In 1969, Congress changed the rules for obtaining the charitable estate tax deduction for interests that pass into trusts that benefit both charitable and noncharitable beneficiaries. In particular, Congress was concerned that taxpayers were establishing charitable remainder trusts that were shortchanging charities. In those trusts, individuals would be the income beneficiaries, and the remaindermen would be charities. Taxpayers would take a charitable deduction for the actuarial valuation of the charitable remainder interest. However, in operation, they would invest the trust to maximize income to the income beneficiaries (and thus effectively reduce the value of the remainder interests), so that the charities would often never receive anything near to the projected actuarial values for which a deduction was allowed. Under the split-interest rules under Code Section 2055(e), a charitable deduction is now allowed only if the trusts qualify as an annuity trust, unitrust, or pooled income trust – these types of trusts protect the values that will be passing to the charitable remaindermen.
In a recent case, the decedent established a trust that provided for benefits to both charitable and noncharitable beneficiaries. However, the trust did not provide for an income interest to noncharities with a remainder interest in charities, so the abuse behind the split-interest rules was not present. More particularly, the trust provided that property was to be retained in trust for a fixed number of years, and then the trust would terminate, with specified shares then being distributed to certain charities and other shares to noncharitable beneficiaries. Since income could not be distributed before termination to just noncharitable beneficiaries, there really was no way to cheat the charities out of their actuarial shares.
The estate took a charitable deduction for the actuarial shares of the charities under the trust. The IRS audited, and said that since Code Section 2055(e) applies when there are both charitable and noncharitable beneficiaries in a single trust, no charitable deduction is allowed.
The estate took the IRS to court, claiming that Code Section 2055(e) was not intended to apply to its type of trust, and thus (based on the legislative history of the split-interest rules) the charitable deduction should not be allowed. The trial court held that Code Section 2055(e) did apply. The Third Circuit Court of Appeals has now upheld the trial court, finding that a split-interest trust exists which is not an annuity trust, unitrust or pooled income trust, and thus no charitable deduction is available. The fact that the trust did not have noncharitable income beneficiaries with charitable remaindermen was not determinative – the only issue was whether charitable and noncharitable beneficiaries existed in the same trust. The Court declined to rely on the legislative history of Code Section 2055(e), finding that there was no ambiguity in the statute allowing for it to look at or rely upon legislative history.
The lesson for taxpayers and their advisors is clear – be careful not to mix together charitable and noncharitable beneficiaries, in any manner, in a trust that is not structured to be an annuity trust, unitrust, or pooled income trust if a charitable deduction is desired.
GALLOWAY v. U.S., 99 AFTR 2d 2007-XXXX, (CA3), 06/21/2007)