IRD AND CHARITIES: THE SEPARATE SHARE REGULATIONS AND THE ECONOMIC EFFECT REQUIREMENT

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1 IRD AND CHARITIES: THE SEPARATE SHARE REGULATIONS AND THE ECONOMIC EFFECT REQUIREMENT F. Ladson Boyle & Jonathan G. Blattmachr* Authors Synopsis: Taxpayers sometimes die with a right to gross income that has not been received at the time of death and is not reportable on the decedent s final or other pre-death income tax return, that is, with an entitlement to items of income in respect of a decedent (IRD). An estate with charitable beneficiaries that receives IRD will want a section 642(c) income tax charitable deduction for amounts of gross income distributed or distributable to or set aside for a charitable purpose to offset the gross income realized when the IRD is collected and reportable in gross income. This is possible when the IRD is distributable to or set aside for the charity pursuant to the terms of the governing instrument. This Article analyzes the potential application of the separate share regulations under section 663(c) and the income tax charitable deduction under section 642(c) when the estate has both charitable and non-charitable residuary beneficiaries. This Article concludes that a charity s interest in the residue of an estate is not a separate share within the meaning of the separate share regulations. Next, this Article considers whether a direction in the decedent s will to distribute items of IRD to charity as a part of the charity s interest in the decedent s residuary estate satisfies the economic effect requirement found in the Treasury Regulations for section 642(c). This Article suggests that it does, but that the conclusion is not certain. Finally, the Article suggests possible solutions to assure that the income tax charitable deduction is available for an estate when it pays over the proceeds from items of IRD to a charity. F. Ladson Boyle and Jonathan G. Blattmachr All Rights Reserved. * F. Ladson Boyle, Esq. is the Charles E. Simon, Jr. Professor of Federal Law Emeritus at the University of South Carolina School of Law. Jonathan G. Blattmachr, Esq. is the Director of Estate Planning for the Peak Trust Company and a director at Pioneer Wealth Partners, LLC, a wealth management firm in New York City. They are co-authors of BLATTMACHR ON THE INCOME TAXATION OF ESTATES AND TRUSTS (16th ed. 2017). The authors thank James Smith Harrison, III, Real Property, Trust & Estate Law Journal Editor in Chief, for his editorial work.

2 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL I. INTRODUCTION II. GIVING IRD TO CHARITY III. IRD PAID TO AN ESTATE SEPARATE SHARES? A. The Separate Share Regulations in Operation Decedent s Will Silent as to Allocation of IRD Decedent s Will Directs the IRD be Used to Satisfy One Beneficiary s Share of the Estate B. Is a Charity a Separate Share Under the Separate Share Regulations? IV. CHARGING CHARITABLE DEDUCTIONS AGAINST CLASSES OF INCOME: THE ORDERING RULES A. Income Ordering Overview B. Economic Effect C. Distributing IRD D. IRD to Charity E. Reconciling the Various Ordering Regulations F. What is the Effect of the Ordering Regulation on the Douglas Estate? G. But Alas H. Discretion to Allocate Types of Income V. WHAT TO DO? VI. CONCLUSION I. INTRODUCTION Taxpayers may die with a right to gross income that has not been received (or accrued for an accrual-basis taxpayer) 1 at the time of death. 2 1 See I.R.C. 451(b). Any references to the Code, I.R.C., or section refer to the Internal Revenue Code, Title 26, United State Code, and any reference to the Regulations refer to the Regulations promulgated thereunder. All Internal Revenue Code and state statutory citations in this Article refer to the current statute unless otherwise indicated. The same applies to regulations. 2 The determination of whether income received on the date of a decedent s death is reported on the decedent s final income tax return or the estate s first income tax return is less than clear. For a discussion of the issues, see F. LADSON BOYLE & JONATHAN G. BLATTMACHR, BLATTMACHR ON INCOME TAXATION OF ESTATES AND TRUSTS 2:2 (16th ed. 2017) [hereinafter BLATTMACHR].

3 WINTER 2018 IRD & Charities 371 That income is not includible on a decedent s final individual income tax return. 3 Instead, under special rules found in section 691, the gross income is reportable by the decedent s estate or other successor to the decedent s right to the income who receives the income. 4 This income is known as IRD for income in respect of a decedent and is typically referred to as IRD. 5 Rights to IRD differ from other types of a decedent s property not only because of the section 691 treatment, but more important, because the new basis rules of section 1014(a) 6 do not apply to rights to IRD. 7 Rather, under section 1014(c), the right to IRD is denied a section 1014(a) change in basis at the decedent s death. 8 IRD is includible in the recipient s gross income when received and is not treated as a return of capital. 9 If the decedent had an income tax basis in the IRD asset, the recipient is entitled to the decedent s basis but not an adjustment to fair market value as of the date of death. 10 An installment note with some basis, in the seller s hands, is an example of a decedent s basis carrying over to the estate or other taxpayer who inherits the IRD. 11 In addition, 3 See I.R.C. 691(a)(1); Treas. Reg (a)-1(b)(2). 4 See Treas. Reg (a)-1(a). 5 IRD is not defined in the Internal Revenue Code. For a complete discussion of what is IRD and the tax consequences, see BLATTMACHR, supra note 2, 2:3. 6 A new basis at a decedent s death is commonly called the income tax-free, stepup in basis, which provides for the basis of certain inherited assets to equal their fair market value as of the date of death of the decedent. Jonathan G. Blattmachr, Howard M. Zaritsky & Mark L. Ascher, Tax Planning with Consensual Community Property: Alaska s New Community Property Law, 33 REAL PROP. PROB. & TR. J. 615, 624 n.36 (1998); see also I.R.C. 1014(a). Section 2032 provides that an estate may elect to value all property, other than rights to IRD, as of the alternate valuation date, rather than the date of death. See I.R.C. 2032(a)(1)-(3). 7 See I.R.C. 1014(c). 8 See id. 9 See I.R.C. 691(a)(1). Under I.R.C. section 1001(a), gain (gross income) is the amount by which the amount realized in a sale or other disposition of property exceeds the taxpayer s adjusted basis. See I.R.C. 1001(a). 10 See I.R.C. 691(a)(4)(A)-(B); see also Rev. Rul , C.B. 1015, For example, a taxpayer has a basis of $100,000 in a building that the taxpayer sells before death for $250,000 and elects to report the income using the section 453 installment sales method (that is, to report gain only as payments from the purchaser are received). Each payment received after death will consist of a 40% non-taxable return of the taxpayer s basis and 60% IRD gross income, just as the taxpayer were reporting during his or her lifetime.

