Threat of Litigation Eliminates Charitable Set Aside Deduction for Estate

Estates and trusts with charitable beneficiaries often seek to employ the Code Section 642(c) charitable set aside deduction for income earned by the estate and trust that will eventually (but not in the current tax year) be distributed to the charity. This deduction is needed when the income cannot be currently distributed, since in that case neither a distribution deduction nor a charitable deduction would otherwise be available. Oftentimes, income cannot be currently distributed because it is too early in the administrative process to distribute to the beneficiary, especially when the beneficiary is a residuary beneficiary.

Code Section 642(c) will allow a deduction to the estate or trust in the year income is earned if the income is permanently set aside for a charitable purpose.  However, Treas. Reg. §1.642(c)-2(d) provides that no amount will be considered permanently set aside  “unless under the terms of the governing instrument and the circumstances of the particular case, the possibility that the amount set aside...will not be devoted to such purpose or use is so remote as to be negligible.”

In a recent Tax Court case, there was a charitable residuary beneficiary, and there was income earned in a year that was not paid out to the charity in that year. Subsequent to the earning of the income, the estate was engaged in litigation with another beneficiary. The charity did not receive all of the previously earned income due to expenses of the litigation.

The IRS asserted, and the Tax Court agreed, that the charging of the set-aside amounts with litigation expenses was not “so remote as to be negligible,” and thus disallowed the charitable set-aside deduction. The Court borrowed from case law in other contexts to equate “so remote as to be negligible” as meaning “a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction” or ““a chance which every dictate of reason would justify an intelligent person in disregarding as so highly improbable and remote as to be lacking in reason and substance.”

Under the facts of the case, the Tax Court found clear indications that at the time of the set-aside, there was a reasonable likelihood of litigation and that the costs of such litigation could impact the funds ultimately passing to the charitable residuary beneficiary. Thus, no set-aside deduction was allowed

It is important to note that the estate did not lose the set-aside deduction only on the set-aside funds actually expended on the litigation, but on the entire set-aside amount even though a large portion of the set-aside was not applied to the litigation expenses. It is not a question of the actual amount of funds applied out of the set-aside that is relevant – what is relevant is how much of the set-aside is at risk of being lost such that the risk of loss is not “so remote as to be negligible.”

It would have been helpful for the court to have specifically ruled that the entire amount was at risk to litigation expenses and the remaining administrative expenses (i.e., that the risk to the whole income amount was more than negligible. By not doing so and disallowing the entire set-aside deduction, it is unclear if the case can be stretched to support an interpretation that the entire set-aside can be lost even if only a PORTION of the income that was set-aside was at risk which risk was more than so remote as to be negligible.

Estate of Eileen S. Belmont, et al.v. Commissioner, 144 T.C. No. 6