Today’s blog post about the Heckerling Institute is written by Withum’s Estate & Trust Services Partner, Donald Scheier.
The Nuts and Bolts of Private Foundations (for Estate Planners)” – presented by Alan F. Rothschild, Jr.
This session focused on understanding the rules and intricacies of private foundations, their operations and how they differ from other types of qualified charitable tax exempt organizations, particularly public charities. These are some of the highlights of the presentation.
An income tax charitable deduction is allowed for contributions of cash or property to or for the benefit of a qualified charitable organization. The amounts of the charitable deductions are limited by 1) type of property contributed 2) type of organization the contribution was made to 3) taxpayer’s Adjusted Gross Income. Some examples of the more common qualified organizations for the purposes of the income tax deduction include the following:
- Federal, state, and other governmental units in the United States or its possessions.
- A domestic (U.S.) entity “organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes . . .”
- War veterans organizations.
- A domestic fraternal society, order, or association operating under the lodge system.
- A nonprofit cemetery company operated exclusively for the benefit of its members or for burial purposes.
- Foreign organizations with qualified domestic organizations or certain charities in countries with tax treaties permitting contributions.
In order to confirm that an organization is qualified you can access The IRS’ Exempt Organizations Select Check; an alternative source of this information is Guidestar, a nonprofit online database that draws from the IRS records, tax returns, and information submitted by charities themselves.
In addition to getting an income tax deduction, contributions made to tax exempt organizations whether classified as private foundations or public charities are deductible for estate and gift tax purposes; however, the allowable deduction for income tax purposes differs significantly.
An organization must qualify as a public charity (“PC”) by meeting certain criteria. The Internal Revenue Code does not expressly define the term “public charity,” but instead classifies all nonprofit entities by default as private foundations (“PF”), then provides “exceptions” to this default classification. PFs are further divided into private operating foundations and private non-operating foundations. Private operating foundations typically operate their own charitable programs, while private non-operating foundations’ primary activity is grant making.
Some of the benefits of establishing a private foundation are 1) Retain control – the donor and his or her family retains control over the investment of the assets, governance and operation of the entity and the ultimate selection of the charitable recipients. 2) Accelerated charitable deduction – contributions to a PF are deductible at the time of the gift, although the donor or his or her designee retains control over the assets. 3) Structured philanthropy – a family PF can provide a variety of non-tax benefits, including the building of a significant fund with which to accomplish greater philanthropic objectives, institutionalizing the family’s giving for present and future generations, and providing a buffer between the donor and prospective grantees.
Private Foundations have strict rules that must be followed as enumerated in IRC sections 4940-4945. These rules relate to a variety of areas and some examples are i) amount of annual distributions (5% of non-charitable assets), ii) types of investments it can make, iii) % of business holdings (excess business holdings), iv) types of transactions (taxable expenditures), v) dealings between certain persons (disqualified persons and self-sealing rules). A private foundation is also required to file an annual tax return on Form 990. Although a PF is tax exempt it is still subject to an annual excise tax of either 1% or 2% depending on the amount it distributes.
Knowing the Ropes and Binding the IRS when Fiduciaries are involved in Settlements and Modification: Income and Transfer Tax Issues every Fiduciary should know about – presented by Melissa J. Willms.
In this day and age where litigation and settlements are so prevalent, we were given an overview of the significant federal tax issues and problems that arise through various aspects of resolving estate and trust controversies.
Every aspect of estate and trust administration has one or more transfer tax (gift, estate, inheritance, and generation-skipping transfer tax) and fiduciary or personal income tax ramifications. Litigation and other dispute resolution measures in estate, trust, and guardianship administration are no different. Dealing competently with the tax ramifications is the responsibility of the fiduciary. Therefore, it is important for any party to actual or threatened litigation to consider the transfer and income tax consequences of any matter or issue that arises in any stage of the controversy.
The executor of a decedent’s estate is required to pay federal estate tax (and Generation Skipping Tax, if applicable) if the decedent died owning property worth more than the amount of his or her estate tax applicable exclusion amount. Living individuals, who make taxable gifts, must report those gifts annually, and pay any resulting gift tax (and Generation Tax, if applicable) if the gifts exceeds his or her remaining exclusion amount.