4 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL the basis adjustment for a surviving spouse s half of community property under section 1014(b)(6) does not apply to the rights to IRD. 12 Estates and trusts 13 are generally allowed an income tax charitable deduction under section 642(c) for distributions of gross income for a charitable purpose 14 but only if the distribution is pursuant to the terms of the governing instrument. 15 This charitable deduction is in lieu of a section 170(a) charitable deduction that is available to other taxpayers 16 and is not limited to a percentage of adjusted gross income. 17 Also, the deduction is in lieu of an estate s deduction for a distribution to a beneficiary, 18 even though under the controlling document and state law the charity is considered a beneficiary of the estate. 19 An estate with charitable beneficiaries that receive IRD will want a section 642(c) income tax charitable deduction for amounts of gross income distributed or distributable to charity to offset the gross income realized when the IRD is collected and reportable in gross income. 20 This is possible when the IRD is distributable to the charity pursuant to the terms of the governing instrument. 21 Nevertheless, the receipt of IRD by an estate raises unique issues that may involve the separate share Regulations under section 663(c) and the income tax charitable deduction under section 642(c), where the estate has both charitable and non-charitable 12 See Holt v. United States, 39 Fed. Cl. 525, 528 (1997). 13 Estates and trusts sometimes will collectively be inferred hereinafter as estate[s]. 14 See I.R.C. 642(c)(1); Treas. Reg (c)-1(a)(1), -2(a)(2). Trusts, however, in general, are not entitled to a set aside income tax charitable deduction. See infra note See I.R.C. 642(c)(1). For a thorough discussion of the income tax charitable deduction for an estate or trust, see BLATTMACHR, supra note 2, 3:2.1[J]. 16 See I.R.C. 642(c)(1). 17 See id. The percentage limitations of section 170 charitable deductions are not applicable to the deduction under section 642(c); however, the section 642(c) deduction is disallowed under section 681 to the extent the trust distributes unrelated business income as defined in that section. See I.R.C. 681(a). In this situation, the trust s deduction is determined pursuant to section 170, including the limitations on deductions related to the taxpayer s adjusted gross income (as specially defined). See I.R.C. 642(c). 18 See I.R.C. 651(a), 661(a). For a full discussion of the distribution deduction, see BLATTMACHR, supra note 2, 3:5. 19 See I.R.C. 642(c)(1). Under I.R.C. section 663(a)(2), distributions of a nature that would qualify them to be taken as a charitable deduction are not treated as deductible distributions to beneficiaries pursuant to section 661(a). See I.R.C. 663(a)(2). 20 See BLATTMACHR, supra note 2, 2:3. 21 See I.R.C. 642(c).

5 WINTER 2018 IRD & Charities 373 remainder beneficiaries. 22 Also, the estate s receipt of IRD may implicate the economic effect requirement found in the Treasury Regulations for section 642(c). 23 Part I introduces IRD. Part II discusses the potential consequences of giving IRD to charities. Part III considers the application of the separate share Regulations where an estate or trust has multiple remainder beneficiaries. Part IV analyzes the economic effect rule for the charitable income tax deduction found in the Treasury Regulations. 24 Part V suggests some choices to deal with IRD where there is a potential for an income tax charitable deduction. Part VI concludes. II. GIVING IRD TO CHARITY For estates that pay estate taxes, the federal tax rate is forty percent of each dollar of estate value above the applicable exclusion amount, 25 as well as a potential for additional state death taxes. 26 When the estate assets include IRD, there is potentially another 40.8% federal income tax, as well as additional state or local income taxes that may be owed See I.R.C. 642(c), 663(c); Treas. Reg (c)-3, 1.663(c) Treas. Reg (c)-3(b)(2). 24 See Treas. Reg (c)-3(b)(2), 1.652(b)-2(b), 1.662(b)-2 ex. 1(b). 25 This amount is $11.18 million in The estate tax value of IRD included in a decedent s gross estate is not reduced by the potential income tax liability associated with the IRD; rather, section 691(c) provides an income tax deduction for the federal estate taxes attributable to the IRD. See I.R.C. 691(c)(1); see also BLATTMACHR, supra note 2, 2: In the state of Washington, the top state estate tax rate is 20%. See WASH. REV. CODE In many other states, it is as high as 16%. See, e.g., MASS. GEN. LAWS ch. 65C 2(a). State death taxes imposed on property included in the federal gross estate are deductible, under section 2058, for purposes of determining the Federal taxable estate. See I.R.C. 2058(a). For example, where the state rate is 19%, only 81% of what otherwise would be the taxable estate is exposed to the 40% federal estate tax rate. See I.R.C. 2001(c). Forty percent of 81% is 32.4%, which is the effective federal estate tax rate. When that is added to a 19% state estate tax, the combined effective estate tax rate is 51.4% at the margin. The 32.4% Federal estate tax rate is deductible, pursuant to section 691(c), for purposes of determining the amount of the IRD right that is subject to income tax. See I.R.C. 691(c)(1). Section 68, which is in effect for tax years before 2018 and after 2025, can reduce the deduction allowed by section 691(c) by 80%, meaning that of the 32.4% effective federal tax, only 20% of it or 6.48% is deductible. See I.R.C. 68(a)(2). That would mean 93.52% of the distribution may be subject to ordinary income tax as high as 39.6% in tax years before 2018 and after 2025, producing an effective income tax of 37.03%. As a result, the effective net income tax rate of 37.03% combined with the 51.4% effective state and federal estate tax rate brings the total taxes to 88.43%. If the distribution also is subject to state and local income tax, the combined

