Featured Article – Nonexempt Charitable Trusts – Issues & Answers (Part I)

Law Office of Jonathan Ackerman, LLC Newsletter - Volume 6.1 (2019)

BY JONATHAN D. ACKERMAN, ESQUIRE

Scene – While you calmly gaze out of your office window at a beautiful sunny day, you suddenly wince with pain as you look down at a deep and pulsing paper cut from an envelope that you were opening.

As you manage through the sting, you pull the letter out of the blood laced envelope. It’s from a law firm and includes a six figure check made payable to your institution. The letter states that this check represents a payment from a trust, and you should expect to continue receiving an annual check from the trust.

At this point, the excitement from the contents of this letter overwhelms any sting or loss of blood.

So now what?

You wonder what type of payment this could be – a distribution from a private foundation, a charitable lead trust, or some other type of trust.

After contacting the law firm, you find out that the trust was created at the death of one of your donors and will exist in perpetuity. The trust will make an annual payment of income to your institution. You were a bit surprised, as this particular donor had always stated that she had planned on making an outright bequest to your institution with certain broad use restrictions which were well within your charitable mission.

At your request, the attorney said that he would send over a copy of the testamentary trust for your files. Upon receipt, you send it to your tax counsel, and she sends you back the following response:

“It is likely that this trust constitutes, what’s been referred to as, a nonexempt charitable trust (“NECT”). Technically speaking, Section 4947(a)(1) of the Internal Revenue Code of 1986, as amended (“Code”), provides that trusts meeting the following conditions are treated as “charitable trusts” under the Code:

(i) trusts that are not exempt from tax under Code Section 501(a), (ii) all of the unexpired interests in which are devoted to one or more religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals, and (iii) contributions, bequests, and gifts to which were allowed as deductions for income, estate, or gift tax purposes.

With regard to (i), this generally means that the trust has not filed Form 1023 (Application for Tax-Exempt Status) with the IRS to be recognized as a tax-exempt organization. In terms of (ii), the only beneficiary of the trust is a charity, and (iii) generally means that a charitable deduction was allowable for the dedication of the trust’s unexpired interests solely to charity.

So, assuming this trust constitutes an NECT, there are some potentially wasteful and peculiar consequences that arise. First, an NECT is a separate legal entity and would need to get its own taxpayer ID number and maintain its own separate accounting and investment account. Second and generally, an NECT must annually file two different tax and informational returns with the IRS – (A) a Form 1041 (for trust income tax filing purposes), and (B) the applicable Form 990 (for charitable organization filing purposes).

Third, an NECT is technically a taxable entity – so it may be subject to income taxes. However, a taxable trust will be entitled to an unlimited charitable deduction for amounts paid to charity so long as specific governing instrument language is contained in the trust instrument, See Code Section 642(c). In addition, an exception to this favorable unlimited charitable deduction rule exists and, if applicable, the NECT will be subject to the same charitable deduction as an individual contribution under Code Section 170. To make matters even more complex, there is an exception to this exception. But suffice it to say, an NECT may pay income tax and, in that event, will diminish its asset value notwithstanding the fact that all of the income is dedicated to, and will actually be distributed to, charity.

Fourth and finally, an NECT is treated as a Code Section 501(c)(3) organization for purposes of the rules, definitions, taxes, and prohibited acts relating to private foundations, as the basic purpose of Code Section 4947 is to prevent trusts described in that Section from being used to avoid the requirements and restrictions applicable to private foundations. In common parlance, if the trust looks like a duck and quacks like a duck, it will be treated as a duck. Thus, the cumbersome rules that relate to the excise tax regime under Code Sections 4940 – 4946 for a private foundation, which includes operational rules and additional excise taxes, such as an annual excise tax on investment income, will apply to the trust.”

Having considered this response, you call your attorney to let her know what a great job she did (and marvel at the light-hearted duck analogy provided in such a technical response). But you have to ask – what does all of this mean to my institution?

In your subsequent discussions with your attorney, you learn that the trust will basically treated like a private foundation, will be subject to all of the private foundation excise taxes, and will have to annually file Form 990-PF.

In that regard, your attorney explains that, if the trust owns basically cash and a diversified portfolio of marketable securities (with no assets bought on margin that may raise unrelated business income (“UBI”) tax issues, and with no alternative investments that may raise the jeopardy investments excise tax), the risks relating to the private foundation rules should be limited. However, if the trust owns other types of assets, such as real estate or business assets, great care would need to be exercised with regard to UBI and all of the private foundation excise taxes, but especially the excess business holdings tax. In any and all events, the trust will have to annually pay the excise tax on investment income.

Lastly, your attorney clarifies that the trust, as an NECT, must also file a Form 1041 and may possibly pay some tax on its income, notwithstanding the annual distribution to your institution. However, a trust that distributes all of its income to charity and contains the required governing instrument language will be entitled to an unlimited charitable deduction. For example, if the trust earned $200,000 of taxable income and made a $200,000 distribution to charity, the trust should pay no tax, as the $200,000 of income is fully offset by the $200,000 charitable deduction/distribution. Unfortunately, that general rule may not apply to an NECT. In that case, the trust’s income tax deduction is subject to the same percentage limitations, etc., as an individual taking a charitable income tax deduction under Code Section 170.

Now, while all of this information is swirling around in your head, you are of course grateful for this generous gift, and from a practical perspective, it is not a bad scenario – your institution will be receiving annual checks based on the income of the trust…forever, and your institution doesn’t have to worry about the administrative issues associated with the trust. However, you are disappointed in that you felt the donor’s intent was to make an outright bequest with broad use restrictions, and the complications, duplications, and additional costs associated with an NECT seem unnecessary.

In this instance, you wonder (i) whether the donor actually understood the implications of this type of testamentary trust, and (ii) whether the donor’s intent in making this testamentary gift could be met in a less burdensome and costly fashion. So, you ask your attorney to research possible solutions.

The attorney’s response and the charity’s possible options will be included in the next installment of this article – Part II - Some Solutions.

The Nonexempt Charitable Trust is a sophisticated vehicle, and as with all such vehicles, professional counsel should be retained to fully analyze the effectiveness of a particular vehicle given a particular set of circumstances.