Trusts may hold the key to salvaging charitable contribution deductions
The 45th Annual Notre Dame Tax & Estate Planning Institute in South Bend, IN brings together some of the top estate planners from around the country to lecture at a two day conference. This is the 2nd in a series of articles elaborating on some of the many planning nuggets gleaned from the conference that might have important planning implications to readers. Charitable giving has always been a core American value. The 2017 Tax Cut Jobs Act severely restricted itemized deductions, and doubled the standard deduction, so that most Americans will lose their deduction for donations. But tax benefits from charitable giving are about much more than just the itemized deduction. If you can salvage a deduction it may enable you to boost the amount you donate.
If you won’t get a contribution deduction because of the doubled standard deduction ($24,400 in 2019 for a married couple) some have recommended you bunch deductions. Example, defer donations for 2019 to 2020. In 2020 pay the deductions for 2019, 2020 and even accelerate what you would have paid in 2021 into 2020. That might get you over the hurdle of the standard deduction, but its complicated, and most people are not likely to tell charities that they have supported ever year “wait until next year.” So some have suggested using donor advised funds for the bunched donations so that you can still distribute out your regular annual contributions. Bunching will help some people, but not all that many.
Another approach that will salvage deductions for many taxpayers involves creating what is called a non-grantor trust. That’s a trust that pays its own income taxes. Why? Because trusts are generally taxed like people, subject to certain exceptions. One of those exceptions is that trusts don’t get a standard deduction. While that’s generally a negative, for charitable planning it means donations made by a trust don’t have to exceed the hurdle of a standard deduction to qualify.
Example: Have your estate planner set up a relatively simple non-grantor trust naming charities and all your descendants. Gift $200,000 to the trust. The trust earns 5% on the $200,000 investment or $10,000. The trust makes donations to charities you listed in the trust agreement. The trust, without a standard deduction can deduction the full $10,000 of donations against the $10,000 of income. No trust tax. Had you not done this plan you would have had the $10,000 of investment income reported on your personal return but might have had no charitable contribution deduction because your itemized deductions are under the $24,400 standard deduction. You have effectively shifted both the income and the lost deduction to a trust that can offset the two. That’s a great deal for you and charity!
Well, the above sounds like such a great deal can you re-purpose existing trust for this type of planning? Maybe, but be careful. If the old trust did not provide for charitable beneficiaries you cannot add them and get this tax benefit. Why? If you modify the trust to allow charitable distributions, will that allow the trust to take charitable contribution deduction? According to the IRS, no. Amounts paid, permanently set aside, or to be used for charitable, etc., purposes are deductible by estates or trusts only as provided in Code Section 642(c). This Section requires that the trust agreement (the the contract or document creation the trust, the so-called “governing instrument”) permit charitable deductions.
So if you have an old trust that doesn’t provide for charitable beneficiaries you might be able to add them by having the trustee merge the trust into a new trust that includes charities (called “decanting”). It may also be possible for the trustee and all beneficiaries to agreed to modify the terms of the trust to add a charitable beneficiary (called “non-judicial modification”). Unfortunately, changing an old trust to permit this type of planning by adding charities is a no go according to the IRS, so the trust won’t get the contribution deduction. the IRS’ position is that adding charities to a modified or decanted trust does not meet the tax law requirement that the “governing instrument” designate charites.
The IRS view is that the only way you can meet this requirement is when the provision permitting charitable gifts was in the original trust instrument. So this type of planning works for new trusts, but maybe not for existing trusts.
Is there a way to get charitable contribution deductions for an old trust that did not name charitable beneficiaries? Perhaps.
First you create a partnership or limited liability company (“LLC”). You and the trust contribute income producing assets to the LLC in exchange for ownership (membership) interests in the LLC. The LLC then donates income it earns to charity. The LLC’s K-1 (the tax form the LLC gives to each of its partners, e.g. you and the trust) issued to the trust reflects the trust’s pro-rata share of the LLC’s donation. The trust can then indirectly get a contribution deduction if it can offset trust income by the donation that passes to it from the LLC. A trust that is a member of the LLC should benefit from a charitable contribution made by the LLC even if the trust itself has no charitable beneficiaries. See Rev. Rul. 2004-05. So there may be a way to skin the trust contribution deduction cat.