6 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL As a consequence, when all taxes are considered, a decedent s noncharitable beneficiaries may net only a small portion of the IRD asset after tax if they inherit it. When IRD is left to charity instead, presumably both the estate taxes and income taxes are avoided because the devise 28 qualifies for an estate tax deduction under section 2055 and the charity receives the full amount 29 free of income taxes. However, the choice of beneficiary charitable or noncharitable is the decedent s to make. For IRD assets of an estate, which may have a designated survivor beneficiary, such as a retirement plan benefit or an IRA, designating a beneficiary other than the decedent s estate is usually preferable, whether the recipient of the IRD will be an individual or a charity. 30 Notwithstanding the wisdom of designating a beneficiary of retirement plan benefits or IRAs, some plan benefits or IRAs are payable to a decedent s estate for a variety of reasons, including no named or then living beneficiary, or a desire for the decedent s will to control the proceeds of the IRA or other retirement benefit. When an IRA is payable to an estate, the Service, in several private letter rulings, 31 has permitted decedents estates to assign IRAs and other tax also could be very significant. Distributions from qualified retirement plans and individual retirement accounts (IRAs) are not subject to the net investment income tax imposed by section 1411 but might result in other income being pushed into the section 1411 tax. See BLATTMACHR, supra note 2, 4: Devise means a testamentary gift of both real and personal property and is used throughout this Article. See UNIF. PROBATE CODE (amended 2010), 8 pt. I U.L.A. 47 (2013). 29 Under federal estate tax law, and in virtually all states, property passing to (or in some circumstances in trust for) the decedent s surviving spouse may not be subject to federal estate tax. See I.R.C However, the IRD will be included in the gross income of the spouse (or trust for the spouse) when collected. See I.R.C. 691(a)(1). 30 See NATALIE B. CHOATE, LIFE AND DEATH PLANNING FOR RETIREMENT BENEFITS , at (7th ed., rev. 2011) (discussing the advantages of leaving charity benefits through an estate over a trust); see also Christopher R. Hoyt, Structuring a Charitable Bequest of IRD Assets: Maximize the Impact of Your Client s Gift, TRS. & ESTS., June 2015, at 47, [hereinafter Structuring a Charitable Bequest]; Christopher R. Hoyt, Tax Savings with Income-Based Charitable Bequests, PROB. & PROP., Sept./Oct. 2017, at 38, 39 [hereinafter Tax Savings]; Christine W. Hubbard, Draft Trust to Avoid Tax on IRD From IRA Left to Charity, EST. PLAN. Aug. 2015, at 28, 28; infra note 238 and accompanying text. 31 See Priv. Ltr. Rul (Dec. 12, 2008); Priv. Ltr. Rul (Nov. 7, 2008) (ruling a distribution of interest in a defined benefit plan to charity is not a transfer within the scope of I.R.C. section 691(a)(2)); Priv. Ltr. Rul (Aug. 18, 2006) (ruling a distribution of IRAs to charity in satisfaction of its share of the

7 WINTER 2018 IRD & Charities 375 retirement benefits to charities and not invoke the income tax acceleration rule of section 691(a)(2). 32 The favorable rulings involved estates with both charitable and non-charitable beneficiaries and the decedents estates were the beneficiaries of the retirement benefits. 33 Rather than withdrawing the funds from the retirement accounts and reporting gross income, the estates proposed to assign the accounts to charitable beneficiaries who would receive the gross income when distributions were made from the accounts. 34 The charities usually are income tax-exempt entities, so no income taxes are due on the distributions from the retirement accounts to them. 35 The rulings seem to be dependent on the estates authority to make non-pro rata distributions of estate assets and on whether the residuary estate is payable to both charitable and noncharitable remainder beneficiaries. 36 The Service ruled similarly when an IRA was payable to an estate and the estate s beneficiary was a trust whose corpus was divided among several charities. 37 residue of [the] Estate will not be a transfer within the meaning of 691(a)(2) ); Priv. Ltr. Rul (May 20, 2005) (ruling a distribution of IRAs and 401(k) plan benefits to charity as its share of residuary estate does not invoke the I.R.C section 691(a)(2) acceleration of income rule); Priv. Ltr. Rul (Aug. 23, 2002) (ruling an estate does not include IRA distributions in gross income where the estate had assigned them to charity pursuant to a bequest of them under decedent s will to the charity); Priv. Ltr. Rul (June 28, 2002); Priv. Ltr. Rul (May 24, 2002). Under I.R.C. section 6110, neither a National Office Technical Advice Memorandum nor a Private Letter Ruling may be cited or used as precedent. See I.R.C. 6110(k)(3). 32 Section 691(a)(2) provides that if a decedent s estate or a person who is entitled to IRD transfers the right to the IRD asset before it is received and reportable in income, the transfer may accelerate the reporting of the IRD. See I.R.C. 691(a)(2); Treas. Reg (a)-4. For a full discussion of section 691(a)(2), see BLATTMACHR, supra note 2, 2: See supra note 31. Under I.R.C. 6110(k)(3), neither a National Office Technical Advice Memorandum nor a Private Letter Ruling may be cited or used as precedent. See I.R.C. 6110(k)(3). 34 See supra note See I.R.C. 501(c)(3). 36 Cf. Rev. Rul , C.B. 159, See Priv. Ltr. Rul (Apr. 2, 2010). Under I.R.C. 6110(k)(3), neither a National Office Technical Advice Memorandum nor a Private Letter Ruling may be cited or used as precedent. See I.R.C. 6110(k)(3).

