After the Tax Cuts and Jobs Act which came into effect in 2018, charitable deduction planning has changed. This is a result of a handful of changes, but the primary changes for purposes of this discussion relate to a doubling of the standard exemption, elimination of most itemized deductions, and reduction in individual income tax rates.1 With these changes, the value of a charitable income tax deduction for many taxpayers has been significantly diminished. As a result, people (and charities) are looking elsewhere to maximize the tax benefits of charitable giving.
One source to consider for potential charitable giving is trusts. Assuming the relevant rules applicable to trust charitable deductions are satisfied, giving through an irrevocable trust can allow an individual to fully utilize his or her full standard deduction while still obtaining a charitable deduction for gifts made. Also, trust income tax rates can be higher than for an individual. For example, an individual with $25,000 of taxable income typically would be in the 12% tax bracket. However, a trust with $25,000 of taxable income would be in the 37% bracket. This is because, in 2019, a trust reaches the highest tax bracket at $12,750 of income. The higher the applicable tax bracket, the more valuable the charitable deduction.
The purpose of this article is to discuss some of the considerations applicable in analyzing how a trust may benefit from a charitable income tax deduction, broken down by different types of trusts. This article will not discuss trusts which are specifically formed as charitable trusts such as charitable remainder trusts, charitable lead trusts, or private foundations established as trusts.
Gifts may be made by preexisting trusts. Alternatively, a new trust may be formed. Especially attractive may be trusts formed as incomplete gift non-grantor trusts, often formed in states without a state income tax to additionally minimize state income taxes on the trust’s investments. These trusts are sometimes referred to as NING’s (Nevada), DING’s (Delaware), WING’s (Wyoming), etc. Some of the benefits are that the grantor can:
- avoid state income tax, obtain a charitable deduction while not itemizing personally;
- remain a beneficiary of the trust; and
- avoid making a gift for wealth transfer tax purposes.
A “grantor trust” is a trust (or portion of a trust) which is ignored for income tax purposes.2 As a result, the trust’s income or loss is taxed to the income tax grantor of the trust directly. A typical example of a grantor trust is a revocable trust during the lifetime of the grantor, or settlor, of the trust. A number of irrevocable trusts are established as “intentionally defective” grantor trusts by including provisions which intentionally cause the trust to be ignored for income tax purposes. Also, in certain circumstances, an irrevocable trust can be created to be “beneficiary defective” such that the trust’s beneficiary is the deemed grantor for income tax purposes.
Regardless what type of “grantor trust” a trust may be, because it is ignored for federal income tax purposes, the charitable deduction rules otherwise applicable to trusts do not apply. Rather, any charitable gift made by the trust is considered to have been made by the individual who is the deemed “grantor” for income tax purposes. As such, the rules applicable to that individual’s charitable deduction would apply.
Non-grantor trusts are separate taxable entities subject to their own tax laws applicable to such trusts and their beneficiaries. These laws are found in Subchapter J of the Internal Revenue Code (which also applies to estates). An area of significant difference between income tax of individuals and trusts is the deduction for charitable gifts. Trust income tax deductions are governed by IRC § 642(c) as opposed to § 170(a) which governs charitable deductions for individuals. For a complex trust (a trust which does not distribute all of its income to its beneficiaries3) to benefit from an income tax charitable deduction, the gift must be:
- Paid for a charitable purpose during the taxable year;
- Traceable to gross income; and
- Made pursuant to the terms of the governing instrument.4
What Difference Exists between Individuals and Trust Charitable Deductions?
Some of the more important differences between charitable deductions for individuals and charitable deductions for trusts include:
- There are no income-based percentage limitations applicable to charitable gifts of trusts like there are for individuals, i.e. a trust can deduct up to 100% of its net income for the year.5
- Charitable deductions from a trust must be traceable to trust income.6
- Depending on the circumstances, a trust may have the ability to deduct charitable contributions made in the prior year.7
- A trust is not allowed to carry forward unused charitable deductions.8
- Charitable deductions for trusts are not limited to U.S. charities.
Of course, this is not a comprehensive list of differences. However, these items are some of the more significant differences. There are situations where these differences may benefit taxpayers, and times when they do not. It simply depends on the circumstances. In any event, knowing these differences as well as the requirements for a trust to take a charitable income tax deduction allows for careful planning.
Traceable to Gross Income9
One important requirement for a trust to benefit from a charitable income tax deduction is that the gift be made out of gross income. Tracing is required to determine the source of the gift.10 Contributions may be made out of accumulated income from previous years as long as no deduction was taken with respect to such amount in any previous year.11 It is insufficient that the trust have income to support the distribution. Rather, the contribution must actually be made from assets traceable to income rather than principal.12 In kind contributions of assets purchased with trust income is permitted.13
A recent development in this area relates to gifts of appreciated property purchased with trust income. What happens if a trust donates appreciated property purchased with trust income? Is the full fair market value deductible? Alternatively, is the deduction limited to the trust’s cost basis in the property? The Tenth Circuit Court of Appeals has recently held that the deduction should be limited to the trust’s cost basis.14 In essence, the court’s position is that unrealized appreciation has not yet entered into the trust’s gross income. As such, no deduction is allowed.
