Charitable income tax deductions for trusts and estates

By Amber Hopp, CPA, Chicago, and Laura Hinson, CPA, Raleigh, N.C.

Editor:Alexander J. Brosseau, CPA

Ever since a group of philanthropists created the Giving Pledge in 2010, taxpayers have expressed greater interest in potential estate planning strategies that would allow them to leave a significant portion of their assets to charity upon their death. This increased charitable interest expanded in 2020 because (1) the amount of charitable contributions that individuals and corporations can deduct was increased by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, and (2) charities are generally in need of additional support due to the economic effects of the COVID-19 pandemic.

Suppose a client does not want to part with assets he or she holds individually and would prefer to donate assets currently held in trust. If his or her trust or estate makes a charitable contribution, is that deductible for income tax purposes?

The answer to this question is, "It depends." Income tax charitable deductions for trusts and estates are governed by Sec. 642(c). Note that these rules are substantially different from those for charitable contribution deductions for individuals and corporations under Sec. 170. Sec. 642(c)(1) provides that an estate or nongrantor trust "shall be allowed as a deduction . . . any amount of the 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)" (emphasis added). The term "gross income" has been interpreted for this purpose to mean "gross taxable income," specifically excluding tax-exempt income, which separates this from the legal concept of fiduciary accounting income.

For trusts that were created on or before Oct. 9, 1969, (and some trusts created by estates after that date that meet specific exceptions) and for all estates, Sec. 642(c)(2) expands the scope of the deduction to also allow for a deduction of the gross income "permanently set aside" for charitable purposes.

With this overview in hand, this discussion now digs into the specific requirements.

Governing instrument requirement

The document governing the trust or estate must provide for payments to charity. If the document does not allow for these payments, the trust or estate cannot deduct them for income tax purposes.

Gross income requirement

Once it is confirmed that the governing instrument allows for distributions to charity, the type of asset contributed and how it was acquired by the trust or estate will determine whether a deduction can be taken.

In Green, 880 F.3d 519 (10th Cir. 2018), the Tenth Circuit attempted to clarify the meaning of the statutory language, "any amount of the gross income," which was quoted above. After a discussion of the possible interpretations of this phrase, the decision states:

As an initial matter, the IRS asserts, and the Trust agrees, that the statutory phrase "any amount of the gross income" means that charitable donations must be made out of a trust's gross income[.] . . . [However,] real property purchased with gross income can also be treated as the equivalent of gross income for purposes of the deduction outlined in § 642(c)(1). [880 F.3d at 528]

To further clarify, the court stated:

As we have concluded, it is consistent with this latter principle — of construing charitable deductions liberally in favor of taxpayers — to construe the term "gross income," as used in § 642(c)(1), to extend to properties purchased with gross income. . . . We agree with the IRS, however, that the better argument is that, construing § 642(c)(1) in light of other provisions of the Code, the amount of the deduction must be limited to the adjusted basis of the property. [Id. at 529]

General guidance post-Green indicates that the following rules apply when a trust or estate donates to charity assets it owns. (Note that this discussion does not cover charitable contributions of conservation easements, which are outside the present scope.)

Cash: A trust's or estate's cash donations to charity can be deducted to the extent of the lesser of the taxable income for the year or the amount of the contribution.

Noncash assets purchased by the trust/estate: If the trust or estate purchased marketable securities with income, the cost basis of the asset is considered the amount contributed from gross income. Green clarified the IRS's position that a trust or estate cannot avoid recognizing capital gain on a noncash asset that is donated while also deducting the full value of the asset contributed. This treatment contrasts with the ability of an individual or corporation to deduct the full value of certain noncash assets without recognizing the related gain. The trust's or estate's charitable deduction is limited to the asset's cost basis. This was the result the taxpayer received inGreen.

Noncash assets contributed to the trust/estate: If the trust or estate acquired the asset donated to charity as part of the funding of the fiduciary arrangement (that is, the asset is part of the trust's or estate's corpus), no charitable deduction is allowable for income tax purposes. By definition, corpus is not gross income.

Assets owned inside a passthrough entity: Evaluating a charitable contribution through a partnership or S corporation is inherently more complex than assessing donations made by the taxpayer outright. It first needs to be determined whether the ownership in the passthrough entity was acquired by gift or inheritance or by purchase or exchange. If the ownership interest was contributed to the fiduciary arrangement, any assets owned by the passthrough entity at the time of contribution are considered principal, not gross income. However, if (1) the passthrough entity donates cash or assets that the entity acquired after the trust or estate obtained its ownership interest and (2) the passthrough entity generates gross income that can be offset by this contribution, the above rules will apply as if the taxpayer directly contributed the assets. If the passthrough ownership was purchased by the trust or estate, the trust or estate may be able to deduct a passthrough contribution to the extent of the passthrough entity's gross income.

