“Our Greatest Hits” is an effort to show our readers the most popular – and still avidly read – articles from our archives. This article originally appeared in our August 2004 Issue.
Estates and trusts entail a unique form of property ownership: Even though legal ownership is held by an entity, equitable ownership belongs to the beneficiaries. These beneficiaries may be present or future recipients of income or principal. This scenario provides the backdrop for the income tax framework created by IRC subchapter J. Because an estate or trust can be either a pass-through or tax-paying entity, the income tax deductibility of estates and trusts’ charitable contributions can be ambiguous.
An executor or trustee has the fiduciary duty of administering property in accordance with the testator’s/grantor’s wishes as expressed in the governing document. As such, if the controlling instrument is silent as to charitable contributions, making a contribution would constitute a breach of fiduciary duty. Only contributions directed by the will or trust document are allowed, as established by Riggs National Bank of Washington D.C. v. United States [(173 Ct. Cl. 478 (1965)] and Sid Richardson Foundation v. United States [430 F.2d 710 (5th Cir., 1970)]. The source of permitted contributions provides direction as to the proper tax treatment. Generally, contributions from principal, or corpus, are bequests to charitable organizations governed by IRC section 2055 and the estate tax regulations. The charitable bequest serves to reduce the gross estate in arriving at the amount subject to estate taxes on Form 706. On the other hand, contributions on a Form 1041 return serve as income tax deductions and are governed by IRC section 642 and the income tax regulations.
The life of an estate is determined by the amount of time required by the executor or administrator to settle the affairs of the decedent. The regulations refer to this period—which can last years—as the time required to complete the ordinary duties of administration, such as the collection of assets and the payments of debts, taxes, legacies, and bequests. Income earned during the period of administration is of course subject to income taxes. Consequently, distributions made during this period may “carry out” taxable income. Similarly, income earned by trusts is subject to income taxes at the entity level, the beneficiary level, or both, depending on the terms of the governing instrument and applicable state laws. Simple trusts are required to distribute all current income and are, by definition, prohibited from making charitable contributions. Complex trusts may retain all or part of their current income and, if directed by the trust instrument, may make charitable contributions. As a result, the income taxation for estates and complex trusts is similar.
Taxing the income distributed to the beneficiaries of an estate or trust would result in “double taxation.” Treatment as partners (recipients of conduit income), however, would not reflect the myriad rights of the different types of beneficiaries (e.g., the right to accumulate). Additionally, taxing the income of an estate or trust under the rules and regulations for individuals would ignore payments made to beneficiaries entitled to current distributions. Consequently, IRC subchapter J brings together concepts applicable to other entities while addressing the unique attributes of estates and trusts, effectively taxing accumulated income to the entity while taxing distributed income to the appropriate beneficiaries.
Embedded within IRC subchapter J is a concept unique to the income for estates, trusts, and their beneficiaries. Specifically, distributable net income (DNI) comprises the IRC section 643–mandated methodology for the distribution deduction, which the entity deducts from income but which is taxed to beneficiaries. Concurrently, the character of those distributions is identified. Fiduciary accounting income is determined in accordance with the appropriate state statutes, the governing instrument, and the IRC impact on DNI. State statutes, generally in the form of a principal and income act, serve as a default for situations not addressed by the governing document. These generic statutes attempt to equalize the treatment of current income beneficiaries and corpus remainders in discretionary situations. This treatment often conflicts with a grantor’s desires. In essence, the distribution deduction and the contribution deduction are interrelated and must be analyzed in that context.
Simple Versus Complex Trust
Classification of a trust as simple or complex is determined annually. To be classified as simple, a trust must satisfy three statutory requirements of IRC section 651(a):
- All of the income must be distributed currently.
- The trust must not provide for any amounts to be paid for charitable purposes during the taxable year.
- No amounts, other than the current income, can be distributed during the year. Therefore, a corpus distribution during the taxable year renders a trust complex.
