November 2005
By Professor David A. Pratt, Albany Law School
Co-authors are Deborah S. Kearns, Lavelle & Finn, Albany
and Tara Anne Pleat, Jones & Wilcenski, Clifton Park

The House and Senate unanimously passed the Katrina Emergency Tax Relief Act (“KETRA”, H.R. 3768) on September 21, 2005, and President Bush signed the bill into law on September 23, 2005 (Pub. L. 109-73). The Act provides temporary tax relief for the victims of Hurricane Katrina located in designated disaster areas, and also provides charitable tax incentives to taxpayers throughout the United States.

The focus of this article is the charitable tax incentives for taxpayers throughout the country, but the article also provides a brief explanation of the tax relief provided only to the victims of Hurricane Katrina.²

Temporary Increase of Limitations on Charitable Contributions
Individuals
As a general rule, income tax deductions for charitable contributions are limited to a percentage of the individual’s contribution base, which is his or her adjusted gross income (“AGI”) computed without regard to any net operating loss (NOL) carryback.³ The deduction for cash contributions to public charities is limited to 50% of the contribution base, while the deduction for contributions of property to public charities is generally limited to 30% of the contribution base. There is a five year carryover for any amounts that cannot be deducted in the year the contribution is made because of these percentage limitations.

The deduction for charitable contributions is an itemized deduction. In addition to the percentage limitations, a portion of an individual’s itemized deductions may be disallowed by IRC Section 68, which reduces the amount of the allowable itemized deductions by the lesser of (i) 80% or (ii) 3% of the taxpayer’s AGI in excess of $145,950.⁴ The amount of the reduction under Section 68 may not be carried over.

KETRA temporarily suspends the percentage of income limitation on charitable contributions by providing that the 50% limitation will not apply to any “qualified contributions”. A qualified contribution⁵ is any cash donation to an IRC Section 170(b)(1)(A) organization (other than a donor advised fund, supporting organization or private nonoperating foundation)⁶ made between August 28, 2005 and December 31, 2005.⁷ Also, these qualified contributions are not taken into account in applying the limitations of IRC section 170(b) and (d) to other contributions made during the year.⁸

In addition, the portion of the total deduction allowed for the year under section 170 that does not exceed the qualified contributions paid during the year is not treated as an itemized deduction for purposes of the reduction under Section 68.⁹

Thus, for qualified contributions made during this period, the taxpayer may, if he or she so elects,¹⁰ deduct currently an amount up to (1) 100% of the contribution base, minus (2) the total amount of other charitable contributions deductible for the year under IRC section 170(b)(1).¹¹ If the total amount of qualified contributions exceeds this limitation, the excess can be carried over to the five succeeding tax years.¹²

For New York taxpayers, the increased federal charitable deduction would generally be allowed in computing their state and local income tax liability. However, in the case of a taxpayer whose New York AGI exceeds $100,000 ($200,000 if married filing jointly), the overall itemized deduction is subject to reduction by up to 50%.¹³

Although this liberalization of the charitable deduction rules was enacted in connection with Hurricane Katrina relief, these contributions do not have to be made to a charity whose activities are related to Hurricane Katrina in any way.

Special Opportunity for Retirement Plan Owners
KETRA does not allow retirement funds to be distributed to charity without being included in the donor’s gross income. However, the increase in the deduction limitation does provide a short-term opportunity for those who want to donate retirement funds to charity during their lifetime.

For example, if (before any withdrawal) Tom Jones has a federal and New York State AGI (and contribution base) of $100,000 for 2005 and wants to withdraw $1,000,000 from a retirement plan and donate it to a public charity, the maximum deduction would normally be $550,000 (50% of $1,100,000). Also, because the withdrawal has increased the AGI, he would lose his personal exemption(s) and some of the federal and New York itemized deductions.¹⁴ However, if the withdrawal is taken during 2005, and a qualified contribution made by December 31, 2005, he will be entitled to a full $1 million deduction on his federal return.¹⁵ He will, however, still lose the federal exemption(s) and suffer a reduction of itemized deductions for New York purposes.

