Use of IRAs/IRD assets in estate plans

The information below is part of an ongoing discussion from an email exchange on the GIFT-PL site to which I subscribe. I thought you might find this interesting, perhaps helpful.

“”We are beneficiaries of a substantial estate the residue of which has been left pro rata to a group of charities.  Problem is, about 20% of the estate is in an IRA and charities were not named as beneficiaries of the IRA.  The IRA is being paid to the estate.  The executor, who is also the attorney who drew up the will and one would hope might have prevented this situation, has determined that the estate is subject to income tax on the entire IRA value and proposes to stretch out the payments over five years, to minimize the tax effect.””

Yes, it looks like a problem.  Ideally, the charity would have been named as the direct beneficiary of the IRA.  If the IRA cuts a check directly to the charity, no income would appear on the estate’s income tax return.  Reg. Sec. 1.691-1.  However, since the estate was the beneficiary, the estate has taxable income.

The issue, then, is whether the estate can claim an offsetting charitable income tax deduction for the transfer to charity.  The problem is that an estate’s charitable income tax deductions must be “traced” to an income source, as explained below.

TO AVOID THIS SCENARIO IN THE FUTURE, one solution is for every will (and living trust, if appropriate) of everybody in the nation who intends to make a charitable bequest to contain instructions that all charitable gifts, bequests & devises should be made, to the extent possible, from assets that constitute income in respect of a decedent.  Something along these lines:

“I INSTRUCT THAT ALL CHARITABLE GIFTS, BEQUESTS & DEVISES SHOULD BE MADE, TO THE EXTENT POSSIBLE, FROM ASSETS THAT CONSTITUTE INCOME IN RESPECT OF A DECEDENT, AS THAT TERM IS DEFINED IN THE INTERNAL REVENUE CODE.”

With that language, you should not have a problem if the estate makes an outright (as opposed to a deferred) charitable transfer, even if it flows through the probate estate.

EXAMPLE ** EXAMPLE **  EXAMPLE **  EXAMPLE:
Estate receives a $100,000 distribution from an IRA in YEAR 1.  The entire $100,000 is IRD / taxable income.  The decedent’s will provides for a $120,000 charitable bequest, which in fact is paid to the charity in YEAR 2.
WITHOUT the above suggested language, there probably is NOT a charitable INCOME tax deduction.  Please see United States Trust Co. v. Commissioner, 803 F.2d 1363, 1365 (5th Cir. 1986), mentioned at the end of this message.

WITH THE ABOVE SUGGESTED LANGUAGE IN THE WILL, the estate should be able to can claim both (1) a $120,000 ESTATE TAX charitable deduction and (2) a $100,000 INCOME TAX charitable deduction in YEAR 1, since all charitable bequests were required to be made with “income in resepct of decedent” assets.  The Sec.  642©(1) set-aside language—mentioned by Susan Thomas in her message— permits the estate to deduct the $100,000 charitable gift on the YEAR 1 return even though it was not in fact paid until YEAR 2.  Ideally, the executor will deposit the entire $100,000 and all other IRD into a separate checking account to facilitate the “tracing” requirement for charitable gifts, described below.

Citations of legal authority are at the end of this message.

Hope that this helps .... at least in the future.  Again, this issue could be avoided with IRAs and retirement plans if the charity is named as the direct beneficiary of the IRA or retirement  plan.  Of course, that strategy creates other problems for required distributions at age 70 ½.   Yada yada yada.
CHRIS HOYT

Christopher R. Hoyt
Professor of Law
University of Missouri (Kansas City) School of Law
5100 Rockhill Road
Kansas City, Missouri 64110

Voice: (816) 235-2395
[[fax:   (913) 338-5276]]
hoytc@umkc.edu

DISCLAIMER: The opinions expressed in this message are
those of the author and do not necessarily reflect the views
of the University of Missouri.  This message is intended as
general discussion of legal issues and not as legal advice
or a legal opinion.  No attorney-client relationship is created
by this message.  Seek independent counsel to act upon any
laws discussed in this communication.

ESTATES (BUT NOT MOST TRUSTS) CAN CLAIM A CHARITABLE INCOME TAX DEDUCTION FOR INCOME THAT IS PERMANENTLY SET ASIDE FOR CHARITABLE PURPOSES PURSUANT TO THE GOVERNING INSTRUMENT, EVEN THOUGH NOT ACTUALLY PAID UNTIL A LATER YEAR. I.R.C.  Sec. 642©(2); Treas. Reg. Secs.. 1.642©-3, -2(a), (b), (d).

Still, the complexity of tracing whether the payment came from income or from corpus, as well as whether the payment was made pursuant to the governing instrument, can pose problems.  UNLIKE THE RULES THAT APPLY TO MOST TRUST OR ESTATE INCOME DISTRIBUTION DEDUCTIONS, CHARITABLE INCOME TAX DEDUCTIONS MUST STILL BE “TRACED” TO AN INCOME SOURCE, WHICH CAN LEAD TO COMPLICATIONS.

Although many deductions of trusts and estates used to be subject to a tracing rule, the laws were changed in 1954 so as to remove such a requirement for most deductions.  HOWEVER, THE TRACING RULE WAS KEPT FOR CHARITABLE DEDUCTIONS.  The Tax Court explained the rules and the reasons for them in Van Buren v.
Commissioner, 89 T.C. 1101, at 1108-1109 (1987):

“”Section 642©(1) allows a trust a charitable deduction for any amount of its gross income which, pursuant to the trust instrument, is paid for charitable purposes.  Tracing is required since the statute specifically requires that the source of the contribution be gross income.  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. . . .(citations omitted).””

THIS CAN POSE HAZARDS IF THE PROBATE ESTATE WILL MAKE A CHARITABLE CONTRIBUTION See, e.g., Estate of O’Connor v. Commissioner, 69 T.C. 165 (1977) (holding that a widow’s assignment of income from a marital trust to a charitable foundation was nondeductible by the estate under either Sec. 642, as a charitable contribution, or Sec. 661, as a distribution to a beneficiary).

FOR EXAMPLE, THE WILL MUST PROVIDE THAT THE CHARITABLE DEDUCTION IS DERIVED FROM INCOME, RATHER THAN CORPUS, IN ORDER FOR THE ESTATE TO CLAIM AN INCOME TAX DEDUCTION. See United States Trust Co. v. Commissioner, 803 F.2d 1363, 1365 (5th Cir. 1986) (allowing an estate tax deduction equal to 10 percent of the gross estate but disallowing any Sec. 642© income tax deduction for the distribution, because the will “did not direct that the distributions come from gross income”).