Charitable Planning to Avoid New 3.8% Tax on Investment Income

Charitable Planning to Avoid New 3.8% Tax on Investment Income

Article posted in Income Tax on 29 July 2013| comments
audience: National Publication | last updated: 27 April 2017
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Summary

The 3.8% Medicare tax on net investment income provides tax incentives for implementing certain charitable giving arrangements. In this comprehensive article from the August 2013 issue of Estate Planning, attorney Richard L. Fox of  the Philadelphia office of Buchanan Ingersoll & Rooney reviews the application of the tax to estates and a variety of planned giving vehicles. 

By Richard L. Fox, J.D., LL.M.


This article is reprinted with the publisher's permission from ESTATE PLANNING, a monthly journal on strategies for saving taxes, building wealth, and managing assets published by RIA under the WGL imprint. Copying or distribution without the publisher's permission is prohibited. To subscribe to ESTATE PLANNING or other RIA journals please visit http://www.riahome.com/journals/. For information on ESTATE PLANNING, click here.


As has been widely publicized and discussed,1 new Section 1411 subjects individuals, estates, and trusts to a 3.8% Medicare tax on net investment income (NII), effective for tax years beginning after 2012.2 The threshold for the imposition of the tax on individuals is an adjusted gross income (AGI) of $250,000 for married couples filing joint returns and $200,000 for single filers. In contrast,3 the threshold for an estate or trust is AGI of the relatively nominal amount at which the highest income tax bracket begins under Section 1(e), a mere $11,950 for the tax year 2013. 4 With the increase in the top income tax rates under the American Taxpayer Relief Act of 20125 to 39.6% on ordinary income and 20% on long-term capital gain income, and the imposition of the new 3.8% tax under Section 1411, individuals, estates, and trusts now face a substantial tax of up to 43.4% on ordinary investment income and 23.8% on long-term capital gain income.

Although a charitable contribution that is deductible under Section 170 can reduce an individual's income tax liability, the contribution has no effect on a taxpayer's liability under Section 1411.6 Even so, certain charitable planning vehicles can be used to minimize the tax imposed under Section 1411. These vehicles can also result in favorable income, estate, and gift tax consequences, thus providing excellent tax planning opportunities to reduce the overall tax burden of a taxpayer. Of course, the use of these vehicles is premised on the taxpayer having a desire to advance his or her philanthropy, an ever-growing goal among individuals in the U.S.7 Proposed regulations that have been issued under Section 1411 are particularly helpful in the charitable planning context, as they clarify the application of the Section 1411 tax to various charitable entities and charitable split-interest trusts.8

Background on the 3.8% tax

Section 1411 imposes a 3.8% tax on the NII of individuals, estates, and trusts to the extent that the taxpayer's AGI 9 exceeds certain applicable thresholds.10 In the case of an individual, the 3.8% tax is imposed for each tax year on an amount equal to the lesser of:

(1) The individual's NII for such tax year.
(2) The excess, if any, of (a) the individual's AGI for such tax year, over (b) the “threshold amount.”11
The threshold amount is $250,000 in the case of taxpayers filing a joint return, $125,000 in the case of a married taxpayer filing a separate return, and $200,000 for single filers.12 Section 1411 tax liability results, therefore, only where a taxpayer has NII and the taxpayer's AGI exceeds the applicable threshold amount. The following examples involving a husband and wife, who file a joint income tax return, illustrate the application of the tax:

Example. Their salaries total $275,000. This is their only source of income; they have no NII, and their AGI is $275,000. Because they have no NII, Section 1411 does not apply even though their AGI exceeds the applicable threshold amount of $250,000.

Example. They have NII of $150,000, salaries of $100,000, and an AGI of $250,000. The 3.8% tax does not apply because although they have NII, their $250,000 AGI does not exceed the $250,000 threshold amount.

Example. They have NII of $150,000, salaries of $275,000, and an AGI of $425,000. The 3.8% tax under Section 1411 applies to the entire $150,000 of NII because this is less than the $175,000 excess of the $425,000 AGI over the $250,000 threshold amount.

Example. They have NII of $150,000, salaries of $200,000 and an AGI of $350,000. The 3.8% tax under Section 1411 applies to only $100,000 of their NII, the excess of the $350,000 AGI over the $250,000 threshold amount.

NII generally means the excess, if any, of (1) the sum of (a) interest, dividends, annuities, royalties, and rents; (b) gross income derived from a passive activity or a trade or business of trading in financial instruments or commodities; and (c) net gain attributable to the disposition of property derived from a passive activity or a trade or business of trading in financial instruments or commodities;13 over (2) deductions that are allocable to such gross income or net gain.14 Income that does not fall within the definition of NII is generally referred to as “excluded income” for purposes of the Section 1411 tax regime.15

Application of the 3.8% Medicare tax to estates and trusts

In the case of an estate or trust, the 3.8% tax under Section 1411 is imposed for each tax year on an amount equal to the lesser of:

(1) The undistributed NII of the estate or trust.

(2) The excess, if any, of (a) the AGI of the estate or trust16 over (b) the inflation-adjusted dollar threshold at which the highest tax bracket in Section 1(e) begins (a relatively nominal amount of only $11,950 for 2013).

Similar to an individual, if an estate or trust has no undistributed NII or its AGI does not exceed the applicable threshold amount for the year, no tax is imposed under Section 1411. Because the threshold applicable to estates and trusts is at such a low level relative to the thresholds for the individual beneficiaries, it is particularly important to appreciate the application of the Section 1411 tax to estates and trusts and to focus on possible techniques to minimize the exposure. This may include shifting NII of an estate or trust into the hands of individual beneficiaries by making additional distributions to such beneficiaries, who may be subject to a lesser tax or no tax at all on their NII because of the higher Section 1411 thresholds applicable to individuals.17

By combining the effects of the higher AGI thresholds applicable to individual beneficiaries and spreading out the NII of the trust among many beneficiaries, a trustee could possibly eliminate or substantially reduce the tax on the NII of the trust. Of course, if all of the beneficiaries of the trust are sufficiently affluent that the excess of their respective AGIs over their applicable thresholds equals or exceeds their NII, shifting NII from a trust to its beneficiaries will not reduce the Section 1411 tax. Moreover, even if making distributions to beneficiaries results in an overall reduction of the Section 1411 tax, trustees should consider other tax and nontax factors, such as the potential estate tax savings and asset protection benefits of keeping the assets in trust.18

The AGI of an estate or trust is reduced by distributions to beneficiaries to the extent of distributable net income (DNI)19 that is deductible under Sections 651 or 661,20 and its undistributed NII is reduced to the extent that such DNI consists of NII distributed to beneficiaries.21 The respective amounts of the DNI and NII that are deducted by the estate or trust are subject to tax in the hands of the beneficiaries.22 Unless capital gain income is included in DNI, which generally is not the case,23 it is not deductible under Sections 651 or 661. Rather, it is taxed entirely at the estate or trust level and is not passed out to the beneficiaries for tax purposes. The same concept applies to NII, so that only NII of an estate or trust that is included in DNI and deductible under Section 651 or 661 as a result of distributions to a beneficiary is taxed at the beneficiary level.24

Example. In 2013, a trust has $50,000 of NII and $70,000 of AGI. Unless the trust makes a distribution to a beneficiary of DNI that is deductible under Sections 651 or 661, and therefore carries out NII to the beneficiary, the trust has undistributed NII of $50,000, with none of its NII passing out to a beneficiary. In this situation, the trust would be subject to a 3.8% tax under Section 1411 on $50,000. This amount is the lesser of (1) the trust's undistributed NII of $50,000 or (2) $58,050, its $70,000 AGI less the $11,950 threshold applicable for 2013.

