Tax Topics

Deutsche Bank Private Wealth Management 07/27/10

By Blanche Lark Christerson

In plain sight. We are now on the downward slope of 2010, and 2011 will be here before we know it. There is much unfinished tax business, not the least of which is the unsettled state of the estate tax, and what will happen with the rates for ordinary income, capital gains and dividends. (See the 07/01/10 Tax Topics for more on this.) If Congress does nothing, those rates automatically will go up in 2011 because the 2001 and 2003 tax cuts will have expired; if Congress does something, as in enacting President Obama’s desired tax changes, those rates will go up for “higher earners” – individuals making more than $200,000, and married couples filing jointly making more than $250,000. (Note that at this writing, some Democrats appear to be having second thoughts about these increases, given what they perceive to be a still-fragile economy and, perhaps, the upcoming mid-term elections; by contrast, Treasury Secretary Timothy Geithner and House Speaker Nancy Pelosi (D-CA) have since separately reaffirmed the administration’s commitment to this plan.)

“PEP” and “Pease.” Assuming, then, that rates go up next year, “PEP” and “Pease,” which finally disappeared – just for this year – will also reappear in 2011. PEP is the acronym for the “personal exemption phase-out,” and “Pease” is shorthand for limitations on itemized deductions. Both provisions were designed to reduce tax benefits for higher income taxpayers, and represented indirect tax increases, something Congress long ago realized carried less political baggage than direct tax increases, such as higher rates. PEP meant that if you made “too much,” you could entirely lose your personal exemptions; Pease gave most itemized deductions a haircut, but not enough to make them bald.

This year, because there’s no limit on personal exemptions or itemized deductions, regardless of how much you make, these benefits will reduce your “regular” income tax. Unfortunately, they’re also likely to increase your alternative minimum tax (AMT), since personal exemptions don’t count against the AMT, and many itemized deductions, such as those for state and local income taxes and property taxes, are “add-backs” for AMT purposes: if your taxes calculated under the AMT are higher than your regular taxes, you pay that higher amount.

But the AMT is not the real point here. Rather, it’s that charitable contributions, which help reduce both your regular tax AND your AMT, are itemized deductions that will be subject to Pease limitations next year, assuming they reappear. This suggests that if you’ve been contemplating making a significant charitable contribution, 2010 might be a good time to do it, considering that in 2011, your contribution is likely to be reduced. How much? That depends on your income.

To illustrate, the classic Pease limitations applied to all itemized deductions, except those for medical expenses, investment interest, and casualty, theft and wagering losses. In other words, deductions, such as those for state and local income taxes, property taxes, mortgage interest AND charitable contributions, were effectively “Pease deductions” and could be reduced.

The limitation worked as follows: if your adjusted gross income (AGI) exceeded a threshold amount (generally, $100,000, indexed for inflation), your Pease deductions were reduced by the lesser of: 1) 3% of your AGI over that threshold amount, or 2) 80% of your Pease deductions. Although that potential 80% reduction sounds Draconian, as a practical matter, most people never hit it unless their AGI was exponentially larger than their deductions – in which case, they might simply take what could have been the slightly higher standard deduction available to taxpayers who didn’t itemize their deductions.

To illustrate, suppose it’s the early 90’s and the threshold amount is $100,000. Mom and Dad file jointly, and have $25,000 in Pease deductions; their total AGI is $150,000. These deductions would be reduced by $1,500 [.03($150,000 – $100,000)]. For the deductions to be reduced by 80% ($20,000), Mom and Dad would need AGI of $766,666 [.03($766,666 – $100,000)]. In that case, they would have been better off taking the standard deduction of $5,700 rather than their reduced itemized deduction of $5,000.

Next year, even though the Pease threshold likely will be much higher than $100,000 indexed for inflation – presumably, it will be based on the $200,000/$250,000 “high income” thresholds mentioned above, indexed for inflation – it will still whittle down deductions for higher earners. Thus, although those deductions will be more valuable next year, in that they’re presumably offsetting a higher top rate (say, 39.6% versus 35%), the Pease haircut will lessen that value.

