Charitable/IRA Tax-Free Distributions Redux ... American Taxpayer Relief Act of 2012

For information about Conrad Teitell’s publications and lectures visit: taxwisegiving.com. For information about Cummings & Lockwood visit: cl-law.com.

The new law (H. R. 8 Section 208) is a scant-half page. Here is the English version, fleshed out with my interpretation and examples. Then read on for a detailed explanation of all the qualified charitable/individual retirement account distribution requirements.

• Qualified charitable/IRA distributions allowed for all of 2013.

• Available for all of 2012 for the rare donors who made direct  distributions from their IRAs before the retroactive extension for 2012 was enacted.

• Election available for individuals who took distributions from their IRAs in December 2012 (the December 2012 people). They can contribute cash up to their December withdrawals (remember the maximum $100,000 for the year, discussed later) to qualified charities during January 2013 (only this month) and treat those cash payments as qualified distributions made on Dec. 31, 2012.  Although not specifically stated in the law, I believe that this rule includes required minimum distributions (RMDs) taken by the taxpayer in December 2012. This rule benefits only individuals who took distributions in December 2012—not those who took distributions in the first 11 months of 2012. The December 2012 people don’t have to make any new IRA transfers directly to charity to retroactively take advantage of tax-free IRA distributions in 2012. By making the election and giving cash (no other type of gift) to charity, the law treats the cash payments as IRA distributions made directly to charity on Dec. 31, 2012.

• Election available for ALL individuals. They can, in January 2013 (this month only), direct distributions from their IRAs directly to qualified charities. Those distributions will, under the election, be treated as made on Dec. 31, 2012. This enables individuals to, in effect, use their IRAs to make 2012 tax-free gifts to charity. But amounts withdrawn from their IRAs in 2012, including RMDs, remain taxable. The December 2012 people can turn already-taken withdrawals into tax-free transfers to charity. But for all others, additional IRA distributions directly to charity must be made in January 2013 to have distributions treated as Dec. 31, 2012 distributions.

Example. Laggard (actually, he’s pretty savvy because he lets his IRA grow tax free as long as possible) took his required minimum distribution of $70,000 in December 2012. He can now take his magic election wand in January 2013, pay $70,000 in cash to charity and his 2012 RMD isn’t taxable.

Example. Eager Beaver took his $70,000 RMD for 2012 before December 2012. If his IRA distributes $70,000 directly to charity in January 2013 and he makes the election, that  distribution is treated as being paid on Dec. 31, 2012. That distribution isn’t taxable. But he is still taxable on the $70,000 RMD taken before December 2012.

Bottom lines:

• The December 2012 people can, in January 2013, turn otherwise taxable 2012 IRA withdrawals into non-taxable withdrawals using the timely contribution of cash election.

• Distributions directly from IRAs to charity in January 2013, under the election, can be treated as Dec. 31, 2012 distributions and won’t be taxable in 2012. But those distributions won’t change the tax treatment of IRA distributions taken in 2012.

• The January 2013 election enables a generous donor to contribute up to $100,000 from his IRA to charity in each of the years 2012 and 2013.

• The usual requirements (age 70½, qualified charities, $100,000 maximum and substantiation rules) apply.

• The new law provides that the IRS will tell how to make the election. And, presumably, it will flesh out the language of the Code.

• The window for taking advantage of the election closes at midnight January 31.

Caveat on assuring compliance with special January 2013 charitable/IRA election rules. The usual date of mailing by U.S. mail rules for establishing date of delivery for charitable gifts of cash and securities don’t, in my opinion, apply. To assure compliance with the January 2013 election, the cash payments by the December 2012 people and distributions from IRAs directly to charity must be received by the charity by Jan. 31, 2013.

SUGGESTION: Charities should lobby vigorously to make permanent the law for direct transfers and expand the law to include transfers for life-income gifts. Except for donors who took their required minimum (and other) distributions in December 2012 (and the limited number of donors who made direct IRA transfers to charity in 2012 in the hope that the law would be retroactively enacted), the tax-free distribution benefit was unavailable for most taxpayers in 2012. This is especially tax-disadvantageous for the approximately two-thirds of taxpayers who take the standard deduction. They, unlike itemizers, receive no tax benefit for their charitable gifts. Tax-free distributions to charity from IRAs are equivalent to charitable deductions.

