Charitable Gift Planning in Times of Low Interest Rates

Charitable Gift Planning in Times of Low Interest Rates

Article posted in General Counsel Memoranda on 17 March 1999| comments
audience: National Publication | last updated: 18 May 2011
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Summary

The monthly Charitable Midterm Federal Rate affects computations of charitable contribution deductions for split-interest charitable gift vehicles. In this edition of Planned Giving Online, PGDC editor Marc Hoffman explores the evolution of the Charitable Midterm Federal Rate and the planning ramifications it has on charitable lead trusts and charitable remainder trusts.

by Marc D. Hoffman

On Thursday, October 15th, the Federal Reserve Bank, in an effort to ease the international credit crunch and stimulate the world economy, reduced the Federal Funds Rate for the second time in as many weeks to five percent. And this may not be the end of rate slashing. Wall Street pundits predict that additional cuts could take the rate as low as 3.5 percent by year-end.

On October 20th, the Treasury published the monthly interest rate that is used to determine the present value of annuities, interests for life or for a term of years, and remainder or reversionary interests. Known as the "charitable midterm federal rate" or CMFR, the rate for the month of November is 5.4 percent. The last time that the federal discount rate was less than six percent was 1970!

With respect to charitable gift planning, the CMFR affects the computation of income, gift, and estate tax charitable deductions for transfers to charitable remainder trusts, pooled income funds, charitable gift annuities, charitable lead trusts, and life estate agreements.

With year-end tax and gift planning underway, we thought it appropriate to review the types of gift vehicles that provide enhanced income, gift, and estate tax benefits in such low interest rate environments.

HISTORIC DISCOUNT RATES

Interest rate watching has always been a part of split-interest charitable gift planning. Prior to the introduction a monthly indexed CMFR, a fixed discount rate was established and adjusted periodically as an add-on to tax legislation.

For Transfers and Valuation Dates Discount Rate
Prior to January 1, 1952 4%
January 1, 1952 through December 31, 1970 3.5%
January 1, 1971 through November 30, 1983 6%
December 1, 1983 through April 30, 1989 10%


As one might expect, however, prevailing market interest rates did not behave in such an orderly fashion.

Fig 1

Figure 1. This graph compares average annual Intermediate U.S. Treasury Bond yields to applicable federal discount rates in effect from 1952 through 1988.

INTRODUCTION OF THE CMFR

In order to eliminate the "rate chasing" that existed under prior law, Section 5031 of the Technical and Miscellaneous Revenue Act of 1988 amended the Internal Revenue Code by adding section 7520.1 Under this section, the value of an annuity, interest for life or for a term of years, or remainder or reversionary interest is determined under new tables that are to be prescribed by the Secretary. Section 7520 is applicable to gifts and certain other transfers made after April 30, 1989, and to estates of decedents dying after April 30, 1989.

The monthly rate prescribed by section 7520 is determined by multiplying the monthly applicable federal midterm rate by 120 percent and rounding the product to the nearest two-tenths of a percent. The result is the CMFR.

For purposes of present value computations, the taxpayer may use the CMFR for the month of valuation (i.e., the date of transfer) or the CMFR in effect during either of the two months preceding the month in which the valuation date falls.2

Fig 2

Figure 2. This graph illustrates the correlation between average annual Intermediate U.S. Treasury bonds and the indexed CMFR from 1989 through 1997.

As would be predicted, since 1989, the CMFR has closely followed market interest rates thereby eliminating the possible disparities that existed under the prior system.

WHY THE CMFR IS IMPORTANT

If all planned gifts were invested solely in fixed income instruments in which rates were locked for the entire life of instrument, there would be nothing left to discuss. However, most types of planned gifts do not operate in that world. In fact, there exist several vehicles that flourish in times of low interest rates. The CMFR (and the income, gift, and estate tax deductions it influences) is based on a snapshot of economic conditions that exist at the time of the gift. Consequently, the CMFR has little bearing on the types of investments that will be made or how they will perform over the measuring term of a gift instrument that may operate for decades.

The balance of this article will review the effect the CMFR has on various gift planning vehicles with specific emphasis of those that can prosper when established during periods in which the CMFR is low.

CHARITABLE LEAD TRUSTS

If there is one planned giving vehicle that has flourished in times when the discount rate was low, it is the charitable lead trust. Referring back to Figure 1, the late 1970s and early 1980s witnessed unprecedented inflation and double-digit interest rates. Until November 1, 1983, however, the discount rate was fixed at a mere six percent.

With the discount rate was so low in relation to market rates, many donors took advantage of this phenomenon to create nongrantor nonreversionary charitable lead trusts to maximize their charitable contribution gift or estate deduction and thereby transfer significant wealth to their heirs at a discounted transfer tax cost. The lower the discount rate, the lower the present value of the remainder interest (i.e., the taxable transfer).

