The IRS has finalized regulations (T.D. 9582) regarding whether the order in which a trust or estate distributes income to charity under its governing instrument will be respected for federal income tax purposes. The final regulations adopt the proposed regulation with a new example.
A trust or an estate is allowed a deduction under Section 642(c) for any amount of gross income that is paid for a charitable purpose under the terms of the governing instrument. This deduction is in lieu of the charitable deduction allowed an individual under Section 170. The governing instrument of most charitable lead trusts (CLTs) contains a provision that dictates the order in which income items are treated as distributed to charity upon the payment of the annuity or unitrust amount. Generally, the payment is to consist of the following class of items until each class has been exhausted: (1) ordinary income other than qualified dividend income, (2) qualified dividend income and capital gain, (3) other income (including tax-exempt income) and (4) corpus. Some governing instruments provide that income that is not unrelated business taxable income is to be distributed before income that is unrelated business taxable income.
The goal of these ordering rules is to maximize the benefit of the charitable deduction under Section 642(c). Because a CLT is a taxable trust, any amount of income not paid to charity through the annuity or unitrust payment is taxable to the CLT. Thus, ordering rules attempt to distribute income subject to higher tax rates first and retain lower taxed or tax-exempt income.
The IRS has generally taken the position in private letter rulings that Treas. Reg. Secs. 1.642(c)-3(b)(2) and 1.643(a)-5(b) require that if an estate or a trust's governing instrument or local law has a specific provision addressing the sourcing of payments to be made to a charity, that provision will be respected only if it has economic effect independent of income tax consequences. Accordingly, the IRS has ruled that the ordering rules in the governing instruments of CLTs generally do not have economic effect independent of income tax consequences and will not be respected for federal income tax purposes.
In 2008, the IRS proposed regulations (REG-101258-08) to specifically incorporate this position directly into the Section 642 regulations. The proposed regulations required that a provision in a governing instrument or in local law that specifically mandated the source of amounts paid to charity must have economic effect independent of income tax consequences in order to be respected for federal income tax purposes. If such a provision did not have economic effect, the income distributed for a charitable purpose would 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.
The new final regulations adopt these proposed regulations but add an example of a situation in which the provisions of the governing instrument have economic effect independent of income tax consequences and, therefore, would be respected for federal income tax purposes.
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