By Kim Kamin
I. SYNOPSIS1
This article first reviews some fundamentals of how charitable deductions apply in the context of trusts and then shares ideas for how estate planning professionals can help clients think about situations when it might be desirable to tap into noncharitable trusts for charitable giving. The piece examines (1) how to utilize existing irrevocable trust assets for desired or obligatory gifts to charity either (a) directly from the trust, (b) through an entity like a partnership, or (c) by distributing to an individual beneficiary who then donates to charity, and (2) suggests how to draft new trusts to promote flexibility for future family philanthropy.
II. INTRODUCTION
Affluent families typically accumulate the vast majority of their generational wealth in irrevocable trusts that have been designed primarily to benefit individual family members and their descendants.2 This can pose a challenge for philanthropically inclined clients and their advisors who wish to tap into the family’s non-charitable trusts for charitable giving. Charitable deductions can be desirable either for transfer tax purposes (to avoid paying estate or generation-skipping transfer taxes when a trust terminates) or for income tax planning purposes. While taking a charitable deduction isn’t always a primary motivation for why a family might want to use trust assets for their philanthropy, it is important to understand how charitable income tax deductions work, both at the trust level and at the beneficiary level. Theoretically, there are three ways to engage in charitable giving using assets held in an existing irrevocable trust: (1) the trust can distribute directly to charity; (2) the trust can invest in an entity taxed as a partnership that donates directly to charity; or (3) the trust can distribute to a beneficiary who then donates to charity. Below is a high-level summary of how the deductions work for each of these three approaches.
First, if permitted by the governing trust instrument, the trust itself could donate directly to charity. If the trust is a grantor trust, then direct donations to charity will pass through the trust and are eligible to be taken as deductions by the grantor on their own 1040 income tax return up to the grantor’s own deduction limitations.3 If the trust that distributes to a qualified charitable organization is a non-grantor trust, then it is eligible to take the charitable income tax deduction on its 1041 income tax return. Generally, federal income tax deductions taken at the trust level are more beneficial than if taken at the individual level, because trusts can deduct up to 100% of their adjusted gross income (“AGI”) and reach the highest marginal tax bracket at much lower dollar levels than individuals.4 In 2023, the top marginal tax bracket for trusts is reached at only $14,450 of income.5 In contrast, an individual doesn’t reach the top income tax bracket until having $578,125 of AGI, or $693,750 if married and filing jointly.6
Second, the trust could donate indirectly to charity by investing in a pass-through entity that donates to charity. If the pass-through entity is an LLC that is treated as a disregarded entity, either (i) because it is owned only by one or more grantor trusts and the grantor or (ii) because it is owned 100% by a non-grantor trust, then its income and deductions will flow directly to the grantor or to the non-grantor trust as the case may be. A single-member LLC that is a disregarded entity and has no employees nor any excise tax liability doesn’t typically even need its own taxpayer identification number.7 If the pass-through entity is a partnership or an LLC that is taxed as a partnership, then the partnership reports its charitable contributions on its 1065 income tax return, and each partner receives a Schedule K-1 listing their respective (distributive) share of that contribution to then report on their own respective income tax return. Similarly, an S-Corporation may also report the entity’s charitable contributions on its own 1120-S income tax returns and issue a Schedule K-1 to each owner to report that owner’s share of the deduction, but it is more complicated for a non-grantor trust to own S-Corporation stock.8
Third, the trust could distribute cash or other assets to a trust beneficiary who then donates to a qualified charitable organization themselves. This could be desirable with a non-grantor trust, for example, if the beneficiary wishes to increase their itemized deductions, or if the irrevocable trust is in a state without income taxes while the beneficiary lives in a state with high income tax rates. Distributions to a beneficiary from a non-grantor trust generally carry out distributable net income (“DNI”) and thus become income reported by the beneficiary on their individual 1040 income tax return. Donations to charity from such distributions can then be personally deducted by the beneficiary. If the trust distributes assets in-kind to beneficiaries and such assets have substantial unrealized gain and are long-term capital assets, the beneficiary could take a deduction for the full fair market value of such assets.9 To benefit from the charitable deduction, however, the value of the donation plus other qualified deductions would need to exceed the beneficiary’s standard deduction for that year in order to be itemized.
The extent to which the above-described three options might be available to a particular trust, and any actual income tax deduction benefits, will depend on the governing instruments and law at the time of distribution. This piece next explores the practical aspects of each of these three options for giving from existing irrevocable noncharitable trusts and then makes recommendations for designing new noncharitable trusts to facilitate a family’s philanthropy.
III. GIVING DIRECTLY FROM AN EXISTING IRREVOCABLE TRUST
A. Internal Revenue Code Requirements for Trust Income Tax Charitable Deductions
For a non-grantor irrevocable trust to take an income tax charitable deduction, the donation must meet the requirements of Internal Revenue Code (“IRC”) Section 642(c)(1), which provides that a trust is allowed such deductions for “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 IRC Section 170(c) . . .” 10 (emphasis added).
The trust agreement must, therefore, allow payments to charity. These payments can be cash up to the lesser of (i) the amount of the contribution, or (ii) the total value of the trust’s taxable income for the year. The trust also can get a deduction for non-cash asset contributions of assets that the trust had purchased with gross income, but only up to the value of the adjusted basis.11 Another benefit under IRC Section 642 is that, unlike individuals, a trust can receive deductions for donations to foreign organizations operated exclusively for a charitable purpose.12 The primary question for trust donations to charity under IRC Section 642, however, becomes whether or not the statute will be applied to permit a charitable deduction. Just because it is possible to donate trust assets to charity doesn’t ensure the donation is eligible for tax deductions.
