ESTATE AND TAX PLANNING JUNE 1994 REPORT Charitable Planning This report highlights recent legislative and judicial developments having an impact on charitable planning. Certain developments provide planning opportunities for tax savings associated with assisting charitable organizations, while others establish new hurdles. More Disclosure and Substantiation Requirements on Gifts to Charity in 1994 The 1993 Tax Act contains a number of significant provisions affecting charitable gifts, including new substantiation requirements for donors and new public disclosure requirements for charities. Failure to comply may result in a loss of the charitable deduction for donors and penalties imposed on charities. For 1994 and later tax years, no income tax deduction will be allowed for any contribution of $250 or more to a charitable organization unless the donor has obtained a contemporaneous written acknowledgment, or substantiation, of the contribution from the charity. Cancelled checks will no longer be sufficient substantiation. The statute defines "contemporaneous" to mean the due date for the individual's income tax return, with extensions. The acknowledgment of a contribution must state the deductible portion of the contribution, if made in cash, or a description (but not a value) if made in the form of property. The responsibility for obtaining the acknowledgment and for valuing property other than cash lies with the donor, not the charity. Separate payments (provided such payments are not designed to evade the rules) are regarded as independent contributions and will not be aggregated for purposes of the $250 threshold. For their part, charities must provide a written disclosure statement to donors who make a payment in excess of $75 consisting partly of a charitable contribution and partly as a payment for goods or services (a "quid pro quo contribution"). Separate payments of $75 or less made at different times during the year are not aggregated unless such payments are designed to evade the rules. The disclosure statement must be furnished either in connection with the charity's solicitation of the donation or in the form of a receipt, and must provide sufficient valuations of the deductible portion and the goods or services received by the donor. Failure by a charity to submit such statements may result in substantial penalties for the charity. Expiration of the Full Deductibility for Qualified Appreciated Securities gifted to Private Foundations Section 170(e)(5) of the Internal Revenue Code currently permits a taxpayer who contributes qualified appreciated securities (securities held as long-term capital assets, and for which there are readily available market quotations) to a private foundation described under § 509 to deduct the full fair market value of the securities. Built into the statute, however, is a sunset provision; the deduction is scheduled to expire on December 31, 1994. After 1994, § 170(e)(1)(B)(ii) will allow a donor of qualified appreciated securities to a private foundation to deduct only an amount equal to the lesser of the donor's adjusted cost basis in the securities and the fair market value of such securities. The expiration of the full deduction for gifts of qualified appreciated securities to private foundations presents two options. First, taxpayers who face significant capital gains upon the sale of their qualified appreciated securities and who may wish to contribute such securities to a new or existing private foundation would be well advised to make such a gift during 1994. Second, the sunset provision does not apply to contributions made to public charities. Accordingly, a contribution to a "supporting foundation" may be a more attractive way of contributing to charity while retaining some measure of personal involvement in the charitable disposition of the donor's assets. A supporting foundation permits a donor to determine the public charity or charities which the foundation will support. In addition, § 170 allows higher deduction limits for contributions to supporting foundations than to private foundations (up to 50% of adjusted gross income versus 30%). Supporting foundations are also not subject to the annual 2% excise tax imposed on the income of private foundations. Special rules, however, limit the actual control a donor may exert over a supporting foundation. Under § 509(a)(3), the foundation (a) must be organized and operated for charitable purposes, (b) must be operated, supervised or controlled by or in connection with one or more public charities, and (c) may not be controlled directly or indirectly by a "disqualified person." Under proposed rules, a donor's siblings are added to the list of disqualified persons, which currently include a substantial contributor to the supporting foundation and his spouse, ancestors, descendants and spouses of descendants. Contributions of Fractional Shares of Art to Charities In a recent private letter ruling (No. 9303007), the IRS held that a donor may make a gift of a fractional share in a work of art and receive a charitable deduction therefor. In the ruling, the donor proposed making a gift of undivided fractional interests in several works of art from her collection to a museum, while retaining some control over the display of the art during a stated term. If the museum breached its obligations under the terms of the donation, the interests in the art would revert to the donor or her estate. Section 170(f)(3)(B)(ii) of the Internal Revenue Code permits a charitable deduction for contributions, not in trust, of an undivided portion of a donor's interest in property, provided the charitable organization is given effective control over the property. Under Treas. Reg. § 1.170A-1(e), the chance that the gift may revert to the donor must be "negligible". The IRS ruled that the museum met the § 170 control requirements and that the likelihood of the art reverting to the donor was negligible. Accordingly, the IRS permitted a charitable deduction equal to the fractional share of the property