8 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL Similar to the IRA rulings, the Service determined in Private Letter Ruling that the assignment of an annuity contract (representing the right to IRD) by a trust to the charitable beneficiaries of the trust was not a section 691(a)(2) taxable disposition. 39 In the private letter ruling, the decedent owned a non-qualified, deferred annuity contract 40 and named the trust the beneficiary of the contract. 41 Under applicable state law, the trustee had the power to make distributions in kind (as opposed to only in cash). 42 Consequently, in the ruling, the income was attributed only to the charities, 43 which presumably were not subject to income taxes because of their tax-exempt status. 44 If a charity is a devisee of a sum certain, the assignment of an IRA, an annuity contract, or any other IRD asset to the charity in satisfaction of the amount due, will accelerate the recognition of income by the estate. 45 This result follows general income tax concepts that the satisfaction of a fixed (pecuniary) obligation, such as a specific devise, is a gain recognition event to the payor when the income tax adjusted basis of the transferred property is less than amount of the obligation Priv. Ltr. Rul (Jan. 18, 2008). Under I.R.C. 6110(k)(3), neither a National Office Technical Advice Memorandum nor a Private Letter Ruling may be cited or used as precedent. See I.R.C. 6110(k)(3). 39 See id. The annuity contract in the letter ruling appears to be similar to the annuity described in Revenue Ruling , C.B. 1015, A tax-deferred annuity is a type of annuity contract that delays payments until the investor elects to receive them. This type of annuity has an initial investment phase in which money is invested in the contract, but the annuity owner does not receive distributions and is not taxed on earnings gain. See I.R.C. 403(b); Pub. 575, 4 (Jun. 4, 2017). 41 See Priv. Ltr. Rul (Jun. 18, 2008). Under I.R.C. 6110(k)(3), neither a National Office Technical Advice Memorandum nor a Private Letter Ruling may be cited or used as precedent. See I.R.C. 6110(k)(3). 42 See id. Under I.R.C. 6110(k)(3), neither a National Office Technical Advice Memorandum nor a Private Letter Ruling may be cited or used as precedent. See I.R.C. 6110(k)(3). 43 See id. Under I.R.C. 6110(k)(3), neither a National Office Technical Advice Memorandum nor a Private Letter Ruling may be cited or used as precedent. See I.R.C. 6110(k)(3). 44 See generally I.R.C. 501(c)(3). 45 See, e.g., Chief Couns. Adv. Mem (Nov. 3, 2006) (triggering taxable income by distributing a share from an IRA to charity in satisfaction of specific pecuniary or dollar amount devise). 46 See Kenan v. Comm r, 114 F.2d 217, 220 (2d Cir. 1940); Treas. Reg (a)- 4(b)(2).

9 WINTER 2018 IRD & Charities 377 III. IRD PAID TO AN ESTATE SEPARATE SHARES? Although the Service generally accepts that the transfer or distribution in kind of IRD to charity is without income recognition, it is still possible that a decedent s estate will be required to include the IRD in its gross income. 47 The decedent s estate may still receive IRD assets, such as a decedent s final paycheck. 48 Another example of IRD the estate is likely to receive is one or more post-mortem payments from an installment sales contract the decedent held at death. These and other IRD assets of an estate that do not have a designated beneficiary will pass in accordance with the decedent s estate planning documents, typically a decedent s will or possibly a revocable trust used as a will substitute. 49 In situations where IRD will be included in an estate s gross income, the separate share rule of section 663(c) may come into play if the estate has multiple beneficiaries, such as where an estate is divided among several residuary beneficiaries. 50 Section 663(c) provides that, for the sole purpose of determining the distributable net income (DNI) 51 for the application of sections 661 and 662, 52 substantially separate and independent shares of different beneficiaries in the trust shall be treated as separate trusts. 53 A 1997 amendment to section 663(c) made estates subject to the separate share rule as well. 54 The separate share rule is not applicable to simple trusts, which are governed by sections 651 and See I.R.C. 691(a)(1). 48 See Pub. No. 559, 10 (Feb. 6, 2017). 49 See generally id. For purposes of simplicity, collectively, these documents will be referred to as the decedent s will, unless noted otherwise. 50 See I.R.C. 663(c). 51 Distributable Net Income (DNI) is defined in section 643(a) and is the cornerstone in the computation of the taxation of estates, trusts, and their beneficiaries. See BLATTMACHR, supra note 2, 3:3.2 (for a complete discussion of DNI). 52 See I.R.C Sections 661 and 662 determine the amount of the distribution deduction allowed for an estate or trust and the amount of gross income a beneficiary must report. 53 I.R.C. 663(c). 54 Before 1998, separate share treatment applied only to trusts. See Taxpayer Relief Act of 1997, Pub. L. No , 1307, 111 Stat. 788 (1997). 55 See I.R.C Simple trusts are defined as trusts that are required to distribute all accounting income, do not have a charitable beneficiary, and are not estates or complex trusts. See Treas. Reg (a)-1.

