In April 2012, the Treasury and the Internal Revenue Service issued final Treasury regulations under Internal Revenue Code Section 642(c), which provide rules for determining the character of income distributed to charity from a trust. These rules are particularly important for trustees of charitable lead trusts (CLTs) because they affect the ability of a CLT to deduct distributions to charity. Unfortunately, the new regulations leave several questions unanswered.
Taxation of CLTs
A CLT is a split-interest trust that pays an annuity or unitrust amount to charity each year during its term. At the end of the CLT’s term, the assets remaining in the CLT are paid to or for the benefit of noncharitable beneficiaries, either outright or in further trust.1 A CLT will receive a charitable deduction under IRC Section 642(c) for amounts of gross income that it pays to charities pursuant to the terms of the governing instrument. Section 642(c)(1) specifically provides:
In the case of an estate or trust (other then a trust meeting the specifications of subpart B), there shall be allowed as a deduction in computing its taxable income (in lieu of the deduction allowed by section 170(a) relating to deduction for charitable, etc., contributions and gifts) 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) (determined without regard to section 170(c)(2)(A)).
There’s no requirement that the income out of which the payment is made be gross income of the trust in the year of payment. The Treasury regulations allow a charitable deduction for “an amount paid during the taxable year in respect of gross income received in a previous taxable year, but only if no deduction was allowed for the amount so paid.”2 To the extent the payments aren’t made out of gross income, no deduction is allowed. This means, for example, that if a CLT receives tax-exempt interest that isn’t included in its gross income, the deduction allowable under Section 642(c) can’t include the portion of the income that consists of the CLT’s tax-exempt interest.
Similarly, IRC Section 681 disallows the Section 642(c) charitable deduction for payments to charity to the extent the payment is allocable to the unrelated business taxable income (UBTI) of the trust. A trust will have UBTI, for example, if it invests in pass-through entities that are engaged in trades or businesses or that have debt-financed investments, or if it makes debt-financed investments directly.
Despite the fact that the amount of a CLT’s deduction may depend on the source of trust property used to make the payment to charity, neither Section 642(c) nor Section 681 provides rules for determining the source of trust property used to make distributions to charity.
Old Ordering Rules
As a result of the uncertainty regarding the sourcing rules, practitioners often included in their CLT agreements provisions that would specify the ordering in which the various types of trust income and principal would be allocated to the annuity or unitrust payments of the CLT. For example, a typical ordering provision would have read:
Payment of each Annuity Amount shall be allocated first to the gross income of the Trust other than unrelated business taxable income within the meaning of § 512 of the Code, then to unrelated business taxable income, then to tax-exempt income, and, finally, to principal.
Here’s how this type of ordering provision would have worked: Suppose a CLT in its first year of existence, pursuant to its governing instrument, made a $50,000 payment to a public charity. Its income for the year consisted of $10,000 of UBTI, $30,000 of taxable interest income, $20,000 of long-term capital gain and $9,000 of tax-exempt interest. If the CLT’s governing instrument included an ordering provision, such as the one described above, the annuity amount would have been allocated as follows:
$30,000 taxable interest income
$20,000 long-term capital gain
This type of ordering provision, if respected, would have minimized the taxes payable by the CLT because no portion of the annuity amount would have been allocated to the tax-exempt interest or the UBTI.
