DESCRIPTION OF THE CHAIRMAN’S MODIFICATION 

TO THE PROVISIONS OF THE 

“TAX RELIEF ACT OF 2005” 

Scheduled for Markup 

By the 

SENATE COMMITTEE ON FINANCE 

on November 15, 2005 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

November 14, 2005 

JCX-77-05
ii 

CONTENTS 

Page

INTRODUCTION .......................................................................................................................... 1 

A. Modifications to Provisions in the Chairman’s Mark...................................................... 2 

1. Modification to low income housing credit (item I.A.6)........................................... 2 

2. Modifications to increased expensing for reforestation expenditures of small 

timber producers (item I.A.12) .................................................................................. 2 

3. Modifications to five-year NOL carryback of certain timber losses (item I.A.13) ... 2 

4. Modification to AMT exemption amounts (item III.B.2).......................................... 3 

5. Deletion of provision relating to the special look-back rule for determining 

earned income credits and refundable child credits (item II.F) ................................. 3 

6. Deletion of provision relating to Secretarial authority to make certain 

adjustments regarding taxpayer dependency status (item II.G)................................. 3 

7. Deletion of extension of reduced rates on dividends and capital gains 

(item III.A.1).............................................................................................................. 3 

8. Modification relating to the research credit (item III.B.4)......................................... 3 

9. Deletion of provision relating to parity in the application of certain limits to 

mental health benefits (item III.B.5).......................................................................... 4 

10. Deletion of extension of rum excise tax cover over (item III.B.8) ............................ 4 

11. Modifications to extension of expensing for environmental remediation costs 

(item III.B.11) ............................................................................................................ 5 

12. Deletion of provision relating to prohibition on deferral of certain stock option 

and restricted stock gains (item IV.F.5)..................................................................... 5 

13. Deletion of provision related to elimination of double deduction of mining 

exploration and development cost under the minimum tax (item IV.F.7)................. 5 

14. Deletion of provision related to the holding period requirement for reduced 

tax rate on dividends on preferred stock (item IV.F.9).............................................. 5 

B. Additional Provisions....................................................................................................... 6 

1. Charitable deduction for nonitemizers; floor on deductions for itemizers ................ 6 

2. Tax-free distributions from individual retirement arrangements for charitable 

purposes ..................................................................................................................... 8 

3. Charitable deduction for contributions of food inventory ....................................... 15 

4. Basis adjustment to stock of S corporation contributing property........................... 17 

5. Modify tax treatment of certain payments to controlling exempt organizations 

and public disclosure of information relating to UBIT............................................ 18 

6. Encourage contributions of real property made for conservation purposes ............ 21 

7. Charitable deduction for contributions of book inventory....................................... 24 

8. Tax involvement by exempt organizations in tax-shelter transactions.................... 25 

9. Apply an excise tax to acquisitions of interests in insurance contracts in which 

certain exempt organizations hold an interest.......................................................... 30 
iii 

10. Increase the amounts of excise taxes imposed on public charities, social welfare 

organizations, and private foundations .................................................................... 35 

11. Improve accountability of donor advised funds....................................................... 40 

12. Improve accountability of supporting organizations ............................................... 51 

13. Reform rules for charitable contributions of easements on buildings in 

registered historic districts ....................................................................................... 62 

14. Reform rules relating to charitable contributions of taxidermy and recapture 

tax benefit on property not used for an exempt use................................................. 66 

15. Limit charitable deduction for contributions of clothing and household items 

and modify recordkeeping and substantiation requirements for certain charitable 

contributions ............................................................................................................ 70 

16. Contributions of fractional interests in tangible personal property ......................... 74 

17. Provisions relating to substantial and gross overstatement of valuations of 

property.................................................................................................................... 76 

18. Expand the base of the tax on private foundation net investment income............... 79 

19. Establish additional exemption standards for credit counseling organizations ....... 83 

20. Impose loan and redemption requirements on pooled financing bonds .................. 90 

21. Amend information reporting requirements to include interest on tax-exempt 

bonds........................................................................................................................ 93

22. Modification of credit for fuel from a non-conventional source ............................. 94 

23. Modification of individual estimated tax safe harbor.............................................. 95 

24. Time for payment of corporate estimated taxes....................................................... 96 

25. Extension and modification of new markets tax credit............................................ 96 

26. Expansion of Hope and Lifetime Learning Credits for students in the Gulf 

Recovery Zone......................................................................................................... 98 

27. Restructure New York Liberty Zone tax incentives .............................................. 103 

28. Treatment of S corporation passive investment income........................................ 108 

29. Revaluation of LIFO inventories of large integrated oil companies...................... 109 

30. Capital expenditure limitation for qualified small issue bonds ............................. 110 
1 

INTRODUCTION 

This document,1

 prepared by the staff of the Joint Committee on Taxation, provides a 

description of the Chairman’s modification to the provisions of the “Tax Relief Act of 2005,” 

which is scheduled to be marked up by the Senate Committee on Finance on November 15, 

2005. 

 1

 This document may be cited as follows: Joint Committee on Taxation, Description of the 

Chairman’s Modification to the Provisions of the “Tax Relief Act of 2005,” (JCX-77-05), November 14, 

2005. 
2 

A. Modifications to Provisions in the Chairman’s Mark2

1. Modification to low income housing credit (item I.A.6)3

Under the modification to the Chairman’s mark dealing with the low income housing 

credit, the Gulf Opportunity Zone is treated as a high-cost area for purposes of the low income 

housing credit for property placed-in-service in calendar years 2006, 2007, 2008 and 2009. 

Therefore, buildings located in the Gulf Opportunity Zone are eligible for the enhanced credit. 

Under the enhanced credit, the 70-percent and 30-percent credits are increased to 91-percent and 

39-percent credits, respectively. The 20-percent of population restriction is waived for this 

purpose. This enhanced credit applies regardless of whether the building receives its credit 

allocation under the otherwise applicable low-income housing credit cap or the additional credit 

cap. 

2. Modifications to increased expensing for reforestation expenditures of small timber 

producers (item I.A.12) 

The modification eliminates the aggregation provisions of the Chairman’s mark, which 

apply for purposes of determining whether a taxpayer’s aggregate holdings of qualified timber 

property exceed 500 acres at any time during the taxable year. The modification also amends the 

"large timber producer" test to exclude from the increased expensing limit those taxpayers who 

held in excess of 500 acres as of August 28, 2005 (in the case of qualified timber property any 

portion of which is located in the Gulf Opportunity Zone), September 23, 2005 (in the case of 

qualified timber property any portion of which is located in the Rita Zone and no portion of 

which is located in the Gulf Opportunity Zone), or October 23, 2005 (in the case of qualified 

timber property any portion of which is located in the Wilma Zone). Finally, the modification 

excludes public corporations and Real Estate Investment Trusts (“REITs”) from eligibility for 

the increased reforestation expensing limit. 

3. Modifications to five-year NOL carryback of certain timber losses (item I.A.13) 

The modification eliminates the aggregation provisions of the Chairman’s mark, which 

apply for purposes of determining whether a taxpayer’s aggregate holdings of qualified timber 

property exceed 500 acres as of August 28, 2005 (in the case of qualified timber property any 

portion of which is located in the Gulf Opportunity Zone), September 23, 2005 (in the case of 

qualified timber property any portion of which is located in the Rita Zone and no portion of 

which is located in the Gulf Opportunity Zone), or October 23, 2005 (in the case of qualified 

timber property any portion of which is located in the Wilma Zone). The modification also 

excludes public corporations and REITs from taking into account income and loss attributable to 

 2

 For a description of the Chairman’s mark, see Joint Committee on Taxation, Description of the 

Chairman’s Mark of the “Tax Relief Act of 2005” (JCX-71-05), November 8, 2005. 

3

 Item numbers refer to provisions in the Chairman’s mark. 
3 

qualified timber property for purposes of computing the amount of farming loss eligible for a 

five-year NOL carryback. 

4. Modification to AMT exemption amounts (item III.B.2) 

Under the Chairman’s modification, the individual alternative minimum tax exemption 

amounts for 2006 are adjusted for inflation. 

5. Deletion of provision relating to the special look-back rule for determining earned 

income credits and refundable child credits (item II.F) 

The Chairman’s modification deletes the proposal relating to the special look-back rule 

for determining earned income credits and refundable child credits contained in item II.F. 

6. Deletion of provision relating to Secretarial authority to make certain adjustments 

regarding taxpayer dependency status (item II.G) 

The Chairman’s modification deletes the proposal relating to the Secretarial authority to 

make adjustments regarding taxpayer dependency status for taxpayers affected by Hurricane Rita 

and Hurricane Wilma contained in item II.G. 

7. Deletion of extension of reduced rates on dividends and capital gains (item III.A.1) 

Under the modification, the extension of reduced rates on dividends and long-term capital 

gains through 2009 is deleted from the Chairman’s mark. 

8. Modification relating to the research credit (item III.B.4) 

The modified proposal eliminates the rule in the Chairman’s mark requiring that research 

credit amounts earned in 2006 not be taken into account in computing estimated tax payments 

required to be paid for taxable years beginning in 2006. 

The modified proposal increases the rates of the alternative incremental credit: (1) a 

credit rate of three percent (rather than 2.65 percent) applies to the extent that a taxpayer’s 

current-year research expenses exceed a base amount computed by using a fixed-base percentage 

of one percent (i.e., the base amount equals one percent of the taxpayer’s average gross receipts 

for the four preceding years) but do not exceed a base amount computed by using a fixed-base 

percentage of 1.5 percent; (2) a credit rate of four percent (rather than 3.2 percent) applies to the 

extent that a taxpayer’s current-year research expenses exceed a base amount computed by using 

a fixed-base percentage of 1.5 percent but do not exceed a base amount computed by using a 

fixed-base percentage of two percent; (3) a credit rate of five percent (rather than 3.75 percent) 

applies to the extent that a taxpayer’s current-year research expenses exceed a base amount 

computed by using a fixed-base percentage of two percent. 

The modified proposal also creates, at the election of the taxpayer, an alternative 

simplified credit for qualified research expenses. The alternative simplified research is equal to 

12 percent of qualified research expenses that exceed 50 percent of the average qualified 

research expenses for the three preceding taxable years. The rate is reduced to 6 percent if a 
4 

taxpayer has no qualified research expenses in any one or more of the three preceding taxable 

years. 

An election to use the alternative simplified credit applies to all succeeding taxable years 

unless revoked with the consent of the Secretary. An election to use the alternative simplified 

credit may not be made for any taxable year for which an election to use the alternative 

incremental credit is in effect. A special transition rule applies which permits a taxpayer to elect 

to use the alternative simplified credit in lieu of the alternative incremental credit if such election 

is made during the taxable year which includes the date of enactment of the modified proposal. 

The transition rule only applies to the taxable year which includes the date of enactment. 

The modified proposal also expands the definition of “funded research” ineligible for the 

research credit. In general, under the modified proposal, all payments pursuant to any 

government contract are treated as funding research and are therefore ineligible for the research 

credit. Payments received pursuant to a subcontracting agreement or similar contract are also 

considered government funded to the extent they would be government funded under the prime 

contract. 

Two exceptions apply with respect to government funded research. Under the first 

exception, government contracts having no new and significant performance specifications are 

not treated as funding research under the modified proposal, except where the contractor does 

not retain substantial rights to the research. For purposes of this exception, contracts under the 

modified proposal are not treated as having new and significant performance specifications 

where the contractor reasonably expects that not more than ten percent of the total costs of 

performing under the contract will be allocable to qualified research. In determining whether 

more than ten percent of total costs are allocable to qualified research, all research costs under a 

contract (including costs reasonably expected to be incurred by subcontractors and independent 

contractors) are considered. For purposes of this exception, options under a contract that may be 

exercised at the discretion of the government are treated as separate contracts. Under the second 

exception, qualified research undertaken by a government contractor is not to be treated as 

funded research unless the research is required to meet the contract’s performance specifications. 

The modified proposal applies to taxable years ending after December 31, 2005. 

9. Deletion of provision relating to parity in the application of certain limits to mental 

health benefits (item III.B.5) 

The modification strikes the provision in the Chairman’s mark relating to parity in the 

application of certain limits to mental health benefits. 

10. Deletion of extension of rum excise tax cover over (item III.B.8) 

The modification strikes the provision in the Chairman’s mark that extends the presentlaw limitation on the rate of rum excise tax cover over to Puerto Rico and the Virgin Islands. 
5 

11. Modifications to extension of expensing for environmental remediation costs 

(item III.B.11) 

The modification provides that petroleum products are treated as hazardous substances 

for purposes of applying the brownfields expensing provision (as extended).4

 Petroleum 

products are defined by reference to section 4612(a)(3), and include crude oil, crude oil 

condensates and natural gasoline.5

 Thus, for example, the release of crude oil upon property held 

for use in a trade or business results in such property being treated as a qualified contaminated 

site. Expenditures paid or incurred to abate the contamination on or after December 31, 2005 

and before December 31, 2006, would be eligible for expensing.6

 

12. Deletion of provision relating to prohibition on deferral of certain stock option and 

restricted stock gains (item IV.F.5) 

The modification strikes the provision of the Chairman’s mark relating to prohibition on 

deferral of certain stock option and restricted stock gains. 

13. Deletion of provision related to elimination of double deduction of mining exploration 

and development cost under the minimum tax (item IV.F.7) 

Under the modification, the provision related to elimination of double deduction of 

mining exploration and development cost under the minimum tax is deleted from the Chairman’s 

mark. 

14. Deletion of provision related to the holding period requirement for reduced tax rate on 

dividends on preferred stock (item IV.F.9) 

Under the modification, the provision related to the holding period requirement for the 

reduced tax rate on dividends on preferred stock is deleted from the Chairman’s mark. 

 4

 The proposal applies to expenditures paid or incurred after December 31, 2005. 

5

 The present law exceptions for sites on the national priorities list under CERCLA, and for 

substances with respect to which a removal or remediation is not permitted under section 104 of 

CERCLA by reason of subsection (a)(3) thereof, would continue to apply to all hazardous substances 

(including petroleum products). 

6

 Note that under item I.A.15 of the Chairman’s mark, petroleum products are treated as 

hazardous substances, effective for expenditures paid or incurred after August 28, 2005, and before 

December 31, 2007, to abate contamination in the Gulf Opportunity Zone. 
6 

B. Additional Provisions 

1. Charitable deduction for nonitemizers; floor on deductions for itemizers 

Present Law

In computing taxable income, an individual taxpayer who itemizes deductions generally 

is allowed to deduct the amount of cash and up to the fair market value of property contributed to 

a charity described in section 501(c)(3),7

 to certain veterans’ organizations, fraternal societies, 

and cemetery companies,8

 or to a Federal, State, or local governmental entity for exclusively 

public purposes.9 The deduction also is allowed for purposes of calculating alternative minimum 

taxable income. 

The amount of the deduction allowable for a taxable year with respect to a charitable 

contribution of property may be reduced depending on the type of property contributed, the type 

of charitable organization to which the property is contributed, and the income of the taxpayer.10

A taxpayer who takes the standard deduction (i.e., who does not itemize deductions) may 

not take a separate deduction for charitable contributions.11

A payment to a charity (regardless of whether it is termed a “contribution”) in exchange 

for which the donor receives an economic benefit is not deductible, except to the extent that the 

donor can demonstrate that the payment exceeds the fair market value of the benefit received 

from the charity. To facilitate distinguishing charitable contributions from purchases of goods or 

services from charities, present law provides that no charitable contribution deduction is allowed 

for a separate contribution of $250 or more unless the donor obtains a contemporaneous written 

acknowledgement of the contribution from the charity indicating whether the charity provided 

any good or service (and an estimate of the value of any such good or service) to the taxpayer in 

consideration for the contribution.12 In addition, present law requires that any charity that 

receives a contribution exceeding $75 made partly as a gift and partly as consideration for goods 

 7

 All section references are to the Internal Revenue Code of 1986, unless otherwise indicated. 

8

 Secs. 170(c)(3)-(5). 

9

 Sec. 170(c)(1). 

10 Secs. 170(b) and (e). 

11 Sec. 170(a). The Economic Recovery Tax Act of 1981 adopted a temporary provision that 

permitted individual taxpayers who did not itemize income tax deductions to claim a deduction from 

gross income for a specified percentage of their charitable contributions. The maximum deduction was 

$25 for 1982 and 1983, $75 for 1984, 50 percent of the amount of the contribution for 1985, and 100 

percent of the amount of the contribution for 1986. The nonitemizer deduction terminated for 

contributions made after 1986. 

12 Sec. 170(f)(8). 
7 

or services furnished by the charity (a “quid pro quo” contribution) is required to inform the 

contributor in writing of an estimate of the value of the goods or services furnished by the charity 

and that only the portion exceeding the value of the goods or services is deductible as a 

charitable contribution.13

Under present law, total deductible contributions of an individual taxpayer to public 

charities, private operating foundations, and certain types of private nonoperating foundations 

may not exceed 50 percent of the taxpayer’s contribution base, which is the taxpayer’s adjusted 

gross income for a taxable year (disregarding any net operating loss carryback). To the extent a 

taxpayer has not exceeded the 50-percent limitation, (1) contributions of capital gain property to 

public charities generally may be deducted up to 30 percent of the taxpayer’s contribution base, 

(2) contributions of cash to private foundations and certain other charitable organizations 

generally may be deducted up to 30 percent of the taxpayer’s contribution base, and (3) 

contributions of capital gain property to private foundations and certain other charitable 

organizations generally may be deducted up to 20 percent of the taxpayer’s contribution base. 

Contributions by individuals in excess of the 50-percent, 30-percent, and 20-percent limit 

may be carried over and deducted over the next five taxable years, subject to the relevant 

percentage limitations on the deduction in each of those years. 

In addition to the percentage limitations imposed specifically on charitable contributions, 

present law imposes a reduction on most itemized deductions, including charitable contribution 

deductions, for taxpayers with adjusted gross income in excess of a threshold amount, which is 

indexed annually for inflation. The threshold amount for 2005 is $145,950 ($72,975 for married 

individuals filing separate returns). For those deductions that are subject to the limit, the total 

amount of itemized deductions is reduced by three percent of adjusted gross income over the 

threshold amount, but not by more than 80 percent of itemized deductions subject to the limit. 

Beginning in 2006, the overall limitation on itemized deductions phases-out for all taxpayers. 

The overall limitation on itemized deductions is reduced by one-third in taxable years beginning 

in 2006 and 2007, and by two-thirds in taxable years beginning in 2008 and 2009. The overall 

limitation on itemized deductions is eliminated for taxable years beginning after December 31, 

2009; however, this elimination of the limitation sunsets on December 31, 2010. 

Description of Proposal

In the case of an individual taxpayer who does not itemize deductions, the proposal 

allows a deduction for nonitemizers from adjusted gross income for charitable contributions paid 

in cash during the taxable year. This deduction is allowed in addition to the standard deduction. 

The deduction is available only for that portion of contributions made during the year that in the 

aggregate exceed $250 ($500 in the case of a joint return). Contributions that are below the 

minimum amount may not be carried over for purposes of a subsequent taxable year’s 

calculation of the deduction. 

 13 Sec. 6115. 
8 

The proposal does not otherwise alter present-law rules regarding the carryover of 

contributions to or from a taxable year, including a taxable year in which the taxpayer elects the 

standard deduction. The deduction for nonitemizers generally is subject to the tax rules normally 

governing charitable contribution deductions, such as the substantiation requirements. The 

deduction is allowed in computing alternative minimum taxable income. 

Under the proposal, an individual taxpayer who itemizes deductions is subject to a floor 

on all charitable contributions, cash and noncash, of $250 ($500 in the case of a joint return). 

Accordingly, the first $250 ($500 in case of a joint return) of charitable contributions of such 

taxpayer (whether as carryovers of excess contributions or otherwise) for each taxable year are 

not allowed. The proposal does not otherwise change the present-law rules pertaining to 

charitable contributions. 

Effective Date

The proposal is effective for contributions made in taxable years beginning after 

December 31, 2005, and before January 1, 2008. 

2. Tax-free distributions from individual retirement arrangements for charitable purposes 

Present Law

In general

If an amount withdrawn from a traditional individual retirement arrangement (“IRA”) or 

a Roth IRA is donated to a charitable organization, the rules relating to the tax treatment of 

withdrawals from IRAs apply to the amount withdrawn and the charitable contribution is subject 

to the normally applicable limitations on deductibility of such contributions. 

Charitable contributions

In computing taxable income, an individual taxpayer who itemizes deductions generally 

is allowed to deduct the amount of cash and up to the fair market value of property contributed to 

a charity described in section 501(c)(3), to certain veterans’ organizations, fraternal societies, 

and cemetery companies,14 or to a Federal, State, or local governmental entity for exclusively 

public purposes.15 The deduction also is allowed for purposes of calculating alternative 

minimum taxable income. 

 14 Secs. 170(c)(3)-(5). 

15 Sec. 170(c)(1). 
9 

The amount of the deduction allowable for a taxable year with respect to a charitable 

contribution of property may be reduced depending on the type of property contributed, the type 

of charitable organization to which the property is contributed, and the income of the taxpayer.16

A taxpayer who takes the standard deduction (i.e., who does not itemize deductions) may 

not take a separate deduction for charitable contributions.17

A payment to a charity (regardless of whether it is termed a “contribution”) in exchange 

for which the donor receives an economic benefit is not deductible, except to the extent that the 

donor can demonstrate, among other things, that the payment exceeds the fair market value of 

the benefit received from the charity. To facilitate distinguishing charitable contributions from 

purchases of goods or services from charities, present law provides that no charitable 

contribution deduction is allowed for a separate contribution of $250 or more unless the donor 

obtains a contemporaneous written acknowledgement of the contribution from the charity 

indicating whether the charity provided any good or service (and an estimate of the value of any 

such good or service) to the taxpayer in consideration for the contribution.18 In addition, present 

law requires that any charity that receives a contribution exceeding $75 made partly as a gift and 

partly as consideration for goods or services furnished by the charity (a “quid pro quo” 

contribution) is required to inform the contributor in writing of an estimate of the value of the 

goods or services furnished by the charity and that only the portion exceeding the value of the 

goods or services may be deductible as a charitable contribution.19

Under present law, total deductible contributions of an individual taxpayer to public 

charities, private operating foundations, and certain types of private nonoperating foundations 

may not exceed 50 percent of the taxpayer’s contribution base, which is the taxpayer’s adjusted 

gross income for a taxable year (disregarding any net operating loss carryback). To the extent a 

taxpayer has not exceeded the 50-percent limitation, (1) contributions of capital gain property to 

public charities generally may be deducted up to 30 percent of the taxpayer’s contribution base, 

(2) contributions of cash to private foundations and certain other charitable organizations 

generally may be deducted up to 30 percent of the taxpayer’s contribution base, and (3) 

contributions of capital gain property to private foundations and certain other charitable 

organizations generally may be deducted up to 20 percent of the taxpayer’s contribution base. 

Contributions by individuals in excess of the 50-percent, 30-percent, and 20-percent 

limits may be carried over and deducted over the next five taxable years, subject to the relevant 

percentage limitations on the deduction in each of those years. 

 16 Secs. 170(b) and (e). 

17 Sec. 170(a). 

18 Sec. 170(f)(8). 

19 Sec. 6115. 
10 

In addition to the percentage limitations imposed specifically on charitable contributions, 

present law imposes a reduction on most itemized deductions, including charitable contribution 

deductions, for taxpayers with adjusted gross income in excess of a threshold amount, which is 

indexed annually for inflation. The threshold amount for 2005 is $145,950 ($72,975 for married 

individuals filing separate returns). For those deductions that are subject to the limit, the total 

amount of itemized deductions is reduced by three percent of adjusted gross income over the 

threshold amount, but not by more than 80 percent of itemized deductions subject to the limit. 

Beginning in 2006, the overall limitation on itemized deductions phases-out for all taxpayers. 

The overall limitation on itemized deductions is reduced by one-third in taxable years beginning 

in 2006 and 2007, and by two-thirds in taxable years beginning in 2008 and 2009. The overall 

limitation on itemized deductions is eliminated for taxable years beginning after December 31, 

2009; however, this elimination of the limitation sunsets on December 31, 2010. 

In general, a charitable deduction is not allowed for income, estate, or gift tax purposes if 

the donor transfers an interest in property to a charity (e.g., a remainder) while also either 

retaining an interest in that property (e.g., an income interest) or transferring an interest in that 

property to a noncharity for less than full and adequate consideration.20 Exceptions to this 

general rule are provided for, among other interests, remainder interests in charitable remainder 

annuity trusts, charitable remainder unitrusts, and pooled income funds, and present interests in 

the form of a guaranteed annuity or a fixed percentage of the annual value of the property.21 For 

such interests, a charitable deduction is allowed to the extent of the present value of the interest 

designated for a charitable organization. 

IRA rules

Within limits, individuals may make deductible and nondeductible contributions to a 

traditional IRA. Amounts in a traditional IRA are includible in income when withdrawn (except 

to the extent the withdrawal represents a return of nondeductible contributions). Individuals also 

may make nondeductible contributions to a Roth IRA. Qualified withdrawals from a Roth IRA 

are excludable from gross income. Withdrawals from a Roth IRA that are not qualified 

withdrawals are includible in gross income to the extent attributable to earnings. Includible 

amounts withdrawn from a traditional IRA or a Roth IRA before attainment of age 59-1/2 are 

subject to an additional 10-percent early withdrawal tax, unless an exception applies. 

If an individual has made nondeductible contributions to a traditional IRA, a portion of 

each distribution from an IRA is nontaxable, until the total amount of nondeductible 

contributions has been received. In general, the amount of a distribution that is nontaxable is 

determined by multiplying the amount of the distribution by the ratio of the remaining 

nondeductible contributions to the account balance. In making the calculation, all traditional 

IRAs of an individual are treated as a single IRA, all distributions during any taxable year are 

 20 Secs. 170(f), 2055(e)(2), and 2522(c)(2). 

21 Sec. 170(f)(2). 
11 

treated as a single distribution, and the value of the contract, income on the contract, and 

investment in the contract are computed as of the close of the calendar year. 

In the case of a distribution from a Roth IRA that is not a qualified distribution, in 

determining the portion of the distribution attributable to earnings, contributions and 

distributions are deemed to be distributed in the following order: (1) regular Roth IRA 

contributions; (2) taxable conversion contributions;22 (3) nontaxable conversion contributions; 

and (4) earnings. In determining the amount of taxable distributions from a Roth IRA, all Roth 

IRA distributions in the same taxable year are treated as a single distribution, all regular Roth 

IRA contributions for a year are treated as a single contribution, and all conversion contributions 

during the year are treated as a single contribution. 

Split-interest trust filing requirements

Split-interest trusts, including charitable remainder annuity trusts, charitable remainder 

unitrusts, and pooled income funds, are required to file an annual information return23 (Form 

1041A). Trusts that are not split-interest trusts but that claim a charitable deduction for amounts 

permanently set aside for a charitable purpose24 also are required to file Form 1041A. The 

returns are required to be made publicly available.25 A trust that is required to distribute all trust 

net income currently to trust beneficiaries in a taxable year is exempt from this return 

requirement for such taxable year. A failure to file the required return may result in a penalty on 

the trust of $10 a day for as long as the failure continues, up to a maximum of $5,000 per return. 

In addition, split-interest trusts are required to file annually Form 5227.26 Form 5227 

requires disclosure of information regarding a trust’s noncharitable beneficiaries. The penalty 

for failure to file this return is calculated based on the amount of tax owed. A split-interest trust 

generally is not subject to tax and therefore, in general, a penalty may not be imposed for the 

failure to file Form 5227. Form 5227 is not required to be made publicly available. 

Description of Proposal

Qualified charitable distributions from IRAs

The provision provides an exclusion from gross income for otherwise taxable IRA 

distributions from a traditional or a Roth IRA in the case of qualified charitable distributions.27 

 22 Conversion contributions refer to conversions of amounts in a traditional IRA to a Roth IRA. 

23 Sec. 6034. This requirement applies to all split-interest trusts described in section 4947(a)(2). 

24 Sec. 642(c). 

25 Sec. 6104(b). 

26 Sec. 6011; Treas. Reg. sec. 53.6011-1(d). 

27 The proposal does not apply to distributions from employer sponsored retirements plans, 

including SIMPLE IRAs and simplified employee pensions (“SEP”). 
12 

Special rules apply in determining the amount of an IRA distribution that is otherwise taxable. 

The present-law rules regarding taxation of IRA distributions and the deduction of charitable 

contributions continue to apply to distributions from an IRA that are not qualified charitable 

distributions. Qualified charitable distributions are taken into account for purposes of the 

minimum distribution rules applicable to IRAs to the same extent the distribution would have 

been taken into account under such rules had the distribution not been directly distributed under 

the provision. An IRA does not fail to qualify as an IRA merely because qualified charitable 

distributions have been made from the IRA. It is intended that the Secretary will prescribe rules 

under which IRA owners are deemed to elect out of withholding if they designate that a 

distribution is intended to be a qualified charitable distribution. 

A qualified charitable distribution is defined as any distribution from an IRA that is made 

after December 31, 2005, and before January 1, 2008, directly by the IRA trustee either to (1) an 

organization to which deductible contributions can be made (a “direct distribution”) or (2) a 

“split-interest entity.” A split-interest entity means a charitable remainder annuity trust or 

charitable remainder unitrust (together referred to as a “charitable remainder trust”), a pooled 

income fund, or a charitable gift annuity. Direct distributions are eligible for the exclusion only 

if made on or after the date the IRA owner attains age 70-1/2. Distributions to a split interest 

entity are eligible for the exclusion only if made on or after the date the IRA owner attains age 

59-1/2. In the case of split-interest distributions, no person may hold an income interest in the 

amounts in the split-interest entity attributable to the charitable distribution other than the IRA 

owner, the IRA owner’s spouse, or a charitable organization. 

The exclusion applies to direct distributions only if a charitable contribution deduction 

for the entire distribution otherwise would be allowable (under present law), determined without 

regard to the generally applicable percentage limitations. Thus, for example, if the deductible 

amount is reduced because of a benefit received in exchange, or if a deduction is not allowable 

because the donor did not obtain sufficient substantiation, the exclusion is not available with 

respect to any part of the IRA distribution. Similarly, the exclusion applies in the case of a 

distribution directly to a split-interest entity only if a charitable contribution deduction for the 

entire present value of the charitable interest (for example, a remainder interest) otherwise would 

be allowable, determined without regard to the generally applicable percentage limitations. 

If the IRA owner has any IRA that includes nondeductible contributions, a special rule 

applies in determining the portion of a distribution that is includible in gross income (but for the 

provision) 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 aggregate amount that 

would be includible in gross income (but for the provision) if the aggregate balance of all IRAs 

having the same owners were distributed during the same year. In determining the amount of 

subsequent IRA distributions includible in income, proper adjustments are made to reflect the 

amount treated as a qualified charitable distribution under the special rule. 

Special rules apply for distributions to split-interest entities. For distributions to 

charitable remainder trusts, the provision provides that subsequent distributions from the 

charitable remainder trust are treated as ordinary income in the hands of the beneficiary, 
13 

notwithstanding how such amounts normally are treated under section 664(b).28 In addition, for 

a charitable remainder trust to be eligible to receive qualified charitable distributions, the 

charitable remainder trust has to be funded exclusively by such distributions. For example, an 

IRA owner may not make qualified charitable distributions to an existing charitable remainder 

trust any part of which was funded with assets that were not qualified charitable distributions. 

Under the provision, a pooled income fund is eligible to receive qualified charitable 

distributions only if the fund accounts separately for amounts attributable to such distributions. 

In addition, all distributions from the pooled income fund that are attributable to qualified 

charitable distributions are treated as ordinary income to the beneficiary. Qualified charitable 

distributions to a pooled income fund are not includible in the fund’s gross income. 

In determining the amount includible in gross income by reason of a payment from a 

charitable gift annuity purchased with a qualified charitable distribution from an IRA, the portion 

of the distribution from the IRA used to purchase the annuity is not an investment in the annuity 

contract. 

Any amount excluded from gross income by reason of the provision is not taken into 

account in determining the deduction for charitable contributions under section 170. 

Qualified charitable distribution examples 

The following examples illustrate the determination of the portion of an IRA distribution 

that is a qualified charitable distribution and the application of the special rules for a qualified 

charitable distribution to a split-interest entity. In each example, it is assumed that the 

requirements for qualified charitable distribution treatment are otherwise met (e.g., the applicable 

age requirement and the requirement that contributions are otherwise deductible) and that no 

other IRA distributions occur during the year. 

