We serve as trustee for two trusts that annually file Form 990-PF tax returns for private foundations. Generally, the rules governing private foundations under Section 501(c)(3) of the Internal Revenue Code require the trusts to annually distribute funds for their charitable purposes equal to at least 5% of the fair market value of the trusts’ assets. In this case, the majority of the trusts’ assets are farmland, and the only way to distribute funds equal to 5% of their assets would be to sell the farmland. Is there a way to avoid this? Can the type of the trusts be changed to preserve the assets, since the grantor did not intend for the land to be sold?

We do not believe that the trusts you have described would qualify for any exceptions related to the requirement of a private foundation to make distributions for charitable purposes. Additionally, trusts may be modified by the settlor only if the trust expressly provides that the trust is revocable or amendable, or by a court according to the doctrine of cy pres. But we are not tax law experts, and we strongly recommend consulting with bank counsel before selling the trusts’ farmland assets.

Private foundations are generally required to make qualifying distributions (i.e. distributions that further charitable purposes) that equal 5% of the foundation’s assets held for noncharitable use annually, with certain adjustments. There are limited exceptions to this requirement if the private foundation qualifies as a private operating foundation or an exempt operating foundation, though based on your description, we cannot determine whether the trusts at issue would qualify for these exceptions.

Under the Illinois Trust Code, a trust’s settlor may modify the trust only if the trust instrument expressly provides that the trust is revocable or amendable. Such revocable trusts can be amended by substantially complying with the method provided in the trust instrument, or if there is no method specified, by a later instrument in writing other than a will, signed by the settlor and specifically referring to the trust. Whether the trusts in this case can be modified will depend on the language of the specific trust instruments.

Additionally, a court may apply the doctrine of cy pres to modify a charitable trust when its charitable purpose becomes unlawful, impracticable, impossible to achieve, or wasteful, but this may only be done in order to apply or distribute trust property, in whole or in part, in a manner consistent with the settlor’s charitable purposes. Whether a court will decide to modify a charitable trust in accordance with cy pres is a question that depends on the specific circumstances of each trust, and the likelihood of application is a matter that should be discussed with bank counsel.

For resources related to our guidance, please see:

IRS, Taxes on Failure to Distribute Income – Private Foundations (“A foundation that fails to pay out the distributable amount in a timely manner is subject to a 30 percent excise tax under section 4942 on the undistributed income. The tax is charged for each year or partial year that the deficiency remains uncorrected. An additional 100 percent tax is triggered if the foundation fails to make up the deficient distribution within 90 days of receiving notification from the IRS of its failure to make minimum distributions. Limited exceptions to the tax may apply.”)

IRS, Tax on Private Foundation Failure to Distribute Income: “Distributable amount” (“Distributable amount is equal to the minimum investment return of a private foundation reduced by the sum of any income taxes and the tax on investment income, and increased by—

1. Amounts received or accrued as repayments of amounts taken into account as qualifying distributions for any tax year,

2. Amounts received or accrued from the sale or other disposition of property to the extent that the acquisition of the property was considered a qualifying distribution for any tax year, and

3. Any amount set aside for a specific project to the extent the amount was not necessary for the purposes for which it was set aside.”)

IRS, Minimum Investment Return (“The minimum investment return for any private foundation is 5 percent of the excess of the combined fair market value of all assets of the foundation, other than those used or held for use for exempt purposes, over the amount of indebtedness incurred to buy these assets.”)

IRS, Assets Used for Exempt Purposes – Private Foundation Minimum Investment Return (“An asset is used (or held for use) for exempt purposes only if it is actually used by the foundation in carrying on the charitable, educational, or similar function that gives rise to its exempt status, or if the foundation owns the asset and establishes to the satisfaction of the Service that its immediate use in exempt functions is not practical and that definite plans exist to begin the use within a reasonable period of time.”)

IRS, Exceptions – Taxes on Failure to Distribute Income (“The tax does not apply to the undistributed income of a private operating foundation or of an exempt operating foundation. . . and to the undistributed income of a private foundation that failed to distribute only because of an incorrect valuation of assets.”)

IRS, Definition of Private Operating Foundation (“A private operating foundation is any private foundation that spends at least 85 percent of its adjusted net income or its minimum investment return, whichever is less, directly for the active conduct of its exempt activities (the income test). In addition, the foundation must meet one of the following tests:

the assets test

the endowment test

the support test

Certain private foundations that provide long-term care facilities are treated as operating foundations only for the purposes of the excise tax on failure to distribute income.”)

IRS, Definition of Exempt Operating Foundation (“To qualify as an exempt operating foundation for a tax year, a private foundation must meet all the following requirements:

1. It is a private operating foundation.

2. It has been publicly supported for at least ten tax years or was a private operating foundation on January 1, 1983,

3. Its governing body, at all times during the tax year, consists of individuals fewer than 25 percent of whom are disqualified individuals, and is broadly representative of the general public, and

4. It has no officer who is a disqualified individual at any time during the tax year.”)

Illinois Trust Code, 760 ILCS 3/602(a) (“The settlor may revoke a trust only if the trust instrument expressly provides that the trust is revocable or that the settlor has an unrestricted power of amendment. The settlor may amend a trust only if the trust expressly provides that the trust is revocable or amendable by the settlor.”)

Illinois Trust Code, 760 ILCS 3/602(c) (“The settlor may revoke or amend a revocable trust instrument:

(1) by substantially complying with a method provided in the trust instrument; or

(2) if the trust instrument does not provide a method or the method provided in the terms is not expressly made exclusive, by a later instrument in writing other than a will, signed by the settlor and specifically referring to the trust.”)

Illinois Trust Code, 760 ILCS 3/412 (“Modification or termination because of unanticipated circumstances or inability to administer trust effectively.

(a) The court may modify the administrative or dispositive terms of a trust or terminate the trust if, because of circumstances not anticipated by the settlor, modification or termination will further the purposes of the trust. To the extent practicable, the modification must be made in accordance with the settlor’s probable intention.

(b) The court may modify the administrative terms of a trust if continuation of the trust on its existing terms would be impracticable or wasteful or impair the trust’s administration.

(c) Upon termination of a trust under this Section, the court shall order the distribution of the trust property as agreed by the beneficiaries, or if the beneficiaries cannot agree, then as the court determines is equitable and consistent with the purposes of the trust.

(d) Notwithstanding any other provision in this Section, if the trust contains a charitable interest, the modification cannot diminish the charitable interest or alter the charitable purpose, except as would be permitted under Section 413, and upon termination of a trust under this Section, any charitable distribution shall be made in a manner consistent with the settlor’s charitable purpose as determined by the court.”)

Illinois Trust Code, 760 ILCS 3/413 (“(a) Except as otherwise provided in subsection (b), if a particular charitable purpose becomes unlawful, impracticable, impossible to achieve, or wasteful:

(1) the trust does not fail, in whole or in part;

(2) the trust property does not revert to the settlor or the settlor’s successors in interest; and

(3) the court may apply cy pres to modify or terminate the trust by directing that the trust property be applied or distributed, in whole or in part, in a manner consistent with the settlor’s charitable purposes.”

(b) A provision in the terms of a charitable trust that would result in distribution of the trust property to a noncharitable beneficiary prevails over the power of the court under subsection (a) to apply cy pres to modify or terminate the trust only if, when the provision takes effect:

(1) the trust property is to revert to the settlor and the settlor is still living; or

(2) fewer than 21 years have elapsed since the date of the trust’s creation.”)