10 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL The separate share rule was a Congressional response to what was considered an unfair result where some income of a trust might be accumulated for one beneficiary, although the trust corpus was simultaneously distributed to another beneficiary. As a result, the income tax reporting by the trust and their beneficiaries was distorted because the beneficiary receiving the distribution (or proportionately greater distribution) would be taxed on more than a proportionate share of the trust s DNI. 56 A share may be considered as separate from other shares even though more than one beneficiary has indeterminate interests in it; also, the same person may be a beneficiary of more than one separate share. 57 A share may be separate even if there is a remote possibility that it can be invaded for another but not if there is a strong possibility of an invasion that would change the beneficiaries proportionate shares. 58 Under the separate share rule, an estate s DNI is divided among the separate shares, as provided in the Regulations, before the distribution deduction for the estate is computed and the gross income of a beneficiary is determined. 59 DNI for each share is computed as if each share is a separate trust. 60 This calculation of DNI is based upon its portion of gross income that is includible in distributable net income and its portion of any applicable deductions or losses. 61 Treasury Regulation section 1.663(e)-2(b)(2) expands the general instruction by stating that gross income that is included in DNI and is fiduciary accounting principal is allocated to the separate shares in accordance with the amount of income that each share is entitled to under the terms of the governing instrument or applicable local law. 62 The Regulations direct that separate share treatment is mandatory when applicable and is not elective. 63 The separate share rule applies 56 See Treas. Reg (c)-1(a). 57 See Treas. Reg (c)-3(c) (governing trusts); Treas. Reg (c)-4(c) (governing estates and trusts making the I.R.C. section 645 election to be treated, for a specific period of time, as a part of the grantor s estate for income tax filing purposes). 58 See Treas. Reg (c)-3(b), (d). 59 See Treas. Reg (c)-2(b). 60 See Treas. Reg (c)-2(b)(1). 61 Id. 62 Treas. Reg (c)-2(b)(2). 63 See Treas. Reg (c)-1(d). Separate-share treatment applies in the determinations under the throwback provisions of I.R.C. sections , except insofar as the separate share rule applies (circa pre-1979) to successive interests in points of time. See

11 WINTER 2018 IRD & Charities 379 only to allocate the DNI of an estate or trust among the shares and does not create DNI. 64 Therefore, an estate or trust must first compute its gross income, taxable income (before any distribution deduction), and DNI, then apply the separate share rule to determine the amount of DNI that may be attributable to a share, the amount of the distribution deduction, and the amount of income a beneficiary must report. If there were no distributions to any noncharitable beneficiary, the calculation of section 663(c) DNI would not be necessary as there would be no distribution deduction. A. The Separate Share Regulations in Operation Before considering how a charitable beneficiary might impact the allocation of DNI among remainder beneficiaries of estates, an example of how the separate share rule operates with the receipt of IRD by an estate with individual beneficiaries but without a charitable beneficiary is instructive. For purposes of this example and throughout this Article, it is assumed that IRD assets of an estate are fiduciary accounting principal Decedent s Will Silent as to Allocation of IRD Allen Estate: The decedent s will devises the estate equally to individuals Art, Bee, and Claire. The total value of the estate is $1.5 million and includes a $150,000 IRA. During its first tax year, the estate withdraws the entire $150,000 from the IRA, all of which is included in its gross income. The IRA, it is assumed, is fiduciary accounting principal. 66 The estate has an additional $15,000 of dividend income and $15,000 of interest income; both are fiduciary accounting income. 67 Treas. Reg (b)-1(c); Rev. Rul , C.B. 154, 155 (applying separate share rule to nonexempt employees trust). There is also a separate share rule for generation-skipping transfer tax purposes. See I.R.C. 2654(b). 64 See Treas. Reg (c)-1(a) ( [Separate] shares are treated as separate trusts (or estates) for the sole purpose of determining the amount of distributable net income allocable to the respective beneficiaries under sections 661 and 662. ). 65 See UNIF. PRINCIPAL INCOME ACT 409(c) (amended 2008), 7A pt. IV U.L.A. 389 (2017) [hereinafter UPIA]. An IRA is generally accounting principal, which it would not be in the first year of an estate except for a decedent s required minimum distribution not yet taken in the year of a decedent s death, in which event 10% of the distribution is income. 66 See supra note 65 and accompanying text. 67 See id. 409(b), 7A pt. IV U.L.A. 389.

12 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL Section 643(a) DNI is computed as follows: Dividend Income $15,000 Interest Income $15,000 IRA Income $150,000 Total Gross Income $180,000 Personal Exemption ($600) Taxable Income 68 $179,400 Plus the Personal Exemption 69 $600 DNI $180,000 The interests of Art, Bee, and Claire in the Allen Estate are separate shares under section 663(c) because distributions to them will be made in substantially the same manner as if separate trusts had been created. 70 Income in respect of a decedent within the meaning of section 691(a) that is not fiduciary accounting income, such as the IRA in the Allen Estate, is allocated among the separate shares that could potentially be funded with IRD based upon the relative value of each share to the extent each could be funded with the IRD. 71 Note the difference in treatment when the IRD is accounting income or accounting principal. 72 In the Allen Estate, the potential DNI attributable to the IRD, which is fiduciary accounting principal, is divided equally among the three shares that can be funded with the IRD because each of the shares could be funded with the IRD. 73 In the Allen Estate, the IRA is all IRD and is all fiduciary accounting principal. 74 Therefore, when DNI is separately computed for 68 Ignoring any possible distribution deduction under section 661(a) and after considering other possible deductions, however, no other deductions are present in the example. See I.R.C. 643(a). 69 DNI is taxable income computed without the distribution deduction or the personal exemption deduction and with other possible modifications. See I.R.C. 643(a). On these facts, DNI equals the taxable income plus the personal exemption. See I.R.C. 643(a); BLATTMACHR, supra note 2, 3:3.2 (providing a detailed discussion of the computation of DNI). 70 Treas. Reg 1.663(c)-3(a). 71 See Treas. Reg (c)-2(b)(3), (c)-5 exs. 9, When IRD is accounting income and not principal, no special rule applies, and the IRD would be apportioned among the shares in the same manner as other accounting income, unless the governing instrument or local law requires a different allocation that has economic effect. See I.R.C. 643(a). 73 See Treas. Reg (c)-2(b)(3), (c)-5 exs. 9, See supra note 65 and accompanying text.

