Section 642(c) of the Internal Revenue Code clearly describes the requirements for a trust to deduct any charitable distributions. A trust can deduct for “any amount of 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).” The trust must explicitly be permitted under the document to distribute to charity. So if a trust lacks language naming a charity as a current or contingent beneficiary, does that mean a charity may not receive a distribution from assets of the trust? Surprisingly the answer is an emphatic no. Three practical solutions are use of the HEMS standard, limited liability companies (LLCs) and decanting.*
1. HEMS standard
Distributions from a trust pursuant to the health, education, maintenance and support of the beneficiary not only keep the assets from the gross estate of the beneficiary but also create a flexible standard. Could philanthropic giving be considered part of the beneficiary’s support? The most persuasive argument for allowing such a payment would be maintaining the beneficiary’s lifestyle which includes philanthropy. A thoughtfully drafted trust could specifically state that charitable giving is included in the HEMS standard. The fiduciary and beneficiary must, however, be alert to avoid inclusion of income from the discharge of a debt (pledge payment) pursuant to Section 108 of the Code.
2. Use of LLCs
Though a trust lacks charitable beneficiaries, its trustee(s) could contribute assets to a newly created LLC. Assets going into the LLC could be then distributed to charity. The trust would be the sole member of the LLC, and the deduction would flow through to the trust.
The trustee, of course, should fully disclose this plan of using the trust as an intermediary and confirm the agreement of the non-charitable beneficiaries. Because trusts reach the highest marginal tax rate at much lower dollars of taxable income than individuals ($13,050 in 2021), the deduction would be more valuable than if made by individuals.
The ABC Trust (Trust) begins 2021 with a fair market value of $1,000,000. The corporate trustee projects it will earn about $14,000 in interest and qualified dividends. Its sole beneficiaries are Henrietta and Harold, who are equal beneficiaries of the Trust. Henrietta and Harold presently are in the 32% bracket, with sufficient income in 2021 to meet their financial goals. The trustee distributes some of the Trust into the ABC, LLC (LLC), whose sole member is the Trust. Henrietta and Harold remain the beneficiaries as before. The charitable distributions of the LLC follow through the Trust. So the Trust’s charitable contributions reduce its taxable income. The Trust now has a way to avoid paying the highest marginal rates on any accumulated income. A carefully designed trust could specifically state the discretion of the trustee to fund a limited liability company with trust assets.
The irrevocability of a trust is not a barrier to its modification. One such technique of modification is decanting. Decanting is a method resulting in the trustee changing the terms of the trust by distributing the original assets of the trust to a newly created recipient trust. Most states give a trustee a right to decant based on either the terms of the trust, state law or judicial precedents. The decanting statutes of some jurisdictions permit addition of new beneficiaries, including charity, if the trustee has absolute discretion.
Notwithstanding the growing use of decanting in some states, the guidance from the IRS on the income, gift, estate and generation-skipping consequences will not be forthcoming. Pursuant to IRS’s continuation in Rev. Proc. 2019-3 of Rev. Proc. 2011-3, decanting is an area “under study in which rulings or determinations letters will not be issued.” The IRS explicitly lists it will not rule on whether the decanting distribution is a taxable gift, triggers the loss of the GST exempt status or whether the decanting qualifies as a distribution deduction under Sec. 661 or is an inclusion of gross income under Sec. 662.
If properly structured, the decanting should not trigger adverse income and transfer tax consequences. In a future post, I will show the tax traps that may (or may not) be avoided or managed.
By Professor Chris Woehrle, Chair & Professor of Tax & Estate Planning Department, College for Financial Planning, Centennial, Colorado
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