The ABC’s of Charitable Trust Administration: Primer

1. The ABC’s of Charitable Trust Administration: Primer Common Errors that Could Result in Surcharge Presented by Richard S. Caputo, Esquire

2. 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

3. Presentation Outline • Compliance with the Reporting Requirements of the Code • Summary of Charitable Trust Compliance Issues • Action Steps

4. Introduction

5. Richard S. Caputo • Consults with banks and trust companies on tax compliance matters and frequently assists such clients in obtaining tax-exempt 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

6. 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

7. 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

8. What is a Charitable Trust?

9. 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

10. Income Tax Compliance Issues: Understate Income by Taking Unallowable Charitable Deductions

11. 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?

12. How to Avoid These Income Tax Compliance Issues

13. 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

14. 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 income-only trust

15. Second Recommendation(cont’d) • Capital gains are “trapped” and, therefore, are taxable • Exposure could be minimized by an Act 141 election

16. Best Recommendation • File a Form 1023 Application for Each Post-1969 Charitable Trust • Prospective exemption • May still be surcharged for past noncompliance • Retroactive exemption

17. Why are Form 1023 Applications Not Filed on Behalf of Every Post-1969 Charitable Trust

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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 non-exempt charitable trusts

25. Excise Tax Compliance Issues (cont’d) • “Minimum Distributable Amount” • Two years to distribute • 15% excise tax (PPA: 30%)

26. 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)

27. 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%

28. Compliance with Reporting Requirements of the Code Failure to File the Proper Annual Return

29. Reporting Requirements • Most trustees are unaware that the private foundation rules of the Code apply to their non-exempt 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

30. Consequences of Failing to File Proper Return • Failure to file penalty • Failure to pay penalty • Open statute of limitations

31. Summary of Charitable Trust Compliance Issues

32. 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?

33. Action Steps

34. 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

35. 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

36. 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

37. 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)

38. Non-Exempt Pre-1969 Charitable Trusts • Revenue Procedure 72-50 Letters • Scholarship Approval Letters

39. 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