Would You Believe?

It is a specialized issue, but I am going to write about it anyway.

Why?

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.

Business League: A Different Type Of Tax-Exempt

You may have heard about business leagues.

One very much in the news recently is the National Football League, which has been considering giving up its tax-exempt status.

In the tax world, exempt entities obtain their exempt status under Section 501(c). There is then a number, and that number is the “type” of exempt under discussion. For example, a classic charity like the March of Dimes would be a 501(c)(3). When we think of tax-exempts, we likely are thinking of (c)(3)’s, for which contributions are deductible to the donor and nontaxable to the recipient charity.

The (c)(3) is about as good as it gets.

A business league is a (c)(6). So is a trade association.

Right off the bat, payments to a (c)(6) are not deductible as contributions. They are, however, deductible as a business expense- which makes sense as they are business leagues. You and I probably could not deduct them, but then again you and I are not businesses.

There are some benefits. For example, a (c)(6) has virtually no limit on its lobbying authority, other than having to pro-rate the member dues between that portion which represents lobbying (and not deductible by anybody) and the balance (deductible as a business expense).

There are requirements to a (c)(6):

(1)  There must be members.

a.     The members must share a common business interest.

                                                              i.     Members can be individuals or businesses.

                                                            ii.     If membership is available to all, this requirement has not been met. This makes sense when you consider that the intent of the (c)(6) is to promote shared interests.

(2)  Activities must be directed to improving business conditions in a line of business.

a.     Think of it as semi-civic: to advance the general welfare by promoting a line of business rather than just the individual companies.

b.    This pretty much means that membership must include competitors.

c.     Sometimes it can be sketchy to judge. For example, the IRS denied exemption to an organization whose principal activity was publishing and distributing a directory of member names, addresses and phone numbers to businesses likely to require their services. The IRS felt this went too close to advertising and too far from the improvement of general business conditions.

(3)  The primary activities must be geared to group and not individual interests.

a.     The American Automobile Association, for example, had its application denied as it was primarily engaged in rendering services to members and not improving a line of business.

(4)  The main purpose cannot be to run a for-profit business.

a.     This requirement is standard in the not-for-profit world. You can run a coffee shop, but you cannot be Starbucks.

b.    For example, a Board of Realtors normally segregates its MLS activities in another – and separate – company. The Board itself would be a (c)(6), but the MLS is safely tucked away in a for-profit entity – less it blow-up the (c)(6).

(5)  Must be not-for-profit.

a.     Meaning no dividends to shareholders or distributions rights if the entity ever liquidates.

b.    BTW – and to clarify – a not-for-profit can show a profit. Hypothetically it could show a profit every year, although it is debatable whether it could rock the profit level of Apple or Facebook and keep its exemption. The idea here is that profits – if any – do not “belong” to shareholders or investors.

(6)  There must be no private inurement or private benefit to key players or a restricted group of individuals.

a.     Again, this requirement is standard in the not-for-profit world.

b.    This issue has been levelled against the NFL. Roger Goodell (the NFL Commissioner) has been paid over $44 million a year for his services. It does not require a PhD in linguistics to ask at what point this compensation level becomes an “inurement” or “benefit” disallowed to a (c)(6).

There is litigation around (4) and (6). The courts have allowed some business activity and some benefit to the members, as long as it doesn’t get out of hand. The courts refer to this as “incidental benefit.”

Which can lead to interesting follow-up issues. Take a case where the organization runs a business (within acceptable limits) and then uses the profit to subsidize something for its members. Can this amount to private inurement? The members are – after all - receiving something at a lower cost than nonmembers.

Let’s take a look at a recent application. I think you know enough now to anticipate how the IRS decided.

(1)  The (c)(6) members are convenience stores and franchisees of “X.”

(2)  Revenues will be exclusively from member fees.

(3)  One-quarter of member fees will be remitted annually to the national franchisee (that is, the franchise above “X”)

(4)  Member franchisees will elect the Board.

(5)  The (c)(6) will educate and assist with franchise policies.

(6)  The (c)(6) will facilitate resolution between members and executives of “X.”

How did it go?

The IRS bounced the application.

Why?

We could have stopped at (1). There is no “line of business” happening here. Members are limited to franchisees of “X.” Granted, “X” participates in an industry but “X” does not comprise an industry. 

The organization tried to clean-up its application after being rejected but it was too little too late.

The organization was not promoting the industry as a whole. It rather was promoting the interest of the franchisee-owners. 

Nothing wrong with that. You just cannot get a tax exemption for it.

The New Israeli Trust Tax

Have you settled (that is, funded) a trust with an Israeli beneficiary?

I have not, but many have.

If this is you: heads up. The tax rules have changed, and they have changed from the Israeli side, not the U.S.

Until this year, Israel has not taxed a trust set up by a foreign person, even if there were Israeli beneficiaries. It also did not bother to tax the beneficiaries themselves. This was a sweet deal.

The deal changed this year. The Israel Tax Authority (ITA) now says that many trusts previously exempt will henceforth be taxable.

