When is an amount permanently set aside for a charitable contribution deduction on an estate income tax return?
Taxpayer Says: During the taxable year ending March 31, 2008, it permanently set aside $219,580 of its gross income for the benefit of a charitable organization and thus is entitled to a charitable contribution deduction for that amount.
Internal Revenue Service Says: The $219,580 was not permanently set aside for charitable purposes as required by the code and regulations and therefore is not properly deductible by the estate.
From Internal Revenue Code Section 642(c)(2): Under this section, an estate is allowed a current charitable contribution income tax deduction, notwithstanding that the amount will not be paid or used for a charitable purpose until sometime in the future. The deduction under sec. 642(c)(2) is to be distinguished from the deduction afforded to an estate under sec. 642(c)(1), which allows a deduction for amounts actually paid during the taxable year to a charity by an estate.
Section 642(c)(2) provides, in pertinent part: In the case of an estate * * * there shall also be allowed as a deduction in computing its taxable income any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, permanently set aside for a purpose specified in section 170(c), or is to be used exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals, or for the establishment, acquisition, maintenance, or operation of a public cemetery not operated for profit. * * *.
From Federal Income Tax Regulation 1.642(c)-2(d) : An amount will not be deemed “permanently set aside” for a charitable purpose under section 642(c)(2) “unless under the terms of the governing instrument and the circumstances of the particular case the possibility that the amount set aside, or to be used, will not be devoted to such purpose or use is so remote as to be negligible.”
From Rev. Rul. 70-452, 1970-2 C.B. 199 : The Commissioner has interpreted the “so remote as to be negligible” standard from a quantitative perspective in the estate tax context, requiring at least a 95% probability that a bequest will pass to a qualifying charity before a deduction is permitted.
From 885 Inv. Co. v. Commissioner, 95 T.C. 156, 161 (1990) (quoting United States v. Dean, 224 F.2d 26, 29 (1st Cir. 1955)): We defined “so remote as to be negligible” as “‘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.’”
From Briggs v. Commissioner, 72 T.C. 646, 657 (1979), aff’d without published opinion, 665 F.2d 1051 (9th Cir. 1981): We construed the standard as being “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.”
From Commissioner v. Upjohn’s Estate, 124 F.2d 73 (6th Cir. 1941): The Court of Appeals for the Sixth Circuit stated: the bare possibility, considered abstractly and merely in terms of power, of an invasion of a fund devoted to charitable purposes, that is so remote that it may not, as a practical matter, be said to exist at all, does not render incapable of definite ascertainment the fund devoted to the beneficent purposes recited in the act.
THE CAUSE OF THE DISPUTE
Like individuals, estates can deduct charitable contributions from current income. This is true even if the contribution has not yet been paid, as long as the amount is from the estate’s gross income, made pursuant to the terms of a governing instrument, and permanently set aside for charitable purposes.
To meet the requirement of “permanently set aside for charitable purposes”, the estate must be able to establish that “under the terms of the governing instrument and the circumstances of the particular case, the possibility that the amount set aside, or to be used, will not be devoted to such purpose or use is so remote as to be negligible.”
In this case, the disagreement arose over the question of whether the estate met that standard.
The estate was created in April 2007 in Ohio. The estate property consisted of a primary residence in Ohio, a condominium in California, and a retirement account. Under the will, the estate residue was to be distributed to two heirs: $50,000 to an individual and the remainder to a qualified charity named in the will.
The estate liquidated the retirement account and deposited $219,117 into its checking account during 2007. The estate sold the Ohio residence for $217,900 in February 2008. Both transactions took place before the estate filed its initial income tax return (Form 1041) for the period ended March 31, 2008. At that point, the estate had $285,009 in its checking account and owned no income-producing assets. The estate still owned the condominium in California.
On the basis of the provision in the will leaving the estate remainder to the charity, the estate deducted $219,580 as a charitable contribution on the initial tax return. The contribution had not been made as of July 2008 when the tax return was filed and the estate did not segregate the amount from other funds in the checking account.
In 2007, the individual heir indicated he wanted to exchange his $50,000 bequest for a life tenancy interest in the California condo, where he had been living since 2006. In February 2008, the estate informed the heir the estate did not want to hold investment property and was not interested in making an exchange. The estate offered $10,000 as a stipend for vacating the condo.
The heir refused the $10,000 and filed a claim in May 2008 alleging the estate was breaching an oral contract between him and the decedent that gave him a life estate in the condo and that was not reflected in the will. In 2012, the heir won his lawsuit. The estate appealed. In 2013, the estate lost the appeal. In 2013, after the costs of the litigation, the estate had $185,000 remaining in its checking account, which was less than the amount required to pay the previously deducted charitable contribution.
The IRS disallowed the $219,580 charitable contribution deduction, saying the amount was not permanently set aside for charity as required by the code. The IRS argued there was a substantial possibility of a prolonged and expensive legal fight that would have required the estate to dip into the funds it allegedly ‘set aside’ for charity in order to pay for the litigation and the additional administrative costs for the estate probate proceedings. The IRS believed the estate was clearly on notice that a prolonged legal fight was more than a remote possibility at the time it claimed the charitable deduction. The estate should have known there was more than a ‘negligible chance’ that it would have to apply some of the funds to cover the administrative costs as the probate proceedings continued.
The estate argued there was no “reasonably foreseeable possibility” it would incur unanticipated costs associated with litigating the claims on the California condominium. At the time of the lawsuit (and the initial tax return), the estate believed it would prevail, as the heir had no ownership interest in the funds the decedent used to purchase the condo or in the condo itself.
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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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The information that was known or reasonably knowable to the estate when it filed its Form 1041 on July 17, 2008, indicates that the heir’s claim to a life tenancy interest in the California condo was a serious claim based on alleged events that predated the end of the taxable year ending March 31, 2008.
The estate was aware of its financial situation. As of March 31, 2008, after subtracting the funds that had been ostensibly set aside for the charity, there was approximately $65,000 remaining in the estate’s residue to cover the remaining expenses associated with the estate administration. When the estate filed its Form 1041 on July 17, 2008, there were no income-producing assets remaining in the estate. From the amount remaining in its residue, the estate was responsible for various expenses.
The heir’s actions leading up to the estate filing its Form 1041 on July 17, 2008, provided information indicating that he would put up a litigious fight. The estate was aware of the heir’s claims and filed its objections. The heir’s active litigation of his property rights to the condo created a real possibility that the funds set aside for the charity would be depleted during the pendency of the lawsuit.
All of these events occurred and were known to the estate before July 17, 2008, when the estate claimed a $219,580 charitable contribution deduction on its Form 1041. The facts and circumstances were sufficient to put the estate on notice that the possibility of an extended and expensive legal fight–and consequently the dissipation of funds set aside for the charity–was more than “so remote as to be negligible”.
Therefore, the estate did not “permanently set aside” the charitable contribution amount as required under Internal revenue code section 642(c)(2).