Simplified Example: Assume that Tom Jones is a single taxpayer with no dependents and that he has $20,000 of itemized deductions ($10,000 of taxes, and $10,000 home mortgage interest) before any contribution from his retirement funds. His taxable income is $76,800¹⁶ and his federal income tax liability is $16,011. If he takes the $1 million withdrawal and makes a $1 million qualified contribution by December 31, 2005, his taxable income will be $96,000¹⁷ and his federal income tax liability will be $21,387, an increase of $5,376. On these facts, he does not have any AMT liability, but there will also be a small increase in his New York State (and local) income tax.

This technique may not work for everyone, and requires consideration of the following factors:

1. If the funds are held in an employer plan rather than an IRA, the employee must be entitled to a current distribution under the terms of the plan. For instance, an in-service distribution may not be allowed. In addition, if the individual is married, spousal consent may be required.

2. If the funds are held in an employer plan or by an institutional trustee or custodian, the withdrawal request must be made early enough that it can be processed by year-end.

3. If the individual is younger than 59 ½, the entire $1 million will generally be subject to a 10% additional income tax unless an exception can be found (which appears unlikely).¹⁸

4. The individual must consider the state and local income tax costs of taking the withdrawal, and the effect on his or her AMT liability.

5. The increase in the taxpayer’s AGI may have an effect on the individual’s other itemized deductions (e.g., medical expenses, casualty losses, miscellaneous itemized deductions), personal exemptions, and other deductions. It may also increase the amount of tax payable on Social Security benefits.¹⁹

Corporations
Generally, the charitable deduction for contributions made by a corporation is limited to 10% of the corporation’s taxable income (computed without regard to net operating loss or capital loss carry-backs and certain other items) for the year in which the contribution is made.²⁰

Like individual taxpayers, a corporate taxpayer may elect to have the percentage limitation not apply to qualified contributions (as defined above) made between August 28, 2005 and December 31, 2005. Unlike individual taxpayers, these contributions must be made for relief efforts related to Hurricane Katrina.²¹ If a corporation makes this election, these contributions will be deductible to the extent that (i) the total of the qualified contributions does not exceed (ii) the excess of the corporation’s taxable income (as determined under IRC section 170(b)(2)) over the amount of all other deductible charitable contributions made by the corporation for the year. If the qualified contributions exceed this limitation, then the excess is added to the amounts carried forward for the succeeding five years.

Additional Personal Exemptions for Housing Displaced Individuals
In calculating taxable income, an individual reduces his or her adjusted gross income by personal exemptions and by the greater of the standard deduction or the itemized deductions. Generally, one personal exemption is allowed for each of the taxpayer, his or her spouse (if filing jointly) and each dependent. Personal exemptions are phased out for taxpayers with AGI over a threshold amount,²² and are not permitted for AMT purposes.

KETRA provides an additional personal exemption for any individual who has provided housing to a “Hurricane Katrina Displaced Individual” (“Displaced Individual”).²³ The additional exemption is $500 for each Displaced Individual, subject to the limitations described below. For this purpose, a Displaced Individual is any natural person:

1. whose primary residence was located in the Hurricane Katrina disaster area as of August 28, 2005 and the person is displaced from their residence; or

2. whose primary residence is located outside the core disaster area and their residence was damaged by Hurricane Katrina or the person was evacuated from their residence as a result of Hurricane Katrina; and

3. the individual is provided housing free of charge by the taxpayer in the taxpayer’s principal residence for a period of at least 60 consecutive days, which ends in the tax year for which the taxpayer claims the exemption; and

4. The Displaced Individual is not the spouse or a dependent of the taxpayer.

There are limitations. The exemption may not be claimed for more than four individuals and the total additional exemption, for both years (2005 and 2006), is $2,000. A taxpayer can only receive an exemption for housing a particular Displaced Individual once, either in 2005 or 2006, but not in both years. The taxpayer must report the taxpayer identification number of each individual for whom the taxpayer is claiming the exemption.

