Are Charitable Contributions Deductible on Form 1041?

Every time a testator decides to make a charitable organization a beneficiary in either their will or trust, the question arises: “Are charitable contributions deductible on Form 1041?” Many people assume that since a charitable deduction is allowed for individual Form 1040 returns, any amount distributed to a charity from an estate or trust is also deductible. Unfortunately, as Lemony Snicket observed:

“Assumptions are dangerous things to make, and like all dangerous things to make — bombs, for instance, or strawberry shortcake — if you make even the tiniest mistake you can find yourself in terrible trouble.”

Terrible trouble certainly awaits the assumptive charitable testator. While the Internal Revenue Code (IRC) does allow estates and trusts an income tax deduction for charitable contributions, wills or trust agreements must contain specific instructions in the document before the testator’s death. If an element is omitted, the amount donated to charity is not deductible and the estate, trust or beneficiary must still pay the resulting income tax on the amount donated.

To be eligible for a charitable deduction, the governing document (i.e., trust document) must contain specific instructions requiring the estate or trust to make charitable bequests out of gross income. If these instructions are included, then under IRC § 642, a 1041 charitable contribution deduction is allowed in two circumstances:

The general rule

The general rule under §642(c)(1) allows estates and trusts to deduct amounts distributed to charity as long as the distribution is made pursuant to the terms of the governing instrument.

The §642(c)(1) deduction supersedes the §170(a) deduction percentage limitations, effectively allowing estates and trusts an unlimited charitable deduction. An added benefit is that the §642(c)(1) deduction does not refer to the §170(c)(2)(A) restriction to charities organized in the US. Thus, amounts paid to foreign charities are deductible.

Finally, an election under §642(c)(2) also allows distributions to charities made in one year to be treated as made in a prior year for 365 days. This is similar to the 65-day election under §663(b).

The “set aside” deduction

In an estate, §642(c)(2) allows for a “set aside” deduction. This is a special deduction for amounts not currently distributed but set aside for future distribution to a charity. The plain text of §642(c)(2) does not apply to trusts unless they were created prior to October 1969.

However, under §645, a trust and an estate can elect to both be treated as part of the estate for tax purposes for the first two years. Thus under this election, a revocable trust is eligible for the “set aside” deduction after making the election under §645, but only for two years.

Tax liability trouble arises when the governing document neglects to instruct the fiduciary to pay out charitable bequests from income. In these cases, the courts have overwhelmingly denied an estate or trust a charitable income tax deduction. Surprisingly, even if the instructions are included, and the estate or trust qualifies under one of the two above situations, a charitable deduction is still not guaranteed. Depending on the type of income generated by the estate or trust assets, a charitable bequest may be only partially allowed as a charitable deduction.

To avoid this problem, designating a charitable organization as an outright beneficiary to assets, such as a retirement account, keeps the income outside of the estate or trust and is usually the most tax-efficient strategy. If the asset is transferred outside of the estate or trust, a deduction is not claimed, nor is income included, resulting in the equivalent of offsetting a charitable contribution deduction 100%. Since a charitable deduction can easily be limited, it is usually more tax efficient to transfer the asset outright to the charity.

Conscientious testators will transfer assets outside of the estate or trust when possible and include qualifying instructions in the governing document. Careful planning for charitable contributions can help avoid tiny mistakes and terrible trouble, allowing for greater flexibility and tax savings for testators, their estates/trusts and their beneficiaries.

Schedule a consultation with Aprio’s Wealth Management team to review your charitable contributions and their taxability.