TO GET TAX-FREE CHARITABLE/IRA DISTRIBUTIONS NUMEROUS REQUIREMENTS MUST BE MET. The details of the ongoing rules, ramifications and reminders follow; plus a discussion of the potential advantages since the law’s enactment in 2006 and the increased potential advantages under the new tax law for high-income taxpayers.

Tax-free IRA/Charitable distributions—maltum in parvo (in a nutshell). An individual age 70½ or older can make direct charitable gifts from an IRA, including required minimum distributions, of up to $100,000 to public charities (other than donor advised funds and supporting organizations) and not have to report the IRA distributions as taxable income on his or her federal income tax return. Most private foundations are ineligible donees, but private-operating and passthrough (conduit) foundations are. Tax-free distributions are for outright (direct) gifts only—not life-income gifts. There is no charitable deduction for the IRA distributions. However, not paying tax on otherwise taxable income is the equivalent of a charitable deduction.

Traditional and Roth IRAs only. Distributions from traditional and Roth IRAs are the only ones that are tax free. Distributions from employer-sponsored retirement plans, including SIMPLE IRAs and simplified employee pensions (SEPs) aren’t qualified charitable distributions; nor are distributions from Keoghs, 403(b) plans, 401(k) plans, profit sharing and other plans. 

Doing a two step to qualify: (1) Roll over a non-qualified pension plan into a qualified IRA. That’s generally tax free (make sure that’s so). (2) The qualified IRA then makes the distributions directly to the charity.

Pointer re donor-advised funds of community foundations. As noted, IRA distributions to those funds don’t qualify. But IRA distributions to a community foundation’s endowment and field-of-interest funds do qualify—as long as the donor has no advisory rights.

Distributions from a qualified IRA must be made directly by the IRA’s administrator or trustee to a qualified charity. A payment to the donor who one honko-second later gives it to the charity doesn’t qualify (a honko-second is the shortest measure of time—the time that elapses between a traffic signal turning green and the driver of the car behind honking his horn). Note the election (above) for donors who took distribution in December 2012 and make cash gifts to qualified charities in January 2013.

Required minimum distributions—a big plus. As noted, those distributions are deemed to be qualified charitable distributions. 

The entire distribution must be paid to the charity with no quid pro quo. The exclusion applies only if a charitable deduction for the entire distribution would have  been allowable (determined without regard to the generally applicable percentage limitations). Thus, if the donor receives (or is entitled to receive) a chicken dinner in connection with the transfer to the charity from the IRA, the exclusion isn’t available for any part of the IRA distribution. 

Example. $100,000 from a donor’s IRA is distributed to the charity. He receives (or is entitled to receive) a benefit worth $25. The entire $100,000 will be taxable to the donor.

Substantiation required. The exclusion won’t be available if the IRA distribution to the charity isn’t sufficiently substantiated. The charity must give the donor a timely written acknowledgment that it has received the IRA distribution and that no goods or services were given in connection with the IRA distribution. 

Favorable rules on charitable distributions when the donor had made earlier deductible and nondeductible contributions to his IRA. If the IRA owner has any IRAs that include contributions that were nondeductible when contributed to the IRA, a special rule applies in determining the portion of a distribution that is includable in gross income (but for the qualified IRA/charitable distribution) and, thus, is eligible for qualified charitable distribution treatment. The special rule works this way: The distribution is treated as consisting of income first, up to the aggregate amount that would be includable in gross income (but for the qualified charitable distribution) if the aggregate balance of all of the donor’s IRAs were distributed during the same year. In determining the amount of subsequent IRA distributions includable in income, adjustments are to be made to reflect the amount treated as qualified charitable distributions.

Qualified charitable distributions—examples. These examples illustrate the determination of the portion of an IRA distribution that is a qualified charitable distribution. In each example, it is assumed that the requirements for qualified charitable distribution treatment are otherwise met (for example, 70½ or older, qualified public charity) and that no other IRA distributions are made during the year.

Example 1. Arnold, over 70½, has an IRA with a $100,000 balance, consisting solely of deductible contributions and earnings. He has no other IRA. The entire IRA balance is distributed to an Internal Revenue Code Section 170(b)(1)(A) charity (other than a supporting organization or a donor advised fund). Under earlier law, the entire $100,000 distribution would have been includable in Arnold’s gross income. Under the IRA/charitable distribution rules, the entire $100,000 distribution is a qualified charitable distribution and thus no amount is includable in his income. Further, the distribution is not taken into account in determining the amount of Arnold’s allowable charitable deductions for the year.

