CHANGES FOR CHARITIES

THE SECURE 2.0 ACT AND QUALIFIED CHARITABLE DISTRIBUTIONS TO SPLIT-INTEREST ENTITIES

BY SHELDON R. SMITH, CPA

Tax law allows for qualified charitable distributions (QCDs), which are nontaxable transfers from a traditional IRA to a qualifying charity. Those who use QCDs can get the tax benefit of a charitable contribution without itemizing and without having the IRA distribution included in AGI, which can have many other benefits. This benefit became more important with the increase in the standard deduction from the Tax Cuts and Jobs Act of 2017 (TCJA), meaning fewer taxpayers are itemizing.

A QCD must be a transfer directly from an IRA to the charity. The IRA account holder must be at least 70½ at the time of the transfer. Most entities that qualify for charitable de- duction status will qualify for a QCD. The annual maximum amount for a QCD is $100,000 per taxpayer (indexed starting in 2024). Any amount transferred as a QCD counts toward the annual required minimum distribution (RMD) for taxpayers old enough to have RMDs.

The SECURE 2.0 Act of 2022 included provisions that relate to QCDs, one of which allows a one-time QCD to certain split-interest entities. However, the implications of this new provision make it unlikely that charities will encourage it and unlikely that many seniors will use it.

SPLIT-INTEREST ENTITIES

The new tax provision allowing a QCD to a split-interest entity only applies to certain entities: a charitable remainder annuity trust (CRAT), a charitable remainder unitrust (CRUT), or a charitable gift annuity (CGA). In general, these types of charitable gifts operate by having an individual create a trust or transfer assets to a charity with the provision that the trust or charity will provide income from the assets to a beneficiary for a period of time, perhaps the remaining life of the donor (the lead beneficiary), with the charity (the remainder beneficiary) claiming the remainder interest at the end of the life of the agreement.

A CRAT is one where the donor transfers assets into an irrevocable trust from which fixed annuity payments are made at least annually to one or more beneficiaries. The life of the trust can be for a fixed term in years (not to exceed 20) or for the life or lives of the individual or individuals named as beneficiaries. The fixed annuity payment must be between 5% and 50% of the initial fair market value of the assets contributed to the trust.

When the life of the trust ends, the remainder interest is transferred to a charity. The value of the remainder interest must be at least 10 percent of the initial fair market value of assets contributed, with this percentage being verified with actuarial calculations at the time the trust is created.

Trust distributions to the non-charitable beneficiary(ies) are taxed as ordinary income to the extent the trust has ordinary income to distribute. Similarly, if trust ordinary income is all distributed, payments can be taxed, in order, as capital gain, other income, or a non-taxable return of corpus, depending on the nature of the payment to the beneficiary(ies).

A CRUT is like a CRAT except that the payments to the lead beneficiaries are a fixed percentage (between 5% and 50%) of the fair market value of the assets, valued annually. Thus, whereas a CRAT has fixed dollar payments to lead beneficiaries, a CRUT has variable payments.

A CGA involves the transfer of assets to a charity. In turn, the charity promises to make fixed annuity payments for life on at least an annual basis to one or two beneficiaries. The annuity amount is calculated such that the value of the contributed assets is larger than the actuarial value of the annuity, providing a remainder interest for the charity.

IRC section 72 allows an exclusion from income for annuity payments received, up to the value invested in the annuity. In addition, if appreciated assets are contributed, the capital gain can be recognized by the donor over the life of the annuity.

Because each of these split-interest entities leaves a remainder interest to a charity, a charitable contribution deduction is allowed for a portion of the amount of the donation. The deduction allowed is based on an IRS formula. However, a taxpayer’s AGI can further limit the charitable contribution deduction.

