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August 13, 2018
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by Andrew S. Rusniak

With the pace of bank mergers and consolidations showing no signs of slowing down anytime soon, trust officers and administrators continue to be tasked with reviewing the past administration of old trusts and integrating the administration of those trusts into their systems. As these old trusts are reviewed in connection with that onboarding process, many of our clients are discovering outdated governing documents that are inadequate to support effective and tax-efficient administration. In no area is this difficulty encountered more often than in connection with charitable trusts that have not applied for and received recognition of tax-exempt status from the Internal Revenue Service (the “IRS”).

In general, a trust cannot be treated as being exempt from federal income tax unless and until it has applied for and received a tax-exempt determination letter from the IRS. In order to apply for tax-exempt status, the trustee must first submit a Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, to the IRS for processing. However, in order to submit a Form 1023 and receive a tax-exempt determination letter, the trust’s governing document must contain certain required provisions in order to qualify as Section 501(c)(3) organization. Specifically, the governing document must contain, among other things, certain required charitable purpose and dissolution clauses. Unfortunately, many outdated governing documents do not contain these required provisions, which prohibits the trustee from submitting the Form 1023.

As a result, before these trusts can receive a tax-exempt determination letter, the governing document must be modified. In general, there are 2 primary options to modify the trust instrument under these circumstances:

1. Petition to Modify – The first option is to file a Petition to Modify the trust instrument with the Orphans’ Court having jurisdiction over the trust. Pennsylvania law allows a court to approve the modification of a trust instrument to reform or correct mistakes, to achieve a settlor’s tax objectives, and to modify the administrative provisions of a charitable trust to the extent necessary to preserve the trust. If a trustee decides to file a Petition to Modify, advanced notice to the Office of Attorney General is required, and it is generally advisable to obtain the consent of the charitable beneficiaries and the Attorney General as well.
2. Pennsylvania Charitable Instruments Act – An alternative to filing a Petition to Modify is to proceed under the Pennsylvania Charitable Instruments Act (20 Pa.C.S. 7901-7906) (the “Act”), which became effective as of January 1, 2017. The Act provides a list of provisions that are deemed to be included or prohibited by the governing instrument of charitable organizations (including charitable trusts). The Act applies to (i) any trust established after December 31, 1969, and (ii) “a charitable organization created before January 1, 1970, unless a court of competent jurisdiction in a proceeding institute before January 1, 1972, explicitly decided that the operation of the chapter would substantially impair the accomplishment of the purposes of the charitable organization involved in that proceeding.”

   The deemed provisions supersede any contrary provision of the governing instrument. The statute provides that the governing instrument of a charitable trust is deemed to include certain provisions, the effects of which are to: (1) “require distributions for each taxable year in such amounts and at such times and in such manner as not to subject the organization to tax under section 4942. . .” and (2) “prohibit the organization from (i) engaging in an act of self-dealing. . .(ii) retaining excess business holdings. . .(iii) making an investment in such a manner as to subject the organization to tax under section 4944. . . and (iv) making a taxable expenditure. . .” 20 Pa. C.S. § 7903.

   In addition, the trustee of a charitable trust is specifically granted “the power, acting alone, without the approval of a member, court, donor or beneficiary, to amend the instrument governing the charitable organization in any manner required for the sole purpose of ensuring that: (1) gifts and bequests to the charitable organization qualify for charitable deductions for Federal income, gift and estate tax purposes, and (2) the charitable organization qualifies for tax-exemptions available for Federal income tax purposes.” 20 Pa. C.S. § 7904 (emphasis added).

   The Act provides authority to amend the governing instrument of the trust “in any manner required for the sole purpose of ensuring that. . .the charitable organization qualifies for tax exemptions available for Federal income tax purposes.” A trustee is therefore statutorily empowered with the authority, acting alone, to amend the governing instrument to provide for charitable purpose and dissolution clauses.

   It should also be noted that § 7905 of the Act further provides that “[n]othing in this chapter precludes a court of competent jurisdiction from authorizing a deviation from the express terms of an instrument governing a charitable organization.” Therefore, if a trustee preferred to obtain a court order instead of relying solely on the authority granted by the statute, a declaratory judgment petition could be filed with the Orphans’ Court to confirm the modification and acknowledge or approve the amendment to the governing instrument. After the amendment, the trustee could file a Form 1023 to request recognition of tax-exempt status.

There are many factors to be weighed when considering which option is right for a particular trust. However, once tax-exempt status has been obtained, administration and compliance burdens are generally reduced, and the tax-drag associated with a non-exempt trust is generally lessened. If you have questions concerning the Pennsylvania Charitable Instruments Act, trust administration or modification, or the tax-exempt determination application process, please contact a member of the McNees team.

© 2018 McNees Wallace & Nurick LLC
McNees Fiduciary Litigation Update is presented with the understanding that the publisher does not render specific legal, accounting or other professional service to the reader. Due to the rapidly changing nature of the law, information contained in this publication may become outdated. Anyone using this material must always research original sources of authority and update this information to ensure accuracy and applicability to specific legal matters. In no event will the authors, the reviewers or the publisher be liable for any damage, whether direct, indirect or consequential, claimed to result from the use of this material.