Example 1.−Individual A has a traditional IRA with a balance of $100,000, consisting 

solely of deductible contributions and earnings. Individual A has no other IRA. The entire IRA 

balance is distributed in a direct distribution to a charitable organization. Under present law, the 

entire distribution of $100,000 would be includible in Individual A’s income. Accordingly, 

under the provision, the entire distribution of $100,000 is a qualified charitable distribution. As a 

result, no amount is included in Individual A’s income as a result of the distribution and the 

distribution is not taken into account in determining the amount of Individual A’s charitable 

deduction for the year. 

Example 2.−The facts are the same as in Example 1, except that the entire IRA balance of 

$100,000 is distributed to a charitable remainder unitrust, which contains no other assets and 

which must be funded exclusively by qualified charitable distributions. Under the terms of the 

trust, Individual A is entitled to receive five percent of the net fair market value of the trust assets 

 28 Although qualified charitable distributions by definition must be made after August 28, 2005, 

and before January 1, 2006, the rules of the provision (including rules relating to later distributions from 

an IRA or a split-interest entity) are effective with respect to and after such time period. 
14 

each year. As explained in Example l, the entire $100,000 distribution is a qualified charitable 

distribution, no amount is included in Individual A’s income as a result of the distribution, and 

the distribution is not taken into account in determining the amount of Individual A’s charitable 

deduction for the year. In addition, under a special rule in the provision for charitable remainder 

trusts, any distribution from the charitable remainder unitrust to Individual A is includible in 

gross income as ordinary income, regardless of the character of the distribution under the usual 

rules for the taxation of distributions from such a trust. 

Example 3.−Individual B 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. 

Individual B has no other IRA. In a direct distribution to a charitable organization, $80,000 is 

distributed from the IRA. Under present law, a portion of the distribution from the IRA would 

be treated as a nontaxable return of nondeductible contributions. The nontaxable portion of the 

distribution would be $16,000, determined by multiplying the amount of the distribution 

($80,000) by the ratio of the nondeductible contributions to the account balance 

($20,000/$100,000). Accordingly, under present law, $64,000 of the distribution ($80,000 minus 

$16,000) would be includible in Individual B’s income. 

Under the provision, notwithstanding the present-law tax treatment of IRA distributions, 

the distribution is treated as consisting of income first, up to the total amount that would be 

includible in gross 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. 

Accordingly, under the provision, the entire $80,000 distributed to the charitable organization is 

treated as includible in income (before application of the provision) and is a qualified charitable 

distribution. As a result, no amount is included in Individual B’s income as a result of the 

distribution and the distribution is not taken into account in determining the amount of 

Individual B’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 Individual B’s nondeductible contributions (i.e., not subject to tax upon distribution). 

Split-interest trust filing requirements

The provision increases the penalty on split-interest trusts for failure to file a return and 

for failure to include any of the information required to be shown on such return and to show the 

correct information. The penalty is $20 for each day the failure continues up to $10,000 for any 

one return. In the case of a split-interest trust with gross income in excess of $250,000, the 

penalty is $100 for each day the failure continues up to a maximum of $50,000. In addition, if a 

person (meaning any officer, director, trustee, employee, or other individual who is under a duty 

to file the return or include required information)29 knowingly failed to file the return or include 

required information, then that person is personally liable for such a penalty, which would be 

imposed in addition to the penalty that is paid by the organization. Information regarding 

beneficiaries that are not charitable organizations as described in section 170(c) is exempt from 

 29 Sec. 6652(c)(4)(C). 
15 

the requirement to make information publicly available. In addition, the provision repeals the 

present-law exception to the filing requirement for split-interest trusts that are required in a 

taxable year to distribute all net income currently to beneficiaries. Such exception remains 

available to trusts other than split-interest trusts that are otherwise subject to the filing 

requirement. 

Effective Date

The provision relating to qualified charitable distributions is effective for distributions 

made in taxable years beginning after December 31, 2005, and before January 1, 2008. The 

provision relating to information returns of split-interest trusts is effective for returns for taxable 

years beginning after December 31, 2005. 

3. Charitable deduction for contributions of food inventory 

Present Law

Under present law, a taxpayer’s deduction for charitable contributions of inventory 

generally is limited to the taxpayer’s basis (typically, 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 (sec. 170(e)(3)). In general, a C 

corporation’s charitable contribution deductions for a year may not exceed 10 percent of the 

corporation’s taxable income (sec. 170(b)(2)). To be eligible for the enhanced deduction, the 

contributed property generally must be inventory of the taxpayer, contributed to a charitable 

organization described in section 501(c)(3) (except for private nonoperating foundations), and 

the donee must (1) use the property consistent with the donee’s 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 donee’s use of the 

property will be consistent with such requirements. In the case of contributed property subject to 

the Federal Food, Drug, and Cosmetic Act, the property must satisfy the applicable requirements 

of such Act on the date of transfer and for 180 days prior to the transfer. 

A donor making a charitable contribution of inventory must make a corresponding 

adjustment to the cost of goods sold by decreasing the cost of goods sold by the lesser of the fair 

market value of the property or the donor’s basis with respect to the inventory (Treas. Reg. sec. 

1.170A-4A(c)(3)). Accordingly, if the allowable charitable deduction for inventory is the fair 

market value of the inventory, the donor reduces its cost of goods sold by such value, with the 

result that the difference between the fair market value and the donor’s basis may still be 

recovered by the donor other than as a charitable contribution. 
16 

To use the enhanced deduction, the taxpayer must establish that the fair market value of 

the donated item exceeds basis. The valuation of food inventory has been the subject of disputes 

between taxpayers and the IRS.30

Description of Proposal

Under the proposal, any taxpayer, whether or not a C corporation, engaged in a trade or 

business is eligible to claim the enhanced deduction for donations of food inventory. For 

taxpayers other than C corporations, the total deduction for donations of food inventory in a 

taxable year generally may not exceed 10 percent of the taxpayer’s net income for such taxable 

year from all sole proprietorships, S corporations, or partnerships (or other non C corporation) 

from which contributions of apparently wholesome food are made. For example, if a taxpayer is 

a sole proprietor, a shareholder in an S corporation, and a partner in a partnership, and each 

business makes charitable contributions of food inventory, the taxpayer’s deduction for 

donations of food inventory is limited to 10 percent of the taxpayer’s net income from the sole 

proprietorship and the taxpayer’s interests in the S corporation and partnership. However, if only 

the sole proprietorship and the S corporation made charitable contributions of food inventory, the 

taxpayer’s deduction would be limited to 10 percent of the net income from the trade or business 

of the sole proprietorship and the taxpayer’s interest in the S corporation, but not the taxpayer’s 

interest in the partnership. 

The 10 percent limitation does not affect the application of the generally applicable 

percentage limitations. For example, if 10 percent of a sole proprietor’s net income from the 

proprietor’s trade or business was greater than 50 percent of the proprietor’s contribution base, 

the available deduction for the taxable year (with respect to contributions to public charities) 

would be 50 percent of the proprietor’s contribution base. Consistent with present law, such 

contributions may be carried forward because they exceed the 50 percent limitation. 

Contributions of food inventory by a taxpayer that is not a C corporation that exceed the 10 

percent limitation but not the 50 percent limitation could not be carried forward. 

For purposes of calculating the enhanced deduction, taxpayers who do not account for 

inventories under section 471 and who are not required to capitalize indirect costs under section 

263A are able to elect to treat the basis of the contributed food as being equal to 25 percent of the 

food’s fair market value.31 

The proposal changes the amount of the present-law enhanced deduction for eligible 

contributions of food inventory to the lesser of fair market value or twice the taxpayer’s basis in 

the inventory. For example, a taxpayer who makes an eligible donation of food that has a fair 

market value of $10 and a basis of $4 could take a deduction of $8 (twice basis). If the 

 30 Lucky Stores Inc. v. Commissioner, 105 T.C. 420 (1995) (holding that the value of surplus 

bread inventory donated to charity was the full retail price of the bread rather than half the retail price, as 

the IRS asserted). 

31 This includes, for example, taxpayers who are eligible for administrative relief under Revenue 

Procedures 2002-28 and 2001-10. 
17 

taxpayer’s basis was $6 instead of $4, then the deduction would be $10 (fair market value). By 

contrast, under present law, a C corporation’s deduction in the first example would be $7 (fair 

market value less half the appreciation) and in the second example would be $8. (Under present 

law, taxpayers other than C corporations generally could take a deduction for a contribution of 

food inventory only for the $4 basis in either example.) Taxpayers that do not account for 

inventories under section 471 and who are not required to capitalize indirect costs under section 

263A would be able to elect to treat the basis of the contributed food as being equal to 25 percent 

of the food’s fair market value. 

Under the proposal, the enhanced deduction is available only for food that qualifies as 

“apparently wholesome food.” “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. 

In addition, the proposal provides that the fair market value of donated apparently 

wholesome food that cannot or will not be sold solely due to internal standards of the taxpayer or 

lack of market is determined without regard to such internal standards or lack of market and by 

taking into account the price at which the same or substantially the same food items (as to both 

type and quality) are sold by the taxpayer at the time of the contribution or, if not so sold at such 

time, in the recent past. 

Effective Date

The proposal is effective for contributions made in taxable years beginning after 

December 31, 2005, and before January 1, 2008. 

4. Basis adjustment to stock of S corporation contributing property 

Present Law

Under present law, if an S corporation contributes money or other property to a charity, 

each shareholder takes into account the shareholder’s pro rata share of the contribution in 

determining its own income tax liability.32 A shareholder of an S corporation reduces the basis 

in the stock of the S corporation by the amount of the charitable contribution that flows through 

to the shareholder.33

 32 Sec. 1366(a)(1)(A). 

33 Sec. 1367(a)(2)(B). 
18 

Description of Proposal

The proposal provides that the amount of a shareholder’s basis reduction in the stock of 

an S corporation by reason of a charitable contribution made by the corporation will be equal to 

the shareholder’s pro rata share of the adjusted basis of the contributed property.34

Thus, for example, assume an S corporation with one individual shareholder makes a 

charitable contribution of stock with a basis of $200 and a fair market value of $500. The 

shareholder will be treated as having made a $500 charitable contribution (or a lesser amount if 

the special rules of section 170(e) apply), and will reduce the basis of the S corporation stock by 

$200. 

Effective Date

The proposal applies to contributions made in taxable years beginning after December 

31, 2005, and before January 1, 2008. 

5. Modify tax treatment of certain payments to controlling exempt organizations and 

public disclosure of information relating to UBIT 

Present Law

Payments to controlling exempt organizations

In general, interest, rents, royalties, and annuities are excluded from the unrelated 

business income of tax-exempt organizations. However, section 512(b)(13) generally treats 

otherwise excluded rent, royalty, annuity, and interest income as unrelated business income if 

such income is received from a taxable or tax-exempt subsidiary that is 50 percent controlled by 

the parent tax-exempt organization. In the case of a stock subsidiary, “control” means ownership 

by vote or value of more than 50 percent of the stock. In the case of a partnership or other entity, 

control means ownership of more than 50 percent of the profits, capital or beneficial interests. 

In addition, present law applies the constructive ownership rules of section 318 for purposes of 

section 512(b)(13). Thus, a parent exempt organization is deemed to control any subsidiary in 

which it holds more than 50 percent of the voting power or value, directly (as in the case of a 

first-tier subsidiary) or indirectly (as in the case of a second-tier subsidiary). 

Under present law, interest, rent, annuity, or royalty payments made by a controlled 

entity to a tax-exempt organization are includable in the latter organization’s unrelated business 

income and are subject to the unrelated business income tax to the extent the payment reduces 

the net unrelated income (or increases any net unrelated loss) of the controlled entity (determined 

as if the entity were tax exempt). 

 34 See Rev. Rul. 96-11 (1996-1 C.B. 140) for a rule reaching a similar result in the case of 

charitable contributions made by a partnership. 
19 

The Taxpayer Relief Act of 1997 (the “1997 Act”) made several modifications to the 

control requirement of section 512(b)(13). In order to provide transitional relief, the changes 

made by the 1997 Act do not apply to any payment received or accrued during the first two 

taxable years beginning on or after the date of enactment of the 1997 Act (August 5, 1997) if 

such payment is received or accrued pursuant to a binding written contract in effect on June 8, 

1997, and at all times thereafter before such payment (but not pursuant to any contract provision 

that permits optional accelerated payments). 

Public disclosure of returns

In general, an organization described in section 501(c) or (d) is required to make 

available for public inspection a copy of its annual information return (Form 990) and exemption 

application materials.35 A penalty may be imposed on any person who does not make an 

organization’s annual returns or exemption application materials available for public inspection. 

The penalty amount is $20 for each day during which a failure occurs. If more than one person 

fails to comply, each person is jointly and severally liable for the full amount of the penalty. The 

maximum penalty that may be imposed on all persons for any one annual return is $10,000. 

There is no maximum penalty amount for failing to make exemption application materials 

available for public inspection. Any person who willfully fails to comply with the public 

inspection requirements is subject to an additional penalty of $5,000.36 

These requirements do not apply to an organization’s annual return for unrelated business 

income tax (generally Form 990-T).37

Description of Proposal

Payments to controlling exempt organizations

The proposal provides that the general rule of section 512(b)(13), which includes interest, 

rent, annuity, or royalty payments made by a controlled entity to a tax-exempt organization in the 

latter organization’s unrelated business income to the extent the payment reduces the net 

unrelated income (or increases any net unrelated loss) of the controlled entity, applies only to the 

portion of payments received or accrued in a taxable year that exceed the amount of the specified 

payment that would have been paid or accrued if such payment had been determined under the 

principles of section 482. Thus, if a payment of rent by a controlled subsidiary to its tax-exempt 

parent organization exceeds fair market value, the excess amount of such payment over fair 

market value (as determined in accordance with section 482) is included in the parent 

organization’s unrelated business income, to the extent that such excess reduced the net unrelated 

income (or increased any net unrelated loss) of the controlled entity (determined as if the entity 

were tax exempt). In addition, the provision imposes a 20-percent penalty on the larger of such 

 35 Sec. 6104(d). 

36 Sec. 6685. 

37 Treas. Reg. sec. 301.6104(d)-1(b)(4)(ii). 
20 

excess determined without regard to any amendment or supplement to a return of tax, or such 

excess determined with regard to all such amendments and supplements. 

The proposal provides that if modifications to section 512(b)(13) made by the 1997 Act 

did not apply to a contract because of the transitional relief provided by the 1997 Act, then such 

modifications also do not apply to amounts received or accrued under such contract before 

January 1, 2001. 

Require public availability of unrelated business income tax returns

The proposal extends the present-law public inspection and disclosure requirements and 

penalties applicable to the Form 990 to the unrelated business income tax returns of charitable 

organizations.38 The proposal provides that certain information may be withheld by the 

organization from public disclosure and inspection if public availability would adversely affect 

the organization, similar to the information that may be withheld under present law with respect 

to applications for tax exemption and the Form 990 (e.g., information relating to a trade secret, 

patent, process, style of work, or apparatus of the organization, if the Secretary determines that 

public disclosure of such information would adversely affect the organization). 

Require a UBIT certification for certain large charitable organizations 

A charitable organization that normally has annual total gross revenues (including 

contributions and grants, program service revenue, investment income, and revenues from an 

unrelated trade or business or other sources) or gross assets of at least $10 million must include 

with its Form 990 and Form 990-T filings (if any) a certification by an independent auditor or by 

independent counsel that the organization’s filings accurately reflect the unrelated business 

income tax liability of the organization for the taxable year. 

The certification must attest that the independent auditor or counsel with respect to the 

taxable year that is the subject of the return: 

1. has reviewed the trades and businesses of the organization, the organization’s sources of 

investment income, and the organization’s sources of program service revenues, and, to 

the best of his or her knowledge, the reporting and descriptions of such items as 

contained in the Form 990 and, where applicable, Form 990-T, are complete and 

accurate; 

2. reasonably believes that the organization’s expense allocations between exempt, 

unrelated business income activities, and other activities used to determine the 

organization’s unrelated business income tax comply with the requirements set forth in 

Treasury Regulations section 1.512(a)-1; and 

 38 For purposes of this proposal, a charitable organization is any organization described in section 

501(c)(3) and exempt from tax under section 501(a). 
21 

3. has or has not reviewed or provided a tax opinion regarding the organization’s treatment 

of income or an activity under the unrelated business income tax rules.39 

Failure to satisfy the certification requirement results in a penalty, imposed on the 

organization, of one half of one percent (0.5 percent) of the organization’s total gross revenues 

for the taxable year, excluding revenues from contributions and grants. 

Effective Date

The proposal related to payments to controlling organizations applies to payments 

received or accrued after December 31, 2000. The public availability requirements of the 

proposal apply to returns filed after the date of enactment. The certification requirement applies 

to returns for taxable years that begin after the date of enactment. 

6. Encourage contributions of real property made for conservation purposes 

Present Law

Charitable contributions generally

In general, a deduction is permitted for charitable contributions, subject to certain 

limitations that depend on the type of taxpayer, the property contributed, and the donee 

organization. The amount of deduction generally equals the fair market value of the contributed 

property on the date of the contribution. Charitable deductions are provided for income, estate, 

and gift tax purposes.40

In general, in any taxable year, charitable contributions by a corporation are not 

deductible to the extent the aggregate contributions exceed 10 percent of the corporation’s 

taxable income computed without regard to net operating or capital loss carrybacks. For 

individuals, the amount deductible is a percentage of the taxpayer’s contribution base, which is 

the taxpayer’s adjusted gross income computed without regard to any net operating loss 

carryback. The applicable percentage of the contribution base varies depending on the type of 

donee organization and property contributed. Cash contributions of an individual taxpayer to 

public charities, private operating foundations, and certain types of private nonoperating 

foundations may not exceed 50 percent of the taxpayer’s contribution base. Cash contributions 

to private foundations and certain other organizations generally may be deducted up to 30 

percent of the taxpayer’s contribution base. 

In general, a charitable deduction is not allowed for income, estate, or gift tax purposes if 

the donor transfers an interest in property to a charity while also either retaining an interest in 

that property or transferring an interest in that property to a noncharity for less than full and 

 39 If the certifying party has provided or reviewed such an opinion, it also must include a 

description of the material facts regarding the income or activity that was the subject of such opinion. 

40 Secs. 170, 2055, and 2522, respectively. 
22 

adequate consideration. Exceptions to this general rule are provided for, among other interests, 

remainder interests in charitable remainder annuity trusts, charitable remainder unitrusts, and 

pooled income funds, present interests in the form of a guaranteed annuity or a fixed percentage 

of the annual value of the property, and qualified conservation contributions. 

Capital gain property

Capital gain property means any capital asset or property used in the taxpayer’s trade or 

business the sale of which at its fair market value, at the time of contribution, would have 

resulted in gain that would have been long-term capital gain. Contributions of capital gain 

property to a qualified charity are deductible at fair market value within certain limitations. 

Contributions of capital gain property to charitable organizations described in section 

170(b)(1)(A) (e.g., public charities, private foundations other than private non-operating 

foundations, and certain governmental units) generally are deductible up to 30 percent of the 

taxpayer’s contribution base. An individual may elect, however, to bring all these contributions 

of capital gain property for a taxable year within the 50-percent limitation category by reducing 

the amount of the contribution deduction by the amount of the appreciation in the capital gain 

property. Contributions of capital gain property to charitable organizations described in section 

170(b)(1)(B) (e.g., private non-operating foundations) are deductible up to 20 percent of the 

taxpayer’s contribution base. 

For purposes of determining whether a taxpayer’s aggregate charitable contributions in a 

taxable year exceed the applicable percentage limitation, contributions of capital gain property 

are taken into account after other charitable contributions. Contributions of capital gain property 

that exceed the percentage limitation may be carried forward for five years. 

Qualified conservation contributions

Qualified conservation contributions are not subject to the “partial interest” rule, which 

generally bars deductions for charitable contributions of partial interests in property. A qualified 

conservation contribution is a contribution of a qualified real property interest to a qualified 

organization exclusively for conservation purposes. A qualified real property interest is defined 

as: (1) the entire interest of the donor other than a qualified mineral interest; (2) a remainder 

interest; or (3) a restriction (granted in perpetuity) on the use that may be made of the real 

property. Qualified organizations include certain governmental units, public charities that meet 

certain public support tests, and certain supporting organizations. Conservation purposes 

include: (1) the preservation of land areas for outdoor recreation by, or for the education of, the 

general public; (2) the protection of a relatively natural habitat of fish, wildlife, or plants, or 

similar ecosystem; (3) the preservation of open space (including farmland and forest land) where 

such preservation will yield a significant public benefit and is either for the scenic enjoyment of 

the general public or pursuant to a clearly delineated Federal, State, or local governmental 

conservation policy; and (4) the preservation of an historically important land area or a certified 

historic structure. 

Qualified conservation contributions of capital gain property are subject to the same 

limitations and carryover rules of other charitable contributions of capital gain property. 
23 

Description of Proposal

In general

Under the proposal, the 30-percent contribution base limitation on contributions of capital 

gain property by individuals does not apply to qualified conservation contributions (as defined 

under present law). Thus, individuals may include the fair market value of any qualified 

conservation contribution of capital gain property in determining the amount of the charitable 

contributions subject to the 50-percent contribution base limitation. 

Individuals are allowed to carryover any qualified conservation contributions that exceed 

the 50-percent limitation for up to 15 years. The 50-percent contribution base limitation applies 

first to contributions other than qualified conservation contributions and then to qualified 

conservation contributions. For example, assume an individual with a contribution base of $100 

makes a qualified conservation contribution of property with a fair market value of $80 and 

makes other charitable contributions subject to the 50 percent limitation of $60. The individual 

is allowed a deduction of $50 in the current taxable year for the other contributions (50 percent 

of the $100 contribution base) and is allowed to carryover the excess $10 for up to 5 years. No 

current deduction is allowed for the qualified conservation contribution but the entire $80 

qualified conservation contribution may be carried forward for up to 15 years. 

Farmers and ranchers

In the case of an eligible farmer or rancher, a qualified conservation contribution is 

allowable up to 100 percent of the taxpayer’s contribution base (after taking into account other 

charitable contributions). This rule applies both to individuals and corporations. In addition, 

corporate (as well as non-corporate) eligible farmers and ranchers are allowed to carryover any 

excess qualified conservation contributions for up to 15 years. The 100-percent contribution 

base limitation applies first to contributions other than qualified conservation contributions (to 

the extent allowable under other percentage limitations) and then to qualified conservation 

contributions. For example, assume an individual farmer or rancher with a contribution base of 

$100 makes a qualified conservation contribution of property with a fair market value of $80 and 

makes other charitable contributions subject to the 50 percent limitation of $60. The individual 

is allowed a deduction of $50 in the current taxable year for the other contributions (50 percent 

of the $100 contribution base) and is allowed to carryover the excess $10 for up to 5 years. The 

individual also is allowed a deduction of $50 in the current taxable year for the qualified 

charitable contribution (the amount of the remaining contribution base). The remaining $30 

qualified conservation contribution may be carried forward for up to 15 years. 

For this purpose, an eligible farmer or rancher means a taxpayer (other than a publicly 

traded C corporation) whose gross income from the trade of business of farming is at least 51 

percent of the taxpayer’s gross income for the taxable year. 

Effective Date

The proposal is effective for contributions made in taxable years beginning after 

December 31, 2005 and before January 1, 2008. 
24 

7. Charitable deduction for contributions of book inventory 

Present Law

Under present law, a taxpayer’s deduction for charitable contributions of inventory 

generally is limited to the taxpayer’s basis (typically, 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 (sec. 170(e)(3)). In general, a C 

corporation’s charitable contribution deductions for a year may not exceed 10 percent of the 

corporation’s taxable income (sec. 170(b)(2)). To be eligible for the enhanced deduction, the 

contributed property generally must be inventory of the taxpayer, contributed to a charitable 

organization described in section 501(c)(3) (except for private nonoperating foundations), and 

the donee must (1) use the property consistent with the donee’s 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 donee’s use of the 

property will be consistent with such requirements. In the case of contributed property subject to 

the Federal Food, Drug, and Cosmetic Act, the property must satisfy the applicable requirements 

of such Act on the date of transfer and for 180 days prior to the transfer. 

A donor making a charitable contribution of inventory must make a corresponding 

adjustment to the cost of goods sold by decreasing the cost of goods sold by the lesser of the fair 

market value of the property or the donor’s basis with respect to the inventory (Treas. Reg. sec. 

1.170A-4A(c)(3)). Accordingly, if the allowable charitable deduction for inventory is the fair 

market value of the inventory, the donor reduces its cost of goods sold by such value, with the 

result that the difference between the fair market value and the donor’s basis may still be 

recovered by the donor other than as a charitable contribution. 

To use the enhanced deduction, the taxpayer must establish that the fair market value of 

the donated item exceeds basis. 

Description of Proposal

The proposal modifies the present-law enhanced deduction for C corporations so that it is 

equal to the lesser of fair market value or twice the taxpayer’s basis in the case of qualified book 

contributions. The proposal provides that the fair market value for this purpose is determined by 

reference to a bona fide published market price for the book. Under the proposal, a bona fide 

published market price of a book is a price of a book, determined using the same printing and 

same edition, published within seven years preceding the contribution, determined as a result of 

an arm’s length transaction, and for which the book was customarily sold. For example, a 

publisher’s listed retail price for a book would not meet the standard if the publisher could not 

demonstrate to the satisfaction of the Secretary that the price was one at which the book was 

customarily sold and was the result of an arm’s length transaction. If a publisher entered into a 

contract with a local school district to sell newly published textbooks six years prior to making a 

qualified book contribution of such textbooks, the publisher could use as a bona fide published 
25 

market price, the price at which such books regularly were sold to the school district under the 

contract. By contrast, if a publisher listed in a catalogue or elsewhere a “suggested retail price,” 

but books were not in fact customarily sold at such price, the publisher could not use the 

“suggested retail price” to determine the fair market value of the book for purposes of the 

enhanced deduction. Thus, in general, a bona fide published market price must be independently 

verifiable by reference to actual sales within the seven-year period preceding the contribution, 

and not to a publisher’s own price list. 

As an illustration of the mechanics of calculating the enhanced deduction under the 

proposal, a C corporation that made a qualified book contribution with a bona fide published 

market price of $10 and a basis of $4 could take a deduction of $8 (twice basis). If the 

taxpayer’s basis is $6 instead of $4, then the deduction is $10. Also, in such latter case, if the 

book’s bona fide market published market price was $5 at the time of the contribution but was 

$10 five years before the contribution, then the deduction is $10. 

A qualified book contribution means a charitable contribution of books to: (1) an 

educational organization that normally maintains a regular faculty and curriculum and normally 

has a regularly enrolled body of pupils or students in attendance at the place where its 

educational activities are regularly carried on; (2) a public library; or (3) an organization 

described in section 501(c)(3) (except for private nonoperating foundations), that is organized 

primarily to make books available to the general public at no cost or to operate a literacy 

program. The donee must: (1) use the property consistent with the donee’s exempt purpose; (2) 

not transfer the property in exchange for money, other property, or services; and (3) provide the 

taxpayer a written statement that the donee’s use of the property will be consistent with such 

requirements and also that the books are suitable, in terms of currency, content, and quantity, for 

use in the donee’s educational programs and that the donee will use the books in such 

educational programs. 

Effective Date

The proposal is effective for contributions made in taxable years beginning after 

December 31, 2005, and before January 1, 2008. 

8. Tax involvement by exempt organizations in tax-shelter transactions 

Present Law

Disclosure of listed and other reportable transactions by taxpayers

Present law provides that a taxpayer that participates in a reportable transaction 

(including a listed transaction) and who is required to file a tax return must attach to its return a 

disclosure statement in the form prescribed by the Secretary.41 For this purpose, the term 

 41 Treas. Reg. sec. 1.6011-4(a). 
26 

taxpayer includes any person, including an individual, trust, estate, partnership, association, 

company, or corporation.42

Under existing regulations, a reportable transaction includes a listed transaction and five 

other categories of transactions: (1) confidential transactions, which are transactions offered to a 

taxpayer under conditions of confidentiality and for which the taxpayer has paid an advisor a 

minimum fee; (2) transactions with contractual protection, which include transactions for which 

the taxpayer or a related party has the right to a full or partial refund of fees if all or part of the 

intended tax consequences from the transaction are not sustained, or for which fees are 

contingent on the taxpayer’s realization of tax benefits from the transaction; (3) loss transactions, 

which are transactions resulting in the taxpayer claiming a loss under section 165 that exceeds 

certain thresholds, depending upon the type of taxpayer; (4) transactions with a significant booktax difference; and (5) transactions involving a brief asset holding period.43 A listed transaction 

means a reportable transaction which is the same as, or substantially similar to, a transaction 

specifically identified by the Secretary as a tax avoidance transaction for purposes of section 

6011 (relating to the filing of returns and statements), and identified by notice, regulation, or 

other form of published guidance as a listed transaction.44 The fact that a transaction is a 

reportable transaction does not affect the legal determination of whether the taxpayer’s treatment 

of the transaction is proper.45 Present law authorizes the Secretary to define reportable 

transaction on the basis of such transaction being of a type which the Secretary determines as 

having a potential for tax avoidance or evasion.46 

Treasury regulations provide guidance regarding the determination of when a taxpayer 

participates in a transaction for these purposes.47 A taxpayer has participated in a listed 

transaction if the taxpayer’s tax return reflects tax consequences or a tax strategy described in the 

published guidance that lists the transaction, or if the taxpayer knows or has reason to know that 

the taxpayer’s tax benefits are derived directly or indirectly from tax consequences or a tax 

strategy described in published guidance that lists a transaction. A taxpayer has participated in a 

confidential transaction if the taxpayer’s tax return reflects a tax benefit from the transaction and 

the taxpayer’s disclosure of the tax treatment or tax structure of the transaction is limited under 

conditions of confidentiality. A taxpayer has participated in a transaction with contractual 

protection if the taxpayer’s tax return reflects a tax benefit from the transaction, and the taxpayer 

has the right to the full or partial refund of fees or the fees are contingent. 

Present law provides a penalty for any person who fails to include on any return or 

statement any required information with respect to a reportable transaction.48 The penalty 

 42 Sec. 7701(a)(1); Treas. Reg. sec. 1.6011-4(c)(1). 

43 Treas. Reg. sec. 1.6011-4(b). 

44 Sec. 6707A(c)(2); Treas. Reg. sec. 1.6011-4(b)(2). 

45 Treas. Reg. sec. 1.6011-4(a). 

46 Sec. 6707A(c)(1). 

47 Treas. Reg. sec. 1.6011-4(c)(3). 

48 Sec. 6707A. 
27 

applies without regard to whether the transaction ultimately results in an understatement of tax, 

and applies in addition to any other penalty that may be imposed. 

The penalty for failing to disclose a reportable transaction is $10,000 in the case of a 

natural person and $50,000 in any other case. The amount is increased to $100,000 and 

$200,000, respectively, if the failure is with respect to a listed transaction. The penalty cannot be 

waived with respect to a listed transaction. As to reportable transactions, the IRS Commissioner 

may rescind all or a portion of the penalty if rescission would promote compliance with the tax 

laws and effective tax administration. 

Disclosure of listed and other reportable transactions by material advisors

Present law requires each material advisor with respect to any reportable transaction 

(including any listed transaction) to timely file an information return with the Secretary (in such 

form and manner as the Secretary may prescribe).49 The information return must include (1) 

information identifying and describing the transaction, (2) information describing any potential 

tax benefits expected to result from the transaction, and (3) such other information as the 

Secretary may prescribe. The return must be filed by the date specified by the Secretary. 

A “material advisor” means any person (1) who provides material aid, assistance, or 

advice with respect to organizing, managing, promoting, selling, implementing, insuring, or 

carrying out any reportable transaction, and (2) who directly or indirectly derives gross income 

in excess of $250,000 ($50,000 in the case of a reportable transaction substantially all of the tax 

benefits from which are provided to natural persons) or such other amount as may be prescribed 

by the Secretary for such advice or assistance.50

The Secretary may prescribe regulations which provide (1) that only one material advisor 

is required to file an information return in cases in which two or more material advisors would 

otherwise be required to file information returns with respect to a particular reportable 

transaction, (2) exemptions from the requirements of this section, and (3) other rules as may be 

necessary or appropriate to carry out the purposes of this section.51

Present law imposes a penalty on any material advisor who fails to timely file an 

information return, or who files a false or incomplete information return, with respect to a 

reportable transaction (including a listed transaction).52 The amount of the penalty is $50,000. If 

the penalty is with respect to a listed transaction, the amount of the penalty is increased to the 

greater of (1) $200,000, or (2) 50 percent of the gross income derived by such person with 

respect to aid, assistance, or advice which is provided with respect to the transaction before the 

date the information return that includes the transaction is filed. An intentional failure or act by a 

 49 Sec. 6707(a), as added by the American Jobs Creation Act of 2004, P.L. No. 108-357, sec. 

816(a). 