Example 2. Barbara, over 70½, has a $100,000 IRA consisting of $80,000 of deductible and $20,000 of nondeductible contributions. $80,000 is distributed directly to charity. She has no other IRA.

Notwithstanding the usual treatment of IRA distributions, the distribution to the charity is treated as consisting of income first, up to the total amount that would be includable in gross income (but for the charitable IRA distribution rules). Under these rules, the entire $80,000 distributed to the charity is a qualified charitable distribution and no amount is included in Barbara’s income as a result of the distribution. Further, the distribution isn’t taken into account in determining the amount of Barbara’s charitable deductions for the year. And when the $20,000 remaining in Barbara’s IRA is distributed to her, it will not be subject to tax because it came from nondeductible IRA contributions when placed in her IRA.

You turn 70½ for purposes of qualifying for the IRA/charitable distribution when you are actually 70½.  Professor Christopher R. Hoyt, University of Missouri-Kansas City, School of Law, highlights a major pitfall: “It is true that all distributions that are made at any time during [the year that a person turns 70½] can be applied toward satisfying the minimum distribution requirement to avoid the 50 percent penalty tax. But ONLY distributions that are made on or after attaining the age of 70½ qualify for the charitable exclusion! Play it safe and tell clients/donors not to have any distributions made to charity until at least one or two days after they reach age 70½.”

Caveat on year-end charitable distributions. A donor who by U.S. mail sends checks and securities to a charity this year that are received by the charity next year has made a charitable gift this year. Will a distribution mailed by the IRA trustee/custodian to the charity this year, but received by it next year, qualify for tax-free treatment? Unless clarified by the IRS, make sure that the charity actually receives the distribution this year.

Guidance from the IRS. In 2007, the IRS—fleshing out the Code and the explanation by the staff of the Joint Committee on Taxation—favorably filled in the blanks to some unanswered (and some already answered) questions:

• Check payable to charity but delivered to the charity by the IRA owner. The payment to the charity will be considered a direct payment by the IRA trustee to the charity and, thus, a qualified charitable distribution (QCD).

• For inherited IRAs. The exclusion from gross income for QCDs is available for distributions from an IRA maintained for the benefit of a beneficiary after the death of the IRA owner if the beneficiary has attained age 70½ before the distribution is made. 

• Multiple IRAs. The income exclusion for qualified charitable distributions only applies to the extent that the aggregate amount of QCDs made during any taxable year for an IRA owner doesn’t exceed $100,000. Thus distributions from multiple IRAs are capped at a maximum total of $100,000. 

• For married individuals filing jointly. The limit is $100,000 per individual IRA owner. 

• QCDs don’t affect the AGI deductibility ceiling. Although charitable IRA distributions aren’t deductible IRC Section 170 charitable contributions, QCDs that are excluded from income under IRC Section 408(d)(8) aren’t taken into account for purposes of the AGI ceilings for traditional charitable gifts. 

• Substantiation requirements. Although not deductible, QCDs  must still satisfy the deductibility requirements under IRC Section 170 (other than the AGI percentage limits of IRC Section 170(b)) and the substantiation requirements under IRC Section 170(f)(8). 

• QCDs aren’t subject to withholding. An IRA owner who requests a charitable distribution is deemed to have elected out of withholding under IRC Section 3405(a)(2). 

• IRA trustees and custodians are off the hook. In determining whether a distribution requested by an IRA donor satisfies the QCD requirements, the IRA trustee or custodian may rely upon reasonable representations made by the IRA owner. 

• Required minimum distributions. A QCD is taken into account in determining whether the required minimum distribution (RMD) requirements have been satisfied. 

• Treatment of a QCD manqué. If an intended QCD is paid to a charity, but fails to satisfy IRC Section 408(d)(8)’s requirements, the amount paid is treated as: (1) a distribution from the IRA to the IRA owner that is includable in gross income (under IRC Sections 408 and 408A’s rules), and (2) a contribution from the IRA owner to the charity that is subject to IRC Section 170's deductibility rules (including the AGI percentage limits and the substantiation rules).