The deductions attributable to distributions of DNI by an estate or trust to its beneficiaries, and the related income to the beneficiaries, are treated as consisting of the same proportion of each class of items of income entering into the computation of DNI as the total of each class bears to the total DNI.25

Example. A trust has DNI of $40,000, consisting of $10,000 of taxable interest (equal to 25% of DNI) and $30,000 of royalties (equal to 75% of DNI). It distributes $10,000 to a beneficiary. The trust's $10,000 deduction and the $10,000 of income taxable to the beneficiary are deemed to consist of $2,500 (25% × $10,000) of interest and $7,500 (75% × $10,000) of royalties.

Where DNI consists of both NII and “excluded income,” a distribution of DNI to the beneficiary must similarly be allocated between the NII and the excluded income, so that a proportionate amount of the total NII of the estate or trust is deemed to be distributed to the beneficiaries.26 All items of NII that are considered distributed to the beneficiaries retain their character as NII for purposes of computing the Section 1411 tax on the NII of the recipient beneficiaries.27

Example. In 2013, a trust has dividend income of $15,000, interest income of $10,000, capital gain of $5,000, and $60,000 of taxable income attributable to a distribution from an individual retirement account (IRA). The trust has no expenses. The trust distributes $8,500 to A, an individual beneficiary of trust. The trust's DNI is $85,000 ($15,000 in dividends, $10,000 in interest, and $60,000 of taxable income from the IRA),28 from which the $8,500 distribution is paid to A. The trust's DNI deduction is $8,500, which reduces each class of income comprising DNI on a proportionate basis. Because the $8,500 distribution equals 10% of DNI ($8,500 divided by $85,000), the $8,500 of DNI distributed to the beneficiary consists of dividend income of $1,500 (10% × $15,000), interest income of $1,000 (10% × $10,000), and ordinary income attributable to the IRA of $6,000 (10% × $60,000). The $5,000 of capital gain allocated to principal does not enter into the computation of DNI, so no portion of that amount is included in the $8,500 distribution; likewise, it does not qualify for a DNI deduction.

The trust's NII is $30,000, consisting of $15,000 of dividends, $10,000 of interest, and $5,000 of capital gain. The trust's $60,000 of taxable income attributable to the IRA is excluded income for Section 1411 purposes and, therefore, is not NII. The trust has undistributed NII of $27,500, which is the trust's NII of $30,000, less the $1,500 of dividend income and $1,000 of interest income considered distributed to A. The $27,500 of undistributed NII is comprised of the $5,000 capital gain, the undistributed dividend income of $13,500, and the undistributed interest income of $9,000.

A has $1,500 in dividend income and $1,000 of interest income for purposes of calculating his or her own NII, but does not include the $6,000 of ordinary income attributable to the IRA in NII because it is excluded income.

Reduction of NII allocated to Section 642(c) deduction for charitable contributions. In lieu of the charitable income tax deduction under Section 170(a),29 a charitable income tax deduction is available under Section 642(c) to estates and trusts for charitable contributions made from gross income.30 Unlike individuals, whose charitable income tax deductions are limited to a certain percentage of their AGI under Section 170(b), estates and trusts are entitled to claim an unlimited charitable income tax deduction against their gross income.31

In computing its undistributed NII, an estate or trust is allowed a deduction for that portion of its NII that is allocated to amounts allowable as a charitable deduction under Section 642(c).32 As a result, a Section 642(c) charitable deduction will effectively shift NII from an estate or trust into the hands of a tax-exempt charitable beneficiary. Unless all of the requirements of Section 642(c) are satisfied, however, a transfer to charity by an estate or trust is not deductible.33 Specifically, Section 642(c)(1) allows an estate and trust an income tax deduction for “any amount of gross income, without limitation,34 which pursuant to the terms of the governing instrument is, during the tax year, paid for a purpose specified in Section 170(c).” The key to the charitable income tax deduction for an estate and trust under Section 642(c)(1) is that the amount is paid:

(1) During the tax year.
(2) From gross income (i.e., not from corpus or principal), including gross income accumulated in earlier years.35
(3) Pursuant to the terms of the governing instrument (i.e., the will or trust document).
(4) For a purpose specified in Section 170(c).36

For purposes of the Section 642(c) deduction, the contribution must be paid “pursuant to the terms of the governing instrument.” Therefore, if an executor or trustee voluntarily makes a payment to charity that is not authorized under the will or trust document, no charitable income tax deduction is available under Section 642(c).37 The governing instrument need not “definitively direct” the charitable contribution in order to support a deduction under Section 642(c), as long as it specifically authorizes a payment to charity.38

In addition to the available deduction under Section 642(c)(1), estates, as well as certain trusts created on or before 10/9/1969, are allowed a charitable income tax deduction under Section 642(c)(2) for amounts of gross income that are permanently set aside for charitable purposes. Specifically, under Section 642(c)(2), a charitable deduction is allowed in computing taxable income for “any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, permanently set aside for a purpose specified in IRC § 170(c), or is to be used exclusively for religious, charitable, scientific, literary or educational purposes” and certain other specified purposes.39

A charitable deduction under Section 642(c) generally reduces DNI40 and is allocated proportionately among the items of income entering into the computation of estate or trust income.41 For purposes of allocating items of income entering into the computation of DNI to beneficiaries “to whom income is required to be distributed currently, the amount of the charitable contribution deduction is disregarded to the extent that it exceeds the [fiduciary accounting] income of the trust for the taxable year reduced by amounts for the taxable year required to be distributed currently.”42 Thus, for purposes of determining the items of income distributed currently to a noncharitable beneficiary, DNI is computed without regard to any portion of the Section 642(c) deduction to the extent that fiduciary accounting income exceeds the income required to be distributed to a noncharitable beneficiary.

As a result, a contribution to a charity by an estate or trust that is otherwise deductible under Section 642(c) does not reduce the taxable income of a beneficiary to the extent of distributions of income required to be distributed to such beneficiary. In determining the income of a discretionary beneficiary to whom income is not required to be distributed currently, however, the entire charitable contribution deduction under Section 642(c) is taken into account for purposes of determining the DNI and NII of such beneficiary.43

Example. A trust instrument provides that $30,000 of its income must be distributed currently to A, an individual, and the balance may either be distributed to B, an individual, to X, a designated charity, or accumulated. Accumulated income may be distributed to B and to the charity. For its tax year, the trust has $40,000 of taxable interest and $10,000 of tax-exempt income, with no expenses; fiduciary accounting income of the trust is $50,000. The trustee distributes the required $30,000 to A, and makes discretionary distributions of $50,000 to charity X and $10,000 to B out of current and accumulated income. The charitable contribution deduction under Section 642(c) for purposes of determining the DNI of A is taken into account only to the extent of $20,000, the excess of the $50,000 fiduciary accounting income of the trust over the $30,000 of income required to be distributed currently to A.

The $20,000 charitable contribution deduction is allocated proportionately to the items of income of the trust: $16,000 to taxable interest and $4,000 to tax-exempt income. The $30,000 of income required to be distributed currently to A consists of the balance of these items, $24,000 of taxable interest, and $6,000 of tax-exempt income. In determining the amount to be included in the gross income of B, the entire charitable contribution deduction is taken into account, with the result that there is no DNI. B therefore has no gross income or NII attributable to the trust.44

Although a Section 642(c) charitable deduction does not reduce the AGI of an estate or trust, in computing its undistributed NII, an estate or trust is allowed a deduction for that portion of its NII that is allocated to amounts allowable as a charitable deduction under Section 642(c).45 As a result, a Section 642(c) charitable deduction effectively shifts NII from an estate or trust (and therefore reduces its undistributed NII) to the charitable beneficiary, which is exempt from the Section 1411 tax. Under Prop Reg. 1.1411-3(e)(3), where an estate or trust has both NII and excluded income, the Section 642(c) deduction must be allocated between the NII and excluded income in a manner similar to rules under Reg. 1.662(b)-1, so that a proportionate amount of the trust's NII is considered distributed to the charitable beneficiary.46

Example. A trust has dividend income of $15,000, interest income of $10,000, capital gain of $5,000, and $25,000 of taxable income relating to a distribution from an IRA. The trust has no expenses. The trust is required to distribute $30,000 to individual A. In addition, the trust makes a discretionary distribution of $10,000 to each of individual B and charity X, with the distribution to X qualifying for a charitable deduction under Section 642(c). The trust's DNI is $50,000 ($15,000 of dividends, $10,000 of interest, and $25,000 of IRA income). The trust has NII of $30,000 ($15,000 of dividends, $10,000 in interest, and $5,000 in capital gain.)

