Charitable Income Tax Deductions for Non-Grantor Trusts

Take-Away: With the compressed income tax brackets faced by non-grantor trusts, along with the possible imposition of additional income tax surcharges of 5% and 3%, more irrevocable non-grantor trust should be drafted to include the authority of the trustee to make charitable distributions.

Background: For years now we have come to deal with the high income taxation of non-grantor trusts that accumulate income. Currently an irrevocable non-grantor trust will be at the highest marginal federal income tax bracket of 37% once the trust’s accumulated income exceeds $13,050 for the year. The trust will also be subject, at that level of accumulated income, to the 3.8% net investment income tax. [[IRC 1411.] Congress is currently debating whether to add an additional surtax if the trust’s accumulated income exceeds $200,000, and yet another surtax of 3% if the trust’s accumulated income exceeds $500,000. That is a very heavy income tax burden for the non-grantor trust to carry and something to try to avoid.

Aggressive use of non-grantor trusts: At this same time, many individuals are seriously considering the use of their $11.7 million federal applicable exemption amount before it disappears in 2026 to fund a discretionary, dynasty-type, trust that will avoid future federal estate and GST taxation for future generations. It might not be too difficult for a fully funded non-grantor trust to face these very high income tax burdens.
DNI: If discretionary non-grantor trusts are an estate planning strategy that will be used by many wealthy individuals, those trusts should include the express authorization that permit the trustee to make discretionary distributions of income to charities. If the trustee makes a distribution from the non-grantor trust to a charity, the distribution will carry out the trust’s distributable net income (DNI), thus reducing the trust’s retained accumulated (taxable) income. While distributions from the no-grantor trust to individual trust beneficiaries will also carry out taxable income to the trust beneficiaries, some of those beneficiaries may also be at the highest marginal federal income tax bracket, thus exposing the distributed taxable income to the same marginal income tax bracket as if the non-grantor trust had retained and accumulated its taxable income.
Charitable Beneficiary: Thus, if a charity is also included in the non-grantor trust as a potential trust beneficiary to receive distributions of income, the trustee has far more flexibility to manage the trust’s ultimate federal income tax burden, which might grow even higher in the years to come if the two proposed surtaxes become a reality.

However, there are a couple of rules that must be followed when a trustee makes a discretionary distribution to a charity.

IRC 642(c): IRC 642 allows an income tax charitable deduction for an estate or non-grantor trust if specific requirements are met. The general rule is that estates and complex trusts are permitted an income tax deduction in computing taxable income, in lieu of the deduction allowed under IRC 170(a) (governing individual donors) “for any amount of gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in Section 170(c) determined without regard to Section 170(c)(2)(A).” While that is an overly technical text, what this section really means to say is that an income tax deduction from the trust or estate’s gross income is permitted in two situations: (i) where income is actually distributed [IRC 642(c)(1)]; and (ii) where the income is set-aside for future distributions to a charity. [IRC 642(c)(2).]

Example #1: Barbara has $5,000 of cash and a painting worth $5,000. Barbara will receive an individual income tax charitable deduction if she gives either the cash or the painting to a charity. A trust or estate would not receive a fiduciary income tax charitable deduction even though if it gave the painting to charity, as the painting is not an item of gross income. The trust or estate would only claim the charitable income tax deduction if it gave the $5,000 of cash to charity, and even then only if the trust or estate’s governing instrument authorized the payment of income to charity.
Example #2: An estate has $5,000 of income. The only beneficiary of the estate is Barbara, the decedent’s daughter. Barbara tells the estate’s Personal Representative to give the $5,000 of cash to Western Michigan University. The estate’s Personal Representative follows Barbara’s directions. The estate is not allowed a fiduciary income tax charitable deduction. While the amount was paid out of the gross income of the estate, there was no direction in the decedent’s Will to pay any amount to charity. Accordingly, the amount of gross income paid by the estate to the charity was not paid pursuant to the terms of the governing instrument.
Trust Amendments and Decantings: The IRS applies a very narrow interpretation of what pursuant to means in a governing instrument. Specifically, if this authorization to make charitable distributions is not included in the original Will or trust, and it is only added through a later trust decanting or trust modification proceeding, that will not be sufficient. [Chief Counsel Advice, (CCA) 201651013 (December 16, 2016).] However, if a trust beneficiary is originally granted a limited power of appointment over trust income, which power can be exercised in favor of charities, the exercise of that limited power of appointment will satisfy the ‘governing instrument’ requirement of IRC 642(c). [Private Letter Rulings 200906008 and 201225004.]