In general, private parties cannot simply agree as between themselves what the tax consequences of resolving their dispute will be. The shifting of valuable property rights as a result of litigation, or in compromising bona fide disputes between adverse parties, will have tax consequences to the parties that are largely dependent upon the nature of the underlying claim. Thus, for example, amounts received in settlement of a will contest are generally treated as amounts received in the nature of an inheritance, and as a result, are not subject to income tax. If a dispute is resolved by means of a settlement agreement instead of a final judgment, the IRS will generally respect the outcome so long as the settlement agreement resolves a bona fide dispute and the participants are bona fide claimants. Conversely, if there is no actual dispute, a settlement agreement that is a voluntary rearrangement of property interests may not be recognized by the IRS. Is the IRS bound by a state court adjudication of property rights when the United States was not a party to the state court action? To resolve any doubt, the taxpayer could seek a private letter ruling asking the IRS to approve the tax consequences of the action.
There are a number of obligations imposed by federal and state tax laws on an estate’s representative or a trustee in administering an estate or trust such as Duty to File Tax Returns and Duty to Pay tax Liabilities. Federal taxing authorities, to a large extent, use executors as their collection agents. They do so primarily through the notion of “fiduciary liability.” Pursuant to the concept of fiduciary liability, the executor is personally liable for tax liabilities of the decedent, at least to the extent that assets of the decedent come within the reach of the executor. More broadly, fiduciary liability may be personally imposed on every executor, administrator, assignee or “other person” who distributes a living or deceased debtor’s property to other creditors before he or she satisfies a debt due to the United States. While a liability is normally focused upon a court-appointed executor where one exists, where there is none, a wider net may be cast.
On its face, Section 3713(a) seems to impose absolute liability upon an executor. It essentially provides that debts due to the United States must be paid before the debts of any other creditor. No exceptions are made in the statute for the payment of administrative expenses or for the satisfaction of earlier liens out of the debtor’s property or estate. However, courts and the IRS have held that this apparent absolute priority is subject to a number of exceptions. First, costs of administering an estate may be paid before a tax claim. These expenses include court costs and reasonable compensation for the fiduciary and attorney. The theory for permitting the payment of these items is that they were not incurred by the debtor but are for the benefit of all creditors, including the United States. However, payments of state income taxes, general creditors, and other claims constitute the payment of debts in derogation of the government’s priority. . Likewise, distributions to beneficiaries are not “charges” against the estate, but are treated as the payment of a “debt.” In addition, a distribution to the executor-beneficiary cannot be treated as the payment of “administration expenses” unless the executor demonstrates that the expenses were used for that purpose. As a result, liability arises if the executor makes distributions to beneficiaries from an insolvent estate before payment of estate or gift taxes.
An executor may request a discharge from personal liability for estate, income, and gift tax liabilities of the decedent (which gives the IRS nine months to notify the executor of the amount of the relevant tax) by making a request for such a discharge (IRS Form 5495, “Request for Discharge from Personal Liability Under Internal Revenue Code Section 2204 or 6905″) pursuant to Code Section 2204 (as to estate tax), or 6905 (as to income and gift tax).
For estate tax returns filed prior to June 1, 2015, the IRS routinely issued an Estate Tax Closing Letter confirming that if a request for discharge of personal liability under Code Section 2204 was made and the executor paid the amount shown as due, the executor was released from personal liability. The letter further provided that the IRS would not reopen the return for further review absent (1) evidence of fraud, malfeasance, collusion, concealment or misrepresentation of a material fact, (2) a clearly defined substantial error based upon an established IRS position, or (3) a serious administrative error. In June, 2015, the IRS issued an administrative announcement indicating that, commencing with estate tax returns filed on or after June 1, 2015, it will only issue estate tax closing letters upon request by the taxpayer. Taxpayers are advised that they should wait at least four months after filing the return before requesting a closing letter in order to allow sufficient time for the IRS to process the return.script of Tax Return,” and such transcript can serve as a substitute for a closing letter.