The trust's DNI deduction under Section 661 for the distribution to A is $30,000, which reduces each class of income comprising DNI proportionately. The $30,000 distribution equals 60% of DNI ($30,000 divided by $50,000). Therefore, the distribution to A consists of dividend income of $9,000, interest income of $6,000, and ordinary income attributable to the IRA of $15,000.

A's mandatory distribution of $30,000 consists of $15,000 of NII ($9,000 of dividends and $6,000 of interest) and $15,000 of excluded income (IRA income). The trust's remaining DNI and undistributed NII is $20,000 and $15,000, respectively. The $10,000 deduction under Section 642(c) is allocated in the same manner as the distribution to A, where the $10,000 distribution equals 20% of the DNI ($10,000 divided by $50,000).

For purposes of determining its undistributed NII, by virtue of the Section 642(c) deduction, the trust's NII is reduced by $5,000 (dividend income of $3,000, interest income of $2,000, but with no reduction for amounts attributable to the IRA of $5,000). With respect to the discretionary distribution to B, the trust's remaining DNI is $10,000, and the trust's remaining undistributed NII is $10,000.

The trust's DNI deduction under Section 661 for the distribution to B is $10,000. The $10,000 distribution equals 20% of the DNI ($10,000 divided by $50,000). Therefore, the distribution consists of dividend income of $3,000, interest income of $2,000, and ordinary income attributable to the IRA of $5,000. B's distribution consists of $5,000 of NII and $5,000 of excluded income. The trust's undistributed NII is $5,000 after taking into account distribution deductions and the Section 642(c) deduction. To arrive at the trust's undistributed NII of $5,000, the trust's NII of $30,000 is reduced by $15,000 of the mandatory distribution to A, $5,000 of the Section 642(c) deduction, and $5,000 of the discretionary distribution to B.

Charitable trusts and entities not subject to the Section 1411 tax. In general, Section 1411 applies to all trusts except those trusts that are specifically exempted under the regulations.47 Among the trusts that are not subject to tax under Section 1411 are a trust all the unexpired interests of which are devoted to one or more purposes described in Section 170(c)(2)(B);48 a trust exempt from tax under Section 501(c)(3);49 and a charitable remainder trust (CRT) described in Section 664. Also exempt from the Section 1411 tax is any organization described in Section 501(c)(3), whether or not the organization is in trust or corporate form.50

Charitable planning strategies

Because it does not reduce the NII or the AGI of an individual, a charitable contribution deduction under Section 170 has no effect on the Section 1411 tax of an individual, no matter how great the charitable contribution. Notwithstanding, charitable planning vehicles can be used to avoid, minimize, or defer the 3.8% tax imposed on NII under Section 1411. These charitable planning vehicles may also offer significant income, gift, or estate tax benefits, making their use even more attractive from an overall tax planning perspective.

CRTs

A CRT can be particularly useful in planning to avoid the impact of the NII. Because a CRT is wholly exempt from Section 1411,51 property having significant appreciation can be transferred to a CRT and then sold without the imposition of the 3.8% tax on NII (or the imposition of any regular income tax).52 Moreover, although annuity and unitrust payments shift NII to the trust's noncharitable beneficiaries,53 a CRT annually smooths out NII that is passed through to such beneficiaries and subjects the taxation of such NII to the higher AGI thresholds applicable to individuals. Depending on the recipient beneficiaries' respective NII and AGI, the use of a CRT may result in the elimination, reduction, or at the very least, the deferral, of the 3.8% tax on NII realized by the CRT.

Background on CRTs. The CRT has become a staple among estate planners and is often a recommended vehicle for individuals with substantial appreciated capital gain property, a charitable intent, and a need for a stream of income during their lifetimes.54 The basic concept of a CRT involves a transfer of property to an irrevocable trust, the terms of which provide for the payment of a specified amount, at least annually, to the grantor or other designated noncharitable beneficiaries for life or another predetermined period of up to 20 years.

The amount remaining in the trust after the expiration of that period (i.e., the remainder interest) must be transferred to one or more qualified charitable organizations or continue to be held in the trust for the benefit of such organizations. Thus, unlike an outright gift to charity, a CRT blends the philanthropic intentions of a donor with his or her financial needs or the financial needs of others. There is generally no gain recognition on the transfer of appreciated property to a CRT,55 and because it is exempt from income tax,56 the transferred property may be sold by the CRT without tax consequences.

While the CRT itself is exempt from income tax, the annual annuity or unitrust payments carry out income to the noncharitable beneficiary or beneficiaries based on specified ordering rules under a special four-tier system, generally treating the most highly taxed income of the trust as being distributed first.57 Under these ordering rules, the annuity or unitrust payments carry out income from the CRT in the following order:

(1) From ordinary income.
(2) From capital gain income.
(3) From other income, including tax-exempt income.
(4) As a tax-free return of principal.58

The CRT regulations provide specific rules for characterizing a distribution from a CRT to take into account differences in the federal income tax rates applicable to classes of income that are assigned to the same category, basically considering the highest-taxed classes of income within the same category to be distributed first.59 Thus, within the ordinary income and capital gains categories, income is treated as distributed from the classes of income in that category beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest federal income tax rate.60 The regulations also provide that the tax rates applicable to a distribution from a CRT to a noncharitable beneficiary are the tax rates applicable to the classes of income from which the distribution is derived in the year of the distribution and not the tax rates applicable to the income in the year it is realized by the CRT.61

Section 1411 and the CRT. A CRT can be particularly useful in planning to avoid the impact of the tax on NII under Section 1411 assuming, of course, that the taxpayer is willing to give the remainder interest in the trust to charity. Eligible charities include the taxpayer's own private foundation, a donor-advised fund sponsored by a public charity, or a public charity. CRTs are not subject to the NII tax under Section 1411.62 Therefore, similar to the income tax context, a taxpayer can transfer substantially appreciated property to a CRT that can then be sold by the CRT free of any Section 1411 tax.

While a CRT is exempt from the Section 1411 tax, annuity and unitrust distributions by a CRT carry out NII to the individual noncharitable beneficiaries. A CRT, however, has the favorable effect of smoothing out the NII that is carried out to its beneficiaries on a year-to-year basis and subjects the taxation of such NII to the higher thresholds applicable to individuals. Thus, by using a CRT, NII of the CRT trust is harbored in a tax-exempt environment within the CRT, while at the same time leveling out the NII of the CRT in the hands of the individual noncharitable beneficiaries over a substantial period63 so as to minimize (or at least defer) the Section 1411 tax imposed on the NII earned by the CRT. Thus, in addition to its other benefits, including an upfront income tax deduction, its exemption from income tax, and its ability to avoid the imposition of tax on the sale of substantially appreciated property, CRTs now offer the benefit of avoiding, minimizing, or deferring the tax on NII imposed under Section 1411.

Example. A, a single taxpayer, has a salary of $150,000 and no other income. If A were to sell long-term capital gain property at a gain of $350,000, her NII and AGI would be $350,000 and $500,000, respectively. A would have $300,000 of NII subject to the Section 1411 tax—the lesser of (1) the NII of $350,000 and (2) $300,000, the excess of the $500,000 of AGI over the $200,000 threshold amount.

If instead of A selling the property, A contributed the property to a CRT which then sold the property, the $350,000 gain would not be subject to the Section 1411 tax or the regular income tax. If the annual annuity or unitrust payment were $50,000 for a particular year, and the payment consisted of only long-term capital gain, then A would be considered to realize long-term capital gain income from the CRT of $50,000. In such a case, A's NII and AGI would be equal to $50,000 and $200,000, respectively. Because A's AGI would not exceed the $200,000 threshold, A would not be subject to any tax under Section 1411.