The additional exemption is allowed as a deduction for AMT purposes, and is not subject to the income-based phase out. If the taxpayer is receiving rent or any other amount (from any source) for providing housing, the taxpayer cannot claim the exemption (and generally should report any rent paid as taxable income).

Increase in Standard Mileage Rates for Charitable Use of Vehicles
In general, a taxpayer may claim a charitable contribution deduction of 14 cents per mile when a vehicle is used for charitable purposes.²⁴ KETRA provides that a person who uses a vehicle in providing donated services to charity during the period beginning on August 25, 2005 and ending on December 31, 2006, solely for the provision of relief related to Hurricane Katrina, may take a charitable deduction using a rate equal to 70% of the business mileage rate in effect on the date the vehicle is used.²⁵ The business mileage rate is 40.5 cents per mile for expenses incurred from August 25, 2005, through August 31, 2005, and is 48.5 cents per mile for expenses incurred from September 1, 2005 through December 31, 2005.²⁶ Thus, the KETRA charitable mileage rates are 29 cents and 34 cents, respectively. The rate for travel after December 31, 2005 and before January 1, 2007 will be announced by the Internal Revenue Service at a future date.

Mileage Reimbursements to Charitable Volunteers Excluded from Gross Income
Some charities reimburse volunteers for the costs of using a private vehicle in providing services to the charity. KETRA provides that, for the period beginning August 25, 2005 and ending December 31, 2006, such reimbursements for use of an automobile in connection with providing Hurricane Katrina relief will not be treated as taxable income to a volunteer, to the extent that the reimbursement does not exceed the business standard mileage rate at the time the services are provided.²⁷ A volunteer may not claim a deduction or credit with respect to amounts excluded under this provision.

Additional Provisions
KETRA also provides special rules for (1) charitable deductions for contributions of food inventory by businesses and (2) charitable deductions for contributions of book inventories to public schools.²⁸ In each case, the contribution must be made between August 28, 2005 and December 31, 2005.

KETRA also:

1. Provides an income tax exclusion of certain cancellations of non-business indebtedness by reason of Hurricane Katrina;²⁹

2. Suspends certain limitations on the deduction of personal casualty losses in the disaster area;³⁰

3. Provides relief for the filing of returns relating to, and the payment of, certain federal taxes;³¹

4. Includes special rules for mortgage revenue bonds that provide financing with respect to a “qualified Hurricane Katrina recovery residence”;³²

5. Extends the involuntary conversion replacement period [IRC section 1033] from 2 years to 5 years with respect to property located in the Hurricane Katrina disaster area;³³

6. Provides special rules for determining earned income for purposes of the child tax credit and the earned income credit;³⁴

7. Authorizes the Secretary of the Treasury to make adjustments regarding taxpayer and dependency status in the case of temporary relocations by reason of Hurricane Katrina;³⁵ and

8. Extends the work opportunity tax credit to “Hurricane Katrina employees” and provides an employee retention credit for employers affected by Hurricane Katrina.³⁶

Use of Retirement Funds³⁷

The following provisions benefit only taxpayers directly affected by the hurricane:

1. KETRA excepts up to $100,000 of “qualified Hurricane Katrina distributions” from the 10% additional income tax imposed by IRC section 72(t) on most distributions received before age 59 ½.³⁸ Unless the taxpayer elects otherwise, the amount distributed will be included in income ratably over a 3 year period. These distributions may also be repaid.