The income tax consequences of all settlements and controversies must be analyzed in detail. Although the general rule that an inheritance is not taxable there could be exceptions due to the nature of the controversy and the type of settlement. Broadly speaking, income earned by a trust or estate in any year is taxed to the trust or estate to the extent that the income is retained, but is taxed to the beneficiaries to the extent that it is distributed to them. The Code sets forth a detailed method to determine which trust or estate distributions carry income out to the beneficiaries. Thus, the structure of the payments or distribution from a trust or estate may subject the beneficiary to income tax.
Reprise! The State Taxation of Trust Income Five years later – presented by Richard W. Nemmo
This session clearly indicated the major difference of how various States tax trusts and how they are defined in the different jurisdictions. In general, States tax all income of a “Resident Trust” but just the “source income” of a “Nonresident Trust. They define “Resident Trust” in several different ways, however, leading to inconsistent income-tax treatment of the same entity, often resulting in double (or more) state income taxes being imposed on the same income. Moreover, recognizing the constitutional limits on their ability to tax, some states do not tax Resident Trusts in certain circumstances.
Practitioners must consider the state income-tax treatment of the trusts that are created for their clients into their estate-planning recommendations. They must take steps to assure that the income of these trusts is not taxed by any state, or by no more than one state in any event. Trustees of trusts that do not already reflect this planning must consider whether there is any way to reduce the incidence of state income taxation on the trusts’ income. Failure of the estate planner and the trustee to consider these issues may give rise to claims of malpractice or breach of the trustee’s fiduciary duty of competence.
All income of a trust that is treated as a grantor trust for federal income-tax purposes normally is taxed to the trustor, distributed ordinary income of a non-grantor trust generally is taxed to the recipient, and source income of a trust (e.g., income attributable to real property, tangible personal property, or business activity) usually is taxed by the state where the property is situated or the activity occurs.
In summary – The income of trusts based on one or more of five criteria: (1) the residence of the testator, (2) the residence of the trustor, (3) the place of administration, (4) the residence of the trustee, and (5) the residence of the beneficiary. Only the testator, trustor, or beneficiary can change residence for criteria (1), (2), and (5). But, it is possible to control the place of administration (criterion (3)) and the residence of the trustee (criterion (4)).
If it has been determined that a trust has paid tax erroneously, the trustee should request refunds for all open years.
Feel Good Doing Good: Impact investing when Settlors and Beneficiaries want to do more than make Money – presented by Susan N. Gary
This session’s focus was on clients who want to make sure that they are doing the “right thing”. How can they make sure that the directors of a charity align investment of the charity’s endowment with the mission of the charity? Can they do that and still comply with their fiduciary duties to the charity? Does the expected return on the investments matter? How can a new client draft a will with trusts for his children having the trustees of the trusts invest only in companies with good labor practices and with good ratings on corporate governance?
Explanation and analysis of some of the different types of investment strategies that consider social and environmental factors in addition to traditional financial analysis are shown below:
- Socially Responsible Investing (SRI): is a type of investing that combines financial goals with social goals.
- Impact Investing: often used in place of SRI, as a generic term to encompass various types of investing that combine traditional financial goals with social and environmental goals.
- Values Based Investing, Triple Bottom Line Investing, Ethical Investing, Green Investing: Used without precision and somewhat interchangeably with SRI and impact investing. A variety of additional terms convey the idea of combining traditional financial goals with social or environmental goals.
- Blended Value: Refers to an investment strategy that seeks all three forms of value. Targeted impact investing seeks blended value, as do mission-related investing and program related investing.
- Mission-Related Investing (MRI): are terms used to describe investments that carry out a charity’s mission.
- Program Related Investments (PRIs): Investments entered into by a private foundation primarily to carry out a purpose of the private foundation. A PRI is an investment entered into primarily for a program-related reason, but one that will generate some amount of financial return.
- ESG Investing: (also called ESG integration) combines traditional financial analysis with material information about environmental, social and governance factors that may not be reflected in usual market data. Use of ESG integration has grown in recent years.