I had a difficult conversation with a client recently over
an issue I had not seen in a while.
It involves an estate. The same issue would exist with
a trust, as estates and trusts are (for the most part) taxed the same way.
Let’s set it up.
Someone passed away, hence the estate.
The estate is being probated, meaning that at least
some of its assets and liabilities are under court review before payment or distribution. The
estate has income while this process is going on and so files its own income
tax return.
Many times, accountants will refer to this tax return as the “estate” return, but it should not be confused with the following, also called the “estate” return:
What is the difference?
Form 706 is the tax – sometimes called the death tax –
on net assets when someone passes away. It is hard to trigger the death tax, as
the Code presently allows a $13.6 million lifetime exclusion for combined
estate and gift taxes (and twice that if one is married). Let’s be honest:
$13.6 million excludes almost all of us.
Form 1041 is the income tax for the estate. Dying does
not save one from income taxes.
Let’s talk about the client.
Dr W passed away unexpectedly. At death he had bank
and brokerage accounts, a residence, retirement accounts, collectibles, and a
farm. The estate is being probated in two states, as there is real estate in the
second state. The probate has been unnecessarily troublesome. Dr W recorded a
holographic will, and one of the states will not accept it.
COMMENT: Not all estate assets go through probate, by the way. Assets passing under will must be probated, but many assets do not pass under will.
What is an example of an asset that can pass outside
of a will?
An IRA or 401(k).
That is the point of naming a beneficiary to your IRA
or 401(k). If something happens to you, the IRA transfers automatically to the
beneficiary under contract law. It does not need the permission of a probate judge.
Back to Dr W.
Our accountant prepared the Form 1041, I saw interest,
dividends, capitals gains, farm income and … a whopping charitable donation.
What did the estate give away?
Books. Tons of books. I am seeing titles like these:
· Techniques
of Chinese Lacquer
· Vergoldete
Bronzen I & II
· Pendules
et Bronzes d’Ameublement
Some of these books are expensive. The donation wiped
out whatever income the estate had for the year.
If the donation was deductible.
Look at the following:
§ 642 Special rules for credits and deductions.
(c) Deduction for amounts paid or permanently set aside
for a charitable purpose.
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.
This not one of the well-known Code sections.
It lays out three requirements
for an estate or trust to get a charitable deduction:
- Must be paid out of gross income.
- Must be paid pursuant to the terms of the governing instrument.
- Must be paid for a purpose described in IRC Sec. 170(c) without regard to Section 170(c)(2)(A).
Let’s work backwards.
The “170(c) without …” verbiage opens up donations to foreign charities.
In general, contributions must be paid to domestic
charities to be income-tax deductible. There are workarounds, of course, but
that discussion is for another day. This restriction does not apply to estates,
meaning they can contribute directly to foreign charities without a workaround.
This issue does not apply to Dr W.
Next, the instrument governing the estate must permit payments
to charity. Without this permission, there is no income tax deduction.
I am looking at the holographic will, and there is something
in there about charities. Close enough, methinks.
Finally, the donation must be from gross income. This term
is usually interpreted as meaning gross taxable income, meaning sources such as
municipal interest or qualified small business stock would create an issue.
The gross income test has two parts:
(1) The donation cannot exceed the estate’s cumulative
(and previously undistributed) taxable income over its existence.
(2) The donation involves an asset acquired by
that accumulated taxable income. A cash donation easily meets the test (if it does
not exceed accumulated taxable income). An in-kind distribution will also qualify
if the asset was acquired with cash that itself would have qualified.
The second part of that test concerns me.
Dr W gave away a ton of books.
The books were transferred to the estate as part of
its initial funding. The term for these assets is “corpus,” and corpus is not
gross income. Mind you, you probably could trace the books back to the doctor’s
gross income, but that is not the test here.
I am not seeing a charitable deduction.
“I would not have done this had I known,” said the frustrated
client.
I know.
We have talked about a repetitive issue with taxes:
you do not know what you do not know.
How should this have been done?
Distribute the books to the beneficiary and let him
make the donation personally. Those rules about gross income and whatnot have
no equivalent when discussing donations by individuals.
What if the beneficiary does not itemize?
Understood, but you have lost nothing. The estate was
not getting a deduction anyway.
