Giving or Leaving IRA Assets to Charity

For years, charities in the United States have promoted the so-called “individual retirement account charitable rollover” as well as the idea of leaving IRA assets to charity at death. The arguments in favor of these ways of giving are well known in the charitable community and among tax advisors. The devil, as is usually the case, is in the details.

IRA Charitable Rollover

The term “IRA rollover” is a misnomer when applied to charitable giving, but it’s taken hold. The technical term for this way to give is “qualified charitable distribution” (QCD). The Tax Code lays out the requirements for a QCD:

• The individual making the QCD must be at least 70½ years old at the time it’s made.

• The individual must make the QCD to a garden variety public charity such as a college, hospital, religious organization or an arts organization. Private foundations, supporting organizations and donor-advised funds may not receive QCDs.

• The individual may not receive anything of economic value in exchange for the QCD. The individual, however, may receive recognition for the QCD, and the individual and the donee organization may agree on the side that the QCD shall be used for a particular purpose.

• The individual must cause the assets comprising the QCD to flow directly from the IRA to the donee organization.

• The individual can use only a traditional IRA or Roth IRA to make a QCD. QCDs can’t be made from other kinds of retirement plans, such as an active Savings Incentive Match Plans for Employees IRA, Simplified Employee Pension IRA or an IRC Section 401(k) plan (401(k)). Although much has been written online and elsewhere about making a tax-free transfer from a 401(k) to an IRA, and then making a QCD from the IRA, I’m uneasy with this plan because of the step-transaction doctrine, given that the transfer from the 401(k) to the IRA has no independent economic purpose. 

• The individual is limited to making no more than $100,000 in QCDs during a calendar year. This rule doesn’t prohibit a married couple that files jointly from each giving up to $100,000 per year via QCDs.¹ 

That’s pretty straightforward, but there are a slew of questions about QCDs, many of which have no clear answers. For example:

When is a QCD deemed made for tax purposes? There are various fact patterns here. The simplest one: The IRA custodian mails a QCD check to the charity on Dec. 30. The check arrives at the charity on Jan. 2. Is this a December QCD or a January QCD? The Internal Revenue Service has provided no guidance on this question.² 

What’s the amount of the QCD? The typical fact pattern here is that the IRA custodian wires stock to the charity on Day 1, and the charity receives the stock on Day 2. This fact pattern presents two questions: (1) When is the QCD complete for tax purposes?; and (2) Which is the day to value the stock for purposes of determining the amount of the QCD? Again, the IRS has provided no guidance.

The timing question is especially important given that many individuals initiate QCD transfers at year’s end. Two fact patterns here are especially troubling.

The first involves the situation in which the IRA custodian cuts a check payable to the charity in late December and mails the check to the donor in late December.³ The donor subsequently mails the check to the charity, which receives the check in January. The question is, when is the QCD complete for tax purposes? When the IRA custodian mails the check to the donor? When the donor receives the check? When the donor mails the check to the charity? When the charity receives the check? I suspect it’s when the donor mails the check to the charity, but that’s just an educated guess. The IRS hasn’t said.

The second is when the donor has check-writing privileges on her IRA. In late December, she writes a check on the IRA made payable to the charity.⁴ Then, still in late December, the donor either mails or hand delivers the check to the charity. The charity doesn’t deposit the check, however, until January. The apparent question is, when is the QCD complete for tax purposes? Depending on the precise facts, this may be a real, burning question. The more fascinating question, though, is how will the IRA custodian report the QCD to the IRS?⁵ From the custodian’s perspective, the donor likely will have made a January QCD, because the QCD check will be presented for payment in January, and except for seeing the date on the check, the custodian will be in the dark as to all the other details of the QCD transaction, including when the donor hand-delivered or mailed the check.  

QCD Substantiation

Despite the fact no federal income tax charitable deduction is allowed for a QCD, IRS Publication 590-B provides with respect to QCDs:

[Y]ou must have the same type of acknowledgment of your contribution that you would need to claim a charitable deduction for a charitable contribution.

This means that for a QCD of $250 or more, the donor must have an acknowledgment (gift receipt) from the donee stating whether the donee provided any goods or services to the donor in consideration of the QCD.⁶

The quoted language from Publication 590-B suggests that the IRS views QCDs as being subject to the same date-of-gift rules as deductible charitable contributions. One of these rules is that a gift made via a check mailed to a charity is complete for tax purposes on the date of mailing, provided the check clears the donor’s bank in due course.⁷ If the distribution date for a QCD is determined by date-of-gift rules, it would be best for IRS to come right out and say so.

