It is a specialized issue, but I am going to write about it anyway.
Because I believe this may be the only time I have had this issue, and I have been in practice for over thirty years. There isn’t a lot in the tax literature either.
As often happens, I am minding my own business when someone – someone who knows I am a tax geek – asks:
“Steve, do you know the tax answer to ….”
For future reference: “Whatever it is - I don’t. By the way, I am leaving the office today on time and I won’t have time this weekend to research as I am playing golf and sleeping late.”
You know who you are, Mr. to-remain-unnamed-and-anonymous-of-course-Brian-the-name-will-never-pass-my-lips.
Here it is:
Can a trust make a charitable donation?
Doesn’t sound like much, so let’s set-up the issue.
A trust is generally a three-party arrangement:
- Party of the first part sets up and funds the trust.
- Party of the second part receives money from the trust, either now or later.
- Party of the third part administrates the trust, including writing checks.
The party of the third part is called the “trustee” or “fiduciary.” This is a unique relationship, as the trustee is trying to administer according to the wishes of the party of the first part, who may or may not be deceased. The very concept of “fiduciary” means that you are putting someone’s interest ahead of yours: in this case, you are prioritizing the party of the second part, also called the beneficiary.
There can be more than one beneficiary, by the way.
There can also be beneficiaries at different points in time.
For example, I can set-up a trust with all income to my wife for her lifetime, with whatever is left over (called the “corpus” or “principal”) going to my daughter.
This sets up an interesting tension: the interests of the first beneficiary may not coincide with the interests of the second beneficiary. Consider my example. Whatever my wife draws upon during her lifetime will leave less for my daughter when her mom dies. Now, this tension does not exist in the Hamilton family, but you can see how it could for other families. Take for example a second marriage, especially one later in life. The “steps” my not have that “we are all one family” perspective when the dollars start raining.
Back to our fiduciary: how would you like to be the one who decides where the dollars rain? That sounds like a headache to me.
How can the trustmaker make this better?
A tried-and-true way is to have the party of the first part leave instructions, standards and explanations of his/her wishes. For example, I can say “my wife can draw all the income and corpus she wants without having to explain anything to anybody. If there is anything left over, our daughter can have it. If not, too bad.”
Pretty clear, eh?
That is the heart of the problem with charitable donations by a trust.
Chances are, some party-of-the-second-part is getting less money at the end of the day because of that donation. Has to, as the money is not going to a beneficiary.
Which means the party of the first part had better leave clear instructions as to the who/what/when of the donation.
Our case this week is a trust created when Harvey Hubbell died. He died in 1957, so this trust has been around a while. The trust was to distribute fixed amounts to certain individuals for life. Harvey felt strongly about it, because - if there was insufficient income to make the payment – the trustee was authorized to reach into trust principal to make up the shortfall.
Upon the last beneficiary to die, the trust had 10 years to wrap up its affairs.
Then there was this sentence:
All unused income and the remainder of the principal shall be used and distributed, in such proportion as the Trustees deem best, for such purpose or purposes, to be selected by them as the time of such distribution, as will make such uses and distributions exempt from Ohio inheritance and Federal estate taxes and for no other purpose.
This trust had been making regular donations for a while. The IRS picked one year – 2009 – and disallowed a $64,279 donation.
Here is IRC Sec 642(c):
(c) Deduction for amounts paid or permanently set aside for a charitable purpose
(1) General rule
In the case of an estate or trust (other than a trust meeting the specifications of subpart B), there shall be allowed as a deduction in computing its taxable income (in lieu of the deduction allowed by section 170(a), relating to deduction for charitable, etc., contributions and gifts) any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c) (determined without regard to section 170(c)(2)(A)). If a charitable contribution is paid after the close of such taxable year and on or before the last day of the year following the close of such taxable year, then the trustee or administrator may elect to treat such contribution as paid during such taxable year. The election shall be made at such time and in such manner as the Secretary prescribes by regulations.
The key here is the italicized part:
“which pursuant to the terms of the governing instrument…”
The Code wants to know what the party of the first part intended, phrased in tax-speak as “pursuant to the terms of the governing instrument.”
The trustees argued that they could make donations via the following verbiage:
in such proportion as the Trustees deem best, for such purposes or purposes, to be selected by them as the time of such distribution….”
Problem, said the IRS. That verbiage refers to a point in time: the time when the trust enters its ten-year wrap-up and not before then. The trustees had to abide by the governing instrument, and said instrument did not say they could distribute monies to charity before that time.
The trustees had to think of something fast.
Here is something: there is a “latent ambiguity” in the will. That ambiguity allows for the trustees’ discretion on the charitable donations issue.
Nice argument, trustees. We at CTG are impressed.
They are referring to a judicial doctrine that cuts trustees some slack when the following happens:
(1) The terms of the trust are crystal-clear when read in the light of normal day: when it snows in Cincinnati during this winter, the trust will ….
(2) However, the terms of the trust can also be read differently in the light of abnormal day: it did not snow in Cincinnati during this winter, so the trust will ….
The point is that both readings are plausible (would you believe “possible?”).
It is just that no one seriously considered scenario (2) when drafting the document. This is the “latent ambiguity” in the trust instrument.
Don’t think so, said the Court. That expanded authority was given the trustees during that ten-year period and not before.
In fact, prior to the ten years the trustees were to invade principal to meet the annual payouts, if necessary. The trustmaker was clearly interested that the beneficiaries receive their money every year. It is very doubtful he intended that any money not go their way.
It was only upon the death of the last beneficiary that the trustees had some free play.
The Court decided there was no latent ambiguity. They were pretty comfortable they understood what the trustmaker wanted. He wanted the beneficiaries to get paid every year.
And the trust lost its charitable deduction.
For the home gamers, our case this time was Harvey C. Hubbell Trust v Commissioner.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.