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Payment of Charitable Bequests from IRD Assets

Jason Meredith and Susann Montgomery-Clark

The desire to minimize taxes is a significant driver for many in estate planning. It is not the primary factor that motivates people to plan, but it is a driving force for certain planning techniques. As the estate tax exemption has increased, the tax-oriented aspects of estate planning have turned more and more to income tax issues.

The primary tax issue faced by most is income tax on certain tax-qualified retirement plans and other assets that carry ordinary income tax liability. The options for avoiding income tax on them are limited. In fact, using them for charitable bequests is really the only way to avoid tax on them entirely, and even that must be done carefully.

Terminology

The term "qualified retirement plan" or "retirement account" generally means a plan qualified under Section 401 of the Internal Revenue Code. These include, but are not limited to, profit sharing plans, money sharing plans, thrift plans, 401(k) plans, employee stock ownership plans (ESOPs), simplified employee pension plans (SEPs), SIMPLE plans and other defined contribution plans, such as IRAs, Roth IRAs, and tax–sheltered annuities (TSA) . The term "Participant" means the employee who participates in a qualified plan, or the account owner in the case of an IRA or TSA.

Tax Issues Facing Retirement Accounts

Capital assets left by a decedent will be transferred to the recipients with a fair market value basis. The recipient will be deemed to have paid for the asset what it was worth at the date of death of the decedent. While this is referred to as a step up in basis, one can see that there could actually be a step down in basis. Generally, however, the result is an increase in the basis, which saves the recipient capital gains taxes if he or she sells the asset.

Unlike capital assets, inherited qualified retirement benefits carry with them potential income tax consequences to the recipient at the owner’s death. Qualified retirement benefits are considered to be “income with respect of a decedent” (IRD) property subject to income tax to the recipient. IRD is an income interest that a deceased person earned that he or she would have recognized the interest as income if he or she had lived long enough to receive it since the decedent did not live long enough to receive the income, it is taxed to the party who does receive it.

Using IRD for Charitable Bequests

A charity is a tax–exempt entity, so it will not pay tax on IRD that it receives by "bequest, devise, or inheritance."  So, just as a lifetime gift of a capital asset to charity produces a double tax benefit (i.e., avoidance of capital gains and an income tax deduction), so should a bequest of retirement plan benefits transferred directly to a charity. One should strive to leave the taxable assets (i.e., the IRD items) to the nontaxable beneficiaries (the charities), and the nontaxable assets (i.e., all capital and non-IRD assets) to the taxable beneficiaries (heirs).

It can be quite difficult to coordinate IRD assets with an entire estate plan by using a beneficiary designation. For example, how would a person give 10% of his or her total estate to charity with a beneficiary designation? If one had a $500,000 estate, then 10% equals an intended $50,000 gift to charity. If $250,000 of this estate was comprised of IRD assets, then only the $250,000 portion could be left by beneficiary designation. One option would be to draft a specific beneficiary designation and attach it to the beneficiary designation form with some kind of formula to direct a portion of the retirement account/s to charity that happens to equal 10% of the total estate. (20% of the $250,000 could be left by beneficiary designation to equal the intended $50,000 charitable gift) The hope, then, is that the retirement account administrator will accept the special designation submitted.

In estate planning in recent years, many attorneys began directing these IRD assets to the client’s estate (naming the estate the beneficiary) or to a revocable living trust (RLT) and then including language to designate the gift to charity in the client’s last will and testament (Will) or RLT. A problem arose, however, in the IRS interpretation of this method. The IRS takes the position that gifts to charity should come from trust principal at death, and not from income or from IRD assets.

A Safe Alternative

A cautious approach that is certain to work in the meantime is to determine what percentage of the IRD assets is equal to the value of the total charitable gift intended, and then making direct beneficiary designations to the charity or charities from the IRD accounts.

For example, a person with a $1 million estate, which includes $200,000 in an IRA, wants to leave 10% (or $100,000) of his or her estate to charity at death. Then he or she could designate the intended charity as a beneficiary of 50% of the IRA ($100,000). Then, the charity would receive the charitable gift of $100,000 directly from the IRA.

The downside of this option that it requires continued monitoring of asset values as a proportion of the overall estate. In our example, if the overall estate value remained the same but the IRA grew to be $300,000 of that $1 million estate, then the beneficiary designation would need to be revised to direct one-third of the account to charity (for a total of $100,000). However, every option has its benefits and drawbacks. Planners and their clients need to weigh the risks and determine which risk is more manageable or tolerable.