B. Historical Application of IRC Section 642
Historically, courts generously permitted deductions for charitable giving from trusts. In the 1930’s, the Supreme Court in the Helvering v. Bliss case had provided general guidance that charitable deductions for income donated to charity stems from public policy motives to support charity and should be liberally, rather than narrowly, construed in the taxpayer’s favor.13 More specifically, the Supreme Court noted in the Old Colony Trust case that Congress sought to encourage donations of a trust’s gross income to charitable organizations, and that the relevant statute was subject to a liberal interpretation.14
Subsequently, certain appellate courts began to take a narrower view when construing charitable deductions in the trust context.15 These cases borrowed from the more restrictive analysis used in cases analyzing corporate and other non-charitable tax deductions as stemming from “legislative grace.” The IRS has adopted this approach in its attacks on charitable deductions sought by trusts in the context of charitable donations.
For example, the Brownstone v. United States case in 2006 involved the trustee of a testamentary trust who was denied a charitable deduction because the distribution to the charity at issue was determined not to have been made “pursuant to” the trust’s “governing instrument” as is required under IRC Section 642. Given the facts of the case, the conclusion isn’t surprising and provides little guidance for most clients who are contemplating a distribution to charity from a trust. In Brownstone, the decedent’s will created a testamentary trust for his wife. The trust granted the wife a general power of appointment. Twenty years later, she died and, in her will, exercised the power of appointment by directing the trust principal to be distributed to her own estate. Her will then directed that after certain specific bequests, the residue of her estate be distributed to charity. At issue was whether the trust could take an income tax deduction in the year of the widow’s death for funds that eventually made their way to charity through her estate. The district court granted summary judgment and the Court of Appeals confirmed. The widow’s will was not the governing instrument for the testamentary trust.
The part of the case providing a little more guidance was the analysis of the general power of appointment. The court quoted from the Weir case that “the instrument must be shown to possess some positive charitable intent or purpose of the settlor – not merely that the settlor did not exclude charity from all the possible beneficiaries of his bounty.”16 This suggests that where the governing instrument simply grants a testamentary general power of appointment without specifically referencing the possibility of appointing property to charity, that alone is unlikely to be sufficient to permit an income tax deduction for the trust’s distribution of income to charity following the powerholder’s death.
C. Analysis to Determine if Charitable Donations Can Be Made Directly from an Existing Trust
When reviewing a trust to determine if it can make charitable donations directly, the following questions should be asked.
- Charity as Beneficiary of the Trust. Are charitable organizations permissible current beneficiaries? For example, if the trust permits distributions to more than one beneficiary, does the trust expressly permit the trustee in its discretion to distribute trust income not only to family members but also to one or more of the family’s private foundations, donor-advised funds, to other specifically named public charities, or more broadly to charitable organizations in general? If so, then each year the trustee can determine whether it might be beneficial to donate all or a portion of the trust’s income to charity. As a practical matter, even if one or more charitable organizations are permitted as a current beneficiary, the trustee may want to confirm that the family members who are current trust beneficiaries don’t object to such charitable distributions.
- Specific Power to Add Charitable Beneficiaries. Does the trust specifically give a non-adverse party the power to add charitable beneficiaries? This power is often included in a trust to cause the trust to be a grantor trust for income tax purposes while not being subject to estate tax at the grantor’s death. The inclusion of this power arguably evidences that the settlor intended that charities could be added to receive donations. If a non-adverse party has this power, and the trust beneficiaries are in favor of adding charitable beneficiaries, this may be a relatively easy way to allow a trust to directly distribute to charities. For example, the non-adverse party could add the family’s private foundation and/or donor advised funds as permissible beneficiaries, and then the trustee can make direct donations to the family’s charitable giving entities whenever doing so is determined to be in the best interests of the non-charitable beneficiaries.
- Trust Protector Powers to Add Beneficiaries. Is there a trust protector with authority to add or remove beneficiaries of the trust? Sometimes a trust may contain a provision that permits a trust protector to add charitable beneficiaries. If a trust protector (who may or may not be a fiduciary) has this power, then the trust protector can add charitable beneficiaries when it is determined to be in the overall best interests of the trust and consistent with the purposes of the trust. Granting the trustee power to distribute to charity should be considered as in the beneficiaries’ best interests because providing flexibility to use trust funds to contribute to charity directly can then be utilized to maximize benefits to the family. The actual decision to donate to charity in a particular year would then be exercised subject to the trustee’s fiduciary duties of loyalty and impartiality to the other beneficiaries. It is unclear the extent to which the power to add beneficiaries may need to expressly indicate charities as a possible beneficiary to be added (rather than just a broad power to add any beneficiary) to constitute a positive expression of charitable intent for purposes of satisfying the IRS’ requirements for income tax deductions.
- Lifetime Special Powers of Appointment. Does a primary beneficiary or other individual have a lifetime power to appoint trust assets to charity? If so, then such beneficiary or other individual can exercise that power by instructing the trustee to make the distribution. For example, although a surviving spouse can’t hold a lifetime power over a marital trust, the spouse may have a broad special lifetime power over a Spousal Lifetime Access Trust (“SLAT”) or a Testamentary Family Trust and could determine that it is desirable to direct the trustee to distribute some or all of the trust’s income to charity during their life.
