On August 17, 2006, the President signed into law The Pension Protection Act of 2006 (the 'Act'). While the Act itself is 900 pages and includes numerous changes to our country's pension laws, this article summarizes various highlights of the Act which provide individuals with estate and income tax planning opportunities that did not previously exist. In addition, as discussed below, certain provisions of existing law were made permanent which otherwise would have expired at the end of 2010.
Tax Deferral Allowed On Transfer Of Inherited IRA To Non-Spouse Beneficiaries
Under the Act, for distributions made after December 31, 2006, non-spouse beneficiaries may rollover to an IRA, in a direct trustee-to-trustee transfer, benefits inherited from a decedent under a qualified retirement plan. This allows a non-spouse beneficiary, including a decedent's child or same-sex partner, the ability to defer immediate income taxation of the inherited benefits by rolling the amount into an IRA. Under prior law, a non-spouse beneficiary generally was required to take distributions of the entire plan within five (5) years of a decedent's death. This distribution pay-out resulted in short-term recognition of income taxes to the non-spouse beneficiary. Now a non-spouse beneficiary has the opportunity to defer the recognition of income by rolling the plan benefits income tax-free into an IRA. The new law requires that the inherited IRA must be titled in the name of the original owner (i.e., the decedent) and must be payable to the designated beneficiary of the original benefit.
Long-Term Care ('LTC') Riders On Life Insurance And Annuity Contracts
Individuals owning annuity contracts can now have LTC riders with special tax consequences. The Act allows the cash value of annuity contracts to be used to pay premiums on LTC contracts. The payment of premiums in this manner will reduce the cost basis of the annuity contract. In addition, the Act also allows annuity contracts with LTC riders to be exchanged for contracts without such a rider in a tax-free transfer under Section 1035 of the Internal Revenue Code of 1986, as amended ('IRC').
This provision may prove beneficial to individuals who own annuities with a large cost basis. The cash value of the annuity can be used to purchase LTC insurance which, in itself, has become more prominent as we think about planning in our retirement years. This provision is effective for exchanges which take place after 2009.
Qualified Charitable Distributions From An IRA
Under prior law, an individual's donation to charity of his distribution from an IRA was taxable. Under the Act, for tax years 2006 and 2007, an otherwise taxable distribution from an IRA (including a Roth IRA) is non-taxable up to $100,000 if the IRA distribution is considered a 'qualified charitable distribution' for income tax purposes. A 'qualified charitable distribution' is a distribution that is: (a) transferred directly by the IRA trustee to a charitable organization described in IRC Section 170(b)(1)(A)(generally public charities other than donor-advised funds and supporting organizations); (b) made on or after the date that the IRA owner reaches age 70 1/2; and (c) fully deductible as a charitable contribution under the IRC, disregarding any threshold for deductibility based on an individual's adjusted gross income ('AGI'). No exclusion is allowed for contributions made to charitable remainder trusts, pooled income funds or other split interest charitable trusts. If an individual makes a qualified charitable distribution that is excluded from gross income, the amount excluded from gross income is not taken into account in determining the individual's charitable contribution deduction.
This planning opportunity can be significant for an individual who does not itemize deductions (and, therefore, does not benefit from a charitable contribution deduction) or an individual who, because of AGI limitations, is subject to a phase-out of itemized deductions (which would include limiting a deduction for charitable contributions).
Qualified Conservation Contributions
For 2006 and 2007, the Act raises the charitable deduction limit from 30% of AGI to 50% of AGI for qualified conservation contributions. Generally, a qualified conservation contribution is a contribution of real property to public charities, governmental units and certain supporting organizations for conservation purposes. Conservation purposes generally include: preservation of land for open space or outdoor recreation, preservation of an historic land area or historic structure and protection of a natural fish, wildlife or similar habitat. For eligible farmers and ranchers, the charitable contribution limit is 100% of AGI. Under these provisions, a taxpayer may carry forward any unused charitable contribution of conservation property for up to 15 years.
Charitable Contributions Of Clothing And Household Items
The Act prohibits a deduction for charitable contributions of clothing and household items if such items are not in good used condition or better. Further, a charitable deduction may be denied if the item is of minimal monetary value.
