Estate and Income Tax Charitable Deduction Denied

Estate and Income Tax Charitable Deduction Denied

News story posted in Field Service Advice on 26 June 1999| comments
audience: National Publication | last updated: 18 May 2011
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Summary

In apparently related FSA's (FSA 1999-1193 and FSA 1999-1172), the Service (i) disallowed an income tax deduction for a payment from the estate's income to an entity which was not a qualified charity, and (ii) held that the estate does not qualify for a charitable deduction because (A) there was more than a negligible possibility that the bequest will pass to a nonqualifying entity, and (B) section 2055(e) of the Code disallows a deduction for a split interest in property, where such property is bequeathed to a qualifying charity and a nonqualifying entity received income in the property, not in a qualifying split interest format.

FSA 1999-1193 and FSA 1999-1172

PGDC SUMMARY:

In FSA 1999-1193, an estate claimed an income tax deduction under section 642(c)(2) of the Code for a payment from the estate's income to an entity which was not a qualified charity under section 501(c)(3) of the Code. The estate claims that the money was transferred with the provision that it could only be used for charitable purposes. Holding that the estate is not entitled to the deduction, the Service, in part, cited a Ninth Circuit Court of Appeals case which held that funds must be paid or permanently set aside for specific charities in order to qualify for a deduction and that the ultimate destination of the funds is not determinative.

In FSA 1999-1172, the Service further elaborated on the facts and informed us that this distribution of income to a nonqualifying entity, which was specifically named in the decedent's will, was contingent upon the entity qualifying as a charitable entity, and failing qualification, the bequest was to pass to alternative charitable beneficiaries. The nonqualifying entity had filed an Application for Exemption, but the IRS denied it. Stating that this partial payment to a nonqualifying entity indicated that there was more than a negligible possibility that the bequest will pass to a nonqualifying entity, the Service held that the estate does not qualify for a charitable deduction under section 2055(a) of the Code. In fact, the estate had represented to the IRS that such a payment would not be made. Additionally, the Service disallowed the estate tax deduction for property which was bequeathed to a qualifying charity because section 2055(e)(2) of the Code disallows a split interest gift. In this case, property was bequeathed to a qualifying charity but a nonqualifying entity received income from the property. Such a structure did not qualify as a charitable remainder trust or a pooled income fund.

POINTS TO PONDER:

Could a reformation save the day? Would a bequest to a newly-created charity contingent upon its receipt of a favorable determination letter ordinarily disallow an estate tax charitable deduction?

FULL TEXT:

FSA 1999-1193:

INTERNAL REVENUE SERVICE
MEMORANDUM
* * *
CC:FS:P&SI

date: * * *
to: District Counsel, * * *
CC: * * *
Attn: * * *
from: Assistant Chief Counsel (Field Service)
CC: FS
subject: * * *

I.R.C. section 642(c)

This is in response to your request for Field Service Advice dated * * *.

ISSUE

Does the "set aside" and payment of income earned by the estate to an entity which was not organized exclusively for religious or literary purposes qualify for a charitable deduction under I.R.C. section 642(c)(2)?

CONCLUSION
No.

FACTS

The issue above arose during the income tax audit of the * * * taxable year of the estate of * * * died in * * *. The audit relates to the Form 1041 filed by the estate. On its * * * Form 1041, the estate claimed a deduction under section 642(c)(2) in the amount of $* * * for amounts "set aside" for the benefit of * * * a branch of * * * founded my * * *. The money in question was transferred to * * * in * * * The attorney for the estate, in connection with the related estate tax * * * case, had claimed that no part of the estate had been transferred to * * *. She now claims that the transferred money represents income of the estate and that the trust did not distribute any corpus. Furthermore, the attorney represents that the money was transferred with the provision that it could only be used for charitable purposes.

The * * * recently held that * * * was not organized exclusively for religious or literary purposes, and hence, does not qualify as a charitable organization under section 501(c)(3). We expect * * * to appeal this decision. The Examinstion Division proposes to issue a notice of deficiency disallowing the deduction claimed on the * * * estate return on the grounds that no deduction was permitted under section 642(c).

DISCUSSION

The issue is whether money set aside and later paid to * * * qualifies for a charitable deduction. This, in turn, depends on whether * * * is a qualified charitable entity. In this regard, section 642(c)(2) generally permits a deduction for the amount of the gross income of an estate which, pursuant to the terms of the governing instrument is, during the taxable year, permanently set aside for a purpose specified in section 170(c).

Section 170(c) allows a deduction for a contribution to a corporation organized or created in the United States and organized exclusively for religious or literary purposes. In addition, section 642(c)(2) separately permits a deduction for the same purposes without limiting the deduction to contributions to U.S. entities. Thus, the contribution to * * * will generate a charitable deduction if * * * is a corporation organized and operated exclusively for religious or literary purposes, regardless of where it was created or organized.