Whether the IRS would honor this type of ordering provision, however, wasn’t clear. The old Treasury regulations, under Section 642(c), which state that a trust’s income sourcing provision in a governing instrument will control in all cases, provide:
[I]n determining whether the amounts of income so paid . . . include particular items of income of an estate or trust not included in gross income, the specific provision controls if the governing instrument specifically provides as to the source out of which amounts are to be paid. . . . In the absence of specific provisions in the governing instrument, an amount to which section 642(c)(1), (2), or (3) applies is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes.3
The old regulations, therefore, specifically state that income ordering provisions in a governing instrument will control in all cases. However, notwithstanding the old Section 642(c) regulations, in various private letter rulings, the IRS indicated that it was adding an additional hurdle. In these rulings, the IRS held that an ordering provision in a trust’s governing instrument would need to have economic effect independent of tax consequences before it would be respected. For example, in PLR 9750020 (Sept. 8, 1997), the IRS ruled:
[I]n addition, the ordering of income distributions provided in . . . the trust agreement will not be given effect for federal income tax purposes because the ordering provision has no economic effect on the distributions independent of tax consequences. Although Section 1.642(c)-3(b)(2) does not specifically provide that an allocation of income in a trust instrument must have economic effect, we believe that an allocation of income items to a charity beneficiary should generally be made on a pro-rata basis. A specific allocation will only be allowed when trust provisions have an economic effect on Trust’s distributions independent of tax consequences.4
New Ordering Rules
On June 18, 2008, the Treasury and the IRS proposed a change to the regulations under Section 642(c). The proposed regulations provided:
[I]n determining whether the amounts of income so paid, permanently set aside, or used for a purpose specified in section 642(c)(1), (2), or (3) include particular items of income of an estate or trust, whether or not included in gross income, a provision in the governing instrument or in local law that specifically provides the source out of which amounts are to be paid, permanently set aside, or used for such a purpose controls for Federal tax purposes to the extent such provision has economic effect independent of income tax consequences. See §1.652(b)–2(b). In the absence of such specific provisions in the governing instrument or in local law, the amount to which
section 642(c) applies is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes.5
On April 16, 2012, the Treasury and the IRS published final regulations on this subject in the Federal Register.6 The final regulations, with minor revisions, are identical to the proposed regulations. They took effect on April 16, 2012. The preamble summarizes, and then rejects, various public comments made with respect to the 2008 proposed regulations.
What does it mean for an income ordering provision to have economic effect independent of income tax consequences? According to Examples 1 and 2 of the new Treasury regulations, a provision has economic effect if the amount to be paid to a charity is dependent on the type of income from which it’s to be paid. In Example 1, a CLT is required to pay an annuity of $10,000 per year to a charity. The trust agreement provides that the $10,000 annuity should be deemed to come first from ordinary income, second from short-term capital gain, third from 50 percent of the UBTI, fourth from long-term capital gain, fifth from the balance of UBTI, sixth from tax-exempt income and seventh from principal. According to the example, this provision in the trust agreement doesn’t have economic effect independent of income tax consequences; therefore, the amount distributed is deemed to consist of the same proportion of each class of the items of income of the trust as the total of each class bears to the total of all classes.
In Example 2, however, a trust agreement provides that 100 percent of the trust’s ordinary income must be distributed currently to charity, and all remaining items of income must be distributed to the noncharitable beneficiary. The trust in Example 2 isn’t a CLT. This income ordering provision has economic effect independent of income tax consequences because the amount to be paid to charity depends on the amount of the trust’s ordinary income. Therefore, for purposes of Section 642(c), the full amount distributed to charity is deemed to consist of ordinary income.
In the preamble to the final regulations, the IRS specifically stated that ordering provisions in CLTs will never have economic effect independent of their tax consequences because the amount paid to charity isn’t dependent on the type of income that’s allocated to it. According to the preamble, this is true whether the CLT pays an annuity amount or a unitrust amount to charity.
Notwithstanding the statement in the preamble, there are instances when the way in which a CLT’s income is allocated to its payment to charity will affect the amount to be paid to charity.
Example: A CLT has an obligation to pay $90,000 to charity each year. The trustees, however, are required to pay: (1) to Charity A, an amount equal to the lesser of $90,000 and the CLT’s income from sources other than UBTI and tax-exempt income; (2) to Charity B, an amount equal to the lesser of $90,000, reduced by the amount paid to Charity A, and the CLT’s UBTI and tax-exempt income; and (3) to Charity C, an amount equal to $90,000 reduced by the amounts paid to Charity A and Charity B. In this case, because the income ordering of the CLT will affect how much is paid to each charity, there are clear economic consequences that flow from the CLT’s ordering rules.
Issues Not Addressed
The new regulations leave uncertainty as to two important issues that trustees of CLTs must face.
1. How do the ordering rules work when a CLT has undistributed income earned in prior years? The new regulations don’t offer any guidance as to how the income ordering rules should operate when an annuity or unitrust payment is to be made to charity from a CLT in a year when the CLT has undistributed income earned in a prior year, as well as income earned in the current year. Should the prior year’s income be allocated to the annuity or unitrust payment first, or should the prior year’s income be allocated with the current income on a pro rata basis? The answer to this question will affect the CLT’s taxable income.
