When planning for charitable gifts, especially those accomplished using strategies that result in the gifts unfolding over an extended time, donors and those advising them need to consider the possibility that the rules on how those gifts are treated for federal income tax purposes may change.

There are many proposals calling for a change in the tax treatment of charitable gifts. While some proposals advocate limiting or eliminating the charitable income tax deduction, others revisit the types of organizations that are eligible to receive tax-deductible contributions. Some proposals have suggested that only organizations that actively benefit the underprivileged and fulfill other missions that benefit society in general should be subsidized through allowing charitable deductions from income, estate and gift tax. These proposals would disallow the deductions for gifts to specialized missions that only benefit a limited group.

While Congress debates the ultimate fate of charitable tax benefits, astute planners should begin to make provisions for possible limitations on the tax-exempt status of charitable recipients. Limits on the types of charities that are qualified to receive tax-deductible gifts would affect planning strategies in different ways.

Will the Estate be Taxable?

When considering charitable bequests in wills or distributions to charities from insurance policies, for example, the threshold issue will be whether the dispositions at death will likely be made from a taxable or nontaxable estate. If the estate won't be subject to tax, then the issue is moot. If the estate will be taxable under the law at the time of the donor's death, planners should ask clients how important the tax-qualified status of an intended recipient is to them. In other words, what would they like to happen if their estate is taxable and the charitable recipient is no longer eligible to receive tax-deductible gifts?

Naming Alternate Charities

Some donors may wish to name alternate charities to receive the gift funds that would have been distributed to a charity that's no longer a qualified recipient at the time of the donor's death. Or they may wish to give their personal representative the discretion to choose alternate charities that are still tax-exempt at the time of the donors' death. Others may decide that they would still like the gift to be made, just as if the gift were to a relative who would only receive after-tax dollars.

Planners should ask clients what they would like to happen if no charities are tax-exempt at the time of their death. Some clients may still wish to make the gifts to the charitable interests they name, especially if they have no close relatives. When an individual names a charity in his will or in other estate plans, he's elevating that charity to the level of a family member or very close friend. So it's conceivable that an individual would prefer funds go to one or more charitable interests, even if those funds are taxed, instead of what may otherwise be distant relatives he doesn't wish to support.

Inter Vivos Gifts

Inter vivos gifts with retained income present other scenarios. For example, a charitable gift annuity isn't affected by a change in the future tax status of the gift annuity. That's because a gift annuity is a completed gift at the time the annuity is funded. If the charity issuing the gift annuity is tax-exempt at the time the gift is funded, then the donor is entitled to an income tax deduction. The assets used to fund the gift annuity won't be in the donor's estate at the time of the donor's death. In the case of a two-life gift annuity, if the donor retained the right to revoke the survivor's income interest by will, the value of the surviving annuitant's interest is included in the estate as something of value left to another person. The charity's tax status isn't, however, relevant at that point, as no charitable deduction will be taken for that amount.

Different issues can arise with a charitable remainder unitrust (CRUT) or charitable remainder annuity trust (CRAT). As far as the charitable income tax deduction is concerned, as in the case of the charitable gift annuity, it's the status of the charity at the time the trust is funded that determines whether the donor is entitled to a deduction for the value of the charitable gift portion. At the death of the donor, however, the assets in the trust are included in the estate of the donor because of the retained life income interest in the trust.

Typically this isn't a concern, as the assets flow back out of the estate under the estate tax charitable deduction. A problem could arise, however, if one or more of the charitable remainder interests are no longer organizations that are eligible to receive tax-deductible transfers. The Internal Revenue Service sample forms for charitable remainder trusts (CRTs) address this issue by giving the trustee discretion to distribute the assets to other charities:

4. Distribution to Charity. At the termination of the unitrust period, the Trustee shall distribute all of the then principal and income of the trust (other than any amount due the Recipient under the terms of this trust) to [designated remainderman] (hereinafter “the Charitable Organization”). If the Charitable Organization is not an organization described in §§170(c), 2055(a), and 2522(a) of the Code at the time when any principal or income of the trust is to be distributed to it, then the Trustee shall distribute the then principal and income to one or more organizations described in §§170(c), 2055(a), and 2522(a) of the Code as the Trustee shall select, and in the proportions as the Trustee shall decide, in the Trustee's sole discretion.

The situation in which one or more of the organizations named to receive the remainder of a CRT is no longer a qualified charity at the time of termination, raises similar issues as those involved with gifts via wills, life insurance and certain other testamentary dispositions. If the estate isn't taxable, it doesn't matter whether the recipient is qualified for a tax-deductible transfer from terminating a CRUT or CRAT. On the other hand, if the estate is taxable under the law at the time of the trust termination, the drafter of the trust should provide for the donor's wishes in that event. Some donors may list alternate charities, split the remainder among the charities that remain qualified or follow the IRS sample language and direct that the trustee choose a qualified charity that most closely matches the donor's intentions for that portion of the estate. In this case, having the funds go to a charity even if not qualified for tax-deductible contributions isn't an option, as that would result in disqualifying the trust itself.

Charitable lead trusts (CLTs) present a slightly different challenge. As with CRUTs and CRATs, the IRS sample language requires that the annual distribution from the trust go to qualified organizations for the CLT to remain qualified for estate, gift and income tax purposes. The pro forma documents provide that the trustee choose a tax-qualified charity if one of the named recipients is no longer qualified to receive tax-deductible contributions. As in the case of CRTs, planners should ask clients if they want to name alternate “back up” charities, should their primary charities not be qualified or whether the clients want to leave the decision about alternate charities to the trustee's discretion.

Bankrupt or Merged Charities

Even if Congress doesn't change the types of organizations that are qualified to receive tax-favored transfers, it pays to plan ahead for other changes to charitable planning that may occur in the current economic environment. There have been a number of high-profile bankruptcies of charitable organizations and mergers of others to achieve economies of scale to stabilize charities that may have been struggling on their own.

Planners and clients should consider drafting wills, trusts and other charitable vehicles that address the possibility that a charity may be bankrupt or have been absorbed in a merger. Few donors would like a bequest to be distributed to a bankrupt charity so the funds can be immediately used to satisfy creditor's claims. That possibility can be dealt with by directing that an executor or trustee not be required to distribute funds in the event the charitable recipient is insolvent at the time of the donor's death or other termination event. As in the case of charities that are no longer tax-qualified, the donor should name alternate recipients or grant someone the discretion to make the decision as to what other solvent charity should receive the funds or whether the surviving charity (in the case of a merger) is still essentially the same charity the donor wished to benefit.

Many more issues exist when considering the impact of possible future tax legislation and the future economic health of charitable recipients. As is often the case, the key is to anticipate possible issues and work with clients as they make their plans to take steps to avoid unfortunate and unintended future outcomes.


Train in Vain

This album “London Calling,” by The Clash sold for $2,665 at the Christie's Popular Culture: Rock and Pop Memorabilia auction on June 14, 2011 in South Kensington, London. The album's front cover is signed by John Mellor, Michael Jones, Paul Simonon and NB Headon. “London Calling” was the album that made the Clash popular in the states in 1979. Rolling Stone magazine declared it the best album of the 1980s.