Limiting the unlimited charitable deduction for trusts

Trusts and estates may benefit from the “unlimited” charitable income tax deduction under Sec. 642(c), which may be especially attractive to a philanthropic grantor seeking to completely eliminate taxable income through charitable deductions. In reality, however, many of these trusts may be limited to a smaller percentage.

Sec. 642(c) has many nuances that create unexpected complexity, but an often-overlooked limitation is found in Sec. 681, which serves to limit a trust’s charitable deduction under Sec. 642(c). Specifically, Sec. 681 provides, “In computing the deduction allowable under section 642(c) to a trust, no amount otherwise allowable under section 642(c) as a deduction shall be allowed as a deduction with respect to income of the taxable year which is allocable to its unrelated business income [UBI] for such year.” For ease of discussion, this article uses UBI to refer to both unrelated business income and unrelated business taxable income. Although a technical discussion of UBI is beyond the scope of this article, it generally includes income from a trade or business or from leveraged assets (Sec. 512).

As a result of Sec. 681, trusts claiming charitable deductions must determine whether and to what extent their income is UBI and reduce their deduction accordingly. With respect to the Sec. 681 limit, a trust may be eligible for a partial deduction, “subject to percentage limitations … applicable to contributions by an individual under [Secs.] 170(b)(1)(A) and (B)” (Regs. Sec. 1.681(a)-1). Thus, the “unlimited” Sec. 642(c) deduction may be easily limited.

As the number of trusts and estates with charitable beneficiaries continues to rise (see IRS Statistics of Income, “Domestic Private Foundation and Charitable Trust Statistics,” 2000–2020), it is helpful to understand the interplay of Secs. 642(c), 681, and 170. Given that Sec. 681 does not apply to estates, fiduciaries may find the Sec. 645 election to include the trust with the estate for income tax purposes even more valuable, to the extent that there are significant transfers to be made to charity from an irrevocable trust that was revocable prior to death.

Overview of Secs. 170 and 642(c)

Sec. 170 permits individuals to claim charitable income tax deductions and imposes percentage limitations on those amounts based upon the type of cash or property transferred and the type of donee organization. Under current law, cash gifts may not exceed 60% of the individual’s adjusted gross income (AGI), and gifts of certain appreciated property to private foundations may not exceed 20% of AGI (Secs. 170(b)(1)(G) and (D)). To the extent an individual makes charitable contributions exceeding these limits, a five-year carryover is available for the disallowed amounts (Sec. 170(d)). However, if the taxpayer dies before utilizing the carryover, any remaining unused amount is lost (Regs. Sec. 1.170A-10(d)(4)).

Trusts taking a charitable income tax deduction are governed by Sec. 642(c), which operates differently than Sec. 170. In general, trusts are only allowed a charitable income tax deduction for amounts paid from income as permitted by the trust instrument (Sec. 642(c)(1)).

Each of these Code sections has its own nuances, but when all requirements are met, the combination allows a trust to completely eliminate its income tax liability through charitable contributions. If charitable contributions exceed taxable income, no carryover is allowed. If the trust is a grantor trust for income tax purposes or if it is an electing small business trust (ESBT), then charitable income tax deductions will be governed by Sec. 170 rather than Sec. 642(c) (Sec. 671 and Regs. Sec. 1.641(c)-1(d)(2)(ii)).

Sec. 681

Because the Sec. 170 percentage limitations apply to charitable income tax deductions taken by a trust to the extent that income constitutes UBI, trusts that invest in alternative investments, that have business interests, or that acquired property with loans, for example, should pay close attention to these rules when calculating their charitable income tax deductions under Sec. 642(c). In addition, charitable deductions limited by Sec. 681 must actually be paid from the trust (Regs. Sec. 1.681(a)-1). Notably, although the charitable income tax deduction is subject to the limits imposed on individuals, Sec. 681 does not result in a broad application of Sec. 170. For example, the five-year carryover is not available, and disallowed deductions due to excess charitable contributions are permanently lost. The strict substantiation rules of Sec. 170 also do not apply.

