a direct rollover and the IRA owner has the responsibility to keep track of the amount of after-tax contributions. This provision was scheduled to expire at the end of 2010, but was made permanent by the Pension Protection Act of 2006. This provision is effective for taxable years beginning after December 31, 2006.

Key point. EGGTRA reduced the income tax rates for all taxpayers. These rate reductions, like EGGTRA’s retirement provisions, are scheduled to expire after 2010 as a result of a ‘sunset’ provision. However, the Pension Protection Act of 2006 does not make the income tax rate cuts permanent.

7. Waiver of 60-day rollover rule

A tax-deferred rollover occurs when you withdraw cash or other assets from one eligible retirement plan and contribute all or part of it within 60 days to another eligible retirement plan. Prior to EGGTRA the IRS could waive the 60-day requirement in only two situations: (1) a taxpayer was performing military service in a combat zone, or (2) a taxpayer was affected by a Presidentially-declared disaster. EGGRTRA provided a third exception—the IRS can waive the 60-day requirement where failure to do so would be against ‘equity or good conscience,’ such as in the event of a casualty, disaster, or other event beyond your reasonable control. This expanded basis for qualifying for a waiver of the 60-day rollover requirement was scheduled to expire after 2010.

The enactment of the Pension Protection Act of 2006 makes the ‘equity and good conscience’ exception permanent.

Miscellaneous IRA Changes

The Pension Protection Act of 2006 contains a number of other changes to IRAs, including:

1. Rollovers by nonspouse beneficiaries

Under present law, a distribution from a qualified retirement plan, a 403(b) annuity, or an IRA generally is included in income for the year distributed. However, eligible rollover distributions may be rolled over tax free within 60 days to another plan, annuity, or IRA. In general, an eligible rollover distribution includes any distribution to the plan participant or IRA owner other than certain periodic distributions, minimum required distributions, and distributions made on account of hardship. Distributions to a participant from a qualified retirement plan or 403(b) annuity generally can be rolled over to any of such plans or an IRA. Similarly, distributions from an IRA to the IRA owner generally are permitted to be rolled over into a qualified retirement plan, a 403(b) annuity, or another IRA.

Similar rollovers are permitted in the case of a distribution to the surviving spouse of the plan participant or IRA owner, but not to other persons.

The Pension Protection Act of 2006 provides that benefits of a beneficiary other than a surviving spouse may be transferred directly to an IRA. The IRA is treated as an inherited IRA of the nonspouse beneficiary. As a result, distributions from the inherited IRA are subject to the distribution rules applicable to beneficiaries. The provision applies to amounts payable to a beneficiary under a qualified retirement plan or a 403(b) annuity.

The provision is effective for distributions after December 31, 2006.

2. Direct deposit of tax refunds in an IRA

Under current IRS procedures, a taxpayer may direct that his or her tax refund be deposited into a checking or savings account with a bank or other financial institution (such as a mutual fund, brokerage firm, or credit union) rather than having the refund sent to the taxpayer in the form of a check.

The Pension Protection Act of 2006 directs the IRS to develop forms under which all or a portion of a taxpayer’s refund may be deposited in an IRA of the taxpayer (or the spouse of the taxpayer in the case of a joint return). The provision does not modify the rules relating to IRAs, including the rules relating to timing and deductibility of contributions.

The form required by the provision is to be available for taxable years beginning after December 31, 2006.

3. Tax-free distributions from IRAs for charitable purposes

The Pension Protection Act of 2006 allows tax-free ‘qualified charitable distributions’ of up to $100,000 from an IRA to a church or other charity. This provision is addressed earlier in this article.

4. Tax-free distributions to persons called to active duty for at least 179 days

Under present law, a taxpayer who receives a distribution from a qualified retirement plan prior to age 59½, death, or disability generally is subject to a 10-percent early withdrawal tax on the amount includible in income, unless an exception to the tax applies. Among other exceptions, the early distribution tax does not apply to distributions made to an employee who separates from service after age 55, or to distributions that are part of a series of substantially equal periodic payments made for the life (or life expectancy) of the employee or the joint lives (or life expectancies) of the employee and his or her beneficiary. Certain amounts held in a 401(k) plan or a 403(b) annuity may not be distributed before severance from employment, age 59½, death, disability, or financial hardship of the employee.

The Pension Protection Act specifies that the 10-percent early withdrawal tax does not apply to a qualified reservist distribution. A qualified reservist distribution is a distribution (1) from an IRA or attributable to elective deferrals under a 401(k) plan, 403(b) annuity, or certain similar arrangements, (2) made to an individual who by reason of being a member of a reserve component was ordered or called to active duty for a period in excess of 179 days or for an indefinite period, and (3) that is made during the period beginning on the date of such order or call to duty and ending at the close of the active duty period. A 401(k) plan or 403(b) annuity does not violate the distribution restrictions applicable to such plans by reason of making a qualified reservist distribution.

