Navigating the Estate-bequest Terrain

As a general rule, inherited assets are not subject to federal income tax. But if a beneficiary receives a gift before the death of the donor, it is considered “Income in Respect of a Decedent” and will be subject to income tax in the hands of that beneficiary.

There are many of these IRD assets: savings bonds, lottery winnings, IRAs, etc. Since these assets carry income tax burdens, they’re excellent candidates for charitable giving.

This especially is true for qualified-plan and IRA assets in light of the revised regulations issued recently by the Internal Revenue Service, which govern the computation of minimum-required distributions. Since 2001, the identity of the beneficiary of a qualified plan or IRA does not impact how much the participant or owner must take out of the account each year, e.g., the computation of the minimum-required distribution.

Qualified plans and IRAs
Because funds held in qualified plans and IRAs are subject to federal income tax when withdrawn by the beneficiary, they are better suited for charitable transfers at death, rather than doled out sporadically during the donor’s lifetime.

For example, a father has $50,000 in an IRA and $50,000 in low-basis appreciated securities. He intends to leave half his estate to his college, half to his son.

A smart college development officer will suggest that he execute a will, leaving his probate estate to his son, and designate his alma mater as a beneficiary of the IRA.

Assuming there is no change in value, both the college and son will receive $50,000. But the college will not be taxed on the IRD included in the IRA.

The son, on the other hand, will receive a “step-up” in basis for the securities he inherits and will not be taxed on the capital gained that otherwise would be attributed to the appreciation in value.

Had the donor simply left half of his assets to his son and alma mater, respectively, the college would have wasted half the benefit of the step-up in basis on the appreciated securities and the son would be burdened with half the IRD.

Therefore, creative use of qualified plans and IRAs can produce a win-win situation for all involved.

Challenges of beneficiary designations
The most common way of passing interest in a qualified plan or IRA is through a beneficiary designation. If a donor names a charitable organization as the sole beneficiary of a qualified plan or IRA, the charity can simply collect the plan or account proceeds upon her death.

As a tax-exempt organization, the charity will not pay federal income tax on the amounts distributed, and the estate will receive a tax deduction for the amount passing to the organization. If, however, the donor wants to divide the qualified plan or IRA assets between a charity and an individual, more planning is necessary.

Naming a charity as one of multiple beneficiaries of a qualified plan or IRA will not affect the interest of the charity, but it can affect interest of the individual beneficiaries — and not necessarily in a favorable way.

The balance in the qualified plan or IRA must be distributed within five years of the death — if the donor had not attained age 70.5 at death. Otherwise, it would be distributed over the donor’s remaining life expectancy, if death occurs after age 70.5. But there are ways to avoid this.

If the interest passing to the charity is fully distributed before Sept. 30 of the year following the year of the donor’s death, it will be ignored for purposes of determining whether all beneficiaries are individuals.

But if the interests of the charity and the individual beneficiary constitute separate accounts — e.g., one half to charity, one half to the daughter — the daughter will be able to use her life expectancy to compute the minimum-required distributions from his separate account.

And, if the surviving spouse is the only non-charitable beneficiary, she can roll any interest gained into an account under her own name.

But if the donor designates a specific sum to the charitable organization and the balance to an individual ($10,000 to charity; balance to daughter), the separate account rule noted above will not apply, and the $10,000 pecuniary bequest should be paid before the Sept. 30 deadline.

All beneficiaries are not created equal
But what if the estate of the donor is designated as the beneficiary of the qualified plan or IRA and his will leaves one-half to a charity and the other half to his son? Can the personal representative of the estate distribute one-half of the plan to the charity before Sept. 30 of the year following death and avoid the “all beneficiaries must be individuals” rule?

The answer, alas, is no. The estate will be deemed the beneficiary, and no matter how quickly distribution is made, not all beneficiaries will be considered individuals.

While this doesn’t harm the charitable organization’s interest, it can affect the son’s interest. Prospective donors may appreciate a heads up on this important point.

As a rule, naming a charitable organization as a beneficiary of a trust that is, in turn, the beneficiary of a qualified plan or IRA also presents problems for the non-charitable beneficiaries.

The regulations require that all trust beneficiaries be individuals and any charitable interest, no matter how remote or contingent, will cause the trust to fail to meet this test.

That said, the qualified plans and IRAs are good candidates to fund a charitable remainder unitrust, or CRUT.

Consider a CRUT
If the CRUT is the beneficiary of the qualified plan or IRA, it may take a lump-sum withdrawal and avoid the income tax that would otherwise be imposed on the IRD because of its charitable status.

Thus, if a donor wants to benefit a charity but also needs to provide for another individual, a CRUT should do the trick.

The CRUT takes the lump-sum withdrawal, then pays the unitrust amount to the individual beneficiary. The unitrust amount will be larger because the underlying principal was not reduced by the payment of income tax on the IRD. The estate will receive a charitable deduction for the value of the charitable remainder.

Had the individual been the sole beneficiary of the qualified plan or IRA, all distributions to her would have been taxed at ordinary rates.

However, distributions from a CRUT will be taxed to the individual beneficiary according to the type of income it represents, under special “tiering” rules applicable only to remainder trusts.

Thus, it is possible that a unitrust distribution may be taxed to the individual beneficiary — at least in part, at capital gains rates.

Unfortunately, for the moment, the benefits of funding charitable gifts using qualified plan or IRA assets are available only at death. There are not many opportunities to use these assets for lifetime charitable planning.

However, a perennial bill in Congress could alter this reality. In its most recent state, the bill allows direct transfers from an IRA to a charity without requiring the owner to include the distribution in her taxable income.

These bills pass the House and Senate regularly, but they never seem to make it out of conference. If they become law, a whole new source of charitable giving will be available:

1. Profit sharing plans, 401(k) and 403(b) accounts.
2. Roth IRAs are not subject to federal income tax.

Kathleen A. Stephenson is of counsel with the Philadelphia office of Pepper Hamilton LLP. Lisa B. Petkun is a partner in the tax department of Pepper Hamilton. On the Record keeps readers up to date on the latest tax and planning issues pertaining to fundraising endeavors and charitable organizations.