The actual determination of the NII that is deemed to be distributed each year to individual noncharitable beneficiaries through an annuity or unitrust payment from a CRT is governed by the proposed regulations promulgated under Section 1411, rather than under Section 664 or its regulations, which otherwise govern the taxation of a CRT and its distribution of annuity or unitrust payments to its beneficiaries. Prop. Reg. 1.1411-3(c)(2)(i) provides that distributions from a CRT to a beneficiary for a tax year consist of NII equal to the lesser of (1) the total amount of the distributions for that year or (2) the current and accumulated NII of the CRT. For CRTs with multiple annuity or unitrust beneficiaries, the NII is apportioned among the beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the trust for that tax year.64

The term “accumulated NII” is defined as the total amount of NII received by a CRT for all tax years beginning after 2012, reduced by the total NII distributed for all prior tax years beginning after 2012.65 Thus, under the proposed regulations, current and accumulated NII of a CRT is deemed to be distributed before amounts that are not items of NII for purposes of Section 1411, irrespective of the four-tier ordering rule that is otherwise applicable under the Section 664 tax regime for determining the character of income attributable to annuity or unitrust payments.66

Depending on the character of the income realized by the CRT, the difference in the ordering rules may result in the worst of both tax worlds for a beneficiary of a CRT. For example, if a CRT's income consists of taxable income from an IRA and long-term capital gain, an annuity or unitrust payment could carry out only IRA income (which is not NII) for Section 664 purposes and only long-term capital gain (which is NII) for Section 1411 purposes. Recognizing that the ordering rule applicable to distributions of NII under the Section 1411 proposed regulations are not consistent with the four-tier ordering rule under Section 664, the Preamble to the proposed regulations under Section 1411 states that the Treasury Department and the IRS considered an alternative method for determining the distributed amount of NII, in which NII would be determined class by class within each of four-tier categories under the Section 664 tax regime.

This alternative method would have created a sub-class system of NII and non-NII within each class and category of the four-tier Section 664 framework. The Preamble states, however, that “[a]lthough differentiating between net investment income and non-net investment income within each class and category might be considered more consistent with the structure created for charitable remainder trusts by section 664 and the corresponding regulations, the Treasury Department and the IRS believe that the recordkeeping and compliance burden that would be imposed on trustees by this alternative would outweigh the benefits.” The benefits, of course, would be potentially lower taxes imposed on the noncharitable beneficiaries of the CRT.67

Charitable gift annuities

Charitable gift annuities are another vehicle that can be used to avoid the immediate imposition of capital gain tax on the sale of substantially appreciated property and stretch out NII over a multiple years. Thus, similar to a CRT, a charitable gift annuity can be a useful to avoid, minimize, or defer tax on NII under Section 1411,68 as well as to produce an immediate upfront income tax deduction. A charitable gift annuity is a simple contract between a donor and a charity, whereby the charity agrees to pay a fixed annuity to a donor, his or her spouse, or a third party for life, in exchange for an irrevocable gift of cash or property. In order to provide for a gift component to the charity issuing the annuity, the rates are lower than those available from commercial insurance carriers, with the purchase of the annuity generally resulting in an immediate charitable income tax deduction of approximately 50% of the annuity purchase price.

The annuitant is generally allowed to exclude from income a predetermined portion of each annuity payment as a tax-free return of the “investment in the contract” until the amount is fully repaid. Thus, if the charitable gift annuity is funded with cash, the annuity payment consists of two components:

(1) A tax-free return of principal.
(2) Ordinary income.69

If, however, a charitable gift annuity is funded with long-term capital gain property, such as appreciated securities or real estate owned more than one year, and the donor is receiving the annuity payments, the transaction is treated as a bargain sale. Any long-term capital gain arising from the sale portion is reported by the annuitant on the installment basis over his or her expected lifetime.70 Thus, when appreciated property is transferred, and the donor is also the annuitant (or in the case of a joint and survivorship annuity, the initial annuitant), the gain resulting from the application of the bargain sale rules may be deferred and recognized over the expected term of the annuity.71 Deferring the gain does not affect the computation of the portion of each annuity payment deemed to be ordinary income. Rather, the deferral results in the partial recharacterization of the otherwise tax-free portion of each annuity payment during the expected annuity term as capital gain income.

Although the annuity payments are considered NII (other than the portion of the annuity payment considered to be a tax-free return of principal), the charitable gift annuity levels out such income over the annuity period. If the donor is the annuitant, any capital gain inherent in property used to fund the charitable gift annuity is similarly leveled out over the period. Thus, as in the case of a CRT, depending on the annuitant's NII and AGI, the purchase of a charitable gift annuity in exchange for appreciated property may eliminate or reduce the Section 1411 tax or, at a minimum, defer the imposition of such tax.

Charitable lead trusts

A charitable lead trust (CLT), which can take the form of a charitable lead annuity trust (CLAT) or a charitable lead unitrust (CLUT), is a powerful and increasingly popular estate planning tool that, consistent with other types of “split-interest” vehicles, allows an individual to provide benefits to both charitable and noncharitable beneficiaries. A CLT is an irrevocable trust that provides a current benefit to charity, either in the form of a guaranteed annual annuity payment (for CLATs) or unitrust payment (for CLUTs), for a period known as the “lead term,” which can be a specified number of years or the life or lives of certain individuals. On the termination of the lead term, the remaining assets in the CLT pass to noncharitable beneficiaries, typically family members of the settlor or a trust for their benefit. Thus, at the creation of a CLT, two gifts are made by the settlor:

(1) A gift of the annuity or unitrust interest to charity.
(2) A gift of the remainder interest to noncharitable beneficiaries.

A CLT is basically the opposite of a CRT, which provides payments to noncharitable beneficiaries during an initial term, followed by a payment to charity at the end of such term. If the CLT conforms to the requirements of the Code, a charitable gift or estate tax deduction is available for the present value (determined using the Section 7520 rate) of the stream of annuity or unitrust payments payable to the charity over the lead term. This gift or estate tax charitable deduction offers a significant benefit because the taxable gift or the amount subject to estate tax equals the amount transferred to the CLT less the available charitable deduction. This can potentially result in substantial wealth being transferred to noncharitable beneficiaries on the termination of the lead term at little or no gift or estate tax cost.

Because of the relatively nominal Section 7520 interest rate environment, the “zeroed-out CLAT” that produces no taxable gift on its creation can be particularly advantageous. Unless certain powers are retained by the settlor that would trigger Section 2036 or 2038, the property transferred to an inter vivos CLT and all appreciation are not included in the donor's gross estate.72

Grantor versus nongrantor CLT. In addition to offering a gift or estate tax charitable deduction, a CLT created during life can be structured to provide an income tax charitable deduction to the settlor. This is possible, however, only if the CLT is a “grantor trust” for income tax purposes, which can be accomplished where a provision in the trust document triggers the grantor trust rules. Although an upfront income tax charitable deduction is available, there is a price to pay for this benefit. The grantor trust status of the CLT causes the settlor to recognize all the taxable income of the trust during the lead term, without any further charitable income tax deduction for the annual payments from the trust to charity. In effect, therefore, the upfront income tax charitable deduction is recaptured over time through the recognition of the taxable income earned by the CLT. For this reason, most inter vivos CLTs are structured as nongrantor trusts, in which case it is imperative that the CLT trust form not inadvertently contain any grantor trust provision.

In a nongrantor trust situation, the CLT is treated as a complex trust that is taxable as a separate entity with its own tax identification number under the provisions of Subchapter J of the Code. The settlor of a nongrantor CLT neither obtains an income tax charitable deduction (either upon the funding of the trust or at any time thereafter) nor recognizes any taxable income earned by the trust. Instead, each year, the CLT recognizes the taxable income earned by the trust and is also entitled to an income tax charitable deduction under Section 642(c)(1) (in lieu of the charitable income tax deduction otherwise available under Section 170(a)) for the annuity or unitrust amount paid to charity each year.