- Testamentary Special Powers of Appointment. Does a trust beneficiary have testamentary powers of appointment that include charity? If so, such powers can of course be helpful to direct some assets directly out of the trust and to charity upon the powerholder’s death. In addition, or instead, the testamentary power of appointment could be used to direct trust assets into a new trust that could expand the beneficiaries to include charity following that powerholder’s death. While not as immediate as utilizing special lifetime powers of appointment, a surviving spouse or other primary beneficiary may be able to appoint trust assets to a new trust that can include charity at death. Although the gift would be postponed until the powerholder’s death, this can be another way to create a new governing instrument that would more expressly permit family members to make charitable gifts out of that new trust’s assets.17
- Lifetime or Testamentary General Powers of Appointment. Does anyone have lifetime or testamentary general powers of appointment over the trust? If so, then the trust assets at issue likely are not exempt from generation skipping transfer (“GST”) taxes or may be in a Marital Trust that requires estate inclusion in a surviving spouse’s estate. In this case, taking an estate tax deduction is more likely to be driving the decision of whether to direct some or all of the trust assets directly to charity at the powerholder’s death rather than the consideration of taking income tax deductions at the trust level. If the holder of the power desires to set up a new trust, and the scope of the powers are broad enough to permit the beneficiary to do so, then the best way to utilize general powers of appointment would be simply to extract all assets from the original trust and have the powerholder start from scratch with a brand new trust that builds in the flexibility that is recommended in Section VI below.
- Decant or Merge Trust into a New Trust. Does the trust instrument and/or state law permit decanting or merger into a new trust? If there aren’t satisfactory ways to distribute to charity with the current instrument, explore decanting or merger into a new trust with more flexible philanthropic provisions like the ones included in Section VI below. Depending on the circumstances, statutory decanting might not permit the addition of new beneficiaries, but there are some other potential approaches. The applicable statute may allow the new instrument to add or amend lifetime powers of appointment to specifically include charity. Expanding powers of appointment avoids the trustee taking the initiative to try to add charitable beneficiaries to the trust. For example, in the Illinois Trust Code, a trustee can decant to modify a powerholder’s power of appointment to expand the class of permissible appointees, but it doesn’t permit the trustee to add charitable beneficiaries.18 Other states are similar, but state legislatures might consider updating their decanting statutes to expressly permit a decanted instrument to add a grantor trust power for an independent trustee to add charitable beneficiaries.
With respect to all methods of trying to establish a new governing instrument to add charities (rather than working within the expressed authority of the original instrument), without some expression of intent to benefit charity in the instrument from which the assets were appointed or decanted, there is some risk that the IRS may not respect the trust into which the assets are appointed or decanted as a new governing instrument for purposes of IRC 642 income tax deductions. Certainly, one clear way to create a new governing instrument is to terminate the trust outright to a beneficiary and then have the beneficiary create a new trust directly (rather than via a power of appointment). That may be more desirable when the alternative would be exercise of a general power of appointment, but it may be less desirable when the alterative would be a limited power of appointment that otherwise avoids estate inclusion for the beneficiary if they would have a taxable estate. If obtaining a charitable deduction is paramount, investing in a pass-through entity that makes the donation might be considered a preferable option if there is a concern that the IRS would otherwise deny the deduction at the trust level.
IV. Trust Investment in a Pass-Through Entity that Donates to Charity
Even if the trust doesn’t permit distributions to charity, a trustee could consider contributing all or a portion of trust assets into a partnership or a limited liability company (“LLC”). The entity can then make donations to charity directly. The charitable deductions would pass through to the LLC members, which would be 100% to the trust if it is the sole LLC member.
The IRS has permitted trusts to take charitable deductions, even when the governing instrument doesn’t authorize charitable distributions, when such deductions were made by a pass-through entity in which the trust owned an interest. For example, in Revenue Ruling 2004-5, the IRS permitted a deduction under Section 642(c) because the trust owned an interest in a partnership that made a charitable contribution. The IRS ruled:
Under these circumstances, a trust’s deduction for its distributive share of a charitable contribution made by a partnership will not be disallowed . . . merely because the trust’s governing instrument does not authorize the trustee to make charitable contributions.19
While a non-grantor trust could be the sole member of an LLC that donates to charity and should receive the benefits of the deduction, it may be advisable to have at least one other member of the LLC and for the entity to be taxed as a partnership rather than treated as a disregarded entity. As with other approaches that seek to utilize noncharitable trust assets for charitable giving, if the trustee is forming a new LLC or partnership with charitable donations in mind, the trustee should fully disclose this approach to the beneficiaries and confirm they don’t object.
The business reasons for the formation of the entity (beyond gifts to charity) and also the authority of the Manager or other individual(s) who control the entity to donate to charity should be documented in the entity’s governing documents.
V. Distribution to Beneficiary for Donation
With some trusts, it may not be possible to distribute to charity directly from the trust or it may not be feasible to donate from a pass-through entity owned by the trust, in which case distributing to a beneficiary to donate may be the only option. Alternatively, it may simply be desirable for certain charitable donations to be made at the beneficiary level. Here are some questions to help determine if such distributions are permissible.