An individual who receives a qualified reservist distribution may, at any time during the two-year period beginning on the day after the end of the active duty period, make one or more contributions to an IRA of such individual in an aggregate amount not to exceed the amount of such distribution. The dollar limitations otherwise applicable to contributions to IRAs do not apply to any contribution made pursuant to the provision. No deduction is allowed for any contribution made under the provision.

This provision applies to individuals ordered or called to active duty after September 11, 2001, and before December 31, 2007. The two-year period for making recontributions of qualified reservist distributions does not end before the date that is two years after the date of enactment.

5. Inflation indexing of income limitations on certain retirement plans

There are two general types of IRAs: traditional IRAs, to which both deductible and nondeductible contributions may be made, and Roth IRAs. The maximum annual deductible and nondeductible contributions that can be made to a traditional IRA and the maximum contribution that can be made to a Roth IRA by or on behalf of an individual varies depending on the particular circumstances, including the individual’s income. However, the contribution limits for IRAs are coordinated so that the maximum annual contribution that can be made to all of an individual’s IRAs is the lesser of a certain dollar amount ($4,000 for 2006) or the individual’s compensation. In the case of a married couple, contributions can be made up to the dollar limit for each spouse if the combined compensation of the spouses is at least equal to the contributed amount. An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions to an IRA. For this purpose, the dollar limit is increased by a certain dollar amount ($1,000 for 2006).

Traditional IRAs

An individual may make deductible contributions to a traditional IRA up to the IRA contribution limit if neither the individual nor the individual’s spouse is an active participant in an employer-sponsored retirement plan. If an individual (or the individual’s spouse) is an active participant in an employer-sponsored retirement plan, the deduction is phased out for taxpayers with adjusted gross income over certain levels for the taxable year.

The adjusted gross income phase-out ranges are: (1) for single taxpayers, $50,000 to $60,000; (2) for married taxpayers filing joint returns, $75,000 to $85,000 for 2006 and $80,000 to $100,000 for years after 2006; and (3) for married taxpayers filing separate returns, $0 to $10,000. If an individual is not an active participant in an employer-sponsored retirement plan, but the individual’s spouse is, the deduction is phased out for taxpayers with adjusted gross income between $150,000 and $160,000.

To the extent an individual cannot or does not make deductible contributions to an IRA or contributions to a Roth IRA, the individual may make nondeductible contributions to a traditional IRA, subject to the same limits as deductible contributions. An individual who has attained age 50 before the end of the taxable year may also make nondeductible catch-up contributions to an IRA.

Roth IRAs

Individuals with adjusted gross income below certain levels may make nondeductible contributions to a Roth IRA, subject to the overall limit on IRA contributions described above. The maximum annual contribution that can be made to a Roth IRA is phased out for taxpayers with adjusted gross income over certain levels for the taxable year. The adjusted gross income phase-out ranges are: (1) for single taxpayers, $95,000 to $110,000; (2) for married taxpayers filing joint returns, $150,000 to $160,000; and (3) for married taxpayers filing separate returns, $0 to $10,000.

Taxpayers generally may convert a traditional IRA into a Roth IRA, except for married taxpayers filing separate returns. The amount converted is includible in income as if a withdrawal had been made, except that the 10-percent early withdrawal tax does not apply.

Amounts held in a Roth IRA that are withdrawn as a qualified distribution are not includible in income, or subject to the additional 10-percent tax on early withdrawals. A qualified distribution is a distribution that (1) is made after the five-taxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA, and (2) is made after attainment of age 59½, on account of death or disability, or is made for first-time homebuyer expenses of up to $10,000.

Distributions from a Roth IRA that are not qualified distributions are includible in income to the extent attributable to earnings. The amount includible in income is also subject to the 10-percent early withdrawal tax described above.

The Pension Protection Act of 2006

The Act indexes the income limits for IRA contributions beginning in 2007. The indexing applies to the income limits for deductible contributions for active participants in an employer-sponsored plan, the income limits for deductible contributions if the individual is not an active participant but the individual’s spouse is, and the income limits for Roth IRA contributions. Indexed amounts are rounded to the nearest multiple of $1,000. The provision does not affect the phase-out ranges under present law. Thus, for example, in the case of an active participant in an employer-sponsored plan, the phase-out range is $20,000 in the case of a married taxpayer filing a joint return and $10,000 in the case of an individual taxpayer.

Saver’s Credit

Present law provides a temporary nonrefundable tax credit for eligible taxpayers for qualified retirement savings contributions. The maximum annual contribution eligible for the credit is $2,000. The credit rate depends on the adjusted gross income (“AGI”) of the taxpayer. Joint returns with AGI of $50,000 or less, head of household returns of $37,500 or less, and single returns of $25,000 or less are eligible for the credit. The AGI limits applicable to single taxpayers apply to married taxpayers filing separate returns.

