The ABC’s of Charitable Trust
Administration: Primer
Common Errors that Could
Result in Surcharge
Presented by Richard S. Caputo, Esquire
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Presentation Outline




Introduction
What is a Charitable Trust
Income Tax Compliance Issues
How to Avoid These Income Tax Compliance
Issues
 Why are Form 1023 Applications Not Filed on
Behalf of Every Post-1969 Charitable Trust
 Excise Tax Compliance
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Presentation Outline
 Compliance with the Reporting
Requirements of the Code
 Summary of Charitable Trust Compliance
Issues
 Action Steps
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Introduction
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Richard S. Caputo
 Consults with banks and trust companies on tax compliance
matters and frequently assists such clients in obtaining taxexempt status for the charitable trusts they administer
 Represents corporate fiduciaries in various Orphans’ Court
proceedings, such as cy pres proceedings, surcharge
actions, court accountings and trust reformations
 Prepares estate planning documents, such as wills, trusts,
powers of attorney and living wills
 Forms public charities, private foundations, supporting
organizations and other tax-exempt organizations
 Addresses tax-exempt compliance issues such as
intermediate sanctions, self-dealing, excess business
holdings, qualifying distributions and taxable expenditure
responsibility
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Charitable Trusts
 Whether the charitable trusts you
administer have any income and/or
excise tax compliance issues
 Whether such trusts have complied with
the reporting requirements set forth in the
Internal Revenue Code
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Four Common Errors
 Trustees understate the charitable trust’s income by
taking unallowable charitable deductions
 Trustees do not pay excise taxes on the charitable
trust’s net investment income
 Trustees do not distribute 5% of the fair market value of
the Trust’s assets each year
 Trustees do not file the appropriate tax returns for their
charitable trusts
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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What is a Charitable Trust?
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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What is a Charitable Trust?
 A non-exempt trust that only has charitable
beneficiaries
 Examples-income to Church
- Intervivos Trust
- Testamentary Trust
- Split-Interest Trust – upon income
beneficiary’s
death
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Income Tax Compliance Issues:
Understate Income by Taking Unallowable
Charitable Deductions
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Example
 Testamentary trust; Trustee pays net income to
church
 $10,000 of income, $30,000 of capital gains
 Trustee distributes $10,000 to church
 Most Trustees take a $40,000 charitable
deduction; is this appropriate?
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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How to Avoid These Income Tax
Compliance Issues
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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First Recommendation
 Deduct those amounts that are actually
distributed to the beneficiary
 Trustee would be taking the proper amount of
charitable deductions BUT if the trust earns
more income than the trustee distributes, the
trust would be taxed in such income
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Second Recommendation
 Distribute all of the income that the Trust
earns and deduct such amounts
- The trust could still be taxed on its
capital gains if the trust is an incomeonly trust
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Second Recommendation
(cont’d)
-
Capital gains are “trapped” and,
therefore, are taxable
Exposure could be minimized by an Act
141 election
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Best Recommendation
 File a Form 1023 Application for Each
Post-1969 Charitable Trust
 Prospective exemption
-
May still be surcharged for past
noncompliance
 Retroactive exemption
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Why are Form 1023
Applications Not Filed on
Behalf of Every
Post-1969 Charitable Trust
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Private Foundation Rules
 Most post-1969 Charitable Trusts would
be exempt private foundations had Form
1023 Applications been filed on their
behalf
- These trusts would be subject to the
private foundation rules of the Code,
which impose stringent
limitations
and requirements upon the day-to-day
activities of private foundations
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Private Foundation Rules (cont’d)
 Subject to the tax reporting requirements
and operational restrictions and excise
taxes
-
Section 4940 – Excise Tax on Net
Investment Income
Section 4941 – Self-dealing
Section 4942 – Minimum Distribution
Requirements
4943 – Excess Business Holdings
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Private Foundation Rules (cont’d)
-
-
Section 4944 – Jeopardy Investments
Section 4945 – Taxable Expenditure
Responsibility
 Many trustees choose not to file Form
1023 Applications on behalf of the
charitable trusts they administer in order
to avoid being subject to the private
foundation rules
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Code Section 4947
 If a trust is described in Code Section
4947, then it is treated, as if the trustee
actually filed a Form 1023 Application on
behalf of such trust
- Subject to the private foundation rules
of the Code
- Post-1969 charitable trusts continue to
be subject to income tax
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Practical Effect of Code Section
4947
 Many trustees do not file Form 1023
Applications in order to avoid the private
foundation rules of the Code
 Post-1969 charitable trusts: Not beneficial to
forego filing Form 1023 Applications
- If a trust is subject to the private foundation
rules, it should at least be exempt from