Thus, although a nongrantor CLT is not exempt from income tax, it may ultimately be the equivalent of a tax-exempt entity by virtue of the income tax charitable deduction available during the lead term. Moreover, the class of permissible charitable recipients for obtaining a deduction under Section 642(c)(1) is broader than the class of such recipients under Section 170(a), so that, for example, an income tax charitable deduction is available for a contribution to a foreign charity under Section 642(c)(1) by a nongrantor CLT, whereas no such deduction is available to an individual under Section 170(a) for a contribution to a foreign charity.

Section 1411 and the grantor CLT. A grantor CLT itself is not subject to Section 1411.73 However, consistent with the grantor trust rules, any NII earned by the trust is taxable to the settlor, which is not offset to any extent by the annuity or unitrust payments made to charity from the CLT. As a result, a grantor CLT is not particularly useful in planning for the Section 1411 tax.

Section 1411 and the non-grantor CLT. Although not specifically addressed within Section 1411 or its proposed regulations,74 non-grantor CLTs are subject to the 3.8% tax under Section 1411. Consistent with the treatment of a taxable trust, a CLT is allowed a deduction for that portion of its NII that is allocated to amounts allowable as a charitable deduction under Section 642(c).75 As a result, the Section 642(c) charitable deduction available to a CLT effectively shifts NII away from the CLT (and, therefore, reduces its undistributed NII) and into the hands of a tax-exempt beneficiary that is not subject to the Section 1411 tax.

As a taxable trust, if a CLT has both NII and excluded income, the Section 642(c) deduction must be allocated between the NII, so that a proportionate amount of the CLT's NII is considered distributed to the charitable beneficiary.76 Because the annuity or unitrust payment to charity by a CLT reduces its NII, thereby minimizing the Section 1411 tax, more assets are available in the CLT to be distributed to the noncharitable remainder beneficiaries of the trust. Thus, unlike a grantor CLT, a non-grantor CLT can be effective in planning for the Section 1411 tax, although it is important to keep in mind that any undistributed NII of a non-grantor CLT is subject to tax under Section 1411 and the relatively nominal AGI threshold applicable to trusts.

Trusts distributing gross income to charity

Because a charitable contribution by a trust under Section 642(c) can effectively shift NII to a charity, it reduces the Section 1411 tax that would otherwise be imposed on the trust. As a result, from a Section 1411 tax perspective, it is advantageous for an individual to fund charitable contributions from a trust as opposed to making direct charitable contributions.77 Thus, in addition to an ability of a trust to shift NII into the hands of individual beneficiaries who may not be subject to the Section 1411 tax because of the higher Section 1411 thresholds applicable to individuals, the Section 642(c) charitable income tax deduction allows a trust to shift NII to charitable entities that are exempt from the Section 1411 tax. As discussed above, however, a Section 642(c) deduction is not available unless the trust document specifically provides for the distributions of gross income of the trust to charity, which include discretionary distributions to charity by the trustee.

Outright gifts to charity

A charitable contribution of NII-producing property to a tax-exempt organization described in Section 501(c)(3) 78 shifts the NII associated with such property to the donee charity, thereby exempting such NII from tax under Section 1411.79 Donors wishing to retain control over their charitable contributions (rather than making an unrestricted gift),80 which is often the case,81 can make the contribution to a donor's private foundation or a donor-advised fund maintained by a public charity with respect to which the donor is an advisor. In this situation, the donor can obtain a current income tax deduction,82 shift NII to a tax-exempt charity, and use the contributed property and its investment income, or the proceeds realized on a sale of the property, to further his or her ongoing philanthropic goals and objectives, including by directing distributions over time to other charitable organizations.

A private foundation, but not a donor-advised fund, is subject to a special excise tax on NII under Section 4940. Consequently, the investment income attributable to contributed property subjects the foundation to either a 2% or 1% tax,83 thereby reducing the benefit otherwise realized by avoiding the 3.8% tax under Section 1411 by contributing the property to a private foundation.

As an alternative to contributing NII-producing property to a private foundation or donor-advised fund, such property can be contributed to a public charity (such as a university or hospital) that has established a restricted endowment fund for a specified purpose. Although the donor cannot retain ongoing control over the endowment, 84 the funds can be earmarked for specified purposes as initially determined by the donor. Again, the contribution will produce a current income tax deduction and shift NII into the hands of a tax-exempt entity not subject to tax under Section 1411.

Nonexempt charitable trusts under Section 4947(a)(1)

Because a trust “all of the unexpired interests in which are devoted to one or more of the purposes described in section 170(c)(2)(B)” 85 is exempt from tax under Section 1411,86 a Section 4947(a)(1) nonexempt charitable trust is not subject to the 3.8% tax on NII.87 Although nonexempt charitable trusts are not exempt from income tax (because they have not applied for tax-exempt status under Section 501(c)(3)), they may be essentially the equivalent of Section 501(c)(3) tax-exempt status by virtue of the charitable income tax deduction under Section 642(c) generally available to such trusts. They are also allowed to receive contributions that are deductible by the donors for income, gift, and estate tax purposes.

Unlike a Section 501(c)(3) tax-exempt organization, there is no requirement that such trusts notify the IRS that they wish to be described in Section 4947(a)(1). To prevent nonexempt charitable trusts from being used to escape the restrictions and limitations imposed on Section 501(c)(3) organizations (particularly those imposed on private foundations) by simply failing to apply for tax-exempt status, Section 4947(a)(1) specifically provides that a nonexempt charitable trust described in that section “shall be treated as an organization described in section 501(c)(3).” As a result, a Section 4947(a)(1) nonexempt charitable trust is subject to the same requirements and restrictions as are imposed on private foundations, including the Section 4940 excise tax on net investment income as defined under Section 4940(c), unless the trust can qualify as a supporting organization under Section 509(a)(3) (and therefore not be considered a private foundation).

Although a Section 4947(a)(1) trust may automatically arise under a variety of circumstance,88 intentionally creating a Section 4947(a)(1) status may be advantageous where the trust is intended solely to make distributions to charitable beneficiaries (as opposed to engaging in programmatic or other activities) because (1) no IRS determination letter is needed in order for deductions to be allowed for charitable contributions to the trust89 and (2) the trust is generally eligible for an unlimited charitable income tax deduction under Section 642(c) for distributions of gross income made to other charities, potentially making it the equivalent of a tax-exempt entity under Section 501(c)(3). Similar to a private foundation and donor-advised fund, a donor to a Section 4947(a)(1) trust may, by serving as trustee, retain control over the contributions to the trust, obtain a current income tax deduction, shift NII to a tax-exempt charity, and use the contributed property and its investment income, or the proceeds realized on a sale of the property, to further ongoing philanthropic goals.

A Section 4947(a)(1) nonexempt charitable trust is not entitled to a permanent set-aside deduction under Section 642(c)(2) for gross income that is set aside for future distribution to charity (as opposed to a current distribution that is deductible under Section 642(c)(1)).90 As a result, such income is currently subject to income tax. Interestingly, however, a Section 4947(a)(1) nonexempt charitable trust is exempt from the Section 1411 tax on NII in all events, regardless of whether the income is currently distributed.91 In effect, therefore, a Section 4947(a)(1) nonexempt charitable trust is entitled to a permanent set-aside deduction for its NII. Unless the trust can qualify as a public charity, such as a Section 509(a)(3) supporting organization, it is, however, subject to the Section 4940 excise tax on investment income of 2% or, if it qualifies for the reduction, a 1% tax, on its NII.

Conclusion

Although the charitable income tax deduction does not reduce an individual's tax on NII under Section 1411, charitable planning vehicles can still be used to mitigate the impact of this tax. These vehicles should, of course, be used only if they are consistent with the philanthropic goals and objectives of the individual. Because they can also result in favorable income, estate, and gift tax consequences, these charitable planning vehicles can provide excellent tax planning opportunities to reduce the overall tax burden of a taxpayer.