Israel is looking for a beneficiary trust, meaning that all settlors are foreign persons and at least one beneficiary is a resident Israeli.

EXAMPLE: The grandparents live in Cincinnati; the son moves to Israel, marries and has children; the grandparents fund a grandchildren’s trust.

A beneficiary trust can be either

·        A “relatives trust,” meaning the settlor is still alive and related (as defined) to the beneficiary

·        A “non-relatives trust,” meaning the settlor is not alive or not related (as defined) to the beneficiary 

EXAMPLE: The grandparents in the above trust pass away.

The tax will work as follows:

·        A relatives trust

o   Pay tax currently at 25% on the portion allocable to Israeli beneficiaries, or

o   Delay the tax until distributed to an Israeli beneficiary, at which time the tax will be 30%.

·        A non-relatives trust

o   Pay tax on income allocable to Israeli beneficiaries at regular tax rates (meaning up to 52%)

If one does nothing by the end of 2014, a relatives trust is presumed to have elected the “pay currently” regime.

The ITA has indicated verbally that any U.S. tax paid will be accepted as a tax credit against the Israeli tax, whether the tax was paid by the settlor (think grantor trust), the trust itself or the beneficiary.

The retroactive part of the tax goes back to 2006, and the ITA is allowing two ways for beneficiary trusts to settle up:

·        The trust can pay a portion of its regular tax liability, depending upon the influence on the trust by the Israeli beneficiary.

·        The trust can pay tax on the value of the trust as of December 31, 2013.

Again, the rules have changed, and – if this is you – please contact your attorney or other advisor immediately. 

What Happens To Inherited IRAs in Bankruptcy?

Let us discuss IRAs.

You may be aware that there is bankruptcy protection for IRAs. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 exempts up to $1 million in IRAs created and funded by the debtor. Employer plans have even more favorable protection.

Why? The government has expressed interest that citizens be able to save for their retirement. This diminishes the odds of future government assistance and deemed in the public interest.

Fair enough. But I have one more question.

Let us say that you inherited the IRA. Does the above protection still apply to you?

Why wouldn’t it, you might ask. It is like an ice cream bar. It is still an ice cream bar whether you or I take it from the freezer, right?

This very question made it to the Supreme Court in the recent case of Clark v Rameker. While a bankruptcy case, it does have tax implications.

In 2001 Ruth Heffron established a traditional IRA and named her daughter as beneficiary.

NOTE:  “Traditional” means the classic IRA: contributions to it are deductible and withdrawals from it are taxable. Contrast this with a “nondeductible” IRA (contributions are nondeductible and withdrawals are taxable, according to a formula) and Roths (contributions are nondeductible and withdrawals are nontaxable).

Mrs Heffron passed away a year later – 2001 – and left approximately $400,000 to her daughter in the IRA account. Inherited IRAs have special rules on distributions, and one has to take distributions over a life expectancy or withdraw the entire balance within five years. Her daughter – Ms. Heffron-Clark - elected to use life expectancy with monthly distributions.

Fast forward to 2010 and Ms. Heffron-Clark and her husband file for Chapter 7 bankruptcy. The IRA has approximately $300,000 remaining, and you can bet that the couple considered the IRA to be an exempt asset. The unsecured creditors of the bankruptcy estate disagreed, thus beginning the litigation.

·       The Bankruptcy Court said that the IRA was not exempt and could be reached by creditors.

·       The District Court reversed, saying that the IRA was exempt and could not be reached by creditors.

·       The Appeals Court for the Seventh Circuit reversed, saying that the IRA was not exempt and could be reached by creditors.

This set up disagreement between the Fifth and Seventh Circuits, so the Supreme Court agreed to hear the case.

Believe it or not, the Bankruptcy Code does not define the term “retirement funds,” resulting in the above courts drawing such different conclusions. The Supreme Court declared that the term must be defined in order to arrive at a correct conclusion. The Court looked a dictionary and saw that “retirement” is defined as …

       … withdrawal from one’s occupation, business or office.”

The Court wanted to look at the legal characteristics of funds set aside for the day one stops working. It focused on three:

(1)  One can put additional monies into a retirement account.

POINT: One cannot put additional monies into an inherited account. In fact, if one inherits again, one cannot mingle the two accounts. Each is to remain separate and unique.

COUNTERPOINT: One cannot put additional monies into an IRA after age 70 ½.

(2)  Holders of an inherited account are required to begin distributions in the year following the death.

POINT: There are no age 59 ½ or 70 ½ minimum distribution requirements here. It does not matter whether the beneficiary is three years old or ninety-three; distributions must begin in the year following death, unless one fully depletes the account over 5 years.

OBSERVATION: The Court asked obvious question: how does this distribution requirement tie-in to the beneficiary’s retirement in any way?

(3)  The beneficiary can withdraw the entire balance at any time, without penalty.

POINT: You and I cannot do that with our own IRA until we are age 59 ½. 

