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

19-Nov-18

Retirement Plan Distributions to Charities – Remember The Economic Effect Doctrine

Take-Away: The attempt to use a governing instrument like a Will or Trust to expressly allocate taxable income from a retirement plan or IRA account to a charity will be unsuccessful unless that allocation directive has an economic effect independent of the income tax consequences.

Background: Sometimes a 401(k) account or a traditional IRA are made payable to the owner’s revocable trust. The trust then expressly allocates that retirement plan distribution, which is taxed as income in respect of a decedent (or IRD), to a charity. The bequest might work to shift that taxable IRD income to the charity, which is a tax exempt entity,  but that depends on how the bequest is phrased in the trust (or Will.) Distributions of IRD will be included in the taxable gross income of the trust (or estate), but will then be eligible for a charitable income tax deduction. As reported in the past,  the governing instrument must expressly authorize that distribution of income in order for the trust (or estate) to claim a charitable income tax deduction. [Treas. Reg. 1-642(c)-1(a)(1) and (3).]

  • Drafting: Many trusts that contain a charitable bequest often direct the trustee that the charitable bequest should be paid first of IRD, if the trust has any IRD. That direction may work, then again it may not, to shift the taxable IRD income to the charity and away from other trust beneficiaries.
  • Duel Deductions: When an item of IRD, e.g. IRA proceeds, is payable to charity, often both an estate tax charitable deduction and an income tax charitable deduction will be available to the trust (or estate.) That dual deduction is the result of the fact that IRD is included in both the decedent’s gross estate for federal estate tax calculation purposes and also in gross income for fiduciary income tax reporting purposes of the trust (or estate.). A deduction will be available to the trust (or estate) for any federal estate taxes attributable to the inclusion of the IRD in the decedent’s taxable estate. [IRC 691(c).]
  • Caution: However, often that express allocation of the IRD to be paid to the charity in the trust (or Will) will not work due to highly complex income tax rules that apply to distributions from a trust (or estate), including the application of the economic effect doctrine.

Unique Income Tax Rules for Charitable Distributions by Estates or Trusts: There are several different rules that are applied to a trust (or an estate) than what are applied to individuals when a distribution is made to a charity.

  • No Income Limits: Unlike an individual who faces adjusted gross income (AGI) limits on how much of a charitable income tax deduction that he/she can claim in a calendar year, trusts (and estates) may deduct charitable contributions in any amount of income, up to the total amount of gross income for the trust (or estate), including capital gains. [IRC 642(c)(1).]
  • Private Foundations: Unlike an individual, a trust (or estate) can make contributions to private foundations; individuals must comply with separate limitations on deductions on gifts to private foundations.
  • Foreign Charities: Unlike an individual, a trust (or estate) can deduct a contribution to a foreign charity; individuals can only deduct contributions to U.S. based charities.
  • Substantiation: Generally a trust (or estate) does not need to comply with the detailed IRC 170 charitable gift substantiation requirements; an individual must have the gift acknowledgement from the charity in his/her possession by the time the Form 1040 is filed on which the charitable deduction is claimed.
  • Only Income: As a generalization, the direction in a trust (or an estate) to pay a charity must authorize the payment the charitable contribution only from income from the trust (or estate) for the trust to be able to deduct the distribution as a charitable income tax deduction. [IRC 642(c).] Restated, if principal is distributed to a charity, neither a distribution deduction by the trust (or estate) nor a charitable income tax deduction will be allowed for income tax reporting purpose. [CCA 200644020.] An individual can obtain a charitable income tax deduction for the gift of a capital asset to a charity.
  • Income Set-Asides: An estate will be able to permanently set-aside and deduct an amount of income for a charity. This means an estate can elect to deduct a charitable contribution made in one year as if the gift had been paid in the prior year. If an election is made to treat an estate and the decedent’s trust as a single entity for two years after the decedent’s death [authorized under IRC 645], then a trust can also take advantage of this special rule to apply a charitable contribution to the prior year’s income tax return.
  • No Carry-forwards: Unlike an individual  taxpayer who faces AGI limitations, who makes a large charitable gift in one year which then causes some of that ‘unused’ charitable income tax deduction to be carried over for up to 5 years, a trust and an estate are not permitted to carry-forward an ‘excess’ charitable income tax deduction. [IRC 642(h)(2).]