IRC section 642(c) allows an estate or complex trust to deduct amounts paid for charitable purposes. The contribution must be from gross income and paid for a purpose specified in section 170(c), without regard to section 170(c)(2)(A). There are no percentage limitations like those for individual taxpayers. Deductible amounts can be paid during the taxable year. Additionally, amounts paid after the close of the taxable year and on or before the close of the following taxable year can, by election, be deducted in the current year. To be deductible, however, any charitable contribution must be pursuant to the governing instrument.
IRC Section 642(c)
Paid or permanently set aside. “Paid” denotes the actual delivery of money or property to a qualifying charitable recipient, which, unlike individual contributions, can include foreign charities. Contributions of property require caution: The property must have been received by the entity as gross income in order to qualify as a charitable contribution. IRC section 661 uses similar language in describing the distribution deduction. Section 661(a)(2) terminology incorporates “properly paid or credited” in defining the allowable deduction.
Estate of Johnson v. Commissioner [T.C. 225 (1987)] provides insight into a common accounting practice that may be detrimental in certain situations. Among other issues, one focus of the case revolved around whether the workpaper entries by the accountants, which served both the estate and the beneficiary, constituted constructive receipt of the distribution. Keith W. Johnson passed away on March 28, 1975, leaving five beneficiaries, each entitled to 20% of his residuary estate. One beneficiary, Willard Johnson, passed away shortly thereafter. Both estates named the same executor and used the same accountants. The executor of the K. Johnson Estate instructed the accountants to annually transfer 20% of the income to the W. Johnson Estate through book entries. This method was chosen because the K. Johnson Estate was involved with litigation on other issues. All beneficiaries of the W. Johnson Estate were charitable organizations. Because of this technique, no income taxes were paid on the distributions to this estate. Taking this issue to court, the IRS contended that the book entries were not sufficient to constitute a “proper credit.” The taxpayer countered that, with the same executors and accountants, actual separation of the funds was not necessary to bring the distributions within the relevant IRC section. The court found for the IRS. In its findings, the court cited the Second Circuit in Commissioner v. Stearns [65 F.2d 371, 373 (2d. Cir. 1933), cert. denied sub nom. Stearns v. Burnet, 290 U.S. 670 (1933)]:
The income must be so definitively allocated to the legatee as to be beyond recall; “credit” for practical purposes is the equivalent of “payment.” Therefore, a mere entry on the books of the fiduciary will not serve unless made in such circumstances that it cannot be recalled. If the fiduciary’s account be stated inter partes, that would probably be enough … But the unilateral act of entering items in the account is not conclusive [emphasis added].
The court found that, although this case dates from 1933, the relevant language has not changed, and noted that the holding did not suggest that funds must be physically segregated to satisfy the “properly credited” requirement; book entries may be sufficient. Workpaper entries, however, did not have the same force as book entries. An allocation beyond recall is a standard necessary to achieve the desired results. Because the distributions were not properly credited to the W. Johnson Estate, the estate was not then entitled to the deductions taken.
“Permanently set aside” has a narrow application. Only certain trusts created on or before October 9, 1969, can deduct amounts permanently set aside for charity [IRC section 642(c)(2)(A)(i) and (ii)]. Furthermore, the set-aside amount must be from income on assets transferred to the trust on or before October 9, 1969 [Treasury Regulations section 1.642(c)-2(b)(2)]. An estate is not limited in this manner; that is, amounts can be permanently set aside from gross income for charitable purposes and constitute a qualifying deduction. Care should be taken if this is contemplated. In Berger Estate v. Commissioner (T.C. Memo 1990-554), the IRS prevailed when it contended that an estate’s administration had been unduly prolonged. Although the estate made the permanent set aside, it was deemed to have been made by the resulting residuary trust. Because the trust did not qualify as a pre-1969 trust, the set aside was not deductible.
Governing instrument. For an estate, the governing instrument is the will; for a trust, the governing instrument is the trust document. If the will or trust instrument does not address charitable contributions, this automatically precludes any contribution deduction made by the entity.
