Final Regs on Income Ordering Rules for Payments to Charitable Beneficiaries

For a trust to qualify for the charitable deduction, a charitable contribution must be made from gross income. [See IRC § 642(c).] IRC Section 642 requires tracing since the source of the charitable contribution must be gross income rather than principal. The provisions of the governing instrument which specify the source of the payments will control in determining whether the amounts of income paid or set aside for the charitable purpose include items of income not includable in gross income.

Key Element - Economic Effect:  On April 16, 2012, the IRS issued final regulations (T.D. 9582 (I.R.S. 2012)) which provide guidance with regard to the federal tax consequences of an ordering provision in a trust, will, or a provision of local law attempting to determine the tax character of the amounts paid to a charitable beneficiary of the trust or estate. The final regulations also require that a specific provision of the governing instrument or a local law provision must have economic effect independent of income tax consequences for it to be respected for federal income tax purposes. Treas Reg § 1.642(c)-3(b)(2).

Example: What Doesn't Qualify: The final regulations include an example of a charitable lead annuity trust paying an amount to a charity for a determinable period. The governing instrument provides the annuity will be deemed to come:

  • First from ordinary income;
  • Second from short-term capital gain;
  • Third from 50 percent of the unrelated business taxable income;
  • Fourth from long-term capital gain;
  • Fifth from the balance of unrelated business taxable income;
  • Sixth from tax-exempt income; and
  • Seventh from principle.

According to the regulations, this provision in the governing instrument does not have economic effect independent of tax consequences because the amount paid to charity is not dependent upon the type of income from which it is paid. Therefore, the amount to which IRC Section 642(c) applies is deemed to consist of the same proportion of each class of the items of income of the trust as the total of each class bears to the total of all classes. Prop Treas Reg § 1.642(c)-3(b)(2), Ex.

The final regulations also clarify
Treasury Regulation Section 1.643(a)-5(b) language: If the governing instrument or local law specifically provides as to the source out of which the amounts are paid, permanently set aside or to be used for charitable purposes, the specific provision will control to the extent the provision has economic effect independent of income tax consequences.

...

Discover the features and benefits of LexisNexis® Tax Center

For quality Tax & Accounting research resources, visit the LexisNexis® Store