Differences in a Trust or Estate’s Charitable Income Tax Deduction: There are several other difference in the charitable income tax deduction claimed by a non-grantor trust or an estate from the rules and limitations of what an individual can claim as a federal charitable income tax deduction. Some of those differences are described below. For brevity, a “fiduciary income tax charitable deduction” is simply referred to as the deduction.

Pursuant to Requirement: The trust or estate must show specific authority in the governing instrument for the payment to a charity, i.e. the pursuant to the governing instrument requirement;
Charitable Purpose: Estates and some trusts may deduct amounts paid for a charitable purpose as opposed to qualifying tax-exempt charities. Restated, it is apparently not necessary that the recipient of the trust or estate’s income be a tax-exempt charity in order to qualify for the deduction;
Not Limited to Public Charities: The deduction for estates and trusts is not affected by the type of charitable organization that receives the contribution, unlike individuals. It does not matter if the charity is a public charity or a private non-operating foundation to which the distribution is made;
Listed Charities: IRC 642(1) and (2) lists the charities that qualify for the deduction;
Unlimited Amount: The deduction is an unlimited amount, not limited to a percentage of an individual donor’s ‘contribution base;’
Only a Complex Trust Can Deduct: A complex trust can take the deduction; a ‘simple trust’ for tax reporting purposes cannot claim the deduction;
No Substantiation: The deduction is not subject to the substantiation requirements faced by individual donors who make charitable contributions;
No Carryover of the Deduction: A carryover of an excess deduction is not allowed, in contrast to individuals who can carryforward unused charitable income tax deductions for 5 years;
Choice of Years Claimed: A trust or an estate may deduct a distribution to a charity on the fiduciary income tax return for the year in which the contribution was actually made, or the preceding taxable year; in contrast, an individual donor must pay the amount to charity by the end of the calendar year;
World-wide Charities: Unlike an individual, a trust or an estate may make contributions to charities organized anywhere in the world, while individuals may only deduct contributions to charitable organizations that are established in the USA. However, an estate is not allowed a ‘set aside’ deduction for amounts ultimately paid to a foreign charity;
Deductions Only from Gross Income: A trust or an estate may only deduct contributions made out of gross income, meaning taxable income, not trust accounting income. Consequently, a trust or an estate may not deduct contributions made from trust principal or out of tax-exempt income.

Summary: To summarize these key requirements, a non-grantor trust or an estate must satisfy four basic requirements in order to qualify for a fiduciary income tax charitable deduction under IRC 642(c):

The amount paid to charity is paid for the gross income of the trust or the estate, i.e. the payment is traced to the trust’s gross (taxable) income;
The amount is paid pursuant to the governing instrument;
The amount is actually paid (or permanently set-aside in case of an estate, or a pre-October 10, 1969 non-grantor trust) during the tax year (or in the next year and elected to be deemed paid in the prior year); and
The amount is paid for a purpose specified in IRC 170 (c), which means the non-grantor trust can deduct contributions to an organization that is not otherwise eligible for IRC 501(c)(3) tax exempt status, i.e. ‘any organizations organized and operated exclusively for religious, charitable, scientific, literacy or educational purposes, or the prevention of cruelty to children or animals and that has received an IRS determination letter of their exempt status under IRC 170(c).

Conclusion: These rules are admittedly complex with many ‘hoops to jump through’ before a non-grantor trust or an estate can deduct distributions to charities. However with the heavy income tax burdens that non-grantor trusts face, which might become even more onerous if the two proposed surtaxes become law, ‘new’ non-grantor trusts should include provisions that give the trustee the authority to make discretionary distributions of a trust’s taxable income to charities in order to reduce the trust’s exposure to the high income tax burdens it will otherwise face.