A Retrospective: Based on a discount rate of six percent, an individual could create a charitable lead annuity trust that, for example, paid a 12 percent annuity amount to charity for a period of eleven years, seven months. Under this scenario, the present value of the remainder interest equaled the fair market value of the amount transferred. As a result, the taxable gift to the noncharitable remaindermen was reduced to zero. Furthermore, with market interest rates so high, the trustee could easily satisfy the annuity obligation of the trust without taking undue risk by simply purchasing treasury bonds.

Under the current method of monthly CMFR indexing, the possibility of such intense interest rate tax arbitrage no longer exists. The long Treasury bond rate is currently about 5.2 percent. However, charitable lead trusts are not required to invest exclusively in debt instruments, but can invest in equities and other types of assets as well. Accordingly, with the CMFR currently at 5.4 percent, gift planners may be well advised to examine opportunities for donors to establish certain forms of charitable lead trusts.

HOW THE CMFR AFFECTS CHARITABLE LEAD TRUST DEDUCTIONS

The steps involved in calculating the present value of the remainder interest for charitable lead annuity trusts differ from those for charitable lead unitrusts. As a result, the effect of the CMFR on these computations differs significantly as well.

For charitable lead annuity trusts, the CMFR is used as the discount rate for the purpose of determining the present value of the annuity interest. The lower the CMFR, the higher the relative income, gift, and estate tax charitable deductions.

With respect to charitable lead unitrusts, however, it may come as a surprise to many planners that the trust's payout rate, rather than the CMFR, is used as the discount rate for determining the present value of the unitrust interest. As a result the CMFR has almost no effect on the computation of the deduction.

COMPARING ANNUITY TRUST AND UNITRUST FORMATS

The effect of the CMFR on charitable contribution deductions for charitable lead trusts is most easily illustrated by performing trial computations with varying CMFRs.

In this analysis, we will assume that $100,000 is transferred to two trusts -- to a charitable lead annuity trust bearing a seven percent annuity rate and to a charitable lead unitrust bearing a seven percent payout rate. Payments are made at the beginning of each annual period for a term of fifteen years.

The only variable in this analysis is the CMFR, which begins at five percent and increases in one-percent increments through ten percent. The effect of varying CMFRs on the present value of income interest (PVI) is as follows:

Fig 3

Figure 3. This graph compares the present value of income interests attributable to charitable lead annuity trusts and charitable lead unitrusts based on varying CMFRs.

As would be expected, the PVI attributable to the unitrust does not vary significantly whereas the PVI for the annuity trust is reduced as the CMFR increases. The theory behind the relative sensitivity of unitrusts and annuity trusts to the CMFR is quite logical. The unitrust, which bases its annual payment on the annual fair market value of trust corpus, is self-adjusting. In other words, if due to the prevailing interest rate markets the trust is unable to produce sufficient income to satisfy its payout obligation, it will invade trust corpus. Under such a scenario, on the next valuation date, the trust would theoretically be worth less, thereby reducing the required unitrust amount for the following year. This payment adjustment reduces potential invasions of trust corpus and, therefore, protects the remainder interest.

Compare this scenario with the annuity trust. The payment from the annuity trust is fixed from inception; therefore, a higher annuity rate in relation to the CMFR when the trust is created will assume that corpus is distributed every year to satisfy the annuity amount. Therefore, the present value of the remainder interest is dramatically reduced as corpus is invaded in theoretically increasing amounts. Conversely, if the CMFR is higher than the annuity rate, the calculation assumes that excess income will be added to corpus and thereby increase the remainder.

Effect of CMFR on Payment Sequence Adjustment Factors of Charitable Lead Annuity Trusts. With respect to computation of the present value of the annuity, the CMFR also affects the Table J and Table K factors. These factors adjust the annuity rate based on frequency with which annuity payments are made (i.e., weekly, monthly, quarterly, semi-annual, or annual). Table J provides factors for payments made at the beginning of the payment interval, whereas Table K provides factors for payments made at the end of the payment interval.

If the trust makes payments at the beginning of each year, the CMFR has no effect on the adjustment factor. If payments are made at the end of any payment period, or are made semi-annually, quarterly, monthly, or weekly, the factor is affected by the CMFR.

Effect of CMFR on Payment Sequence Adjustment Factors on Charitable Lead Unitrusts. The only role the CMFR plays in present value computation for charitable lead unitrusts is with the Table F payment frequency adjustment factor. If the unitrust makes one payment at the beginning of each trust year, the CMFR has no effect on the deduction whatsoever. Conversely, if the number of months between the valuation date and the first regular payment exceeds zero, or payments are made semi-annually, quarterly, monthly, or weekly, the factor is affected by the CMFR.