50 Sec. 6707(b)(1). 

51 Sec. 6707(c). 

52 Sec. 6707(b). 
28 

material advisor with respect to the requirement to disclose a listed transaction increases the 

penalty to 75 percent of the gross income derived from the transaction. 

The penalty cannot be waived with respect to a listed transaction. As to reportable 

transactions, the IRS Commissioner can rescind all or a portion of the penalty if rescission would 

promote compliance with the tax laws and effective tax administration. 

Description of Proposal

In general

In general, under the proposal, many tax-exempt entities are subject to penalties for 

participating in a prohibited tax shelter transaction as accommodation parties. A prohibited tax 

shelter transaction is a transaction that the Secretary determines is a listed transaction (as defined 

in section 6707A(c)(2)) or a reportable transaction that is a confidential transaction or a 

transaction with contractual protection (as defined by the Secretary in regulations). The proposal 

also clarifies that an exempt organization that participates in a reportable transaction (including a 

listed transaction) in order to shelter from tax the organization’s own tax liability (e.g., the 

unrelated business income tax) is subject to the present-law rules (sec. 6707A and sec. 6011) 

pertaining to disclosure of such transactions. 

The proposal generally applies to all tax-exempt organizations and entities organized in 

the United States, including charitable and other organizations described in section 501(c) (other 

than instrumentalities of the United States, i.e., section 501(c)(1) organizations, and foreign 

organizations, i.e., section 501(c)(3) organizations not organized in the United States), State and 

local governments, Indian tribal governments, and tax qualified pension plans, individual 

retirement arrangements (“IRAs”), and similar tax-favored savings arrangements (such as 

Coverdell education savings accounts, health savings accounts, and qualified tuition plans). 

Entity level tax

Under the proposal, if a tax-exempt entity participates in a transaction, knowing or with 

reason to know that the transaction is a prohibited tax shelter transaction, the entity is subject to a 

tax of the greater of 100 percent of the entity’s net income (after taking into account any income 

tax imposed with respect to the transaction) or 75 percent of the gross proceeds that is 

attributable to the entity’s participation in the prohibited transaction. 

In addition, if a transaction is not a tax shelter prohibited transaction at the time a taxexempt entity participates in the transaction, but the transaction subsequently is determined by 

the Secretary to be a prohibited tax shelter transaction (a “subsequently prohibited tax shelter 

transaction”), the entity must pay an excise tax at the highest unrelated business taxable income 

rate times the greater of (i) any income that is properly allocable to the transaction after the time 

the transaction becomes prohibited, and (ii) 75 percent of the gross income properly allocable to 

the organization from the transaction after the time the transaction becomes prohibited. The 

Secretary has the authority to provide guidance regarding the determination of the allocation of 

net income of a tax-exempt entity that is attributable to a transaction to various periods, including 

before and after the listing of the transaction. 
29 

Neither entity level tax applies if the entity’s participation is not willful and is due to 

reasonable cause. The entity level taxes do not apply to tax qualified pension plans, IRAs, and 

similar tax-favored savings arrangements (such as Coverdell education savings accounts, health 

savings accounts, and qualified tuition plans). 

Disclosure of participation in prohibited tax shelter transactions

A person who fails to include information with respect to a prohibited tax shelter 

transaction on any return or statement as required by the Secretary must pay a penalty of $10,000 

in the case of a natural person or $50,000 in any other case. In addition, the proposal requires 

that a party to a prohibited tax shelter transaction that is not a tax-exempt entity disclose to the 

tax-exempt entity that the transaction is a prohibited tax shelter transaction. Failure to make such 

disclosure is subject to the penalties described above. 

The proposal requires disclosure by a tax-exempt entity to the IRS of each participation 

in a prohibited tax shelter transaction and disclosure of other known parties to the transaction if 

the tax-exempt entity knows that such transaction is a reportable transaction. The penalty for 

failure to disclose is imposed on the entity (or entity manager, in the case of qualified pension 

plans and similar tax favored retirement arrangements) at $100 per day the failure continues, not 

to exceed $50,000. If any person fails to comply with a demand for payment by the Secretary of 

such penalty, such person or persons shall pay a penalty of $100 per day (beginning on the date 

of the failure to comply) not to exceed $10,000 per reportable transaction. 

Penalty on entity managers

A penalty of $20,000 is imposed on each entity manager that approves or otherwise 

causes a tax-exempt entity’s participation in a prohibited tax shelter transaction, knowing or with 

reason to know that the transaction is a prohibited tax shelter transaction. An entity manager is 

defined as a person with authority or responsibility similar to that exercised by an officer, 

director, or trustee of an organization, except: (1) in the case of an entity described in section 

501(c)(3) or (c)(4), an entity manager is an organization manager as defined in section 

4958(f)(2), and (2) in the case of tax qualified pension plans, IRAs, and similar tax-favored 

savings arrangements (such as Coverdell education savings accounts, health savings accounts, 

and qualified tuition plans), an entity manager is a person responsible for causing the entity to 

participate in the prohibited tax shelter transaction. 

Effective Date

The proposal generally is effective for transactions after the date of enactment, except 

that no tax applies with respect to income that is properly allocable to the period ending on the 

date that is 90 days after the date of enactment. The effective date for disclosure obligations and 

penalties for failure to disclose is returns and statements the due date of which is after the date of 

enactment. 
30 

9. Apply an excise tax to acquisitions of interests in insurance contracts in which certain 

exempt organizations hold an interest 

Present Law

Amounts received under a life insurance contract

Amounts received under a life insurance contract paid by reason of the death of the 

insured are not includible in gross income for Federal tax purposes.53 No Federal income tax 

generally is imposed on a policyholder with respect to the earnings under a life insurance 

contract (inside buildup). 54 

Distributions from a life insurance contract (other than a modified endowment contract) 

that are made prior to the death of the insured generally are includible in income to the extent 

that the amounts distributed exceed the taxpayer’s investment in the contract (i.e., basis). Such 

distributions generally are treated first as a tax-free recovery of basis, and then as income.55

Transfers for value

A limitation on the exclusion for amounts received under a life insurance contract is 

provided in the case of transfers for value. If a life insurance contract (or an interest in the 

contract) is transferred for valuable consideration, the amount excluded from income by reason 

of the death of the insured is limited to the actual value of the consideration plus the premiums 

and other amounts subsequently paid by the acquiror of the contract.56 

 53 Sec. 101(a). 

54 This favorable tax treatment is available only if a life insurance contract meets certain 

requirements designed to limit the investment character of the contract (sec. 7702). 

55 Sec. 72(e). In the case of a modified endowment contract, however, in general, distributions 

are treated as income first, loans are treated as distributions (i.e., income rather than basis recovery first), 

and an additional 10-percent tax is imposed on the income portion of distributions made before age 59-1/2 

and in certain other circumstances (secs. 72(e) and (v)). A modified endowment contract is a life 

insurance contract that does not meet a statutory “7-pay” test, i.e., generally is funded more rapidly than 

seven annual level premiums (sec. 7702A). 

56 Section 101(a)(2). The transfer-for-value rule does not apply, however, in the case of a 

transfer in which the life insurance contract (or interest in the contract) transferred has a basis in the hands 

of the transferee that is determined by reference to the transferor’s basis. Similarly, the transfer-for-value 

rule generally does not apply if the transfer is between certain parties (specifically, if the transfer is to the 

insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which 

the insured is a shareholder or officer). 
31 

Tax treatment of charitable organizations and donors

Present law generally provides tax-exempt status for charitable, educational and certain 

other organizations, no part of the net earnings of which inures to the benefit of any private 

shareholder or individual, and which meet certain other requirements.57 Governmental entities, 

including some educational organizations, are exempt from tax on income under other tax rules 

providing that gross income does not include income derived from the exercise of any essential 

governmental function and accruing to a State or any political subdivision thereof.58

In computing taxable income, a taxpayer who itemizes deductions generally is allowed to 

deduct the amount of cash and the fair market value of property contributed to an organization 

described in section 501(c)(3) or to a Federal, State, or local governmental entity for exclusively 

public purposes.59 

State-law insurable interest rules

State laws generally provide that the owner of a life insurance contract must have an 

insurable interest in the insured person when the life insurance contract is issued. State laws 

vary as to the insurable interest of a charitable organization in the life of any individual. Some 

State laws provide that a charitable organization meeting the requirements of section 501(c)(3) of 

the Code is treated as having an insurable interest in the life of any donor,60 or, in other States, in 

the life of any individual who consents (whether or not the individual is a donor).61 Other States’ 

insurable interest rules permit the purchase of a life insurance contract even though the person 

paying the consideration has no insurable interest in the life of the person insured if a charitable, 

benevolent, educational or religious institution is designated irrevocably as the beneficiary.62

Transactions involving charities and non-charities acquiring life insurance

Recently, there has been an increase in transactions involving the acquisition of life 

insurance contracts using arrangements in which both exempt organizations, primarily charities, 

 57 Section 501(c)(3). 

58 Section 115. 

59 Section 170. 

60 See, e.g., Mass. Gen. Laws Ann. ch. 175, sec. 123A(2) (West 2005); Iowa Code Ann. sec. 

511.39 (West 2004) (“a person who, when purchasing a life insurance policy, makes a donation to the 

charitable organization or makes the charitable organization the beneficiary of all or a part of the proceeds 

of the policy . . . ”). 

61 See, e.g., Cal. Ins. Code sec. 10110.1(f) (West 2005); 40 Pa. Cons. Stat. Ann. sec. 40-512 

(2004); Fla. Stat. Ann. sec. 27.404 (2) (2004); Mich. Comp. Laws Ann. sec. 500.2212 (West 2004). 

62 Or. Rev. Stat. sec. 743.030 (2003); Del. Code Ann. Tit. 18, sec. 2705(a) (2004). 
32 

and private investors have an interest in the contract.63 The exempt organization has an insurable 

interest in the insured individuals, either because they are donors, because they consent, or 

otherwise under applicable State insurable interest rules. Private investors provide capital used 

to fund the purchase of the life insurance contracts, sometimes together with annuity contracts. 

Both the private investors and the charity have an interest in the contracts, directly or indirectly, 

through the use of trusts, partnerships, or other arrangements for sharing the rights to the 

contracts. Both the charity and the private investors receive cash amounts in connection with the 

investment in the contracts while the life insurance is in force or as the insured individuals die. 

Description of Proposal

The proposal imposes an excise tax, equal to 100 percent of the acquisition costs, on the 

taxable acquisition of any interest in an applicable insurance contract. An applicable insurance 

contract is any life insurance, annuity or endowment contract in which both an applicable exempt 

organization and any person that is not an applicable exempt organization have, directly or 

indirectly, held an interest in the contract (whether or not the interests are held at the same time). 

An applicable exempt organization is any organization described in section 170(c), 

168(h)(2)(A)(iv), 2055(a), or 2522(a). Thus, for example, an applicable exempt organization 

generally includes an organization that is exempt from Federal income tax by reason of being 

described in section 501(c)(3) (including one organized outside the United States), a government 

or political subdivision of a government, and an Indian tribal government. 

A taxable acquisition is the acquisition of any direct or indirect interest in an applicable 

insurance contract by an applicable exempt organization, or by any other person if the interest in 

the contract in that person’s hands is not described in the specific exceptions to “applicable 

insurance contract.” 

Under the provision, acquisition costs mean the direct or indirect costs (including 

premiums, commissions, fees, charges, or other amounts) of acquiring or maintaining an interest 

in an applicable insurance contract. Except as provided in regulations, if acquisition costs of any 

taxable acquisition are paid or incurred in more than one calendar year, the excise tax under the 

provision is imposed each year with respect to costs are paid or incurred during that year. In the 

case of an acquisition of an interest in an entity that directly or indirectly holds an interest in an 

applicable insurance contract, acquisition costs are intended to include the amount of money or 

value of property (including an applicable insurance contract) contributed to an entity or 

otherwise transferred or paid to acquire or increase an interest in the entity, that directly or 

indirectly holds an interest in an applicable insurance contract. 

For example, acquisition costs include (1) each premium, commission, or fee with respect 

to the contract, (2) each amount paid or incurred to acquire or increase an interest in the contract, 

(3) each amount paid or incurred to acquire or increase an interest in an entity (such as a 

partnership, trust, corporation, or other type of entity or arrangement) that has a direct or indirect 

 63 Davis, Wendy, “Death-Pool Donations,” Trusts and Estates, May 2004, 55; Francis, Theo, 

“Tax May Thwart Investment Plans Enlisting Charities,” Wall St. J., Feb. 8, 2005, A-10. 
33 

interest in the contract, and (4) if the contract is contributed to an entity, the greater of the value 

of the contract or the total amount of premiums, commissions, and fees paid or incurred to 

acquire and maintain the insurance contract. It is intended that, under regulatory authority 

provided as necessary to carry out the purposes of the provision, any other similar or 

economically equivalent amount paid or incurred is to be treated as acquisition costs. 

Under the provision, an interest in an applicable insurance contract includes any right 

with respect to the contract, whether as an owner, beneficiary, or otherwise. An indirect interest 

in a contract includes an interest in an entity that, directly or indirectly, holds an interest in the 

contract. In the case of a section 1035 exchange of an applicable insurance contract, any interest 

in any of the contracts involved in the exchange is treated as an interest in all such contracts. An 

increase in an interest in an applicable insurance contract is treated as a separate acquisition, for 

purposes of application of the excise tax under the provision. 

If an interest of an applicable exempt organization exists solely because the organization 

holds, as part of a diversified investment strategy, a de minimis interest in an entity which 

directly or indirectly holds an interest in the contract, such interest is not taken into account for 

purposes of the proposal. For example, if an applicable exempt organization owns a de minimis 

amount of stock in a corporation which in turn owns life insurance contracts covering key 

employees, the excise tax under the provision does not apply because the stock ownership is not 

treated as an indirect interest in this circumstance. It is intended that Treasury regulations 

provide guidance as to the application of this rule so that it does not permit circumvention of the 

provision. 

Except as provided in regulations, if a person acquires an interest in a contract before the 

contract is treated as an applicable insurance contract, the acquisition is treated as a taxable 

acquisition of an interest in applicable insurance contract as of the date the contract becomes an 

applicable insurance contract. 

It is intended that an interest in an applicable insurance contract includes, for example, 

(1) a right with respect to the applicable insurance contract pursuant to a side contract or other 

similar arrangement, (2) an interest as a trust beneficiary in distributions from or income of a 

trust holding an interest in a contract, and (3) a right to distributions, guaranteed payments, or 

income of a partnership that holds an interest in a contract. It is not intended that a right with 

respect to the contract include typical rights of issuers of applicable insurance contracts. 

Exceptions to the term “applicable insurance contract” apply under the proposal. First, 

the term does not apply if each person (other than an applicable exempt organization) with a 

direct or indirect interest in the contract has an insurable interest in the insured independent of 

any interest of the exempt organization in the contract. Second, the term does not apply if the 

sole interest in the contract of each person other than the applicable exempt organization is as a 

named beneficiary. Third, the term does not apply if the sole interest in the contract of each 

person other than the applicable exempt organization is either (1) as a beneficiary of a trust 

holding an interest in the contract, but only if the person’s designation as such a beneficiary was 

made without consideration and solely on a purely gratuitous basis, or (2) as a trustee who holds 

an interest in the contract in a fiduciary capacity solely for the benefit of applicable exempt 

organizations or of persons otherwise meeting one of the first two exceptions. 
34 

An exception to the term “applicable insurance contract” also is provided under the 

proposal in certain cases in which a person other than an applicable exempt organization has an 

interest solely as a lender64 with respect to the contract, and the contract covers only one 

individual who is an officer, director, or employee of the applicable exempt organization with an 

interest in the contract, provided other requirements are met. This exception applies only if the 

number of insured persons under loans by such lenders with respect to such contracts does not 

exceed the greater of: (1) the lesser of 5 percent of the total officers, directors, and employees of 

the organization or 20, or (2) 5. Under this exception, the aggregate amount of indebtedness 

with respect to 1 or more contracts covering a single individual may not exceed $50,000. 

In addition, Treasury regulatory authority is provided to except certain contracts from 

treatment as applicable insurance contracts. Contracts may be excepted based on specific factors 

including (1) whether the transaction is at arms’ length, (2) whether the economic benefits to the 

applicable exempt organization substantially exceed the economic benefits to all other persons 

with an interest in the contract (determined without regard to whether, or the extent to which, 

such organization has paid or contributed with respect to the contract), and (3) the likelihood of 

abuse. 

The application of the exceptions can be illustrated as follows. Assume that an individual 

acquires a life insurance contract in which the individual is the insured person, and the named 

beneficiaries are the individual’s son and a university that is an organization described in section 

170(c). The contract is not an applicable insurance contract because the first exception applies. 

That is, because both the individual and his son have an insurable interest in the individual, all 

persons holding any interest in the contract (other than applicable exempt organizations) have an 

insurable interest in the insured independent of any interest of an applicable exempt organization 

in the contract. The second exception also applies in this situation. 

As another example, assume that the three named beneficiaries are the insured’s son, an 

unrelated friend, and a charity. The contract is not an applicable insurance contract because the 

second exception applies. That is, each beneficiary’s sole interest is as a named beneficiary. In 

addition, the first exception also applies in this situation. 

As a further example, assume that the insured individual creates an irrevocable trust for 

the benefit of the insured’s descendants, and that the trustee of the trust uses trust funds to 

purchase a life insurance policy on the insured’s life, and the trust is both the owner and 

beneficiary of the insurance policy. The insured individual’s naming of his or her descendants as 

trust beneficiaries is a gratuitous act, done without consideration. As a result, the contract is not 

an applicable insurance contract under the third exception. 

No Federal income tax deduction is permitted for the excise tax payable under the 

proposal, as provided under the rule of Code section 275(a)(6). The amount of the excise tax 

 64 For this purpose, an interest as a lender includes a security interest in the insurance contract to 

which the loan relates. 
35 

payable under the proposal is not included in the investment in the contract for purposes of 

section 72. 

Treasury regulatory authority is provided to carry out the purposes of the provision. This 

includes authority to provide appropriate rules in the case in which a person acquires an interest 

before a contract is treated as an applicable insurance contract. This also includes authority to 

prevent, in cases the Treasury Secretary determines appropriate, the imposition of more than one 

tax if the same interest is acquired more than once (otherwise, the tax under the provision applies 

to each acquisition). Treasury regulatory authority is also provided to prevent avoidance of the 

provision, including through the use of intermediaries. 

The proposal provides reporting rules requiring an applicable exempt organization or 

other person that makes a taxable acquisition of an applicable insurance contract to file a return 

containing required information and such other information as is prescribed by the Treasury 

Secretary. Under these rules, a statement is required to be furnished to each person whose 

taxpayer identification information is required to be reported on the return. Penalties apply for 

failure to file the return or furnish the statement, including, in the case of intentional disregard of 

the return filing requirement, a penalty equal to the amount of the excise tax that has not been 

paid with respect to the items required to be included on the return. 

Effective Date

The provision is effective for contracts issued after May 3, 2005. 

The application of the effective date with respect to prior acquisitions of interests may be 

illustrated as follows. Assume that an exempt organization and a person that is not an exempt 

organization described in section 170(c) form a partnership before May 3, 2005. After May 3, 

2005, the partnership acquires an interest in a life insurance contract that is issued after May 3, 

2005. The acquisition by the partnership of the interest in the contract is treated as a taxable 

acquisition under the provision by each of the partners (i.e., the exempt organization and the 

other person). 

The provision also requires reporting of existing life insurance, endowment and annuity 

contracts issued on or before that date, in which an applicable exempt organization holds an 

interest on that date and which would be treated as an applicable insurance contract under the 

provision. This reporting is required within one year after the date of enactment. 

10. Increase the amounts of excise taxes imposed on public charities, social welfare 

organizations, and private foundations 

Present Law

Public charities and social welfare organizations

The Code imposes excise taxes on excess benefit transactions between disqualified 

persons (as defined in section 4958(f)) and charitable organizations (other than private 
36 

foundations) or social welfare organizations (as described in section 501(c)(4)).65 An excess 

benefit transaction generally is a transaction in which an economic benefit is provided by a 

charitable or social welfare organization directly or indirectly to or for the use of a disqualified 

person, if the value of the economic benefit provided exceeds the value of the consideration 

(including the performance of services) received for providing such benefit. 

The excess benefit tax is imposed on the disqualified person and, in certain cases, on the 

organization manager, but is not imposed on the exempt organization. An initial tax of 25 

percent of the excess benefit amount is imposed on the disqualified person that receives the 

excess benefit. An additional tax on the disqualified person of 200 percent of the excess benefit 

applies if the violation is not corrected. A tax of 10 percent of the excess benefit (not to exceed 

$10,000 with respect to any excess benefit transaction) is imposed on an organization manager 

that knowingly participated in the excess benefit transaction, if the manager’s participation was 

willful and not due to reasonable cause, and if the initial tax was imposed on the disqualified 

person.66 If more than one person is liable for the tax on disqualified persons or on management, 

all such persons are jointly and severally liable for the tax.67

Private foundations

Self-dealing by private foundations

Excise taxes are imposed on acts of self-dealing between a disqualified person (as 

defined in section 4946) and a private foundation.68 In general, self-dealing transactions are any 

direct or indirect: (1) sale or exchange, or leasing, of property between a private foundation and a 

disqualified person; (2) lending of money or other extension of credit between a private 

foundation and a disqualified person; (3) the furnishing of goods, services, or facilities between a 

private foundation and a disqualified person; (4) the payment of compensation (or payment or 

reimbursement of expenses) by a private foundation to a disqualified person; (5) the transfer to, 

or use by or for the benefit of, a disqualified person of the income or assets of the private 

foundation; and (6) certain payments of money or property to a government official.69 Certain 

exceptions apply.70

 65 Sec. 4958. The excess benefit transaction tax is commonly referred to as “intermediate 

sanctions,” because it imposes penalties generally considered to be less punitive than revocation of the 

organization’s exempt status. 

66 Sec. 4958(d)(2). Taxes imposed may be abated if certain conditions are met. Secs. 4961 and 

4962. 

67 Sec. 4958(d)(1). 

68 Sec. 4941. 

69 Sec. 4941(d)(1). 

70 See sec. 4941(d)(2). 
37 

An initial tax of five percent of the amount involved with respect to an act of self-dealing 

is imposed on any disqualified person (other than a foundation manager acting only as such) who 

participates in the act of self-dealing. If such a tax is imposed, a 2.5-percent tax of the amount 

involved is imposed on a foundation manager who participated in the act of self-dealing knowing 

it was such an act (and such participation was not willful and was due to reasonable cause) up to 

$10,000 per act. Such initial taxes may not be abated.71 Such initial taxes are imposed for each 

year in the taxable period, which begins on the date the act of self-dealing occurs and ends on the 

earliest of the date of mailing of a notice of deficiency for the tax, the date on which the tax is 

assessed, or the date on which correction of the act of self-dealing is completed. A government 

official (as defined in section 4946(c)) is subject to such initial tax only if the official participates 

in the act of self-dealing knowing it is such an act. If the act of self-dealing is not corrected, a 

tax of 200 percent of the amount involved is imposed on the disqualified person and a tax of 50 

percent of the amount involved (up to $10,000 per act) is imposed on a foundation manager who 

refused to agree to correcting the act of self-dealing. Such additional taxes are subject to 

abatement.72

Tax on failure to distribute income

Private nonoperating foundations are required to pay out a minimum amount each year as 

qualifying distributions. In general, a qualifying distribution is an amount paid to accomplish 

one or more of the organization’s exempt purposes, including reasonable and necessary 

administrative expenses.73 Failure to pay out the minimum results in an initial excise tax on the 

foundation of 15 percent of the undistributed amount. An additional tax of 100 percent of the 

undistributed amount applies if an initial tax is imposed and the required distributions have not 

been made by the end of the applicable taxable period.74 A foundation may include as a 

qualifying distribution the salaries, occupancy expenses, travel costs, and other reasonable and 

necessary administrative expenses that the foundation incurs in operating a grant program. A 

qualifying distribution also includes any amount paid to acquire an asset used (or held for use) 

directly in carrying out one or more of the organization’s exempt purposes and certain amounts 

set-aside for exempt purposes.75 Private operating foundations are not subject to the payout 

requirements. 

 71 Sec. 4962(b). 

72 Sec. 4961. 

73 Sec. 4942(g)(1)(A). 

74 Sec. 4942(a) and (b). Taxes imposed may be abated if certain conditions are met. Secs. 4961 

and 4962. 

75 Sec. 4942(g)(1)(B) and 4942(g)(2). In general, an organization is permitted to adjust the 

distributable amount in those cases where distributions during the five preceding years have exceeded the 

payout requirements. Sec. 4942(i). 
38 

Tax on excess business holdings

Private foundations are subject to tax on excess business holdings.76 In general, a private 

foundation is permitted to hold 20 percent of the voting stock in a corporation, reduced by the 

amount of voting stock held by all disqualified persons (as defined in section 4946). If it is 

established that no disqualified person has effective control of the corporation, a private 

foundation and disqualified persons together may own up to 35 percent of the voting stock of a 

corporation. A private foundation shall not be treated as having excess business holdings in any 

corporation if it owns (together with certain other related private foundations) not more than two 

percent of the voting stock and not more than two percent in value of all outstanding shares of all 

classes of stock in that corporation. Similar rules apply with respect to holdings in a partnership 

(“profits interest” is substituted for “voting stock” and “capital interest” for “nonvoting stock”) 

and to other unincorporated enterprises (by substituting “beneficial interest” for “voting stock”). 

Private foundations are not permitted to have holdings in a proprietorship. Foundations 

generally have a five-year period to dispose of excess business holdings (acquired other than by 

purchase) without being subject to tax.77 This five-year period may be extended an additional 

five years in limited circumstances.78

The initial tax is equal to five percent of the value of the excess business holdings held 

during the foundation’s applicable taxable year. An additional tax is imposed if an initial tax is 

imposed and at the close of the applicable taxable period, the foundation continues to hold excess 

business holdings. The amount of the additional tax is equal to 200 percent of such holdings. 

Tax on jeopardizing investments

Private foundations and foundation managers are subject to tax on investments that 

jeopardize the foundation’s charitable purpose.79 In general, an initial tax of five percent of the 

amount of the investment applies to the foundation and to foundation managers who participated 

in the making of the investment knowing that it jeopardized the carrying out of the foundation’s 

exempt purposes. The initial tax on foundation managers may not exceed $5,000 per investment. 

If the investment is not removed from jeopardy (e.g., sold or otherwise disposed of), an 

additional tax of 25 percent of the amount of the investment is imposed on the foundation and 

five percent of the amount of the investment on a foundation manager who refused to agree to 

removing the investment from jeopardy. The additional tax on foundation managers may not 

exceed $10,000 per investment. An investment, the primary purpose of which is to accomplish a 

charitable purpose and no significant purpose of which is the production of income or the 

appreciation of property, is not considered a jeopardizing investment.80

 76 Sec. 4943. Taxes imposed may be abated if certain conditions are met. Secs. 4961 and 4962. 

77 Sec. 4943(c)(6). 

78 Sec. 4943(c)(7). 

79 Sec. 4944. Taxes imposed may be abated if certain conditions are met. Secs. 4961 and 4962. 

80 Sec. 4944(c). 
39 

Tax on taxable expenditures

Certain expenditures of private foundations are subject to tax.81 In general, taxable 

expenditures are expenses: (1) for lobbying; (2) to influence the outcome of a public election or 

carry on a voter registration drive (unless certain requirements are met); (3) as a grant to an 

individual for travel, study, or similar purposes unless made pursuant to procedures approved by 

the Secretary; (4) as a grant to an organization that is not a public charity or exempt operating 

foundation unless the foundation exercises expenditure responsibility82 with respect to the grant; 

or (5) for any non-charitable purpose. For each taxable expenditure, a tax is imposed on the 

foundation of 10 percent of the amount of the expenditure, and an additional tax of 100 percent is 

imposed on the foundation if the expenditure is not corrected. A tax of 2.5 percent of the 

expenditure (up to $5,000) also is imposed on a foundation manager who agrees to making a 

taxable expenditure knowing that it is a taxable expenditure. An additional tax of 50 percent of 

the amount of the expenditure (up to $10,000) is imposed on a foundation manager who refuses 

to agree to correction of such expenditure. 

Description of Proposal

Self-dealing and excess benefit transaction initial taxes and dollar limitations

For acts of self-dealing other than the payment of compensation by a private foundation 

to a disqualified person, the proposal increases the initial tax on the self-dealer from five percent 

of the amount involved to 10 percent of the amount involved. For acts of self-dealing regarding 

the payment of compensation by a private foundation to a disqualified person, the proposal 

increases the initial tax on the self-dealer from five percent of the amount involved (none of 

which is subject to abatement) to 25 percent of the amount involved (15 percent of which is 

subject to abatement). The proposal increases the initial tax on foundation managers from 2.5 

percent of the amount involved to five percent of the amount involved and increases the dollar 

limitation on the amount of the initial and additional taxes on foundation managers per act of 

self-dealing from $10,000 per act to $20,000 per act. Similarly, the proposal doubles the dollar 

limitation on organization managers of public charities and social welfare organizations for 

participation in excess benefit transactions from $10,000 per transaction to $20,000 per 

transaction. 

Failure to distribute income, excess business holdings, jeopardizing investments, and 

taxable expenditures

The proposal doubles the amounts of the initial taxes and the dollar limitations on 

foundation managers with respect to the private foundation excise taxes on the failure to 

distribute income, excess business holdings, jeopardizing investments, and taxable expenditures. 

 81 Sec. 4945. Taxes imposed may be abated if certain conditions are met. Secs. 4961 and 4962. 

82 In general, expenditure responsibility requires that a foundation make all reasonable efforts 

and establish reasonable procedures to ensure that the grant is spent solely for the purpose for which it 

was made, to obtain reports from the grantee on the expenditure of the grant, and to make reports to the 

Secretary regarding such expenditures. Sec. 4945(h). 
40 

Specifically, for the failure to distribute income, the initial tax on the foundation is 

increased from 15 percent of the undistributed amount to 30 percent of the undistributed amount. 

For excess business holdings, the initial tax on excess business holdings is increased from 

five percent of the value of such holdings to 10 percent of such value. 

For jeopardizing investments, the initial tax of five percent of the amount of the 

investment that is imposed on the foundation and on foundation managers is increased to 10 

percent of the amount of the investment. The dollar limitation on the initial tax on foundation 

managers of $5,000 per investment is increased to $10,000 and the dollar limitation on the 

additional tax on foundation managers of $10,000 per investment is increased to $20,000. 

For taxable expenditures, the initial tax on the foundation is increased from 10 percent of 

the amount of the expenditure to 20 percent, the initial tax on the foundation manager is 

increased from 2.5 percent of the amount of the expenditure to five percent, the dollar limitation 

on the initial tax on foundation managers is increased from $5,000 to $10,000, and the dollar 

limitation on the additional tax on foundation managers is increased from $10,000 to $20,000. 

Effective Date

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

11. Improve accountability of donor advised funds 

UPresent Law

Requirements for section 501(c)(3) tax-exempt status

Charitable organizations, i.e., organizations described in section 501(c)(3), generally are 

exempt from Federal income tax and are eligible to receive tax deductible contributions. A 

charitable organization must operate primarily in pursuance of one or more tax-exempt purposes 

constituting the basis of its tax exemption.83 In order to qualify as operating primarily for a 

purpose described in section 501(c)(3), an organization must satisfy the following operational 

requirements: (1) the net earnings of the organization may not inure to the benefit of any person 

in a position to influence the activities of the organization; (2) the organization must operate to 

provide a public benefit, not a private benefit;84 (3) the organization may not be operated 

primarily to conduct an unrelated trade or business;85 (4) the organization may not engage in 

 83 Treas. Reg. sec. 1.501(c)(3)-1(c)(1). The Code specifies such purposes as religious, charitable, 

scientific, testing for public safety, literary, or educational purposes, or to foster international amateur 

sports competition, or for the prevention of cruelty to children or animals. In general, an organization is 

organized and operated for charitable purposes if it provides relief for the poor and distressed or the 

underprivileged. Treas. Reg. sec. 1.501(c)(3)-1(d)(2). 

