Monday, March 27, 2017
Charitable giving is an important part income tax and estate planning for some clients. Often the charitable gift is made directly by the individual, but there can be benefits to making the contributions from a trust. Individuals can be limited in the amount given to charity. For example, the amount an individual can deduct for charitable contributions generally is limited to 50% of adjusted gross income (AGI). The deduction may be further limited to 30% or 20% of AGI, depending on the type of property donated and the type of organization it is donated to. Other limits can apply to qualified conservation contributions, unless the donor is a qualified farmer or rancher. However, trusts are entitled to an unlimited deduction.
The benefit of making charitable contributions via a trust is the topic of todays’ blog post.
The general rule is that an individual can’t take a charitable deduction for more than 50 percent of AGI for the year. This limit applies to the so-called “50 percent organizations” unless the donation is of capital gain property and the taxpayer computes the deduction using the donated property’s fair market value without reducing for depreciation. In that instance, the limitation is 30 percent unless fair market value of the property is reduced by the amount that would have been long-term capital gain if the property had been sold rather than donated. A “50 percent organization” includes churches, educational organizations, hospitals, the U.S., publicly supported charities, and private foundations.
A 30 percent limitation applies to contributions to all other qualified organizations, except that the limitation is 20 percent if the contribution is of capital gain property.
For qualified conservation contributions, the limit is 50 percent of AGI, less the deduction for all other charitable contributions. A carryover rule applies. For qualified farmers and ranchers, the deduction for a qualified conservation contribution is 100 percent of AGI. A qualified farmer or rancher has gross income from the trade or business of farming that exceeds 50 percent of gross income for the tax year.
What About Trusts?
Unlimited deduction. There are advantages in making charitable contributions from a trust compared to contributions from an individual. Trusts are not subject to percentage limitations on the amount of the charitable deduction. The deduction is unlimited (I.R.C. §642(c)) unless the donated amount of the trust’s gross income consists of unrelated business income. I.R.C. §170. Thus, the trust language should specify that payments to charity should be paid from gross income first to the extent that gross income is not unrelated business income. But, it remains uncertain whether such clause language would prevail for tax purposes. In the right case, the IRS might challenge that language, and the law is not entirely clear on the point.
Flexibility and additional tax benefit. In addition, a trust takes a charitable deduction in the year in which the income is donated to charity even if it was earned in prior years. In that situation, the trust can make an election to treat the payment as having been made in the prior year in which the gross income was earned. I.R.C. §642(c)(1). In addition, if a trust is potentially subject to the 3.8 percent net investment income tax of I.R.C. §1411 (which is triggered when trust income reaches $12,500 for 2017), the trust can reduce its net investment income subject to the 3.8 percent tax by the amount donated to charity.
Obtaining the deduction. A trust can claim a charitable deduction under I.R.C. §642(c) if the donated amount is from gross income, is made in accordance with the trust’s terms, and is made for a charitable purpose – one that is specifically denoted in I.R.C. §170(c). For a case on the issue of having the payments being authorized by and made in accordance with the trust’s terms see Hubbell Trust v. Commissioner, T.C. Sum. Op. 2016-67. Also, a donation to charity from a trust made pursuant to the exercise of a power of appointment would appear to meet the test. However, for a contrary view see Brownstone v. United States., 465 F.3d 525 (2nd Cir. 2006).
What if a trust fails to contain language that authorizes distributions to charity and the objective now is to make such contributions? One possibility is to decant the asset to be contributed to charity to another trust. That trust could then contain a power of appointment granting the power to a third party to make charitable distributions. Whether this strategy would actually work is an open question. Does the original grantor have to have the charitable intent? Another possibility, according to an IRS revenue ruling is to contribute assets to a partnership where a partnership interest is a trust asset and then have the partnership make the charitable contribution from the partnership’s gross income. See Rev. Rul. 2004-5, 2004-3 IRB 295.
Are mandatory distributions required? That answer is clearer – as long as the trust authorizes discretionary charitable distributions, the distributions will qualify for the charitable deduction.
Also, the trust can authorize either the trustee, the beneficiaries or others to direct that charitable distributions be made. In addition, trust language can provide for beneficiary (or third party) consent before charitable distributions can be made. The same consent can be made applicable before the exercise of a power of appointment in a charity’s favor, and restrictions can be placed on distributions without eliminating the deduction.
What is “gross income”? What does it mean to satisfy the requirement that the donated amount come from “gross income”? That’s a more difficult question to answer because tracing the source of the income is not necessarily easy. A recent case provides some helpful, and some would assert, surprising guidance. In Green v. United States, 144 F. Supp. 3d 1254 (W.D. Okla. 2015), a dynasty trust created in 1993 expressly authorized the trustee to “distribute to charity such amounts from the gross income of the Trust as the trustee determines appropriate.” The trust also provided that “[a] distribution may be made from the Trust to charity only when both the purpose of the distribution and the charity are as described in Section 170(c) of the Code.” The trust wholly owned a single-member LLC and, in 2004, the LLC donated properties that it had purchased to three qualified charities. Each property had a fair market value that exceeded basis. The LLC received the funds to buy the properties from a limited partnership's distribution to the trust in which the trust was a 99 percent limited partner. The limited partnership owned and operated most of the Hobby-Lobby stores in the U.S. The IRS claimed that the trust could not take a charitable deduction equal to the full fair market value, but instead took the position that the charitable deduction should be limited to the trust's basis in each property. The trust claimed a charitable deduction in excess of $20 million on Form 1041 for 2004, and later filed an amended Form 1041 increasing the claimed charitable deduction to just shy of $30 million, and seeking a tax refund of over $3 million. The IRS denied the refund, claiming that the charitable deduction was limited to cost basis. The trust paid the deficiency and sued for a refund. On the trust's motion for summary judgment, the parties agreed that the donated properties were acquired by the trust with funds coming from gross income from a pre-2004 tax year. Thus, according to the trust, I.R.C. Sec. 642(c)(1) allowed the charitable deduction to be computed based on the donated property's fair market value. The court agreed, noting that I.R.C. Sec. 642(c)(1) allowed a deduction without limitation contrary to the basis limitation contained in I.R.C. Sec. 170, and that charitable deduction provisions are to be construed liberally in the taxpayer's favor. The court noted that the donated properties were all acquired with distributions from the limited partnership to the trust, and each distribution was part of the LLC's gross income for the year of distribution. Thus, the donated properties were clearly bought with funds traceable to the trust's gross income and were donated under the terms of the trust. The court noted that the IRS admitted that there was no caselaw or other substantial authority that supported the government's position. The court granted summary judgment for the trust – the trust was entitled to a deduction for the full fair market value of the appreciated property.
Donating to charity from a trust can be beneficial. There are no percentage limitations that apply. However, there are other requirements that apply and care should be taken in drafting trust language so that those requirements are satisfied.