QCDs and Inherited IRAs

I’ll focus on inherited IRAs later, but at this point the question is, can a QCD be made from an inherited IRA?  

Inherited IRAs are subject to special Tax Code rules, but nothing in the Tax Code suggests that a QCD can’t be made from an inherited IRA, even though the party who’s a beneficiary of an inherited IRA isn’t considered the IRA owner (except for a surviving spouse who claims the inherited IRA as her own). The prevailing view, which I believe is correct, is that a QCD may be made from an inherited IRA. This view is bolstered by the fact that in the scant written guidance the IRS has provided on QCDs, it’s indicated that a QCD may be made from an inherited IRA, provided the IRA beneficiary is at least 70½ years old.⁸

Using a QCD to Pay a Pledge

The IRS has taken the position that a QCD may be used to pay any pledge, even an enforceable one.⁹ In taking this position on enforceable pledges, the IRS has ignored Revenue Ruling 81-110. In that ruling, which has precedential value and hasn’t been revoked, Party B paid Party A’s enforceable pledge to charity. The IRS ruled that Party B thereby made a gift to Party A for federal gift tax purposes and that Party A was entitled to the federal income tax charitable deduction for Party B’s payment. What underlies the ruling is the IRS’ ability to reconfigure transactions according to their substance; that is, the IRS isn’t bound by the form of a transaction.

If the principles of Rev. Rul. 81-110 were applied to the use of a QCD to pay an enforceable pledge, the QCD would be deemed to be a taxable distribution to the donor, and the donor, with the correct form of acknowledgment from the charity, could claim a federal income tax charitable deduction for the money paid to the charity.

This whole matter is important, given the wide variability among state laws on what makes a pledge enforceable. As just one example, an appellate court in New Jersey has held that a mere spoken promise to make a charitable gift is enforceable, notwithstanding lack of consideration for the promise.¹⁰

QCDs and State Income Tax Laws

One might think the states would follow the federal government in not subjecting the donor to income tax on a QCD. To my knowledge, all the states except one follow the federal government this way.

The lone exception is New Jersey. Its department of taxation says a QCD is reportable as income by the donor for New Jersey income tax purposes.¹¹ 

IRA Custodian Handling of QCDs

Despite the fact that the QCD made its appearance in 2006, some IRA custodians still haven’t gotten the message.

A remarkable actual example involved an individual who, in late 2017, instructed his IRA custodian to make a QCD. The custodian made the check payable to the individual and mailed it to him. The individual subsequently asked a gift officer if he could endorse the check over to the gift officer’s organization and treat the check as a QCD.  

The answer was, of course, no. The check, having been made payable to the individual, couldn’t qualify as a QCD, because the endorsement over to the charity would constitute a gift from the individual, not a distribution from his IRA directly to the charity.¹² 

A bad practice mentioned above, to which some IRA custodians adhere, is that of sending the QCD check (made payable to the charitable donee) to the donor and leaving it up to the donor to get the QCD check to the donee organization. Even though the IRS has said it’s acceptable, the practice introduces into the QCD process both uncertainty as to the date of the QCD and delay.

There’s no good reason for an IRA custodian not to mail the QCD check directly to the donee organization. My instincts tell me IRA custodians do this out of a fear of some law, perhaps the Patriot Act. But, if that’s the concern, sending the QCD check to the donor isn’t going to help. The donor is being used as a courier (agent) by the IRA custodian, and therefore the donor doesn’t shield the custodian from whatever the custodian fears.

Some IRA custodians wire the QCD to the donee. This is an excellent practice. 

IRA Assets Left to Charity at Death

Unlike the QCD, as to which there’s a specific Tax Code provision, the leaving of IRA assets to charity at death has to be analyzed using various provisions of the law.  The starting point in the analysis is IRC Section 408, which contains the definition of an IRA.

IRAs are widely regarded as mere custodial arrangements. An IRA is in fact a trust for federal tax purposes.¹³ The custodian of an IRA is the trustee of the trust.¹⁴ These facts are critically important. They mean that IRA custodians are subject not only to federal tax law requirements but also to common law fiduciary duties.¹⁵ These duties typically include those of loyalty, obedience, diligence, impartiality and care. These duties are owed not only to the individual who created the IRA but also to the beneficiaries of the IRA. In many if not all states, a deliberate breach of fiduciary duties can lead to both compensatory and punitive damage awards.¹⁶

We’ll return to these fiduciary duties and what they mean for charities that are named IRA beneficiaries, but first we need to look at how charity beneficiaries are routinely treated by IRA custodians.