QCDs TO SPLIT-INTEREST ENTITIES

IRC section 408(d)(8) details the requirements for a QCD. The SECURE 2.0 Act amended this section by adding a new possibility for a QCD. On a one-time basis, a taxpayer can now make a QCD to one of the split-interest entities described above. Each must be funded exclusively by QCDs. In addition, in the case of a CGA, fixed annuity payments of 5% or greater must commence within one year of the date of the funding. The maximum amount for this new QCD is $50,000. The lead beneficiary(ies) can only be the IRA account holder, a spouse, or both; in addition, the income interest cannot be assignable.

Other special rules also apply to this type of QCD. For either of the trust options, the payments to the non-charitable beneficiary(ies) will be treated as ordinary income and cannot qualify as capital gains or tax-free income. QCDs used for a charitable gift annuity are not treated as investments in the contract, so none of the annuity payments received from a charitable gift funded by a QCD can be excludable and will all be treated as ordinary income.

Advantages And Disadvantages

Perhaps the most important benefit from this new law is the tax advantage to the donor. If the new QCD is used to contribute to a split-interest entity, although there is no tax deduction available for the calculated remainder interest to the charity, there is no tax liability for the amount withdrawn from the IRA. In this case, the donor gets a tax advantage for the entire amount of the IRA distribution rather than just for the partial amount of the remainder interest, and the taxpayer does not need to itemize to get this advantage. In addition, the amount withdrawn from the IRA can still count toward the annual RMD for that year but never becomes part of AGI.

However, that tax advantage comes with multiple possible disadvantages.

1. The trust or CGA payments to the non-charitable beneficiary(ies) will be defined as ordinary income; there will be no potential tax advantage for any of the life income (excludable or capital gain treatment).

2. A split-interest entity in this case can only come from QCDs. For any individual, this would mean the maximum amount would be $50,000 (indexed). While charities might be willing to set up a CGA for this amount, the costs of setting up and administering a trust may necessitate larger asset transfers to make a trust worthwhile.

3. If both spouses have IRAs and transfer $50,000 each through a QCD to the same split-interest entity, it is possible the total contribution could be $100,000 (indexed). This amount may still be too small to be worthwhile to trust companies.

4. If spouses desire to make QCDs to the same split-interest entity, this would either need to be done by both spouses simultaneously or they would have to be done through a CRUT. Because CRATs and CGAs make payments based on the initial fair value, they cannot accept additional contributions after the initial amount.

5. One or both parents creating a split-interest entity through a QCD cannot designate a child a beneficiary, as they can with split-interest entities created in other ways. In addition, there cannot be more than two lead beneficiaries of a trust funded through a QCD, as there can be with a trust created in another way. CGAs are already limited to not more than two lead beneficiaries; for a CGA created through a QCD, they can only be the IRA owner, a spouse, or both.

6. A split-interest entity may not provide much life income based on the dollar limitation of the QCD and the limit of a one-time-only transfer. Annual income of 5% of $50,000 would only be $2,500. If this small amount of income is not really needed, it might be better to just make a QCD directly to the charity rather than to a split-interest entity. That way the charity would get the full benefit of the QCD amount rather than just the remainder interest.

7. A $50,000 QCD to a split-interest entity may not be very helpful to those who want to make exceptionally large charitable gifts with a significant amount of lifetime income.

The potential increased tax advantage of a QCD to a split-interest entity makes this new tax provision sound quite helpful, both to charities and to those with IRAs who desire to support charities. However, taken together, the disadvantages may make it difficult for charities and trust companies to focus a lot of effort in this area. In addition, the dollar limit for this QCD and the one-time limitation may not be adequate to motivate many qualified seniors to take advantage of this opportunity. n

This article is based on a longer article that was published in Tax Notes Federal (https://taxnotes.co/3J8Wwb3) and Tax Notes State (https://taxnotes.co/3X3vCa5) on June 12, 2023.

Sheldon R. Smith is a professor of accounting at the Woodbury School of Business at Utah Valley University in Orem, Utah. He graduated from BYU with a B.S. degree in accounting and a joint MAcc/MBA. He completed a Ph.D. degree in accounting at Michigan State University.