About the Author

Richard L. Fox, Esq. is a partner in the Philadelphia-based law firm of Buchanan Ingersoll & Rooney. He concentrates his practice in the areas of charitable giving, private foundations, tax-exempt organizations, estate planning, trusts and estates, and family planning.  Mr. Fox is the author of the treatise, Charitable Giving; Taxation, Planning and Strategies, a Warren, Gorham and Lamont publication, writes a national bulletin charitable giving, and writes and speaks frequently on issues pertaining to nonprofit organizations, estate planning and philanthropy.  He is a member of the advisory board of the Estate Planning Journal and BNA Tax Management and is a commentator for Leimberg Information Services, Inc.  He is also a member of the American College Chartered Advisor in Philanthropy Board of Advisors, where he previously headed the Chartered Advisor in Philanthropy Program as the Sallie B. and William B. Wallace Chair in Philanthropy, is a member of the Planned Giving Committee of Temple University. Mr. Fox, who holds an LL.M. degree in taxation from New York University School of Law, is a frequent contributor to the Estate Planning Journal. He was recently named by Worth Magazine as one of the Top 100 Attorneys in the country representing affluent families and individuals, including in the areas of estate planning, private foundations and philanthropy, as well as a Pennsylvania Super Lawyer in these areas.  He was also recently named a top wealth management attorney based on client satisfaction by Philadelphia Magazine. Mr. Fox can be reached at (215) 575-7163 and richard.fox@bipc.com.


Footnotes

See, e.g., Pear, “New Taxes to Take Effect to Fund Health Care Law,” N.Y. Times, 12/8/201); Saunders, “Are You Ready for the New Investment Tax,” Wall St. J., 4/27/2013; Rosen, “Planning Ahead, With An Eye on Tax Changes,” N.Y. Times, 2/9/2013; Seago, Orbach, and Schnee, “Working With the Unearned Income Medicare Tax,” 118 J. Tax'n 108 (March 2013); Blattmachr, Gans, and Zeydel, “Imposition of the 3.8% Medicare Tax on Estates and Trusts,” 40 EPTL 3 (April 2013); Saret, “The 3.8-Percent Medicare Contribution Tax,” 91 Taxes 27 (January 2013).

2 Section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010 (Pub. L. 111-152, 3/30/2010) added Section 1411 to a new Chapter 2A (“Unearned Income Medicare Contribution”) of Subtitle A (“Income Taxes”) of the Internal Revenue Code effective for tax years beginning after 2012.

3 The threshold for individuals is actually stated in term of “modified AGI.” Section 1411(e) uses the term “modified AGI” in the case of an individual. Section 1411(d) defines modified AGI as a taxpayer's AGI increased by the excess of (1) the amount excluded from gross income under Section 911(a)(1) over (2) any deductions (taken into account in computing AGI) or exclusions disallowed under Section 911(d)(6) with respect to the amount excluded from gross income under Section 911(a)(1). Thus, a taxpayer's “modified AGI” differs from “AGI” only if the taxpayer has a tax home in a foreign country and uses the foreign earned income exclusion. For purposes of this article, an individual's modified AGI is assumed to be the same as his or her AGI. Note also that the Section 1411 tax does not apply to a nonresident alien. Section 1411(e)(1).

4 AGI for individuals is defined in Section 62(a), and AGI for estates and trusts is defined in Section 67(e).

5 Pub. L. 112-240, 1/2/2013.

6 As discussed below, however, the charitable income tax deduction available to an estate or trust under Section 642(c) does reduce the NII of the estate or trust. Thus, from a Section 1411 perspective, the fact that a charitable income tax deduction is available to an estate or trust, but not to an individual, may provide an estate or trust with an advantage over an individual.

7 Giving by Americans to charity consistently amounts to approximately $300 billion each year. The highly publicized “Giving Pledge” campaign created by Warren Buffett and Bill Gates in June 2010 to spur philanthropy by very affluent people has now grown to over 100, all of them billionaires, including individuals within and without the United States. Members who sign the pledge agree to donate at least half of their fortunes during their lifetimes or on their deaths. A listing of those taking the pledge and personal letters by many of these individuals outlining their charitable commitment are available at http://www.givingpledge.org.

8 Proposed regulations under Section 1411(REG-130507-11) were issued on 11/30/2012. Although the Section 1411 tax is imposed for tax years beginning on or after 1/1/2013, the effective date of the proposed regulations is 1/1/2014, one year after the effective date of the Section 1411 tax. Notwithstanding, taxpayers may rely on the proposed regulations for compliance purposes until the effective date of the final regulations issued under Section 1411. In conjunction with the issuance of the proposed regulations, the IRS also issued a series of frequently asked questions under Section 1411 on 12/3/2012, which can be found at www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs.

9 Section 1411(e) uses the term “modified AGI” in the case of an individual. See note 3, supra.

10 See Sections 1411(a)(1) and (a)(2). The tax does not apply to nonresident aliens. Section 1411(e)(1). In addition, as addressed further below, the tax also does not apply to various trusts. Section 1411(e)(2); Prop. Reg. 1.1411-3(b).

11 Section 1411(a)(1).

12 Section 1411(b). Note that these threshold amounts are not indexed for inflation, but are fixed. Because the threshold AGI is $200,000 for single taxpayers and $250,000 for married taxpayers filing jointly (or $125,000 for married taxpayers filing separately), there is a marriage penalty implicit in the Section 1411 tax regime.

13 Section 1411(c)(1)(A) defines NII to include income from trades or businesses described in Section 1411(c)(2). A trade or business is described in Section 1411(c)(2) and its income (including both business and nonbusiness income) is considered NII if such trade or business is (1) a passive activity (within the meaning of Section 469) with respect to the taxpayer, or (2) a trade or business of trading in financial instruments or commodities (as defined in Section 475(e)(2)). Note that the determination of whether a trust is considered to materially participate in a trade or business, so that the trade or business is not considered a passive activity with respect to the trust, is currently unclear. Although regulations contain rules describing material participation for individual taxpayers, no regulations have been promulgated for trusts or estates in this area. In Mattie K. Carter Trust, 91 AFTR 2d 2003-1946, 2003-1 USTC ¶50418, 256 F Supp 2d 536 (DC Tex., 2003), contrary to the IRS position, the court held that the activities of the agents of the trustee are to be taken into account in determining whether the trust is materially participating in a trade or business. In TAM 200733023, the IRS ruled that only the activities of the trustees of a trust are to be considered for this purpose. See also Ltr. Rul. 201029014, where the IRS ruled, consistent with its position in the Mattie K. Carter Trust case, that material participation of a trust could be determined based only on the activities of the trustee.

14 Section 1411(c)(1). These deductions may include such expenses as investment advisory fees, investment interest expense, expenses incurred in connection with the production of rental and royalty income, and state and local income taxes imposed on NII.

15 The term “excluded income” under Section 1411 is specifically defined at Prop. Reg. 1.1411-3(e)(5), which excludes such items as tax-exempt municipal bond interest, wages, income from an activity in which the taxpayer is actively involved, and distributions from IRAs or qualified retirement plans.

16 An estate or trust's AGI is computed in the same way as an individual's AGI, except that it is further reduced by deductions for (1) costs paid or incurred in connection with the administration of the trust that would not have been incurred if the property were not held in trust; (2) the deduction for personal exemptions under Section 642(b); and (3) the deduction for estate or trust income required to be distributed currently under Section 651 and for other amounts properly paid or credited or required to be distributed under Section 661. Section 67(e).

17 For an article discussing possible planning, see Morrow, “Avoid the 3.8 Percent Medicare Surtax,” 151 Tr. & Est. 32 (December 2012). For a complete analysis of the application of the Section 1411 tax to estates and trusts, see Blattmachr, Gans, and Zeydel, supra note 1.