Charitable purpose requirement/eligible donees

Sec. 642(c) refers to "a purpose specified in section 170(c) (determined without regard to section 170(c)(2)(A))" to explain the types of payments that are deductible. Sec. 170(c), which provides the definition of a charitable contribution, sets out a detailed list of eligible recipients for charitable contributions. Tax practitioners often interpret the broad guidelines of Sec. 642(c) to indicate that any eligible donee listed in Sec. 170(c) is an eligible donee for purposes of Sec. 642(c).

Because Sec. 170(c)(2)(A) is disregarded under Sec. 642(c), a notable addition is made to eligible donees for charitable contributions for trusts and estates. Sec. 170(c)(2)(A) limits charitable deductions for individual and corporate taxpayers to domestic organizations organized for the specified purposes provided. By disregarding Sec. 170(c)(2)(A), Sec. 642(c) indicates that a foreign organization organized and operated exclusively for a charitable purpose is an eligible donee for a charitable deduction for a trust or estate.

Charitable set-aside deductions

As noted above, estates and some older trusts may be eligible for an expanded charitable deduction for amounts permanently set aside for charity. For an irrevocable trust to qualify for a charitable set-aside deduction, in general, (1) no assets may have been contributed to the trust after Oct. 9, 1969, unless they are from an estate that meets the exceptions stated in Sec. 642(c)(2)(B); and (2) the trust's gross income must be reserved exclusively for charitable purposes. Practically speaking, that means if the trust has any remaining noncharitable beneficiaries, their right to income and principal must be limited to an amount that can be calculated (for instance, net income and a percentage of total principal), and this amount will be specifically excluded for charitable deduction purposes.

If an estate provides for distributions to charity, and income is permanently set aside from the assets identified as passing to charity, the income is eligible for a charitable set-aside deduction in the year earned. This is true even if the income is not paid to the charity within the tax year. However, a taxpayer may need to reconsider this treatment if there is any possibility that the will might be contested and the assets designated for charity might have to be transferred to noncharitable beneficiaries. Addressing this situation, Regs. Sec. 1.642(c)-2(d) provides that a set-aside deduction is not allowed "unless under the terms of the governing instrument and the circumstances of the particular case the possibility that the amount set aside, or to be used, will not be devoted to such purpose or use is so remote as to be negligible" (emphasis added). In Estate of Belmont,144 T.C. 84 (2015), the Tax Court noted that while the IRS has not interpreted the phrase "so remote as to be negligible" from a quantitative perspective in the income tax context, it has done so in the estate tax arena, requiring at least a 95% probability that the bequest will pass to the charity (see Rev. Rul. 70-452).

Additional planning and reporting considerations
  • If a trust has any income that would be considered unrelated business income if it were a tax-exempt organization under Sec. 501(a), the charitable deduction may be limited in accordance with Sec. 681.
  • If the individual transferors used their applicable exclusion amount for transfers made to a fiduciary arrangement from which they are considering making a donation, they should evaluate whether they have other assets that are held outside that particular trust that could be donated. The objective is to ensure clients do not squander their applicable exclusion amount.
  • If the trust or estate has taxable income in a given year, the fiduciary may elect to treat charitable distributions made in the subsequent year as paid in the first year. For example, when preparing the 2020 Form 1041, U.S. Income Tax Return for Estates and Trusts, a fiduciary discovers a trust has $500,000 of taxable income. The fiduciary may make a $500,000 distribution to charity by the time the return is filed in 2021 and elect to treat this payment as a distribution made in tax year 2020. See Sec. 642(c)(1) and Regs. Sec. 1.642(c)-1(b) for additional requirements to make this election. This may allow for flexibility in planning across tax years to reduce overall liability.
  • If a trust claims a charitable deduction, it must file Form 1041-A, U.S. Information Return: Trust Accumulation of Charitable Amounts, for the relevant tax year unless it meets one of the exceptions noted in the instructions to the form.
  • The ordering of charitable deductions, compared to distribution deductions under Sec. 661, can cause additionalcomplexity in tax planning and reporting. Required distributions to noncharitable beneficiaries must be accounted for first, and, under Sec. 662(a), the Sec. 642(c) charitable deduction is not taken into account in calculating distributable net income. In other words, the recipients of these distributions do not get the benefit of the charitable deduction. The charitable distributions are considered next, potentially offsetting any remaining taxable income. Discretionary distributions to noncharitable beneficiaries are considered last, so these beneficiaries may receive the largest benefit from any charitable deduction.

If a client is interested in charitable giving through a trust or estate, careful planning is needed to understand in advance the resulting tax impact.

EditorNotes

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.

For additional information about these items, contact Mr. Brosseau at 202-661-4532 or abrosseau@deloitte.com.

Contributors are associated with Deloitte Tax LLP.

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

Newsletter Articles

TECHNOLOGY

2020 tax software survey

COVID-19 upended tax season. Did CPAs’ tax software help them cope? Read the results of our annual tax software survey

TAX RELIEF

Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.