84 Treas. Reg. sec. 1.501(c)(3)-1(d)(1)(ii). 

85 Treas. Reg. sec. 1.501(c)(3)-1(e)(1). Conducting a certain level of unrelated trade or business 

activity will not jeopardize tax-exempt status. 
41 

substantial legislative lobbying; and (5) the organization may not participate or intervene in any 

political campaign. 

Classification of section 501(c)(3) organizations

Section 501(c)(3) organizations are classified either as “public charities” or “private 

foundations.”86 Private foundations generally are defined under section 509(a) as all 

organizations described in section 501(c)(3) other than an organization granted public charity 

status by reason of: (1) being a specified type of organization (i.e., churches, educational 

institutions, hospitals and certain other medical organizations, certain organizations providing 

assistance to colleges and universities, or a governmental unit); (2) receiving a substantial part of 

its support from governmental units or direct or indirect contributions from the general public; or 

(3) providing support to another section 501(c)(3) entity that is not a private foundation. In 

contrast to public charities, private foundations generally are funded from a limited number of 

sources (e.g., an individual, family, or corporation). Donors to private foundations and persons 

related to such donors together often control the operations of private foundations. 

Because private foundations receive support from, and typically are controlled by, a small 

number of supporters, private foundations are subject to a number of anti-abuse rules and excise 

taxes not applicable to public charities.87 For example, the Code imposes excise taxes on acts of 

“self-dealing” between disqualified persons (generally, an enumerated class of foundation 

insiders88) and a private foundation. Acts of self-dealing include, for example, sales or 

exchanges, or leasing, of property; lending of money; or the furnishing of goods, services, or 

facilities between a disqualified person and a private foundation.89 In addition, private nonoperating foundations are required to pay out a minimum amount each year as qualifying 

distributions. In general, a qualifying distribution is an amount paid to accomplish one or more 

of the organization’s exempt purposes, including reasonable and necessary administrative 

expenses.90 Certain expenditures of private foundations are also subject to tax.91 In general, 

taxable expenditures are expenditures: (1) for lobbying; (2) to influence the outcome of a public 

election or carry on a voter registration drive (unless certain requirements are met); (3) as a grant 

to an individual for travel, study, or similar purposes unless made pursuant to procedures 

 86 Sec. 509(a). Private foundations are either private operating foundations or private nonoperating foundations. In general, private operating foundations operate their own charitable programs in 

contrast to private non-operating foundations, which generally are grant-making organizations. Most 

private foundations are non-operating foundations. 

87 Secs. 4940 - 4945. 

88 See sec. 4946(a). 

89 Sec. 4941. 

90 Sec. 4942(g)(1)(A). A qualifying distribution also includes any amount paid to acquire an 

asset used (or held for use) directly in carrying out one or more of the organization’s exempt purposes and 

certain amounts set-aside for exempt purposes. Sec. 4942(g)(1)(B) and 4942(g)(2). 

91 Sec. 4945. Taxes imposed may be abated if certain conditions are met. Secs. 4961 and 4962. 
42 

approved by the Secretary; (4) as a grant to an organization that is not a public charity or exempt 

operating foundation unless the foundation exercises expenditure responsibility92 with respect to 

the grant; or (5) for any non-charitable purpose. Additional excise taxes may also apply in the 

event a private foundation holds certain business interests (“excess business holdings”)93 or 

makes an investment that jeopardizes the foundation’s exempt purposes.94 

Charitable contributions

Contributions to organizations described in section 501(c)(3) are deductible, subject to 

certain limitations, as an itemized deduction from Federal income taxes.95 Such contributions 

also generally are deductible for estate and gift tax purposes.96 However, if the taxpayer retains 

control over the assets transferred to charity, the transfer may not qualify as a completed gift for 

purposes of claiming an income, estate, or gift tax deduction. 

Public charities enjoy certain advantages over private foundations regarding the 

deductibility of contributions. For example, contributions of appreciated capital gain property to 

a private foundation generally are deductible only to the extent of the donor’s cost basis.97 In 

contrast, contributions to public charities generally are deductible in an amount equal to the 

property’s fair market value, except for gifts of inventory and other ordinary income property, 

short-term capital gain property, and tangible personal property the use of which is unrelated to 

the donee organization’s exempt purpose. In addition, under present law, a taxpayer’s deductible 

contributions generally are limited to specified percentages of the taxpayer’s contribution base, 

which generally is the taxpayer’s adjusted gross income for a taxable year. The applicable 

percentage limitations vary depending upon the type of property contributed and the 

classification of the donee organization. In general, contributions to non-operating private 

foundations are limited to a smaller percentage of the donor’s contribution base (up to 30 

percent) than contributions to public charities (up to 50 percent).98

 92 In general, expenditure responsibility requires that a foundation make all reasonable efforts 

and establish reasonable procedures to ensure that the grant is spent solely for the purpose for which it 

was made, to obtain reports from the grantee on the expenditure of the grant, and to make reports to the 

Secretary regarding such expenditures. Sec. 4945(h). 

93 Sec. 4943. 

94 Sec. 4944. 

95 Sec. 170. 

96 Secs. 2055 and 2522. 

97 A special rule in section 170(e)(5) provides that taxpayer are allowed a deduction equal to the 

fair market value of certain contributions of appreciated, publicly traded stock contributed to a private 

foundation. 

98 Sec. 170(b). 
43 

In general, taxpayers who make contributions and claim a charitable deduction must 

satisfy recordkeeping and substantiation requirements.99 The requirements vary depending on 

the type and value of property contributed. A deduction generally may be denied if the donor 

fails to satisfy applicable recordkeeping or substantiation requirements. 

Intermediate sanctions (excess benefit transaction tax)

The Code imposes excise taxes on excess benefit transactions between disqualified 

persons and public charities.100 An excess benefit transaction generally is a transaction in which 

an economic benefit is provided by a public charity directly or indirectly to or for the use of a 

disqualified person, if the value of the economic benefit provided exceeds the value of the 

consideration (including the performance of services) received for providing such benefit. 

For purposes of the excess benefit transaction rules, a disqualified person is any person in 

a position to exercise substantial influence over the affairs of the public charity at any time in the 

five-year period ending on the date of the transaction at issue.101 Persons holding certain powers, 

responsibilities, or interests (e.g., officers, directors, or trustees) are considered to be in a position 

to exercise substantial influence over the affairs of the public charity. 

An excess benefit transaction tax is imposed on the disqualified person and, in certain 

cases, on the organization managers, but is not imposed on the public charity. An initial tax of 

25 percent of the excess benefit amount is imposed on the disqualified person that receives the 

excess benefit. An additional tax on the disqualified person of 200 percent of the excess benefit 

applies if the violation is not corrected within a specified period. A tax of 10 percent of the 

excess benefit (not to exceed $10,000 with respect to any excess benefit transaction) is imposed 

on an organization manager that knowingly participated in the excess benefit transaction, if the 

manager’s participation was willful and not due to reasonable cause, and if the initial tax was 

imposed on the disqualified person. 

Community foundations

Community foundations generally are broadly supported section 501(c)(3) public 

charities that make grants to other charitable organizations located within a community 

foundation’s particular geographic area. Donors sometimes make contributions to a community 

foundation through transfers to a separate trust or fund, the assets of which are held and managed 

by a bank or investment company. 

 99 Sec. 170(f)(8). 

100 Sec. 4958. The excess benefit transaction tax is commonly referred to as “intermediate 

sanctions,” because it imposes penalties generally considered to be less punitive than revocation of the 

organization’s exempt status. The tax also applies to transactions between disqualified persons and social 

welfare organizations (as described in section 501(c)(4)). 

101 Sec. 4958(f)(1). A disqualified person also includes certain family members of such a person, 

and certain entities that satisfy a control test with respect to such persons. 
44 

Certain community foundations are subject to special rules that permit them to treat the 

separate funds or trusts maintained by the community foundation as a single entity for tax 

purposes. This “single entity” status allows the community foundation to be classified as a 

public charity. One of the requirements that community foundations must meet is that funds 

maintained by the community foundation may not be subject by the donor to any material 

restrictions or conditions. The prohibition against material restrictions or conditions is designed 

to prevent a donor from encumbering a fund in a manner that prevents the community foundation 

from freely distributing the assets and income from it in furtherance of the community 

foundation’s charitable purposes. Under Treasury regulations, whether a particular restriction or 

condition placed by the donor on the transfer of assets is material must be determined from all of 

the facts and circumstances of the transfer. The regulations set out some of the more significant 

facts and circumstances to be considered in making a determination, including: (1) whether the 

transferee public charity is the fee owner of the assets received; (2) whether the assets are held 

and administered by the public charity in a manner consistent with its own exempt purposes; (3) 

whether the governing body of the public charity has the ultimate authority and control over the 

assets and the income derived from them; and (4) whether the governing body of the public 

charity is independent from the donor. The regulations provide several non-adverse factors for 

determining whether a particular restriction or condition placed by the donor on the transfer of 

assets is material. In addition, the regulations list numerous factors and subfactors that indicate 

that the community foundation is prevented from freely and effectively employing the donated 

assets and the income thereon. 

Donor advised funds

Some charitable organizations (including community foundations) establish accounts to 

which donors may contribute and thereafter provide nonbinding advice or recommendations with 

regard to distributions from the fund or the investment of assets in the fund. Such accounts are 

commonly referred to as “donor advised funds.” Donors who make contributions to charities for 

maintenance in a donor advised fund generally claim a charitable contribution deduction at the 

time of the contribution. Although sponsoring charities frequently permit donors (or other 

persons appointed by donors) to provide nonbinding recommendations concerning the 

distribution or investment of assets in a donor advised fund, sponsoring charities generally must 

have legal ownership and control of such assets following the contribution. If the sponsoring 

charity does not have such control (or permits a donor to exercise control over amounts 

contributed), the donor’s contributions may not qualify for a charitable deduction, and, in the 

case of a community foundation, the contribution may be treated as being subject to a material 

restriction or condition by the donor. 

In recent years, a number of financial institutions have formed charitable corporations for 

the principal purpose of offering donor advised funds, sometimes referred to as “commercial” 

donor advised funds. In addition, some established charities have begun operating donor advised 

funds in addition to their primary activities. The IRS has recognized several organizations that 

sponsor donor advised funds, including “commercial” donor advised funds, as section 501(c)(3) 

public charities. The term "donor advised fund" is not defined in statute or regulations. 

Under the Katrina Emergency Tax Relief Act of 2005, certain of the above-described 

percent limitations on contributions to public charities are temporarily suspended for purposes of 
45 

certain “qualified contributions” to public charities. Under the Act, qualified contributions do 

not include a contribution if the contribution is for establishment of a new, or maintenance in an 

existing, segregated fund or account with respect to which the donor (or any person appointed or 

designated by such donor) has, or reasonably expects to have, advisory privileges with respect to 

distributions or investments by reason of the donor’s status as a donor. 

DDDDescription of Proposal

UDefinitions

UDonor advised fund

The proposal defines a “donor advised fund” as a fund or account that is: (1) separately 

identified by reference to contributions of a donor or donors102TP (2) owned and controlled by a 

sponsoring organization and (3) with respect to which a donor (or any person appointed or 

designated by such donor (a “donor advisor”) or by a donor advisor) has, or reasonably expects 

to have, advisory privileges with respect to the distribution or investment of amounts held in the 

separately identified fund or account by reason of the donor’s status as a donor. Notwithstanding 

the foregoing, the term "donor advised fund" does not include a fund or account from which are 

made grants to individuals for travel, study, or other similar purposes by such individual, 

provided that (1) a donor's or donor advisor's advisory privileges are performed exclusively by 

such donor or donor advisor in their capacity as a member of a committee appointed by the 

sponsoring organization, (2) no combination of a donor and persons related to or appointed by 

such donor, control, directly or indirectly, such committee, and (3) all grants from such fund or 

account satisfy requirements similar to those described in section 4945(g) (concerning grants to 

individuals by private foundations). 

USponsoring organization

The proposal defines a “sponsoring organization” as an organization that: (1) is 

described in section 170(c) (other than section 170(c)(1), and without regard to section 

170(c)(2)(A)); and (2) maintains one or more donor advised funds. 

UDonor

Under the proposal, a “donor” is an individual, corporation, partnership, trust, estate, or 

other person that makes a contribution to a sponsoring organization, which contribution is 

maintained or intended to be maintained in a donor advised fund. 

UInvestment advisor

 102 The requirement that a donor advised fund be separately identified by reference to 

contributions of a donor or donors is intended to exclude from the definition of “donor advised fund” 

certain types of funds or accounts maintained by community foundations and other charities, such as 

field-of-interest funds and scholarship funds, provided such funds or accounts are not separately identified 

by reference to contributions of a donor or donors. 
46 

Under the proposal, the term “investment advisor” means, with respect to any sponsoring 

organization, any person (other than an employee of the sponsoring organization) compensated 

by the sponsoring organization for managing the investment of, or providing investment advice 

with respect to, assets maintained in donor advised funds owned by the sponsoring organization. 

UDeductibility of contributions to a sponsoring organization for maintenance in a donor 

advised fund

UContributions to certain sponsoring organizations for maintenance in a donor advised 

fund not eligible for a charitable deduction

Under the proposal, contributions to a sponsoring organization for maintenance in a 

donor advised fund will not be eligible for a charitable deduction for income tax purposes if the 

sponsoring organization is an organization described in sections 170(c)(3), 170(c)(4), 170(c)(5), 

or 509(a)(3); for gift tax purposes if the sponsoring organization is an organization described in 

sections 2522(a)(3) or 2522(a)(4); or for estate tax purposes if the sponsoring organization is an 

organization described in sections2055(a)(3) or 2055(a)(4). 

UAdditional substantiation requirements

In addition to satisfying present-law substantiation requirements under section 170(f), a 

donor must obtain, with respect to each charitable contribution to a sponsoring organization to be 

maintained in a donor advised fund, a contemporaneous written acknowledgment from the 

sponsoring organization providing that the sponsoring organization has exclusive legal control 

over the assets contributed. 

UMinimum distributions

UAggregate payout requirement

Under the proposal, a sponsoring organization is required, before the end of a taxable 

year of the organization, to make qualifying distributions, from the assets of donor advised funds 

maintained by the organization, equivalent to five percent of the aggregate asset value of donor 

advised funds maintained by the sponsoring organization in the immediately preceding taxable 

year. The proposal excludes from the computation of the required distributable amount for a 

taxable year the assets of donor advised funds that have been in existence for less than one full 

year as of the end of the immediately preceding taxable year.TP

103PT The aggregate payout rule does 

 103 Assume, for example, that a sponsoring organization (“S”) initially maintained 10 donor 

advised funds, each established in Year 1. In Year 3, a new donor advised fund is established. For 

purposes of determining S’s aggregate payout requirement for Year 4, the donor advised fund established 

in Year 3 is excluded, because it was in existence for less than a year as of the end of Year 3. For these 

purposes, a donor advised fund is deemed created when the account is first established (rather than when 

a donor achieves the minimum account balance required under the sponsoring organization’s rules to 

begin grantmaking, if later). 
47 

not apply in the case of a donor advised fund maintained by a private foundation that is subject to 

the requirements of section 4942. 

UAccount-level activity requirement

UGeneral rule 

Under the proposal, each donor advised fund maintained by a sponsoring organization 

must distribute at least a certain amount in qualifying distributions during any applicable threeyear period. If such amount is not distributed from a donor advised fund during such period, the 

proposal requires that the sponsoring organization distribute such amount from such account as 

qualifying distributions within 120 days. The required distributable amount is the greater of (1) 

$250 or (2) two and one-half percent of the sponsoring organization’s average required minimum 

initial contribution amount for such periodTP

104PT (or average required minimum balance, if greater) 

for the type of donorTP

105PT at issue. An applicable three-year period must correspond with three 

consecutive taxable years of the sponsoring organization. The first applicable three-year period 

for a donor advised fund begins only after the fund has been in existence for one full year.TP

106PT 

UAccount-level distribution requirement for accounts that hold illiquid assets

If, as of the end of any taxable year of the sponsoring organization, a donor advised fund 

holds assets other than cash and marketable securities (i.e., “illiquid assets”) that equal more than 

10 percent of the total value of assets in the account (determined using the following valuation 

procedures), the donor advised fund must distribute as qualifying distributions within 12 months 

of the close of such taxable year at least five percent of the value of the assets in the donor 

advised fund as of the end of such year (the “illiquid asset payout requirement”). If such amount 

is not distributed from a donor advised fund by such time, the proposal requires that the 

sponsoring organization distribute such amount from such fund as qualifying distributions within 

120 days. 

If a donor advised fund holds illiquid assets representing 10 percent of the fund’s value as 

of the end of a taxable year of the sponsoring organization, but did not hold such assets for a 

 104 For purposes of the proposal, the required minimum initial contribution amount is the 

minimum contribution amount required by the sponsoring organization in order to open a donor advised 

fund. 

105 Under some circumstances, for example, a sponsoring organization may establish higher 

minimum initial contribution amounts for corporate donors than for individual donors. 

106 Applicable three-year periods for any donor advised fund run consecutively, such that the 

second three-year period begins immediately after the first three-year period ends. For example, assume 

donor advised fund X is established on March 30 of Year 1, and the sponsoring organization's taxable 

year corresponds to the calendar year. As of the end of Year 1, X has not been in existence for one full 

year; therefore, X's first applicable three-year period does not begin in Year 2. Instead, the first such 

period begins on January 1 of Year 3 and runs through December 31 of Year 5. X's second applicable 

three-year period begins on January 1 of Year 6 and ends on December 31 of Year 8. 
48 

period of 12 months, the fund is treated as holding only cash and marketable securities for 

purposes of the illiquid asset payout requirement for such year. If, however, the donor advised 

fund holds illiquid assets at the beginning of a taxable year of a sponsoring organization and such 

assets are during such year exchanged for illiquid assets that are held at the end of such year, the 

donor advised fund is deemed to have held illiquid assets for the entire taxable year of the 

sponsoring organization, and the account is subject to the illiquid asset payout requirement. The 

Secretary is authorized to promulgate anti-abuse rules to prevent the circumvention of the 

proposal through transactions designed to avoid application of illiquid asset payout requirement, 

such as through exchanges of illiquid assets for other assets. 

Qualifying distributions

For purposes of all of the distribution requirements described in the proposal, qualifying 

distributions are amounts paid to organizations described in section 170(b)(1)(A) (other than 

supporting organizations described in section 509(a)(3) or a sponsoring organization if the 

amount is for maintenance in a donor advised fund). Distributions to the sponsoring 

organization are qualifying distributions if the distribution is designated for use in connection 

with a charitable program of the sponsoring organization (e.g., if funds are transferred to a 

scholarship fund (that does not meet the definition of donor advised fund because, for example, 

the scholarship fund is not separately identified by reference to donors) for the awarding of 

scholarships consistent with the sponsoring organization’s exempt purposes).107 Amounts 

permanently set aside for purposes, and under procedures similar to those, described in section 

4942(g) will be treated as qualifying distributions. 

Valuation

Special valuation rules apply for purposes of determining the required distributable 

amount for a taxable year under the aggregate payout requirement and the account-level payout 

requirement applicable to accounts that hold illiquid assets. For such purposes, the fair market 

values of cash and of securities for which market quotations are readily available are determined 

on a monthly basis. All other assets (“illiquid assets”) transferred by a donor to a sponsoring 

organization for maintenance in a donor advised fund are valued at the sum of (1) the value 

claimed by the donor for purposes of determining the donor’s charitable deduction for the 

contribution of such assets to the sponsoring organization,TP

108PT and (2) an assumed annual rate of 

return of five percent. If a donor advised fund invests in illiquid assets, such assets are valued at 

the sum of (1) the purchase price paid for the assets, and (2) an assumed annual rate of return of 

five percent.TP The Secretary of the Treasury is authorized to specify the requirements for making 

such computations. Under the proposal, the Secretary of the Treasury is also authorized to 

 107 Neither the payment of administrative expenses, nor distributions to the sponsoring 

organization for administrative expenses, qualifies for purposes of the aggregate payout requirement. 

108 The donor is required to report to the sponsoring organization the value of the asset claimed 

by the donor for charitable deduction purposes either by supplying to the sponsoring organization a copy 

of the donor's completed Form 8283 related to the deduction (if applicable) or by following any 

alternative procedures specified by the Secretary in regulations. 
49 

promulgate rules permitting adjustments in the value of an illiquid asset in situations where the 

asset declines significantly in value following a contribution or purchase of the asset. 

Treatment of qualifying distributions

Distributions made in satisfaction of any of the above-described distribution requirements 

are counted for purposes of all payout requirements described in the proposal. For purposes of 

any distribution requirement described in this proposal, the taxpayer may designate a qualifying 

distribution as being made out of the undistributed amount remaining from any prior taxable year 

or as being made in satisfaction of the distribution requirement for the current taxable year. 

Amounts distributed in excess of the undistributed amount for the current year and all previous 

taxable years may be carried forward for up to five taxable years following the taxable year in 

which the excess payment is made. 

Penalties for failure to distribute

In the event of a failure to distribute the required amount in connection with any of the 

above-described distribution requirements within the prescribed time period, the proposal 

imposes excise taxes similar to the private foundation excise taxes under section 4942. 

Specifically, a first-tier excise tax equal to 30 percentTP

109PT of the undistributed amount is imposed. 

The first-tier tax may be abated if the failure was due to reasonable cause and not to willful 

neglect. If the failure is not corrected within the taxable period (as defined in existing section 

4942(j)(1)), a second-tier tax equal to 100 percent of the undistributed amount is imposed. 

UProhibited transactions and sanctions

The proposal provides that donors, donor advisors, and investment advisors to donor 

advised funds (as well as persons related to the foregoing personsTP

110PT) automatically are treated as 

disqualified persons with respect to the sponsoring organization under section 4958 or under 

section 4946(a). 

The proposal also provides that distributions from a donor advised fund to a person that 

with respect to such fund is a donor, donor adviser, or a person related to a donor or donor 

adviser (though not an investment advisor) automatically will be treated as an excess benefit 

transaction under section 4958, with the entire amount paid to the disqualified person being 

deemed the amount of the excess benefit. (The section 4958 tax on organization managers also 

would apply.) This rule applies regardless of whether the sponsoring organization is a public 

 109 Under a separate proposal, the first-tier tax under section 4942 would be increased from 15 

percent to 30 percent. 

110 For purposes of the proposal, a person is treated as related to another person if (1) such person 

bears a relationship to such other person similar to the relationships described in sections 4958(f)(1)(B) 

and 4958(f)(1)(C). 
50 

charity or a private foundation and regardless of whether, but for this rule, the transaction would 

have been subject to the section 4941 self-dealing rules.TP

111PT 

Any amount repaid as a result of correcting such an excess benefit transaction shall not 

be held in or credited to any donor advised fund with respect to which the donor or donor advisor 

has or reasonably expects to have advisory privileges. The Secretary is authorized to issue 

regulations specifying how such payments may be made. 

Under the proposal, distributions from a donor advised fund (as opposed to a sponsoring 

organization’s non donor advised funds or accounts) to any person other than the sponsoring 

organization’s non donor advised funds or accounts or organizations described in section 

170(b)(1)(A)TP

112PT (other than supporting organizations described in clause (viii) or sponsoring 

organizations for maintenance in a donor advised fund) are prohibited.TP

113PT The proposal provides 

for a penalty in the event a distribution is made from a donor advised fund to an ineligible 

person, such as a private non-operating foundation or a supporting organization. In the event of 

such a distribution, an excise tax equal to 20 percent of the amount of the distribution is imposed 

against any donor or donor advisor who advised that such distribution be made. In addition, an 

excise tax equal to five percent of the amount of the distribution is imposed against any manager 

of the sponsoring organization (defined in a manner similar to the term “foundation manager” 

under section 4945) who knowingly approved the distribution. The taxes described in this 

paragraph are subject to abatement. 

Under the proposal, if a donor, a donor advisor, or a person related to a donor or donor 

advisor of a donor advised fund receives, directly or indirectly, a benefit as a result of a 

distribution from such donor advised fund, and such benefit is more than incidental, excise taxes 

are imposed against any donor or donor advisor who recommended the distribution, and against 

the recipient of the benefit. The amount of the tax is determined by multiplying the rate of the 

initial tax imposed against a disqualified person under section 4958 by the amount of the 

distribution that gave rise to the more-than-incidental benefit. Persons subject to the tax are 

jointly and severally liable for the entire amount of the tax. In addition, if a manager of the 

 111 This rule includes any distribution to a donor, donor advisor, or a related person, whether in 

the form of a grant, loan, compensation arrangement, expense reimbursement, or other payment. If the 

excess benefit results from the payment of compensation, the entire amount paid as compensation will be 

deemed the amount of the excess benefit, whether the sponsoring organization is a private foundation or a 

public charity. 

112 By requiring that distributions from a donor advised fund be made only to certain entities, the 

proposal prohibits distributions from a donor advised fund to a donor or donor advisor (or person related 

to a donor or donor advisor), whether as compensation, loans, or reimbursement of expenses. 

113 Under the proposal, distributions from donor advised funds to individuals are prohibited. 

However, sponsoring organizations may make grants to individuals from amounts not held in donor 

advised funds and may establish scholarship funds that are not donor advised funds. A donor may choose 

to make a contribution directly to such a scholarship fund (or advise that a donor advised fund make a 

distribution to such a scholarship fund). 
51 

sponsoring organization (defined in a manner similar to the term “foundation manager” under 

section 4945) who participated in the approval of the distribution knew at the time of such 

participation that the distribution would confer a more-than-incidental benefit on a donor, a 

donor-advisor, or a person related to a donor or donor advisor of a donor advised fund, the 

manager also is subject to an excise tax, calculated by multiplying the rate of the initial tax 

specified under section 4958 with respect to organization managers by the amount of the 

distribution that gave rise to the more-than-incidental benefit. The taxes described in this 

paragraph are subject to abatement if it is established that the taxable event was due to 

reasonable cause and not to willful neglect. 

UReporting and disclosure

The proposal requires each sponsoring organization to disclose on its information return: 

(1) the total number of donor advised funds it owns; (2) the aggregate value of assets held in 

those funds at the end of the organization’s taxable year; and (3) the aggregate contributions to 

and grants made from those funds during the year.T The statute of limitations for assessing any 

tax arising under the proposal in any year with respect to which the required information has not 

been provided shall not expire before three years after the date on which the required information 

is disclosed to the IRS. 

In addition, when seeking recognition of its tax-exempt status, a sponsoring organization 

must disclose whether it intends to maintain donor advised funds and must provide detailed 

information regarding its planned operation of such funds, including, for example, a description 

of procedures it intends to use to: (1) communicate to donors and donor advisors that assets held 

in donor advised funds are the property of the sponsoring organization; and (2) ensure that 

distributions from donor advised funds do not result in more than incidental private benefit to 

any person. 

UEffective Date

The proposal is generally applicable on the date of enactment. Payout requirements are 

effective for taxable years beginning after the date of enactment. Information return 

requirements are effective for taxable years ending after the date of enactment. The 

requirements concerning disclosures on an organization’s application for tax exemption are 

effective for organizations applying for recognition of exempt status after the date of enactment. 

Requirements relating to charitable contributions to donor advised funds are effective 

contributions made after 180 days from the date of enactment. 

12. Improve accountability of supporting organizations 

Present Law

Requirements for section 501(c)(3) tax-exempt status

Charitable organizations, i.e., organizations described in section 501(c)(3), generally are 

exempt from Federal income tax and are eligible to receive tax deductible contributions. A 
52 

charitable organization must operate primarily in pursuance of one or more tax-exempt purposes 

constituting the basis of its tax exemption.114 In order to qualify as operating primarily for a 

purpose described in section 501(c)(3), an organization must satisfy the following operational 

requirements: (1) the net earnings of the organization may not inure to the benefit of any person 

in a position to influence the activities of the organization; (2) the organization must operate to 

provide a public benefit, not a private benefit;115 (3) the organization may not be operated 

primarily to conduct an unrelated trade or business;116 (4) the organization may not engage in 

substantial legislative lobbying; and (5) the organization may not participate or intervene in any 

political campaign. 

Section 501(c)(3) organizations (with certain exceptions) are required to seek formal 

recognition of tax-exempt status by filing an application with the IRS (Form 1023). In response 

to the application, the IRS issues a determination letter or ruling either recognizing the applicant 

as tax-exempt or not. 

In general, organizations exempt from Federal income tax under section 501(a) are 

required to file an annual information return with the IRS.117 Under present law, the information 

return requirement does not apply to several categories of exempt organizations. Organizations 

exempt from the filing requirement include organizations (other than private foundations), the 

gross receipts of which in each taxable year normally are not more than $25,000.118

 114 Treas. Reg. sec. 1.501(c)(3)-1(c)(1). The Code specifies such purposes as religious, 

charitable, scientific, testing for public safety, literary, or educational purposes, or to foster international 

amateur sports competition, or for the prevention of cruelty to children or animals. In general, an 

organization is organized and operated for charitable purposes if it provides relief for the poor and 

distressed or the underprivileged. Treas. Reg. sec. 1.501(c)(3)-1(d)(2). 

115 Treas. Reg. sec. 1.501(c)(3)-1(d)(1)(ii). 

116 Treas. Reg. sec. 1.501(c)(3)-1(e)(1). Conducting a certain level of unrelated trade or business 

activity will not jeopardize tax-exempt status. 

117 Sec. 6033(a)(1). 

118 Sec. 6033(a)(2); Treas. Reg. sec. 1.6033-2(a)(2)(i); Treas. Reg. sec. 1.6033-2(g)(1). Sec. 

6033(a)(2)(A)(ii) provides a $5,000 annual gross receipts exception from the annual reporting 

requirements for certain exempt organizations. In Announcement 82-88, 1982-25 I.R.B. 23, the IRS 

exercised its discretionary authority under section 6033 to increase the gross receipts exception to 

$25,000, and enlarge the category of exempt organizations that are not required to file Form 990. 
53 

Classification of section 501(c)(3) organizations

In general

Section 501(c)(3) organizations are classified either as “public charities” or “private 

foundations.”119 Private foundations generally are defined under section 509(a) as all 

organizations described in section 501(c)(3) other than an organization granted public charity 

status by reason of: (1) being a specified type of organization (i.e., churches, educational 

institutions, hospitals and certain other medical organizations, certain organizations providing 

assistance to colleges and universities, or a governmental unit); (2) receiving a substantial part of 

its support from governmental units or direct or indirect contributions from the general public; or 

(3) providing support to another section 501(c)(3) entity that is not a private foundation. In 

contrast to public charities, private foundations generally are funded from a limited number of 

sources (e.g., an individual, family, or corporation). Donors to private foundations and persons 

related to such donors together often control the operations of private foundations. 

Because private foundations receive support from, and typically are controlled by, a small 

number of supporters, private foundations are subject to a number of anti-abuse rules and excise 

taxes not applicable to public charities.120 For example, the Code imposes excise taxes on acts of 

“self-dealing” between disqualified persons (generally, an enumerated class of foundation 

insiders121) and a private foundation. Acts of self-dealing include, for example, sales or 

exchanges, or leasing, of property; lending of money; or the furnishing of goods, services, or 

facilities between a disqualified person and a private foundation.122 In addition, private nonoperating foundations are required to pay out a minimum amount each year as qualifying 

distributions. In general, a qualifying distribution is an amount paid to accomplish one or more 

of the organization’s exempt purposes, including reasonable and necessary administrative 

expenses.123 Certain expenditures of private foundations are also subject to tax.124 In general, 

taxable expenditures are expenditures: (1) for lobbying; (2) to influence the outcome of a public 

election or carry on a voter registration drive (unless certain requirements are met); (3) as a grant 

to an individual for travel, study, or similar purposes unless made pursuant to procedures 

approved by the Secretary; (4) as a grant to an organization that is not a public charity or exempt 

 119 Sec. 509(a). Private foundations are either private operating foundations or private nonoperating foundations. In general, private operating foundations operate their own charitable programs in 

contrast to private non-operating foundations, which generally are grant-making organizations. Most 

private foundations are non-operating foundations. 

120 Secs. 4940 - 4945. 

121 See sec. 4946(a). 

122 Sec. 4941. 

123 Sec. 4942(g)(1)(A). A qualifying distribution also includes any amount paid to acquire an 

asset used (or held for use) directly in carrying out one or more of the organization’s exempt purposes and 

certain amounts set-aside for exempt purposes. Sec. 4942(g)(1)(B) and 4942(g)(2). 