Charitable Contribution Recordkeeping
For charitable contributions of money, regardless of the amount, the donor must maintain a record of the contribution. Taxpayers must either have a cancelled check or other bank record, or a written communication from the donee organization showing the name of the donee organization and the amount and date of the contribution.
Section 529 Plans
The Act makes permanent the tax benefits of IRC Section 529 plans. These tax benefits include the following: (a) distributions from 529 plans for qualified higher education expenses are permanently tax-free; (b) assets in one 529 plan may be rolled over tax-free to another 529 plan once every 12 months; and (c) changes and rollovers among beneficiaries of the 529 plan are permitted.
Relief For Reservists
Reservists who are ordered or called to active duty after September 11, 2001 and before December 31, 2007 can avoid a 10% tax on early withdrawals from a qualified retirement plan. This distribution is referred to as a 'qualified reservist distribution.' A 'qualified reservist distribution' must be made to a reservist who is ordered or called to active duty for a period exceeding 179 days and must be made during the period beginning on the date of the order or call to duty and ending on the close of the active duty period. If a reservist already has received distributions that were subject to the 10% tax and otherwise would have qualified for this relief, the reservist may apply for a tax refund.
Direct Deposit Of Tax Refund To IRA
For taxable years beginning after 2006, the Act allows an individual to direct that a portion of any tax refund or overpayment be paid to the individual's IRA.
Direct Rollovers From Retirement Plans to Roth IRA's
Under prior law, if an individual desired to rollover a distribution from a qualified plan to a Roth IRA, the individual had to first rollover the plan assets to a traditional IRA and then do a second rollover to a Roth IRA. The Act eliminates the first step by allowing an individual who meets the AGI limits to rollover tax-free a distribution from a qualified plan directly to a Roth IRA. This provision is effective in 2008.
Favorable Tax Basis Adjustment For S Corporation Stock
Prior to the Act, if an S corporation contributed money or other property to charity, the S corporation shareholder was treated as making a pro-rata charitable contribution equal to the fair market value of the money or property contributed. The shareholder's basis in the S corporation stock also was reduced by this same amount. Under the Act, the shareholder's basis in the S corporation stock is reduced by the shareholder's pro rata basis of the contributed property, not the fair market value . Thus, there likely will be a smaller reduction in the shareholder's S corporation basis in his stock as a result of this new law. This favorable S corporation treatment applies for charitable contributions made by S corporations in taxable years beginning after December 31, 2005 and before January 1, 2008.
Taxability Of Certain Company-Owned Life Insurance
As a general rule, life insurance proceeds are excluded from the gross income of the beneficiary receiving the proceeds. Changes under The Act now tax, as ordinary income, certain life insurance proceeds a company receives on company-owned life insurance. The amount subject to tax by the employer is equal to the amount of any insurance proceeds received in excess of the premiums plus any other amounts paid by the employer. This new law applies to: (a) any life insurance policy issued after the date of enactment or an existing policy materially changed after the date of enactment; and (b) any such policy that is owned by a person engaged in a trade or business and that insures the life of an employee, officer or director of the business. Two situations exist where a beneficiary's receipt of insurance proceeds will continue to be excluded from gross income:
(1) if the insurance proceeds are paid to a beneficiary because of the death of the insured and such proceeds are paid to: (a) a member of the insured's family; (b) an individual designated beneficiary of the insured (other than the policyholder); (c) a trust established for any such member of the insured's family or designated beneficiary; or (d) the insured's estate.
(2) if the insured was employed by the policyholder within the year ending on the date of death or was, when the contract was issued, a director, highly compensated employee or highly compensated individual of the policyholder. This exception only applies if the insured is notified in writing: (a) before issuance of the policy, that the policyholder intends to insure the person; (b) of the maximum face amount for which he can be insured; and (c) that an applicable policyholder will be the beneficiary of the death benefit. In addition to the above notice requirements, the insured must consent in writing to being insured and having coverage continue after the insured's employment terminates.
It is important that these notice and consent provisions are included in corporate buy-sell agreements where insurance may be used to fund a redemption or buy-out of a deceased shareholder on death.
Rita M. Danylchuk is Of Counsel at Gibbons, Del Deo, Dolan, Griffinger & Vecchione, a full-service law firm with offices in Newark, Trenton, New York and Philadelphia and Chair of the Private Client Group. She can be reached at 973-596-4653.