13 WINTER 2018 IRD & Charities 381 each share as though a separate trust, DNI for each share is $60,000 because the IRA income is divided equally among the three shares as is one-third of the regular income. The section 663(c) DNI of each share is computed as follows: Dividend Income (1/3 of $15,000) $5,000 Interest Income (1/3 of $15,000) $5,000 IRA Income 75 (1/3 of $150,000) $50,000 Total Gross Income $60,000 Personal Exemption ($600) Taxable Income 76 $59,400 Plus the Personal Exemption 77 $600 DNI of Each Share for Section 663(c) Purposes $60,000 In the Allen Estate, the distribution deduction for distributions by the estate to Art, Bee, or Claire will be limited to $60,000 each. 78 If Art s share of the estate ($510,000 calculated by adding one-third of the $1.5m estate, one-third of $15,000 of dividend income, and one-third of the $15,000 interest income) is fully distributed to him, but Bee and Claire receive no distributions from the estate, then the distribution deduction will be limited to $60,000 and the estate will pay tax on the balance as follows: Dividend Income $15,000 Interest Income $15,000 IRA Income $150,000 Total Gross Income $180,000 Personal Exemption ($600) Distribution Deduction ($60,000) Taxable Income $119, Income in respect of a decedent within the meaning of section 691(a) that is not fiduciary accounting income is allocated among the separate shares that could be potentially funded with IRD, based upon the relative value of each share to the extent each could be funded with the IRD. See Treas. Reg (c)-2(b)(3). 76 Ignoring any possible distribution deduction under section 661(a) and after considering other possible deductions, however, no other deductions are present in the example. See I.R.C. 643(a). 77 DNI is taxable income computed without the distribution deduction or the personal exemption deduction and with other possible modifications. See I.R.C. 643(a). 78 See Treas. Reg (c)-1(a).

14 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL Without the separate share rule, the estate s distribution deduction would be $180,000 and the estate would have no taxable income as a result, but Art would report $180,000 of gross income. Note that if there were no distributions to Art, Bee, or Claire, the calculation of section 663(c) DNI would not be necessary as there would be no distribution deduction Decedent s Will Directs the IRD be Used to Satisfy One Beneficiary s Share of the Estate An example of how the separate share rule operates with IRD and with a direction to fund one Beneficiary s share of the residuary estate with the IRD asset or the proceeds of the IRD asset, but without a charitable beneficiary, is instructive. Brown Estate: The decedent s will devises the estate equally to individuals Art, Bee, and Claire. The decedent s will directs that any IRD asset or the proceeds of an IRD asset be used to fund Claire s share of the estate. The total value of the estate is $1.5 million and includes a $150,000 IRA. During its first tax year, the estate withdraws the entire $150,000 from the IRA, all of which is included in its gross income. The IRA is fiduciary accounting principal. 80 The estate has an additional $15,000 of dividend income and $15,000 of interest income; both are fiduciary accounting income See I.R.C. 663(c). 80 See supra note 65 and accompanying text. 81 See UPIA 409(b) (amended 2008), 7A pt. IV U.L.A. 389 (2017).

15 WINTER 2018 IRD & Charities 383 Section 643(a) DNI is computed as follows: Dividend Income $15,000 Interest Income $15,000 IRA Income $150,000 Total Gross Income $180,000 Personal Exemption ($600) Taxable Income 82 $179,400 Plus the Personal Exemption 83 $600 DNI $180,000 The interests of Art, Bee, and Claire in the Brown Estate are separate shares under section 663(c) because distributions to them will be made in substantially the same manner as if separate trusts had been created. 84 Income in respect of a decedent within the meaning of section 691(a) that is not fiduciary accounting income, such as the IRA in the Brown Estate, is allocated among the separate shares that could be potentially funded with IRD based upon the relative value of each share to the extent each could be funded with the IRD. 85 Note the difference in treatment when the IRD is accounting income or accounting principal. 86 In the Brown Estate, the potential DNI attributable to the IRD that is fiduciary accounting principal is allocated exclusively to Claire s share of the estate because the decedent so directed and the IRD is less than the value of Claire s interest in the Brown Estate. None of the IRA income is 82 Ignoring any possible distribution deduction under section 661(a) and after considering other possible deductions, however, no other deductions are present in the example. See I.R.C. 643(a). 83 DNI is taxable income computed without the distribution deduction or the personal exemption deduction and with other possible modifications. See I.R.C. 643(a). On these facts, DNI equals the taxable income plus the personal exemption. See I.R.C. 643(a); BLATTMACHR, supra note 2, 3:3.2 (providing a detailed discussion of the computation of DNI). 84 Treas. Reg 1.663(c)-3(a). 85 See Treas. Reg (c)-2(b)(3), (c)-5 exs. 9, When IRD is accounting income and not principal, no special rule applies, and the IRD would be apportioned among the shares in the same manner as other accounting income, unless the governing instrument or local law requires a different allocation which has economic effect. See Treas. Reg (b)-2(b)(2) ( The terms of the trust are considered specifically to allocate different classes of [fiduciary accounting] income to different beneficiaries only to the extent that the allocation is required in the trust instrument, and only to the extent that it has an economic effect independent of the income tax consequences of the allocation. ); see also I.R.C. 643(a).