- Non-Ascertainable Distribution Standards. Can the trustee distribute in its sole and absolute discretion or for a beneficiary’s best interests? This is the most flexible distribution standard, but typically will be available only to an independent trustee (one who isn’t a beneficiary or a related or subordinate party). If an independent trustee is authorized to distribute to a beneficiary pursuant to these types of very broad standards, in many circumstances the trustee should be comfortable making distributions to facilitate the beneficiary’s philanthropic giving.
- Ascertainable Standards. Is the trustee limited to distributions pursuant to ascertainable standards like health, education, maintenance and support (“HEMS”)? If so, is the trustee comfortable treating annual charitable giving as part of the beneficiary’s support? Could one typically consider a beneficiary’s ordinary charitable giving obligations (for example, to church, synagogue, private school, or memberships at important cultural institutions) to be part of that beneficiary’s support in reasonable comfort and in the standard to which they’re accustomed? If the trustee (including any beneficiary who is acting as trustee) is comfortable that the distribution is in furtherance of maintaining the beneficiary’s lifestyle, which includes charitable giving or related membership dues, then such distributions could be permitted. In some cases, such as paying tuition for religious school or expected donations to a private elementary school, the distributions might even be appropriately deemed to be for a beneficiary’s education.
- Trustee Guidance. Does the trust instrument elaborate on whether the ascertainable standards for maintenance and support can include charitable giving? If not, is there a letter of wishes or other instruction or communication that may help illuminate settlor intent? In the estate planning field, there has been increasing desire to solicit more guidance for trustees. In this regard, documenting the trust settlor’s views on charitable giving from the trust or to enable beneficiaries to give can be instructive for the future administration of the trust.
VI. Trust Design for New Trusts
In addition to creative thinking about already existing irrevocable trusts, estate-planning professionals can advocate for designing new trusts that maximize future flexibility for charitable giving. There’s a tremendous opportunity for advisors to be proactive in encouraging clients who are still in the process of designing (or re-designing) family trusts to incorporate provisions that preserve the opportunity for future philanthropy from such trusts. Below are some important design features that should be considered for all new trusts, even when the primary objective of such trusts is to provide for individual beneficiaries. Much of the below incorporates the analysis in the sections above about permitting charitable distributions directly from irrevocable trusts or to beneficiaries who can make their own donations. The new concept introduced below, however, that requires the most explanation is about permitting disclaimer planning in trusts.
A. Revocable Trust Powers.
While competent settlors usually can make or direct charitable gifts from trust assets, revocable trusts should also give a successor trustee the ability (1) to continue the settlor’s annual charitable gifting programs and (2) to make other charitable gifts that are consistent with the settlor’s wishes or pattern of giving during any period of time that the settlor may be incapacitated.
B. Include Charities as Permissible Beneficiaries of Irrevocable Trusts.
As a default in a spray trust (or a non-marital and non-IRC Section 2503(c) single beneficiary trust), the trust can include particular charities such as the family’s private foundation or donor advised fund as a permissible beneficiary. Or the instrument could leave it open for the trustee to distribute to any charity. In order to protect the trustee, if the trust permits distributions directly to charity, it can be helpful to also include a provision that such distributions can be made after providing notice to any other current beneficiaries as long as no beneficiary objects within a certain period (e.g., 30 days) after notice of the intended distribution.
C. Special Powers of Appointment.
Trusts should ideally grant the primary beneficiary of a trust special lifetime and testamentary powers that expressly permit the holder to direct the trustee to make distributions to charity. This would be a non-fiduciary power and puts the charitable donation decision in the hands of the primary beneficiary each year and at death.
The broadest special powers of appointment would permit lifetime or testamentary exercise to include any recipients other than the powerholder, the powerholder’s estate or the creditors of either. While broad special powers are more limited than the general powers of appointment that have been problematic in certain cases, it is nonetheless helpful to always affirmatively indicate that the settlor had charitable intent to avoid the arguments that the IRS has made in those general power of appointment cases. This can be accomplished by including language in the instrument that references that such powers may be exercised to benefit specific charities or charity generally so that there is language that can be used to support that the settlor had specific charitable intent in the original governing instrument.
D. Trust Provisions to Permit Disclaimer to Charity.20
Philanthropic disclaimer planning is often overlooked, but it can be a tax-efficient approach for putting charitable giving decisions in the hands of trust beneficiaries. That said, disclaimer planning needs to be done with intention, with an understanding of how the disclaimer rules work, and implemented carefully. Practitioners should also pay attention to tax apportionment provisions to make it clear that any disclaimed amount to qualified charities won’t be liable for any estate taxes.
Permitting a disclaimer to charity places the decision in the hands of the trust beneficiaries directly, or perhaps their trustees, whether to accept the property in trust and potentially pay estate and/or GST taxes or whether to disclaim all or some of the assets to take advantage of the charitable deduction that would permit them to avoid paying transfer taxes under IRC Section 2055.21
1. Formula Disclaimers to Charity. Often a disclaimer that is made under a revocable living trust or another irrevocable trust that might be taxable at a beneficiary’s death will be based on a formula, including a formula to direct to charity the amount of property necessary to reduce estate tax to zero at the time of the settlor’s or beneficiary’s death. A charitable disclaimer works only if the governing documents are drafted so the disclaimed property passes to charity without direction by the disclaimant. In 2008, the tax court case Estate of Christiansen v. Commissioner22 confirmed that formula disclaimers to charity can be entitled to charitable deductions.
