The general tax rule is that trusts compute their income and deductions as if they were individuals.1 Probably the most significant exception to this rule is the charitable deduction: The rules are so different for trusts that it may be easier to forget everything you know about individual income tax rules and start over.2 Grantors of grantor trusts deduct the contributions made by the trust as if the grantor had made them personally.3 If a trust is only partially a grantor trust, then the contributions made in the grantor portion are deductible by the grantor.4

For non-grantor trusts, it's a whole different ball game for charitable deductions. These trusts enjoy advantages over individuals when it comes to unlimited deductions and contributions to non-U.S. charities. But non-grantor trusts are more constrained in their deductions than individuals depending on the source of their income, the asset donated and the terms of their trust instruments. There also are specific limitations on deductions allocated from pass-through investments such as partnerships and Subchapter S corporations.

KEY DIFFERENCES

Unlike individuals who are subject to various percentage limitations, trusts are allowed an unlimited charitable deduction.5 This deduction is allowed if the payment is made in accordance with the provisions of the trust document. These payments may be required payments, such as in charitable lead trusts, or may be subject to the trustee's discretion in those situations in which the trust agreement grants the trustee power to distribute to a charity.6

For decades, there was a question regarding cash contributions made by trust-owned partnerships. Because the Internal Revenue Code requires that, to be deductible by a trust, a charitable contribution has to be made in accordance with the document's terms, there was confusion about what happens if the trust has no charitable provisions but received an allocation of charitable contributions on its Schedule K-1 from the partnership. Does the lack of a charitable distribution provision in a typical family trust preclude deduction for contributions by a partnership, which under the partnership rules are deemed made directly by the partner?7 This issue was addressed in the 1950 Bluestein8 case, but only finally resolved in 2004 by Revenue Ruling 2004-5,9 which treats trusts that own partnerships in the same manner as electing small business trusts (ESBTs). Rev. Rul. 2004-5 waives the requirement that the charitable distribution provision appear in the trust document itself. All other limitations continue to apply.

Also unlike individuals, trusts may deduct charitable contributions only to the extent the source of the deduction is taxable income. If a trust has tax-exempt income, the charitable deduction is treated as being made proportionately from the tax-exempt income and such portion is disallowed.

For example, if a trust has $100 of tax-exempt income and $200 of taxable interest income and makes a charitable contribution of $75, the charitable deduction is limited to $50 ($200/$300 × $75). If instead the trust had made a distribution of $600 to charity, the limitation would be $200 ($200/$300 × $600 is $400, but there is only $200 of taxable income.)

For this limitation, there is no difference between ordinary income and capital gain income; either can be wholly sheltered by a charitable transfer of that income.10 Trusts do not have a charitable contribution carryover, so a deduction in excess of taxable income provides no benefit.

This taxable-income limitation may seem innocuous, but it caused problems for taxpayers for most of the 20th century, and that pain continues to this day. The reason: an unlimited deduction for transfers made “out of income” precludes a deduction for charitable transfers “out of corpus.” Taxpayers from 191711 to 200612 found that the courts consistently upheld this limitation; a trust may not deduct a transfer of trust corpus to charity. In practical terms, this means that a trust that transfers assets other than cash to a charity is not entitled to a tax deduction. This prohibition extends to charitable contributions made by pass-through entities. Thus, because both cash contributions to private foundations and non-cash contributions to public charities are subject to a 30 percent of adjusted gross income (AGI) limitation, close inspection or additional inquiries may be required to determine if a partnership or S Corporation K-1 does not disclose whether the 30 percent contribution was paid in cash or in kind.

At first glance, there's one application of this rule that looks like an exception. Charitable lead trusts that use appreciated property to satisfy their annuity or unitrust obligation are entitled to a charitable deduction for the amount of any gain inherent in the asset transferred. If a lead trust owes its charitable beneficiary a payment of $100,000, and uses property worth $100,000 with a basis of $70,000, a capital gain of $30,000 will be triggered, and a deduction of $30,000 will be allowed. Note, however, that this is not really an exception, because the deduction is only in the amount of the capital gain, not the property value of $100,000.13

Faced with these limitations, some taxpayers and their advisors have attempted to take the position that, although the criteria for the deduction under Section 642 have not been met, they still should be allowed a deduction for a distribution under Section 661 as if the charity were any other beneficiary. So far, they have been unsuccessful.14

Congress is aware of these limitations on trust deductions, and at one point apparently considered changing them to more closely parallel the individual tax rules.15 So far, such changes have not been enacted.

