Life and Death Planning for Retirement Benefits

Chapter 7: Charitable Giving

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If a trustee has received both ordinary taxable income and tax-exempt income in a particular year, and then makes a distribution to charity out of the trust’s income account (pursuant to the governing instrument of course), how does the trustee know whether what he paid the charity came from the trust’s taxable income (deductible) or from its tax-exempt income (nondeductible)? That should be easy to answer—look at the governing instrument! After all, Reg. § 1.642(c)-(3)(b)(2) provides that “if the governing instrument specifically provides as to the source out of which amounts are to be paid…” for a charitable purpose, “the specific provision controls.” Reg. § 1.643(a)-5(b) says the same thing. Accordingly, to minimize taxes, the drafter of a nongrantor charitable lead annuity trust (for example) might specify that the annual “lead interest” payments to charity would be made, first, out of ordinary taxable income that was not UBTI, secondarily from long-term capital gain, and only lastly from tax-exempt income or UBTI. Unfortunately, despite its own clear unqualified statement in two regulations that a specific governing instrument provision “controls,” the IRS has long maintained that such a specific provision in the governing instrument does not control, and a payment to charity from gross income will be deemed to come proportionately from all classes of the trust’s income , unless the “specific provision” has economic effect independent of income tax consequences . See Ferguson/Freeman/Ascher § 6.09, Note 16. The Treasury has now codified this “hidden rule” in Regs. § 1.643(a)-5(b) and § 1.642(c)-3(b) , but the Preamble to these regulations when issued in proposed form claimed that the economic effect requirement was not new—it was there all along if you read a chain of regulations cited in the Preamble. Vol. 73 F.R. 118, p. 34670 (6/18/08). For the meaning of “economic effect independent of income tax consequences,” the proposed regulation cross-references Reg. § 1.652(b)-2(b) , which deals with the allocation of classes of DNI among beneficiaries. Generally it means that the direction must affect the amount the beneficiary receives, not just the tax characteristics of such amount, but the “boundaries” of this test are not clear in all cases. G. Example: directing payment to charity out of retirement benefits. We know that retirement plan death benefits, to the extent includible in gross income, are “IRD,” and that IRD is includible in DNI. We know that IRD is considered “gross income” for purposes of the requirement that, in order to be eligible for a charitable deduction, a payment to charity must be made from “gross income.” Now let’s put this all together and see what happens when a governing instrument directs that a charitable bequest must be satisfied out of retirement benefits that are payable to the trust. Steve Example: Steve dies on January 1, Year 1, leaving his $100,000 IRA to a trust as beneficiary, along with $900,000 of other assets. The IRA is 100 percent pre-tax money. Under applicable local law, the $100,000 date-of-death balance of the IRA is considered principal for trust accounting purposes. The trust provides that, upon Steve’s death, the trustee shall pay $100,000 to Charity Y, and shall hold the balance of the assets in trust for Steve’s daughter. The daughter is to receive income and principal of the trust for life in amounts determined annually in the trustee’s discretion. The trust provides that the charitable bequest shall be funded, to the maximum extent possible, from the IRA. In Year 1, the trustee receives the following amounts of gross income: $100,000 IRA proceeds; $25,000 of tax-exempt income (municipal bond interest);