Estates and trusts entail a unique form of property ownership: Even though legal ownership is held by an entity, equitable ownership belongs to the beneficiaries. These beneficiaries may be present or future recipients of income or principal. This scenario provides the backdrop for the income tax framework created by IRC subchapter J. Because an estate or trust can be either a pass-through or tax-paying entity, the income tax deductibility of estates and trusts' charitable contributions can be ambiguous.
An executor or trustee has the fiduciary duty of administering property in accordance with the testator's/grantor's wishes as expressed in the governing document. As such, if the controlling instrument is silent as to charitable contributions, making a contribution would constitute a breach of fiduciary duty. Only contributions directed by the will or trust document are allowed, as established by Riggs National Bank of Washington D.C. v. United States [(173 Ct. Cl. 478 (1965)] and Sid Richardson Foundation v. United States [430 F.2d 710 (5th Cr., 1970)]. The source of permitted contributions provides direction as to the proper tax treatment. Generally, contributions from principal, or corpus, are bequests to charitable organizations governed by IRC section 2055 and the estate tax regulations. The charitable bequest serves to reduce the gross estate in arriving at the amount subject to estate taxes on Form 706. On the other hand, contributions on a Form 1041 return serve as income tax deductions and are governed by IRC section 642 and the income tax regulations.
The life of an estate is determined by the amount of time required by the executor or administrator to settle the affairs of the decedent. The regulations refer to this period-which can last years-as the time required to complete the ordinary duties of administration, such as the collection of assets and the payments of debts, taxes, legacies, and bequests. Income earned during the period of administration is of course subject to income taxes. Consequently, distributions made during this period may "carry out" taxable income. Similarly, income earned by trusts is subject to income taxes at the entity level, the beneficiary level, or both, depending on the terms of the governing instrument and applicable state laws. Simple trusts are required to distribute all current income and are, by definition, prohibited from making charitable contributions. Complex trusts may retain all or part of their current income and, if directed by the trust instrument, may make charitable contributions. As a result, the income taxation for estates and complex trusts is similar.
Taxing the income distributed to the beneficiaries of an estate or trust would result in "double taxation." Treatment as partners (recipients of conduit income), however, would not reflect the myriad rights of the different types of beneficiaries (e.g., the right to accumulate). Additionally, taxing the income of an estate or trust under the rules and regulations for individuals would ignore payments made to beneficiaries entitled to current distributions. Consequently, IRC subchapter J brings together concepts applicable to other entities while addressing the unique attributes of estates and trusts, effectively taxing accumulated income to the entity while taxing distributed income to the appropriate beneficiaries.
Embedded within IRC subchapter J is a concept unique to the income for estates, trusts, and their beneficiaries. Specifically, distributable net income (DNI) comprises the IRC section 643-mandated methodology for the distribution deduction, which the entity deducts from income but which is taxed to beneficiaries. Concurrently, the character of those distributions is identified. Fiduciary accounting income is determined in accordance with the appropriate state statutes, the governing instrument, and the IRC impact on DNI. State statutes, generally in the form of a principal and income act, serve as a default for situations not addressed by the governing document. …