In the Christiansen case, the decedent left everything to her daughter at death. The testamentary instrument provided that any amounts the daughter disclaimed would pass 75% to a charitable lead annuity trust (the “CLAT”) and 25% to the decedent’s private foundation. The daughter made a timely disclaimer of a portion of the estate. The disclaimer was set up as a fractional formula and the definition of fair market value used was the value as finally determined for federal estate tax purposes. The IRS audited the decedent’s estate tax return seeking an increased valuation of certain partnerships. The parties agreed on modified values of the partnerships, which increased the estate value. As a result of the increased value of the estate, under the formula disclaimer, an additional $3.1 million passed to the CLAT and private foundation. If the transfer of that additional sum qualified for the estate tax charitable deduction, there would be no additional estate tax due.
The tax court addressed whether the disclaimer was valid and whether the charitable deduction applied to the assets passing to the CLAT. The CLAT was designed for annuity payments to charity for a fixed term starting at the decedent’s death and payment of the remainder to the daughter, if then living, at the end of the CLAT term. Because the daughter didn’t disclaim her contingent remainder interest in the CLAT, the disclaimer was found not qualified because the disclaimed property did not pass solely to a person other than the disclaimant. Accordingly, no charitable deduction was allowed for the value of either the daughter’s remainder interest or the portion of the disclaimed property that would pass to charity over the course of the term. The tax court determined that the interests were not severable under IRC Section 2518 because the disclaimer attempted to “horizontally” divide the interest by disclaiming the income interest but retained the remainder interest, so the disclaimer was not qualified as to any assets passing to the CLAT.
The IRS also took the position that the charitable deduction generated by the disclaimer to the private foundation should be based on the value of the estate as reported on the estate tax return, instead of the value agreed to during audit. The tax court disagreed and found that the transfer to the private foundation wasn’t contingent on any event that occurred after the decedent’s death. The court characterized the IRS’s audit as a dispute about the past (the value of the estate as of the date of death), and not a future event occurring after the decedent’s death.
The IRS also attempted to argue against the formula approach on the grounds of public policy, but the tax court was “hard-pressed to find any fundamental public policy against making gifts to charity.” The court reasoned that the disclaimer formula merely resulted in a post-audit reallocation between the daughter, the CLAT and the private foundation, which was not a violation of public policy. The court additionally commented on the fiduciary duties of the executors and private foundation directors as safeguards against the intentional undervaluation of assets passing to charity.
The Eighth Circuit affirmed both holdings of the tax court, finding the formula disclaimer valid (although still not effective to obtain a charitable deduction for the allocation to the CLAT). They rejected the IRS’s condition precedent arguments relying on Treasury Regulation Section 20.2055-2(b)(1), which provides that if, at the time of a decedent’s death, a transfer for charitable purposes is dependent upon the performance of some act or the occurrence of a precedent event in order for the transfer to become effective, the charitable deduction is not allowed unless the possibility that the charitable transfer will not become effective is so remote as to be negligible. The court found that the regulation clearly and unambiguously speaks in terms of the existence of a transfer at the date of death, not to the estate’s valuation, and therefore, the value of the charitable donation. The foundation’s right to receive twenty-five percent of the residual disclaimed amounts was certain, only the final value was uncertain.
As to the public policy argument, the court noted that the IRS’s role is to enforce tax laws, not merely to maximize tax receipts. To the contrary, Congress encourages charitable gifts through the full charitable deduction. The Eighth Circuit also noted that there are numerous mechanisms other than estate tax audits, including fiduciary liability, rules against self-dealing, and the oversight of the charity to which the assets pass, to police gifts to charity to protect against undervaluing estate assets to cheat charities.
2. Overview of Disclaimers to Private Foundations and Donor Advised Funds. When charitably minded individuals are creating their estate plans, directing disclaimed assets to a charitable fund to be controlled by their descendants may be appealing from both a tax planning standpoint and as a way to promote continued charitable gifting within their family following death rather than simply disclaiming directly to an operating charity.
A client may direct any disclaimed assets to pass to a charitable fund, such as a private foundation or donor advised fund, which enables the client’s family to use the assets for charitable giving over time. If drafted properly, this approach allows each inheritor to make their own decision which will not affect any other beneficiary. They can either receive their legacy, subject to any applicable transfer tax, or disclaim all or part of their legacy into a charitable fund free of any transfer tax. However, this needs to be done carefully because for the disclaimer to be valid, the disclaimant cannot exercise impermissible control over the ultimate disposition of the disclaimed assets. The charitable fund may be either a private foundation or a donor advised fund, but there are special considerations for each option.
3. Disclaiming to a Private Foundation. When disclaimed property passes to a private foundation in which the disclaimant has a role, the IRS has ruled that the disclaimer will be qualified provided the disclaimant does not retain any power to direct the beneficial enjoyment of the disclaimed property.23
In Private Letter Ruling 200802010, a decedent’s children disclaimed trust assets. Under the terms of the decedent’s will, the disclaimed assets passed to private foundations to be established by each of decedent’s children, whereby the assets disclaimed by one child passed to a private foundation established by that child and the assets disclaimed by the other child passed to a separate private foundation. For each private foundation, a board of directors made the investment decisions, and each child served as a board member for her respective foundation. The foundations’ bylaws were amended to provide that any assets passing to the foundation as the result of a qualified disclaimer by any director or officer of the foundation were to be segregated and maintained in separate accounts and that the disclaiming director would be excluded from any decisions involving the disclaimed assets. Accordingly, the IRS found that, because the children-directors had no power to determine the ultimate disposition of the disclaimed assets, their disclaimers were qualified.
