In an era of unprecedented bank mergers and consolidations, many bank trust officers and wealth managers may find themselves undertaking responsibility for hundreds, and in some cases, thousands of trusts formerly administered by another institutional fiduciary or agent. As institutions work to integrate these trusts into their existing systems, it is important to determine whether such trusts have been properly administered in accordance with applicable federal and state laws since their formation. In particular, common errors in the administration and tax reporting of trusts that have only charitable beneficiaries remaining may result in substantial federal taxes, penalties, and interest, as well as potential liabilities for breaches of fiduciary duty to the remaining charitable beneficiaries. This Alert describes the complex federal tax requirements that apply to such trusts, common pitfalls in their administration, the potential liabilities that may result, and strategies for managing these risks.
Tax Rules Applicable to Trusts with Exclusively Charitable Beneficiaries
Section 4947(a)(1) of the Internal Revenue Code of 1986, as amended (the “Code”)1, applies to any trust that has not applied for and received recognition of tax-exemption from the Internal Revenue Service, if all of that trust’s unexpired interests are devoted to one or more religious, charitable, scientific, etc., purposes, and if a charitable deduction was allowed for contributions to the trust. Treas. Reg. §53.4947-1(b)(1). Section 4947(a)(1) trusts often arise in the following ways: (1) a revocable trust established for the benefit of a grantor, or the grantor’s family members becomes irrevocable upon the grantor’s death and, after any required distributions to individuals outright or for a set period of time, the remainder is held in trust for charitable beneficiaries either indefinitely, or for a set period of years; (2) a testamentary trust funded at the testator’s death provides for distributions to individual beneficiaries outright or for a set period of time, with the remainder of the trust to be held for charitable beneficiaries either indefinitely or for a set period of years; or (3) a testamentary trust funded at the testator’s death is established exclusively for the benefit of charitable beneficiaries.
Any trust that is described in section 4947(a)(1) is subject to the federal income taxes that apply to all taxable trusts, and must file an annual return, the IRS Form 1041. Such a trust is also subject to the private foundation rules, described in sections 4940-4945 of the Code2, and must also file an IRS Form 990-PF annual information return. As a result, a section 4947(a)(1) trust must:
- Pay the section 4940 2 percent tax on investment income
- Avoid section 4941 self-dealing transactions with disqualified persons, who include: the trust’s institutional trustees, individual trustees, substantial contributors, and the family members of individual trustees and substantial contributors
- Distribute annually at least 5 percent of the fair market value of its investment assets for charitable purposes and reasonable administrative expenses (known as section 4942 qualifying distributions). Such distributions are required by federal tax law, even if the trust instrument only authorizes distributions of a lesser amount, such as distributions of “income only”
- Generally avoid holding, along with disqualified persons, more than a 20 percent interest in any business enterprise in accordance with the section 4943 excess business holding rules
- Avoid jeopardizing investments as described in section 4944
- Avoid certain types of expenditures described in section 4945, including, but not limited to: distributions to non-public charities without exercising oversight practices known as “expenditure responsibility,” and making certain grants to individuals without pre-approval from the Internal Revenue Service
In addition, the termination of such a trust is subject to the private foundation termination rules described in section 507.
Frequently, a section 4947(a)(1) trust is not properly categorized as such when it is funded after the death of a testator, or when the interest of the trust’s last non-charitable beneficiary terminates. In many cases, such trusts are administered to make only those distributions stipulated by the trust instrument, even if such distributions are less than the minimum qualifying distributions required under section 4942. (Generally, state law automatically amends such trust provisions to require annual distributions equal to the qualifying distributions required under section 4942.) Commonly, these improperly categorized trusts file IRS Form 1041 returns, but fail to file the required IRS Form 990 returns.
As a result, such trusts may owe:
- A penalty for failure to file a Form 990 for each year in which the trust qualified as a section 4947(a)(1) trust. The maximum penalty is generally equal to 5 percent of the gross receipts for the tax filing year or $10,000, whichever is less, or $50,000 for trusts with gross receipts of $1 million or more
- 2 percent tax on investment income per year, plus interest
- Excise taxes and penalties for failure to make annual qualifying distributions. For undistributed amounts for 2006 and prior years, the excise tax is equal to 15 percent of the undistributed amount for each year. For 2007 and future years, the excise tax is equal to 30 percent of the undistributed amounts. The trust may also owe penalties on these excise taxes equal to 25 percent of the amount of tax due, as well as interest on the tax due.
It is important to note that where the trust has failed to file a Form 990, there is likely no statute of limitations on its tax liability. Such trust’s potential tax liabilities continue to accrue from the date it was first described under section 4947(a)(1) until these tax liabilities are addressed. As a result, even trusts with relatively modest assets that failed to comply with section 4947(a)(1) may have significant tax liabilities. For example, a non-compliant trust that has been operating for a number of years could easily have potential tax liabilities that equal or exceed 50 percent of its total asset value. If the trust has also engaged in self-dealing transactions, has excess business holdings, or has taxable expenditures that have not been corrected for a period of years, it is quite possible that the excise taxes, penalties, and interest owed could exceed the current value of the trust. Institutional trustees administering such trusts may also face liabilities for violating the private foundation rules and breaching their state law fiduciary duties to the trust’s charitable beneficiaries as a result of such violations. As long as these issues remain unaddressed with respect to a section 4947(a)(1) trust, the actual and potential liabilities of such a trust and its institutional trustee or agent may continue to compound.
Section 4947(a)(1) does not apply to any trust with unexpired interests devoted exclusively to charitable purposes where the trust satisfies the requirements of section 501(c)(3) of the Code, submits an Application for Recognition of Exemption to the Internal Revenue Service, and is granted a determination of qualification of tax-exemption under section 501(c)(3) of the Code. As soon as a trust becomes subject to section 4947(a)(1) (typically as a result of expiration of the trust’s non-charitable interests or funding after a testator’s death), the institutional trustee can generally avoid the potential liabilities for the trust and the trustee as described above by treating the trust as if it were a private foundation and, if the trust will qualify, applying for section 501(c)(3) status retroactive to the date the trust became subject to section 4947(a)(1). (In order for the trust to qualify for taxexemption, the trust instrument must include a charitable purpose and a dissolution clause that satisfies the requirements of section 501(c)(3), unless such provisions will be included by operation of law under the state law that applies to the trust, which is common.)
In the event that an institutional trustee or agent discovers that a section 4947(a)(1) trust has been inappropriately administered for some time, potential liabilities can often be contained and mitigated by immediately distributing any undistributed qualifying distributions from past years, correcting any other violations of the private foundation rules, filing a Form 990, seeking abatement of excise taxes and penalties, and where available, requesting that the Internal Revenue Service grant section 501(c)(3) exemption to the trust retroactive to the time the trust became subject to section 4947(a)(1). (The Internal Revenue Service has the discretion to grant such requests.) In very rare cases, trusts may also be successful in securing retroactive classification as a public charity, which can further mitigate liabilities. We have been very successful with these strategies recently, and thus, there is precedent for them.
Institutional trustees and agents that are in the process of assuming responsibility for trust accounts previously administered by other institutions can address the potentially serious risk management issues associated with section 4947(a)(1) trusts by creating procedures and protocols to: (1) identify section 4947(a)(1) trusts; (2) address any past mishandling of such trusts; (3) determine whether such trusts should apply to the Internal Revenue Service for exemption; and (4) ensure proper administration of such trusts going forward.