Take-Away: With the high taxation of income accumulated in an irrevocable Trust, and the current threat of even higher income taxes faced by irrevocable Trusts, a Trust may need to have included in the Trust instrument as a ‘safety valve’ the trustee’s ability to make charitable gifts. Consider naming a donor advised fund as a beneficiary of the irrevocable Trust to shift income away from the Trust, while not adding taxable income to the trust beneficiaries.

Background: Trusts are notoriously taxed. A Trust faces the top marginal federal income tax bracket of 37% when its income exceeds $13,050. The House Ways and Means Committee bill currently before Congress would make that income taxation even more onerous, if the highest income tax rate is increased to 39.6%, the capital gains rate is increased from 20% to 25%,  a 3% tax surcharge is imposed on trust income in excess of $100,000, a $10,000 limit is imposed on a Trust’s qualified business income deduction [IRC 199A], and the Trust’s exposure to the 3.8% net investment income tax is increased.  While distributions from a Trust normally carry out distributable net income (DNI), some Trusts are structured so that not all income can, or should, be distributed to the trust beneficiaries, or the beneficiaries may be at the same income tax bracket as the Trust. As a result, some trustees, to avoid the high income tax burdens placed on the Trust they administer, might want to make charitable distributions from the Trust to avoid accumulating too much taxable income in the Trust and exposing that accumulated income to such high income taxation.

Charitable Income Tax Deductions: In general, there are two different ways that the trustee of an irrevocable Trust can make charitable gifts.

  • Distributions to Beneficiaries: The trustee can distribute cash or other assets to the trust beneficiaries who can then make the charitable donation for themselves. Distributions to the trust beneficiary will normally carry out distributable net income (DNI) and thus be income reported by the beneficiary on his or her individual Form 1040, but hopefully at a much lower marginal federal income tax bracket. Donations to the charity by the trust beneficiary from such distributions can then be personally deducted by the beneficiary, subject to the limits the trust beneficiary may face with respect to the beneficiary’s adjusted gross income for the year, with any excess charitable income tax deduction carried forward for 5 additional years.. If the trustee distributes assets in-kind to the trust beneficiary, and those assets have substantial unrealized gain and are long-term capital assets, the trust beneficiary can take a deduction for the full fair market value of such assets. [Regulation 1.170A-1(c) and 1.170A-4.]
  • Direct Distributions to Charity: If permitted, the Trust instrument itself could donate directly to charity. The trustee can then take the charitable income tax deduction in these situations. The federal income tax deductions taken at the Trust’s level may be more beneficial than if the deduction taken at the trust beneficiary’s level. [IRC 642(c).]

IRC 642(c): In order for a Trust to take an income tax charitable deduction, the donation must meet the requirements of IRC 642(c), which provides that a Trust is allowed to claim such deductions for “any amount of the gross income, without limitation, which is pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in IRC Section 170(c).” In short, the Trust instrument must expressly authorize payments to a charity. These payments can be cash to the extent of the lesser of taxable income for the year or the amount of the contribution. The Trust can also receive a charitable deduction for non-cash asset contributions that the Trust purchases with trust income, but only as to the adjusted basis of such donated asset. If those assets were contributed to the Trust, the trustee cannot claim a charitable income tax deduction for a donation of such assets to a charity. Note, too, that unlike individual donors, a Trust can claim an income tax charitable deduction for donations to foreign organizations that are operated exclusively for a charitable purpose.

Options for Moving Trust Income or Assets to Charities: There are various ways in which a trustee, or trust beneficiaries, can move trust assets to a charity and claim an income tax deduction:

Charity as Named Trust Beneficiary: It is possible for a charitable organization to be expressly named as a permissible current beneficiary of the Trust. For example, a Trust could be written so that the trustee possesses discretion to spray trust income among a group of trust beneficiaries that consists of the settlor’s family members, a donor-advised fund established by the settlor, or to a specifically named charity. Therefore, each year, the trustee can determine whether it might be more beneficial to donate all or a portion of the Trust’s income to the charity or donor advised fund. If the trustee exercises that discretion, the trustee would be wise to confirm with the family members of the trustee’s intent to make a charitable distribution from the Trust.

Adding Charitable Beneficiaries: It is also possible to give a non-adverse party the power to add a charitable beneficiary to the Trust. Often this ‘power’ is included in a Trust to cause the Trust to be taxed as a grantor trust for income tax purposes, while not being subject to federal estate taxes on the settlor’s death. If a non-adverse party possesses this power to add a trust beneficiary, this could be a mechanism to allow the trustee to directly distribute assets to charities who are added to the Trust as current beneficiaries. For example, if the non-adverse party adds a donor advised fund as a permissible trust beneficiary, then the trustee could make direct distributions to the family’s donor advised fund whenever doing so is determined by the trustee to be in the best interests of the non-charitable beneficiaries.

Caution: While a trust director could be empowered to add a charitable beneficiary to a Trust, that might be problematic since in Michigan a trust director serves in a fiduciary capacity and must always act in the trust beneficiaries’ best interests. [MCL 700.7703a((5)(a).]  Adding another potential distributee to the Trust might not be viewed by the non-charitable trust beneficiaries as a decision that is in their best interests.

Lifetime Power of Appointment: The trust instrument could give a trust beneficiary a lifetime power of appointment, which could be exercised to direct the trustee to make a distribution to a charity, if the special lifetime power of appointment is broad enough to include charities, such as a donor advised fund.

“Back-door” Option: Assume that a Trust instrument does not authorize distributions directly to a charity. The trustee might consider investing trust assets in an LLC. The manager of the LLC can then make donations to a charity directly from the LLC. The charitable deductions would then pass through to the LLC members, which would be 100% to the Trust if the Trust was the sole LLC member. Again, if this strategy were to be pursued, the trustee would surely want the ‘buy-in’ of the trust beneficiaries before forming an LLC for the sole purpose of making tax deductible charitable distributions from the Trust.

Conclusion: As Trusts continue to face high income taxes, and perhaps even higher income taxes in the near future, long-term discretionary Trusts might be created, or amended (or decanted) to authorize the trustee to make direct distributions to a charity. Perhaps ‘hard-wiring’ a family’s donor advised fund into the Trust as a trust beneficiary of a discretionary Trust would be a helpful provision to move taxable income away from the Trust and to a charity that the other trust beneficiaries might then be able to use to fulfill their own philanthropic objectives. Building ‘safety-valve’ provisions in irrevocable Trust may make even more sense with the possible change in the income tax laws.