HYPOTHETICAL UBTI

As with many provisions of the IRC, the word “unlimited” has its limitations. Section 681 appears to completely disallow any charitable deduction to the extent that the trust has income that would be unrelated business taxable income (UBTI) if the trust were an exempt organization (“hypothetical UBTI”). This limitation applies only to trusts, not to estates, which is a great advantage to estates that hold UBTI-generating assets such as S Corporation stock, operating limited liability companies (LLCs) or leveraged real estate partnerships. This exception is a significant incentive to trustees of formerly revocable trusts to make the election under IRC Section 645 to include their trusts as part of the decedent's estate for income tax purposes. This election can expire at unexpected or inconvenient times,16 but it's valuable as long as the election is effective.

Although IRC Section 681 disallows any charitable deduction against trusts' hypothetical UBTI, IRC Sections 512(b)(11) and (12) allow a partial deduction for charitable distributions when hypothetical UBTI is present. The examples in the regulations under Section 681 make this clear. Assume a trust has $51,000 taxable income, all of which is to be distributed to a public charity under the terms of the document. Assume further that $31,000 of the income is hypothetical UBTI and the remainder is taxable interest income. The trust is allowed a deduction of $1,000 under Section 512(b)(12), leaving $30,000 as its net hypothetical UBTI. With respect to the charitable deduction, $20,000 of taxable interest income may be offset by 100 percent and the remaining $30,000 of UBTI may be offset by 50 percent, leaving $15,000 in taxable income. If the charitable beneficiary were a private foundation, the limitation would be 30 percent of $30,000, leaving $21,000 in taxable income.

Astute readers will notice that these percentages (50 percent for public charities, 30 percent for private foundations) reflect the limitations for individuals making cash charitable donations. Indeed, these limits are cross-referenced in IRC Section 512(b)(11). These limitations on the charitable income tax deduction should be considered when planning for the funding of charitable trusts such as charitable lead trusts, especially if the assets that might be used to fund the trust are real estate partnership units or other assets that are almost certain to generate hypothetical UBTI.

S Corporation stock, because its income is automatically characterized as hypothetical UBTI,17 is another asset that requires special consideration in connection with the charitable deduction for trusts. In addition to wholly grantor trusts, there are four types of trusts that may hold S Corporation stock, each with its own set of rules.

  1. Qualified Subchapter S Trust (QSST) — Donations made by the corporation are passed through to the trust beneficiary along with all other S corporation tax attributes.18 The QSST itself cannot make charitable contributions because, to qualify as a QSST, the trust income and principal can only be distributed to a single (non-charitable) beneficiary.

  2. ESBT — Donations made by the S corporation are deductible on the trust's return, subject to the same limitations that would apply if the trust had made them directly.19 This means that donations of property made by an S Corporation are not deductible in calculating the ESBT's income, and therefore any such deduction allocated to ESBT shareholders is wasted. The S corporation's cash donations are deductible subject to the 30 percent and 50 percent limitations. However, cash donations made by the trust itself, even if using the cash distributed from the S corporation, are not deductible at all against that portion of the trust that contains the S corporation income.20 If the ESBT trust also has non-S corporation income, the regular trust charitable deduction rules apply to that portion of the trust. Charitable lead trusts may hold S corporation stock if they make an ESBT election.21 Thus, these rules apply to any charitable lead trust S shareholders.

  3. Formerly revocable trusts for the two-year period after the death of the settlor22 — These trusts are subject to the general rule that any charitable deduction paid in cash is limited to 30 percent or 50 percent of the S corporation income. This limitation applies whether the donations are made by the S corporation or the trust itself.

  4. Formerly revocable trusts if the trustee or executor makes the election under IRC Section 645 to have the trust treated as part of the estate for income-tax purposes — As long as the trust is considered part of the estate, the estate limitations apply to the charitable deduction calculation. Because the Section 681 limitations do not apply to estates, a trust under a Section 645 election may deduct up to 100 percent of its taxable income that it distributes to charity in cash, regardless of its characterization as hypothetical UBTI. The electing trust and the associated estate are treated as separate shares,23 so any cash payments in excess of the trust's income cannot be deducted against the estate's taxable income. Donations made in cash by the S corporation will be fully deductible against any trust taxable income.

SET-ASIDE ELECTION

Another benefit allowed to trusts and not to individuals is the one-year “set aside” election under Section 642(c)(1). A trust may set aside any amount of its taxable income for charity if that amount is to be distributed to charity within its next taxable year. This provision is often used by charitable lead trusts that have income or capital gains in excess of their annual charitable required payment. As an example, assume that such a trust has an annual payment of $100,000. In 2006, after expenses, it has dividend income of $40,000 and a long-term capital gain of $150,000. The trust has made no prior set-aside elections. It may deduct the $100,000 required payment in 2006. In addition, the trustee may elect on its 2006 Form 1041 to set aside all or part of its remaining $90,000 of taxable income to be paid to charity before Dec. 31, 2007. If the trust has only $50,000 of dividend income in 2007, the required 2007 charitable payment of $100,000 is applied first to the “set aside” from 2006, leaving $10,000 of the payment to be applied against the $50,000 dividend income. The trustee may make another set-aside election for the $40,000 remaining 2007 dividend income.