The point is that this year, charitable deductions are only subject to the usual AGI limitations and not Pease limitations as well. AGI limitations for charitable contributions range from 20% to 50%, and are a function of what type of property you donate, and whether the charity is “public” or “private.” For example, you can deduct a cash gift to a public charity (such as your alma mater) against 50% of your AGI, whereas you can only deduct the same cash gift to your private foundation against 30% of your AGI. (If the AGI limitation curtails your deduction, you have five successive years in which to use it.)

Thus, because Pease is not currently an issue, a well-placed charitable contribution could go far to help offset, for example, the income generated by converting a traditional IRA into a Roth.

Example: Sally has concluded that she really wants to convert her Rollover IRA into a Roth. She knows the entire conversion will be taxable, but is OK with that: she’s young enough to “make up” the loss of those dollars, and likes the idea of sheltering the Roth’s future earnings from income tax. Plus she’s got plenty of money to pay the taxes. She knows that if she converts this year, she’ll have to recognize half of the income in 2011, and the other half in 2012, unless she elects to recognize all of the income this year. Although the two-year income spread is tempting, Sally would rather take advantage of what she assumes are 2010’s lower tax rates. She’s also been considering making a handsome gift to her law school, and realizes that if she couples that gift with the IRA conversion this year, her charitable dollars can go a long way towards offsetting the tax on conversion – especially since there’s no Pease limitation. Sally converts her IRA, and makes the gift. She feels she’s made an investment in her future, and in her school.

While the example above is simplistic, it illustrates the point: although we don’t know what taxes will look like next year, it’s likely they’ll be higher – AND that we’ll see the return of PEP and Pease. Assuming that’s the case, you’ll get more “direct” mileage from a charitable gift this year than you probably will for quite some time.

p.s. Why are they called “Pease” limitations? The late Rep. Don Pease (D-OH) introduced this legislation back in 1990. Originally designed to be a temporary revenue raiser, the limitations were made permanent in 1993…and the rest is history (or infamy, depending on your point of view).

Nice try department. Many cases cross our desk. Some are highly technical, some are dull, and others manage to entertain while still illustrating a tax principle. We recently came across two such cases, and thought you might appreciate the diversion during this very hot summer. Coincidentally, both cases have to do with charity.

From the frying pan to the fire. We’ll start with James and Lori, who want to build a bigger and better house on the lot they own. To do so, they’ll have to demolish the existing house, at a cost of $10,000. Hmmm. What if, instead, they contribute the house to the local fire department for training? When they’ve burned it down, James and Lori can get their lot back AND have a nice charitable contribution they can deduct. So they consult with someone at Deloitte and Touche about the plan, and are advised that it is “aggressive, and not explicitly sanctioned by the Internal Revenue Code.”

Undeterred, James and Lori get an appraisal for the house and lot, which are determined to be worth $520,000. The appraisal lists the appraiser’s license number (but not her qualifications), and doesn’t mention anything about the particulars of the contemplated “donation” or that the appraisal is being done “for income tax purposes” – just that it’s being done to assist in estimating the property’s fair market value.

James and Lori and the City of Upper Arlington enter into a contract, which gives the city the right to use the property for fire department training; it pointedly expresses no opinion regarding the tax consequences of the transaction, and advises James and Lori to consult with a tax advisor.

Poof, voilà, the house goes up in smoke. James and Lori build a new house, and claim a deduction for almost $290,000 (they presumably subtract the value of the lot from the property’s total value). The IRS denies the deduction, and says they owe over $100,000 in tax. James and Lori pay the deficiency and file for a refund, which is also denied; they sue in a District Court in Southern Ohio. Both they and the IRS move for summary judgment, meaning that each party thinks that because there’s no issue as to any material fact, that party is entitled to a favorable judgment “as a matter of law.”

The court sets forth four core issues: 1) the adequacy of the qualified appraisal; 2) whether James and Lori had a sufficient “contemporaneous acknowledgment” of their purported donation; 3) whether the tax law precludes a deduction for that “donation”; and 4) whether James and Lori have “otherwise established” that they are entitled to a deduction.

The court finds that the appraisal is not remotely “qualified.” Even if taxpayers could finesse the requirements for a qualified appraisal by “substantially complying” with them, James and Lori haven’t done so: their appraisal lacks “even a modicum of content in critical areas,” including details about the appraiser’s qualifications (listing the appraiser’s license number to “implicitly” represent her qualifications is “simply without merit”).