From a planning perspective, the net effect of varying CMFRs on payment sequence adjustment factors for annuity trusts and unitrusts was negligible (a PVI variance of approximately 2.5 percent) and in the opinion of the author would not influence planning recommendations.

Effect of CMFR on Trust Measuring Term. Most nonreversionary nongrantor lead trusts are designed to accomplish specific gift or estate tax planning goals. For example, suppose an individual desires to transfer real property worth $2,000,000 to a charitable lead trust bearing a seven percent annuity / payout rate. The trust will have a measuring term that will produce a present value of the remainder interest that is equal to their gift and estate tax unified credit equivalent amount of $625,000. In this case, the planning variable is the measuring term of the trust.

The following graph compares the measuring terms that would be required for an annuity trust verses a unitrust to accomplish the $625,000 present value of remainder interest based on varying CMFRs:

Fig 4

Figure 4. This graph compares the required measuring terms for charitable lead annuity trusts and charitable lead unitrusts that are required to accomplish a specified target deduction based on varying CMFRs.

In this case, the required measuring term for the annuity trust varies from 13.5 to 30.9 years. The measuring term required for the unitrust varied only between 16.8 and 17.75 years. Based on the current CMFR of 5.4 percent, the required measuring term for the annuity trust is approximately 13 years whereas the term required for the unitrust is about 16 years, 11 months.

Keep in mind, these numbers are based on an annuity rate of seven percent. Higher rates, as might be accommodated by assets that may qualify for valuation discounts (such as fractional interests in real property or limited partnership interests) may reduce the required measuring term yet further.

CHARITABLE REMAINDER TRUSTS

Like charitable lead trusts, the steps involved in calculating the present value of the remainder interest for charitable remainder annuity trusts differ from those for charitable remainder unitrusts.

HOW THE CMFR AFFECTS CHARITABLE REMAINDER TRUST DEDUCTIONS

In this analysis, we will assume that $100,000 is transferred to a charitable remainder annuity trust bearing a seven percent annuity rate, and to a charitable remainder unitrust bearing a seven percent payout rate. Payments are made for the lives of two 65-year-old income recipients at the beginning of each annual period.

The only variable in this analysis is the CMFR, which begins at five percent and increases in one-percent increments through ten percent. The effect of varying CMFRs on the present value of remainder interest is as follows:

Fig 5

Figure 5. This graph compares the present value of remainder interests for charitable remainder annuity trusts and charitable remainder unitrusts based on varying CMFRs.

As with charitable lead trusts, the present value of the remainder interest attributable to the charitable remainder unitrust is not affected by the CMFR whereas the annuity trust is affected significantly.

Effect of CMFR on Five-Percent Probability Test. One result the line graph in Figure 3 does not show is the effect that varying CMFRs have on a charitable remainder annuity trust's ability to pass the "five-percent probability test." A gift to a charitable remainder annuity trust will not qualify for income, gift, and estate tax deduction purposes if the probability exceeds five percent that the trust's assets will be exhausted prior to charity receiving the remainder interest. The test does not apply to charitable remainder unitrusts or to annuity trusts that are measured by a fixed term of years.3

The five-percent probability test is extremely sensitive to the CMFR. In the previous analysis, the annuity trusts that were created based on CMFRs of five and six percent both failed the test. Irrespective of this test, the trust bearing the five percent CMFR also failed to be a qualified charitable remainder trust because the present value of the remainder interest was less than ten percent.

The five-percent probability test should always be performed prior to implementing any charitable remainder annuity trust for which the test applies; however, as a general rule, planners should be particularly cautious at any time the CMFR is equal to or less than the annuity rate.

SUMMARY

With the CMFR at the lowest rate in nearly thirty years, charitable gift planners should explore the role that charitable lead annuity trusts can play in helping clients accomplish their philanthropic and personal financial and estate planning objectives. Deductions for contributions to charitable lead unitrusts remain virtually unaffected by lower CMFRs, however.

Likewise, the charitable remainder unitrust, which comprises over 90 percent of all charitable remainder trusts created, continues as an effective asset conversion vehicle that is virtually unaffected by a lower CMFR. Conversely, planners should carefully examine the appropriateness of charitable remainder annuity trusts because such trusts currently offer lower relative deductions to their unitrust counterparts and may fail the five percent probability test at much lower annuity rates than we have been accustomed. So, in general, CLATs and CRUTs are in, and CLUTs and CRATs while not being out are definitely less attractive purely from a deduction standpoint.


  1. Pub. L. No. 100-647, 102 Stat. 3342 (1988)back

  2. Notice 89-60, 1989-1 C.B. 700back

  3. Rev. Rul. 77-374, 1977-2 C.B. 329back

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