On April 13, 2012, the IRS issued final regs providing guidance under Code Sec. 642(c) with regard to the federal tax consequences of an ordering provision in a trust, will or local law that attempts to determine the tax character of the amounts paid to a charitable beneficiary. Specifically, the regs confirm that a provision in a governing instrument or local law that specifically provides the source from which amounts are to be paid, permanently set aside, or used for a purpose specified in Code Sec. 642(c) must have economic effect independent of income tax consequences in order to be respected for federal tax purposes.
Observation. The IRS says that a chain of references in the pre-existing regs imposed the same economic effect requirement. The IRS says it made the changes to the regs to make the concept clear and easier to understand.
Background. An estate or complex trust may deduct any amount of income which, under the terms of its governing instrument, is paid for the purpose of making a charitable deduction. This deduction is in lieu of the deduction allowed by Code Sec. 170, and is allowed “without limitation” — that is, there is no deduction ceiling on the amount of charitable deduction allowed.
Reg. §1.642(c)-3 provides guidance concerning adjustments and other special rules for computing the charitable contributions deduction.
Reg. §1.643(a)-5 provides guidance concerning rules for computing the amount of tax-exempt income included in distributable net income.
A charitable lead trust (CLT) is a charitable gift of an annuity or unitrust interest followed by a noncharitable remainder interest. A gift or estate tax deduction is allowed for the present value of the charity’s interest, but a gift of the remainder interest is subject to transfer tax. The charity’s interest may be for a set number of years or for the life or lives of certain individuals living on the date the trust was created. The regs set forth the individuals who can be measuring lives. An income tax deduction is allowed only if the grantor is treated as the owner of the entire trust under the grantor trust rules.
Final Regs. The final regs clarify the pre-existing regs under Reg. §1.642(c)-3(b) and Reg. §1.643(a)-5(b).
Under the final regs, a provision in a governing instrument or local law that specifically provides as to the source out of which amounts are to be paid, permanently set aside, or used for a purpose specified in Code Sec. 642(c) must have economic effect independent of income tax consequences in order to be respected for federal tax purposes. If the economic effect rule isn’t met, income distributed for a purpose specified in Code Sec. 642(c) is deemed to consist of the same proportion of each class of the items of income as the total of each class bears to the total of all classes.
Illustration. A charitable lead annuity trust has the calendar year as its tax year, and is to pay an annuity of $10,000 annually to a Code Sec. 170(c) tax-exempt organization. A provision in the trust governing instrument provides that the $10,000 annuity should be deemed to come first from ordinary income, second from short-term capital gain, third from 50% of the unrelated business taxable income, fourth from long-term capital gain, fifth from the balance of unrelated business taxable income, sixth from tax-exempt income and seventh from principal. This provision does not have economic effect independent of tax consequences because the amount to be paid to charity is not dependent upon the type of income from which it is to be paid. Accordingly, the amount to which Code Sec. 642(c) applies is deemed to consist of the same proportion of each class of the items of income of the trust as the total that each class bears to the total of all classes. (Reg. §1.642(c)-3(b)(2), Example 1).
New Example in Final Regs. A commentator requested an example of a provision in a governing instrument that would have economic effect independent of income tax consequences. In response, the IRS added the following example:
A trust instrument provides that 100% of its ordinary income must be distributed currently to a Code Sec. 170(c) tax-exempt organization and that all remaining items of income must be distributed currently to a non-charitable beneficiary. This income ordering provision has economic effect independent of income tax consequences because the amount to be paid to the charitable organization each year is dependent upon the amount of ordinary income the trust earns within that tax year. Accordingly, for purposes of Code Sec. 642(c), the full amount distributed to charity is deemed to consist of ordinary income. (Reg. §1.642(c)-3(b)(2), Example 2).
Effective Date. The regs are effective on April 16, 2012.