Furthermore, charitable gifts of $250 or more must be substantiated with a contemporaneous written acknowledgment from the charity that: 1) describes the property contributed; 2) states whether any goods or services were provided in consideration for the contributed property; and if so, 3) makes a good faith estimate of those goods or services. James and Lori apparently don’t have such an acknowledgment, but maintain that no goods or services were exchanged. That doesn’t matter, the court says; what matters is that James and Lori did not actually disclose whether the city provided any goods or services in consideration for their gift.

In short, because of James and Lori’s failure to substantiate their claimed charitable gift with both a qualified appraisal AND a contemporaneous written acknowledgment from the city, the court doesn’t have to address whether their gift is eligible for a charitable deduction. The IRS wins.

The moral of the story: never underestimate the importance of scrupulously following the requirements necessary to sustain a charitable deduction – both as to a qualified appraisal, and a written acknowledgment from the charity. (In general, a qualified appraisal is required if you’re claiming a deduction for a non-cash contribution over $5,000.) James Hendrix et al. v. United States; No. 2:09-cv-00132.

Nice try #2. Generous person (we’ll call him Bill) believes that he will be “making the world a better place” by creating a free fertility foundation that will provide his sperm, free of charge, to women seeking to become pregnant through artificial insemination or in vitro fertilization. Bill pays to store his sperm with a sperm bank, which distributes Bill’s holdings to recipients of Bill’s choosing. Bill, a software engineer with more than 10 patents on different inventions, creates the foundation as a “nonprofit public benefit corporation” in late 2003, and seeks tax-exempt status for the organization in early 2004.

The foundation’s website chronicles Bill’s life, from infancy to adulthood, and touts his academic and athletic accomplishments, from elementary school to high school (these include spelling bees, science fairs and swimming competitions); it also mentions Bill’s college recognition as a top engineering student.

Bill and his father are the sole members of his foundation, and comprise its board. They create a detailed questionnaire for women wishing to avail themselves of the foundation’s services. The questionnaire probes a woman’s family background, living environment, age, history of fertility treatment, educational level, personal achievements, etc. Preference is given to women “with better education,” and whose family members “have a track record of contributing to their communities.” In addition, women who are ethnic minorities and live in areas where there haven’t been previous recipients stand a better chance of being chosen.

Bill and his father score the questionnaires by hand, and feed the information into a computer program that scores each applicant (Bill and his father can still override the computer’s judgment to take account of what they believe is a critical factor). They are picky! From 2004 through 2005, they receive 819 inquiries, and accept only 24 women (fewer than 3%).

In 2005, the IRS denies the foundation’s tax exemption. Bill protests, and confers, unsuccessfully, with the IRS over its decision. After Bill receives a final denial from the IRS, he sues in Tax Court for a declaratory judgment that his organization satisfies all the requirements to be a 501©(3) organization. Bill loses.

The Tax Court agrees with the IRS that to be eligible for tax-exempt status, an organization must operate exclusively for exempt purposes. Although Bill claims that he is providing free health products and services, he’s only helping a small class of beneficiaries, who are subject to a “very subjective, and possibly, arbitrary, selection process.” In addition, Bill’s foundation doesn’t really promote health, or provide medical care, research, education or other services that advance health, nor do Bill and his father have any health-related education or expertise.

As the court dryly observes:

Simply put, [the foundation’s] activities may promote the propagation of [Bill’s] seed and population growth, but they do not promote health for the benefit of the community.

The moral of the story: as wonderful as you may think you are, that’s probably not enough to justify a tax exemption. Free Fertility Foundation v. Commissioner, 135 T.C. No. 2, 7/7/2010.

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August 7520 rate issued. The IRS has issued the August 2010 applicable federal rates: the 7520 rate is 2.6%, down 0.20% (20 basis points) from July’s 2.8% rate, and down 0.60% (60 basis points) from the June rate of 3.2%. The annual, semiannual, quarterly and monthly short-term rates are also down: 0.53% (53 basis points), or 0.08% (8 basis points) lower than the July annual, semiannual, quarterly and monthly short-term rates of 0.61% (61 basis points).
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Blanche Lark Christerson is a managing director at Deutsche Bank Private Wealth Management in New York City, and can be reached at blanche.christerson@db.com.

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