There’s an undercurrent of grumbling and frustration when executing a transfer of retirement assets from a deceased individual’s retirement account to a charity that was named as a beneficiary of the account. In a survey conducted by the National Association of Charitable Gift Planners, 43% of organizations reported that they experienced difficulty collecting beneficiary proceeds from one or more individual retirement account administrators.1 There also have been reports of IRA administrators who failed to inform charities that they had been named as beneficiaries or who refused to disclose the amount that the charities would receive until after all of the paperwork has been completed.2
In addition to the administrative burdens imposed on both the charity and on the IRA administrator, there’s also the risk that a delay could take away tax advantages from other beneficiaries of the account (for example, children of the deceased). For example, whereas typically, an inherited retirement account can be distributed over 10 years after the year of the decedent’s death, a delay in paying the charities (past Sept. 30 of the year after death) might shorten that time period to just five years. The challenges are even more daunting if the retirement assets are payable to a trust that has both charitable and non-charitable beneficiaries.3 What’s the cause of the problem, and what can estate planners do to minimize the risks, the delays and the administrative burdens?
What’s the Problem?
While a retirement account owner is alive, every distribution from the retirement account is reported to the Internal Revenue Service with a Form 1099-R that contains that individual’s Social Security number.
This includes lifetime distributions made directly from IRAs to charities that can be excluded from the taxpayer’s taxable income as qualified charitable distributions (QCDs).4 The IRA administrator reports these charitable distributions no differently than the taxable distributions that were made directly to the IRA owner. The onus is then on the IRA owner, rather than on the IRA administrator, to identify which recipients of IRA distributions were eligible for the exclusion from income as QCDs and which weren’t.5 It’s the IRA owner who then excludes the charitable distributions from the IRA owner’s taxable income by making a notation of “QCD” on the front page of the IRS Form 1040.
After the retirement account owner’s death, distributions from a retirement account shouldn’t be reported with the decedent’s Social Security number. Instead, income in respect of decedent (IRD) is taxed to the person who has the legal right to the IRD: the beneficiary of the account.6
When the beneficiary is an individual, it’s usually a simple procedure to replace the decedent’s Social Security number with the beneficiary’s Social Security number on the Form 1099-R. The IRA is usually retitled to reflect the fact that the account is an inherited IRA rather than that individual’s own personal IRA. For example, Phil N. D’Blank’s IRA might be retitled to “Phil N. D’Blank, deceased, IRA for the benefit of Siegfried Denroy.” Under the new rules enacted under the Setting Every Community Up for Retirement Enhancement Act, a beneficiary generally has up to 10 years after the year of death to withdraw amounts from the inherited account.7
The problem arises when the beneficiary isn’t a human being but is instead an organization, such as a charity. One would think that the IRA administrator could simply make a distribution from the deceased’s retirement account and then issue a 1099-R that uses the charity’s tax ID number.
But instead, some IRA administrators don’t simply retitle the IRA but treat it as a new account. This isn’t fun for either the IRA administrator or for the charity. The IRA administrator incurs the cost of establishing a new account that will likely be liquidated by the charity within a few days of when it’s established. And then there are the added burdens of meeting numerous financial regulations for new accounts. These rules can vary depending on whether the IRA administrator is a bank, a mutual fund, an insurance company or a trust company, because each type of financial institution is subject to different legal regulations.
Among the more burdensome requirements when a charity opens a new account at any type of financial institution are the ones imposed by the Financial Crimes Enforcement Network (FinCEN). An important mission of FinCEN is to prevent criminals and terrorists from using companies to disguise their illicit activities or to launder money, as had occurred before the terrorist attack of Sept. 11, 2001.
FinCEN promulgated the Customer Due Diligence (CDD) rule, which requires a financial institution “to identify and verify the identity of the natural persons (known as beneficial owners) of legal entity customers who own, control, and profit from companies when those companies open accounts.”8 Thus, even the nation’s most reputable and well-established charities and universities were told that they couldn’t receive a distribution from a decedent’s retirement account unless they first provided to the financial institution the names, addresses, driver’s license numbers and Social Security numbers of certain senior representatives at those organizations. In some cases, charities were asked to provide this information for their entire board of directors.
Financial Institution Perspective
IRA administrators would like to reduce the administrative costs that they incur to open a new account for a charity that will liquidate the account shortly after it’s established. Still, a distribution that’s reported with a new tax ID number can obligate the IRA administrator to meet certain regulatory requirements, including the FinCEN due diligence CDD requirements.
