As 2015 comes to a close, many hedge fund managers are beginning to turn their attention to their offshore deferred compensation. The Emergency Economic Stabilization Act of 2008 enacted Internal Revenue Code 457A, which requires all hedge fund managers to report offshore deferred fees as income no later than Dec. 31, 2017. Though many managers are considering giving a portion of their fees to charities (including their own private foundations) in order to receive an offsetting income tax deduction in 2017, many may not be considering the unintended income tax consequences of dying prior to 2018 if their estate plan isn’t properly structured.1
Income Taxes for IRD
If a manager dies prior to 2018 (and has yet to receive the deferred compensation), the manager’s deferred compensation will be subject to income tax as income in respect of a decedent (IRD) because it was earned prior to the manager’s death but not yet received by the manager. However, there are two methods to avoid income taxes at the estate level for IRD: (1) If the IRD is specifically designated to a charity rather than the estate, the estate will have no IRD and, therefore, no taxable income; (2) if the IRD is payable to the estate, resulting in taxable income to the estate, a properly structured disposition of the IRD to a charity will result in an offsetting income tax deduction under IRC Section 642(c).2
Under IRC 691(a)(1), the estate or person who receives IRD on the death of the decedent is the one who reports the IRD as taxable income.3 In Private Letter Ruling 200002011, 4 an employee designated a charity as the beneficiary of the employee’s deferred compensation in the event of the employee’s death. The Internal Revenue Service held that the deferred compensation would be includible in the income of the charity on receipt from the employer and not includible in the taxable income of the decedent’s estate.
An estate is required to report IRD when it actually collects the income. If pursuant to the governing instrument (that is, the will or the revocable trust) IRD is to be paid to a charitable beneficiary, an income tax deduction is permitted under Section 642(c). It isn’t required that the IRD be immediately distributed to the charity, as long as it’s permanently set aside for the charity pursuant to 642(c)(2).
Pursuant to the Section 642 regulations, if the specific source of income used to fulfill the charitable distribution doesn’t have “economic effect independent of income tax consequences” a full deduction may not be available. Merely stating that a distribution should first be satisfied from IRD may not satisfy the regulations. Therefore, the best practice is to specifically bequeath the item of IRD to the charity to receive a full offsetting income tax deduction.
Though not the first concern for most clients, IRD received by a charity may be subject to income tax resulting in more than one-third going to the government rather than the charity. Charitable organizations (including private foundations) are taxed on unrelated business taxable income (UBTI) at corporate tax rates.5 UBTI is any income derived from a business unless explicitly excluded by IRC Section 512(b).6 Therefore, the receipt of IRD or the assignment of IRD would be UBTI to a charitable organization.
On the other hand, income (including IRD) received by an estate and then distributed to a charity won’t be UBTI to the charity. Typically, pursuant to IRC Section 661(a), an estate is allowed a deduction for any income distributed. Under IRC Section 662(a), there’s a corresponding inclusion in the gross income of the beneficiary receiving such distribution under Section 661(a). However, if a distribution from an estate qualifies for a deduction under Section 642(c), pursuant to IRC Section 663(a), Sections 661(a) and 662(a) are inapplicable.7 Therefore, the deferred compensation received from a manager’s estate isn’t UBTI in the hands of the charitable organization.
The analysis in Private Letter Ruling 79340088 confirms the above result. A decedent left a portion of his interests in two corporations to a charity. The estate converted the corporations into two partnerships and didn’t distribute the partnership interests to the charity for two years. During the two years that the estate held the partnership interests, the partnerships generated income that was paid to the estate and then distributed to the charity. The Internal Revenue Service held that the income generated during the two-year period that the estate owned the partnership interests and distributed to the charity wasn’t UBTI to the charity. The estate was required to include the partnership income in its taxable income and entitled to a deduction under Section 642(c). Because the estate received a deduction under Section 642(c), IRC Section 663(a) was triggered, resulting in Section 662(b) being inapplicable. Therefore, the distribution to the charity wasn’t UBTI under IRC Section 511 because Section 662(b) was inapplicable.9
Maximize Tax Savings
Managers who are considering leaving part of their deferred compensation to charity should confirm with their advisors that their estate plan is set up appropriately to maximize tax savings. This means: (1) confirming with their fund that their deferred fees are designated to their estate rather than directly to charity to avoid the UBTI tax, and (2) confirming their estate plan specifically designates the deferred fee to the charity to receive the full income tax deduction at the estate level.
1. Managers receive gift tax and estate tax charitable deductions under Internal Revenue Code Sections 2522(a) and Section 2055(a), respectively.
2. This could be a specific bequest of income in respect of a decedent (IRD) or if the residuary beneficiary is a charity.
3. IRC Section 691(a)(2) deals with the assignment of the right to IRD before it’s actually received by the estate or the individual.
4. Private Letter Ruling (PLR) 200002011 (Sept. 30, 1999).
5. The tax ranges from 15 percent to 35 percent with the highest bracket applicable on income in excess of $10 million.
6. The exclusions focuses on passive income sources such as dividends, interest and royalties rather than active income sources such as salaries and profit interests.
7. If IRC Sections 661(a) and 662(a) are inapplicable, Sections 661(b) and 662(b) are inapplicable.
8. Private Letter Ruling 7934008 (May 9, 1979).
9. It should be noted that the PLR concluded that the non-application of Section 662(b) rather than Section 662(a) negated the unrelated business taxable income tax. Section 662(b) provides that the character of the amount include under 662(a) shall be the same character in the hands of beneficiary as in the hands of the estate. Though the PLR’s conclusion gives us a favorable result, the analysis may be flawed. When Section 642(c) is applicable, Section 662(a) is inapplicable, not Section 662(b). Instead of holding that the partnership income isn’t includible income in the hands of the charity, the PLR holds that the character of the income isn’t the same as that in the hands of the estate. It doesn’t elaborate further as to what the character of the income is or if it falls under an exclusion under Section 512(b).
Andrew S. Katzenberg is an associate at Kleinberg, Kaplan, Wolff & Cohen, P.C. in the Trusts and Estates group, where his practice focuses on wealth preservation, estate and trust administration, charitable organizations and charitable giving.