OBSERVATION”: The Court noted that there is a ‘stick” if one wants to access a traditional IRA early – the 10% penalty. That expresses Congress’ intent to discourage use of traditional IRA s for day-to-day non-retirement purposes. The inherited IRA has no such prohibition. What does that say about Congress’ intent with inherited IRAs?

Rest assured that Ms Heffron-Clark was arguing furiously that the funds in that inherited IRA are “retirement funds” because, at some point, they were set aside for retirement.

The Court looked at the three criteria above and said that the inherited IRA certainly constitutes “funds,” but it cannot see how they rise to the level of “retirement funds.” They simply do not have the characteristics of normal retirement funds.

The Supreme Court unanimously decided that an inherited IRA do not constitute “retirement funds” and are not exempt from bankruptcy claims. Ms. Heffron-Clark’s creditors could in fact reach that $300 grand.

Granted, this is a bankruptcy case, but I see two immediate tax consequences from this decision:

(1) First, a surviving spouse (that is, the widow or widower) has a tax  option offered no other IRA beneficiary.

The surviving spouse can take the IRA as an inherited IRA (and be subject to bankruptcy claims) or he/she can rollover the IRA to his/her own personal name.

In the past, this decision was sometimes made based on the survivor’s age. For example, if the surviving spouse thought he/she might need the money before age 59 ½, the tax planner would lean towards an inherited IRA. Why? Because there is no 10% penalty for early withdrawals from an inherited IRA. There would be penalties on early withdrawals from a rollover IRA.

This decision now gives planners another reason to consider a spousal rollover.

(2) Second, there may be increased attention to IRA accumulation trusts.

A trust is allowed to be an IRA beneficiary, but at the cost of some highly specific tax rules. There are two types of permitted trusts. The first is the conduit trust. The trust receives the annual minimum required distributions (MRDs) but is required to immediately pay them out to the beneficiary.  While you may wonder what purpose this trust serves, consider that the trust – while unable to protect the annual income – can still protect the principal of the trust.

The second type is the accumulation trust. It is eponymous: it accumulates. There are no required distributions to the beneficiaries. The tax cost for this can be enormous, however. A trust reaches the maximum federal tax rate at the insanely low threshold of approximately $12,000. Obviously, this strategy works best when the beneficiaries are themselves at the maximum tax bracket.

The other point that occurred to me is the future of stretch IRAs. There has been considerable discussion about imposing a five-year distribution requirement (with very limited exceptions) on inherited IRAs. This of course is in response to the popular tax strategy of “stretch” IRAs. The stretch is easy to explain: I leave my IRA to my granddaughter. The IRA resets its mandatory distributions, using her life expectancy rather than mine (which is swell, as I am dead). Say that she is age 11. Whereas there are mandatory distributions, those distributions are spread out over the life expectancy of an eleven-year-old girl. That is the purpose and use of the “stretch.”

Consider that the Court just decided that an inherited IRA does not constitute “retirement funds.” This may make it easier for Congress to eventually do away with stretch IRAs.

Dividing An Inherited IRA

We had a situation where a father left his IRA to his two children. The father was in his 70s, the son was in his 50s and the daughter in her 40s. The tax problem was triggered by having one IRA with two beneficiaries.

There are certain tax no-no's involving an IRA. One is to have your IRA go to your estate. An estate has no “actuarial life expectancy,” as only individuals can have life expectancies. Tax rules require an estate IRA to pay-out much sooner than may be desired or tax-advantageous. A second no-no is what the above father had done.

When there are multiple beneficiaries of an IRA, the IRS requires the IRA to calculate the minimum required distributions (MRD) based on the life of the oldest beneficiary. In our case, it wasn’t too bad, as the siblings were within 10 years of each other. Consider an alternate situation: a son/daughter and a grandchild. In that case the grandchild would be receiving MRDs based on the son/daughter’s life expectancy, which likely would not be in the grandchild’s best financial interest. 

What to do? Split the IRA into two: one for the son and another for the daughter. As long as this is done no later than the last day of the year following the year of death, the IRS will respect the division. This allows the son to use his life expectancy for his withdrawals, and the daughter to use her life expectancy.

 

The jargon for this is “subaccount,” and if you are in this situation (death in 2011), please consider dividing the inherited IRA into subaccounts by December 31.

By the way, there is a tax trap in setting up the subaccounts. These are inherited accounts, and the IRS requires inherited accounts to retain the name of the decedent. What do I mean? Say that Adam Jones passed way, so we would be looking at the “IRA FBO Adam Jones.” When the subaccounts are created, they should be named (something like) “IRA FBO Adam Jones Deceased FBO Benjamin Jones Inherited.” If one does not do this correctly, the IRS can (as has before) consider Benjamin as having withdrawn ALL the inherited IRA and put it into his own separate IRA. Since he withdrew all the inherited IRA, he has to pay tax on all of it, not just the minimum required distribution.

I consider the above tax trap to be unfair, but the IRS has brought down the hammer before. Do not be one of the unfortunate caught in this trap. We have discussed before that even an average person may need a tax pro here and there throughout life. This is one of those moments.