Pursuant to the Governing Instrument
The statute requires the charitable contribution be made “pursuant to the governing instrument;” however, the U.S. Supreme Court has ruled that a specific charitable gift need not be directed in the governing instrument.15 Rather, the trust document merely must authorize charitable gifts. Those gifts may be made directly by the trustee or pursuant to a power of appointment exercised by a beneficiary.16 However, if charitable gifts are not allowed until the trust’s termination, no deductions will be allowed until that time.17
For trusts which own partnership interests, charitable deductions are available notwithstanding failure of the governing instrument to authorize charitable gifts. As long as the partnership’s charitable donation was from the partnership’s gross income the flow through deduction to the trust will be allowed.18
It appears that modifying a trust to allow for charitable distributions will not be sufficient to allow the deduction. In two separate Chief Counsel Advice materials, the IRS has ruled that modifying a trust to include authority to make charitable contributions does not qualify the trust to take a charitable income tax deduction when the original trust did not give that authority.19 Based on these authorities, it appears that the only circumstance the IRS would allow is to modify an existing trust pursuant to a settlement agreement or modification which is based on a conflict about the governing instrument’s terms. It is not clear whether IRS would allow a deduction following a decanting into a new trust allowing charitable distributions from one which did not.
S Corporation Trusts
Only certain types of trusts qualify to hold S corporations. For purposes of this article, those trusts include: (1) grantor trusts, (2) qualified subchapter S trusts (“QSST”), and (3) electing small business trusts (“ESBT”).20 Grantor trusts were discussed above. That leaves QSST’s and ESBT’s, both of which are irrevocable trusts which obtain specific tax treatment relative to their elections to be qualifying S corporation shareholders.
In a QSST, the trust beneficiary is treated as the owner of the S corporation stock.21 As a result, all S corporation income and loss pass through directly to the beneficiary.22 All trust income must be distributed to the one trust beneficiary.23 Essentially a QSST is treated as a grantor trust as to its beneficiary with respect to its interests in the S corporation. As a result, charitable deductions for QSST’s can be broken into two components. Any charitable deduction flowing through the S corporation will be treated as flowing directly to the beneficiary. Any charitable deduction from other assets of the QSST will be treated the same as other non-grantor trusts.
In an ESBT, the S corporation income may be accumulated at the trust level, there being no requirement that all S corporation income be distributed as with a QSST. Therefore, there are two categories of charitable contributions which must be considered: (1) charitable contributions made by the S corporation which flow through to the ESBT; and (2) charitable contributions made with other trust assets (i.e. not shares in the S corporation).
The S corporation portion of the ESBT computes its income in the same way as an individual would, subject to the same limitations and with the same carry forward periods as for an individual (without the limitation applicable to unrelated business income).24 With respect to the non-S corporation portion of an ESBT, the same rules apply as with a typical non-grantor trust. Therefore, if the ESBT makes a gift directly (other than having a pass through the deduction made by the S corporation), then the rules described above apply.25 In such case, gross income is determined with respect to the non-S portion of the trust. If an ESBT donates the S stock to charity, then there is no deduction.26
Individuals may now be looking for creative ways to maximize the income tax benefits of their charitable gifts. There are a number of planning steps which may be taken to maximize charitable deductions for gifts made by trusts. Some of those planning steps are briefly discussed in this writing. A detailed discussion of planning steps which may be taken is beyond the scope of this article.27 Nonetheless, it is important for tax advisors to consider options available to their clients to maximize the benefits of charitable income tax deductions and, as part of that process, analyze whether it may be more advantageous to make gifts from trusts rather than individually. Proper consideration and planning can yield significant benefits.
- TCJA Projected to Lower 2018 Charity Giving by $22 Billion, Penn Wharton, University of Pennsylvania, July 20, 2018. http://budgetmodel.wharton.upenn.edu/issues/2018/7/20/tcja-projected-to-lower-2018-charity-giving-by-22-billion
- Income tax laws to determine whether a trust is treated as a grantor trust are codified at IRC §§ 671-679.
- IRC § 651(a).
- IRC § 642(c).
- IRC § 642(c)(1). For an explanation of income-based percentage limitations applicable to individuals see I.R.S. Pub. 526, Cat. 15050A (March 12, 2019). https://www.irs.gov/pub/irs-pdf/p526.pdf
- IRC § 642(c)(1).
- Treas. Reg. § 1.170A-10(a)(4).
- Although not discussed in this article, IRC § 681 disallows a deduction to income that is allocated to “unrelated business income” of a trust as such income would be defined in IRC § 512.
- Van Buren v. Commissioner, 89 T.C. 1101, 1109; Riggs National Bank v. U.S., 352 F.2d 821 (Ct. Cl. 1965); Mott v. U.S., 462 F.2d 512 (Ct. Cl. 1972).
- Treas. Reg. § 1.642(c)-1(a)(1).
- See Rev. Rul. 2003-123 denying a trust’s charitable conservation easement deduction with respect to property which the trust had owned since its inception.
- CCA 201042023.
- Green v. U.S., 144 F.Supp. 3d 1254 (10th Cir. 2018).
- Old Colony Trust Co. v. Commissioner, 301 U.S. 379 (1937).
- PLR 200906008.
- Rev. Rul. 55-92.
- Rev. Rul. 2004-5.
- CCA 201651013 and CCA 201747005. But see Rev. Rul. 59-15 which held that a settlement agreement following a will contest constituted a governing instrument.
- IRC § 1361(c)(2).
- IRC § 1361(d)(1).
- IRC §§ 671 and 1366.
- IRC § 1361(d)(3).
- IRC § 641(c)(2)(E). This provision became effective in 2018 as part of the Tax Cuts and Jobs Act. Previously, the S portion of an ESBT was subject to the rules typically applicable to non-grantor trusts.
- Treas. Reg. § 1.641(c)-1(g)(4).
- Treas. Reg. § 1.641(c)-1(l), Ex. 4.
- For a discussion of a number of planning ideas see Blattmachr, Jonathan G.; F. Ladson Boyle; and Richard L. Fox, Planning for Charitable Contributions by Estates and Trusts, 44 Est. Plan. 3 (Jan. 2017).