Jane Ditelberg, senior vice president and assistant general counsel at Northern Trust, explains it this way:
Broadly speaking, an IRA provider has to work within its regulatory requirements and its own system limitations in transferring IRA assets. If there’s an IRA where the deceased owner took the RMD before death, and there are four beneficiaries of the IRA, including a charity, the provider has to make sure that the tax reporting is correct and that the due diligence is met on any distributees.
In a lot of cases, the most straightforward way to make sure this gets done properly is to open four inherited IRA accounts. Then the RMD is reported as distributed to the decedent, and the charity’s share is reported as distributed to them, and those decisions are uncoupled from the decisions made by the individual beneficiaries who may not want to withdraw all of their shares of the IRA assets at once. Separating them also may be necessary for privacy reasons since all beneficiaries will get statements on the account before it is divided. When an IRA provider asks the beneficiary to open an inherited IRA, particularly a charity which has every incentive to withdraw the assets immediately, they are typically doing so to make sure the reporting and due diligence are done properly.9
Push-Back From Charities
Several charities were reluctant to provide the sensitive personal information of so many of their volunteers and staff to each and every financial institution that held a retirement account when that organization had been named as a beneficiary. In one private letter ruling, a charity asked the IRS to rule that the tax laws prevented an IRA administrator from requiring a new inherited IRA account for that charity by arguing that only individuals could have an inherited IRA, but the IRS ruled against the charity’s argument.10
Probably the most thorough resource for charities on this topic is the “Release IRA Funds Timely Project”(the RIFT Project), which is supervised by attorney Johni Hays, senior vice president at Thompson & Associates in Johnston, Iowa. The RIFT Project is a database established to help charitable organizations receive the IRA beneficiary distributions they’re entitled to. It lists the financial institutions that make things simple for charities, as well as the institutions that have been more difficult to work with.11
Tax Risks
Whereas the general rule is that beneficiaries have up to 10 years to liquidate an inherited retirement account, that time period can be shortened to as little as five years if a charity is still a beneficiary of the account on Sept. 30 in the year after death.12 This could increase the income tax rates paid by the beneficiaries if the entire account is received and taxed in just five years rather than spread out over 10 years. In theory, the simple solution is to distribute the charity’s share before Sept. 30. An alternative to a distribution is to establish a separate account for the charity within the deceased’s retirement account.13 If the charity received a distribution or had a separate account before Sept. 30, then the other beneficiaries who were individuals (for example, the children and other family members) would qualify for the full 10-year time period. But the delay caused by the administrative challenges of distributing amounts to a charity or establishing a separate account for a charity (for example, the FinCEN requirements) may mean that the charity will still be a beneficiary on that date.
Short- and Long-term Solutions
According to the RIFT Project, some IRA administrators have devised ways to make the transfer simpler. Some issue a check to the charity without the requirement that it become a new customer or establish an inherited IRA. Others issue a paper Form 1099-R with the charity’s tax ID number that overrides the computer system. Thus, a short-term practical solution may be to have the IRA administered at one of the charity-friendly organizations or to move an inherited IRA to such an organization.
A possible long-term solution is to establish a nationwide list of safe-harbor charitable organizations that have been pre-approved by FinCEN, comparable to the TSA PreCheck list. The charities that meet pre-established eligibility standards could then simply post their tax ID numbers and the name of a responsible individual at the charity whom IRA administrators could contact. Those charities would then not have to forward Social Security or driver’s license numbers to each and every IRA administrator that holds an IRA that named the charity as a beneficiary.
How to Make Things Work Smoothly
If a client intends to name five or 10 charities as beneficiaries of a retirement account, then the administrative task of establishing new accounts multiplies fivefold or tenfold. An arrangement that will significantly reduce the administrative hassle is to name just one charity (or a trust with 100% charitable beneficiaries) as the beneficiary of the retirement account, and then that one charity or trust will make distributions to the five or 10 charities. In that case, the IRA administrator’s reporting and due diligence requirements will be limited to that one beneficiary and won’t be extended to the five or 10 charities.