Because estates and trusts hold property, their holdings may include ownership in conduit entities. In the case of an estate, conduit entities of which the decedent was a partner or shareholder [e.g., S corporations and limited liability corporations (LLC)], become assets of the estate. Pertinent regulations allow for a partner’s successor in interest to be regarded as a partner until the entire interest is liquidated [Treasury Regulations 1.731-1–1(a)(6)]. Alternatively, if the conduit is an S corporation and a testamentary trust receives the stock, IRC section 1361(c)(2)(A)(ii) provides a two-year period for the testamentary trust to qualify by becoming a permitted shareholder. During that time, the estate may receive the decedent’s distributive share of a charitable contribution.
Where the distributive shares are not made pursuant to the governing instrument (i.e., the will made no provision for charitable contributions), the Tax Court has found for the taxpayers, in Lowenstein v. Commissioner [12 T.C. 694 (1949), affirmed, 183 F.2d 172 (sub nom First National Bank of Mobile v. Commissioner) (5th Cir 1950)] and in Estate of Bluestein v. Commissioner [15 T.C. 770 (1950)]. Both cases involved partnership interests under the IRC of 1939. At that time, contributions were accounted for as ordinary and necessary business expenses, deducted before the partner’s distributive share of net income was determined. Each estate reported as partnership income only the distributive share of net income. On audit, the IRS stipulated that the correct amount to be taxed was the amount of the distributive share plus the amount of charitable contribution associated with that share. The IRS contended that the contributions were not made pursuant to the governing document in accordance with then IRC section 162 [substantially the same as the current section 642(c)]. Both courts rejected the IRS’ position, reasoning that this would have an inequitable result. The estate could not recoup the amount of its share of the contribution; the active partners, charged with managing the partnership, made the contributions. In that capacity, it could be said that the contributions were made in accordance with the partnership agreement, a pertinent governing document in the situation.
IRS Chief Counsel Memorandum (CCM) 200140080, released October 5, 2002, cited the Lowenstein and Bluestein decisions and used similar language in response to a query detailing the same facts regarding a trust. Because an LLC is taxed as a partnership under the check-the-box regulations, presumably the same results would be achieved when the conduit is an LLC. The recently issued final electing small business trust (ESBT) regulations take the same approach with regard to an S corporation. Treasury Regulations section 1.642(c)-1(d)(2)(ii) provides that if a deduction is attributable to a charitable contribution made by an S corporation, the contribution will be deemed to be paid by the S portion of the trust pursuant to the terms of the governing instrument.
Gross income. Charitable contributions, to be income tax–deductible by the estate or trust, must be made from gross income. When a flow-through entity is the source of the deduction, the entity’s gross income must be in excess of the contribution deduction. If not, the principal is the source of the contribution, and no deduction is allowed. This position is reiterated in IRC section 643.
Limitation. Unlike individuals and corporations, qualifying contributions of an estate or trust have no percentage limitations governing deductibility. As a result, an estate or trust can pay 100% of its income to charity, as long as it meets the IRC section 642(c) qualifications delineated above. The source of the contribution must, however, be from gross income to qualify. Additionally, a deduction limitation is imposed by the character of the income. IRC section 681 disallows any deduction that is allocated to unrelated business income of the estate or trust as defined in IRC section 512. Unless the source of income is stipulated by the governing instrument or applicable state law, contributions are deemed to be made proportionately from all classes of income [Treasury Regulations section 1.642(c)-3(c)(2) and (3)]. Consequently, when the entity receives nontaxable income (e.g., municipal interest), a portion of the contribution will be allocated to those receipts. Therefore, that portion of the contribution is not deductible when arriving at taxable income for either the entity or the beneficiary.
Timing. The fiduciary may elect to treat contributions made one year beyond the close of the taxable year as being made during the current year. This election must be made on a timely filed return (including extensions). The election may also be made on a properly filed amended return. Once made, the election is irrevocable [Treasury Regulations section 1.642(c)-1(b)].
Deductibility of Qualifying Contributions
Having satisfied the requirements set forth in IRC section 642 and related Treasury Regulations for a qualifying contribution, the next step is to quantify the amount of the tax deduction. Its calculation has developed as an interplay between state laws, the IRC, and the governing instrument. Almost all of the states have adopted one of the following acts: Uniform Principal and Income Act (1997),
Revised Principal and Income Act (1962), or the Principal and Income Act (1931). IRC section 643 defines the concept of distributable net income (DNI). State law income, referred to as fiduciary accounting income (FAI), and DNI are usually different. The governing instrument serves to define the grantor’s or decedent’s wishes.