The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution. The credit is available to individuals who are 18 or older, other than individuals who are full-time students or claimed as a dependent on another taxpayer’s return.

The saver’s credit was scheduled to expire after 2006. The Pension Protection Act of 2006 makes it permanent. The Act also provides that an individual may direct that the amount of any refund attributable to the saver’s credit be directly deposited by the government into an IRA, qualified retirement plan, or section 403(b) annuity. In the case of a joint return, each spouse is entitled to designate an applicable retirement plan with respect to payments attributable to such spouse. This provision does not change the rules relating to the tax treatment of contributions to such plans or other arrangements.

The Act also indexes the income limits applicable to the saver’s credit beginning in 2007. Indexed amounts are rounded to the nearest multiple of $500. The indexed income limit for single taxpayers is one-half that for married taxpayers filing a joint return.

The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution. The credit offsets minimum tax liability as well as regular tax liability. The credit is available to individuals who are 18 or older, other than individuals who are full-time students or claimed as a dependent on another taxpayer’s return.

The credit is available with respect to elective deferrals to a 401(k) plan, a 403(b) annuity), a SIMPLE or a simplified employee pension (“SEP”), contributions to a traditional or Roth IRA, and voluntary after-tax employee contributions to a 403(b) annuity or qualified retirement plan.

Church Plans

Federal law not only establishes a variety of tax favored retirement plans, but also heavily regulates those plans. Federal regulation derives primarily from the Internal Revenue Code, Department of Labor regulations, and ERISA (the Employee Retirement Income Security Act), a comprehensive law enacted by Congress in 1974 to regulate pension plans.

“Church plans” are exempt from many of the legal requirements that apply to most other retirement plans. For example, a church plan is exempt from the funding, vesting, and participation requirements of ERISA. Church plans also are exempt from the nondiscrimination rules that apply to 403(b) annuities, and they are not required to file the annual Form 5500 with the IRS.

Section 414(e) of the Internal Revenue Code defines the term church plan to include a plan “maintained for its employees by a church.” The income tax regulations clarify that for the purpose of this definition the term church includes “a religious organization if such organization (1) is an integral part of a church, and (2) is engaged in carrying out the functions of a church, whether as a civil law corporation or otherwise.”

The Pension Protection Act of 2006 has three provisions that pertain to church plans:

(1) church plans that self-annuitize

Minimum distribution rules apply to qualified retirement plans. Special rules apply in the case of payments under an annuity contract purchased with the employee’s benefit by the plan from an insurance company. If certain requirements are satisfied, these special rules apply to annuity payments from a retirement income account maintained by a church even though the payments are not made under an annuity purchased from an insurance company.

The Act provides that annuity payments provided with respect to any account maintained for a participant or beneficiary under a qualified church plan does not fail to meet the minimum distribution rules merely because the payments are not made under an annuity contract purchased from an insurance company if such payments would not fail such requirements if provided with respect to a retirement income account described in section 403(b)(9). For purposes of the provision, a qualified church plan means any money purchase plan described in section 401(a) which is a church plan that was in existence on April 17, 2002.

The provision is effective for years beginning after the date of enactment.

(2) exemption for income from leveraged real estate held by church plans

Debt-financed income of a church or other tax-exempt entity is subject to unrelated business income tax (“UBIT”). Debt-financed property is property that is subject to an “acquisition indebtedness’ and that is held to produce income. There is an exception to the UBIT rules for debt-financed property held by ‘qualifying organizations’ including retirement plans qualified under section 401(a) of the tax code.

The Act provides that a retirement income account of a church (or certain other organizations) as defined in section 403(b)(9) of the tax code is a qualified organization for purposes of the exemption from the UBIT debt-financed property rules. This provision is effective for taxable years beginning on or after the date of enactment.

(3) church plan rule for benefit limitations

Section 415 of the tax code limits the amount of benefits and contributions that may be provided under a tax-qualified plan. In the case of a defined benefit plan, the limit on annual benefits payable under the plan is the lesser of: (1) a dollar amount which is adjusted for inflation ($175,000 for 2006); and (2) 100 percent of the participant’s compensation for the highest three years. Special rules apply in some cases.

The provision provides that the 100 percent of compensation limit does not apply to a plan maintained by a church or ‘qualified church controlled organization’ (defined in section 3121(w)(3)(A) of the tax code) except with respect to “highly compensated benefits”. The term “highly compensated benefits” means any benefits accrued for an employee in any year on or after the first year in which such employee is a ‘highly compensated employee’. For 2006, a highly compensated employee is an employee who receives annual compensation of $100,000 or more. For purposes of applying the 100 percent of compensation limit to highly compensated benefits, all the benefits of the employee which would otherwise be taken into account in applying the limit shall be taken into account, i.e., the limit does not apply only to those benefits accrued on or after the first year in which the employee is a highly compensated employee.

This provision is effective for years beginning after December 31, 2006.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

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