Problems Faced by Charities 

Charities have faced problems in receiving IRA beneficiary distributions. By definition, an IRA beneficiary is a person (individual, charity, etc.) designated to receive IRA assets on the death of the IRA owner.¹⁷ 

Under Treasury Regulations Section 1.401(a)(9)-4, however, only an individual can be a “designated beneficiary.” Some forms that IRA custodians require charity IRA beneficiaries to complete treat the charity as a “designated beneficiary,” which is flat-out wrong.

Also by definition, the IRA owner is either: (1) the individual who established the IRA, or (2) the surviving spouse of such individual, provided the spouse has taken the steps necessary to become owner.¹⁸ These definitions are important to understanding the situation of a charity that finds it’s been named an IRA beneficiary.  

One aspect of this situation is that a charity can never be the owner of an IRA. A charity can set up an inherited IRA. But such an IRA, which can receive a trustee-to-trustee distribution from the deceased donor’s IRA, must be set up in the name of the decedent, who’s still considered the IRA owner.¹⁹ 

So, there’s no point in a charitable beneficiary’s setting up such an IRA; nothing is gained.

In sum, a charity can’t set up an IRA in its own name, either as IRA owner or as an IRA beneficiary. Yet, IRA custodians routinely demand that charities named as IRA beneficiaries do just that, establish an IRA in the charity’s name.

A risk is that a distribution from the decedent’s IRA to such a faux IRA will be subject to federal and state income tax.

Three Real-Life Examples

Charities named as IRA beneficiaries have faced various obstacles in trying to obtain IRA assets. Here are three real-life examples:

Example 1: A donor dies owning an IRA that names a charity as the sole IRA beneficiary. The IRA custodian, a Midwestern financial institution, makes a distribution to the charity but withholds and remits to the IRS 10 percent of the gross distribution, informing the charity that the withholding is mandatory.

In fact, withholding isn’t required, and the charity is wrongfully and needlessly forced to seek a refund from IRS.²⁰ 

Example 2: A donor dies owning an IRA that names a charity as the sole IRA beneficiary. The IRA custodian, a Southwestern financial institution, informs the charity that it will have to set up an inherited IRA account to get its IRA distribution. The inherited IRA will be in the donor’s name but bear the charity’s tax ID number.²¹ The explanation for this requirement is that this procedure is needed to avoid having federal income tax imposed on the distribution.

The explanation is nonsensical. A distribution directly to the charity would be free of income tax because of the charity’s tax-exempt status. Furthermore, putting the charity’s tax ID number on the IRA is equivalent to stating that the charity is the IRA owner, which, as we’ve seen, is impossible.

Example 3: A donor dies owning an IRA that names the charity as the sole IRA beneficiary. The IRA custodian, a large East Coast financial institution, informs the charity that it must set up a “dummy account” with the custodian. It further informs the charity that to establish the account, the charity will have to provide its business officer’s Social Security number and a copy of the business officer’s driver’s license. The custodian’s customer relations representative informs the charity’s gift officer and the charity’s lawyer that the IRA distribution will be made to the “dummy account,” which the charity can promptly drain and collapse.

All of this is unnecessary and, as we’ll see, breaches the custodian’s fiduciary duties.

I could go on and on with other such real-life examples of which I have first- or second-hand knowledge, but there’s an important point that needs to be drawn from these three examples: There’s no uniformity among IRA custodians as to why they don’t simply make distributions directly and without tax withholdings to charity IRA beneficiaries. (To be fair, some IRA custodians do distribute directly to the charity and don’t withhold, which further adds to the lack of uniformity.)

This lack of uniformity tells me something’s going on, and it isn’t application of the law, because the law imposes uniformity. What’s going on, I believe, is that IRA custodians have well-established procedures for making beneficiary distributions to individuals, trusts and estates, but largely, they haven’t developed any procedures for handling charitable beneficiary distributions. This has led to uninformed decision making on how to handle such distributions. That’s what’s caused lack of uniformity.

The Patriot Act

Is the Patriot Act a problem for charity IRA beneficiaries? The answer is both no and yes. It’s no because the Patriot Act isn’t aimed at the typical charity that faces the sort of obstacles just described. Such a charity is a benign, domestic, garden variety IRC Section 501(c)(3) organization such as a college or university, hospital, church or synagogue or museum, which is simply a trust beneficiary.   