Example: A trust in its second year of existence has taxable interest income of $10,000 and tax-exempt income of $90,000. In its first year, it had $100,000 of taxable interest income earned, but not distributed. In Year 2, the trustee makes a $10,000 payment, pursuant to the terms of the governing instrument, to charity. If the prior year’s income and the current year’s income are combined, here’s how the allocation should work:
Total taxable interest:
$110,000/200,000 x $10,000 = $5,500
Total tax-exempt interest:
$90,000/200,000 x $10,000 = $4,500
Amount of Section 642(c) deduction:
However, if the prior year’s income is allocated to the payment to charity first, then the allocation should work differently:
Taxable interest in Year 1:
$100,000/100,000 X $10,000 = $10,000
Amount of Section 642(c) deduction:
Absent guidance from the regulations, the answer is that the income from both years should be combined and then together allocated on a pro rata basis. Until the IRS provides such guidance, practitioners should consider including in their CLT agreements a provision regarding the source of the annuity or unitrust payment that clarifies whether the income earned in a prior year will be combined with the current year’s income and facilitates the ability of the trustee to identify such undistributed income. The CLT provision could state:
Source of Payment. The Annuity Amount shall be paid from the current income of the Trust, combined with undistributed income from prior years, and, to the extent income is insufficient, from principal. In order to facilitate the identification of undistributed income from prior years, any income of the Trust for a taxable year not so paid shall be separately accumulated and shall not be added to principal. For the purpose of this subsection, in accordance with the principles of Treas. Regs. Section 1.642(c)-3(b)(2), the income of the Trust shall mean the gross income of the Trust, including gains from the sale, exchange or other disposition of property, and tax-exempt income.
2. Income attributable to investments in pass-through entities. The new regulations also fail to provide any guidance as to the proper treatment of amounts included in the gross income of a CLT on account of its investment in a pass-through entity (such as a partnership or limited liability company), but not actually received by the trust. Because the Section 642(c) deduction is available only for amounts of gross income paid to charity, no portion of the amount paid to charity should be deemed to be derived from such pass-through income.
For example, suppose a trust in its first year of existence had $100,000 of gross income attributed to an investment in a partnership from which it received no distributions. All of this income is UBTI within the meaning of IRC Section 681. The trust also received $100,000 of taxable interest. The trustee, pursuant to the terms of the trust instrument, paid $50,000 to charity. Because no portion of the payment to charity could have come from gross income other than the taxable interest, the $50,000 payment to charity should be fully deductible.
A similar issue exists with respect to distributions received by a CLT from a pass-through entity. If a CLT receives a distribution from a pass-through entity of an amount equal to or less than its share of the entity’s gross income, will the distribution be treated as gross income or will the trustee be required to show that the distribution made by the entity came from its gross income?
It would be helpful to trustees and their advisors if the IRS would issue regulations clarifying these issues.
—The author thanks Carlyn S. McCaffrey, partner at McDermott Will & Emery LLP in New York, for her assistance with this article. Some of the ideas discussed in this article are based on concepts mentioned in Carlyn’s article, “Charitable Lead Trusts—Estate Planning for the Philanthropic Optimist,” 52nd Annual State Bar of Michigan Probate & Estate Planning Institute (Seminar Handbook 2012).
1. This article doesn’t discuss the income taxation of charitable lead trusts that are treated as owned by their grantors under Internal Revenue Code Sec-tions 671 through 679.
2. Treasury Regulations Section 1.642(c)-1(a).
3. Treas. Regs. Section 1.642(c)-3(b)(2). These regulations were replaced in 2012.
4. See also Private Letter Ruling 1999080002 (Feb. 26, 1999), PLR 199903045 (Jan. 22, 1999), PLR 9539009 (June 29, 1995), PLR 9348012 (Aug. 31, 1993), PLR 9052013 (Sept. 27, 1990) and PLR 8727072 (Dec. 31, 1986).
5. Proposed Treas. Regs. Section 1.642(c)-3(b)(2) (73 Fed. Reg. 34670).
6. 77 Federal Register 22483 (2012).