On September 23, President Bush signed into law the Katrina Emergency Tax Relief Act of 2005 (the "Act"). The Act included a number of provisions designed to provide tax relief to the victims of Hurricane Katrina, and to encourage others to assist those in need in the aftermath of the disaster.

In particular, the Act temporarily removed the percentage limitations on the deductibility of cash contributions to most types of charitable organizations.

Normal Treatment of Charitable Contributions

Under the rules provided in section 170(b) of the Internal Revenue Code (the "Code"), taxpayers are subject to limitations on the amount of charitable contributions they may deduct in determining their taxable income. Individuals may only deduct charitable contributions up to a percentage of their contribution base, which is the individual's adjusted gross income computed without regard to any net operating loss carryback.

Corporations may only deduct charitable contributions up to 10% of their taxable income, computed without regard to any net operating loss or capital loss carryback.

For individuals, this percentage limitation depends upon the type of property donated and the type of organization to which it is donated. In general, individuals may deduct contributions of property to most types of charitable organizations up to 50% of their contribution base.

Contributions of such property to certain private foundations are deductible up to only 30% of the donor's contribution base. Contributions of appreciated capital gain property to most types of charities may be deducted up to 30% of the donor's contribution base, or up to 50% of the contribution base if the long-term capital gain is not taken into account.

Finally, contributions of appreciated capital gain property to certain private foundations may be deducted up to 20% of the donor's contribution base. Contributions by individuals and corporations in excess of these limitations can be carried forward for up to five tax years.

In addition to these percentage limitations, charitable contributions are counted as itemized deductions that are subject to the phaseout of section 68 of the Code. Under this rule, a taxpayer's otherwise allowable itemized deductions are reduced by 3% of the amount by which the taxpayer's adjusted gross income for 2005 exceeds $145,950 ($72,975 for married individuals filing separately).

Such reduction, however, is limited to 80% of the taxpayer's total itemized deductions that were otherwise allowable.

Treatment of Charitable Contributions Under the Act

The Act temporarily suspends these percentage limitations with respect to certain "qualified contributions," as defined below. Under the Act, an individual may claim a charitable deduction for qualified contributions to the extent the amount of such contributions, plus the individual's other allowable contributions for the year, do not exceed the individual's contribution base.

Similarly, a corporation may claim a charitable deduction for its qualified contributions, to the extent such contributions, plus the corporation's other allowable contributions for the year, do not exceed the corporation's taxable income. The Act also permits excess qualified contributions to be carried forward for up to five years, as under the normal rules.

"Qualified contribution" means any cash contribution made between August 28, 2005 and December 31, 2005 to any organization to which the 50% percentage limitation for individuals normally would apply, with the exception of "supporting organizations" of other charities.

In the case of contributions made by corporations, a contribution also must be made for relief efforts related to Hurricane Katrina in order to be a qualified contribution. In addition, all contributors must make an election to have their contributions treated as qualified contributions.

For contributions made by partnerships or S corporations, this election must be made by each partner or shareholder. A contribution is not qualified if it is made to a segregated fund or account over which the donor or his representative can control the distributions or investments by virtue of his status as a donor. On the other hand, a contribution to such a donee may be qualified if the donor's control arises only by virtue of his status as an officer, director, or employee of the donee. In addition, qualified contributions are not treated as itemized deductions that are subject to the phaseout of section 68 of the Code.

Practical Effects

The Act provides a generous incentive for individuals to make large charitable contributions during the remainder of 2005.

By not limiting "qualified contributions" to contributions made by individuals for Hurricane Katrina relief efforts, the Act provides an attractive opportunity for individuals to make large contributions to most types of charities this year.

As an illustration of the provisions of the Act, assume an individual taxpayer has a contribution base for 2005 of $100,000, and has already made non-qualified charitable contributions of $50,000 during the year. Under the Act, he may make an additional $50,000 in qualified contributions during the remainder of 2005 without limitation.

If instead, he makes $80,000 in qualified contributions, $50,000 of the qualified contributions will be deductible in 2005, and the remainder may be carried forward for up to five years. If an individual with a contribution base of $100,000 has already made $60,000 of non-qualified charitable contributions during 2005, he will be subject to the 50% percentage limitation with respect to those contributions, so that $10,000 of the contributions will be disallowed and carried forward.

However, he may still make qualified contributions of $50,000 during the remainder of 2005 which will be fully deductible. Individuals seeking to take advantage of this rule, however, must be sure that their contributions are made in cash and are made to qualified organizations. The Act does not provide any benefit with respect to non-cash contributions, such as appreciated stock. It also does not provide any benefit with respect to contributions to supporting organizations or certain private foundations, or with respect to contributions that are made "for the use" of a charity but are not actually made directly to the charity.

Further, an individual taking full advantage of this provision likely would lose the benefit of any other deductions he had for the year. That is, if his adjusted gross income for 2005 was fully offset by qualified charitable contributions, his taxable income would be zero and his other deductions would not provide a current benefit.

Although itemized deductions can give rise to a net operating loss ("NOL") that may offset income in another year, an individual's nonbusiness deductions can only offset his nonbusiness income in computing a NOL. Thus, nonbusiness deductions such as home mortgage interest, state taxes, and charitable contributions could not offset wage income to create a NOL that could be used in another year.

For more information, contact:

Joseph Rieser
202-857-8964
rieser.joseph@arentfox.com