In * * * the * * * held that * * * was not organized and operated exclusively for religious or literary purposes within the meaning of section 501(c)(3). Since * * * is not a qualified charity under section 501(c)(3), it is not a qualified charity under section 170(c). See Bob Jones University v. United States, 461 U.S. 574 (1983) (the standard for determining a charitable purpose is the same under both sections 501(c)(3) (deduction for estate tax purposes) and 170(c) (deduction for income tax purposes)). Consequently, no deduction is permitted for money set aside and later contributed to * * * under section 642(c).

The trust argues, however, that the limitation on the transfer to * * * that it be used exclusively for religious purposes, brings the contribution within section 642(c) even if * * * is not itself a qualifying organization. The trust argues that the separate clause allowing a deduction "for religious [or] literary purposes" allows the deduction based on the ultimate use of the money regardless of who the initial recipient may be. Petitioner is incorrect. The Ninth Circuit Court of Appeals, * * * has held that the money must be paid or permanently set aside for specific charities in order to qualify for a deduction. John Danz Charitable Trust v. Commissioner, 231 F.2d 673, 676 (9th Cir. 1955), aff'g, 18 T.C. 454 (1952). The court rejected an ultimate destination test. Id. /1/ Thus, a permissible deduction depends on the setting aside of income for specifically named qualifying recipients rather than on the use to which a nonqualifying recipient may put the money.

Even if an "ultimate destination" test were used, there is no assurance that * * * has or will use the contributed money exclusively for a tax exempt purpose. The * * * found that * * * deliberately hid its connection to other * * * of * * * and continually failed to cooperate with the Service during examination and discovery. * * *. Indeed, the court found that this obfuscation and lack of cooperation were * * * Id. In addition, the attorney representing the estate (who also represents * * * has already made statements in your related estate tax case which are arguably misleading. She represented that no distribution of the estate had been made to * * *. You subsequently discovered that an income interest in the estate has in fact been distributed to * * *. Thus, we can not rely on the representations of the estate or * * * as to the use of the contributions. Cf. John Danz Charitable Trust v. Commissioner, supra at 676, n. 2 (rejection of ultimate destination test reflects judicial distrust of charitable conduits which are actively engaged in commercial pursuits); cf. * * *.

Finally, the deduction should be disallowed on the basis that the income was not distributed in accordance with the will. In this regard, section 642(c)(2) permits a deduction only if, "pursuant to the terms of the governing instrument" an amount is permanently set aside for a specified charitable purpose. Under the will, * * * was not entitled to any portion of the bequest unless it first qualified as a charitable organization. The payment to * * * therefore, was not in accordance with the governing instrument. Thus, section 642(c)(2) does not permit a deduction.

Petitioner argues, however, that the money was set aside and paid in accordance with the will. Petitioner states that the will allowed the executor to pick alternative beneficiaries which in his sole discretion he determined qualified as section 501(c)(3) organizations. The executor/trustee determined in his discretion that * * * qualified as a section 501(c)(3) organization, notwithstanding that there had not yet been a final determination as to * * * status as required by the will. Thus, according to petitioner, the set aside and payment were in accordance with the will.

Under the cy pres doctrine, however, the executor/trustee could only pay the income to a qualified charity. Under this rule, where the testator has expressed a general intent that his estate pass to a qualifying charity, the will is construed to accommodate this purpose. See In re Gelatin's Estate, 16 C.A. 3d 644; 94 Cal. Reptr. 295, 296 (1971); Estate of Connolly v. Stiles, 48 Cal. App. 3d 129 (1975); Hamilton v. San Diego County, 108 Cal. 273; 41 P. 305 (1895). See also Rev. Rul. 72-442, C.B. 1972-2. Thus, the payment of income to a nonqualified entity was not in accordance with the will. Since the set aside and payment were not in accordance with the governing instrument, section 642(c)(2) does not permit a deduction.

This document may include confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the IRS, including the taxpayer(s) involved, and its use within the IRS should be limited to those with a need to review the document in relation to the subject matter or case discussed herein. This document also is tax information of the instant taxpayer which is subject to I.R.C. section 6103. Please refer any questions on the above matter to * * * at (202) * * *.

By: Daniel J. Wiles
Passthroughs & Special
Industries Branch

FOOTNOTE

/1/ Compare section 170(c) which provides that "for the purposes of this section, the term 'charitable contribution' means a contribution [to an entity] organized and operated exclusively for [specified tax exempt] purposes." (emphasis supplied)

END OF FOOTNOTE

FSA 1999-1172:

INTERNAL REVENUE SERVICE

MEMORANDUM

* * *

CC:FS:P&SI

date: * * *
to: District Counsel, * * *
CC: * * *
Attn: * * *
from: Assistant Chief Counsel (Field Service)
CC: FS
subject: * * *

I.R.C. sections 2055(a) and (e)

In a previous memorandum we recommended concession of the charitable estate deduction issue in the above case based on facts provided by your office. You have now determined that the facts as represented by petitioner may have been misleading. On this basis you have asked us to reconsider our earlier recommendation.

ISSUE

Does the distribution of income generated by the decedent's estate to a nonqualifying entity disqualify a charitable deduction for the entire bequest?