In situations in which a client has a single existing family foundation, a disclaimer to that foundation is still a viable option since there are private letter rulings permitting a disclaimant to exercise limited authority over disclaimed assets in a private foundation.24 To be on the safe side, the disclaimed assets should be segregated by the foundation, and the disclaimant should avoid participating in decisions about investing or granting those assets.
See below for an example of a trust provision that enables the settlor’s children to disclaim to the family’s private foundation.
At my death, the trust shall terminate, and the trustee shall allocate the remaining principal of the trust, which is not otherwise effectively disposed of, between as many separate equal trusts as shall be necessary to establish one trust named for each child of mine who is either living on the division date or then deceased with one or more descendants then living. Notwithstanding the foregoing:
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- If my child, [CHILD #1’s FULL NAME (“CHILD #1”)], survives me but makes a qualified disclaimer (pursuant to Code Section 2518) of any or all of their interest in the trust named for them, the trustee shall distribute such disclaimed portion to THE FAMILY FOUNDATION, or its lawful successor, if it is then a charitable organization, for its general charitable purposes, or, if it is not then a charitable organization, to such one or more organizations selected by the trustee other than [CHILD #1] each of which is then a charitable organization, in such proportions among such organizations, as that trustee shall decide, for their general charitable purposes;
- If my child, [CHILD #2’s FULL NAME (“CHILD #2)”], survives me but makes a qualified disclaimer (pursuant to Code Section 2518) of any or all of their interest in the trust named for them, the trustee shall distribute such disclaimed portion to THE FAMILY FOUNDATION, or its lawful successor, if it is then a charitable organization, for its general charitable purposes, or, if it is not then a charitable organization, to such one or more organizations selected by the trustee other than [CHILD #2] each of which is then a charitable organization, in such proportions among such organizations, as that trustee shall decide, for their general charitable purposes; and
- In the event that a child of mine makes a qualified disclaimer as described in this paragraph, the disclaiming child’s trust shall be increased in value so as to achieve for it the entire marginal benefit of any estate tax charitable deduction in my estate, and the trust for my other child shall be of the same value as if there had been no such disclaimer. If both of my children shall disclaim, then the marginal benefit of that charitable deduction shall be allocated pro rata between my children’s trusts (based on the relative amounts of property disclaimed).
4. Disclaiming to a Donor Advised Fund. A donor advised fund (“DAF”) is another good option to receive disclaimed assets, especially for families that don’t already have a private foundation or that wish to give the disclaimant more optionality for future charitable giving.
A DAF established through a community foundation or other sponsoring organization helps avoid many of the control-related concerns that arise with private foundations because the community foundation or other sponsoring organization, and not the disclaimant, has legal control over the ultimate disposition of the assets in the charitable fund. Thus, the disclaimant can be an advisor (even the sole advisor) to the fund because the community foundation or other sponsoring organization retains the final decision on any gifts from the fund.
In Private Letter Ruling 200518012, several beneficiaries under a decedent’s revocable trust proposed to disclaim interests which would, as a result, pass under the terms of the trust into a DAF maintained by a public charity not subject to the control or influence of the disclaiming beneficiary. The IRS ruled the disposition would qualify for an estate tax charitable deduction.25
Many clients or their children already have an existing DAF which would be the obvious recipient for any charitable disclaimers. Alternatively, the client may simply name the community foundation or other sponsoring organization (which can be a financial institution like Fidelity Charitable or Schwab Charitable) and provide that the DAF will be established upon receipt of the disclaimed funds with the proviso that it is the donor’s hope the disclaiming person will be the advisor for the fund.
Below is an example of language that could be used in the trust instrument to enable this type of disclaimer to a DAF.
SAMPLE: In the event that a qualified disclaimer within the meaning of IRC Section 2518 is made by either of the settlor’s children (the “Disclaiming Party”), with respect to any amount directed to be distributed to them outright or set aside in a separate share for their benefit (the “Disclaimed Amount”), said Disclaimed Amount shall be distributed to a donor advised fund at [SPONSORING CHARITABLE ORGANIZATION] (the “Disclaimer DAF”). It is the settlor’s hope and desire, without imposing any mandatory direction, that the Disclaiming Party act as an advisor to the Disclaimer DAF to provide recommendations regarding distributions from the Disclaimer DAF.
This concludes the section taking an in-depth look at how to utilize disclaimers for charitable giving out of noncharitable trusts. The below sections provide a few additional suggestions for how to include flexibility in new irrevocable trust instruments.
E. Ultimate Contingent Beneficiaries.
Often the default so-called “atom bomb” beneficiaries are left as the settlor’s heirs at law. Instead, especially for multigenerational trusts, clients may prefer to name a charity as the ultimate contingent beneficiary if the family line dies out. For example, the trust could specifically name the family’s private foundation (if any), otherwise a family DAF (if any), otherwise a charitable organization to be selected by the then-acting trustee after considering the types of organizations or values the settlor supported during life. If the settlor has created a letter of wishes to be kept with the trust records, such letter can incorporate information about the settlor’s charitable values.
