Chapter 16 - § 16.6 • CHARITABLE TRUSTS
| Jurisdiction | Colorado |
§ 16.6.1—Wholly Charitable Trusts
Wholly charitable trusts — that is, trusts of which all of the beneficiaries are charities — have lost favor over the years as vehicles for carrying out gifts and bequests to charity. Because of the existence of considerable statutory guidance and their familiarity and acceptance within the business community, nonprofit corporations have instead become the vastly preferable entity for establishing new charities. Nonetheless, individuals do sometimes still create wholly charitable trusts, usually by means of testamentary transfers. A wholly charitable trust may also result from a charitable remainder trust once all the intervening private interests have expired, if the trust is designed to continue in existence for the benefit of the charitable remaindermen. If those individuals and their successors and advisors are not sufficiently knowledgeable, they may fail or neglect to qualify those wholly charitable trusts under I.R.C. § 501(c)(3). The consequences of that failure are rather unexpectedly burdensome and are the subject of the following discussion.
A contribution to a trust, all of the interests in which are devoted to charity, is not subject to the partial interest rule, I.R.C. § 170(f)(2)(D), although it will be considered a transfer "for the use of" the charitable beneficiaries and thus ineligible for the 50 percent limitation on income tax deductions. See Rockefeller v. Comm'r, 676 F.2d 35 (2d Cir. 1982). Also, because the federal income, estate, and gift tax charitable deductions are allowed by separate provisions of the Internal Revenue Code other than I.R.C. § 501(c)(3), a deduction for a transfer to a wholly charitable trust may be allowed even though the trust has not applied for or received exemption under I.R.C. § 501(c)(3).3 Finally, trusts are allowed to deduct for income tax purposes charitable distributions without limitation. I.R.C. § 642(c).4 The effect of this unlimited deduction is that a wholly charitable trust that distributes all its income each year to charity is effectively tax exempt.
On the other hand, if the trust does not apply for or receive § 501(c)(3) status, even though it may be effectively tax exempt by virtue of the § 642(c) deduction, a number of hazardous consequences may result, since, in all likelihood, such a trust would have been classified as a private foundation were it in fact a § 501(c)(3) organization. See Rev. Proc. 72-50, 1972-2 C.B. 830.
Such taxable charitable trusts are governed by I.R.C. § 4947(a)(1), which provides that a trust, in which all of the interests are devoted to one or more of the purposes described in I.R.C. § 170(c)(2)(B) and for which any deduction was ever allowed under any of the federal income, estate, or gift tax charitable deduction provisions, will be considered to be a § 501(c)(3) organization. Such a trust will not, however, be so treated for purposes of tax exemption under I.R.C. § 501(c)(3), only for purposes of all the burdensome restrictions imposed on § 501(c)(3) organizations — including the private foundation termination tax provisions of I.R.C. § 507 and the private foundation excise tax provisions of I.R.C. §§ 4941 through 4945.
The possible result of all these rules is that an entirely charitable trust that fails to obtain § 501(c)(3) status is not a tax-exempt organization, must rely on distributions of all its income each year to eliminate its tax liability, and will in all likelihood nonetheless be subject to all the onerous private foundation rules.
§ 16.6.2—Charitable Remainder Trusts
Charitable remainder trusts represent an exception, specifically authorized by statute, to the partial interest rule and are trusts created for the benefit of noncharitable beneficiaries for some period of time, followed by a remainder interest that vests exclusively in one or more charities.5 Charitable remainder trusts are private vehicles, and any obligation to pay any annuity or unitrust amount is that of the trust, not the charity. This alternative has an obvious appeal to the charity, for a variety of reasons:
• The charity's assets are not at risk for the payment of the annual amounts to the donor, as they are in the case of bargain sales and gift annuities; and
• The trust can hold assets that the charity would prefer not to own outright, such as stock in a closely held corporation or real estate with possible environmental liabilities.
Charitable remainder trusts may also appeal to donors who desire to retain control, as trustee, of the contributed assets. On the other hand, while charitable remainder trusts are generally more complicated to establish and administer and may therefore be somewhat less attractive to donors, they will also provide a significant degree of flexibility to donors.
The Internal Revenue Code describes two different kinds of charitable remainder trusts: charitable remainder annuity trusts and charitable remainder unitrusts. The following discussion summarizes the restrictions applicable to each kind, as well as the kinds of restrictions applicable to both types of trusts.
Charitable Remainder Annuity Trusts
A charitable remainder annuity trust is one that provides for a stated, fixed amount of money (for example, $10,000 per year) to be paid, in all events, to one or more specified private beneficiaries on at least an annual basis. Upon termination of the private interests, the balance remaining in the trust must be paid to, or held in perpetuity for the use of, one or more charitable organizations.6 The annuity amount can be described either as a specific dollar amount or as a fraction or percentage of the initial fair market value of the property contributed to the trust. Treas. Reg. § 1.664-2(a)(1)(iii) permits the trust agreement to contain provisions requiring that compensating payments be made to the beneficiary if valuation adjustments result in a change in the amount of the annuity.
The stated annuity amount cannot be less than 5 percent or more than 50 percent of the initial fair market value of the property transferred to the trust. I.R.C. § 664(d)(1)(A). Also, the value of the charitable remainder interest cannot be less than 10 percent of the initial fair market value of all property contributed to the trust. I.R.C. § 664(d)(1)(D).
In addition, no income, gift, or estate tax charitable deduction will be allowed if there is more than a 5 percent probability that the trust assets will be exhausted before the charitable beneficiary will take its interest. Revenue Ruling 77-374, 1977-2 C.B. 329, illustrates this requirement with a charitable remainder annuity trust having an initial corpus of $400,000 and paying an annuity of $40,000 per year to a 61-year-old...
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