124 Sec. 4945. Taxes imposed may be abated if certain conditions are met. Secs. 4961 and 4962. 
54 

operating foundation unless the foundation exercises expenditure responsibility125 with respect to 

the grant; or (5) for any non-charitable purpose. Additional excise taxes may apply in the event a 

private foundation holds certain business interests (“excess business holdings”)126 or makes an 

investment that jeopardizes the foundation’s exempt purposes.127 

Public charities also enjoy certain advantages over private foundations regarding the 

deductibility of contributions. For example, contributions of appreciated capital gain property to 

a private foundation generally are deductible only to the extent of the donor’s cost basis.128 In 

contrast, contributions to public charities generally are deductible in an amount equal to the 

property’s fair market value, except for gifts of inventory and other ordinary income property, 

short-term capital gain property, and tangible personal property the use of which is unrelated to 

the donee organization’s exempt purpose. In addition, under present law, a taxpayer’s deductible 

contributions generally are limited to specified percentages of the taxpayer’s contribution base, 

which generally is the taxpayer’s adjusted gross income for a taxable year. The applicable 

percentage limitations vary depending upon the type of property contributed and the 

classification of the donee organization. In general, contributions to non-operating private 

foundations are limited to a smaller percentage of the donor’s contribution base (up to 30 

percent) than contributions to public charities (up to 50 percent).129

Supporting organizations (section 509(a)(3))

The Code provides that certain “supporting organizations” (in general, organizations that 

provide support to another section 501(c)(3) organization that is not a private foundation) are 

classified as public charities rather than private foundations.130 To qualify as a supporting 

organization, an organization must meet all three of the following tests: (1) it must be organized 

and at all times operated exclusively for the benefit of, to perform the functions of, or to carry 

out the purposes of one or more “publicly supported organizations”131 (the “organizational and 

 125 In general, expenditure responsibility requires that a foundation make all reasonable efforts 

and establish reasonable procedures to ensure that the grant is spent solely for the purpose for which it 

was made, to obtain reports from the grantee on the expenditure of the grant, and to make reports to the 

Secretary regarding such expenditures. Sec. 4945(h). 

126 Sec. 4943. 

127 Sec. 4944. 

128 A special rule in section 170(e)(5) provides that taxpayer are allowed a deduction equal to the 

fair market value of certain contributions of appreciated, publicly traded stock contributed to a private 

foundation. 

129 Sec. 170(b). 

130 Sec. 509(a)(3). 

131 In general, supported organizations of a supporting organization must be publicly supported 

charities described in sections 509(a)(1) or (a)(2). 
55 

operational tests”);132 (2) it must be operated, supervised, or controlled by or in connection with 

one or more publicly supported organizations (the “relationship test”);133 and (3) it must not be 

controlled directly or indirectly by one or more disqualified persons (as defined in section 4946) 

other than foundation managers and other than one or more publicly supported organizations (the 

“lack of outside control test”).134

To satisfy the relationship test, a supporting organization must hold one of three 

statutorily described close relationships with the supported organization. The organization must 

be: (1) operated, supervised, or controlled by a publicly supported organization (commonly 

referred to as “Type I” supporting organizations); (2) supervised or controlled in connection with 

a publicly supported organization (“Type II" supporting organizations); or (3) operated in 

connection with a publicly supported organization (“Type III" supporting organizations).135

Type I supporting organizations

In the case of supporting organizations that are operated, supervised, or controlled by one 

or more publicly supported organizations (Type I supporting organizations), one or more 

supported organizations must exercise a substantial degree of direction over the policies, 

programs, and activities of the supporting organization.136 The relationship between the Type I 

supporting organization and the supported organization generally is comparable to that of a 

parent and subsidiary. The requisite relationship may be established by the fact that a majority 

of the officers, directors, or trustees of the supporting organization are appointed or elected by 

the governing body, members of the governing body, officers acting in their official capacity, or 

the membership of one or more publicly supported organizations.137

Type II supporting organizations

Type II supporting organizations are supervised or controlled in connection with one or 

more publicly supported organizations. Rather than the parent-subsidiary relationship 

characteristic of Type I organizations, the relationship between a Type II organization and its 

supported organizations is more analogous to a brother-sister relationship. In order to satisfy the 

Type II relationship requirement, generally there must be common supervision or control by the 

persons supervising or controlling both the supporting organization and the publicly supported 

 132 Sec. 509(a)(3)(A). 

133 Sec. 509(a)(3)(B). 

134 Sec. 509(a)(3)(C). 

135 Treas. Reg. sec. 1.509(a)-4(f)(2). 

136 Treas. Reg. sec. 1.509(a)-4(g)(1)(i). 

137 Id. 
56 

organizations.138 An organization generally is not considered to be “supervised or controlled in 

connection with” a publicly supported organization merely because the supporting organization 

makes payments to the publicly supported organization, even if the obligation to make payments 

is enforceable under state law.139 

Type III supporting organizations

Type III supporting organizations are “operated in connection with” one or more publicly 

supported organizations. To satisfy the “operated in connection with” relationship, Treasury 

regulations require that the supporting organization be responsive to, and significantly involved 

in the operations of, the publicly supported organization. This relationship is deemed to exist 

where the supporting organization meets both a “responsiveness test" and an “integral part 

test."140

In general, the responsiveness test requires that the Type III supporting organization be 

responsive to the needs or demands of the publicly supported organizations. The responsiveness 

test may be satisfied in one of two ways.141 First, the supporting organization may demonstrate 

that: (1)(a) one or more of its officers, directors, or trustees are elected or appointed by the 

officers, directors, trustees, or membership of the supported organization; (b) one or more 

members of the governing bodies of the publicly supported organizations are also officers, 

directors, or trustees of the supporting organization; or (c) the officers, directors, or trustees of 

the supporting organization maintain a close continuous working relationship with the officers, 

directors, or trustees of the publicly supported organizations; and (2) by reason of such 

arrangement, the officers, directors, or trustees of the supported organization have a significant 

voice in the investment policies of the supporting organization, the timing and manner of making 

grants, the selection of grant recipients by the supporting organization, and otherwise directing 

the use of the income or assets of the supporting organization.142 Alternatively, the 

responsiveness test may be satisfied if the supporting organization is a charitable trust under state 

law, each specified supported organization is a named beneficiary under the trust’s governing 

instrument, and the beneficiary organization has the power to enforce the trust and compel an 

accounting under state law.143

 138 Treas. Reg. sec. 1.509(a)- 4(h)(1). 

139 Treas. Reg. sec. 1.509(a)-4(h)(2). 

140 Treas. Reg. sec. 1.509(a)-4(i)(1). 

141 For an organization that was supporting or benefiting one or more publicly supported 

organizations before November 20, 1970, additional facts and circumstances, such as an historic and 

continuing relationship between organizations, also may be taken into consideration to establish 

compliance with either of the responsiveness tests. Treas. Reg. sec. 1.509(a)-4(i)(1)(ii). 

142 Treas. Reg. sec. 1.509(a)-4(i)(2)(ii). 

143 Treas. Reg. sec. 1.509(a)-4(i)(2)(iii). 
57 

In general, the integral part test requires that the Type III supporting organization 

maintain significant involvement in the operations of one or more publicly supported 

organizations, and that such publicly supported organizations are in turn dependent upon the 

supporting organization for the type of support which it provides. There are two alternative 

methods for satisfying the integral part test. The first alternative is to establish that (1) the 

activities engaged in for or on behalf of the publicly supported organization are activities to 

perform the functions of, or carry out the purposes of, such organizations; and (2) these 

activities, but for the involvement of the supporting organization, normally would be engaged in 

by the publicly supported organizations themselves.144 The second method for satisfying the 

integral part test is to establish that: (1) the supporting organization pays substantially all of its 

income to or for the use of one or more publicly supported organizations;145 (2) the amount of 

support received by one or more of the publicly supported organizations is sufficient to insure 

the attentiveness of the organization or organizations to the operations of the supporting 

organization (this is known as the “attentiveness requirement”);146 and (3) a significant amount 

of the total support of the supporting organization goes to those publicly supported organizations 

that meet the “attentiveness requirement.”147

Intermediate sanctions (excess benefit transaction tax)

The Code imposes excise taxes on excess benefit transactions between disqualified 

persons and public charities.148 An excess benefit transaction generally is a transaction in which 

an economic benefit is provided by a public charity directly or indirectly to or for the use of a 

disqualified person, if the value of the economic benefit provided exceeds the value of the 

consideration (including the performance of services) received for providing such benefit. 

For purposes of the excess benefit transaction rules, a disqualified person is any person in 

a position to exercise substantial influence over the affairs of the public charity at any time in the 

 144 Treas. Reg. sec. 1.509(a)-4(i)(3)(ii). 

145 For this purpose, the IRS has defined the term “substantially all” of an organization's income 

to mean 85 percent or more. Rev. Rul. 76-208, 1976-1 C.B. 161. 

146 Although the regulations do not specify the requisite level of support in numerical or 

percentage terms, the IRS has suggested that grants that represent less than 10 percent of the beneficiary's 

support likely would be viewed as insufficient to ensure attentiveness. Gen. Couns. Mem. 36379 (August 

15, 1975). As an alternative to satisfying the attentiveness standard by the foregoing method, a 

supporting organization may demonstrate attentiveness by showing that, in order to avoid the interruption 

of the carrying on of a particular function or activity, the beneficiary organization will be sufficiently 

attentive to the operations of the supporting organization. Treas. Reg. sec. 1.509(a)-4(i)(3)(iii)(b). 

147 Treas. Reg. sec. 1.509(a)-4(i)(3)(iii). 

148 Sec. 4958. The excess benefit transaction tax is commonly referred to as “intermediate 

sanctions,” because it imposes penalties generally considered to be less punitive than revocation of the 

organization’s exempt status. The tax also applies to transactions between disqualified persons and social 

welfare organizations (as described in section 501(c)(4)). 
58 

five-year period ending on the date of the transaction at issue.149 Persons holding certain powers, 

responsibilities, or interests (e.g., officers, directors, or trustees) are considered to be in a position 

to exercise substantial influence over the affairs of the public charity. 

An excess benefit transaction tax is imposed on the disqualified person and, in certain 

cases, on the organization managers, but is not imposed on the public charity. An initial tax of 

25 percent of the excess benefit amount is imposed on the disqualified person that receives the 

excess benefit. An additional tax on the disqualified person of 200 percent of the excess benefit 

applies if the violation is not corrected within a specified period. A tax of 10 percent of the 

excess benefit (not to exceed $10,000 with respect to any excess benefit transaction) is imposed 

on an organization manager that knowingly participated in the excess benefit transaction, if the 

manager’s participation was willful and not due to reasonable cause, and if the initial tax was 

imposed on the disqualified person. 

Description of Proposal

Proposals relating to all (Type I, Type II, and Type III) supporting organizations

Prohibited transactions

Supporting organizations (Type I, Type II, or Type III) are prohibited from making 

grants, loans, compensation, or other similar payments to a substantial contributor (or person 

related to the substantial contributor)150 of the supporting organization. If a prohibited payment 

is made, the substantial contributor is treated as a disqualified person and the transaction is 

treated as an excess benefit transaction with the entire amount of the payment treated as the 

excess benefit. The prohibition does not apply if the substantial contributor is a public charity 

(other than a supporting organization). A substantial contributor is similar to a person as 

described in section 507(d)(2). 

Loans by any supporting organization (Type I, Type II, or Type III) to a disqualified 

person (as defined in section 4958) of the supporting organization are prohibited. With respect 

to any such loan, the loan is treated as an excess benefit transaction and the entire amount of the 

loan is treated as an excess benefit. For this purpose, a disqualified person does not include a 

public charity (other than a supporting organization). 

Disclosure requirements

All supporting organizations are required to file an annual information return (Form 990 

series) with the Secretary, regardless of the organization’s gross receipts. A supporting 

organization must indicate on such annual information return (and on the application for tax-

 149 Sec. 4958(f)(1). A disqualified person also includes certain family members of such a person, 

and certain entities that satisfy a control test with respect to such persons. 

150 For purposes of this proposal, a person is treated as related to another person if such person 

bears a relationship to such other person similar to the relationships described in section 4958(f)(1)(B) or 

section 4958(f)(1)(C). 
59 

exempt status) whether it is a Type I, Type II, or Type III supporting organization. A supported 

organization must identify on its Form 990 filed with the Secretary the organizations with respect 

to which it is a supported organization. 

Supporting organizations must demonstrate annually that the organization is not 

controlled directly or indirectly by one or more disqualified persons (other than foundation 

managers and other than one or more publicly supported organizations) through a certification on 

the annual information return that the majority of the organization’s governing body is 

comprised of individuals who were selected based on their special knowledge or expertise in the 

particular field or discipline in which the supporting organization is operating, or because they 

represent the particular community that is served by the supported public charities, and who have 

no family, personal, or business relationship to any of the organization’s disqualified persons. 

Excess business holdings

The excess business holdings rules of section 4943 are applied to supporting 

organizations. In applying such rules, the term disqualified person has the meaning provided in 

section 4958, and also includes substantial contributors as described in section 507(d)(2) and 

persons related to substantial contributors and persons similar to those described in section 

4943(a)(1)(H). The Secretary has the authority not to impose the excess business holding rules if 

the organization establishes to the satisfaction of the Secretary that the excess holdings are 

consistent with the exempt purposes of the organization. 

Proposals that apply only to Type III supporting organizations

Modify payout requirement of Type III supporting organizations

A Type III supporting organization must pay each taxable year, to or for the use of one or 

more public charities described in section 509(a)(1) or 509(a)(2), the sum of (1) the greater of (i) 

85 percent of its income or (ii) five percent of the aggregate fair market value of all of the assets 

of the organization other than assets that are used (or held for use) directly in supporting the 

charitable programs of the supporting organization or one or more supported organizations, 

determined as of the last day of the taxable year, and (2) any amount received or accrued in such 

year as repayments of amounts that were taken into account as support provided by the 

supporting organization in prior years. In general, the distributable amount for a taxable year 

must be distributed before the first day of the second taxable year following such year, under 

rules similar to the distribution rules under section 4942. For purposes of any distribution 

requirement described in this proposal, the taxpayer may designate a qualifying distribution as 

being made out of the undistributed amount remaining from any prior taxable year or as being 

made in satisfaction of the distribution requirement for the current taxable year. Amounts 

distributed in excess of the undistributed amount for the current year and all previous taxable 

years may be carried forward for up to five taxable years following the taxable year in which the 

excess payment is made. 151

 151 Under present law, certain Type III organizations are required to pay out substantially all of 

their income to section 509(a)(1) or 509(a)(2) organizations. Such Type III organizations also must 
60 

A supporting organization’s administrative and operating expenses do not count as 

expenses to or for the use of a supported organization. The holding of assets for investment 

purposes, or to operate a trade or business, is not considered a use or holding for use directly to 

support a supported organization’s charitable programs. The Secretary may provide guidance as 

to types of uses of assets that are considered to be directly in support of a supported 

organization’s charitable programs similar to guidance provided under Treasury Regulation 

section 53.4942(a)-2(c)(3)(i). 

An organization that fails to meet the payout requirement is subject to an initial tax of 30 

percent of the unpaid amount, increased to 100 percent of the unpaid amount if the payout 

requirement is not met by the earlier of the date of mailing of a notice of deficiency with respect 

to the initial tax or the date on which the initial tax is assessed.

Organizational and operational requirements

A Type III supporting organization may not support more than five organizations, may 

not support an organization that is not organized in the United States,152 and may not be a donor 

with respect to a donor advised fund. However, a Type III supporting organization may provide 

support to a sponsoring organization of a donor advised fund to the extent the support is not for 

maintenance in a donor advised fund. 

Relationship to supported organization(s)

A Type III supporting organization must, as part of its exemption application (Form 

1023) attach a letter from each organization that is designated by the supporting organization as 

receiving its support. 

On the annual information return filed by a Type III supporting organization, the 

organization must indicate that it has obtained letters from organizations that received its 

support. All such letters must be signed by a senior officer or a member of the Board of the 

supported organization and must show (1) that the supported organization agrees to be supported 

by the supporting organization, (2) the type of support provided or to be provided, and (3) how 

such support furthers the supported organization’s charitable purposes. 

 

establish that a substantial amount of the total support provided must go to organizations that meet the 

present law “attentiveness” requirement. The proposal does not change this requirement but does extend 

it to Type III supporting organizations that under present law are not subject to a payout requirement (by 

virtue of satisfying Treasury Regulation section 1.509(a)-4(i)(3)(ii)). 

152 U.S. charities established principally to provide financial and other assistance to a foreign 

charity, sometimes referred to as “friends of” organizations, may not be established as supporting 

organizations under the proposal. Such organizations may continue to obtain public charity status, 

however, by virtue of demonstrating broad public support (as described in sections 509(a)(1) and 

509(a)(2)). 
61 

A Type III supporting organization must apprise each organization it supports of 

information regarding the supporting organization in order to help ensure the supporting 

organization’s responsiveness. Such a showing could be satisfied, for example, through 

provision of documentation such as a copy of the supporting organization’s governing 

documents, any changes made to the governing documents, the organization’s annual 

information return filed with the Secretary (Form 990 series), any tax return (Form 990-T) filed 

with the Secretary, and an annual report (including a description of all of the support provided by 

the supporting organization, how such support was calculated, and a projection of the next year’s 

support). Failure to make a sufficient showing is a factor in determining whether the 

responsiveness test of present law is met. 

A type III supporting organization that is organized as a trust must, in addition to present 

law requirements, establish to the satisfaction of the Secretary, that it has a close and continuous 

relationship with the supported organization such that the trust is responsive to the needs or 

demands of the supported organization. 

Other provisions

If a Type I or Type III supporting organization supports an organization that is controlled, 

directly or indirectly, by a donor (other than a public charity that is not a supporting 

organization) of the supporting organization or person related to the donor (or any combination 

of such persons), then the supporting organization is treated as a private foundation for all 

purposes until such time as the organization can demonstrate to the satisfaction of the Secretary 

that it qualifies as a public charity other than as a supporting organization. 

For purposes of the excess benefit transaction rules, a disqualified person of a supporting 

organization is treated as a disqualified person of the supported organization. 

A non-operating private foundation may not count as a qualifying distribution under 

section 4942 any amount paid to a supporting organization. In addition, any amount paid to a 

supporting organization shall be treated as a taxable expenditure under section 4945 unless the 

private foundation exercises expenditure responsibility with respect to the grant. 

Effective Date

The proposal generally is effective on the date of enactment. The limitation on 

supporting no more than five organizations is effective for organizations established on or after 

the date of enactment (but organizations established before the date of enactment may not 

increase the number of organizations supported above the number of organizations supported on 

the date of enactment, and may not add new supported organizations as beneficiaries unless no 

more than five organizations are supported by the supporting organization following such 

addition). The distribution requirements are effective for taxable years beginning after the date 

of enactment. The prohibited transaction rules are effective for transactions occurring after the 

date of enactment. The excess business holdings requirements generally are effective for taxable 

years beginning after the date of enactment, but transition rules similar to the rules under sections 

4943(c)(4) and 4943(c)(5) shall apply. The limitations on charitable contributions of capital gain 

property are effective for taxable years beginning after the date of enactment. The return 
62 

requirements are effective for returns filed for taxable years ending after the date of enactment. 

Making a showing to a supported organization in satisfaction of the responsiveness test is 

effective for taxable years beginning after the date of enactment. 

13. Reform rules for charitable contributions of easements on buildings in registered 

historic districts 

Present Law

In general

Present law provides special rules that apply to charitable deductions of qualified 

conservation contributions, which include conservation easements and façade easements.153 

Qualified conservation contributions are not subject to the “partial interest” rule, which generally 

bars deductions for charitable contributions of partial interests in property.154 Accordingly, 

qualified conservation contributions are contributions of partial interests that are eligible for a 

fair market value charitable deduction. 

A qualified conservation contribution is a contribution of a qualified real property interest 

to a qualified organization exclusively for conservation purposes. A qualified real property 

interest is defined as: (1) the entire interest of the donor other than a qualified mineral interest; 

(2) a remainder interest; or (3) a restriction (granted in perpetuity) on the use that may be made 

of the real property.155 Qualified organizations include certain governmental units, public 

charities that meet certain public support tests, and certain supporting organizations. 

Conservation purposes include: (1) the preservation of land areas for outdoor recreation 

by, or for the education of, the general public; (2) the protection of a relatively natural habitat of 

fish, wildlife, or plants, or similar ecosystem; (3) the preservation of open space (including 

farmland and forest land) where such preservation will yield a significant public benefit and is 

either for the scenic enjoyment of the general public or pursuant to a clearly delineated Federal, 

State, or local governmental conservation policy; and (4) the preservation of an historically 

important land area or a certified historic structure.156 

 153 Sec. 170(h). 

154 Sec. 170(f)(3). 

155 Charitable contributions of interests that constitute the taxpayer’s entire interest in the 

property are not regarded as qualified real property interests within the meaning of section 170(h), but 

instead are subject to the general rules applicable to charitable contributions of entire interests of the 

taxpayer (i.e., generally are deductible at fair market value, without regard to satisfaction of the 

requirements of section 170(h)). 

156 Sec. 170(h)(4)(A). 
63 

In general, no deduction is available if the property may be put to a use that is 

inconsistent with the conservation purpose of the gift.157 A contribution is not deductible if it 

accomplishes a permitted conservation purpose while also destroying other significant 

conservation interests.158

Taxpayers are required to obtain a qualified appraisal for donated property with a value 

of $5,000 or more, and to attach an appraisal summary to the tax return.159 Under Treasury 

regulations, a qualified appraisal means 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 under section 170;160 (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 

such property on the date of contribution and the specific basis for the valuation; (c) a statement 

that such appraisal was prepared for income tax purposes; (d) the qualifications of the qualified 

appraiser; and (e) the signature and taxpayer identification number of such appraiser; and (4) 

does not involve an appraisal fee that violates certain prescribed rules.161

Valuation

The value of a conservation restriction granted in perpetuity generally is determined 

under the “before and after approach.” Such approach provides that the fair market value of the 

restriction is equal to the difference (if any) between the fair market value of the property the 

restriction encumbers before the restriction is granted and the fair market value of the 

encumbered property after the restriction is granted.162

If the granting of a perpetual restriction has the effect of increasing the value of any other 

property owned by the donor or a related person, the amount of the charitable deduction for the 

conservation contribution is to be reduced by the amount of the increase in the value of the other 

property.163 In addition, the donor is to reduce the amount of the charitable deduction by the 

amount of financial or economic benefits that the donor or a related person receives or can 

reasonably be expected to receive as a result of the contribution.164 If such benefits are greater 

 157 Treas. Reg. sec. 1.170A-14(e)(2). 

158 Treas. Reg. sec. 1.170A-14(e)(2). 

159 Sec. 170(f)(11)(C). 

160 In the case of a deduction first claimed or reported on an amended return, the deadline is the 

date on which the amended return is filed. 

161 Treas. Reg. sec. 1.170A-13(c)(3). 

162 Treas. Reg. sec. 1.170A-14(h)(3). 

163 Treas. Reg. sec. 1.170A-14(h)(3)(i). 

164 Id. 
64 

than those that will inure to the general public from the transfer, no deduction is allowed.165 In 

those instances where the grant of a conservation restriction has no material effect on the value 

of the property, or serves to enhance, rather than reduce, the value of the property, no deduction 

is allowed.166

Preservation of a certified historic structure

A certified historic structure means any building, structure, or land which is (i) listed in 

the National Register, or (ii) located in a registered historic district (as defined in section 

47(c)(3)(B)) and is certified by the Secretary of the Interior to the Secretary of the Treasury as 

being of historic significance to the district.167 For this purpose, a structure means any structure, 

whether or not it is depreciable, and, accordingly, easements on private residences may 

qualify.168 If restrictions to preserve a building or land area within a registered historic district 

permit future development on the site, a deduction will be allowed only if the terms of the 

restrictions require that such development conform with appropriate local, State, or Federal 

standards for construction or rehabilitation within the district.169

The IRS and the courts have held that a facade easement may constitute a qualifying 

conservation contribution.170 In general, a facade easement is a restriction the purpose of which 

is to preserve certain architectural, historic, and cultural features of the facade, or front, of a 

building. The terms of a facade easement might permit the property owner to make alterations to 

the facade of the structure if the owner obtains consent from the qualified organization that holds 

the easement. 

Description of Proposal

The proposal revises the rules for qualified conservation contributions with respect to 

property located in a registered historic district. Under the proposal, a charitable deduction is not 

allowable with respect to a structure or land area located in such a district. A charitable 

deduction is allowable with respect to buildings (as is the case under present law) but the 

qualified real property interest that relates to the exterior of the building must preserve the entire 

 165 Id. 

166 Treas. Reg. sec. 1.170A-14(h)(3)(ii). 

167 Sec. 170(h)(4)(B). 

168 Treas. Reg. sec. 1.170A-14(d)(5)(iii). 

169 Treas. Reg. sec. 1.170A-14(d)(5)(i). 

170 Hillborn v. Commissioner, 85 T.C. 677 (1985) (holding the fair market value of a facade 

donation generally is determined by applying the “before and after” valuation approach); Richmond v. 

U.S., 699 F. Supp. 578 (E.D. La. 1988); Priv. Ltr. Rul. 199933029 (May 24, 1999) (ruling that a 

preservation and conservation easement relating to the facade and certain interior portions of a fraternity 

house was a qualified conservation contribution). 
65 

exterior of the building, including the space above the building, the sides, the rear, and the front 

of the building, and the building must be habitable. In addition, such qualified real property 

interest must provide that no portion of the exterior of the building may be changed or altered in 

a manner inconsistent with the historical character of such exterior. Taxpayers must obtain a 

qualified appraisal of the qualified real property interest (irrespective of the claimed value of 

such interest) and attach the appraisal with the taxpayer’s return. Appraisals must include 

photographs of the entire exterior of the building and descriptions of all current restrictions on 

development of the building, including zoning laws, ordinances, neighborhood association rules, 

restrictive covenants, and other similar restrictions. Failure to obtain and attach an appraisal or 

to include the required information in the appraisal results in disallowance of the deduction. 

Qualified conservation contributions with respect to a building located in a registered 

historic district are not allowed unless the donee organization has been accredited by the 

National Trust for Historic Preservation.171 In developing an accreditation program, the National 

Trust for Historic Preservation shall consult with the Internal Revenue Service, the National Park 

Service, and State Historic Preservation Officers as described in 16. U.S.C. sec 470a(b). Such 

accreditation program is required to develop best practices for donee organizations, such as 

establishing standards for regular monitoring of interests held by an organization, maintenance of 

sufficient resources to monitor and enforce interests held by an organization, and conflicts of 

interest policies to be followed in connection with the solicitation and administration of 

contributions. Accreditation must be obtained at least once every five years, and an organization 

must show that its current resources are sufficient to monitor and enforce existing interests held 

by the organization, that it has effectively monitored and enforced such interests, that the 

organization either has sufficient resources to monitor new interests or can demonstrate that such 

resources will be available for monitoring and enforcing new interests, that the organization 

follows a suitable conflict of interest policy with respect to solicitation and administration of 

contributions, that the organization does not engage in deceptive or misleading promotional 

practices, and that the organization has a policy to ensure that restrictions held by the 

organization will be protected in perpetuity in the event the organization can no longer 

sufficiently monitor and enforce the restriction. Accreditation standards and the procedure for 

accreditation must be complete by January 1, 2007. In addition, under the proposal, a 

governmental unit (as described in section 170(b)(1)(A)(v)) is no longer an eligible donee for 

such contributions. 

Taxpayers claiming a deduction for a qualified conservation contribution with respect to 

the exterior of a building located in a registered historic district are subject to a limitation on the 

amount allowed as a deduction for the qualified conservation contribution equal to the greater of 

three percent of the fair market value of the underlying property or $10,000. As an alternative to 

being subject to such limitation, a taxpayer may pay a $500 fee to the Internal Revenue Service. 

Amounts paid are required to be dedicated to Internal Revenue Service enforcement of qualified 

conservation contributions. 

 171 The National Trust for Historic Preservation is an organization chartered by Congress 

pursuant to 16. U.S.C. secs. 468-468d. 
66 

Effective Date

The proposal generally is effective for contributions made after the date of enactment, 

except that the requirement that a qualified real property interest be with respect to the entire 

exterior of the building is effective for contributions made after December 16, 2004. The 

limitation on the amount that may be deducted and the filing fee is effective for contributions 

made 180 days after the date of enactment. The requirement that a donee organization be 

accredited is effective on January 1, 2008. 

14. Reform rules relating to charitable contributions of taxidermy and recapture tax 

benefit on property not used for an exempt use 

Present Law

Deductibility of charitable contributions

In general

In computing taxable income, a taxpayer who itemizes deductions generally is allowed to 

deduct the amount of cash and the fair market value of property contributed to an organization 

described in section 501(c)(3) or to a Federal, State, or local governmental entity.172 The amount 

of the deduction allowable for a taxable year with respect to a charitable contribution of property 

may be reduced or limited depending on the type of property contributed, the type of charitable 

organization to which the property is contributed, and the income of the taxpayer.173 In general, 

more generous charitable contribution deduction rules apply to gifts made to public charities than 

to gifts made to private foundations. Within certain limitations, donors also are entitled to 

deduct their contributions to section 501(c)(3) organizations for Federal estate and gift tax 

purposes. By contrast, contributions to nongovernmental, non-charitable tax-exempt 

organizations generally are not deductible by the donor,174 though such organizations are eligible 

for the exemption from Federal income tax with respect to such donations. 

Contributions of property

The amount of the deduction for charitable contributions of capital gain property 

generally equals the fair market value of the contributed property on the date of the contribution. 

Capital gain property means any capital asset, or property used in the taxpayer’s trade or 

business, the sale of which at its fair market value, at the time of contribution, would have 

 172 The deduction also is allowed for purposes of calculating alternative minimum taxable 

income. 

173 Secs. 170(b) and (e). 

174 Exceptions to the general rule of non-deductibility include certain gifts made to a veterans’ 

organization or to a domestic fraternal society. In addition, contributions to certain nonprofit cemetery 

companies are deductible for Federal income tax purposes, but generally are not deductible for Federal 

estate and gift tax purposes. Secs. 170(c)(3), 170(c)(4), 170(c)(5), 2055(a)(3), 2055(a)(4), 

2106(a)(2)(A)(iii), 2522(a)(3), and 2522(a)(4). 
67 

resulted in gain that would have been long-term capital gain. Contributions of capital gain 

property are subject to different percentage limitations (i.e., limitations based on the donor’s 

income) than other contributions of property. 

For certain contributions of property, the deductible amount is reduced from the fair 

market value of the contributed property by the amount of any gain, generally resulting in a 

deduction equal to the taxpayer’s basis. This rule applies to contributions of: (1) ordinary 

income property, e.g., property that, at the time of contribution, would not have resulted in longterm capital gain if the property was sold by the taxpayer on the contribution date;175 (2) tangible 

personal property that is used by the donee in a manner unrelated to the donee’s exempt (or 

governmental) purpose; and (3) property to or for the use of a private foundation (other than a 

foundation defined in section 170(b)(1)(E)). 

Charitable contributions of taxidermy are subject to the tangible personal property rule 

(number (2) above). For example, for appreciated taxidermy, if the property is used to further 

the donee’s exempt purpose, the deduction is fair market value. But if the property is not used to 

further the donee’s exempt purpose, the deduction is the donor’s basis. If the taxidermy is 

depreciated, i.e., the value is less than the taxpayer’s basis in such property, taxpayers generally 

deduct the fair market value of such contributions, regardless of whether the property is used for 

exempt or unrelated purposes by the donee. 

Substantiation

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 by the donee organization.176 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.177 C corporations (other than personal 

service corporations and closely-held corporations) are required to file Form 8283 only if the 

deduction claimed is more than $5,000. Information required on the Form 8283 includes, among 

other things, a description of the property, the appraised fair market value (if an appraisal is 

required), the donor’s basis in the property, how the donor acquired the property, a declaration 

by the appraiser regarding the appraiser’s general qualifications, an acknowledgement by the 

 175 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. Sec. 170(e)(3), 170(e)(4), 170(e)(6). 

176 Sec. 170(f)(8). 

177 Sec. 170(f)(11). 
68 

donee that it is eligible to receive deductible contributions, and an indication by the donee 

whether the property is intended for an unrelated use. 