Economic Effect Doctrine: If a trust (or an estate) makes a charitable bequest of a particular class of income, e.g. the trust directs that a charitable bequest must be funded with IRD from the settlor’s traditional IRA paid to the trust, that designation of a particular class of income will not be honored for purposes of the trust’s charitable income tax deduction unless the designation has an economic effect independent of its income tax consequences. Note that this rule applies to any particular class of income, not just IRD.

  • Example #1: A trust contains a ‘specific bequest of $20,000 to charity X’, along with the direction to the trustee ‘that to the extent possible this charitable bequest shall be paid from IRD of this trust.’ That direction will be ineffective for income tax deduction purposes because the actual amounts to be received by the other trust beneficiaries will not be increased or decreased by the amount of IRD that is available; each trust beneficiary will receive the exact same amount, regardless of the IRD that is available. Instead, all the trust beneficiaries will be deemed to each have received a pro rata share of each type of income, both IRD and non-IRD income that was paid to the trust.
  • Example #2: Mom’s Will leaves a $50,000 charitable bequest to her church, with the residue of her estate distributed to her children. The estate collects $20,000 from Mom’s traditional IRA- all of which is IRD. In addition to the IRD, Mom’s estate had other taxable income of $30,000 from dividends and interest. Thus, the total taxable income for Mom’s estate is $50,000. Mom’s Will directs that the charitable ‘bequest to the church is to be satisfied first from income, both IRD and ordinary income, and then from principal.’ The directive given to the Personal Representative has no economic effect, because the charity will receive $50,000 no more, no less, regardless of how much IRD or other income might be received by Mom’s estate.  [Treas. Reg. 1.642(c)-3(b)(2).]
  • Example #3: A trust contains a bequest ‘to charity X of all ordinary income of this trust.’ In this situation the charitable bequest will have independent economic effect, as the amount of the charitable bequest will increase or decrease depending upon the ordinary income that is generated by the trust. As a result, the bequest will cause the charity to receive that income and the charity will be deemed to have received that income for fiduciary income tax reporting purposes. The trustee will be able to make use of a charitable income tax deduction for the full amount of ordinary income that will ultimately be distributed to the charity. [Treas. Reg.1-642(c)-3(b)(2).]
  • Example #4: A trust contains a bequest that directs the trustee to ‘distribute to charity X all of the proceeds of my traditional IRA that is paid to this trust.’ This directive will permit a charitable income tax deduction by the trust because the amount that is distributed to the charity will vary depending on the amount that was held in the settlor’s traditional IRA at his/her death. [Private Letter Ruling 201611002.]
  • Drafting Trusts: The economic effect doctrine is important to remember when a trust  intends the use of a qualified retirement plan or traditional IRA proceeds to fund a charitable bequest. The rule does not necessarily disallow a charitable income tax deduction claimed by the trust. Rather, it affects the allocation of certain classes of income paid to the charity. Consequently, the application of the doctrine might reduce the charitable income tax deduction if there is tax-exempt income held by the trust (which is not deductible by the trust), which would decrease the amount of the charitable income tax deduction claimed by the trust. Or, the economic effect doctrine might cause income to be shifted away from the charity and thus cause the non-charitable trust beneficiaries who receive distributions from the trust to be taxed on a larger share of the trust’s income than would have been the case had the doctrine not applied.

How to Avoid the Economic Effect Doctrine: There are generally two ways the economic effect doctrine can be avoided.

  • Use the Beneficiary Designation to Satisfy the Bequest: Name the charity as the beneficiary of the decedent’s IRA on the beneficiary designation form, and not the decedent’s estate or trust.
  • Direct the Transfer of the Entire Account: Expressly direct that the trustee (or the personal representative of the decedent’s estate) transfer the retirement account, intact, to the charity prior to making any withdrawals from the retirement account.
  • Result: Either way,  the trust (or estate) will not have realized the retirement account income, and thus the charitable income tax deduction will not be required in order to offset the  IRD which is recognized by the trust (or estate) as taxable income. Note, however, that the trust (or estate) will have to recognize income if the IRA is transferred to the charity in satisfaction of a pecuniary bequest.

Conclusion: In sum, rather than specify an amount and the encourage the use of the decedent’s retirement account to satisfy that pecuniary charitable bequest, it is better to direct the transfer of the entire retirement account or a fixed percentage of the retirement account to charity. Example: “The personal representative of my estate shall distribute 45% of my traditional IRA currently held at X trust company, to the Y church as soon as practicable after my death.”  If the trust (or Will) authorizes the distribution of income to a charity, then an offsetting charitable income tax deduction will be available to the trust (or estate.)