F. Designing Trusts to Encourage Philanthropy and/or Express the Settlor’s Charitable Interests.
Clients can incorporate giving directions or suggestions into the instrument itself. Examples might include requiring that a certain percentage of income go to charity each year, like a tithing concept, or a settlor’s expressions of philanthropic values and encouragement of giving back. If a settlor has very specific charitable interests and goals, these can be expressed as philanthropic guidelines or even as mandates regarding future charitable giving. This type of expression could be included in the trust instrument, a letter of wishes or a family philanthropic policy statement that the settlor can create and modify over time.
G. Special Investment Powers.
The trust can expressly authorize fiduciaries to invest for impact, taking into account environmental, social and/or governance (“ESG”) factors, or in other ways that promote the family’s philanthropic values. However, such an authorization should be accompanied by adequate guidelines to protect the fiduciaries if those investments don’t perform as well as more traditional ones in case any beneficiaries later challenge the reasonableness of the fiduciaries’ investment decisions.
VII. CONCLUDING THOUGHTS ON FLEXIBILITY FOR PHILANTHROPY
With the continuing use of long-term trusts as preferred vehicles for the management and administration of a family’s generational wealth, it is important to consider the impact of such trusts on the ability of affluent families to be philanthropic.26 Estate-planning advisors can encourage clients to explore their charitable interests and recommend building in sufficient flexibility to enable use of the trust assets for the family’s philanthropic goals so that the family as a whole can engage in charitable giving from the vehicles with available income and with an eye to maximizing available charitable income and estate tax deductions.
Advisors can help clients analyze whether their existing trusts might permit charitable giving (either directly, through forming a new pass-through entity, or through distributions to beneficiaries); and for new trusts should encourage them to include drafting provisions that satisfy the requirements of IRC Section 642(c)(1) to provide the greatest flexibility for the family in the future. This is especially important as charitable giving methods continue to evolve. It would be unfortunate if new trusts don’t provide such flexibility merely because the settlors were never made aware of all their options.
ENDNOTES
1 An earlier and abbreviated version of this article was published by Kim Kamin and Kirk Hoopingarner entitled “Charitable Giving with Noncharitable Trusts,” Trusts & Estates Magazine, Volume 160, #10 (Oct 2021). The author thanks Tony Oommen of Fidelity for originally suggesting the topic, and thanks Kirk Hoopingarner, Carl Fiore, Brian Whitlock, Turney Berry, Brad Bedingfield and Stevie Casteel for their contributions to this content.
2 “In most families, 90% or more of the financial capital is held in trust by the third generation.” James E. Hughes, Jr., Susan E. Massenzio and Keith Whitaker, Complete Family Wealth, Chapter 2, at p. 32 (John Wiley & Sons, 2018). The author is referring to these types of irrevocable trusts that are held primarily for individual beneficiaries as “noncharitable trusts” in contrast with expressly “charitable trusts” like private foundations, charitable lead trusts and charitable remainder trusts.
3 The grantor benefits for cash donations are up to 60% of AGI, and as a practical matter would require the total value of the donation plus other qualified deductions to exceed the standard deduction for that year in order to be itemized.
4 Treas. Regs. § 1.642(c).
5 Rev. Proc. 2022-38; https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2023.
6 Id.
7 Single Member Limited Liability Companies, https://www.irs.gov/businesses/small-businesses-self-employed/single-member-limited-liability-companies (August 19, 2022).
8 To own S-corporation stuck, a non-grantor trust needs to qualify as either a Qualified Subchapter S Trust (“QSST”) or an Electing Small Business Trust (“ESBT”). For more detail on how charitable giving from S-corporations and partnerships work under current law, see https://www.cpajournal.com/2019/05/13/charitable-contributions-by-s-corporations/.
9 Treas. Regs. § 1.170A-1(c) and § 1.170A-4.
10 See IRC § 672(c)(1) (emphasis added). And IRC § 170(a) is the general rule that permits income tax deductions for qualifying charitable contributions made within the taxable year.
11 Green v. U.S., 880 F.3d 519 (2018) (court limited the deduction for $30 million of donated real estate only to the extent the real estate had been purchased with gross income). This rule means that if the donated assets were contributed to the trust by the settlor, the trust cannot receive a charitable tax deduction for a donation of such assets to charity. See also, Rev. Rul. 83-75 discussing in-kind donations of appreciated securities in the context of a mandatory charitable annuity. The IRS ruled that distributing appreciated securities results in taxable gain to the trust, but that the trust is entitled to a charitable deduction equal to the amount of recognized gain after adjusting for any deductions provided under IRC § 1202.
12 IRC 170(c)(2)(A) limits charitable deductions for individual and corporate taxpayers to domestic organizations organized for the specified purposes provided. IRC Section 170(c)(2)(A) is disregarded under § 642(c). Section 642(c) indicates that a foreign organization organized and operated exclusively for a charitable purpose is an eligible donee for a charitable deduction for a trust. See, e.g., Amber Hopp and Laura Hinson, Charitable Income Tax Deductions for Trusts and Estates, The AICPA Tax Advisor (March 1, 2021) https://www.thetaxadviser.com/issues/2021/mar/charitable-income-tax-deductions-trusts-estates.html.
