Revenue Code 681: Limitation on Charitable Deductions

A specific tax rule within the Internal Revenue Code affects the charitable contributions of trusts. This provision can limit the otherwise generous tax deductions a trust might claim for its charitable giving. The rule comes into play when the trust generates specific types of income, and understanding this limitation is important for trustees to ensure compliance and proper tax reporting.

The General Rule for Trust Charitable Deductions

Under Internal Revenue Code Section 642(c), trusts are afforded a benefit for charitable giving. This rule allows a trust to take an income tax deduction for any amount of its gross income paid to a qualified charitable organization. Unlike the rules for individuals or corporations, there is no percentage-based limit on the amount that can be deducted. So long as the payment is directed by the trust’s governing document and made from gross income, the trust can potentially deduct 100% of its income.

This unlimited deduction allows for substantial support of charitable causes by directly reducing the trust’s taxable income. The requirements are that the contribution must be authorized by the trust’s founding documents and sourced from the trust’s gross income for that tax year. This baseline of an unlimited deduction provides the context for understanding why any limitation is a notable exception.

Understanding Unrelated Business Income

The primary factor that can trigger a limitation on a trust’s charitable deduction is the presence of Unrelated Business Taxable Income (UBTI). Defined under Section 512 of the Internal Revenue Code, UBTI is income from activities not substantially related to an organization’s exempt purpose. For a trust’s income to be classified as UBTI, it must meet three conditions.

First, the income must be from a trade or business, which includes any activity for the production of income from selling goods or performing services. This could mean a trust operating a contributed business or receiving income from a partnership engaged in a trade or business.

Second, the trade or business must be regularly carried on. This test considers the frequency and continuity of the activity compared to similar commercial activities. An activity conducted with the same consistency as a for-profit competitor meets this standard, while infrequent fundraising events typically do not.

Finally, the business activity must not be substantially related to the trust’s charitable purpose. The activity itself must contribute to the trust’s exempt goals beyond simply providing funds. A common source of UBTI for trusts is income from debt-financed property, where a trust uses borrowed funds to acquire an income-producing asset and a portion of that income is treated as UBTI.

How the Limitation on Deductions Works

When a trust has unrelated business income, the limitation rule of Internal Revenue Code Section 681 is triggered. This section curtails the unlimited charitable deduction, stating that no deduction is allowed for a charitable contribution to the extent that the payment is allocable to the trust’s UBTI for the year.

The disallowed amount is then subject to a different set of rules. The portion of the contribution allocable to UBTI is treated as if it were made by a corporation and is subject to the deduction limits found in IRC Section 170. A corporation’s charitable deduction is limited to 10 percent of its taxable income for the year. This means the trust can only deduct a small fraction of the charitable gift that is traced to its business income.

Consider a practical example: a trust has $100,000 of total income, consisting of $80,000 in interest and dividends and $20,000 in UBTI from a small business it operates. The trust’s governing document directs it to make a $30,000 charitable contribution. First, the contribution must be allocated between the two income types. Unless specified otherwise, the allocation is proportional, so $24,000 ($30,000 ($80,000 / $100,000)) is sourced from regular income and $6,000 ($30,000 ($20,000 / $100,000)) is sourced from UBTI.

Under the general rule for trusts, the $24,000 allocated to regular income is fully deductible. The $6,000 allocated to UBTI, however, is disallowed by the limitation rule. This $6,000 amount is then subjected to the corporate limitation. The limit would be 10% of the UBTI, so the trust could deduct $2,000 (10% of $20,000). The remaining $4,000 of the contribution allocated to UBTI is not deductible in the current year but may be eligible for a five-year carryover, similar to the rules for corporations.