Additional questions are raised by the interaction of the one-year set-aside with pass-through entities. Our example assumed that the trust directly earned the income. But what if that 2006 capital gain and dividend income had been passed through to the trust on a partnership K-1? Assume further that the partnership distributed only $100,000, just enough for the lead trust to make its annual payment. Can the trustee still make the set-aside election for the additional $90,000 taxable income?

Although the regulations are silent on this issue, the case law says, “No.” Cases such as Sid Richardson Foundation24 have limited the amount eligible for the set-aside election to the amount of cash distributed to the trust during the year. The judicial logic seems to be that if the trust does not actually have control of the cash, it cannot set aside the associated taxable income. This has been true even when the trust owns 100 percent of the distributing entity, which (barring the case law) would seem to allow the set-aside, because the fiduciary could control distributions from the entity.25 This limitation has not been applied to cash actually distributed to charity during the year (rather than subject to a set-aside), so if the trustee in our example had received no partnership distributions during 2006, but used previously accumulated income for the annual payment, the trust would be entitled to a $100,000 charitable deduction against the 2006 income.26

FOREIGN CHARITIES

A final difference between trusts and individuals is the limitation on deductions for non-U.S. charities. Individuals cannot generally deduct donations to non-U.S. charities on their income tax returns.27 Trusts may deduct transfers for a charitable purpose even if the charity is established outside the United States.28 Still, trustees should exercise caution when making distributions to foreign charities that have not had their exempt status recognized by the Internal Revenue Service. It may be necessary to make an equivalency determination or exercise expenditure responsibility as detailed in the regulations under Section 4945. This is necessary to avoid a 20 percent penalty for a taxable expenditure under Section 4945(a) if the trust is described in Section 4947(a)(2).29

Of course, no job is over until the paperwork is done. A trust that is entitled to a charitable contribution deduction may need to file Forms 1041-A and 5227 in addition to Form 1041.

An awareness of the differences in the deduction rules for trusts and individuals will ensure that the appropriate planning is done in advance to avoid any surprises on April 15 when the tax returns are due.

This article does not constitute tax, legal or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader's particular situation.

Endnotes

  1. Treasury Regulations Sections 1.641(a)-2 and 1.641(b)-1.
  2. Internal Revenue Code Section 642(c).
  3. Treas. Regs. Section 1.671-2(c).
  4. Goldsby v. Commissioner, T.C. Memo. 2006-274.
  5. IRC Sections 170(b) and 642(c).
  6. Old Colony Trust Co. v. Comm'r, 279 U.S. 716 (1929).
  7. Treas. Regs. Section 1.703-1(a)(2)(iv).
  8. Bluestein v. Comm'r, 15 T.C. 770 (1950), acq., 1951-1 C.B. 1.
  9. IRB 2004-3.
  10. Treas. Regs. Section. 1.642(c)-3(c): although out-of-date: the 50 percent capital gain exclusion in the examples is from the 1975 version of the Code and should be disregarded.
  11. Estate of Tyler, 9 BTA 255 (1927).
  12. Goldsby v. Comm'r, supra note 4.
  13. Revenue Ruling 83-75, 1983-1 C.B. 114.
  14. U.S. Trust Co. v. Internal Revenue Service [86-2 USTC ¶ 9777].
  15. Estate of Linen v. IRS [99-1 USTC ¶ 50,545].
  16. Treas. Regs. Section 1.645-1(f).
  17. IRC Section 512(e)
  18. Treas. Regs. Section 1.1361-1(j)(7).
  19. Treas. Regs. Section 1.641(c)-1(d)(2)(ii).
  20. Treas. Regs. Section 1.641(c)-1(g)(4).
  21. Private Letter Ruling 199908002 (Nov. 5, 1998).
  22. Treas. Regs. Section 1.1361-1(h)(1)(ii).
  23. Treas. Regs. Section 1.663(c)-4(a).
  24. [70-2 USTC ¶ 9483] (5th Circuit 1970).
  25. Ibid.
  26. Supra note 6.
  27. IRC Section 170(c). There are limited deductions allowed for U.S., Israeli, and Canadian charities under their respective treaties. Those are beyond the scope of this article. Gift and estate tax deductions are allowed for transfers to qualified foreign charities.
  28. Treas. Regs. Section 1.642(c)-1(a)(2).
  29. Treas. Regs. Section 53.4947-1(c)(1).

SPOTLIGHT

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