income tax
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Excise Tax Compliance Issues
Failure to Pay Excise Tax on Net
Investment Income and Failure
to Distribute Annually Five
Percent of the Fair Market Value
of a Trust’s Assets
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Excise Tax Compliance Issues
 Private foundation rules set forth in Code
Sections 4940 and 4942
 Code Section 4940 imposes a 2% excise tax
on the non-exempt charitable trust’s net
investment income
- Under certain circumstances, the excise tax
can be reduced from 2% to 1%
 Code Section 4942 sets forth the minimum
distribution rules applicable to exempt and nonexempt charitable trusts
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Excise Tax Compliance Issues
(cont’d)
-
“Minimum Distributable Amount”
Two years to distribute
15% excise tax (PPA: 30%)
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Example
 For the year 2004, the John Doe Trust has a Minimum
Distributable Amount of $5,000
 The John Doe Trust is an income-only trust
 In 2004, the Trust earned $3,000 and the Trustee distributed all
$3,000 to its sole beneficiary
 Pursuant to Code Section 4942, the Trustee had to distribute
$2,000 to the beneficiary by the end of 2005
 In 2005, the Trust earned $1,000 and the Trustee distributed all
$1,000 to the beneficiary
 Since $1,000 of the Minimum Distributable Amount was still
undistributed at the end of 2005, the Trust was subject to an initial
15% excise tax
 Consequently, the Trust owed the IRS a $150 excise tax (15% x
$1,000)
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Excise Tax Compliance Issues
(cont’d)
 After receiving a Notice of Deficiency from the IRS, the Trustee
immediately paid the $150 excise tax and distributed the
remaining Minimum Distributable Amount ($1,000) using the
income earned in 2006
 If the Trustee would not have distributed the $1,000 within 90 days
of receiving the Notice of Deficiency, the Trust would have been
subject to a second-tier 100% excise tax of $1,000 (100% x
$1,000)
 Code Section 4942 and recent stock market performance
- Trustees of non-exempt income-only trusts likely failed to
distribute the Minimum Distributable Amount unless such
trustees made Act 141 elections of at least 4%
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Compliance with Reporting
Requirements of the Code
Failure to File the Proper
Annual Return
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Reporting Requirements
 Most trustees are unaware that the private
foundation rules of the Code apply to their nonexempt charitable trusts
-
Most trustees file Form 1041 returns for their
nonexempt charitable trusts
A few trustees file Form 990-PF returns for their
non-exempt
charitable trusts
 Which return(s) should be filed?
-
Pre-1969 charitable trusts
Post-1969 charitable trusts
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Consequences of Failing
to File Proper Return
 Failure to file penalty
 Failure to pay penalty
 Open statute of limitations
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Summary of Charitable Trust
Compliance Issues
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Summary of Charitable Trust
Compliance Issues



Income Tax Compliance Issues
Are you taking unallowable charitable deductions?
Excise Tax Compliance Issues
Did you pay the appropriate amount of excise taxes on the
trust’s net investment income?
Did you distribute annually the Minimum Distributable
Amount?
Reporting Issues
Did you file Form 1041 returns and Form 990-PF returns for
each non-exempt charitable trust that has taxable income?
Did you file Form 990-PF returns for each non-exempt
charitable trust that has no taxable income?
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Action Steps
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© 2011 Fox Rothschild
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Review your Charitable Trust
Portfolio
 Determine whether you administer charitable trusts
 Determine whether these charitable trusts are exempt
or non-exempt trusts
 Exempt charitable trusts
- Determine whether your exempt charitable trusts
qualify as public charities (unlikely), supporting
organizations (possibly) or private foundations
(likely)
- Determine whether Form 990-PF returns were filed
on behalf of the private foundations
- Determine whether Form 990 returns were filed on
behalf of the public charities and supporting
organizations
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Review your Charitable Trust
Portfolio (cont’d)
 Non-exempt charitable trusts
- Determine whether your non-exempt
charitable trusts are “pre-1969 charitable
trusts” or “post-1969 charitable trusts”
- Determine whether proper returns were filed
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Non-exempt Post-1969 Charitable
Trusts
 File a Form 1023 Application for all Post-1969
Charitable Trusts
- Determine whether each trust can qualify as
a supporting organization
- Transitional Rule (November 20, 1970)
- If a trust is unable to qualify as a supporting
organization and it provides scholarships,
determine whether the trust’s grant-making
procedures must be approved
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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File Form 1023 Applications
Immediately
 Trustees should immediately file Form 1023
Applications on behalf of their trusts
- The IRS will likely begin auditing nonexempt
charitable trusts by the second quarter of
2008
- It is becoming increasingly difficult to obtain
supporting organization status (PPA)
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Non-Exempt Pre-1969 Charitable
Trusts
 Revenue Procedure 72-50 Letters
 Scholarship Approval Letters
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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Questions?
For more information, please
contact Richard S. Caputo, Esquire
FOX ROTHSCHILD LLP
747 Constitution Drive, Suite 100
Exton, PA 19341
610-458-3121
rcaputo@foxrothschild.com
The ABC’s of Charitable Trust Administration: Primer
© 2011 Fox Rothschild
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