Nonprofit tax reform: Senate bill targets many revenue streams.

When the United States Senate passed S. 2020, The Tax Relief Act of 2005, this legislation, part of the budget reconciliation process, contained a set of incentives and reforms that will affect the nonprofit sector if and when they become law.

These provisions are the first output of the Senate's charitable reform process that began in June, 2004 with the Senate Finance Committee staff white paper. Now that there is some legislative language, the potential impact on nonprofits can be analyzed.

You should note that the House of Representatives passed a tax relief package in December, 2005 that contained none of these provisions. Thus, they will only become law in this form if they are included in a conference report, approved by both houses of Congress and signed by President George W Bush. At the time this article was written, it is expected that the conference committee will meet early in February. In any case, some of the reform provisions will raise tax revenue for the government, so are likely to be enacted in some form in the near future.

The Act contains a number of incentives to stimulate increased contributions, including a charitable deduction for non-itemizers and tax-free transfers of IRAs to charity. However, the focus of this article is on some of the reform provisions that have received much less media coverage.

Certification, public disclosure of UBIT 

The Act, in Section 306, will extend the public inspection and disclosure rules that currently apply to Forms 990 and 990-PF to Form 990-T, as well. Organizations that currently have unrelated business income must indicate the nature and amount in Part VII of Form 990 and Part XVI-A of Form 990-PE By making Form 990-T public, everyone will be able to see the expenses attributable to earning that income and the amount of tax the organization paid.

Another provision contained in the same section of the Act could impose significant burdens on Section 501(c)(3) organizations that have unrelated business income. If your organization has total gross revenues or gross assets of at least $10 million, and you have unrelated business income, you will have to obtain a certification from an independent auditor or independent counsel.

The certification will have to state that the information on the return (Form 990-T) has been reviewed, to the best of the auditor's or counsel's knowledge it is accurate, and whether the allocation of expenses conforms to the tax rules. The certification will also have to indicate whether the independent auditor or counsel provided a tax opinion regarding the classification of activities or treatment of income or expenses during the year.

A failure to obtain the certification will subject you to a penalty of one-half of 1 percent of your gross revenues other than contributions, unless the failure was due to reasonable cause.

This provision is problematic for several reasons. First, it uses a number of terms (independent auditor, independent counsel, tax rules, among others) without defining them. It is also unclear whether the certification relates only to the items shown on the return or whether the certifier has to look at all sources of revenue to determine that all unrelated items are included. The latter could be a huge undertaking for a hospital or university or any other organization with numerous sources of revenue.

Donor advised funds 

Donor advised funds (DAF) have grown dramatically in recent years. DAFs allow donors to provide funds to a public charity that holds them and only disburses them upon the donor's (or some other designated person's) advice. The sponsor of the DAF must exercise full legal control over the funds and must make sure the proposed donations are proper. There are few rules that currently apply to DAFs and Congress is concerned that some donors have used these funds to avoid the restrictions of the private foundation rules.

The Act contains a number of provisions that will regulate DAFs. First, it will define a donor advised fund for the first time. Review of this provision shows that there should be little concern. Second, a Type III supporting organization (more about this later) cannot sponsor a DAF. Third, donors, donation advisors and investment advisors will become disqualified persons with respect to the excess benefit transaction rules. Donors and donation advisors could not receive grants, loans or compensation from the DAF. Any such payment would automatically trigger excess benefit tax consequences. Investment advisors could receive reasonable compensation.

The centerpiece of the new rules will require DAF sponsors to make distributions from all DAFs that they hold, generally 5 percent. Each individual fund will have to distribute certain amounts under some complicated rules that are beyond the scope of this article. There is a 30 percent penalty for failure to make any of these required distributions. Finally, if you sponsor DAFs, you will have to disclose on your Form 990 the number of DAFs you have, the aggregate value of the assets contained in them and the aggregate contributions and grants paid out during a given year.

Supporting organizations

When Congress created private foundations in 1969, it realized that there were some organizations that might not receive wide support, but that shouldn't be treated as private foundations. They created three categories of organizations that were so closely related to public charities that there wouldn't be concerns about abuse. The tax regulations refer to them as supporting organizations (SO).

The first category of SO is one which is "operated, supervised or controlled by" a public charity. This has come to be called a "Type I SO," and exists when the public charity appoints or elects a majority of the governing body or officers of the SO. The second category, or "Type II SO," is one that is "supervised or controlled in connection with" the public charity. This relationship is shown by having the same persons control or manage both organizations. Merely requiring payments to go to the public charity without the formal control is insufficient to establish a Type II relationship. There must be actual overlap of control.

The third category, or "Type III SO," is one that is "operated in connection with" a public charity. This is a much more informal relationship, and the regulations contain a number of tests that these organizations have to meet. The tests are designed to make sure that the public charity is aware of the activities of the SO and can take actions to ensure it receives the appropriate level of support. There have been a number of reported abuses involving Type III SOs, and the IRS has taken legal action in some of the more egregious situations. However, the Senate believes that more detailed rules are needed to control these organizations.

The Act creates some rules that will affect all SOs and some that will only affect Type III SOs. Among the rules that will affect all SOs are the treatment of any grants, loans, compensation or other payment paid to substantial contributors to the SO, family members or controlled entities as excess benefit transactions.

Also, any loans made to disqualified persons will be treated as excess benefit transactions. All SOs will have to indicate their specific SO type on Form 990, list the organizations they support and certify that they are not controlled by one or more disqualified persons. Finally, contributions to an SO from a private foundation will not count as qualifying distributions by that foundation.

The most stringent new rule for a Type III SO will require mandatory distributions. Each year, the SO will have to distribute to the public charity the greater of 85 percent of its income other than contributions or 5 percent of the fair market value of its investment assets. There is a phase-in of this requirement over three years, going from 3 percent to 4 percent to 5 percent. Reasonable and necessary administrative expenses will count toward meeting this requirement. Failure to comply within one year will result in a 30 percent penalty, which increases to 100 percent if it is not subsequently corrected.

The public charity will have to provide a certification to the IRS that it approves of the arrangement when a new Type III SO applies for tax-exempt status. Each year, the SO will have to obtain a letter that confirms the arrangement and describes how the support furthers the charitable purpose of the public charity. A Type III SO will only be allowed to support up to five public charities. There is a transition rule for existing relationships. A Type III SO cannot support an organization that is not a U.S. public charity, and it cannot transfer assets to a donor advised fund.

Finally, in what may prove to be a difficult rule for some Type III SOs, the excess business holding rules will become applicable. This will limit the SO's holdings to 20 percent of any one business enterprise. There will certainly be transition rules for existing situations.

The Act contains a number of other reforms. Among them is a requirement that small organizations that do not file Form 990 will have to file a notification of their continued existence with the IRS. If they fail to do so, they can lose their tax-exempt status. Organizations that participate in tax shelter transactions will face severe penalties. The value of contributions of household goods and clothing will have to be based on a listing issued by the IRS each year. The IRS will be allowed to share information with state regulators (e.g., state attorneys general) about actions taken with respect to tax-exempt organizations.

All of these provisions and more are included in the Act as passed by the Senate. If these provisions are included in a final bill as it comes out of Conference Committee, we will let you know. In the meantime, if you will be affected by any of these provisions, you should be planning for how you will comply. Net

Harvey J. Berger, CPA, is a partner and national director of not-for-profit tax services in Vienna, Va., for the accounting and management consulting firm Grant Thornton LLP His email address is: [e-mail]. D. Greg Goller, CPA, is the partner-in-charge, Not-For-Profit Solutions Group in Grant Thornton LLP's Washington, D.C. office. His email is [e-mail]