18 See Blattmachr, Gans, and Zeydel, supra note 1; Saret, supra note 1.

19 In computing its taxable income, an estate and trust includes the same items of gross income as an individual and is allowed most of the normal deductions allowed to individuals. However, in order to allocate taxable income among the estate or trust and their beneficiaries, an estate and trust is entitled to a special income tax deduction for distributions to their beneficiaries, which then becomes taxable to the beneficiaries. An income tax concept unique to estates and trusts, known as DNI, determines the maximum amount that can be deducted by an estate or trust resulting from distributions to beneficiaries and, in turn, the maximum amount that can be taxed to the beneficiaries. DNI, which is defined in Section 643, generally means the taxable income of an estate or trust (without regard to any DNI deduction), increased by its personal exemptions, tax-exempt income, and capital gains allocated to corpus and not distributed to beneficiaries.

20 The DNI deductions under Section 651 and 661 are for simple and complex trusts, respectively.

21 Prop. Regs. 1.1411-3(e)(2) and (3).

22 Sections 652(a) and 662(a) (distributions to beneficiaries taxable to the extent of DNI); Reg. 1.1411-3(e)(3)(ii) (distributions of NII retain their character as NII for purposes of computing the NII of the recipient beneficiary who is subject to tax under Section 1411).

23 See Reg. 1.643(a)-3(a), stating that “gains from the sale or exchange of capital assets are ordinarily excluded from distributable net income,” and Reg. 1.643(a)-3(b) indicating the limited circumstances under which capital gain may be included in DNI.

24 See Reg. 1.411-3(e)(i) (deduction from NII allowed for distributions to beneficiaries is limited to the lesser of the amount deductible by the estate or trust under Section 651 or 661, as applicable, or the NII of the estate or trust).

25 Regs. 1.661(b)-1 and 1.662(b)-1. This rule applies in the absence of specific provisions in the governing instrument for the allocation of different classes of income, or unless local law requires such an allocation.

26 Prop. Reg. 1.1411-3(e)(3)(i).

27 Prop. Reg. 1.1411-3(e)(3)(ii).

28 Note that Examples 1 and 2 of Prop. Reg. 1.1411-3(f) provide that DNI does not include that portion of an IRA distribution allocated to principal of the trust. To the contrary, the entire portion of the IRA distribution should have been included in DNI because it is irrelevant under Section 643(a) (which defines DNI) whether an item of income is allocated to income or principal for fiduciary accounting purposes.

29 Section 170(a) is applicable to charitable contributions made by individuals and corporations, but not to estates and trusts.

30 For a complete discussion of Section 642(c), see Fox, Charitable Giving: Taxation, Planning and Strategies, Second Edition (Thomson Reuters/WG&L), Chapter 12.

31 Thus, unlike a charitable contribution deduction under Section 170, a charitable deduction under Section 642(c) is not subject to a percentage-of-AGI limitation. Where, for instance, an estate or trust pays 100% of its income to charity during a tax year, it may deduct the entire amount as a charitable contribution provided, however, the requirements of Section 642(c) are otherwise met. Because of availability of this unlimited deduction, unlike in the case of individuals, Section 642(c) has no provision dealing with the carryover of excess charitable contributions.

32 Prop. Reg. 1.1411-3(e)(4). Note that nothing in this regulation indicates that a permanent set-aside deduction under Section 642(c)(2), discussed below, would not reduce the NII of an estate or trust.

33 See, e.g., Crestar Bank, 47 F2d 670 (DC Va., 1999).

34 Note, however, that Section 681(a) provides that in computing the deduction allowable under Section 642(c) to a trust (but not an estate), no amount otherwise allowable as a deduction under Section 642(c) shall be allowed as a deduction with respect to income of the tax year that is allocable to “unrelated business income.”

35 Reg. 1.642(c)-1(a)(1); Old Colony Trust Co., 18 AFTR 733, 87 F2d 131, 37-1 USTC ¶9017 (CA-1, 1936).

36 See, e.g., Crestar Bank, supra note 33.

37 Love Charitable Foundation, 52 AFTR 2d 83-5487, 710 F2d 1316, 83-2 USTC ¶9441 (CA-8, 1983).

38 See Old Colony Trust Co., 19 AFTR 489, 301 US 379, 81 L Ed 1169, 37-1 USTC ¶9301, 1937-1 CB 227 (1937), where the Supreme Court stated that the governing instrument need not “definitively direct” the charitable contribution in order to support a deduction under Section 642(c), as long as it specifically authorizes a payment to charity. In effect, a deduction is allowed where, in paying income to charity, the executor or trustee is responding to an “implied invitation” of the governing document. GCM 37076.

39 For a complete discussion of the Section 642(c) deduction, see Fox, “Planning and Strategies for Nonexempt Charitable Trusts—Parts 1 and 2,” Part 1: 20 Tax'n of Exempts 18 (May/June 2009); Part 2: 21 Tax'n of Exempts 15 (July/August 2009).

40 This is the case because the starting point for the calculation of DNI under Section 643(a) is the taxable income of an estate or trust, which is reduced by a charitable income tax deduction under Section 642(c).

41 The apportionment rule applies unless the terms of the governing instrument specifically allocate different classes of income to a charity or local law requires such a specific allocation. For any specific allocation to be respected, however, it must have economic effect independent of income. Reg. 1.642(c)-3(b)(2).

42 Reg. 1.662(b)-2.

43 See Reg. 1.662(b)-2.

44 Reg. 1.662(b)-2, Example 1. Because all of its NII is shifted to individual beneficiary A and charity X, the trust in this example has no undistributed NII and is not subject to tax under Section 1411.

45 Prop. Reg. 1.1411-3(e)(4). Note that there is nothing in this regulation that indicates that a permanent set-aside deduction under Section 642(c) would not reduce the NII of an estate or trust.

46 The apportionment rule applies unless the terms of the governing instrument specifically allocate different classes of income to a charity or local law requires such a specific allocation. Reg. 1.662(b)-1. For any specific allocation to be respected, however, it must have economic effect independent of income tax consequences. Reg. 1.642(c)-3.

47 Prop. Regs. 1.1411-3(a)(1)(i) and -3(b).

48 Prop. Reg. 1.1411-3(b)(1).

49 Prop. Reg. 1.1411-3(b)(2).

50 A Section 501(c)(3) tax-exempt organization that is not in trust form is not subject to Section 1411 since Section 1411 applies to only individuals, estate, and trusts. Under Prop. Reg. 1.1441-3(b)(2), a trust that is described in Section 501(c)(3) (and therefore exempt from tax under Section 501) is exempt from the Section 1411 tax.

51 Prop. Reg. 1.1411-3(b)(3).

52 A CRT is wholly exempt from income tax under Section 664(c)(1). Note, however, that a CRT is subject to a 100% tax on its unrelated business taxable income (UBTI). Section 664(c)(2)(A). Even if a CRT has UBTI, it is still wholly exempt from tax under Section 1411.

53 The payment to noncharitable beneficiaries must be formulated in terms of either an annuity or unitrust payment interest, generally requiring a 5% minimum annuity or unitrust payout and a 50% maximum payout. Sections 664(d)(1) and (2).

54 For a complete discussion of CRTs, see Fox, supra note 30, Chapter 25; see also Fox, “A Guide to the IRS Sample Charitable Remainder Trust Forms,” 33 ETPL 13 (January 2006).

55 The exception to this rule is where encumbered appreciated property is transferred to a CRT. That situation is treated like a bargain sale, thereby triggering a gain on the contribution. This is the case because the debt is treated as an amount realized by the settlor, even if the transferee charity does not agree to assume or pay the debt. Reg. 1.1001-2(a)(3); Ltr Ruls. 7808016 and 7903075.

56 Section 664(c)(1).

57 Reg. 1.664-1(d)(1)(ii). Thus, these ordering rules generally provide for the least desirable types of income to be distributed first, as distributions of annuity and unitrust payments are deemed to be distributed in a “worst-in, first-out” order.

58 Section 664(b); Reg. 1.664-1(d)(1)(ii)(a).

59 Section 664(b); Reg. 1.664-1(d)(1)(ii)(b).

60 For example, within the ordinary income class, interest income, which is taxed at a higher federal income tax rate than “qualified dividend income” (as defined in Section 1(h)(11)(B)), is deemed to be distributed prior to qualified dividend income. Similarly, within the capital gain income class, short-term capital gain is deemed distributed prior to long-term capital gain.