One way to accomplish this is to name a community foundation (CF) as the single beneficiary. While alive, the IRA owner can enter into an agreement with the CF that the amounts received from the IRA will be transferred into “designated funds” at the CF for specific public charities that the IRA owner would like to support. A designated fund is a fund at a CF in which the instrument of transfer instructs the CF to use the donated assets to benefit one or more specified public charities described in Internal Revenue Code Sections 509 (a)(1), (2) or (3).14 The donor could establish the designated funds while still alive and then have the IRA proceeds added to them, or the designated funds could be established on receipt of the IRA funds. IRA owners should learn the policies of the CF and ascertain whether their objectives will be met. For example, a few CFs require that designated funds be held as endowments and don’t allow a pass-through of amounts deposited into a fund.
Another way to accomplish this is to transfer the retirement assets into a single donor-advised fund (DAF) administered at a CF or at a national DAF. Whereas a DAF isn’t an eligible recipient for a lifetime QCD from an IRA,15 there’s no tax problem making a testamentary transfer from a retirement account to a DAF. If a child is the advisor of the fund, the IRA assets could fulfill a parent’s desire to increase the child’s philanthropic resources (akin to a philanthropic inheritance). Or if the IRA owner has identified specific charities that the IRA owner would like to support, the IRA owner could enter into an agreement with the DAF administrator on how the retirement assets should be used, similar to the designated funds described in the preceding paragraph. For wealthy individuals, a family private foundation (PF) could serve the same function as a DAF.
A third method is for the retirement account beneficiary to be a trust that has only charities named as beneficiaries. When a trust is the beneficiary of a retirement account, the new or retitled inherited IRA account is in the name of the trust, and the IRA administrator deals directly with the trustee and not with the underlying trust beneficiaries. As Nancy H. Welber points out in her accompanying article in this issue,16 a trust that has both charitable and non-charitable beneficiaries can pose many administrative and tax challenges and should only be done when the trustee has the sophistication to deal with those issues.
The IRA owner can easily change the beneficiaries of such a charitable trust, which can be beneficial. An example that I learned about was an elderly childless individual in Toledo, Ohio, who wanted to benefit approximately 20 charities. That individual made changes on almost a monthly basis—either adding new charities or changing the percentage of assets that different charities would receive. The charities and their respective percentages were listed on the “Appendix A” of the trust instrument, which that individual had the power to constantly modify. This arrangement permitted the IRA owner to make the frequent modifications with much less effort than amending an IRA beneficiary form.
If a trust is the beneficiary, it’s very important that the trust contain instructions that charitable distributions be made from gross income. Such an instruction is necessary for the trust to be able to claim a charitable income tax deduction17 that will fully offset the taxable income that the trust will have from receiving taxable distributions from the retirement account.18 Hopefully the trust will fully distribute all of the retirement assets and terminate shortly after death. This can reduce the risk of tax issues that can apply to a PF or to a non-exempt charitable trust.19 If an estate will be so large that it will be subject to the federal estate tax or to a state estate tax, then naming a CF, PF or a DAF could be a better option than naming such a trust to more easily demonstrate eligibility for a charitable estate tax deduction.
Another strategy is for the IRA owner to have one IRA that benefits only tax-exempt organizations (such as charities, social welfare organizations20 and charitable remainder trusts21) and a separate IRA that benefits only individuals or see-through trusts. This arrangement will eliminate the problem that can occur when both charities and individuals are beneficiaries of the same retirement account on the determination date (Sept. 30 of the year after death).22 When every beneficiary of one IRA is a tax-exempt organization, a delay in paying one of the tax-exempt beneficiaries past Sept. 30 won’t impose burdens on the individuals who will benefit from the other IRA. Although two separate IRAs would solve this post-death administrative problem, some IRA owners may complain about the challenge of keeping each IRA’s asset level at the desired target amount when each IRA has different investment returns.
Reducing Administrative Obstacles
In theory, retirement accounts hold the very best type of asset to use for charitable bequests: taxable IRD. Leaving these assets to a charity or to some other type of tax-exempt organization means that the entire amount of pre-tax dollars that are held in these accounts can be applied to the organization’s exempt purpose without any reduction from income taxes. What we’re learning, though, is that there are practical and administrative obstacles that can make the actual transfer of assets cumbersome after death. By taking steps that will reduce these administrative obstacles, such as naming a single charity or a single charitable trust as the beneficiary of the retirement account, the transfer of assets can be made more efficiently and with less wasted cost and time.
Endnotes
1. Charitable Beneficiary IRA Distribution Resource Center, https://charitablegiftplanners.org/ira-distribution-resource-center.
