No Charitable Deduction If Amount Not Permanently Set Aside
In Estate ofDiMarco,1 the Tax Court denied an estate an income tax charitable deduction for funds purportedly set aside for charity, because the estate was involved in litigation and could not assure, in the year in which it claimed a deduction, the amount of the funds that would definitely be distributed to charity.
John D. DiMarco died testate in December 2008. He was unmarried and had no children. In his will, Mr. DiMarco left his estate remaining after the payment of debts, taxes, and costs of administration to the churches he regularly attended at the time of his death.
A challenge to Mr. DiMarco's will was brought by several of Mr. DiMarco's paternal cousins. Settlement negotiations began among the attorneys for the churches and the cousins. In April 2012, the parties settled the matter in dispute by agreeing that each of two churches would receive one-third of the decedent's gross estate and the cousins collectively would receive the remaining one-third. On 4/26/2012, the parties stipulated on the record in the surrogates court that a settlement had been reached. In December 2012, the parties reached a settlement regarding the payment of all attorney's fees and executor commissions. In January 2013, the surrogates court approved the second settlement.
In April 2012, the lawyer for the estate prepared and untimely filed the estate's Form 1041 for the 2010 tax year. The estate reported income of $335,854 and claimed a charitable contribution deduction of $314,942 from gross income as an amount permanently set aside for charitable purposes. In October 2013, the IRS issued a notice of deficiency denying the charitable deduction, and the estate filed a petition in Tax Court.
The sole issue before the court was whether the estate was allowed a charitable contribution deduction under Section 642(c)(2). An estate may claim a current charitable contribution deduction under Section 642(c)(2), notwithstanding that the amount will not be paid or used for a charitable purpose until sometime in the future. Section 642(c)(2) provides, in pertinent part:
"In the case of an estate ... there shall also be allowed as a deduction in computing its taxable income any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, permanently set aside for a charitable purpose specified in Section 170(c) ...."
For an estate to claim the charitable contribution deduction pursuant to Section 642(c)(2), it must meet three requirements:
(1) The charitable contribution must be an amount from the estate's gross income.
(2) The governing instrument's terms made the charitable contribution.
(3) The charitable contribution was permanently set aside for a charitable purpose as defined under Section 170(c).
In order to establish that the charitable contribution was permanently set aside for a charitable purpose, Reg. 1.642(c)-2(d) requires an estate to prove that the possibility that the amount set aside for the charitable beneficiaries would go to noncharitable beneficiaries was so remote as to be negligible. The Tax Court has defined the "so remote as to be negligible" standard to mean "a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction" and "a chance which every dictate of reason would justify an intelligent person in disregarding as so highly improbable and remote as to be lacking in reason and substance." 2
The estate argued that it permanently set aside the $314,942 for the benefit of the two churches because as of March 2012, it could determine and account for all of its final administrative expenses. The estate also pointed to the settlement meeting that occurred at that date as evidence that the possibility of prolonged legal controversies over estate matters was so remote as to be negligible. The IRS, on the other hand, argued that in light of the uncertainties and legal controversy, the charitable contribution was not permanently set aside under Section 642(c)(2).
As such, the IRS contended that the "so remote as to be negligible" standard of Reg. 1.642(c)-2(a)(1) was not met and, therefore, the contribution is not deductible by the estate. In addition, the IRS argued that as a matter of law, an estate cannot permanently set aside funds when there is a pending will contest or active litigation, the result of which might distribute the estate's funds to noncharitable beneficiaries.
The court found that although the parties' first settlement allocated the beneficial interests in the estate, this first settlement did not make the possibility so remote as to be negligible that the two churches' respective shares would go to noncharitable beneficiaries because the issue of legal fees and executors' commissions remained unsettled. The court noted that the issue of legal fees and executors' commissions remained unresolved until over eight months later when in January 2013, the surrogate's court accepted the parties' second settlement with respect to the attorney's fees and executors' commissions.
The court stated that only after the surrogate's court approved the second settlement in January 2013, were the estate's funds finally dedicated to the respective parties, thereby eliminating any opportunity to challenge the will. The court held that by virtue of the fact that the settlements pertaining to the designation of beneficiaries and consequential legal and administrative expenses were not finalized until after the year at issue and after the estate filed its income tax return, the possibility that the funds would go exclusively to noncharitable beneficiaries was not so remote as to be negligible.
The court, relying on Estate of Belmont, 3 also agreed with the IRS that the presence of active litigation disqualified the funds from meeting the permanently set aside standard. The court rejected the estate's claim that the disagreement in this case, because it primarily involved settlement negotiations, did not rise to the level of active litigation.
This case is important because it clearly illustrates the difficulty of an estate taking a charitable income tax deduction when the will is challenged and the controversy is not finally and totally settled. Extrapolating from the holding of this case to a case involving not settlement among the parties but rather a judicial determination, a charitable income tax deduction may not be allowed until the time for all appeals has expired. While audits of estate income tax returns may not be routine, those estates in which a charitable income tax deduction is claimed prior to payment should be prepared for an inquiry from the IRS and be certain that the time for claiming the charitable deduction is ripe.
1 TC Memo 2015-184 RIA TC Memo ¶2015-184.
2 See Briggs, 72 TC 646 (1979), aff'd665 F.2d 1051 (CA-9, 1981).
3 144 TC 84.
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets his clients have accumulated and minimizing federal and state tax liability. These clients range from homeowners whose property has appreciated to people with significant investment, retirement, business, and real estate holdings. For more on charlitable deductions, contact Frank at (301) 657-0175 or firstname.lastname@example.org.
This article originally appeared in the February 2016 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.