61 Reg. 1.664-1(d)(1)(ii)(a).

62 Prop. Reg. 1.1411-3(b)(3).

63 Payments of annuity or unitrust payments may be made for either the life or lives of a named individual or individuals or for a term not exceeding 20 years. Section 664(d)(1)(A).

64 Prop. Reg. 1.1411-3(c)(2)(ii).

65 Prop. Reg. 1.1411-3(c)(2)(iii). Thus, any NII realized by a CRT in a tax year beginning prior to 2013 is never subject to tax under Section 1411, no matter when it is considered distributed to the noncharitable beneficiaries.

66 The Preamble to the proposed regulations states that this “classification of income as net investment income or non-net investment income is separate from, and in addition to, the four tiers under section 664(b), which continue to apply.”

67 In a letter dated 5/8/2013, commenting on the proposed regulations, Jeffrey A. Porter of the AICPA, after stating the “[w]e do not understand why the statutory rules and the current regulatory rules are not followed with respect to NII in the proposed regulations,” further stated that various types of NII should be treated as separate classes of income within each of the four-tier categories of income under the CRT regulations and that “the normal rules should apply to determine which category of income and which class of income within that category is being distributed to the annuity or unitrust recipient.”

68 Whenever a CRAT is being considered, consideration should be given to using a charitable gift annuity instead. The same charitable deduction is available in either case; however, the charitable gift annuity is not subject to the 5%-probability-of-exhaustion test that applies to a CRAT and is subject to substantially lesser requirements as to governing instruments and administration. Where there are doubts concerning the charity's ability to make the annuity payments, however, a CRAT is preferable. Also, gift annuities for a term of years and for more than two lives are not permitted, whereas such payout schemes, as well as a multitude of others, are permitted in the context of a CRAT.

69 Once the “investment in the contract” has been fully recovered, the entire annuity payment is ordinary income.

70 Because the sale is characterized as a bargain sale, the adjusted tax basis of the property is allocated between the gift portion and the sale portion.

71 Reg. 1.1011-2(a)(4)(ii).

72 For a detailed analysis of a CLT and related tax issues, see Fox, “A Guide to the IRS Sample Charitable Lead Trust Forms, Parts 1 and 2,” Part 1: 36 ETPL 7 (Apr. 2009); Part 2: 36 ETPL 13 (May 2009).

73 Reg. 1.1411-3(b)(5).

74 Note, however, that Reg. 1.1411-3(b), which delineates certain trusts that “are not subject to the tax imposed by section 1411,” does not include a CLT.

75 Prop. Reg. 1.1411-3(e)(4).

76 Prop. Reg. 1.1411-3(e).

77 Of course, the trust must not be a grantor trust; otherwise, the NII shifting benefit of the trust is lost.

78 Although any organization that is tax-exempt under Section 501(c) is exempt from the Section 1411 tax, only those organizations described in Section 501(c)(3), which are by far the most popular form of Section 501(c) entities, are eligible to receive tax-deductible charitable contributions.

79 Section 501(c)(3) tax-exempt organizations are not subject to tax under Section 1411, as the tax applies to only individuals, estates, and trusts. Trusts described in Section 501(c)(3) are specifically exempt from Section 1411 under Prop. Reg. 1.1411-3(b)(2).

80 A charitable contribution deduction generally occurs only when the donor relinquishes dominion and control over the contributed property. See, e.g., Pauley, 29 AFTR 2d 72-1025, 459 F2d 624, 72-1 USTC ¶9396 (CA-9, 1972); Jordan, 23 AFTR 2d 69-1093, 297 F Supp 1326, 69-1 USTC ¶9376 (DC Okla., 1969); Burke, 61 AFTR 2d 88-1027, 88-1 USTC ¶9291 (DC Conn., 1988). Maintaining control through a private foundation or donor-advised fund, however, does not affect the availability of a charitable contribution deduction. See, e.g., In Foxworthy, Inc., TC Memo 2009-203, RIA TC Memo ¶2009-203, 98 CCH TCM 177 . This rule, however, should be contrasted from a situation where a donor to a charity, whether a private foundation or public charity, continues to control and use a contribution for his or her own personal benefit. In this situation, where dominion and control by the donor is exercisable against the donee, such that the donor retains the power to direct the disposition or manner of enjoyment of the gift for his or her own personal benefit, a charitable income tax deduction is not available. See, e.g., Pauley, id.

81 Donors often do not simply want to make an unconditional contribution of money or property to a charity, but instead desire to earmark the contribution for a specified use or purpose and impose other conditions on the contribution. See Fox, “Planning for Donor Control and Other Strings Attached to Charitable Contributions,” 30 ETPL 441 (September 2003). A recent study, entitled “Next-Generation Philanthropy: Changing the World,” commissioned by Forbes magazine and Credit Suisse, found that the wealthier the donor, the less likely a contribution will be in the form of an unrestricted gift.

82 Note that in the case of a contribution of appreciated property to a private foundation, a fair market value deduction is available only if the property is qualified appreciated stock, as defined in Section 170(e)(5)(B). Otherwise, the deduction is limited to the income tax basis under Section 170(e)(1)(B)(ii). Contributions of qualified appreciated stock to a private foundation are also subject to more restrictive percentage limitations based on the donor's AGI. Section 170(b)(1)(B).

83 The general rule under Section 4940(a) is a 2% tax on NII, subject to a reduction to 1% under Section 4940(e) if certain distribution requirements are met.

84 Certain exceptions to this general rule apply where the donor retains only an insubstantial right with respect to the contributed property. See, e.g., Ltr. Rul. 9303007 (contribution of artwork to museum subject to the retention of certain display rights did not prevent contribution from being complete); Ltr. Ruls. 200445023 and 200445024 (involving what is known as a “donor managed investment account,” where the contribution was complete, notwithstanding the donor retained a limited power to manage the contributed assets during a ten-year period); Ltr. Rul. 8152072 (similarly ruling that a contribution was complete notwithstanding that the donor retained the continuing investment control maintained by the donor).

85 As in the case of Section 501(c)(3), such purposes include religious, charitable, scientific, literary, or educational.

86 Prop. Reg. 1.1411-3(b)(1).

87 A trust is only described in Section 4947(a)(1) where “all of the unexpired interests in which are devoted to one or more purposes described in section 170(c)(2)(B).” Note that for a trust to be subject to Section 4947(a)(1), a charitable deduction must have been allowed for contributions to the trust, and the trust must not have received an IRS determination letter classifying it as an organization described under Section 501(c)(3). For a complete discussion of a Section 4947(a)(1) wholly-charitable nonexempt trust, see Fox, “Planning and Strategies for Nonexempt Charitable Trust—Part 1 and 2,” supra note 39.

88 For example, such a trust may arise when an estate that is required to distribute all of its net assets in trust, or free of trust, to charitable beneficiaries is considered a nonexempt charitable trust under Section 4947(a)(1) when the estate is considered terminated for federal income tax purposes. Similarly, where a CRT is required to distribute its remaining assets to the charitable remainder beneficiary (i.e., after the expiration of the noncharitable interests), the CRT is considered a nonexempt charitable trust under Section 4947(a)(1) when it is considered terminated for federal income tax purposes.

89 See, e.g., Ltr. Rul. 200009058, 200302005, 200235035, 200226012, and 9234033. Because no IRS determination is required, no Form 1023 (“Application for Recognition of Exemption”) is required to be filed with the IRS.

90 Such income may, for example, be capital gain income realized by the trust that is not currently distributed for charitable purposes. The permanent set-aside deduction available under Section 642(c)(2) is generally available for only trusts created on or before 10/9/1969.

91 This is the case because under Prop. Reg. 1.1411-3(b)(1), such a trust is wholly exempt from Section 1411.

© 2013 Thomson Reuters/RIA. Used by permission. All rights reserved.

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