As previously noted, grantor trusts and ESBTs are not subject to Sec. 642(c). Instead, their deductions are subject to the general Sec. 170 rules, including the five-year carryover and substantiation requirements (Sec. 671 and Regs. Sec. 1.641(c)-1(d)(2)(ii)).

Step-by-step process for calculating Sec. 642(c) charitable deductions

Step 1. Determine UBI for Sec. 681 purposes: The trust must first determine what portion, if any, of its income is UBI, excluding the charitable contribution deduction allowed under Sec. 512(b)(11). This initial calculation serves two purposes: (1) It limits the amount of the “unlimited” Sec. 642(c) deduction, and (2) it determines the amount against which the percentage limitations apply (Regs. Sec. 1.681(a)-2(b)(1)).

Step 2. Allocate the charitable deduction to UBI: Next, the charitable deduction otherwise deductible under Sec. 642(c) must be allocated between the UBI calculated in step 1 and any other trust income. Generally, this allocation will be in the same ratio as the amount of trust income that is UBI to the trust’s overall taxable income (excluding the personal exemption deduction and the distribution-to-beneficiary deductions). This allocation ensures that the deduction is allocated proportionately based on the income types (Regs. Sec. 1.681(a)-2(b)(2)).

Step 3. Apply limitation to portion allocable to UBI: Finally, the trust will apply the Sec. 170 limits to the amount allocated to UBI in step 2. Any excess amount is disallowed as a charitable deduction (Regs. Sec. 1.681(a)-2(b)(3)).

Example: A trust had the following income for the year:

• $31,000 ordinary income allocated and received from a trade or business organized as a partnership; and
• $19,000 of interest and dividends from an investment portfolio (no leverage).

The trustee distributed $25,000 of this income to make cash contributions to a private foundation under Sec. 170(b)(1)(B) during the year, as permitted by the trust instrument.

Step 1. Determine UBI: The trust has $30,000 of UBI, equal to the trade or business income before any deduction for charitable contributions, less $1,000 for the specific deduction under Sec. 512(b)(12).

Step 2. Allocate charitable deduction: The UBI ($30,000) represents 60% of the trust’s total income ($50,000). Therefore, of the $25,000 charitable contribution deduction that would otherwise be permitted under Sec. 642(c), $15,000 (or 60%) is allocated to UBI. The remaining 40% ($10,000) is unlimited under Sec. 642(c).

Step 3. Apply limitation to portion allocable to UBI: Sec. 170 imposes a 30% limit on cash contributions to private foundations. Because UBI is $30,000, the Sec. 170 limit would be $9,000. Therefore, of the $15,000 allocable to UBI, $9,000 is deductible, and the remaining $6,000 is disallowed without a carryover. The trust’s total charitable deduction is $19,000: $9,000 allocable to UBI and deductible under Sec. 170, plus $10,000 deductible under Sec. 642(c).

Key takeaways

For many grantors, tax-efficiently structuring their philanthropic goals is a critical aspect of their legacy planning. The ability to reduce taxable income with charitable deductions allows more funds to be used for intended charitable purposes rather than be paid to the government or other heirs. Those unfamiliar with Sec. 681 may be surprised to learn that the unlimited Sec. 642(c) charitable deduction can be easily limited and that not all amounts paid to charity may be deductible. For decedents who had funded revocable trusts, understanding that the Sec. 681 limitation does not apply to an estate could provide a valuable reason to make a Sec. 645 election. The income tax consequences to gift or estate planning transactions should not be overlooked, and foresight for issues such as this can add significant value to the success of any philanthropic plan.

— Alexandra O. Mitchell, J.D., LL.M., is a principal, in Seattle; Carol Warley, CPA/PFS, J.D., is a partner in Houston and chair of the AICPA Trust, Estate, and Gift Tax Technical Resource Panel; Tandilyn Cain, CPA, MST, CFP, is a senior manager in Seattle; and Lou Tzamalas, EA, CFP, CAP, is a senior associate in Boston, all with RSM US LLP’s Washington National Tax Practice.To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.