• QCDs aren’t prohibited transactions—even if used to satisfy pledges. The Department of Labor, which has interpretive jurisdiction under IRC Section 4975(d), has advised the IRS that a distribution made by an IRA trustee directly to an IRC Section 170(b)(1)(A) organization (as permitted by IRC Section 408(d)(8)(B)(i)) will be treated as a receipt by the IRA owner under IRC Section 4975(d)(9) and, thus, isn’t a prohibited transaction and that’s so even if the IRA owner had an outstanding pledge to the receiving charity.

 IRS Notice 2007-7

Tax-free distributions from individual retirement plans for charitable purposes. When determining the portion of a distribution that would otherwise be includable in income, the otherwise includable amount is determined as if all amounts were distributed from all of the individual’s IRAs.

Technical Corrections Act ‘07

Satisfying a pledge with an IRA distribution—IRS Information Letter. By analogy to Rev. Rul. 64-240, a taxpayer who satisfies a pledge by making a qualified charitable distribution under IRC Section 408(d)(8) from his or her IRA directly to a charitable organization would not include the distribution in gross income, the IRS said in an Aug. 20, 2010 Information Letter to Harvey P. Dale, University Professor of Philanthropy and the Law, Director, National Center on Philanthropy and the Law at New York University Law School written by Michael J. Montemurro, Office of Associate Chief Counsel.

IRS’s caveat. “This letter is an ‘information letter’, which calls attention to a well-established interpretation or principle of tax law without applying it to a specific set of facts. It is intended for informational purposes only and does not constitute a ruling. See section 2.04 of Rev. Proc. 2010-1, 2010-1 I.R.B. 1, 7.”

My caveat. To avoid income on satisfying a pledge with a distribution from an IRA, the distribution must qualify under the requirements outlined above.

Advantages of IRA/Charitable Distributions:

• A gigantic additional pool of funds is available for charitable gifts.

• The approximately two-thirds of taxpayers who take the standard deduction—and thus can’t deduct their charitable gifts—can get the equivalent of a deduction by making gifts directly from their IRAs to qualified charities. Not being taxed on income is the equivalent of a deduction. So the RMD (required minimum distribution) is now a WMD (weapon of mass deduction).

• Itemizers who bump into the adjusted gross income ceilings on charitable-gift deductibility can use distributions from IRAs to make additional gifts. Because they won’t be taxed on the distributions, they have the equivalent of additional charitable deductions.

• The carryover can be saved. Deductible gifts made in a current year are taken into account before deducting a carryover from earlier years. Making a gift from an IRA (as opposed to making a gift with other funds or assets) means that a carryover can be used in the current year.

• The IRA/charitable distribution (by not increasing adjusted gross income as would be the case if the taxpayer withdraws IRA funds instead of using the charitable distribution) can avoid or minimize the reduction of otherwise allowable benefits that are keyed to adjusted gross income—the 10 percent AGI floor on casualty loss deductions, the increased 10 percent floor on medical and dental expense deductions, the 2 percent AGI floor on miscellaneous itemized deductions.

• As adjusted gross income increases, the following benefits can be reduced or eliminated: social security; savings bond interest exclusion for savings bonds used to pay for higher education tuition and fees; the adoption and child care credits; contributions to Roth IRAs; and passive activity losses and credits,

• If a donor’s state income tax law doesn’t allow charitable deductions: Making the gift from the donor’s IRA to the charity can be the equivalent of a state income tax charitable deduction. 

Caution. State laws differ so check out all the ramifications in your state. For example, in some states IRA distributions directly to the IRA owners aren’t subject to state income tax. A distribution from the IRA to charity thus won’t save state income taxes and the donor could lose a state income tax charitable deduction that might—depending on state law—be available for a gift from the donor to the charity. Of course, consider both the federal and state tax rules. You may have heard this before: Do the arithmetic under various scenarios.

PEP and Pease. The renewed—starting in 2013—phase out of personal exemptions (PEP) and the reduction of otherwise allowable deductions under the so-called Pease provision can make  IRA/charitable distributions especially attractive to high-income donors. Taking distributions from IRAs instead of directing those payments to charity, can place the high-income people in the income levels where PEP and Pease apply. 

© Conrad Teitell 2013. This is not intended as legal, tax, financial or other advice. So, check with your adviser on how the rules apply to you.