Tax Treatment of Charitable Trusts in Pennsylvania and New Jersey

Charitable remainder trusts (CRTs) have been used by taxpayers as a tax-favored way to earmark assets for future transfers to charitable institutions. CRTs are most commonly used by persons who plan to sell or otherwise dispose of highly appreciated assets. The grantor contributes the assets to the CRT, which later sells them. Assume a taxpayer is about to sell a block of highly appreciated stock in a private company that was about to be acquired. The sale price of the stock was $12 million, with a basis of $2 million resulting in a long-term capital gain of $10 million. Combined federal and state income tax would total $1,807,000 on the gain, leaving a net of $8,193,000. If a CRT were established, the stock "could be sold without incurring any federal and presumably any state income tax," leaving a net of $12 million for reinvestment in the trust. Under federal rules amounts distributed by a CRUT are treated as having the following characteristics in the hands of a beneficiary to whom the unitrust amount is paid: •as ordinary income to the extent of the trust's ordinary income for its tax year and its undistributed ordinary income for earlier years; •as capital gain to the extent of the trust's undistributed capital gain; •as other income to the extent of the sum of the trust's other income for the tax year and its undistributed other income for earlier years; and •as a distribution of trust corpus. However, under Pennsylvania statute, a charitable trust is a trust operated exclusively for religious, charitable, scientific, literary, or educational purposes. A trust is a charitable trust only if all net earnings for the tax year and remaining life of the trust are for distribution for such purposes. No part of the earnings of a charitable trust may benefit any private individual. Under Pennsylvania rules, the full $10 million gain would be subject to Pennsylvania income tax at the trust level. The trust would not qualify as a charitable trust, because a part of the trust's retained earnings will benefit a private individual in subsequent years. Thus, the tax would amount to $307,000 (that is, $10 million at 3.07 percent). Therefore, the net left for reinvestment would be $11,693,000, not the full $12 million. Thus, the $307,000 of tax paid is not available to work for the benefit of the trust and the charity. This will have a significant effect on cash flows from the trust. Moreover, the future value of the trust has been reduced. New Jersey's law is similar to Pennsylvania's. A charitable trust for New Jersey gross income tax purposes is a trust operated exclusively for religious, charitable, scientific, literary, or educational purposes. A trust cannot be deemed to be a charitable trust unless it is operated exclusively, during all of the tax years in question, for religious, charitable, scientific, literary, or educational purposes; serves a public interest as opposed to a private interest; and, under the governing instrument, there is no possibility that a noncharitable beneficiary will receive gains or income.12 (See Burke, Clare and Hill, Trustees v. Director, 11 N.J. Tax 29 (1990).) Referring back to our previous example, under New Jersey rules, the full $10 million gain is subject to New Jersey income tax at the trust level. Thus, the tax would amount to $973,180. The top rate in New Jersey is 9.9 percent. Therefore, the net left for reinvestment would be $11,026,820, not the full $12 million. Thus, the $973,180 of tax paid is not available to work for the benefit of the trust and the charity. That would have a significant effect on cash flows from the trust. Moreover, the future value of this trust has been reduced. A CRT enables individuals to support the country's critically important charitable sector, often on a much more substantial scale than if their only option were to part immediately with all benefit from the donated property. There appears to be inherent inequities in the Pennsylvania and New Jersey laws to achieve that objective. It is hoped that Pennsylvania and New Jersey will amend their statutes to conform to the rules as they relate to a federally qualified CRT.