16 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL allocated to the shares for Art and Bee. 87 This result is confirmed by Example 9 of the separate share Regulations. 88 It provides: Example 9. The will of Testator, who dies in 2000, directs the executor to divide the residue of the estate equally between Testator s two children, A and B. The will directs the executor to fund A s share first with the proceeds of Testator s individual retirement account. The date of death value of the estate after the payment of debts, expenses, and estate taxes is $9,000,000. During 2000, the $900,000 balance in Testator s individual retirement account is distributed to the estate. The entire $900,000 is allocated to corpus under applicable local law. This amount is income in respect of a decedent within the meaning of section 691(a). The estate has two separate shares, one for the benefit of A and one for the benefit of B. If any distributions are made to either A or B during the year, then, for purposes of determining the distributable net income for each separate share, the $900,000 of income in respect of a decedent must be allocated to A s share See Treas. Reg (c)-2(b)(3). 88 See Treas. Reg (c)-5 ex Id.

17 WINTER 2018 IRD & Charities 385 When section 663(c) DNI is separately computed for each share of the Brown Estate as though a separate trust, section 663 DNI for Claire s share is different than the DNI for the shares of Art and Bee and is computed as follows: Dividend Income (1/3 of $15,000) $5,000 Interest Income (1/3 of $15,000) $5,000 IRA Income 90 (100% of $150,000) $150,000 Total Gross Income $160,000 Personal Exemption ($600) Taxable Income 91 $159,400 Plus the Personal Exemption 92 $600 DNI of Claire s Share for Section 663(c) Purposes $160, Income in respect of a decedent within the meaning of section 691(a) that is not fiduciary accounting income is allocated among the separate shares that could be potentially funded with IRD, based upon the relative value of each share to the extent each could be funded with the IRD. See Treas. Reg (c)-2(b)(3). 91 Ignoring any possible distribution deduction under section 661(a) and after considering other possible deductions, however, no other deductions are present in the example. See I.R.C. 643(a). 92 DNI is taxable income computed without the distribution deduction or the personal exemption deduction and with other possible modifications. See I.R.C. 643(a).

18 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL The section 663(c) DNI for Art s share and Bee s share is different than the DNI for Claire s share and is computed as follows: Dividend Income (1/3 of $15,000) $5,000 Interest Income (1/3 of $15,000) $5,000 IRA Income 93 (none) $0 Total Gross Income $10,000 Personal Exemption ($600) Taxable Income 94 $9,400 Plus the Personal Exemption 95 $600 DNI of Art s Share and Bee s Share for Section 663(c) Purposes $10,000 In the Brown Estate, the distribution deduction for distributions by the estate to Claire will be limited to $160,000 and will be limited to $10,000 for distributions to Art or Bee, each. If Claire s share of the estate ($510,000 calculated by adding one-third of the $1.5m estate, onethird of $15,000 of dividend income, and one-third of the $15,000 interest income) is fully distributed, but Art and Bee receive no distributions from the estate, the distribution deduction will be limited to $160,000 and the estate will pay tax on the remainder as follows: Dividend Income $15,000 Interest Income $15,000 IRA Income $150,000 Total Gross Income $180,000 Personal Exemption ($600) Distribution Deduction (to Claire) ($160,000) Taxable Income $19, Income in respect of a decedent within the meaning of section 691(a) that is not fiduciary accounting income is allocated among the separate shares that could be potentially funded with IRD, based upon the relative value of each share to the extent each could be funded with the IRD. See Treas. Reg (c)-2(b)(3). 94 Ignoring any possible distribution deduction under section 661(a) and after considering other possible deductions, however, no other deductions are present in the example. See I.R.C. 643(a). 95 DNI is taxable income computed without the distribution deduction or the personal exemption deduction and with other possible modifications. See I.R.C. 643(a).

19 WINTER 2018 IRD & Charities 387 Without the separate share rule, the estate s distribution deduction would be $180,000 and the estate would have no taxable income as a result, but Claire would report $180,000 of gross income. Note that there were no distributions to any beneficiary of the Brown Estate, the calculation of section 663(c) DNI would not be necessary because there would be no distribution deduction. 96 B. Is a Charity a Separate Share Under the Separate Share Regulations? A new example with two individuals and a charity as residuary beneficiaries raises additional issues, including the extent, if any, to which the separate share rule applies. An example illustrates: Cash Estate: The decedent s will devises the estate equally to individuals Art and Bee, and Do-Good, Inc., a charity. The total value of the estate is $1.5 million and includes a $150,000 IRA. During its first tax year, the estate withdraws the entire $150,000 from the IRA, all of which is included in its gross income. The IRA is fiduciary accounting principal. 97 The estate has an additional $15,000 of dividend income and $15,000 of interest income; both are fiduciary accounting income. 98 The interests of Art and Bee in the Cash Estate are separate shares under section 663(c) because distributions to them will be made in substantially the same manner as if separate trusts had been created. 99 However, the Cash Estate facts raise the threshold question of whether the charitable beneficiary s interest in the residue of the estate is also a separate share within the meaning of section 663(c) and the applicable Regulations. 100 The Code provides that substantially separate and independent shares of different beneficiaries in the trust shall be treated as separate trusts, pursuant to the Treasury Regulations. 101 The Treasury Regulations set forth a general rule that separate share treatment will generally depend upon whether distributions of the trust are to be made in 96 See I.R.C. 663(c). 97 See supra note 63 and accompanying text. 98 See UPIA 409(b) (amended 2008), 7A pt. IV U.L.A. 389 (2017). 99 Treas. Reg (c)-3(a). 100 See I.R.C. 663(c). 101 Id.

