Editor: Greg Fairbanks, J.D., LL.M.
Estates, Trusts & Gifts
Trusts are hybrids of entities that pay tax on all their income, like corporations, and entities that pass all their income through to others, like partnerships. Trusts are taxed on income that is retained by the trust and receive a distribution deduction for income treated as distributed to the beneficiaries. The beneficiaries are then taxed on the income that is treated as distributed to them. Only beneficiaries who receive distributions of a specific sum of money or of specific property are exempt from the income distribution rules. For other beneficiaries, trusts are generally not required to trace the source of distributions made to them because the concept of distributable net income, introduced in the Internal Revenue Code in 1954, eliminates the need for such tracing. Distributable net income operates by presuming that distributions are made first from income and allocating that income among the beneficiaries receiving distributions.
Distributions from a trust to charitable organizations are not considered distributions to beneficiaries for purposes of the distribution deduction (Regs. Sec. 1.663(a)-2). (See also U.S. Trust Co., 803 F.2d 1363 (5th Cir. 1986); Mott, 462 F.2d 512 (Ct. Cl. 1972); Rev. Rul. 68-667; and Rev. Rul. 2003-123.) Rather, distributions to charities are deductible only if they meet the requirements of Sec. 642(c).
Under Sec. 642(c)(1), a trust is allowed a deduction in computing its taxable income for any amount of gross income, without limitation, that under the terms of the governing instrument is, during the tax year, paid for a charitable purpose. Because a charitable deduction is available only if the source of the contribution is gross income, tracing the contribution is required to determine its source. As the Tax Court explained in Van Buren, 89 T.C. 1101, 1109 (1987):
Tracing is required since the statute specifically requires that the source of the contribution be gross income. See Riggs National Bank v. United States, 173 Ct. Cl. 479, 352 F.2d 812, 814 (1965). This specific reference forms the basis for a limited exception to the general removal of the tracing requirement accomplished by subchapter J. The exception is limited to the area of charitable deductions. See Mott, 199 Ct. Cl. 127, 462 F.2d 512, 518–519 (1972).
In Rev. Rul. 2003-123, the trust owned parcels of real estate that had been transferred to the trust at its formation. The terms of the trust agreement authorized the trustee to make charitable contributions, and under this authority the trustee conveyed to a charitable organization a perpetual conservation easement in one parcel of real estate. The easement met the definition of a qualified conservation easement under Sec. 170(h) and thus was a transfer for a charitable purpose. The value of the easement did not exceed the trust’s gross income for the year of the contribution. The ruling concludes that it is necessary to trace the source of the contribution in order to determine whether its source is from the trust’s gross income. In the facts of the ruling, the source of the contribution was from property originally contributed to the trust and was not from gross income. As a result, the gross income requirement of Sec. 642(c)(1) was not met, and the trust was not entitled to a charitable deduction for the value of the easement.
But what would have happened if the trust had purchased the property with amounts that were gross income in the past? Is there a requirement that the contribution must be traced to the current year’s gross income? Rev. Rul. 2003-123 assumed a factual situation in which the property transferred to charity was an interest in property that had originally been contributed to the trust. As such, there was no possibility that the property contributed to charity could be traceable to gross income of the current year or any prior year.
The question of whether it is permissible to trace the source of the contribution back to the trust’s gross income earned in years prior to the year of contribution is discussed only in very old cases. One of the two issues before the Supreme Court in Old Colony Trust Co., 301 U.S. 379 (1937), was whether the trust had to show that contributions to charity were made out of gross income received by the trust in the year the contributions were made. The trustee kept a separate account of accumulated and undistributed income and charged the charitable contribution in question to that account. Even though the Supreme Court was interpreting Section 162(a) of the Revenue Act of 1928, a predecessor of Sec. 642(c), the language in both sections is substantially similar—i.e., the trust is allowed a deduction for “any part” (rather than “any amount”) of the gross income, without limitation, which under the terms of the deed of trust is paid for a charitable purpose. The Supreme Court, in concluding that the trustee did not need to prove that the charitable contributions were made from the current year’s income, stated:
This language should be construed with the view of carrying out the purpose of Congress—evidently the encouragement of donations by trust estates. There are no words limiting these to something actually paid from the year’s income. And so to interpret the Act could seriously interfere with the beneficent purpose. One creating a trust might be unwilling to bind it absolutely to pay something to charity but would authorize his trustee so to do after considering then existing circumstances. Capital and income accounts in the conduct of the business of estates are well understood. Congress sought to encourage donations out of gross income, and we find no reason for saying that it intended to limit the exemption to sums which the trust could show were actually paid out of the receipts during a particular year. The design was to [forgo] some possible revenue in order to promote aid to charity. Here the trustee responded to an implied invitation and the estate ought not to be burdened in consequence. [Old Colony Trust Co., 301 U.S. at 384]
Subsequently, in W.K. Frank Trust of 1931, T.C. Memo. 43-516 (1943), aff’d, 145 F. 411 (3d Cir. 1944), a trust gave to charity stock that it had received in a tax-free liquidation of a corporation, the stock of which had been originally contributed to the trust. The taxpayer argued that based on the Old Colony decision, it was immaterial that the trust made the gifts to charity from trust corpus rather than income. The Tax Court stated:
We do not believe, however, that the above case stands for such a proposition. The Supreme Court was not there concerned with the question of whether the gifts were made out of corpus or out of income. It was concerned only with the question of whether they were made out of particular receipts of income.