But it’s also yes, because if the IRA custodian can get such a charity to set up some kind of account, it can point to Section 326 of the Patriot Act (the “know your customer” section) and say that the Patriot Act requires it to do due diligence as to the identity of its customer.  The IRA custodian account rep typically calls such an account a “beneficiary IRA” or an “inheritor IRA.” That term may sound impressive. The problem is that the so-called beneficiary IRA purportedly will be owned by the charitable beneficiary. As discussed above, a charity can never be the owner of an IRA, so the whole idea of a beneficiary IRA is invalid.

At least one financial institution has decided that a charity named as beneficiary of an IRA is a “customer” that’s setting up an account for purposes of Section 326 of the Patriot Act, which supposedly brings into play the Section 326 “know your customer” requirement.  

A charity named as beneficiary of an IRA isn’t a customer of the IRA custodian, merely being an IRA beneficiary, and it’s not setting up an account, merely being an IRA beneficiary. The charity is simply a trust beneficiary.

I understand that financial institutions want to avoid Patriot Act violations. But, in forcing clearly benign U.S. charities to go through unnecessary Patriot Act vetting to receive their IRA beneficiary distributions, financial institutions are behaving badly. The cost to U.S. charities across the board is tremendous and needless.

A Strategy for Charities

Charities are far from united in their response to financial institutions that erect the sort of obstacles I’ve described. Some charities know how to fight back and do fight. They often win their fights. These are a tiny minority of the charitable community. Most charities cave in some way, because they don’t know what else to do, and they want the money.

Here’s a strategy that I’ve found works in some situations. The first step for a gift officer is to grasp that the individual who’s presenting obstacles is a customer relations person who’s typically of low rank in the financial institution. This individual will be articulate and well-trained in presenting the particular obstacles and won’t be trained in the law. The gift officer will make no headway with this individual, who’s been trained not to give an inch and to follow institutional policies, forms and procedures to the letter.

The gift officer needs help. The help needed only can come from someone trained in the law who grasps the situation fully. This someone is a lawyer.

The lawyer’s job is to work his way up the food chain in the financial institution. The way to cut to the chase is to get to the financial institution’s general counsel.

Lawyers like to deal with other lawyers. That’s a little over broad, perhaps, but it’s true more often than not.  This means the general counsel may be willing to speak with the charity’s lawyer.

The general counsel will usually be unaware of the issue or problem. He has other fish to fry. Furthermore, he typically regards IRA distribution matters to be policy or accounting matters, not legal matters.

Here’s when knowing that an IRA is a trust and that the financial institution is the trustee of the trust comes into play. The general counsel typically will perk up on hearing that an IRA is a trust and that the financial institution is the trustee of the trust. He may really perk up on hearing that the financial institution is breaching or is about to breach its fiduciary duties. That’s not something the general counsel will want laid in front of a judge or a bank regulator. The general counsel, who has plenty of other headaches, will want this problem to go away. The general counsel has the power to make it go away.

There’s Really No Tax Problem

In two of the three real-life examples presented above, the IRA custodian was fussing about federal income tax on a charity’s IRA beneficiary distribution. IRS Forms 1099-R and W-4P make absolutely clear that such fussing is needless and pointless, not just annoying and harmful to the charitable beneficiary.²²

Form 1099-R is the basic information form for all pension, IRA and annuity distributions. In the case of an IRA beneficiary distribution to a charity, the “Payer” on the form is the IRA custodian, not the decedent’s IRA. Correspondingly, the custodian’s tax ID number goes in the box labeled “PAYER’S federal identification number.”  The charity’s tax ID number goes in the box labeled “RECIPIENT’S federal identification number.”  

Thus, Form 1099-R doesn’t refer to or identify the deceased donor or his IRA. This fact is important, because it makes clear that the distribution to charity gives the IRS no cause whatsoever to look either at the IRA or at the donor’s estate. All that’s reported to the IRS on a properly completed Form 1099-R is that the custodian made a distribution to a tax-exempt organization.

Box 2A of Form 1099-R asks for the taxable amount of the distribution. In the case of a charitable IRA beneficiary distribution, this box should either: (1) be left blank, or (2) contain a “0.” If Box 2A is left blank, Box 2B should be checked “Taxable amount not determined.” The instructions to Form 1099-R provide that an IRA custodian isn’t required to determine the taxable amount of an IRA distribution. From the 1099-R instructions regarding Box 2B: “Except for IRAs, make every effort to compute the taxable amount.”

