Lame Duck Congress Passes Last Minute Tax Act

Before recessing for its holiday break, Congress passed the Tax Relief and Health Care Act of 2006 (H. R. 6111) (“the Act”). The Act provides many long –awaited extensions of several expiring tax provisions. The extensions include:

1. Qualified tuition deductions for 2006 and 2007;
2. Election for itemizers to deduct sales tax rather than state income tax through 2007;
3. Above-the-line deduction for teacher classroom expenses through 2007;
4. Permanent capital gain treatment for self-created musical works;
5. Inclusion of combat pay as earned income for purposes of calculating the Earned Income Tax Credit through 2007;
6. The ability to make new contributions to Medical Savings Accounts through December 31, 2007;
7. An income tax credit for energy efficient homes placed in service through January 1, 2009;
8. Work opportunity and welfare-to-work tax credits for businesses on wages paid through January 1, 2008;
9. Research and experiment tax credits on qualified expenditures made through December 31, 2007;
10. Fifteen year depreciation for leasehold improvements and restaurant property through 2007; and
11. A charitable contribution deduction for corporate donations of scientific property made on or before December 31, 2007.

The Act also provides for new tax saving provisions and reporting requirements such as:

1. A new itemized deduction for mortgage insurance premiums beginning in 2007;
2. The credit for prior year Alternative Minimum Tax (“AMT”) being refundable after a period of years; and
3. Required information returns in connection with certain stock options.

Unrelated Business Taxable Income, or UBTI, is income earned by a charity or other tax-exempt entity from a business or investment opportunity that has no relation to the business of the charity. The tax first came into existence when a very successful spaghetti factory was donated to New York University School of Law by a group of benefactors. Other businesses complained that they could not compete with the factory in that the factory had an unfair advantage because it did not have to pay income taxes due to its ownership by the School, which is a tax exempt organization. As a result of these complaints, Congress passed a law which treats income earned by tax exempt entities from unrelated business activities differently than income earned from passive investments or business activities directly related to the business purpose of the tax exempt organization or entity.

Under current law, a Charitable Remainder Trust (“CRT”) loses its tax exempt status if it earns even $1 of UBTI. This made it impossible to use a CRT as a strategy to sell an active business and limited partnership on a tax advantaged basis. Section 424 of the Tax Relief and Health Care Act of 2006 modifies the CRT provisions of the Internal Revenue Code to now allow for the sale of an active business, limited partnership, or other investment which generates UBTI on a tax-favored basis by a CRT possible.

Beginning on January 1, 2007, the UBTI rule is changed. A CRT will no longer lose its tax exempt status if it earns UBTI. Instead, the CRT will suffer a 100% excise tax on the amount of UBTI the CRT earns. For instance, if an active business earns $10,000 while it is owned by a CRT, the CRT must pay a $10,000 excise tax to the IRS.

While a severe penalty, this new provision of the Act creates planning opportunities where there is an active business or limited partnership that has a ready and willing buyer available but where sale negotiations have not progressed to the point where any enforceable rights have been created. In these cases, the business or partnership can be contributed to the CRT and the sale transaction can be consummated a short time later. The sale of the business or partnership will be tax-free to the CRT. There will be a 100% excise tax on any UBTI earned in the interim, but it is anticipated that such income would be minimal because of the short holding period prior to sale. This strategy provides for “near-zero” recognition of tax on the sale of the business or limited partnership, and the opportunity for a tax-favored income stream and charitable income tax deduction for the former business owner for a portion of the value of the business contributed to the CRT.

Our office focuses on all aspects of estate planning, including estate planning for the owners of family-owned businesses. The attorneys at the law firm are experienced in planning strategies that can be used to effectively pass the ownership of businesses to future generations, key employees or third parties while also minimizing income, gift, estate and generation-skipping transfer taxes. Contact us to schedule an appointment to learn how we can assist your business and other clients with their estate planning needs.