Taxpayers are required to obtain a qualified appraisal for donated property with a value 

of more than $5,000 or more, and to attach an appraisal summary to the tax return.178 Under 

Treasury regulations, a qualified appraisal means 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 under section 170;179 (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 such property on the date of contribution and the specific basis for the valuation; 

(c) a statement that such appraisal was prepared for income tax purposes; (d) the qualifications of 

the qualified appraiser; and (e) the signature and taxpayer identification number of such 

appraiser; and (4) does not involve an appraisal fee that violates certain prescribed rules.180 In 

the case of contributions of art valued at more than $20,000 and other contributions of more than 

$500,000, taxpayers are required to attach the appraisal to the tax return. Taxpayers may request 

a Statement of Value from the Internal Revenue Service in order to substantiate the value of art 

with an appraised value of $50,000 or more for income, estate, or gift tax purposes.181 The fee 

for such a Statement is $2,500 for one, two, or three items or art plus $250 for each additional 

item. 

If a donee organization sells, exchanges, or otherwise disposes of contributed property 

with a claimed value of $5,000 or more (other than publicly traded securities) within two years 

of the property’s receipt, the donee is required to file a return (Form 8282) with the Secretary, 

and to furnish a copy of the return 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.182

Description of Proposal

Donation of taxidermy for an exempt use

For contributions of exempt-use taxidermy property with a claimed value of more than 

$500 but not more than $5,000, the individual must include on the Form 8283 a photograph of 

the taxidermy and comparable sales data for similar items within the previous six months. 

Valuation must be based on comparable sales. The Secretary shall not allow a deduction if 

sufficient comparable sales are not provided. 

 178 Id. 

179 In the case of a deduction first claimed or reported on an amended return, the deadline is the 

date on which the amended return is filed. 

180 Treas. Reg. sec. 1.170A-13(c)(3). Sec. 170(f)(11)(E). 

181 Rev. Proc. 96-15, 1996-1 C.B. 627. 

182 Sec. 6050L(a)(1). 
69 

For claims of more than $5,000, the taxpayer must request a Statement of Value from the 

IRS by the time the taxpayer files the return claiming the deduction. The Statement of Value is 

similar to that available under present law for items of art. The IRS shall assess an average fee 

of $500 for the Statement of Value. 

Determination of basis in taxidermy

For purposes of the charitable contribution deduction, a taxpayer may not include in the 

taxpayer’s basis of the contributed taxidermy any costs attributable to travel. 

Recapture of tax benefit upon subsequent disposition of tangible personal property 

intended for an exempt use

In general, the proposal recovers the tax benefit for charitable contributions of tangible 

personal property that are not used for exempt purposes. The proposal applies to appreciated 

tangible personal property that is identified by the donee organization as for a use related to the 

donee’s basis for tax exemption, and for which a deduction of more than $5,000 is claimed 

(“applicable property”).183 If the donee organization disposes of applicable property within three 

years of the receipt of the property, the donor is subject to recapture of the tax benefit. If the 

disposition occurs in the contribution tax year, the donor’s deduction generally is basis and not 

fair market value.184 If the disposition occurs in a subsequent year, the donor must include as 

ordinary income for its 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 recapture of the tax benefit if the donee organization makes a certification to 

the Secretary, by written statement signed under penalties of perjury by an officer of the 

organization (other than the donor or a person related to the donor). The certification must 

explain either (1) the use of the property and how such use substantially furthered the purpose or 

function that constitutes the organization’s basis for exemption, or (2) that the intended related 

use of the property became impossible or infeasible to implement. The organization must 

furnish a copy of the certification to the donor (as part of the present-law requirement to furnish 

the Form 8282 to the donor). 

Reporting of exempt use property contributions

In addition to the present-law requirement that the donee organization identify on the 

Form 8283 whether property for which an amount of more than $500 is claimed is for a related 

use, the donee must explain any such intended use of such property. A penalty of $10,000 

 183 Present law rules continue to apply to any contribution of exempt use property for which a 

deduction of $5,000 or less is claimed. 

184 The disposition proceeds are regarded as relevant to a determination of fair market value. 
70 

applies to a person that identifies property as related use property knowing that it is not intended 

for such use.185

The proposal modifies the present-law information return requirements that apply upon 

the disposition of contributed property by a charitable organization (Form 8282, sec. 6050L). 

For property identified by the donee organization on the Form 8283 as exempt use property, the 

return requirement is extended to dispositions made within three years after receipt (from two 

years). The donee organization also must provide, in addition to the information already 

required to be provided on the return, a description of the donee’s use of the property, a 

statement of whether the property was used to substantially further exempt purposes, a 

certification of any such use (described above). 

Effective Date

With respect to contributions of taxidermy property, the proposal is effective for 

contributions made after the date of enactment. With respect to exempt use property generally, 

the proposal is effective for contributions made after June 1, 2006. 

15. Limit charitable deduction for contributions of clothing and household items and 

modify recordkeeping and substantiation requirements for certain charitable contributions 

Present Law

Deductibility of charitable contributions

In general

In computing taxable income, a taxpayer who itemizes deductions generally is allowed to 

deduct the amount of cash and the fair market value of property contributed to an organization 

described in section 501(c)(3) or to a Federal, State, or local governmental entity.186 The amount 

of the deduction allowable for a taxable year with respect to a charitable contribution of property 

may be reduced or limited depending on the type of property contributed, the type of charitable 

organization to which the property is contributed, and the income of the taxpayer.187 In general, 

more generous charitable contribution deduction rules apply to gifts made to public charities than 

to gifts made to private foundations. Within certain limitations, donors also are entitled to 

deduct their contributions to section 501(c)(3) organizations for Federal estate and gift tax 

purposes. By contrast, contributions to nongovernmental, non-charitable tax-exempt 

 185 Other present-law penalties also may apply, such as the penalty for aiding and abetting the 

understatement of tax liability under section 6701. 

186 The deduction also is allowed for purposes of calculating alternative minimum taxable 

income. 

187 Secs. 170(b) and (e). 
71 

organizations generally are not deductible by the donor,188 though such organizations are eligible 

for the exemption from Federal income tax with respect to such donations. 

Contributions of property

The amount of the deduction for charitable contributions of capital gain property 

generally equals the fair market value of the contributed property on the date of the contribution. 

Capital gain property means any capital asset or property used in the taxpayer’s trade or business 

the sale of which at its fair market value, at the time of contribution, would have resulted in gain 

that would have been long-term capital gain. Contributions of capital gain property are subject 

to different percentage limitations than other contributions of property. 

For certain contributions of property, the deductible amount is reduced from the fair 

market value of the contributed property by the amount of any gain, generally resulting in a 

deduction equal to the taxpayer’s basis. This rule applies to contributions of: (1) ordinary 

income property, e.g., property that, at the time of contribution, would not have resulted in longterm capital gain if the property was sold by the taxpayer on the contribution date;189 (2) tangible 

personal property that is used by the donee in a manner unrelated to the donee’s exempt (or 

governmental) purpose; and (3) property to or for the use of a private foundation (other than a 

foundation defined in section 170(b)(1)(E)). 

Charitable contributions of clothing and household items are subject to the tangible 

personal property rule (number (2) above). If such contributed property is appreciated property 

in the hands of the taxpayer, and is not used to further the donee’s exempt purpose, the deduction 

is basis. In general, however, the value of clothing and household items is less than the 

taxpayer’s basis in such property, with the result that taxpayers generally deduct the fair market 

value of such contributions, regardless of whether the property is used for exempt or unrelated 

purposes by the donee. 

Substantiation

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 such 

contribution. For a contribution of money, the donor generally must maintain 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 

 188 Exceptions to the general rule of non-deductibility include certain gifts made to a veterans’ 

organization or to a domestic fraternal society. In addition, contributions to certain nonprofit cemetery 

companies are deductible for Federal income tax purposes, but generally are not deductible for Federal 

estate and gift tax purposes. Secs. 170(c)(3), 170(c)(4), 170(c)(5), 2055(a)(3), 2055(a)(4), 

2106(a)(2)(A)(iii), 2522(a)(3), and 2522(a)(4). 

189 For certain contributions of inventory and other property, 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. Sec. 170(e)(3), 170(e)(4), 

170(e)(6). 
72 

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. For a contribution of property other than money, the donor generally must 

maintain a receipt from the donee organization showing the name of the donee, the date and 

location of the contribution, and a detailed description (but not the value) of the property.190 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.191

In addition to the foregoing recordkeeping requirements, substantiation requirements 

apply in the case of 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 by 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.192 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.193 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. 

Description of Proposal

General rule relating to clothing and household items

The proposal requires the Secretary to prepare and publish an itemized list of clothing 

and household items and to assign an amount to each item on the list. The assigned amount is 

treated as the fair market value of the item for purposes of the charitable contribution deduction 

and is based on an assumption that the item is in good used condition or better. Any deduction 

for a charitable contribution of each such item may not exceed the item’s assigned amount. Any 

deduction for an item not in good used condition or better may not exceed 20 percent of the 

item’s assigned amount. Any deduction for an item that is not functional with respect to the use 

for which it was designed is not allowed. 

The list must be published by the Secretary at least once each calendar year and is 

applicable to contributions of clothing and household items made while the list is effective. The 

 190 Treas. Reg. sec. 1.170A-13(a). 

191 Treas. Reg. sec. 1.170A-13(b). 

192 Sec. 170(f)(8). 

193 Sec. 170(f)(11). 
73 

Secretary has discretion to determine the effective dates for each published list. The list should 

be prepared in consultation with donee organizations that accept charitable contributions of 

clothing and household items. In assigning amounts to particular items, the Secretary should 

take into account the sales price of such contributed items when sold by the donee organizations, 

whether through an exempt program of such organizations or otherwise. If an item of clothing or 

a household item is not included on the list published by the Secretary, present law rules apply to 

the contribution of the item. 

The proposal does not apply to contributions by C corporations. The proposal applies to 

new and used items. Household items include furniture, furnishings, electronics, appliances, 

linens, and other similar items. Food is not considered a household item. Paintings, antiques, 

and other objects of art, jewelry and gems, and collections are excluded from the proposal.

Substantiation

Clothing and household items

As under present law, for contributions with a claimed value of $250 or more, the 

taxpayer must obtain contemporaneous substantiation from the donee organization, which must 

include a description of the property contributed. The proposal provides that, as part of such 

substantiation, the taxpayer obtain an indication of the condition of the item(s) and the number 

and type of items of clothing and household items contributed and either a copy of the published 

list or instructions as to how to find such list. 

Under present law, if a taxpayer claims that the total value of charitable contributions of 

noncash property is more than $500, the taxpayer must include with the taxpayer’s return a 

description of the property contributed and such other information as the Secretary may require 

in order to claim a charitable deduction (sec. 170(f)(11)(B)). This requirement presently is 

satisfied through completion by the taxpayer of the Form 8283 and attachment of the form to the 

taxpayer’s return. The proposal requires that the donor include the information about the 

contribution that is contained in the contemporaneous substantiation obtained from the donee 

organization (for gifts of $250 or more) as part of such requirement. 

Contributions of $100 or more

Under the proposal, the substantiation requirements that currently apply with respect to 

charitable contributions of $250 or more (sec. 170(f)(8)) apply to all charitable contributions 

with a value of $100 or more. 

Contributions of cash

In addition, in the case of a charitable contribution of money, regardless of the amount, 

applicable recordkeeping requirements are satisfied under the proposal only if the donor 

maintains a cancelled check or 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. The recordkeeping requirements may not be satisfied by maintaining other 

written records. 
74 

Effective Date

The proposal relating to clothing and household items is effective for contributions made 

after January 1, 2007. The proposal relating to substantiation more generally is effective for 

contributions made in taxable years beginning after the date of enactment. 

16. Contributions of fractional interests in tangible personal property 

Present Law

In general, a charitable deduction is not allowable for a contribution of a partial interest in 

property, such as an income interest, a remainder interest, or a right to use property.194 A gift of 

an undivided portion of a donor’s entire interest in property generally is not treated as a 

nondeductible gift of a partial interest in property.195 For this purpose, an undivided portion of a 

donor’s entire interest in property must consist of a fraction or percentage of each and every 

substantial interest or right owned by the donor in such property and must extend over the entire 

term of the donor’s interest in such property.196 A gift generally is treated as a gift of an 

undivided portion of a donor’s entire interest in property if the donee is given the right, as a 

tenant in common with the donor, to possession, dominion, and control of the property for a 

portion of each year appropriate to its interest in such property.197

Consistent with these requirements, a charitable contribution deduction generally is not 

allowable for a contribution of a future interest in tangible personal property.198 For this 

purpose, a future interest is one “in which a donor purports to give tangible personal property to 

a charitable organization, but has an understanding, arrangement, agreement, etc., whether 

written or oral, with the charitable organization which has the effect of reserving to, or retaining 

in, such donor a right to the use, possession, or enjoyment of the property.”199 Treasury 

regulations provide that section 170(a)(3), which generally denies a deduction for a contribution 

of a future interest in tangible personal property, "[has] no application in respect of a transfer of 

an undivided present interest in property. For example, a contribution of an undivided onequarter interest in a painting with respect to which the donee is entitled to possession during 

three months of each year shall be treated as made upon the receipt by the donee of a formally 

 194 Secs. 170(f)(3)(A) (income tax), 2055(e)(2) (estate tax), and 2522(c)(2) (gift tax). 

195 Sec. 170(f)(3)(B)(ii). 

196 Treas. Reg. sec. 1.170A-7(b)(1). 

197 Treas. Reg. sec. 1.170A-7(b)(1). 

198 Sec. 170(a)(3). 

199 Treas. Reg. sec. 1.170A-5(a)(4). 
75 

executed and acknowledged deed of gift. However, the period of initial possession by the donee 

may not be deferred in time for more than one year."200

Description of Proposal

Require consistent valuation of fractional interests in the same item of property

In general, under present law and the proposal a donor may take a deduction for a 

charitable contribution of a fractional interest in tangible personal property (such as an artwork), 

provided the donor satisfies the requirements for deductibility (including the requirements 

concerning contributions of partial interests and future interests in property), and in subsequent 

years make additional charitable contributions of interests in the same property.201 Under the 

proposal, a donor’s charitable deduction for the initial contribution of a fractional interest in an 

item of tangible personal property (or collection of such items) shall be determined as under 

current law (e.g., based upon the fair market value of the artwork at the time of the contribution 

of the fractional interest and considering whether the use of the artwork will be related to the 

donee’s exempt purposes). For purposes of determining the deductible amount of each 

additional contribution of an interest (whether or not a fractional interest) in the same item of 

property, under the proposal, the fair market value of the item shall be the lesser of: (1) the value 

used for purposes of determining the charitable deduction for the initial fractional contribution; 

or (2) the fair market value of the item at the time of the subsequent contribution. This portion of 

the proposal applies for income, gift, and estate tax purposes. 

Require actual possession by the donee

The proposal provides for recapture of the income tax charitable deduction or gift tax 

charitable deduction under certain circumstances. Specifically, if, during any one-year period 

following a contribution of a fractional interest in an item of tangible personal property, the 

donee fails to take actual possession of the item for a period of time corresponding substantially 

to the donee’s then-existing percentage interest in the item, then the donee’s charitable deduction 

for all previous contributions of interests in the item shall be recaptured (plus interest). 

Under the proposal, the Secretary of the Treasury is authorized to promulgate rules to 

prevent the circumvention of the proposal by, for example, engaging in a transaction in which a 

donor first transfers one or more items of tangible personal property to a separate entity in 

exchange for ownership interests in the entity, and subsequently makes charitable contributions 

of such ownership interests. 

Effective Date

The proposal is applicable for contributions made after the date of enactment. 

 200 Treas. Reg. sec. 1.170A-5(a)(2). 

201 See, e.g., Winokur v. Commissioner, 90 T.C. 733 (1988). 
76 

17. Provisions relating to substantial and gross overstatement of valuations of property 

Present Law

Taxpayer penalties

Present law imposes accuracy-related penalties on a taxpayer in cases involving a 

substantial valuation misstatement or gross valuation misstatement relating to an underpayment 

of income tax.202 For this purpose, a substantial valuation misstatement generally means a value 

claimed that is 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 is 20 percent of the underpayment of tax resulting from a substantial 

valuation misstatement and rises to 40 percent for a gross valuation misstatement. No penalty is 

imposed unless the portion of the underpayment attributable to the valuation misstatement 

exceeds $5,000 ($10,000 in the case of a corporation other than an S corporation or a personal 

holding company). Under present law, no penalty is 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. Special rules apply to tax shelters. 

In addition, the accuracy-related penalty does not apply if a taxpayer shows there was 

reasonable cause for an underpayment and the taxpayer acted in good faith.203

Penalty for aiding and abetting understatement of tax

A penalty is imposed on a person who: (1) aids or assists in or advises with respect to a 

tax return or other document; (2) knows (or has reason to believe) that such document will be 

used in connection with a material tax matter; and (3) knows that this would result in an 

understatement of tax of another person. In general, the amount of the penalty is $1,000. If the 

document relates to the tax return of a corporation, the amount of the penalty is $10,000. 

Qualified appraisals

Present law requires a taxpayer 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.204 Treasury 

Regulations state that a qualified appraisal means 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 

 202 Sec. 6662(b)(3) and (h). 

203 Sec. 6664(c). 

204 Sec. 170(f)(11). 
77 

contribution of the appraised property and not later than the due date (including extensions) of 

the return on which a deduction is first claimed under section 170; (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 such property on the date of contribution and the specific basis for the valuation; 

(c) a statement that such appraisal was prepared for income tax purposes; (d) the qualifications of 

the qualified appraiser; and (e) the signature and taxpayer identification number of such 

appraiser; and (4) does not involve an appraisal fee that violates certain prescribed rules.205 

Qualified appraisers

Treasury Regulations define a qualified appraiser a person who holds himself or herself 

out to the public as an appraiser or performs 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.206

Appraiser oversight

The Secretary is authorized to regulate the practice of representatives of persons before 

the Department of the Treasury (“Department”).207 After notice and hearing, the Secretary is 

authorized to suspend or disbar from practice before the Department or the Internal Revenue 

Service (“IRS”) a representative who is incompetent, who is disreputable, who violates the rules 

regulating practice before the Department or the IRS, or who (with intent to defraud) willfully 

and knowingly misleads or threatens the person being represented (or a person who may be 

represented). 

The Secretary also is authorized to bar from appearing before the Department or the IRS, 

for the purpose of offering opinion evidence on the value of property or other assets, any 

individual against whom a civil penalty for aiding and abetting the understatement of tax has 

been assessed. Thus, an appraiser who aids or assists in the preparation or presentation of an 

appraisal will be subject to disciplinary action if the appraiser knows that the appraisal will be 

used in connection with the tax laws and will result in an understatement of the tax liability of 

another person. The Secretary has authority to provide that the appraisals of an appraiser who 

has been disciplined have no probative effect in any administrative proceeding before the 

Department or the IRS. 

 205 Treas. Reg. sec. 1.170A-13(c)(3). 

206 Treas. Reg. sec. 1.170A-13(c)(5)(i). 

207 31 U.S.C. sec. 330. 
78 

Description of Proposal

Taxpayer penalties

The proposal lowers the thresholds for imposing accuracy-related penalties on a taxpayer 

who claims a deduction for donated property for which a qualified appraisal is required. Under 

the proposal, a substantial valuation misstatement exists when the claimed value of donated 

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 donated property is 200 percent or 

more the amount determined to be the correct value. Under the proposal, the reasonable cause 

exception to the accuracy-related penalty does not apply in the case of gross valuation 

misstatements. 

Appraiser oversight

Appraiser penalties 

The proposal establishes a civil penalty on any person who prepares an appraisal that is to 

be used to support a tax position if such 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. Under the proposal, the penalty does not 

apply if the appraiser establishes that it was “more likely than not” that the appraisal was correct. 

Disciplinary proceeding 

The proposal eliminates the requirement that the Secretary assess against an appraiser the 

civil penalty for aiding and abetting the understatement of tax before such appraiser may be 

subject to disciplinary action. Thus, the Secretary is authorized to discipline appraisers after 

notice and hearing. Disciplinary action may include, but is not limited to, suspending or barring 

an appraiser from: preparing or presenting appraisals on the value of property or other assets to 

the Department or the IRS; appearing before the Department or the IRS for the purpose of 

offering opinion evidence on the value of property or other assets; and providing that the 

appraisals of an appraiser who have been disciplined have no probative effect in any 

administrative proceeding before the Department or the IRS. 

Qualified appraisers

The proposal defines 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. 
79 

Qualified appraisals

The proposal defines a qualified appraisal as an appraisal of property prepared by a 

qualified appraiser (as defined by the proposal) in accordance with generally accepted appraisal 

standards and any regulations or other guidance prescribed by the Secretary. 

Effective Date

The proposal amending the accuracy-related penalty applies to returns filed after the date 

of enactment. The proposal establishing a civil penalty on any person who prepares an appraisal 

that is to be used to support a tax position if such appraisal results in a substantial or gross 

valuation misstatement applies to appraisals prepared with respect to returns filed after the date 

of enactment. The proposals relating to appraiser oversight apply to returns filed after the date of 

enactment. 

18. Expand the base of the tax on private foundation net investment income 

Present Law

In general

Under section 4940(a) of the Code, private foundations that are recognized as exempt 

from Federal income tax under section 501(a) of the Code are subject to a two-percent excise tax 

on their net investment income. Private foundations that are not exempt from tax, such as certain 

charitable trusts,208 also are subject to an excise tax under section 4940(b) based on net 

investment income and unrelated business income. The two-percent rate of tax is reduced to 

one-percent if certain requirements are met in a taxable year.209 Unlike certain other excise taxes 

imposed on private foundations, the tax based on investment income does not result from a 

violation of substantive law by the private foundation; it is solely an excise tax. 

The tax on taxable private foundations under section 4940(b) is equal to the excess of the 

sum of the excise tax that would have been imposed under section 4940(a) if the foundation were 

tax exempt and the amount of the unrelated business income tax that would have been imposed if 

the foundation were tax exempt, over the income tax imposed on the foundation under subtitle A 

of the Code. 

 208 See sec. 4947(a)(1). 

209 Sec. 4940(e). 
80 

Net investment income

Internal Revenue Code

In general, net investment income is defined as the amount by which the sum of gross 

investment income and capital gain net income exceeds the deductions relating to the production 

of gross investment income.210 

Gross investment income is the gross amount of income from interest, dividends, rents, 

payments with respect to securities loans, and royalties. Gross investment income does not 

include any income that is included in computing a foundation’s unrelated business taxable 

income.211 

Capital gain net income takes into account only gains and losses from the sale or other 

disposition of property used for the production of interest, dividends, rents, and royalties, and 

property used for the production of income included in computing the unrelated business income 

tax (except to the extent the gain or loss is taken into account for purposes of such tax). Losses 

from sales or other dispositions of property are allowed only to the extent of gains from such 

sales or other dispositions, and no capital loss carryovers are allowed.212

Treasury Regulations and case law

The Treasury regulations elaborate on the Code definition of net investment income. The 

regulations cite items of investment income listed in the Code, and in addition clarify that net 

investment income includes interest, dividends, rents, and royalties derived from all sources, 

including from assets devoted to charitable activities. For example, interest received on a student 

loan is includible in the gross investment income of a foundation making the loan.213 

The regulations further provide that gross investment income includes certain items of 

investment income that are described in the unrelated business income tax regulations.214 Such 

additional items include payments with respect to securities loans (an item added to the Code in 

1978), annuities, income from notional principal contracts, and other substantially similar 

income from ordinary and routine investments to the extent determined by the Commissioner.215 

These latter three categories of income are not enumerated as net investment income in the Code. 

 210 Sec. 4940(c)(1). Net investment income also is determined by applying section 103 

(generally providing an exclusion for interest on certain State and local bonds) and section 265 (generally 

disallowing the deduction for interest and certain other expenses with respect to tax-exempt income). 

Sec. 4940(c)(5). 

211 Sec. 4940(c)(2). 

212 Sec. 4940(c)(4). 

213 Treas. Reg. sec. 53.4940-1(d)(1). 

214 Id. 

215 Treas. Reg. sec. 1.512(b)-1(a)(1). 
81 

The Treasury regulations also elaborate on the Code definition of capital gain net income. 

The regulations provide that the only capital gains and losses that are taken into account are (1) 

gains and losses from the sale or other disposition of property held by a private foundation for 

investment purposes (other than program related investments), and (2) property used for the 

production of income included in computing the unrelated business income tax (except to the 

extent the gain or loss is taken into account for purposes of such tax). 

This definition of capital gain net income builds on the definition provided in the Code 

by providing an exception for gain and loss from program related investments and by stating, in 

addition, that “gains and losses from the sale or other disposition of property used for the exempt 

purposes of the private foundation are excluded.”216 As an example, the regulations provide that 

gain or loss on the sale of buildings used for the foundation’s exempt activities are not taken into 

account for purposes of the section 4940 tax. If a foundation uses exempt income for exempt 

purposes and (other than incidentally) for investment purposes, then the portion of the gain or 

loss received upon sale or other disposition that is allocable to the investment use is taken into 

account for purposes of the tax. 

The regulations further provide that “property shall be treated as held for investment 

purposes even though such property is disposed of by the foundation immediately upon its 

receipt, if it is property of a type which generally produces interest, dividends, rents, royalties, or 

capital gains through appreciation (for example, rental real estate, stock, bonds, mineral interest, 

mortgages, and securities).”217 

This regulation has been challenged in the courts. The regulation says that property is 

treated as held for investment purposes if it is of a type that “generally produces” certain types of 

income. By contrast, the Code provides that the property be “used” to produce such income. In 

Zemurray Foundation v. United States, 687 F.2d 97 (5th Cir. 1982), the taxpayer foundation 

challenged the Treasury’s attempt to tax under section 4940 capital gain on the sale of timber 

property. The taxpayer asserted that the property was not actually used to produce investment 

income, and that the Treasury Regulation was invalid because the regulation would subject to tax 

property that is of a type that could generally be used to produce investment income. On this 

issue, the court upheld the Treasury regulation, reasoning that the regulation’s use of the phrase 

“generally used,” though permitting taxation “so long as the property sold is usable to produce 

the applicable types of income, regardless of whether the property is actually used to produce 

income or not” was not unreasonable or plainly inconsistent with the statute.218 However, on 

remand to the district court, the district court concluded that the timber property at issue, though 

a type of property generally used to produce investment income, was not susceptible for such 

use.219 Thus, the district court concluded that the Treasury could not tax the gain under this 

portion of the regulation. 

 216 Treas. Reg. sec. 53.4940-1(f)(1). 

217 Id. 

218 Zemurray Foundation v. United States, 687 F.2d 97, 100 (5th Cir. 1982). 

219 Zemurray Foundation v. United States, 53 A.F.T.R. 2d (RIA) 842 (E. D. La. 1983). 
82 

The question then turned to the taxpayer’s second challenge to the regulation. At issue 

was the meaning of the regulatory phrase “capital gains through appreciation.” The regulation 

provides that if property is of a type that generally produces capital gains through appreciation, 

then the gain is subject to tax. The Treasury argued that the timber property at issue, although 

held by the court not to be property (in this case) susceptible for use to produce interest, 

dividends, rents, or royalties, still was held by the taxpayer to produce capital gain through 

appreciation and therefore the gain should be subject to tax under the regulation. 

On this issue, the court held for the taxpayer, reasoning that the language of the Code 

clearly is limited to certain gains and losses, e.g., the court cited the Code language providing 

that “there shall be taken into account only gains and losses from the sale or other disposition of 

property used for the production of interest, dividends, rents, and royalties . . . .”220 The court 

noted that “capital gains through appreciation” is not enumerated in the statute. The court used 

as an example a jade figurine held by a foundation. Jade figurines do not generally produce 

interest, dividends, rents, or royalties, but gain on the sale of such a figurine would be taxable 

under the “capital gains through appreciation” standard, yet such standard does not appear in the 

statute. After Zemurray, the Treasury generally conceded this issue.221

With respect to capital losses, the Code provides that carryovers are not permitted, 

whereas the regulations state that neither carryovers nor carrybacks are permitted.222

Application of Zemurray to the Code and the regulations

Applying the Zemurray case to the Code and regulations results in a general principle for 

purposes of present law: private foundations are subject to tax under section 4940 only on the 

items of income and only on gains and losses specifically enumerated therein. Under this 

principle, private foundations generally are not subject to the section 4940 tax on other 

substantially similar types of income from ordinary and routine investments, notwithstanding 

Treasury regulations to the contrary. In addition, the regulations provide that gain or loss from 

the sale or other disposition of assets used for exempt purposes, with specific reference to 

program-related investments, is excluded. The Code provides for no such blanket exclusion; 

thus, under the language of the Code and the reasoning of Zemurray, if a foundation provided 

office space at below market rent to a charitable organization for use in the organization’s 

exempt purposes, gain on the sale of the building by the foundation should be subject to the 

section 4940 tax despite the Treasury regulations.223 

 220 Zemurray Foundation v. United States, 755 F.2d 404 (5th Cir. 1985), 413 (citing Code sec. 

4940(c)(4)(A). 

221 G.C.M. 39538 (July 23, 1986). 

222 Treas. Reg. sec. 53.4940-1(f)(3). 

223 See also the example in Treas. Reg. sec. 53.4940-1(f)(1). 
83 

In addition, under the logic of Zemurray, capital loss carrybacks arguably are permitted, 

notwithstanding Treasury regulations to the contrary, because the Code mentions only a bar on 

use of carryovers and says nothing about carrybacks. 

Description of Proposal

The proposal amends the definition of gross investment income to include certain items 

of income not presently enumerated in the Code but identified in Treasury regulations, namely, 

income from notional principal contracts, annuities, and other substantially similar income from 

ordinary and routine investments. In addition, the capital gains and losses subject to the tax are 

modified to include capital gains from appreciation, including capital gains and losses from the 

sale or other disposition of assets used to further an exempt purpose. 

The proposal provides that there are no carrybacks of losses from sales or other 

dispositions of property. 

Effective Date

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

19. Establish additional exemption standards for credit counseling organizations 

Present Law

Under present law, a credit counseling organization may be exempt as a charitable or 

educational organization described in section 501(c)(3), or as a social welfare organization 

described in section 501(c)(4). The IRS has issued two revenue rulings holding that certain 

credit counseling organizations are exempt as charitable or educational organizations or as social 

welfare organizations. 

In Revenue Ruling 65-299,224 an organization whose purpose was to assist families and 

individuals with financial problems, and help reduce the incidence of personal bankruptcy, was 

determined to be a social welfare organization described in section 501(c)(4). The organization 

counseled people in financial difficulties, advised applicants on payment of debts, and negotiated 

with creditors and set up debt repayment plans. The organization did not restrict its services to 

the poor, made no charge for counseling services, and made a nominal charge for certain services 

to cover postage and supplies. For financial support, the organization relied on voluntary 

contributions from local businesses, lending agencies, and labor unions. 

In Revenue Ruling 69-441,225 the IRS ruled an organization was a charitable or 

educational organization exempt under section 501(c)(3) by virtue of aiding low-income people 

who had financial problems and providing education to the public. The organization in that 

 224 Rev. Rul. 65-299, 1965-2 C.B. 165. 

225 Rev. Rul. 69-441, 1969-2 C.B. 115. 
84 

ruling had two functions: (1) educating the public on personal money management, such as 

budgeting, buying practices, and the sound use of consumer credit through the use of films, 

speakers, and publications; and (2) providing individual counseling to low-income individuals 

and families without charge. As part of its counseling activities, the organization established 

debt management plans for clients who required such services, at no charge to the clients.226 The 

organization was supported by contributions primarily from creditors, and its board of directors 

was comprised of representatives from religious organizations, civic groups, labor unions, 

business groups, and educational institutions. 