20 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL substantially the same manner as if separate trusts had been created. 102 As a result, a separate share may exist even if, upon the termination of the beneficiary s interest in the share, the principal and accumulated income will go to other beneficiaries rather than to the beneficiary s estate or appointees. 103 There are several reasons why a charity s interest in an estate might be a separate share for purposes of section 663(c). First, it makes sense as for state law purposes the Cash Estate looks like it has three shares. Second, the charity s interest appears to meet the initial definition of a separate share under section 663(c) quoted supra. 104 Moreover, nothing in the separate share Regulations specifically say a charity interest is not a separate share. The separate share rule applies to beneficiaries of estates and trusts. 105 Section 643(c) defines a beneficiary : For purposes of this part, the term beneficiary includes heir, legatee, [and] devisee. 106 This definition of beneficiary would include a charitable beneficiary of an estate or trust. 107 Treasury Regulation section 1.643(c)-1 confirms the statute with a similar definition of a beneficiary. It provides: An heir, legatee, or devisee (including an estate or trust) is a beneficiary. A trust created under a decedent s will is a beneficiary of the decedent s estate Treas. Reg 1.663(c)-3(a). 103 See id. 104 See id.; see also I.R.C. 663(c). This construction does not consider the limiting language of section 663(c), which provides: For the sole purpose of determining the amount of distributable net income in the application of sections 661 and 662, in the case of a single trust having more than one beneficiary, substantially separate and independent shares of different beneficiaries in the trust shall be treated as separate trusts. Rules similar to the rules of the preceding provisions of this subsection shall apply to treat substantially separate and independent shares of different beneficiaries in an estate having more than 1 beneficiary as separate estates. The existence of such substantially separate and independent shares and the manner of treatment as separate trusts or estates, including the application of subpart D, shall be determined in accordance with regulations prescribed by the Secretary. Id. 105 See I.R.C. 663(c). 106 I.R.C. 643(c). 107 See id. 108 Treas. Reg (c)-1.

21 WINTER 2018 IRD & Charities 389 On the other hand, there are compelling reasons why a charity s interest in an estate or trust should not be treated as a separate share for purposes of section 663(c). First, nothing in the separate share Regulations says specifically or implies that a charity s interest is a separate share. Second, and most important, the separate share rule is limited in application. Section 663(c) provides that the separate share rule is [f]or the sole purpose of determining the amount of distributable net income in the application of sections 661 and Distributions for a charitable purpose (whether directly or for a charitable organization) are not the type of distribution that entitles an estate or trust to a distribution deduction, and the beneficiary must report as gross income, as required under sections 661 and 662. Rather, distributions for a charitable purpose are an income tax deduction, if anything tax wise, under section 642(c). 110 The United States Court of Claims in Mott v. United States, 111 held that sections 661 and 662 apply only to taxable beneficiaries. 112 In addition, Treasury Regulation section 1.663(a)-2 provides: Any amount paid, permanently set aside, or to be used for the charitable, etc., purposes specified in section 642(c) and which is allowable as a deduction under that section is not allowed as a deduction to an estate or trust under section 661 or treated as an amount distributed for purposes of determining the amounts includible in gross income of beneficiaries under section 662. Amounts paid, permanently set aside, or to be used for charitable, etc., purposes are deductible by estates or trusts only as provided in section 642(c) I.R.C. 663(c). As noted supra note 63, there also is a separate share rule for generation-skipping transfer tax purposes. See I.R.C. 2654(b). 110 See I.R.C. 642(c). To the extent a trust (but not a decedent s estate) makes a distribution for a charitable purpose consisting of unrelated business income defined in section 681, no deduction is allowed to the trust under section 642(c), but rather may be allowed under section 170. See Jonathan G. Blattmachr, F. Ladson Boyle & Richard L. Fox, Planning for Charitable Contributions by Estates and Trusts, EST. PLAN., Jan. 2017, at 3 passim F.2d 512 (Ct. Cl. 1972). 112 Id. at But see id. at 518 ( [W]e do not hold that it is a general rule which may be applied in every conceivable situation.... ). 113 Treas. Reg (a)-2.

22 REAL PROPERTY, TRUST AND ESTATE LAW JOURNAL The separate share Regulations begin: If a single trust (or estate) has more than one beneficiary, and if different beneficiaries have substantially separate and independent shares, their shares are treated as separate trusts (or estates) for the sole purpose of determining the amount of distributable net income allocable to the respective beneficiaries under sections 661 and The separate share rule prevents distortions of income reporting among taxable beneficiaries. 115 The Preamble 116 to the proposed separate share Regulations provides: Section 1307 of TRA 1997 amended section 663(c) of the Code by extending the separate share rule to estates. Prior to this amendment, a distribution to an estate beneficiary in the ordinary course of administration often resulted in the beneficiary being taxed on a disproportionate share of the estate s income. The extension of the separate share rule to estates promotes fairness by more rationally allocating the income of the estate among the estate and its beneficiaries thereby reducing the distortion that may occur when a disproportionate distribution of estate assets is made to one or more estate beneficiaries in a year when an estate has distributable net income. Under the separate share rule, a beneficiary is taxed only on the amount of income that belongs to that beneficiary s separate share. 117 Third, section 663(c) addresses the allocation of DNI among beneficiaries who are subject to income taxes, which is the purpose of 114 Treas. Reg (c)-1(a). 115 See id. 116 Preamble is used to refer to the introductory material at the beginning of the proposed regulations. See Federal Register Tutorial, NAT L ARCHIVES (Jan. 4, 2018), This Article uses this term. Please note that this Article refers to different preambles throughout the Article. 117 Prop. Treas. Reg (c), 64 Fed. Reg. 790, 790 (Jan. 6, 1999) (emphasis added).