2. A hardship withdrawal, taken to buy or construct a principal residence in the Hurricane Katrina disaster area, may be recontributed to the plan if the purchase or construction was canceled due to Hurricane Katrina.³⁹

3. KETRA increases the amount of the maximum nontaxable retirement plan loan to a qualified individual to $100,000 or, if less, 100% of the present value of the individual’s accrued benefit under the plan. In the case of outstanding plan loans, to a qualified individual, the due dates for repayment are delayed.⁴⁰

The IRS and U.S. Department of Labor have also granted significant additional relief for employee benefit plan sponsors and participants.⁴¹

_______________________

1. The authors of this article are Deborah S. Kearns, Lavelle and Finn, LLP, Albany; Tara Anne Pleat, Jones & Wilcenski, Clifton Park; and David Pratt, Albany Law School. The authors thank Prof. Ira Bloom of Albany Law School and Jack Trachtenberg, Esq. of Hodgson Russ, LLP, for helpful comments.
2. For a more detailed technical description of the Act’s provisions, see Joint Committee on Taxation, Technical Explanation of H.R. 3768, The Katrina Emergency Tax Relief Act of 2005, JCX-69-05, Sept. 22, 2005, reprinted in Tax Notes Today, Sept. 23, 2005, 2005 TNT 184-15.
3. IRC section 170(b).
4. This is the threshold for 2005. See Rev. Proc. 2004-71, 2004-50 IRB 970, section 3.11.
5. KETRA section 301.
6. A private operating foundation described in section 170(b)(1)(E) is eligible.
7. KETRA section 301(d).
8. KETRA section 301(a).
9. KETRA section 301(c).
10. In the case of a partnership or S corporation, the election must be made separately by each partner or shareholder. [KETRA section 301(d)(3)]
11. KETRA section 301(b)(1)(A).
12. KETRA section 301(b)(1)(B).
13. N.Y. Tax L. section 615(f).
14. IRC sections 68, 151(d)(3); NY Tax L. section 615(f).
15. This assumes that his or her other charitable contributions made during 2005, and deductible under section 170(b)(1), do not exceed $100,000.
16. AGI of $100,000 less personal exemption ($3,200) and itemized deductions ($20,000).
17. AGI of $1,100,000, no personal exemption, and itemized deductions of $1,004,000 ($1,000,000 + $20,000 – (80% * $20,000)).
18. IRC section 72(t).
19. IRC section 86.
20. IRC section 170(b)(2).
21. KETRA section 301(d)(1)(B).
22. The phaseout range depends on filing status. For 2005, it is $218,950 through $341,450 for a married couple filing jointly, and $145,950 through $268,450 for single filers. [Rev. Proc. 2004-71, 2004-50 IRB 970, section 3.17].
23. KETRA section 302.
24. IRC section 170(i).
25. KETRA section 303. The amount is rounded to the next higher cent.
26. IRS Announcement 2005-71, 2005-41 I.R.B. 714, Rev. Proc. 2004-64, 2004-49 I.R.B. 898.
27. KETRA section 304.
28. KETRA sections 305, 306.
29. KETRA section 401.
30. KETRA section 402.
31. KETRA section 403. See also IRS News Release IR-2005-128, Oct. 27, 2005.
32. KETRA section 404.
33. KETRA section 405.
34. KETRA section 406.
35. KETRA section 407.
36. KETRA sections 201, 202.
37. See IRS News Release IR 2005-122, Oct. 17, 2005.
38. KETRA section 101.
39. KETRA section 102.
40. KETRA section 103.
41. See, e.g., IRS Announcement 2005-70 (hardship distribution and loan procedures); IRS Notices 2005-60, 2005-84 (minimum funding); DOL and IRS, Extension of Certain Time Frames for Employee Benefit Plans Affected by Hurricane Katrina, 70 Fed. Reg. 55500, Sept. 21, 2005 (COBRA, HIPAA and claim filing deadlines); IRS News Releases IR-2005-110 and IR-2005-112 and PBGC Notice, PBGC Disaster Relief (Hurricane Katrina, Hurricane Rita) (extension of IRS, DOL and PBGC filing deadlines); IRS Notice 2005-68 (leave donation programs).

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