In a recent decision, Kalapodis v. Comm’r., TC Memo 2014-205 (Oct. 6, 2014), the Tax Court evaluated whether individual taxpayers were entitled to a charitable contribution deduction for scholarship payments made to certain individuals from an irrevocable trust established by the taxpayers.

The taxpayers in this case established an irrevocable trust with $75,000 of life insurance proceeds that they received by reason of the death of their son. The trust directed that all trust income be used for educational purposes, but the taxpayers did not apply for or obtain tax-exempt status for the trust as a charitable organization under Internal Revenue Code (“Code”) §§501(a) and 501(c)(3).

In 2008, distributions of $2,000 each were made to three individual high school students from the trust’s investment income. The checks to the students were written from an account titled solely in the name of the trust. When filing their 2008 income tax return, the taxpayers did not include the trust’s investment income in their own gross income, but claimed the $6,000 worth of scholarship distributions as a charitable contribution deduction on their individual income tax return. The IRS disallowed the deduction.

The Tax Court concluded that the taxpayers were not entitled to the charitable deduction for three reasons.

First, the Tax Court pointed out that it was the trust, not the taxpayers themselves, that made the scholarship distributions. If the trust had been established as a grantor trust (a trust whose settlors are treated as the owners of the trust for income tax purposes), the deduction may have been allowed on the taxpayers’ return. However, the trust was irrevocable, and the taxpayers did not retain any powers that would cause them to be treated as the owners of the trust for grantor trust purposes, therefore, the trust itself was considered the taxpayer.

Second, the Tax Court noted that even if the taxpayers were considered to have personally made the scholarship payments, they would not have been able to deduct them on their individual income tax return, because the payments did not qualify as charitable contributions. Section 170(c) of the Code identifies who must be a recipient of a contribution or gift in order for the transfer to qualify for a charitable contribution deduction. Individual students are not among the parties identified in §170(c), thus, because the trust paid the students directly, rather than to an organization (such as a university) that would have qualified under §170(c), the contributions would not have qualified as deductible charitable contributions.

Finally, even if the contributions had otherwise qualified for a deduction, the taxpayers did not meet the substantiation requirements. In a previous post, we discussed the need for written acknowledgments of charitable contributions in excess of $250. The taxpayers did not have any such written acknowledgments for their contributions.

In short, the taxpayers’ good intentions failed to receive favorable income tax treatment because the charitable vehicle was not properly designed for its purpose. A qualified charitable trust, or even a donor-advised fund, structured to pay the scholarship funds directly to a qualified charitable education institution would have furthered the taxpayers’ charitable intent while offering a favorable income tax result.