In 1976, the IRS denied exempt status to an organization, Consumer Credit Counseling 

Service of Alabama, whose activities were distinguishable from those in Revenue Ruling 69-441 

in that (1) it did not restrict its services to the poor, and (2) it charged a nominal fee for its debt 

management plans.227 The organization provided free information to the general public through 

the use of speakers, films, and publications on the subjects of budgeting, buying practices, and 

the use of consumer credit. It also provided counseling to debt-distressed individuals, not 

necessarily poor or low-income, and provided debt management plans at the cost of $10 per 

month, which was waived in cases of financial hardship. Its debt management activities were a 

relatively small part of its overall activities. The district court determined the organization 

qualified as charitable and educational within section 501(c)(3), finding the debt management 

plans to be an integral part of the agency’s counseling function, and that its debt management 

activities were incidental to its principal functions, as only approximately 12 percent of the 

counselors’ time was applied to such programs and the charge for the service was nominal. The 

court also considered the facts that the agency was publicly supported, and that it had a board 

dominated by members of the general public, as factors indicating a charitable operation.228 

A recent estimate shows the number of credit counseling organizations increased from 

approximately 200 in 1990 to over 1,000 in 2002.229 During the period from 1994 to late 2003, 

1,215 credit counseling organizations applied to the IRS for tax exempt status under section 

501(c)(3), including 810 during 2000 to 2003.230 The IRS has recognized more than 850 credit 

 226 Debt management plans are debt payment arrangements, including debt consolidation 

arrangements, entered into by a debtor and one or more of the debtor’s creditors, generally structured to 

reduce the amount of a debtor’s regular ongoing payment by modifying the interest rate, minimum 

payment, maturity or other terms of the debt. Such plans frequently are promoted as a means for a debtor 

to restructure debt without filing for bankruptcy. 

227 Consumer Credit Counseling Service of Alabama, Inc. v. U.S., 44 A.F.T.R. 2d (RIA) 5122 

(D.D.C. 1978). The case involved 24 agencies throughout the United States. 

228 See also, Credit Counseling Centers of Oklahoma, Inc., v. U.S., 45 A.F.T.R. 2d (RIA) 1401 

(D.D.C. 1979) (holding the same on virtually identical facts). 

229 Opening Statement of The Honorable Max Sandlin, Hearing on Non-Profit Credit Counseling 

Organizations, House Ways and Means Committee, Subcommittee on Oversight (November 20, 2003). 

230 United States Senate Permanent Subcommittee on Investigations, Committee on 

Governmental Affairs, Profiteering in a Non-Profit Industry: Abusive Practices in Credit Counseling, 
85 

counseling organizations as tax exempt under section 501c)((3).231 Few credit counseling 

organizations have sought section 501(c)(4) status, and the IRS reports it has not seen any 

significant increase in the number or activity of such organizations operating as social welfare 

organizations.232 As of late 2003, there were 872 active tax-exempt credit counseling agencies 

operating in the United States.233 

A credit counseling organization described in section 501(c)(3) is exempt from certain 

Federal and State consumer protection laws that provide exemptions for organizations described 

therein.234 Some believe that these exclusions from Federal and State regulation may be a 

primary motivation for the recent increase in the number of organizations seeking and obtaining 

exempt status under section 501(c)(3).235 Such regulatory exemptions generally are not available 

for social welfare organizations described in section 501(c)(4). 

Congress recently conducted hearings investigating the activities of credit counseling 

organizations under various consumer protection laws,236 such as the Federal Trade Commission 

 

Report Prepared by the Majority & Minority Staffs of the Permanent Subcommittee on Investigations and 

Released in Conjunction with the Permanent Subcommittee Investigations’ Hearing on March 24, 2004, 

p. 3 (citing letter dated December 18, 2003, to the Subcommittee from IRS Commissioner Everson). 

231 Testimony of Commissioner Mark Everson before the House Ways and Means Committee, 

Subcommittee on Oversight (November 20, 2003). 

232 Testimony of Commissioner Mark Everson before the House Ways and Means Committee, 

Subcommittee on Oversight (November 20, 2003). 

233 United States Senate Permanent Subcommittee on Investigations, Committee on 

Governmental Affairs, Profiteering in a Non-Profit Industry: Abusive Practices in Credit Counseling, 

Report Prepared by the Majority & Minority Staffs of the Permanent Subcommittee on Investigations and 

Released in Conjunction with the Permanent Subcommittee Investigations’ Hearing on March 24, 2004, 

p. 3 (citing letter dated December 18, 2003 to the Subcommittee from IRS Commissioner Everson). 

234 E.g., The Credit Repair Organizations Act, 15 U.S.C. section 1679 et seq., effective April 1, 

1997 (imposing restrictions on credit repair organizations that are enforced by the Federal Trade 

Commission, including forbidding the making of untrue or misleading statements and forbidding advance 

payments; section 501(c)(3) organizations are explicitly exempt from such regulation). Testimony of 

Commissioner Mark Everson before the House Ways and Means Committee, Subcommittee on Oversight 

(November 20, 2003) (California’s consumer protections laws that impose strict standards on credit 

service organizations and the credit repair industry do not apply to nonprofit organizations that have 

received a final determination from the IRS that they are exempt from tax under section 501(c)(3) and are 

not private foundations). 

235 Testimony of Commissioner Mark Everson before the House Ways and Means Committee, 

Subcommittee on Oversight (November 20, 2003). 

236 United States Senate Permanent Subcommittee on Investigations, Committee on 

Governmental Affairs, Profiteering in a Non-Profit Industry: Abusive Practices in Credit Counseling, 

Report Prepared by the Majority & Minority Staffs of the Permanent Subcommittee on Investigations and 

Released in Conjunction with the Permanent Subcommittee Investigations’ Hearing on March 24, 2004. 
86 

Act.237 In addition, the IRS has commenced a broad examination and compliance program with 

respect to the credit counseling industry, pursuant to which the IRS has initiated audits of 50 

credit counseling organizations, including nine of the 15 largest in terms of gross receipts.238 

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, an 

individual generally may not be a debtor in bankruptcy unless such individual has, within 180 

days of filing a petition for bankruptcy, received from an approved nonprofit budget and credit 

counseling agency an individual or group briefing that outlines the opportunities for available 

credit counseling and assists the individual in performing a related budget analysis.239 The clerk 

of the court must maintain a publicly available list of nonprofit budget and credit counseling 

agencies approved by the U.S. Trustee (or bankruptcy administrator). In general, the U.S. 

Trustee (or bankruptcy administrator) shall only approve an agency that demonstrates that it will 

provide qualified counselors, maintain adequate provision for safekeeping and payment of client 

funds, provide adequate counseling with respect to client credit problems, and deal responsibly 

and effectively with other matters relating to the quality, effectiveness, and financial security of 

the services it provides. The minimum qualifications for approval of such an agency include: 

(1) in general, having an independent board of directors; (2) charging no more than a reasonable 

fee, and providing services without regard to ability to pay; (3) adequate provision for 

safekeeping and payment of client funds; (4) provision of full disclosures to clients; (5) provision 

of adequate counseling with respect to a client’s credit problems; (6) trained counselors who 

receive no commissions or bonuses based on the outcome of the counseling services; (7) 

experience and background in providing credit counseling; and (8) adequate financial resources 

to provide continuing support services for budgeting plans over the life of any repayment plan. 

An individual debtor must file with the court a certificate from the approved nonprofit budget 

 237 15 U.S.C. sec. 45(a) (prohibiting unfair and deceptive acts or practices in or affecting 

commerce; although the Federal Trade Commission generally lacks jurisdiction to enforce consumer 

protection laws against bona fide nonprofit organizations, it may assert jurisdiction over a nonprofit, 

including a credit counseling organization, if it demonstrates the organization is organized to carry on 

business for profit, is a mere instrumentality of a for-profit entity, or operates through a common 

enterprise with one or more for-profit entities). 

238 United States Senate Permanent Subcommittee on Investigations, Committee on 

Governmental Affairs, Profiteering in a Non-Profit Industry: Abusive Practices in Credit Counseling, 

Report Prepared by the Majority & Minority Staffs of the Permanent Subcommittee on Investigations and 

Released in Conjunction with the Permanent Subcommittee Investigations’ Hearing on March 24, 2004, 

p. 31. 

239 This requirement does not apply in certain circumstances, such as: (1) in general, where a 

debtor resides in a district for which the U.S. Trustee has determined that the approved counseling 

agencies for such district are not reasonably able to provide adequate services to additional individuals; 

(2) where exigent circumstances merit a waiver, the individual seeking bankruptcy protection files an 

appropriate certification with the court, and the certification is acceptable to the court; and (3) in general, 

where a court determines, after notice and hearing, that the individual is unable to complete the 

requirement because of incapacity, disability, or active military duty in a military combat zone. 
87 

and credit counseling agency that provided the required services describing the services 

provided, and a copy of the debt management plan, if any, developed through the agency.240

Description of Proposal

Requirements for exempt status of credit counseling organizations

Under the proposal, an organization that provides credit counseling services as a 

substantial purpose of the organization (“credit counseling organization”) is eligible for 

exemption from Federal income tax only as a charitable or educational organization under 

section 501(c)(3) or as a social welfare organization under section 501(c)(4), and only if (in 

addition to present-law requirements) the credit counseling organization is organized and 

operated in accordance with the following: 

1. The organization provides credit counseling services tailored to the specific needs and 

circumstances of the consumer. 

2. The organization makes no loans to debtors and does not negotiate the making of loans 

on behalf of debtors, 

3. The organization is generally does not provide or promote any service for the purpose of 

(a) improving any consumer’s credit record, credit history, or credit rating; 

4. The organization does not refuse to provide credit counseling services to a consumer due 

to inability of the consumer to pay, the ineligibility of the consumer for debt management 

plan enrollment, or the unwillingness of a consumer to enroll in a debt management plan; 

5. The organization establishes and implements a fee policy to require that any fees charged 

to a consumer for its services are reasonable, and prohibits charging any fee based in 

whole or in part on a percentage of the consumer’s debt, the consumer’s payments to be 

made pursuant to a debt management plan, or on projected or actual savings to the 

consumer resulting from enrolling in a debt management plan; 

6. The organization at all times has a board of directors or other governing body (a) that is 

controlled by persons who represent the broad interests of the public, such as public 

officials acting in their capacities as such, persons having special knowledge or expertise 

in credit or financial education, and community leaders; (b) not more than 20 percent of 

the voting power of which is vested in persons who are employed by the organization or 

who will benefit financially, directly or indirectly, from the agency’s activities (other than 

through the receipt of reasonable directors’ fees or the repayment of consumer debt to 

creditors other than the credit counseling agency or its affiliates) and (c) not more than 

49% of the voting power of which is vested in persons who are employed by the 

 240 The Act also requires that, prior to discharge of indebtedness under chapter 7 or chapter 13, a 

debtor complete an approved instructional course concerning personal financial management, which 

course need not be conducted by a nonprofit agency. 
88 

organization or who will benefit financially, directly or indirectly, from the agency’s 

activities (other than through the receipt of reasonable directors’ fees); 

7. The organization receives no amount for providing referrals to others for financial 

services (including debt management services) to be provided to consumers, and pays no 

amount to others for obtaining referrals of consumers; and 

8. The organization is not related to an organization in the business of credit repair, to a 

person that is in the business of lending money, or to a person that provides debt 

management plan services, payment processing, and similar services. Additional 

requirements for charitable or educational organizations. 

Additional requirements for charitable and educational organizations

Under the proposal, a credit counseling organization is described in section 501(c)(3) 

only if, in addition to satisfying the above requirements, the organization is organized and 

operated such that the organization (1) charges no fees (other than nominal fees) for debt 

management plan services and waives any fees if payment of such fees would work a financial 

hardship; (2) does not solicit contributions from consumers during the initial counseling process 

or while the consumer is receiving services from the organization; (3) normally limits debt 

management plan services (in the aggregate) to 25 percent of the organization’s total activities 

(determined by taking into account time, resources, source of revenues or effort expended by the 

organization, and any other measures prescribed by the Secretary).241 The 25-percent limit shall 

be applied with regard only to the activities of the credit counseling organization, and without 

regard to the activities of any affiliates, separately organized entities, or entities that, together 

with the credit counseling organization, are covered by a group exemption determination letter. 

The Secretary is authorized to promulgate rules designed to prevent circumvention of this 

requirement. 

Additional requirements for social welfare organizations

Under the proposal, a credit counseling organization is described in section 501(c)(4) 

only if, in addition to satisfying the above requirements applicable to such organizations, it is 

organized and operated such that the organization charges no fees (other than nominal fees) for 

its credit counseling services, and waives any fees if payment of such fees would work a 

financial hardship. In addition, a credit counseling organization shall not be treated as an 

organization described in section 501(c)(4) unless such organization applies for recognition of 

exempt status under procedures similar to those described in section 508(a) (applicable to section 

501(c)(3) organizations). 

 241 If, under any such measure, the organization’s debt management plan services exceed 25 

percent of the organization’s total activities, the organization is treated as exceeding the 25-percent limit. 

For example, an organization that devotes 30 percent of its total staff time to debt management plan 

services is regarded as exceeding the 25-percent limit, even if the organization devotes less than 15 

percent of its total financial resources to debt management plan services. 
89 

Debt management plan services treated as an unrelated trade or business

Under the proposal, debt management plan services as treated as an unrelated trade or 

business for purposes of the tax on income from an unrelated trade or business to the extent such 

services are not substantially related to the provision of credit counseling services to a consumer 

or are provided by an organization that is not a credit counseling organization. 

Definitions

Credit counseling services

Credit counseling services are (a) the providing educational information to the general 

public on budgeting, personal finance, financial literacy, saving and spending practices, and the 

sound use of consumer credit; (b) the assisting of individuals and families with financial 

problems by providing them with counseling; or (c) any combination of such activities. 

Debt management plan services

Debt management plan services are services related to the repayment, consolidation, or 

restructuring of a consumer’s debt, and includes the negotiation with creditors of lower interest 

rates, the waiver or reduction of fees, and the marketing and processing of debt management 

plans. 

Credit repair organization

A credit repair organization is one defined in section 403(3) of the Consumer Credit 

Protection Act, 15 U.S.C. 1679a(3), without regard to subparagraph (B) thereof. 

Related person

A person is treated as related to another person if such person bears a relationship to such 

other person described in section 4958(f)(1)(B), section 4958(f)(1)(C), or section 

4946(a)(1)(H)(i). 

Effective Date

For organizations that are not described in section 501(c)(3) or section 501(c)(4) prior to 

the date of enactment or that are so described but did not provide credit counseling services prior 

to such date, the proposal is effective for taxable years beginning after the date of enactment. 

For organizations described in section 501(c)(3) or 501(c)(4) prior to the date of enactment that 

provided credit counseling services prior to such date, the proposal is effective for taxable years 

beginning 1 year after the date of enactment. The Secretary has authority to request information 

from an organization providing credit counseling services to ensure that the organization is in 

compliance with the proposal. 
90 

20. Impose loan and redemption requirements on pooled financing bonds 

Present Law

In general

Interest on bonds issued by State and local governments generally is excluded from gross 

income for Federal income tax purposes if the proceeds of such bonds are used to finance direct 

activities of governmental units or if such bonds are repaid with revenues of governmental units. 

These bonds are called “governmental bonds.” Interest on State or local government bonds 

issued to finance certain activities of private persons is taxable unless a specific exception 

applies. These bonds are called “private activity bonds.” The exclusion from income for State 

and local bonds does not apply to private activity bonds, unless the bonds are issued for certain 

permitted purposes. In addition, the Code imposes requirements that apply to all tax-exempt 

State and local bonds. Arbitrage restrictions, for example, limit the ability of issuers to profit 

from investment of tax-exempt bond proceeds. The Code also imposes requirements that only 

apply to specific types of bond issues. For instance, pooled financing bonds (defined below) are 

not tax-exempt unless the issuer meets certain requirements regarding the expected use of 

proceeds. 

Pooled financing bond restrictions

At times, State or local bonds are issued to provide financing for the benefit of a third 

party (a “conduit borrower”). Pooled financing bonds are issues in which the proceeds are used 

to make or finance loans to two or more conduit borrowers, unless the conduit loans are to be 

used to finance a single project.242 The Code imposes several requirements on pooled financing 

bonds if more than $5 million of proceeds are expected to be used to make loans to conduit 

borrowers. For purposes of these rules, a pooled financing bond does not include certain private 

activity bonds.243

A pooled financing bond is not tax-exempt unless the issuer reasonably expects that at 

least 95 percent of the net proceeds will be lent to ultimate borrowers by the end of the third year 

after the date of issue. The term “net proceeds” is defined to mean the proceeds of the issue less 

the following amounts: (1) proceeds used to finance issuance costs; (2) proceeds necessary to 

pay interest on the bonds during a three-year period; and (3) amounts in reasonably required 

reserves.244

An issuer’s past experience regarding loan origination is a criterion upon which the 

reasonableness of the issuer’s expectations can be based. As an additional requirement for tax 

exemption, all legal and underwriting costs associated with the issuance of pooled financing 

 242 Treas. Reg. sec. 1.150-1(b). 

243 Sec. 149(f)(4)(B). 

244 Sec. 149(f)(2)(C). 
91 

bonds may not be contingent and must be substantially paid within 180 days of the date of 

issuance. 

Arbitrage restrictions on tax-exempt bonds 

To prevent the issuance of more Federally subsidized tax-exempt bonds than necessary; 

the tax exemption for State and local bonds does not apply to any arbitrage bond.245 An arbitrage 

bond is defined as any bond that is part of an issue if any proceeds of the issue are reasonably 

expected to be used (or intentionally are used) to acquire higher yielding investments or to 

replace funds that are used to acquire higher yielding investments. In general, arbitrage profits 

may be earned only during specified periods (e.g., defined “temporary periods”) before funds are 

needed for the purpose of the borrowing or on specified types of investments (e.g., “reasonably 

required reserve or replacement funds”). Subject to limited exceptions, investment profits that 

are earned during these periods or on such investments must be rebated to the Federal 

Government (“arbitrage rebate”). 

The Code contains several exceptions to the arbitrage rebate requirement, including an 

exception for bonds issued by small governments (the “small issuer exception”). For this 

purpose, small governments are defined as general purpose governmental units that issue no 

more than $5 million of tax-exempt governmental bonds in a calendar year.246

Pooled financing bonds are subject to the arbitrage restrictions that apply to all taxexempt bonds, including arbitrage rebate. Under certain circumstances, however, small 

governments may issue pooled financing bonds without those bonds counting towards the 

determination of whether the issuer qualifies for the small issuer exception to arbitrage rebate. In 

the case of a pooled financing bond where the ultimate borrowers are governmental units with 

general taxing powers not subordinate to the issuer of the pooled bond, the pooled bond does not 

count against the issuer’s $5 million limitation, provided the issuer is not a borrower from the 

pooled bond.247 However, the issuer of the pooled financing bond remains subject to the 

arbitrage rebate requirement for unloaned proceeds.248

Description of Proposal

In general

The proposal imposes new requirements on pooled financing bonds as a condition of taxexemption. First, the proposal imposes a written loan commitment requirement to restrict the 

issuance of pooled bonds where potential borrowers have not been identified (“blind pools”). 

Second, in addition to the current three-year expectations requirement, the issuer must 

 245 Secs. 103(a) and (b)(2). 

246 The $5 million limit is increased to $15 million if at least $10 million of the bonds are used to 

finance public schools. 

247 Sec. 148(f)(4)(D)(ii)(II). 

248 Treas. Reg. sec. 1.148-8(d)(1). 
92 

reasonably expect that at least 50 percent of the net proceeds of the pooled financing bond will 

be lent to borrowers one year after the date of issue. Third, the proposal requires the redemption 

of outstanding bonds with proceeds that are not loaned to borrowers within the expected loan 

origination periods. Finally, the proposal eliminates the rule allowing an issuer of pooled 

financing bonds to disregard the pooled financing bonds for purposes of determining whether the 

issuer qualifies for the small issuer exception to rebate. 

Loan commitments

Under the proposal, interest on a pooled financing bond is tax exempt only if the issuer 

obtains written commitments with ultimate borrowers for loans equal to at least 50 percent of the 

net proceeds of the pooled bond prior to issuance. For purposes of the proposal, a loan 

commitment exists only if: (a) the issuer is committed to lend bond proceeds to the borrower 

identified in the commitment, and (b) the borrower has applied for, and agreed to execute, a loan 

in an amount certain to finance a specifically identified project and, as part of that application, 

has paid a nonrefundable commitment fee in an amount that is commensurate with fees 

customarily paid for similar loan commitments. 

The loan commitment requirement does not apply to bonds issued by States (or an 

integral part of a State) to provide loans to subordinate governmental units or State entities 

created to provide financing for water-infrastructure projects through the Federally-sponsored 

State Revolving Fund Program. 

Loan origination expectations

The proposal imposes new reasonable expectations requirements for loan originations. 

The issuer must expect that at least 50 percent of the net proceeds of the pooled financing bond 

will be lent to ultimate borrowers one year after the date of issue. This is in addition to the 

present-law requirement that at least 95 percent of the net proceeds will be lent to ultimate 

borrowers by the end of the third year after the date of issue. 

Redemption requirement 

Under the proposal, if bond proceeds are not loaned to borrowers within prescribed 

periods, outstanding bonds equal to the amount of proceeds that were not loaned within the 

required period must be redeemed within 90 days. The bond redemption requirement applies 

with respect to proceeds that are unloaned as of expiration of the one-year and three-year loan 

origination periods. For example, if an amount equal to 45 percent of the net proceeds of an 

issue are used to make loans to ultimate borrowers as of one year after the bonds are issued, an 

amount equal to five percent of the net proceeds of the issue is no longer available for lending 

and must be used to redeem bonds within the following 90-day period. Similarly, if only 85 

percent of the net proceeds of the issue are used to make qualifying loans (or to redeem bonds) as 

of three years after the bonds are issued, 10 percent of the remaining net proceeds is no longer 

available for lending and must be used to redeem bonds within the following 90-day period. 
93 

Small issuer exception

The proposal eliminates the rule disregarding pooled financing bonds from the issuer’s 

$5,000,000 annual limitation for purposes of the small issuer exception to arbitrage rebate. 

Effective Date

The proposal is effective for bonds issued after the date of enactment. 

21. Amend information reporting requirements to include interest on tax-exempt bonds 

Present Law

Tax-exempt bonds

Generally, gross income does not include interest on State or local bonds. State and local 

bonds are classified generally as either governmental bonds or private activity bonds. 

Governmental bonds are bonds the proceeds of which are primarily used to finance 

governmental facilities or the debt is repaid with governmental funds. Private activity bonds are 

bonds in which the State or local government serves as a conduit providing financing to 

nongovernmental persons (e.g., private businesses or individuals). The exclusion from income 

for State and local bonds does not apply to private activity bonds, unless the bonds are issued for 

certain purposes (“qualified private activity bonds”) permitted by the Code. 

Tax-exempt interest reporting by taxpayers

The Code provides that every person required to file a return must report the amount of 

tax-exempt interest received or accrued during any taxable year. The amount of tax-exempt 

interest received is relevant to determining tax liability in a number of instances, despite the 

general exclusion from income. For example, the interest income from qualified private activity 

bonds (other than qualified 501(c)(3) bonds) issued after August 7, 1986, is a preference item for 

purposes of calculating the alternative minimum tax (“AMT”).249 Tax-exempt interest also is 

relevant for determining eligibility for the earned income credit (the “EIC”) and the amount of 

Social Security benefits includable in gross income. Moreover, determining includable Social 

Security benefits is necessary for calculating either adjusted or modified adjusted gross income 

under several Code sections. 

Information reporting by payors

The Code generally requires every person who makes payments of interest aggregating 

$10 or more or receives payments of interest as a nominee and who makes payments aggregating 

$10 or more to file an information return setting forth the amount of interest payments for the 

 249 Sec. 57(a)(5). Special rules apply to exclude refundings of bonds issued before August 8, 

1986, and certain bonds issued before September 1, 1986. 
94 

calendar year and the name, address, and TIN250 of the person to whom interest is paid. Treasury 

regulations prescribe the form and manner for filing interest payment information returns. 

Treasury regulations require the reporting of the account or serial number, or other identifying 

information with respect to obligations on which interest is paid. The regulations also require 

that every person acting as a middleman (e.g., a broker) file information returns for the calendar 

year. Penalties are imposed for failures to file interest payment information returns or payee 

statements. Treasury regulations also impose recordkeeping requirements on any person 

required to file information returns. The Code excludes interest paid on tax-exempt bonds from 

interest reporting requirements.251

Description of Proposal

Under the proposal, interest paid on tax-exempt bonds is subject to information reporting 

in the same manner as interest paid on taxable obligations. 

Effective Date

The proposal is effective for interest paid after December 31, 2005. 

22. Modification of credit for fuel from a non-conventional source 

Present Law

Certain fuels produced from “non-conventional sources” and sold to unrelated parties are 

eligible for an income tax credit equal to $3 (generally adjusted for inflation)252 per barrel or Btu 

oil barrel equivalent (“non-conventional source fuel credit”). Qualified fuels must be produced 

within the United States. 

Qualified fuels include: 

• oil produced from shale and tar sands; 

• gas produced from geopressured brine, Devonian shale, coal seams, tight formations, 

or biomass; and 

• liquid, gaseous, or solid synthetic fuels produced from coal (including lignite). 

Generally, the non-conventional source fuel credit has expired, except for certain biomass 

gas and synthetic fuels sold before January 1, 2008, and produced at facilities placed in service 

 250 The taxpayer’s identification number, generally, for individuals is the taxpayer’s social 

security number. Sec. 7701(a)(41). 

251 Sec. 6049(b)(2)(B). 

252 Generally, the value of the credit in 2004 was $6.56 per barrel-of-oil equivalent produced, 

which is approximately $1.16 per thousand cubic feet of natural gas. The credit for coke or coke gas is 

indexed for inflation using 2004 as the base year instead of 1979. 
95 

after December 31, 1992, and before July 1, 1998. The non-conventional source fuel credit 

provision also includes a credit for producing coke or coke gas at qualified facilities. The 

amount of credit-eligible coke produced at any one facility may not exceed an average barrel-ofoil equivalent of 4,000 barrels per day. 

The non-conventional source fuel credit is reduced (but not below zero) over a $6 phaseout period as the reference price for oil exceeds $23.50 per barrel, adjusted for inflation. The 

reference price is the Secretary’s estimate of the annual average wellhead price per barrel for all 

domestic crude oil. The credit did not phase-out for 2004 because the reference price for that 

year of $36.75 did not exceed the inflation adjusted threshold of $51.35. 

Beginning with taxable years ending after December 31, 2005, the non-conventional 

source fuel credit is part of the general business credit (sec. 38). 

Description of Proposal

The proposal modifies the manner in which the phase-out of the non-conventional source 

fuel credit is calculated. Specifically, in calculating the phase-out of the credit rather than 

relying upon the reference price for the calendar year in which the sale of qualified nonconventional fuel occurs, the proposal uses the reference price for the calendar year preceding 

the calendar year in which the sale occurs. Thus, under the proposal, whether the credit is 

phased out in 2005 is determined by reference to 2004 wellhead prices, whether the credit is 

phased out in 2006 is determined by reference to 2005 wellhead prices, and so on. In addition, 

the proposal repeals the phase-out limitation entirely for coke and coke gas produced under 

section 45K(g). 

The proposal eliminates the inflation adjustment for all fuels other than coke and coke 

gas for 2005, 2006, and 2007. Thus, the current credit amount of $6.56 per barrel of oil 

equivalent will remain in effect through the December 31, 2007. Under the proposal, the credit 

amount of $3 per barrel of oil equivalent for coke and coke gas produced under section 45K(g) 

would continue to be adjusted for inflation using 2004 as the base year. 

Finally, the proposal clarifies that qualifying facilities producing coke or coke gas under 

section 45K(g) do not include facilities that produce petroleum-based coke or coke gas. 

Effective Date

The proposal is effective for fuel sold after December 31, 2004. 

23. Modification of individual estimated tax safe harbor 

Present Law

An individual taxpayer generally is subject to an addition to tax for any underpayment of 

estimated tax. An individual generally does not have an underpayment of estimated tax if he or 

she makes timely estimated tax payments equal to the lesser of: (1) 90 percent of the tax shown 

on the current year’s return or (2) 100 percent of the prior year’s tax. For taxpayers with a prior 

year’s AGI above $150,000, however, the rule that allows payment of 100 percent of prior year’s 
96 

tax is modified. Those taxpayers with AGI above $150,000 generally must make estimated 

payments equal to the lesser of (1) 90 percent of the tax shown on the current year’s return or (2) 

110 percent of the prior year’s tax. 

Description of Proposal

First, the proposal provides that taxpayers with prior year’s AGI above $150,000 who 

make estimated tax payments based on prior year’s tax must do so based on 119 percent of prior 

year’s tax for estimated tax payments made for taxable year 2006. That percentage will revert 

back to 110 percent for taxable years 2007 and thereafter. 

Effective Date

The proposal is effective for estimated tax payments made for taxable years beginning 

after December 31, 2005. 

24. Time for payment of corporate estimated taxes 

Present Law

In general, corporations are required to make quarterly estimated tax payments of their 

income tax liability. For a corporation whose taxable year is a calendar year, these estimated tax 

payments must be made by April 15, June 15, September 15, and December 15. 

Description of Proposal 

With respect to corporate estimated tax payments due on September 15, 2010, 3 percent is 

required to be paid on October 1, 2010. 

Effective Date

The proposal is effective on the date of enactment. 

25. Extension and modification of new markets tax credit 

Present Law

Section 45D provides a new markets tax credit for qualified equity investments made to 

acquire stock in a corporation, or a capital interest in a partnership, that is a qualified community 

development entity (“CDE”).253 The amount of the credit allowable to the investor (either the 

original purchaser or a subsequent holder) is (1) a five-percent credit for the year in which the 

equity interest is purchased from the CDE and for each of the following two years, and (2) a sixpercent credit for each of the following four years. The credit is determined by applying the 

applicable percentage (five or six percent) to the amount paid to the CDE for the investment at 

 253 Section 45D was added by section 121(a) of the Community Renewal Tax Relief Act of 2000, 

P.L. No. 106-554 (December 21, 2000). 
97 

its original issue, and is available for a taxable year to the taxpayer who holds the qualified 

equity investment on the date of the initial investment or on the respective anniversary date that 

occurs during the taxable year. The credit is recaptured if at any time during the seven-year 

period that begins on the date of the original issue of the investment the entity ceases to be a 

qualified CDE, the proceeds of the investment cease to be used as required, or the equity 

investment is redeemed. 

A qualified CDE is any domestic corporation or partnership: (1) whose primary mission 

is serving or providing investment capital for low-income communities or low-income persons; 

(2) that maintains accountability to residents of low-income communities by their representation 

on any governing board of or any advisory board to the CDE; and (3) that is certified by the 

Secretary as being a qualified CDE. A qualified equity investment means stock (other than 

nonqualified preferred stock) in a corporation or a capital interest in a partnership that is acquired 

directly from a CDE for cash, and includes an investment of a subsequent purchaser if such 

investment was a qualified equity investment in the hands of the prior holder. Substantially all 

of the investment proceeds must be used by the CDE to make qualified low-income community 

investments. For this purpose, qualified low-income community investments include: (1) capital 

or equity investments in, or loans to, qualified active low-income community businesses; (2) 

certain financial counseling and other services to businesses and residents in low-income 

communities; (3) the purchase from another CDE of any loan made by such entity that is a 

qualified low-income community investment; or (4) an equity investment in, or loan to, another 

CDE. 

A “low-income community” is a population census tract with either (1) a poverty rate of 

at least 20 percent or (2) median family income which does not exceed 80 percent of the greater 

of metropolitan area median family income or statewide median family income (for a nonmetropolitan census tract, does not exceed 80 percent of statewide median family income). In 

the case of a population census tract located within a high migration rural county, low-income is 

defined by reference to 85 percent (rather than 80 percent) of statewide median family income. 

For this purpose, a high migration rural county is any county that, during the 20-year period 

ending with the year in which the most recent census was conducted, has a net out-migration of 

inhabitants from the county of at least 10 percent of the population of the county at the beginning 

of such period. 

The Secretary has the authority to designate “targeted populations” as low-income 

communities for purposes of the new markets tax credit. For this purpose, a "targeted 

population" is defined by reference to section 103(20) of the Riegle Community Development 

and Regulatory Improvement Act of 1994 (12 U.S.C. 4702(20)) to mean individuals, or an 

identifiable group of individuals, including an Indian tribe, who (A) are low-income persons; or 

(B) otherwise lack adequate access to loans or equity investments. Under such Act, “lowincome” means (1) for a targeted population within a metropolitan area, less than 80 percent of 

the area median family income; and (2) for a targeted population within a non-metropolitan area, 

less than the greater of 80 percent of the area median family income or 80 percent of the 

statewide non-metropolitan area median family income.254 Under such Act, a targeted 

 254 12. U.S.C. 4702(17) (defines “low-income” for purposes of 12. U.S.C. 4702(20)). 
98 

population is not required to be within any census tract. In addition, a population census tract 

with a population of less than 2,000 is treated as a low-income community for purposes of the 

credit if such tract is within an empowerment zone, the designation of which is in effect under 

section 1391, and is contiguous to one or more low-income communities. 