2. Johni Hays, RIFT Project Update: How to Eliminate Delays When Requesting IRA Death Proceeds, at p. 9, https://charitablegiftplanners.org/sites/default/files/CGP2019%20Hays_Johni.pdf.
3. See Nancy H. Welber, “Transforming a Trust Into a See-Through Trust,” Trusts & Estates (June 2021), at p. 38.
4. A qualified charitable distribution (QCD) is a lifetime distribution made to an eligible charity directly from the individual retirement account of someone who’s over the age of 701/2. Internal Revenue Code Section 408(d)(8).
5. For example, distributions to an IRC Section 501(c)(4) civic organization, such as Rotary, or to a charitable donor-advised fund, aren’t eligible for the QCD exclusion from income. IRC Sections 408(d)(8)(B)(i) and 4966(d)(2).
6. IRC Section 691(a)(1) and Revenue Ruling 92-47.
7. IRC Section 401(a)(9)(H). The 10-year rule applies to retirement accounts of individuals who died after the year 2019.
8. Seewww.fincen.gov/resources/statutes-and-regulations/cdd-final-rule:
The CDD rule has four core requirements. It requires covered financial institutions to establish and maintain written policies and procedures that are reasonably designed to:
- identify and verify the identity of customers,
- identify and verify the identity of the beneficial owners of companies opening accounts,
- understand the nature and purpose of customer relationships to develop customer risk profiles,
- conduct ongoing monitoring to identify and report suspicious transactions and, on a risk basis, to maintain and update customer information.
9. With respect to the requirement to obtain beneficial ownership information, financial institutions will have to identify and verify the identity of any individual who owns 25 percent or more of a legal entity, and an individual who controls the legal entity.
10. Email from Jane Ditelberg to Christopher R. Hoyt on May 4, 2021.
11. Private Letter Ruling 201943020 (July 25, 2019). The charity requested that the new account that received the transfer from the decedent’s IRA not be treated as an inherited IRA but as a taxable account.
12. The RIFT Project can be found at https://charitablegiftplanners.org/ira-distribution-resource-center.
13. If both charities and individuals are beneficiaries of the same retirement account on the determination date (Sept. 30 of the year after death), the permissible post-death distribution period could be shortened from 10 years to just five years if the individual died before the required beginning date (that is, died before April 1 of the year that the individual would have attained (or actually attained) age 73). Section 401(a)(9)(H)(i) states: “Except in the case of a beneficiary who is not a designated beneficiary, subparagraph (B)(ii)-(I) shall be applied by substituting ‘10 years’ for ‘5 years’” (emphasis added). Whereas an “individual” is a designated beneficiary, a charity isn’t. Section 401(a)(9)(E)(I). Hence, the 5-year distribution period would still apply if a charity was included as a beneficiary on Sept. 30 in the year after death. Treasury Regulations Section 1.401(a)(9)-3 Q&A 4.
An alternative to a distribution is to establish a separate account for each beneficiary within the deceased individual’s retirement account before the Sept. 30 determination date. In that case, the required distribution to each beneficiary isn’t affected by the identity of a beneficiary of some other separate account. Treas. Regs. Section 1.401(a)(9)-8 Q&A 2(a)(2). Of course, the administrative challenges for establishing a separate account for a charity are the same ones that pose a challenge to making a distribution to a charity (for example, the Financial Crimes Enforcement Network requirements).
14. Treas. Regs. Sections 1.507-2(a)(8)(iii)(B) and 2(a)(8)(iv)(A)(1); Treas. Regs. Section 1.170A-9(e)(11)(v), Example (3).
15. Sections 408(d)(8)(B)(i) and 4966(d)(2).
16. Supra note 3.
17. For a trust to claim a charitable income tax deduction, IRC Section 642(c)(1) requires that the governing instrument contain instructions that charitable distributions be made from gross income.
18. Christopher R. Hoyt, “Structuring a Charitable Bequest of IRD Assets,” Trusts & Estates (June 2015).
19. IRC Sections 509(a) (private foundation) and 4947(a)(1) (non-exempt charitable trust).
20. IRC Section 501(c)(4).
A charitable remainder trust is exempt from income tax unless the trust has unrelated business taxable income. IRC Section 664(c).
Sections 401(a)(9)(B)(ii) and (H)(i) (“Except in the case of ...”); Treas. Regs. Section 1.401(a)(9)-3 Q&A 4. This topic is addressed extensively in supra note 3.