transferred multiplied by the value of the property as a whole, with no adjustment for a retained majority or minority interest. Under the ruling and the cited authority, donors are given more leeway in customizing a gift of a fractional interest in a major work of art while retaining a right to a charitable deduction for the donated portion. The Impact on the Charitable and Marital Deductions of Allocating Administration Expenses to Estate Income Two recent Tax Court decisions have held that administration expenses payable out of the income of a decedent's estate (under both the Will and the local governing law) do not reduce the marital or charitable deductions. In the two cases, Estate of Hubert, 101 T.C. 314 (1993), and Estate of Allen, 101 T.C. 351 (1993), the Tax Court held that the deductions for property passing to a surviving spouse and to a charity were to be reduced only by the portion of those administration expenses allocated to principal, and not by any amounts paid out of estate income. The Tax Court disagreed with the reasoning in Estate of Street v. Commissioner, 974 F.2d 723 (6th Cir. 1992), in which the Sixth Circuit had held that such expenses reduce the marital or charitable deduction regardless of how they were allocated. The Hubert and Allen cases are not likely to be the final word on the subject. In another recent case, Burke v. United States, 994 F.2d 1576 (Fed. Cir. 1993), the Court of Appeals for the Federal Circuit held that legal and accounting administration expenses were properly charged against the estate and must reduce the deduction for the residue passing to charity, even if the Will provided for payment of such charges out of the income of the estate, not the principal. Although state law determined the source of the payment of expenses, Federal law determined the tax implications of the expenses themselves. Under the two recent Tax Court decisions, providing in the Will that expenses are to be paid out of estate income would permit the estate to both deduct the expenses on the estate's income tax return and, more significantly, claim a full charitable deduction for estate tax purposes. Using an IRA as part of Charitable Planning In two recent private letter rulings, the IRS has permitted the proceeds of a decedent's undistributed IRA to be used for charitable purposes, with resulting tax benefits. In PLR 9237020, the IRS permitted an IRA holder to create a Charitable Remainder Unitrust (CRUT) in her Will and to fund the CRUT with her IRA proceeds. In addition to providing an estate tax charitable deduction for the value of the remainder interest in the trust, the trust would not be taxed on the distribution from the IRA (although the unitrust amount would be taxed to the unitrust beneficiary as it is received by him during the trust term). Under current law, if the testator had instead transferred her IRA into an inter vivos CRUT, the IRA proceeds would have all been taxed to the owner in the year of the withdrawal. In a related ruling, PLR 9341008, the IRS permitted a testator to fund a private foundation upon his death with his IRA proceeds. No taxes with respect to the IRA would be imposed on the estate of the testator or his beneficiaries upon the dis-tribution of the IRA proceeds to the foun-dation, nor on the foundation upon its receipt thereof. Although the IRA would be included in the testator's estate, it would be offset by a charitable deduction. These rulings illustrate how the use of a testamentary charitable trust or foundation as a recipient of IRA proceeds may permit a testator to fund a larger trust or foundation, since the income taxes otherwise payable upon the disposition of the IRA proceeds may be delayed or eliminated. Deductibility of Appreciated Property Contributed to Charity Under the 1993 Tax Act, donors who contribute appreciated property, both tangible and intangible, to charities may now deduct the full fair market value of the property for both regular tax and alternative minimum tax (AMT) purposes. Prior to 1991, appreciated property contributed to charity was subject to limitations for AMT purposes. There was an exception, which had expired on July 1, 1992, for tangible personal property contributed to a charity and which could be used by the charity in performing its particular charitable purposes (such as a work of art given to a museum). The Act retroactively extended the treatment of tangible personal property contributed to charity and eliminated the AMT limitations on appreciated property in general. The Act provides a twofold benefit for donors: (i) the deductibility of the full fair market value for contributions of tangible personal property, subject to the donor's maximum percentage limitations, has been restored; and (ii) with regard to the calculation of a donor's AMT, contributions of long-term capital gain property, previously deductible only to the extent of a donor's cost basis in the property, will now be fully deductible, subject, however, to the donor's maximum percentage limitations. Update on United States v. Irvine The U.S. Supreme Court recently reversed the Sixth Circuit decision in United States v. Irvine, a case discussed in our January 1994 report. The case concerned the question of whether the Federal gift tax applies to a current disclaimer of an interest in a trust created before the Federal gift tax was enacted in 1932. The disclaimant's delay of 47 years in disclaiming her interest was considered not to be reasonable by the Court. The Court emphasized that her act of disclaiming was not a pre-1932 transaction and therefore came within the applicability of the gift tax. The Supreme Court decision appears to prevent beneficiaries of trusts created prior to the existence of the U.S. gift tax from using a current disclaimer to pass assets down to a lower generation without transfer tax liability. This report is distributed for general information purposes only. No action should be taken solely on the basis of its contents. ©1998 Dunnington, Bartholow & Miller LLP. All Rights Reserved.