A qualified active low-income community business is defined as a business that satisfies, 

with respect to a taxable year, the following requirements: (1) at least 50 percent of the total 

gross income of the business is derived from the active conduct of trade or business activities in 

any low-income community; (2) a substantial portion of the tangible property of such business is 

used in a low-income community; (3) a substantial portion of the services performed for such 

business by its employees is performed in a low-income community; and (4) less than five 

percent of the average of the aggregate unadjusted bases of the property of such business is 

attributable to certain financial property or to certain collectibles. 

The maximum annual amount of qualified equity investments is capped at $2.0 billion 

per year for calendar years 2004 and 2005, and at $3.5 billion per year for calendar years 2006 

and 2007. 

Description of Proposal

The proposal permits for 2008 a $3.5 billion maximum annual amount of qualified equity 

investments. The proposal also requires that the Secretary prescribe regulations to ensure that 

non-metropolitan counties receive a proportional allocation of qualified equity investments. 

Effective Date

The proposal is effective on the date of enactment. 

26. Expansion of Hope and Lifetime Learning Credits for students in the Gulf Recovery 

Zone 

Present Law

Hope credit

The Hope credit is a nonrefundable credit of up to $1,500 per student per year for 

qualified tuition and related expenses paid for the first two years of the student’s post-secondary 

education in a degree or certificate program.255 The Hope credit rate is 100 percent on the first 

$1,000 of qualified tuition and related expenses, and 50 percent on the next $1,000 of qualified 

tuition and related expenses. The Hope credit that a taxpayer may otherwise claim is phased out 

ratably for taxpayers with modified adjusted gross income between $43,000 and $53,000 

 255 Sec. 25A. The Hope credit generally may not be claimed against a taxpayer’s alternative 

minimum tax liability. However, the credit may be claimed against a taxpayer's alternative minimum tax 

liability for taxable years beginning prior to January 1, 2006. 
99 

($87,000 and $107,000 for married taxpayers filing a joint return) for 2005.256 The first 

adjustment to these amounts as a result of inflation is expected in 2006. Thus, for example, an 

eligible student who incurs $1,000 of qualified tuition and related expenses is eligible (subject to 

the adjusted gross income phaseout) for a $1,000 Hope credit. If an eligible student incurs 

$2,000 or more of qualified tuition and related expenses, then he or she is eligible for a $1,500 

Hope credit. 

The qualified tuition and related expenses must be incurred on behalf of the taxpayer, the 

taxpayer’s spouse, or a dependent of the taxpayer. The Hope credit is available with respect to 

an individual student for two taxable years, provided that the student has not completed the first 

two years of post-secondary education before the beginning of the second taxable year. 

The Hope credit is available in the taxable year the expenses are paid, subject to the 

requirement that the education is furnished to the student during that year or during the first three 

months of the next year. Qualified tuition and related expenses paid with the proceeds of a loan 

generally are eligible for the Hope credit. The repayment of a loan itself is not a qualified tuition 

or related expense. 

A taxpayer may claim the Hope credit with respect to an eligible student who is not the 

taxpayer or the taxpayer’s spouse (e.g., in cases in which the student is the taxpayer’s child) only 

if the taxpayer claims the student as a dependent for the taxable year for which the credit is 

claimed. If a student is claimed as a dependent, the student is not entitled to claim a Hope credit 

for that taxable year on the student’s own tax return. If a parent (or other taxpayer) claims a 

student as a dependent, any qualified tuition and related expenses paid by the student are treated 

as paid by the parent (or other taxpayer) for purposes of determining the amount of qualified 

tuition and related expenses paid by such parent (or other taxpayer) under the provision. In 

addition, for each taxable year, a taxpayer may elect either the Hope credit, the Lifetime 

Learning credit (described below), or the section 222 deduction for qualified tuition and related 

expenses with respect to an eligible student. 

The Hope credit is available for “qualified tuition and related expenses,” which include 

tuition and fees (excluding nonacademic fees) required to be paid to an eligible educational 

institution as a condition of enrollment or attendance of an eligible student at the institution. 

Charges and fees associated with meals, lodging, insurance, transportation, and similar personal, 

living, or family expenses are not eligible for the credit. The expenses of education involving 

sports, games, or hobbies are not qualified tuition and related expenses unless this education is 

part of the student’s degree program. 

Qualified tuition and related expenses generally include only out-of-pocket expenses. 

Qualified tuition and related expenses do not include expenses covered by employer-provided 

educational assistance and scholarships that are not required to be included in the gross income 

 256 The adjusted gross income phase-out ranges are indexed for inflation. Also, each of the 

$1,000 amounts of qualified tuition and related expenses to which the 100-percent credit rate and 50 

percent credit rate apply are indexed for inflation, with the amount rounded down to the next lowest 

multiple of $100. 
100 

of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and related 

expenses are reduced by any scholarship or fellowship grants excludable from gross income 

under section 117 and any other tax-free educational benefits received by the student (or the 

taxpayer claiming the credit) during the taxable year. The Hope credit is not allowed with 

respect to any education expense for which a deduction is claimed under section 162 or any other 

section of the Code. 

An eligible student for purposes of the Hope credit is an individual who is enrolled in a 

degree, certificate, or other program (including a program of study abroad approved for credit by 

the institution at which such student is enrolled) leading to a recognized educational credential at 

an eligible educational institution. The student must pursue a course of study on at least a halftime basis. A student is considered to pursue a course of study on at least a half-time basis if the 

student carries at least one half the normal full-time work load for the course of study the student 

is pursuing for at least one academic period that begins during the taxable year. To be eligible 

for the Hope credit, a student must not have been convicted of a Federal or State felony 

consisting of the possession or distribution of a controlled substance. 

Eligible educational institutions generally are accredited post-secondary educational 

institutions offering credit toward a bachelor’s degree, an associate’s degree, or another 

recognized post-secondary credential. Certain proprietary institutions and post-secondary 

vocational institutions also are eligible educational institutions. In order to qualify as an eligible 

educational institution, an institution must be eligible to participate in Department of Education 

student aid programs. 

For taxable years beginning in 2004 and 2005, the Hope credit offsets the alternative 

minimum tax. For taxable years thereafter, the Hope credit does not offset the alternative 

minimum tax. 

Effective for taxable years beginning after December 31, 2010, the changes to the Hope 

credit made by EGTRRA no longer apply. The EGTRRA change scheduled to expire is the 

change that permitted a taxpayer to claim a Hope credit in the same year that he or she claimed 

an exclusion from an education savings account. Thus, after 2010, a taxpayer cannot claim a 

Hope credit in the same year he or she claims an exclusion from an education savings account. 

Lifetime Learning credit

Individual taxpayers are allowed to claim a nonrefundable credit, the Lifetime Learning 

credit, equal to 20 percent of qualified tuition and related expenses incurred during the taxable 

year on behalf of the taxpayer, the taxpayer’s spouse, or any dependents.257 Up to $10,000 of 

qualified tuition and related expenses per taxpayer return are eligible for the Lifetime Learning 

credit (i.e., the maximum credit per taxpayer return is $2,000). In contrast with the Hope credit, 

the maximum credit amount is not indexed for inflation. 

 257 Sec. 25A. The Lifetime Learning credit generally may not be claimed against a taxpayer's 

alternative minimum tax liability. However, the credit may be claimed against a taxpayer's alternative 

minimum tax liability for taxable years beginning prior to January 1, 2006. 
101 

In contrast to the Hope credit, a taxpayer may claim the Lifetime Learning credit for an 

unlimited number of taxable years. Also in contrast to the Hope credit, the maximum amount of 

the Lifetime Learning credit that may be claimed on a taxpayer’s return will not vary based on 

the number of students in the taxpayer’s family -- that is, the Hope credit is computed on a per 

student basis, while the Lifetime Learning credit is computed on a family-wide basis. The 

Lifetime Learning credit amount that a taxpayer may otherwise claim is phased out ratably for 

taxpayers with modified adjusted gross income between $43,000 and $53,000 ($87,000 and 

$107,000 for married taxpayers filing a joint return) for 2005. These phaseout ranges are the 

same as those for the Hope credit, and are similarly indexed for inflation. 

The Lifetime Learning credit is available in the taxable year the expenses are paid, 

subject to the requirement that the education is furnished to the student during that year or during 

the first three months of the next year. Qualified tuition and related expenses paid with the 

proceeds of a loan generally are eligible for the Lifetime Learning credit. As with the Hope 

credit, repayment of a loan is not a qualified tuition expense. 

As with the Hope credit, a taxpayer may claim the Lifetime Learning credit with respect 

to a student who is not the taxpayer or the taxpayer’s spouse (e.g., in cases in which the student 

is the taxpayer’s child) only if the taxpayer claims the student as a dependent for the taxable year 

for which the credit is claimed. If a student is claimed as a dependent by the parent or other 

taxpayer, the student may not claim the Lifetime Learning credit for that taxable year on the 

student’s own tax return. If a parent (or other taxpayer) claims a student as a dependent, any 

qualified tuition and related expenses paid by the student are treated as paid by the parent (or 

other taxpayer) for purposes of the provision. 

A taxpayer may claim the Lifetime Learning credit for a taxable year with respect to one 

or more students, even though the taxpayer also claims a Hope credit for that same taxable year 

with respect to other students. If, for a taxable year, a taxpayer claims a Hope credit with respect 

to a student, then the Lifetime Learning credit is not available with respect to that same student 

for that year (although the Lifetime Learning credit may be available with respect to that same 

student for other taxable years). As with the Hope credit, a taxpayer may not claim the Lifetime 

Learning credit and also claim the section 222 deduction for qualified tuition and related 

expenses. 

As with the Hope credit, the Lifetime Learning credit is available for “qualified tuition 

and related expenses,” which include tuition and fees (excluding nonacademic fees) required to 

be paid to an eligible educational institution as a condition of enrollment or attendance of a 

student at the institution. Eligible higher education institutions are defined in the same manner 

for purposes of both the Hope and Lifetime Learning credits. Charges and fees associated with 

meals, lodging, insurance, transportation, and similar personal, living or family expenses are not 

eligible for the credit. The expenses of education involving sports, games, or hobbies are not 

qualified tuition expenses unless this education is part of the student’s degree program, or the 

education is undertaken to acquire or improve the job skills of the student. 
102 

In contrast to the Hope credit, qualified tuition and related expenses for purposes of the 

Lifetime Learning credit include tuition and fees incurred with respect to undergraduate or 

graduate-level courses.258 Additionally, in contrast to the Hope credit, the eligibility of a student 

for the Lifetime Learning credit does not depend on whether the student has been convicted of a 

Federal or State felony consisting of the possession or distribution of a controlled substance. 

As with the Hope credit, qualified tuition and fees generally include only out-of-pocket 

expenses. Qualified tuition and fees do not include expenses covered by employer-provided 

educational assistance and scholarships that are not required to be included in the gross income 

of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and fees are 

reduced by any scholarship or fellowship grants excludable from gross income under section 117 

and any other tax-free educational benefits received by the student during the taxable year (such 

as employer-provided educational assistance excludable under section 127). The Lifetime 

Learning credit is not allowed with respect to any education expense for which a deduction is 

claimed under section 162 or any other section of the Code. 

For taxable years beginning in 2004 and 2005, the Lifetime Learning credit offsets the 

alternative minimum tax. For taxable years thereafter, the credit does not offset the alternative 

minimum tax. 

Effective for taxable years beginning after December 31, 2010, the changes to the 

Lifetime Learning credit made by EGTRRA no longer apply. The EGTRRA change scheduled 

to expire is the change that permitted a taxpayer to claim a Lifetime Learning credit in the same 

year that he or she claimed an exclusion from an education savings account. Thus, after 2010, 

taxpayers cannot claim a Lifetime Learning credit in the same year he or she claims an exclusion 

from an education savings account. 

Description of Proposal

The proposal temporarily expands the Hope and Lifetime Learning credits for students 

attending (i.e., enrolled and paying tuition at) an eligible education institution located in the Gulf 

Recovery Zone. 

Under the proposal, the Hope credit is increased to 100 percent of the first $2,000 in 

qualified tuition and related expenses and 50 percent on the next $2,000 of qualified tuition and 

related expenses for a maximum credit of $3,000 per student. The Lifetime Learning credit rate 

is increased from 20 percent to 40 percent. The proposal expands the definition of qualified 

expenses to include expenses associated with books, transportation, and room and board (as 

defined in section 529). 

The proposal applies to taxable years beginning in 2005 or 2006. 

 258 As explained above, the Hope credit is available only with respect to the first two years of a 

student’s undergraduate education. 
103 

Effective Date

The proposal is effective on the date of enactment. 

27. Restructure New York Liberty Zone tax incentives 

Present Law

In general

Present law includes a number of incentives to invest in property located in the New 

York Liberty Zone (“NYLZ”), which is the area located on or south of Canal Street, East 

Broadway (east of its intersection with Canal Street), or Grand Street (east of its intersection with 

East Broadway) in the Borough of Manhattan in the City of New York, New York. These 

incentives were enacted following the terrorist attack in New York City on September 11, 

2001.259

Special depreciation allowance for qualified New York Liberty Zone property

Section 1400L(b) allows an additional first-year depreciation deduction equal to 30 

percent of the adjusted basis of qualified NYLZ property. 260 In order to qualify, property 

generally must be placed in service on or before December 31, 2006 (December 31, 2009 in the 

case of nonresidential real property and residential rental property). 

The additional first-year depreciation deduction is allowed for both regular tax and 

alternative minimum tax purposes for the taxable year in which the property is placed in service. 

A taxpayer is allowed to elect out of the additional first-year depreciation for any class of 

property for any taxable year. 

In order for property to qualify for the additional first-year depreciation deduction, it 

must meet all of the following requirements. First, the property must be property to which the 

general rules of the Modified Accelerated Cost Recovery System (“MACRS”)261 apply with (1) 

an applicable recovery period of 20 years or less, (2) water utility property (as defined in section 

168(e)(5)), (3) certain nonresidential real property and residential rental property, or (4) 

 259 In addition to the NYLZ provisions described above, other NYLZ incentives are provided: 

(1) $8 billion of tax-exempt private activity bond financing for certain nonresidential real property, 

residential rental property and public utility property is authorized to be issued after March 9, 2002, and 

before January 1, 2010; and (2) $9 billion of additional tax-exempt advance refunding bonds is available 

after March 9, 2002, and before January 1, 2006, with respect to certain State or local bonds outstanding 

on September 11, 2001. 

260 The amount of the additional first-year depreciation deduction is not affected by a short 

taxable year. 

261 A special rule precludes the additional first-year depreciation deduction for property that is 

required to be depreciated under the alternative depreciation system of MACRS. 
104 

computer software other than computer software covered by section 197. A special rule 

precludes the additional first-year depreciation under this provision for (1) qualified NYLZ 

leasehold improvement property262 and (2) property eligible for the additional first-year 

depreciation deduction under section 168(k) (i.e., property is eligible for only one 30 percent 

additional first-year depreciation). Second, substantially all of the use of such property must be 

in the NYLZ. Third, the original use of the property in the NYLZ must commence with the 

taxpayer on or after September 11, 2001. Finally, the property must be acquired by purchase263

by the taxpayer after September 10, 2001 and placed in service on or before December 31, 2006. 

For qualifying nonresidential real property and residential rental property the property must be 

placed in service on or before December 31, 2009 in lieu of December 31, 2006. Property will 

not qualify if a binding written contract for the acquisition of such property was in effect before 

September 11, 2001. 264

Nonresidential real property and residential rental property is eligible for the additional 

first-year depreciation only to the extent such property rehabilitates real property damaged, or 

replaces real property destroyed or condemned as a result of the terrorist attacks of September 

11, 2001. 

Property that is manufactured, constructed, or produced by the taxpayer for use by the 

taxpayer qualifies for the additional first-year depreciation deduction if the taxpayer begins the 

manufacture, construction, or production of the property after September 10, 2001, and the 

property is placed in service on or before December 31, 2006265 (and all other requirements are 

met). Property that is manufactured, constructed, or produced for the taxpayer by another person 

under a contract that is entered into prior to the manufacture, construction, or production of the 

property is considered to be manufactured, constructed, or produced by the taxpayer. 

Depreciation of New York Liberty Zone leasehold improvements

Generally, depreciation allowances for improvements made on leased property are 

determined under MACRS, even if the MACRS recovery period assigned to the property is 

longer than the term of the lease.266 This rule applies regardless of whether the lessor or the 

 262 Qualified NYLZ leasehold improvement property is defined in another provision. Leasehold 

improvements that do not satisfy the requirements to be treated as “qualified NYLZ leasehold 

improvement property” maybe eligible for the 30 percent additional first-year depreciation deduction 

(assuming all other conditions are met). 

263 For purposes of this provision, purchase is defined as under section 179(d). 

264 Property is not precluded from qualifying for the additional first-year depreciation merely 

because a binding written contract to acquire a component of the property is in effect prior to September 

11, 2001. 

265 December 31, 2009 with respect to qualified nonresidential real property and residential rental 

property. 

266 Sec. 168(i)(8). The Tax Reform Act of 1986 modified the Accelerated Cost Recovery System 

(“ACRS”) to institute MACRS. Prior to the adoption of ACRS by the Economic Recovery Tax Act of 
105 

lessee places the leasehold improvements in service.267 If a leasehold improvement constitutes 

an addition or improvement to nonresidential real property already placed in service, the 

improvement generally is depreciated using the straight-line method over a 39-year recovery 

period, beginning in the month the addition or improvement is placed in service.268 

A special rule exists for qualified NYLZ leasehold improvement property, which is 

recovered over five years using the straight-line method. The term qualified NYLZ leasehold 

improvement property means property defined in section 168(e)(6) that is acquired and placed in 

service after September 10, 2001, and before January 1, 2007 (and not subject to a binding 

contract on September 10, 2001), in the NYLZ. For purposes of the alternative depreciation 

system, the property is assigned a nine-year recovery period. A taxpayer may elect out of the 5-

year (and 9-year) recovery period for qualified NYLZ leasehold improvement property. 

Increased section 179 expensing for qualified New York Liberty Zone property

In lieu of depreciation, a taxpayer with a sufficiently small amount of annual investment 

may elect to deduct the cost of qualifying property. For taxable years beginning in 2003 through 

2007, a taxpayer may deduct up to $100,000 of the cost of qualifying property placed in service 

for the taxable year. In general, qualifying property for this purpose is defined as depreciable 

tangible personal property (and certain computer software) that is purchased for use in the active 

conduct of a trade or business. The $100,000 amount is reduced (but not below zero) by the 

amount by which the cost of qualifying property placed in service during the taxable year 

exceeds $400,000. The $100,000 and $400,000 amounts are indexed for inflation. 

For taxable years beginning in 2008 and thereafter, a taxpayer with a sufficiently small 

amount of annual investment may elect to deduct up to $25,000 of the cost of qualifying property 

placed in service for the taxable year. The $25,000 amount is reduced (but not below zero) by 

the amount by which the cost of qualifying property placed in service during the taxable year 

exceeds $200,000. In general, qualifying property for this purpose is defined as depreciable 

tangible personal property that is purchased for use in the active conduct of a trade or business. 

 

1981, taxpayers were allowed to depreciate the various components of a building as separate assets with 

separate useful lives. The use of component depreciation was repealed upon the adoption of ACRS. The 

Tax Reform Act of 1986 also denied the use of component depreciation under MACRS. 

267 Former sections 168(f)(6) and 178 provided that, in certain circumstances, a lessee could 

recover the cost of leasehold improvements made over the remaining term of the lease. The Tax Reform 

Act of 1986 repealed these provisions. 

268 Secs. 168(b)(3), (c), (d)(2), and (i)(6). If the improvement is characterized as tangible 

personal property, ACRS or MACRS depreciation is calculated using the shorter recovery periods, 

accelerated methods, and conventions applicable to such property. The determination of whether 

improvements are characterized as tangible personal property or as nonresidential real property often 

depends on whether or not the improvements constitute a “structural component” of a building (as defined 

by Treas. Reg. sec. 1.48-1(e)(1)). See, e.g., Metro National Corp v. Commissioner, 52 TCM (CCH) 1440 

(1987); King Radio Corp Inc. v. U.S., 486 F.2d 1091 (10th Cir. 1973); Mallinckrodt, Inc. v. 

Commissioner, 778 F.2d 402 (8th Cir. 1985) (with respect to various leasehold improvements). 
106 

The amount eligible to be expensed for a taxable year may not exceed the taxable income 

for a taxable year that is derived from the active conduct of a trade or business (determined 

without regard to this provision). Any amount that is not allowed as a deduction because of the 

taxable income limitation may be carried forward to succeeding taxable years (subject to similar 

limitations). No general business credit under section 38 is allowed with respect to any amount 

for which a deduction is allowed under section 179. 

The amount a taxpayer can deduct under section 179 is increased for qualifying property 

used in the NYLZ. Specifically, the maximum dollar amount that may be deducted under 

section 179 is increased by the lesser of (1) $35,000 or (2) the cost of qualifying property placed 

in service during the taxable year. This amount is in addition to the amount otherwise deductible 

under section 179. 

Qualifying property for purposes of the NYLZ provision means section 179 property269

purchased and placed in service by the taxpayer after September 10, 2001 and before January 1, 

2007, where (1) substantially all of the use of such property is in the NYLZ in the active conduct 

of a trade or business by the taxpayer in the NYLZ, and (2) the original use of which in the 

NYLZ commences with the taxpayer after September 10, 2001.270

The phase-out range for the section 179 deduction attributable to NYLZ property is 

applied by taking into account only 50 percent of the cost of NYLZ property that is section 179 

property. Also, no general business credit under section 38 is allowed with respect to any 

amount for which a deduction is allowed under section 179. 

The provision is effective for property placed in service after September 10, 2001 and 

before January 1, 2007. 

Extended replacement period for New York Liberty Zone involuntary conversions

A taxpayer may elect not to recognize gain with respect to property that is involuntarily 

converted if the taxpayer acquires within an applicable period (the “replacement period”) 

property similar or related in service or use (section 1033). If the taxpayer does not replace the 

converted property with property similar or related in service or use, then gain generally is 

recognized. If the taxpayer elects to apply the rules of section 1033, gain on the converted 

property is recognized only to the extent that the amount realized on the conversion exceeds the 

cost of the replacement property. In general, the replacement period begins with the date of the 

disposition of the converted property and ends two years after the close of the first taxable year 

in which any part of the gain upon conversion is realized.271 The replacement period is extended 

 269 As defined in sec. 179(d)(1). 

270 See Rev. Proc. 2002-33, 2002-20 I.R.B. 963 (May 20, 2002), for procedures on claiming the 

increased section 179 expensing deduction by taxpayers who filed their tax returns before June 1, 2002. 

271 Section 1033(a)(2)(B). 
107 

to three years if the converted property is real property held for the productive use in a trade or 

business or for investment.272 

The replacement period is extended to five years with respect to property that was 

involuntarily converted within the NYLZ as a result of the terrorist attacks that occurred on 

September 11, 2001. However, the five-year period is available only if substantially all of the 

use of the replacement property is in New York City. In all other cases, the present-law 

replacement period rules continue to apply. 

Description of Proposal

Repeal of certain NYLZ incentives

The proposal repeals the four NYLZ incentives relating to the additional first-year 

depreciation allowance of 30 percent, the five-year depreciation of leasehold improvements, the 

additional section 179 expensing, and the extended replacement period for involuntary 

conversions.273

Creation of New York Liberty Zone Tax Credits

The proposal provides a credit against tax imposed (other than taxes of section 3111(a), 

3403, or subtitle D) paid or incurred by any governmental unit of the State of New York and the 

City of New York equal to the lesser of (1) the total expenditures during such year by such 

governmental unit for qualifying projects, or (2) the amount allocated to such governmental unit 

for such calendar year. 

Qualifying projects means any transportation infrastructure project, including highways, 

mass transit systems, railroads, airports, ports, and waterways, in or connecting with the New 

York Liberty Zone, which is designated as a qualifying project by the Governor of the State of 

New York and the Mayor of the City of New York. 

The aggregate limit that may be allocated for all calendar years in the credit period is two 

billion dollars. The annual limit for any calendar year in the credit period shall not exceed the 

sum of 200 million dollars plus the aggregate amount authorized to be allocated for all preceding 

calendar years in the credit period which was not allocated. The credit period is the ten-year 

period beginning on January 1, 2006. 

If, at the close of the credit period, the aggregate amounts allocated are less than the 2 

billion dollar aggregate limit, the Governor of the State of New York and the Mayor of the City 

of New York may jointly allocate, for any calendar year following the credit period, for 

 272 Section 1033(g)(4). 

273 The proposal does not change the present-law rules relating to certain NYLZ private activity 

bond financing and additional advance refunding bonds. 
108 

expenditures with respect to qualifying projects, amounts that in sum for all years following the 

credit period would equal such shortfall. 

Under the proposal, any expenditure for a qualifying project taken into account for 

purposes of the credit shall be considered State and local funds for the purpose of any Federal 

program. 

Effective Date

The proposal is effective on the date of enactment, with an exception for property subject 

to a written binding contract in effect on the date of enactment which is placed in service prior to 

the original sunset dates under present law. The extended replacement period for involuntarily 

converted property ends on the earlier of (1) the date of enactment or (2) the last day of the fiveyear period specified in the Jobs Creation and Worker Assistance Act of 2002 (“JCWAA”). 274

28. Treatment of S corporation passive investment income 

Present Law

An S corporation is subject to corporate-level tax, at the highest corporate tax rate, on its 

excess net passive income if the corporation has (1) accumulated earnings and profits at the close 

of the taxable year and (2) gross receipts more than 25 percent of which are passive investment 

income. 

Excess net passive income is the net passive income for a taxable year multiplied by a 

fraction, the numerator of which is the amount of passive investment income in excess of 25 

percent of gross receipts and the denominator of which is the passive investment income for the 

year. Net passive income is defined as passive investment income reduced by the allowable 

deductions that are directly connected with the production of that income. Passive investment 

income generally means gross receipts derived from royalties, rents, dividends, interest, 

annuities, and sales or exchanges of stock or securities (to the extent of gains). Passive 

investment income generally does not include interest on accounts receivable, gross receipts that 

are derived directly from the active and regular conduct of a lending or finance business, gross 

receipts from certain liquidations, or gain or loss from any section 1256 contract (or related 

property) of an options or commodities dealer. 

In addition, an S corporation election is terminated whenever the S corporation has 

accumulated earnings and profits at the close of each of three consecutive taxable years and has 

gross receipts for each of those years more than 25 percent of which are passive investment 

income. 

 274 Pub. Law No. 107-147, sec. 301 (2002). 
109 

Description of Proposal

The proposal increases the 25-percent threshold to 60 percent and eliminates the rule 

terminating an S election by reason of having passive investment income for three consecutive 

taxable years. 

Effective Date

The proposal applies to taxable years beginning after December 31, 2005. 

29. Revaluation of LIFO inventories of large integrated oil companies 

Present Law

A taxpayer is generally permitted to use a last-in, first-out (LIFO) method to inventory 

goods, on the condition that the taxpayer also uses the LIFO method in reporting to shareholders, 

partners, other proprietors, and beneficiaries, and for credit purposes.275 Under the LIFO 

method, a taxpayer (i) treats goods on hand at the close of the taxable year as being: first, those 

goods included in the opening inventory of the taxable year (in the order of acquisition) to the 

extent thereof; and second, those acquired in the taxable year; (ii) inventories the goods at cost; 

and (iii) treats those goods included in the opening inventory of the taxable year in which the 

LIFO method was first used as having been acquired at the same time, and determines their cost 

by the average cost method.276

In periods during which a taxpayer produces or purchases more goods than the taxpayer 

sells (an inventory increment), a LIFO method taxpayer generally records the inventory cost of 

such excess (and separately tracks such amount as the "LIFO layer" for such period), adds it to 

the cost of inventory at the start of the period, and carries such total inventory cost forward to the 

beginning inventory of the following year. 

In periods during which the taxpayer sells more goods than the taxpayer produces or 

purchases (an inventory decrement), a LIFO method taxpayer generally determines the cost of 

goods sold of the amount of the decrement by treating such sales as occurring out of the most 

recent LIFO layer (or the most recent LIFO layers, if the amount of the decrement exceeds the 

amount of inventory in the most recent LIFO layer) in reverse chronological order. 

 275 Sec. 472(c). 

276 Sec. 472. 
110 

Description of Proposal

The proposal disallows a portion of the benefit of the LIFO method to integrated oil 

companies277 with gross receipts in excess of $1 billion for the relevant taxable year. 

Specifically, the proposal requires such taxpayers to revalue each historic LIFO layer of 

crude oil inventories by adding to each layer an amount equal to 75 percent of the increase in the 

price of crude oil between the end of the most recent taxable year of the taxpayer ending in 2005, 

and the date which is twelve months prior to the end of such taxable year, multiplied by the 

number of barrels of crude oil represented by such LIFO layer; the taxpayer must reduce its cost 

of sales for such taxable year by a like amount. 

For example, suppose a taxpayer, which is an integrated oil company with revenues in 

excess of $1 billion, has a 2005 starting inventory of 200 barrels, comprised of a 1955 LIFO 

layer with 50 barrels valued at $5 per barrel (with a total cost of $250); a 1985 LIFO layer with 

100 barrels valued at $18 per barrel (with a total cost $1800); a 2000 LIFO layer with 30 barrels 

valued at $25 per barrel (with a total cost of $750), and a 2004 LIFO layer with 20 barrels valued 

at $35 per barrel (with a total cost $700), for a total inventory value of $3500. Suppose further 

that the price of oil over the relevant period has risen $26.67 per barrel (e.g., from $34 per barrel 

to $60.67 per barrel). Suppose further that the taxpayer’s ending inventory is 200 barrels, i.e., 

the same as the starting inventory, so the taxpayer has neither an inventory increment nor an 

inventory decrement for the taxable year. 

Under the proposal, the taxpayer will revalue each LIFO layer upwards by $20/barrel 

(i.e., 75% of $26.67). Thus, the taxpayer will increase its 1955 LIFO layer by $1000; its 1985 

LIFO layer by $2000; its 2000 LIFO layer by $600; and its 2004 LIFO layer by $400. The 

taxpayer will offset this $4000 increase in inventory by reducing by $4000 the taxpayer’s costs 

of goods sold for the most recent taxable year ending in 2005. 

Effective Date

The proposal is effective for the most recent taxable year of relevant taxpayers ending in 

2005. 

30. Capital expenditure limitation for qualified small issue bonds 

Present Law

Qualified small-issue bonds are tax-exempt State and local government bonds used to 

finance private business manufacturing facilities (including certain directly related and ancillary 

facilities) or the acquisition of land and equipment by certain farmers. In both instances, these 

bonds are subject to limits on the amount of financing that may be provided, both for a single 

 277 The proposal defines an “integrated oil company” by cross-reference to section 291(b)(4), 

which generally includes retailers and large refiners of oil or natural gas or any product derived from oil 

or natural gas. 
111 

borrowing and in the aggregate. In general, no more than $1 million of small-issue bond 

financing may be outstanding at any time for property of a business (including related parties) 

located in the same municipality or county. Generally, this $1 million limit may be increased to 

$10 million if all other capital expenditures of the business in the same municipality or county 

are counted toward the limit over a six-year period that begins three years before the issue date 

of the bonds and ends three years after such date. Outstanding aggregate borrowing is limited to 

$40 million per borrower (including related parties) regardless of where the property is located. 

For bonds issued after September 30, 2009, the Code permits up to $10 million of capital 

expenditures to be disregarded, in effect increasing from $10 million to $20 million the 

maximum allowable amount of total capital expenditures by an eligible business in the same 

municipality or county.278 However, no more than $10 million of bond financing may be 

outstanding at any time for property of an eligible business (including related parties) located in 

the same municipality or county. Other limits (e.g., the $40 million per borrower limit) also 

continue to apply. 

Description of Proposal

The proposal accelerates the application of the $20 million capital expenditure limitation 

from bonds issued after September 30, 2009, to bonds issued after December 31, 2006. 

Effective Date

The proposal is effective on the date of enactment for bonds issued after December 31, 

2006. 

 278 Sec. 144(a)(4)(G) as added by sec. 340(a) of the American Jobs Creation Act of 2004, Pub. L. 

No. 108-357 (2004).