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George F. Bearup, J.D. Senior Legal Trust Advisor

7-Mar-20

Charitable Deductions By a Trust: A Potential Rule Change?

It’s that time of the year when our attention turns to income taxes and we renew our annual search for ways to minimize the amounts that we must pay in income taxes, if not now, in future years. That same search applies to trustees of irrevocable trusts.

Problem: We all know that irrevocable trusts are heavily taxed. An irrevocable trust that accumulates income in excess of $10,400 in a year finds itself at the highest marginal federal income tax bracket of 39.6%. Add to that federal income tax a state income tax at 4.25% and possible exposure to the federal net investment income surtax of 3.8%, and obviously a very high aggregate tax can be imposed on a trust’s accumulated income. It would be helpful if the trustee could distribute income to charities and thus claim a federal income tax charitable deduction in order to reduce this excessive income taxation that it faces, and perhaps use the trust’s distributions to indirectly carry out a trust beneficiary’s philanthropic agenda. But the Tax Code is not very helpful when it comes to an irrevocable trust making deductible charitable contributions.

Basic Rules:

  • An irrevocable trust is permitted a federal income tax charitable deduction for distributions of gross income the trustee makes to a charity, subject to the condition that the income distribution to the charity must be pursuant to the terms of the governing instrument. Restated, if the trustee simply exercises its discretion to make a distribution of income to a charity, no charitable income tax deduction is available if the trust instrument does not expressly authorize that distribution to the charity. IRC 642(c)(1).
  • While normally a trust distribution to a beneficiary will carry out with it distributable net income, which thus reduces the amount of income that remains accumulated inside the irrevocable trust, [IRC 661] in a series of unfortunate federal court cases, it was established that distributions to a charity are deductible only under IRC 642(c)(1) [the pursuant to section of the Code], and not the more general IRC 661 which covers distributions from the trust to other beneficiaries that carries out of the trust distributable net income, which reduces the amount of taxable income accumulated inside the irrevocable trust.

What Changed: The IRS recently issued a Chief Counsel Advice memo that indirectly addressed the ability of an irrevocable trust to claim a charitable income tax deduction, but which may provide more flexibility to a trustee in search of a deduction to reduce the trust’s exposure to confiscatory income tax rates. Chief Counsel Advice 201651013.

Facts: The issue presented to the IRS was whether an existing irrevocable trust, which was silent on the authority given to the trustee to distribute trust income to charities, i.e. there was no pursuant to authority granted in the trust, could be modified by apparently a non-judicial settlement agreement which opened the trust to make distributions of income to charities. Specifically the non-judicial settlement agreement added a lifetime and testamentary power of appointment to a trust beneficiary which allowed the appointment of trust income or principal to a charity by the beneficiary (not the trustee.)  A probate court then approved the trust modification. This power of appointment was then exercised by the beneficiary and trust income was distributed to a private foundation.

Question: The question posed to the IRS was: does the modified trust instrument satisfied the Tax Code’s condition that a distribution to the charity must be pursuant to the terms of the trust instrument?

Bad News: The CCA concluded that the purpose of the probate court order that modified the trust instrument was not to resolve any conflict of a legitimate dispute among beneficiaries and/or the trustee, but only to obtain an economic benefit. In short, the modified trust did not meet the pursuant to condition imposed by IRC 642(c)(1). Thus, the trustee could not claim an income tax charitable deduction under IRC 642(c)(1) for the payment of income to the private foundation;  a trust cannot be modified in order to add the conditional pursuant to ‘magic language.’

Good News:  The CCA also agreed to look at the ambiguous legislative history of IRC 642(c)(1) and subsequent conflicting court decisions with regard to an irrevocable trust that tries to claim a distribution deduction when the recipient of the distribution was a charity. As noted above, to this point in time, a distribution of trust income to a charity was permitted only under the conditional IRC 642(c)(1) and not the more general authority for a deduction for distributions of distributable net income by the trustee under IRC 661, where no deduction was allowed for distributions to a charity of trust income. The CCA concluded that despite the ambiguous legislative history and judicial decisions, a distribution deduction would be permitted under IRC 661 for distributions by the trustee to a charity. Thus, the beneficiary’s exercise of the power to appoint income to a charity would be respected, and that distribution would carry out part of the trust’s distributable net income.

Unresolved: While finding that a distribution deduction under IRC 661 was available to the trustee, the CCA did not address whether capital gains that are includable in the trust’s distributable net income would also be deductible under IRC 661 in light of the fact that no deduction is permitted under that code section from its express language.

Take-aways:

  • If a trustee is to be authorized to make tax deductible distributions of gross income from the irrevocable trust, there must be express language in the trust instrument that permits those income distributions to satisfy the pursuant to condition;
  • The IRC 642(c)(1) charitable deduction is limited to distributions of only income from the irrevocable trust, not for principal distributions from the trust;
  • Unlike an individual taxpayer whose charitable gifts are limited by the amount of their reported adjusted gross income in a calendar year, e.g. the charitable deduction can be no more than 50% of the individual taxpayer’ reported adjusted gross income, an irrevocable trust does not face a similar reported annual income ‘cap’, so that there are more tax-savings available from a trust’s charitable deduction than from an individual’s charitable deduction;
  • In the absence of a legitimate dispute among beneficiaries, a trust instrument cannot be modified, either by non-judicial settlement agreement or probate court order, to add the missing words necessary to claim an income tax charitable deduction under IRC 642(c)(1)- the key language needs to be in the trust instrument when it is first drafted;
  • A distribution can be made by the trustee to a charity under IRC 661 to carry out with it distributable net income to reduce the trust’s accumulated income on which confiscatory federal income taxes are imposed; and
  • An irrevocable trust might be drafted, in truth contrary to the basic Revised Uniform Principal and Income Act principles, i.e. the trust ‘opts out’ of the Uniform Act, to expressly classify capital gains as income for distributable net income purposes, in order to maximize the deduction it can claim under IRC 661 and thus reduce the trust’s exposure to the net investment income surtax.

As we review proposed irrevocable trust instruments with our clients, these tax rules are important to keep in mind. Let me know if you have any questions.