Make Your Charitable Estate Plan Great Again

January 18, 2019

By Marie Arrigo

Christopher R. Hoyt from the University of Missouri (Kansas City) School of Law presented three charitable planning techniques with retirement accounts.

Idea #1: The Charitable IRA Rollover: An individual over age 70 ½ is able to annually make up to $100,000 of charitable gifts directly from an IRA. By making a “qualified charitable distribution” from an IRA, the individual benefits by not having to report the minimum required IRA distribution as taxable income, even though an itemized deduction for the charitable deduction cannot be claimed. A lower adjusted gross income (“AGI”) may enable the individual to avoid the 3.8% net investment income tax by falling below the AGI threshold of $200,000 ($250,000 for married filing jointly). Lower AGI may also result in less social security benefits being taxed and less Medicare B premiums being paid.

This planning technique has become more popular in light of the 2017 Tax Cuts and Jobs Act (“TCJA”). One of the major law changes resulting from TCJA is the higher standard deduction ($24,000 for married filing jointly and $12,000 for single filers), coupled with the elimination or limitation of certain itemized deductions, such as the $10,000 maximum deduction for state income or property taxes paid, elimination of the miscellaneous itemized deduction subject to the 2% of AGI threshold, and limitations on certain home mortgage interest deductions. Although the deduction for charitable contributions was maintained, the actual deductibility depends on whether the individual is able to itemize on his/her income tax return. Hoyt indicated that the number of households claiming an itemized deduction for their charitable gifts is projected to shrink by 21 million, from about 37 million in 2017 to 16 million in 2018. These individuals will take the higher standard deduction, and will find the use of the Charitable IRA Rollover attractive.

Idea #2: Income Tax Deductions for Charitable Bequests of IRD

Hoyt then focused on whether an estate or trust can secure a charitable income tax deduction when income in respect of a decedent (“IRD”) is donated to a charity. IRD is a payment received after death that would have been taxable income had the decedent received the payment before death (IRC Sec. 691(a)). These days, the largest source of IRD are distributions received from a decedent’s retirement account.

For the answer, one needs to review the directives contained in the will of the decedent.

What if the will states that $100,000 is to be left to a charitable organization and that all income of the estate is paid to the child? Since the bequest is paid from assets owned at death, the charitable deduction for $100,000 is taken on Form 706, which is the estate tax return. Because the charitable bequest is not paid from income, no charitable income tax deduction can be taken on the Form 1041, which is the fiduciary income tax return.

What if the will does not provide a bequest to the charity, but instead directs that all income of the estate is to be paid to the charity? In this case, there is no charitable deduction taken on the Form 706. However, the gift can be taken as a charitable deduction on the Form 1041.

The Mott case says that an estate will not be able to claim either a charitable income tax deduction or a distributable net income (“DNI”) deduction for a typical charitable bequest (a distribution of corpus/principal to a charity). In those cases, the charitable bequest is taken on the Form 706.

For example, assume the decedent’s will provides for a $300,000 charitable bequest and the remainder of estate is payable to his children. The assets of the estate are $800,000 in cash and stocks and $100,000 in a 401(k) plan, for a total of $900,000. The income of the estate is $50,000 in interest and dividends earned after the date of death and $100,000 IRD from the 401(k) plan. The default beneficiary of the 401(k) plan is the estate. A total of $950,000 will be distributed: $300,000 to the charity and $650,000 to the children.

The $100,000 in the 401(k) plan is taxable in the estate, since it is an asset of the estate. At the same time, the $100,000 is taxable income and will be reported on the Form 1041. There is a double tax on the IRD. If the governing instrument specifies to distribute all of its IRD to a charity, then the estate should be able to claim a charitable deduction on both the Form 706 and also on the Form 1041, as per Treas. Reg. Section 1.642(c)-3(a). IRD is both corpus and income.

Hoyt discussed the following strategies:

  1. Keep IRD off of the estate’s income tax return. This can be achieved by naming the charity as the beneficiary.
  2. If the estate will recognize taxable IRD, then draft the governing instrument to assure an offsetting charitable income tax deduction.

Idea #3: Income-based Charitable Bequests

While charitable bequests are typically viewed as only providing estate tax savings, there is an income tax savings opportunity. If properly structured, every charitable bequest can reduce the income tax liability of a trust or estate, or their beneficiaries. This can be achieved with income-based charitable bequests. This strategy can be particularly attractive in cases where there is a nontaxable estate.

Hoyt suggested three guiding principles:

  1. An individual will generally achieve greater tax savings by a making lifetime charitable gift rather than a charitable bequest. Use of charitable remainder trusts are especially beneficial.
  2. Make charitable bequests with assets that generate IRD. Shifting inflated-value pre-tax IRD assets to charities will permit a larger amount assets with a step-up in basis to go to the family members.
  3. Draft the governing instrument so that the estate or trust (and its beneficiaries) can get income tax savings from the charitable transfers made by the estate or trust.

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About Marie Arrigo

Marie Arrigo is a Tax Partner and Co-Leader of the Family Office Services Practice for the Personal Wealth Advisors Group which provides tax consulting and compliance services to family offices, individuals, trusts and estates, and closely held businesses.

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