Two new elections: charitable contributions and tax-free incorporations.

On Sept. 23, President Bush signed the 2005 Katrina Emergency Tax Relief Act (P.L. 109-73) into law. Most of the act's provisions are Katrina-related, providing tax relief and assistance to hurricane victims.

One significant provision not solely Katrina-related temporarily suspends the percentage of income limitation on charitable contributions by individuals.

Under existing IRC Sec. 170(b)(1)(A), an individual's annual itemized deduction for cash contributions to public charities cannot exceed 50 percent of the individual's contribution base (adjusted gross income, without any net operating loss carryback). Excess contributions are carried over for five years. Sec. 68 reduces itemized deductions for high-income taxpayers.

However, Katrina Act Sec. 301 allows individuals to deduct "qualified contributions" up to 100 percent of their contribution base--to the extent they exceed other deductible charitable contributions. Excess contributions are eligible for the five-year carryover. Qualified contributions are not considered itemized deductions under Sec. 68.

Qualified Contributions: A "qualified contribution" is any charitable cash contribution paid to a public charity from Aug. 28, 2005-Dec. 31, 2005. (For this purpose, a supporting organization described in Sec. 509(a)(3) is not a public charity.) Also, the individual must elect the application of Katrina Act Sec. 301. In the case of a partnership or S corporation, this election is made separately by each partner or shareholder.

Note: Under Katrina Sec. 301(d)(1)(B), a qualified contribution by a corporation must be for Hurricane Katrina relief efforts.

Nonqualified Contributions: Qualified contributions exclude contributions for establishing new, or maintaining existing, segregated funds or accounts if the donor (or the donor's appointee or designee) has, or reasonably expects to have, advisory privileges regarding distributions or investments because of the donor's status as donor.

Corporate Limitation: Under existing Sec. 170(b)(2), a regular C corporation's deduction for charitable contributions cannot exceed 10 percent of its taxable income (without deducting charitable contributions, special deductions for dividends received, premiums on convertible bond repurchases, and net operating or capital loss carrybacks). Excess contributions are carried over for five years.

Under Katrina Act Sec. 301, a regular C corp can deduct qualified Katrina-related contributions up to 100 percent of its taxable income (computed as above)--to the extent they exceed other deductible charitable contributions. Excess contributions are eligible for the five-year carryover.

This limitation does not apply to S corps. Their charitable contributions are passed through to shareholders.

Tax-Free Incorporations

The Congressional Joint Committee on Taxation staff's investigative report of Enron Corporation and other information revealed that taxpayers were engaging in various tax motivated transactions to duplicate a single economic loss and, subsequently, were deducting such a loss more than once.

Since Congress believes that a single economic loss should only be deducted once, the 2004 American Jobs Creation Act added Sec. 362(e)(2), effective for transactions after Oct. 22, 2004, which generally limits a corporation's basis in property acquired in a "tax-free incorporation" to the property's fair market value (FMV).

For this discussion, a tax-free incorporation includes all transfers of property to a corporation, in exchange for its stock, by one or more persons who control the corporation immediately after that exchange. Control means ownership of the corporation's stock possessing at least 80 percent of the total combined voting power of all voting stock and at least 80 percent of the total number of shares of all other stock.

Election: Instead of limiting the transferred property's basis, Sec. 362(e)(2)(C) permits the transferor and transferee to jointly irrevocably elect to limit the basis in the stock received by the transferor to the transferred property's FMV.

Interim Guidance: The IRS is considering issuing guidance for this election. In the interim, the IRS will accept Sec. 362(e)(2)(C) elections if they are made in the form and manner of the certification set forth in Notice 2005-70 (IRB 2005-41, Oct. 11, 2005).

The IRS also will treat other statements on or with returns as effective Sec. 362(e)(2)(C) elections if they disclose sufficient information to apprise the IRS that an election has been made with respect to a particular transaction and by particular parties.

Procedures: If the transferor is not a controlled foreign corporation (CFC) [as defined in Sec. 957], the transferor may make a valid election by including Notice 2005-70's certification on or with its tax return filed by the due date, including extensions, for filing its original return for the tax year in which the transaction occurred.

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If the transferor is a CFC, its controlling U.S. shareholder(s) [as defined in Regs. Sec. 1.964-1(c)(5)] may make a valid election for the CFC by including the Notice's certification on or with each of their tax returns filed by the due date(s), including extensions, for filing their original returns for the tax year in which the transaction occurred.

The common parent of a consolidated group can elect for its members.

Taxpayers uncertain of Sec. 362(e)(2)'s applicability may make a protective election, which will have no effect if Sec. 362(e)(2) does not apply, but will otherwise be binding and irrevocable.

By Stuart R. Josephs, CPA 

Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].