Thus, the Tax Court interpreted Old Colony as not eliminating the requirement that the contributions be made out of income and not corpus, but as merely not requiring the contributions to be made out of the current year’s income. Because the shares contributed to charity by the Frank Trust were corpus of the trust, the Tax Court concluded that no charitable deduction was allowed to the trust.
In affirming the Tax Court’s decision, the Third Circuit determined that the contributed shares were part of the corpus of the trust and were never income despite the trustees’ having charged the value of the distributed shares against income on the trust’s books. That court stated that the trustees’ resolution to charge the distributed shares against income of the trust did not convert corpus into income. The Third Circuit also noted that the contributed shares were worth more at the time they were gifted to charity than they were when the trust received them but that “[s]uch appreciation in value, unrealized by sale or other disposition, was not gross income” (W.K. Frank Trust, 145 F. at 413).
The Old Colony decision itself and the Tax Court’s interpretation of that decision in W.K. Frank Trust support the position that while a trust’s charitable contribution must be traceable to gross income, it does not have to be gross income earned in the year of the charitable contribution. Based on these cases, a trust’s charitable deduction should not be limited to distributions to charity of amounts of gross income earned in the year that they are contributed to charity. In Chief Counsel Advice (CCA) 201042023, the IRS signals for the first time its agreement with that interpretation.
In the CCA, the trust had purchased three properties with the prior year’s gross income and could trace the source of the purchases to that gross income. The terms of the trust agreement authorize the trustee to distribute to charity such amounts from gross income as the trustee determines to be appropriate. After the properties had appreciated in value, the trust contributed them to three charitable organizations.
The trust claimed a deduction equal to the current fair market value of the three properties at the time of their contribution to the charitable organizations. The CCA acknowledged the court decisions holding that it is not necessary for a trust to make the charitable contribution from the current year’s gross income as long as the contribution can be traced to gross income earned in the past. The amount of gross income embedded in the properties contributed to charity equaled the trust’s adjusted basis in the properties purchased with gross income. The CCA concluded that the trust’s charitable deduction for property contributed to charity is limited to the trust’s adjusted basis in the property that had been purchased from the trust’s gross income and that no charitable deduction is available for the amount of unrealized appreciation in the value of the properties since their purchase.
Practice tip: Just a reminder that trusts claiming a charitable deduction under Sec. 642(c) for the tax year are generally required to file Form 1041-A, U.S. Information Return Trust Accumulation of Charitable Amounts, to satisfy their filing requirement under Sec. 6034(b)(1). Exceptions to this filing requirement are for trusts if all the net income for the year is required to be distributed currently to the beneficiaries (see Sec. 6034(b)(2)(A)) and for trusts described in Sec. 4947(a)(1) (wholly charitable trusts) (see Sec. 6034(b)(2)(B)). In addition, for tax years beginning after 2006, trusts that are split-interest trusts described in Sec. 4947(a)(2) (charitable lead trusts, charitable remainder trusts, and pooled income funds) are required to file only Form 5227, Split-Interest Trust Information Return, and not Form 1041-A (see Sec. 6034(a)).
Thus, a trust that is not required to distribute all its income currently or is not a wholly charitable trust is required to file Form 1041-A for any year in which it claims a charitable deduction under Sec. 642(c). This filing requirement is also applicable to a trust that does not itself contribute directly to charity but that claims a charitable deduction for the trust’s distributive share of gross income paid to charity by a partnership or an S corporation in which the trust owns an interest.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.