Form over substance: district court denies split-interest charitable deduction.

In Galloway, DC PA, 5/9/06, a district court ruled that no charitable deduction was allowed on an estate tax return for a mast specifying distributions to charitable and noncharitable beneficiaries, because the mast did not meet the requirements of Sec. 2055(e)(2). The court barred the deduction even though the charity received all of the income and principal for 50% of the trust assets. This and other similar cases illustrate situations to avoid in obtaining the deduction. With the high number of aging American millionaires and the billions donated to charity, every year, this topic is an important one.

Background

Sec. 2055(a) allows a deduction from the gross estate for transfers to qualified charities. However, under Sec. 2055(e)(2), no deduction is permitted for a trust specifying a split interest in property held for the benefit of charitable and noncharitable beneficiaries. Secs. 2055(e)(2)(A) and (B) and 170(f)(3)(B) provide exceptions to this disallowance rule; the charitable portion of the split interest is deductible if any of these exceptions is met.

Under Sec. 2055(e)(2)(A), a deductible charitable remainder interest must be in a trust that is a charitable remainder annuity trust (CRAT), a charitable remainder unitrust (CRUT) or a pooled income fund (PIF). Sec. 664(d) defines CRATs and CRUTs; for them, payments must be made at least annually of either a fixed amount or a fixed percentage of the trust's assets respectively (determined annually), to at least one noncharitable beneficiary. A PIF is managed by the charity and its payment requirements are based on the PIF's rate of return. Under Sec. 2055(e)(2)(B), for other interests (such as when a charity has only an income interest (i.e., a charitable lead trust)), the charitable interest must be a guaranteed annuity or a fixed percentage of the property's fair market value, determined and distributed annually. Sec. 170(f)(3)(B) includes a contribution not in trust of (1) a remainder interest in a personal residence or farm, (2) an undivided portion of the taxpayer's entire interest in property or (3) a qualified conservation contribution.

The purpose of Sec. 2055(e), enacted in 1969, is to provide a closer connection between the charitable deduction and the amounts the charity ultimately receives. For example, for a charitable remainder trust, the CRAT, CRUT and PIF requirements reduce the incentive and opportunity for the trustee to invest the trust assets in risky securities to obtain higher returns for the noncharitable income beneficiaries, resulting in a smaller remainder interest for the charity if the securities decrease in value.

Cases

Edgar: In Est. of Edgar, 74TC 983 (1980), Clara Edgar created a trust that paid $50-$150 per month to four noncharitable beneficiaries. As the trust's income greatly exceeded these monthly payments, the remaining income was divided among several charities. As each of the noncharitable beneficiaries died, her share of the income passed to the charities. The trustee could not use the principal for the noncharitable beneficiaries' benefit. After all the noncharitable beneficiaries died, the principal (remainder) passed to the charities.

The Tax Court ruled that no charitable deduction was allowed, because the trust did not satisfy Sec. 664(d)(2)(A)'s 5%-minimum rule for CRUTs; economic considerations were irrelevant. Also, the ability to measure the amount of the remainder interest at Edgar's death was necessary--but not sufficient--to obtain the deduction.

Johnson: In Est. of Johnson, 941 F2d 1318 (5th Cir. 1991), a will provided for a trust to support the decedent's sisters, maintain family graves and fund religious education; no remainder interest was specified. In 1989, nearly four years after the estate tax return was filed, the chancery court allowed three separate trusts to be. established for these purposes. The Fifth Circuit ruled that the will provided for one trust with charitable and noncharitable beneficiaries; the same property funded all three purposes. Thus, it was a classic split-interest trust.

One of the objectives, the sisters' support, could not be accurately valued, as their care could use up all of the trust's assets. Thus, the charitable bequest could not be valued, as required by Sec. 2055(e)(2)(B); consequently, the court disallowed the charitable deduction.

Zabel: In Zabel, 995 FSupp 1036 (DC NE 1998), a trust's income was split between charitable and noncharitable beneficiaries, with the remainder to a charity. The trustee established separate accounts for the beneficiaries. He argued that, because 50% of the income and all of the remainder went to a charity, a charitable deduction should be allowed for 50% of the trust.

The court ruled that no deduction was allowed, because the trust did not follow one of the three approaches specified in Sec. 2055(e)(2)(A), thereby violating the statute's clear meaning. As an example, the trustee in Zabel could have invested the trust assets in junk bonds to increase income. If the bonds became worthless, the charitable remainder would have no value. The approaches allowed in Sec. 2055(e)(2)(A) provide little incentive or opportunity for such a result.

Oetting: In Oetting, 712 F2d 358 (8th Cir. 1983), the decedent left a trust specifying distributions of $100 per month to each of three elderly individuals for life, with the rest of the trust income distributed to charity; the remainder went to four charities and one individual. This trust did not satisfy Sec. 2055(e)(2)'s requirements. A state court allowed the trust to distribute most of the $700,000 principal to the remainder interest holders and purchase annuities for the income beneficiaries (avoiding large yearly trustee fees).

The Eighth Circuit allowed the charitable deduction, ruling that Sec. 2055(e) did not apply, because the state court's decree replaced the split-interest trust with direct cash payments to the charities. Also, the amount payable to the noncharitable beneficiaries was easily measurable and separable from the charitable bequests. Finally, the state court's decree conformed to the Hill.

Cassidy: In Est. of Cassidy, TC Memo 1985-37, the decedent transferred a farm to a trust, with life income to her son and the remainder to a charity. The Tax Court ruled that the remainder did not qualify for the charitable deduction; Sec. 170(f)(3) (A) and (B) require the transfers not to be in trust. Congress believed that these transfers were not subject to the abuses Sec. 2055(e) was enacted to curtail; thus, the court did not want to subject the Sec. 170(f)(3)(B) transfers to the Sec. 2055(e)(2) requirements.

Galloway

In the case at issue, the decedent had created a revocable living trust in 1991. On his death in 1998, the trust provided that the residue would be distributed in equal shares to two individuals and two charities, in 2006 and 2016. If the individuals died prior to 2016, their shares would pass to the remaining beneficiaries. The trust terminates in 2016. The Federal estate tax return deducted $399,079 for the anticipated charitable distributions under Sec. 2055(a). The IRS disallowed the deduction, claiming it was a split-interest trust with charitable and noncharitable beneficiaries that did not qualify under Sec. 2055(e)(2).The trustee argued that the trust was essentially two trusts, the situation was not abusive and the IRS was unreasonably emphasizing form over substance.

The District Court denied the deduction, ruling that there was only one trust that did not satisfy Sec. 2055(e)(2). Also, because the individual beneficiaries' heirs had no interest in the trust assets, there was an incentive (albeit remote) to invest in risky, high-income ventures.

Conclusion

To obtain an estate tax charitable deduction, practitioners should make sure that Sec. 2055(e)(2) is strictly followed for a split-interest trust in which charitable and noncharitable beneficiaries have an interest in the same property. The courts have ruled that intent and actual abuses are irrelevant. Alternatively, estates can avoid Sec. 2055(e)(2) by using two or more masts whenever possible (which could have been done in Galloway). Also, for charitable remainders of personal residences or farms, trusts cannot be used.

FROM PETER BARTON, J.D., MBA, CPA, UNIVERSITY OF WISCONSIN-WHITEWATER, WHITEWATER, WI (NOT AFFILIATED WITH CPAMERICA INTERNATIONAL)