State Law Income
The objective of the Uniform Principal and Income Act (1997) is equitable treatment of income beneficiaries and corpus remainders. The distinction between current (income) and remainder (corpus) demarcates state laws from the IRC. As a result, under state law definitions, some tax concepts, such as capital gains or losses, follow the asset as principal rather than the IRC definition of income. Thus, gains and losses on capital assets have been historically taxed at the entity level, representative of the corpus, rather than as income. The 1997 Act, however, allows the fiduciary discretion to distribute capital gains rather than allocating them to corpus. When the fiduciary distributes these gains, they then become part of accounting income and DNI, and constitute part of income for charitable contribution purposes. Additionally, expenses that benefit both income and corpus beneficiaries are to be allocated. Trustee fees, for example, under state laws are generally allocated equally between income and principal.
Under the general rule of IRC subchapter J, taxable income of a trust or estate is determined in the same manner as that of an individual [IRC section 641(b)]. In lieu of the personal exemption amount allowed an individual under IRC section 151, a deduction is provided under IRC section 642(b). Estates are allowed $600, a simple trust is allowed a deduction of $300, and a complex trust is allowed $100. Taxable income computed in this manner serves as the foundation for figuring distributable net income for the entity. Once determined, DNI provides the deduction from taxable income that the trust or estate is allowed for distributions to beneficiaries. After the distribution deduction, the remaining taxable income represents the income retained by the estate or trust. The entity’s tax liability is figured on this amount.
Distributable Net Income
DNI is purely a tax concept with the purpose of determining the maximum amount of deduction allowed to an entity due to distributions to beneficiaries, and, therefore, taxable to the beneficiaries. According to congressional reports, this concept, and IRC subchapter J, was added to the IRC in 1954 to avoid the ambiguity that had previously persisted when distributions were determined by being traced to the source. As such, DNI is commonly called the “yardstick” of measurement for both the maximum amount of and the income characterization of the distribution deduction.
DNI is essentially the taxable income of the entity with modifications: No deductions are permitted for distributions or personal exemption, no capital gains and losses are allocated to corpus, and no extraordinary dividends and taxable stock dividends are allowed. Tax-exempt interest is included in income, while income for a foreign trust and abusive transactions are defined in DNI.
Capital gains and losses. The general rule states that capital gains and losses are not includible in DNI. That is, the classification of the appreciation and depreciation of capital assets rests with the remainders, as corpus. Several exceptions with respect to gains are noted, three of which are statutory.
First, if state law or the governing instrument assigns gains on capital assets to the current income beneficiaries, they are then included in DNI [Treasury Regulations section 1.643(a)-3(a)(1)]. This scenario arises primarily in the context of unproductive assets. Under state laws, in accordance with the Revised Uniform Principal and Income Act (1962), gain realized upon the sale of an unproductive asset will be allocated between current beneficiaries and remainders. Generally, a stipulated percentage of the proceeds (typically, 4% when the assets do not earn 1% of their inventory value) will be allocated to income with the remainder as corpus.
Second, if gains are paid, permanently set aside for, or required to be distributed to any beneficiary during the taxable year, they enter the computation of DNI [Treasury Regulations section 1.643(a)-3(a)(1)(2)]. This differs from the first exception in that the gain, while classed as corpus, is distributed to a corpus beneficiary. Revenue Ruling 68-392 (31 1968-2 C.B. 284) amplifies that distributions of this type are defined in the governing document. A distribution of one-third of the trust’s corpus to a beneficiary upon attaining a certain age would be a qualifying distribution. Any capital gain associated with this distribution would be included in computation of DNI for that taxable year.
Third, gain amounts paid, permanently set aside, or used for charitable purposes are included in the DNI computation. Such a contribution is traced to the gain and, therefore, not subject to allocation among various classes of income, and fully deductible.