It’s true that the instructions to Form 1099-R do require 10 percent withholding on nonperiodic IRA distributions, but one needs to read the fine print. First, the 10 percent withholding rule applies only to taxable distributions. An IRA beneficiary distribution to a charity is non-taxable. Second, even the recipient of a taxable IRA distribution can elect on Form W-4P not to have any federal income tax withheld on the distribution.

This means the Midwestern financial institution that “mandatorily” withheld 10 percent of the charity’s IRA beneficiary distribution in real-life Example 1 did so improperly, thereby breaching its fiduciary duties to the charity. The charity has a cause of action against the financial institution.

In real-life Example 2, in which a Southwestern financial institution is requiring the charity to set up a bizarre account to get its IRA beneficiary distribution without triggering income tax, the charity’s lawyer should send a letter to the institution’s general counsel, pointing out the misplaced tax concern and the fiduciary duties being breached.

Need for Change in Law 

It certainly wouldn’t hurt for the law to be changed, and it could help a great deal for Congress to serve up a law requiring financial institutions to make IRA beneficiary distributions to charities the way they should.

Even without such legislation, however, charities have currently all the law they need to fight successfully for what’s rightfully theirs. The key word, unfortunately, is “fight.”

What’s needed right now is leadership from and unity within the charitable community so that individual charities don’t have to fight in isolation.

If a change in the law is to occur, I’d lean toward an IRS pronouncement, even a private letter ruling, rather than a Congressional enactment, for two reasons: (1) the IRS knows more about IRAs than Congress as a whole does; and (2) IRS pronouncements always come with a club, express or implied. A piece of legislation, on the other hand, is not self-executing and may lack an effective enforcement mechanism.              

Endnotes

1. As to the $100,000 allowance per spouse, see Internal Revenue Service Pub. 590-B.

2. IRS guidance on qualified charitable distributions (QCDs) is scant, because the QCD provisions of the tax law weren’t made permanent until the Protecting Americans from Tax Hikes Act of December 2015.

3. This approach to making the QCD was approved in IRS Notice 2007-7, Q-41 and A-41.

4. The IRS hasn’t spoken to whether a QCD can be made by writing a check, made payable to a qualified charity, on an individual retirement account. This approach to making a QCD should work, however, because it causes a distribution to be made directly from the IRA to the charity.

5. The IRA custodian will report the QCD on IRS Form 1099-R. The question, however, which is one of both fact and law, is whether the 1099-R will reflect a December distribution or a January distribution.

6. Internal Revenue Code Section 170(f)(8)(B)(ii).

7. Treasury Regulations Section 1.170A-1(b).

8. Notice 2007-7, Q-37 and A-37.

9. See ibid., Q-44 and A-44. The IRS’ position as to allowing QCDs to be used to pay any pledge is based on the Department of Labor’s (DOL) interpretation of IRC Section 4975(d)(9), as to which the DOL has interpretive jurisdiction. The DOL has informed the IRS that the DOL considers the QCD to be received by the individual who’s caused the QCD to be made.

10. Jewish Federation of Central New Jersey v. Barondess, 234 N.J. Super 526 (1989). 

11. See NJ-1040, the New Jersey income tax form, and related instructions as to IRA withdrawals (NJ-1040, line 19b). 

12. The endorsement by the donor and delivery of the check to charity constitute a negotiation of the check, which is a change of ownership of the check from ownership by donor to ownership by charity. This is a gift from donor to charity.

13. IRC Section 408(a).

14. Section 408(a)(2).

15. IRA custodians that are banks have fiduciary duties by virtue of being banks. Non-bank IRA custodians are required to demonstrate fiduciary ability to the IRS under Treas. Regs. Section 1.408-2(e)(2).

16. Restatement (Second) of Torts Section 874, Comment b and Section 901, Comment c.

17. IRS Pub. 590-B.

18. Ibid.

19. Ibid.

20. An election not to have income tax withheld from an IRA distribution is available to any IRA beneficiary on line 1 of Form W-4P.

21. IRS Pub. 590-B provides that an inherited IRA is established in the deceased owner’s name. Accordingly, an inherited IRA must bear the deceased owner’s tax ID number.

22. www.irs.gov/pub/irs-pdf/f1099r.pdf.