13 Helvering v. Bliss, 55 S. Ct. 17 (1934).
14 Old Colony Trust Co. v. Comm’r, 301 U.S. 379 (1937).
15 Notably the Eighth Circuit in the Love Charitable Foundation v. U.S., 710 F.2d 1316 (8th Cir. 1983) (where codicil directed decedent’s revocable living trust assets to family’s Private Foundation, but the children contested the will, and the eventual distribution to the Foundation was made pursuant to the settlement, the court denied the deduction – in the author’s view, erroneously); Ernest and Mary Hayward Weir Foundation v. U.S., 508 F.2d 894 (2nd Cir. 1974); and Brownstone v. U.S., 465 F.3d 525 (2nd Cir. 2006).
16 Citing Weir Foundation at 939.
17 As described earlier, any method of creating a new governing instrument other than one where there has been a an outright gift or complete distribution permitting a different settlor creating a brand new trust is potentially subject to challenge under the IRS’s current –if arguably unreasonable– position.
18 See 760 ILCS 3/1211(d)(3) and (e).
19 Rev. Rul. 2004-5 citing Estate of Bluestein v. Comm’r, 15 T.C. 770 (1950), Estate of Lowenstein v. Comm’r, 12 T.C. 694 (1949), and First National Bank of Mobile v. Comm’r, 183 F.2d 172 (5th Cir. 1950).
20 The following section on disclaimers is derived from Miriam W. Henry, Kim Kamin and Daniel S. Rubin, Chapter 13: Don’t Dis The Disclaimer: Know The Rules To Keep Up With A Changing Game, 53rd Annual Heckerling Institute on Estate Planning (January 2019).
21 When assets are transferred to one or more qualified charitable organizations on death, IRC Section 2055(a) allows for a deduction from the value of the decedent’s gross estate. This purpose is to encourage philanthropy.
22 Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. Nov. 13, 2009), aff’g 130 T.C. 1 (2008).
23 IRS Priv. Ltr. Rul. 200802010 (Jan. 11, 2008).
24 See e.g., IRS Priv. Ltr. Rul. 200616026 (April 21, 2006); IRS Priv. Ltr. Rul. 9320008 (Feb. 2, 1993); IRS Priv. Ltr. Rul. 9008011 (Nov. 17, 1989).
25 See also IRS Priv. Ltr. Rul. 9532027 (May 12, 1995).
26 For additional considerations related to this topic, see Al W. King III, “Tips From the Pros: Charitable Giving With Non-Charitable Trusts” (June 2015), www.wealthmanagement.com/estate-planning/tips-pros-charitable-giving-non-charitable-trusts.
About the Author
Kim Kamin is a partner at Gresham Partners LLC, an independent multi-family office currently serving about 116 families nationally and managing ~$8.6 billion. At Gresham, Ms. Kamin serves as Chief Wealth Strategist, leading Gresham’s development and implementation of estate, wealth transfer, philanthropic, educational, and fiduciary planning activities. Previously she was a partner in the Private Clients, Trusts and Estates Group at a large national law firm where for many years her legal practice involved all aspects of trust and estate planning, administration, and dispute resolution; advising families and their privately held businesses on a wide array of wealth preservation, asset protection and succession planning issues; and serving as counsel for the formation and operation of not-for-profit entities.
Ms. Kamin is an adjunct professor at the Northwestern University Pritzker School of Law where she was awarded the William M. Trumbull Lectureship, and has taught Advanced Trusts and Estates, Income Taxation of Trusts and Estates, and Estate Planning. She is also on faculty for the Certified Private Wealth Advisor® (CPWA®) program through the University of Chicago Booth School of Business Executive Education. She is on the UHNW Families & Family Offices Committee of the Trusts & Estates Magazine Editorial Advisory Board and has authored numerous pieces with them that are available online at http://wealthmanagement.com/author/kim-kamin. She has published on a wide variety of topics and is also a frequent lecturer in a variety of venues across the country. She was co-executive editor and co-author for the past two editions of the Leimberg Library Tools & Techniques book, Estate Planning for Modern Families (3rd Edition 2019).
Ms. Kamin is a Regent of the American College of Trust and Estate Counsel (ACTEC), is Past President of the Chicago Estate Planning Council, and serves on the Advisory Board, Leaders Council and as Estate Planning & Legal Issues Domain Chair for the UHNW Institute. She also serves on the Founders’ Committee for the University of Chicago Center of Law and Finance. She received her B.A., with distinction and departmental honors in Psychology, from Stanford University and her J.D. from the University of Chicago Law School. She is an AEP® (Distinguished) Nominee and a 21/64 Certified Advisor.
Disclaimer
Gresham Partners LLC does not provide legal or tax advice and does not assume responsibility for any individual’s reliance on these materials. Please independently verify statements made in the materials before applying them to a particular fact situation, and independently determine both the tax and non-tax consequences of using any particular planning technique before recommending that technique to a client or implementing it on a client’s or your own behalf. The author welcomes your questions or comments about this. In addition, kindly inform the author if you become aware of any errors or omissions within these materials.
Gresham Partners LLC is an independent investment and wealth management firm that has been serving select families and family offices as a multi-family office and an outsourced chief investment officer since 1997. Gresham is wholly owned by its senior professionals, client fees are its sole source of compensation, it avoids conflicts of interest that affect many other firms and it acts as a fiduciary dedicated to serving its clients’ best interests. For more information about Gresham, please go here.
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