A fourth exception evolved as a clarification contained in Private Letter Rulings 9811036 and 9811037. The request involved three equal share trusts created under one governing instrument in 1922. Because the governing document was silent, the trustee requested guidance as to the proper classification of realized short-term capital gains from regulated investment companies (RIC) when computing DNI. The IRS said that the realized short-term capital gain from the RIC is includible in DNI.
The reasoning applied to capital gains is not applied to capital losses or deductible expenses. Losses arising from the sale of capital assets are included in the computation only to the extent the losses entered into the determination of any gains paid, permanently set aside, or required to be distributed to any beneficiary (Revenue Ruling 74-257, 1974-1 C.B. 153). Expenses attributable to capital gains, whether the gains themselves are included or excluded, are deducted in computing DNI [Treasury Regulations 1.643(a)-3(b)].
Extraordinary dividends and taxable stock dividends. The DNI computation differs in the treatment of extraordinary dividends and taxable stock dividends between simple and complex trusts. Because simple trusts, by definition, do not make charitable contributions, only complex trusts are addressed. A corporate distribution that is classified as a return of equity or as a nontaxable stock dividend is not included in DNI. Conversely, regardless of the treatment afforded under state statutes, extraordinary dividends (whether paid in cash or in kind) and taxable stock dividends are not included in DNI [Treasury Regulations 1.643(a)-4].
Tax-exempt interest. Net tax-exempt interest is included in computing DNI. When the governing instrument is silent on the matter, IRC section 265 requires the allocation of a proportionate share of trustee fees to the exempt interest. Additionally, a proportionate share of any charitable contribution is allocated.
Distributions. IRC section 662(a)(1) provides that DNI is not reduced by charitable deductions for income amounts required to be distributed currently (i.e., first-tier distributions). Accordingly, charitable deductions cannot benefit a first-tier beneficiary. Other distributions (i.e., second-tier distributions) are reduced by charitable deductions as provided by IRC section 662(a)(2). For example, assume the following facts:
Trust income $30,000
First-tier distribution $15,000
Charitable deduction $15,000
Under these facts, DNI less the charitable deduction is $10,000; however, the first-tier beneficiary is taxed on $15,000, in accordance with IRC section 662(a)(1). Assume that the trust also distributed $5,000 of accumulated income or corpus to a second-tier beneficiary. DNI for this second-tier distribution is reduced by the charitable deduction to $10,000 and then further reduced by the first-tier distribution of $15,000, leaving a DNI of zero. Therefore, the second-tier distribution is received tax-free by the beneficiary. A charitable deduction effectively creates a middle tier between the different types of beneficiaries.
Ceilings. Computing DNI from taxable income with the modifications specified in the IRC constitutes the maximum amount allowable to the entity for the distribution deduction. If, for example, $20,000 was distributed to a beneficiary, and DNI was $19,000, then the allowable distribution deduction would be $19,000. As shown above, however, DNI includes income not subject to taxation (e.g., tax-exempt interest), and excludes other amounts subject to taxes (e.g., capital gains). Therefore, if the trust or estate receives such incomes, modifications to the computation are necessary before the actual distribution deduction is determined [IRC section 661(a)].
Before the final determination of the distribution deduction available to the estate or trust is made, DNI figured under IRC section 643(a) must be altered. Because the end result of the methodology is to determine the amount of the distribution deduction and, consequently, the charitable contribution deduction allowable for tax purposes, it follows that the components of DNI that are not taxable must be deleted from the amount arrived at through IRC section 643(a). These modifications are prescribed in IRC section 661. Generally, nontaxable incomes are taken out of the DNI computation, which serves to delete the proportionate amount from taxability at the beneficiary level, as well as proportionately reduce the distribution deduction available to the entity.
An open estate will often distribute assets that “carry out” income to a beneficiary trust with the intention of using the former lower brackets available at the entity level of the trust, a practice known as “trapping.” In essence, the distribution from the estate is principal in terms of fiduciary accounting income, but taxable income to the trust. Because it is principal for accounting purposes, it is not includible in the amount required to be distributed for a simple trust. It is, however, taxable income, and thereby includible in the computation of DNI. In such a case, the character of distributions and, presumably, the allocation of a contribution can be greatly altered.
