Split-Interest Prohibition Upheld

The Third Circuit Court of Appeals joined other jurisdictions in affirming IRC § 2055(e)’s prohibition of charitable deductions from an estate for transfers of interests in trust property that are not definitely divided between charitable and noncharitable beneficiaries, even where the arrangement shows little likelihood of being abusive in the way the subsection was enacted to prevent.

In its June 2007 opinion, the Third Circuit upheld the ruling of the District Court for the Western District of Pennsylvania and noted similar facts and holdings previously by the Fifth Circuit (Estate of Johnson v. U.S., 68 AFTR2d 91-6049); the Tax Court (Estate of Edgar v. Commissioner, 74 TC 983); and a Nebraska district court (Zabel v. U.S., 82 AFTR2d 98-6334).

James D. Galloway created a trust naming his son, granddaughter and two charitable entities as equal beneficiaries. The trust directed that residual distributions would be paid in an installment of half of each beneficiary’s share in 2006 and the remainder in 2016. After Galloway’s death in 1998, the estate tax return included a nearly $400,000 deduction for the anticipated charitable distributions. The IRS disallowed the deduction, citing section 2055(e). The estate, with the son as trustee, paid the nearly $160,400 additional assessment, for which it filed a refund claim, complaint and, ultimately, appeal.

The government pointed to the statute’s plain language that allows no deduction for a transfer to a charitable beneficiary where an interest in the same property also passes to a noncharitable beneficiary, except in the case of a charitable remainder annuity trust, charitable remainder unitrust or a pooled income fund. The estate argued that the statute’s phrase “in the same property” was sufficiently vague to seek its meaning in the provision’s legislative history, which indicated it was meant to apply only to charitable remainder trusts. By contrast, the estate said, because the Galloway trust designated equal shares, its terms effectively amounted to separate trusts for the charitable and noncharitable beneficiaries. Otherwise, to allow the government to elevate form so far above substance would ignore and harm the trust’s charitable intent and effect, it said.

The court acknowledged that the kind of split-interest trust that appeared to have been uppermost in the congressional mind was one in which a noncharitable beneficiary held a life interest and the charitable beneficiary a remainder interest. The life interest could be exploited to the hazard of the charitable remainder by high-return, high-risk investments. Thus, Congress allowed such splits only for annual distributions of fixed sums (charitable remainder annuity trust) or percentages of trust assets (unitrust), or for an irrevocable interest to the charity with a life interest retained by the donor (pooled income fund). But it was plain, if regrettable, that the statute itself left no choice: “We recognize the unfortunate result in this case,” since “the abuses Congress sought to protect against are not present here,” the court said. Also, the court found no evidence the estate even attempted to divide the trust property.

Financial advisers are thus put on notice that failure to separate charitable and noncharitable trust interests or distribute trust proceeds in the manner allowed by the statute will most likely result in disallowance of any claimed deductions for charitable transfers.

n Edmond C. Galloway v. U.S., 99 AFTR2d 2007-3412

Prepared by JofA staff member Paul Bonner.