CONCLUSION

Yes. The partial payment to a nonqualifying entity indicates that there is more than a negligible possibility that a nonqualifying entity will receive the bequest. Thus, no deduction is permitted under I.R.C. section 2055(a). In addition, section 2055(e) disallows a deduction for property bequeathed to charity if a nonqualifying entity receives an income interest in the property.

FACTS

The Service issued a notice of deficiency to the estate of * * * disallowing a deduction for a charitable bequest. The executor of the estate filed a petition in Tax Court. At issue is the deductibility of a bequest to * * *, a * * * founded by the decedent. The bequest is contingent on * * * qualifying as a charitable entity which would generate a charitable deduction for the estate. The will provides that, if * * * does not qualify for a charitable deduction, the bequest will pass to another * * * of * * * which does qualify for the deduction. At least * * * other * * * of * * * currently qualify for charitable deduction. We understand that the assets of the estate are currently being held in trust pending a determination of * * * status.

The * * * recently held that * * * is not a qualifying charity. * * * We expect petitioner to appeal. Counsel for the estate has represented that no part of the estate has been distributed to * * * The trustee of the estate is willing to certify to this fact. Petitioner is also willing to enter into a stipulation that no part of the estate will be distributed to * * * or to any other nonqualifying charity if the * * * is upheld on appeal. Based on these facts, in our earlier advice dated * * * we concluded that a court would interpret the will to require, in all events, that the transfer pass to a qualifying charity. On this basis, we concluded that the charitable deduction should be allowed.

In connection with the separate income tax examination of the estate Form 1041 for a later year, however, you discovered that part of the estate has, in fact, been distributed to * * * Counsel for petitioner represents that the distribution was comprised only of income generated by the estate which was required to be distributed. * * * has further represented that the money was distributed to * * * with the limitation that it could only be used for charitable purposes.

DISCUSSION

At issue is whether the charitable deduction taken on the estate tax return was proper under section 2055 in light of the change in facts and arguably misleading representations made by petitioner. Section 2055(a) allows a charitable deduction reducing the taxable estate if a bequest is made to or for the use of a qualifying charitable organization. The bequest will not qualify for a deduction if there is more than a negligible possibility that the bequest will pass to a nonqualifying entity. See Reg. section 20.2055-2(b)(1); Rev. Rul. 70-425, 1970-2 C. B. 151 (there must be a 95% probability that the bequest will pass to a qualifying charity before a deduction is permitted). Neither the Code nor the regulations make any exceptions for a transfer to a nonqualified charity or to an individual person simply because the transfer has charitable limitations attached. See John Danz Charitable Trust v. Commissioner, 231 F. 2d 673, 676 (9th Cir. 1955), aff'g, 18 T. C. 454 (1952) (charitable deduction depends on transfer to qualified charity rather than on use to which nonqualified entity may put the money).

Under the above authority, the estate is not entitled to a charitable deduction. The * * * held that * * * does not qualify as a charitable entity. Even though the will provides for alternative charitable beneficiaries in the event that * * * does not qualify, there is no assurance that the bequest in fact will pass to any of the qualified entities. This is demonstrated by the fact that a payment has already been made to * * * even though the estate had represented that no payment had yet been made. /1/ Given, petitioner's misleading statements, petitioner cannot meet its burden of showing that there is a 95% probability that the bequest will pass to a qualified entity.

Alternatively, even if the estate could show that the remaining corpus will pass to a qualified charity, the split income interest which has already been distributed to * * * disqualifies the entire deduction under section 2055(e)(2). This section provides that, in order to qualify for a charitable deduction, an undivided portion of the decedent's entire interest in property must pass to a qualified charity. See Reg. section 20.2055-2(e)(2)(i). When an income interest passes to a noncharitable beneficiary, a limited exception permits a deduction for a remainder interest in property, but only if the property is in a charitable remainder annuity trust, a charitable remainder unitrust described in section 664, or a pooled income fund described in section 642(c)(5). Id.; Estate of Gillespie v. Commissioner, 75 T. C. 374 (1980). Cf. Levy, When Will Administration Period Distributions Turn Charitable Bequests Into Split Interests?, 11 Estate Planing 38 (1984).

Since an income interest in the property has passed to * * * and petitioner has not argued that the property is in a qualified remainder trust or pooled income fund, the bequest is not deductible under section 2055.

As a final point, even if petitioner should argue that the trust is a qualified trust, this argument would be subject to the same infirmities as the direct transfer, i.e., there is more than a five percent chance that * * * will ultimately receive the remainder. Thus, regardless of the technical elements the trust may meet, no deduction should be permitted.

This document may include confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the IRS, including the taxpayer(s) involved, and its use within the IRS should be limited to those with a need to review the document in relation to the subject matter or case discussed herein. This document also is tax information of the instant taxpayer which is subject to I.R.C. section 6103.

Please refer any questions on the above matter to * * *

By: Daniel J. Wiles
FOOTNOTE

/1/ Petitioner's attorney in the present case is the same attorney that represented * * * in the * * * In * * * the * * * found that * * * deliberately hid its connections to * * * during examination and discovery, and was generally uncooperative during examination and discovery.

END OF FOOTNOTE

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