In Van Buren v. Commissioner [89 T.C. 1101 (1987)], the estate of Maurice Van Buren, situated in New York, transferred assets to a testamentary trust for the benefit of the decedent’s wife. For that tax period, the estate had generated DNI of $110,000. Based on the value of the assets used for the distribution, taxable income of approximately $67,000 was carried out to the trust. Under the terms of the document, the income of the trust was to be disbursed, at least annually, to or for the benefit of the beneficiary. As such, the trust was classed as simple. Because the document was silent as to the description of income, the receipt from the estate was properly classed as principal under state law. Accordingly, it was not distributed, nor was it required to be. The trust itself had income receipts of $45,000; $38,000 was exempt interest and $7,000 was dividend income, all of which was distributed to the wife. In computing the distribution deduction, only the income generated within the trust was taken into consideration. Because a large percentage of the trust’s actual income was exempt interest, a large percentage of the distribution was nontaxable to the beneficiary.
Upon audit, the IRS contended that the DNI computation must take into consideration the income included in the “trapping” mechanism. The Tax Court, noting that fiduciary accounting income classifications of principal and income are not analogous to DNI’s “different classes of income” based on tax significance, found for the IRS. The resulting tax classification of the estate’s DNI and apportionment of the actual distributions among those classes led to a much larger portion of the trust’s distribution to the wife being classified as taxable income. While the scenario did not involve a charitable contribution, the Tax Court voiced its support for the IRS’ allocation of deductions among the total DNI of the trust. This stance provides support for a position that the contribution deduction, under a silent document, would be allocated among all the DNI incomes. While the instant trust was simple, inference for a complex trust, with a silent document, should follow.
Nondeductible Attributes of Charitable Contributions
When the governing instrument is silent, contributions must be allocated among the different classes of income earned by the entity (e.g., rents, dividends, royalties). If the trust or estate received exempt income for the taxable year, the contribution allocated to that income effectively becomes nondeductible and the tax benefit is lost. An additional scenario where the tax benefit is lost occurs when contributions made are in excess of gross income, which is not unusual in the year of termination for an estate or trust. Unlike individuals and corporate taxpayers, estates and trusts do not receive any carryover provisions for unused contributions. While IRC section 642(h) provides some relief for excess deductions in the final year, in that they are available to the beneficiaries, charitable contributions are not afforded comparable treatment and, in essence, expire. Yet another situation exists when the trust instrument or state law does not require a reserve for depreciation. In those instances, depreciation must follow the distribution of accounting income. As a result, income distributed to a charity results in the depreciation deduction being wasted. In the Uniform Principal and Income Act (1997), the trustee is given discretion to set up a reserve for depreciation that could prevent any wastage.
As in most areas of taxation, proper estate and trust planning is necessary to take full advantage of the opportunities available. Without express authority, fiduciaries may be unable to carry out the wishes of the decedent or grantor. Seeking equal treatment of beneficiaries, most states’ statutes provide that expenses benefiting both current income beneficiaries and remainders are to be allocated equally between principal and income. If this does not reflect the wishes of the decedent or grantor, the governing document must be drafted to reflect the desired allocation.
Subchapter J requires that contributions be made from income, and made from income proportionately where the governing instrument provides no direction. The 100% deductibility afforded when the contribution vehicle is a trust or estate may be lost. Avoiding a negative result requires that the document provide that contributions be sourced from taxable income.
The election available to a fiduciary to treat contributions made in the succeeding year as having been made in the current year affords planning opportunities especially in the year of termination, when gross income may be insufficient to cover final charitable contributions. In the 1997 Uniform Principal and Income Act (section 503), a trustee is given discretion to set up a reserve for depreciation that can prevent any wastage of depreciation following income to a charitable recipient that is unable to utilize the deduction. In states that have not adopted the 1997 Act, drafters should incorporate a reserve for depreciation and prevent wastage of depreciation where there is a charitable beneficiary.
Ted Englebrecht, PhD, is the Smolinski Eminent Scholar Chair, and Mary Anderson, MPA, CPA, is a doctoral candidate, both in the school of professional accountancy at Louisiana Tech University, Ruston, La.