Planned Giving in Times of Low Interest Rates

Planned Giving in Times of Low Interest Rates

Article posted in Income Tax on 13 December 2002| comments
audience: National Publication | last updated: 18 May 2011
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Summary

In March of 1999, the PGDC published an article regarding the effect of interest rates on charitable contribution deductions for various planned giving vehicles. Given the current low interest rate environment, we thought a reprise would be timely. In this expanded and updated version, PGDC Editor-in-Chief Marc D. Hoffman reviews the types of gift vehicles that provide enhanced income, gift, and estate tax benefits in low interest rate environments, as well as those that are less attractive or may be unavailable to some donors altogether.

by Marc D. Hoffman

Each month the Treasury publishes a percentage 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 "Section 7520 Rate" or "Charitable Federal Midterm Rate," the rate for November 2002 was 3.6%. The last time the rate was less than 3.6% was between 1954 and 1970 when it was fixed at 3.5%.

With respect to charitable gift planning, the CFMR affects the computation of income, gift, and estate tax charitable deductions for transfers to charitable lead trusts, charitable remainder trusts, charitable gift annuities, and life estate agreements. Certain gift vehicles are highly sensitive to the rate, while others ignore it altogether.

Historic Discount Rates

Interest rate watching has always been a part of split-interest charitable gift planning. Prior to the introduction of the indexed CFMR, 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:

Figure One

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

Introduction of the CFMR

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 one percent. Gift planners have dubbed the result the Charitable Federal Midterm Rate ("CFMR").

For purposes of present value computations, the taxpayer can use the CFMR for the month of valuation (i.e., the date of transfer) or the rate in effect during either of the two months preceding the month in which the valuation date falls (the so-called two-month lookback rule).2

Figure Two

Figure 2. CFMRs from January, 1990 through December, 2002.

Why the CFMR is Important

As the CFMR declines, certain gift vehicles produce higher charitable deductions while others produce lower deductions. Others are unaffected.

The CFMR represents a snapshot of interest rates at the time of the gift. However, many planned giving vehicles are created with measuring terms that can extend for decades. Furthermore, many of these vehicles are created with the intention of investing in other types of assets such as equities, real property, or intangibles that produce capital gains, dividends, rents and royalties. In the case of a life estate agreement, for example, there are no investments at all. Therefore, the CFMR may have little effect on the eventual investment performance of the gift, but may affect the deduction significantly.

Charitable Lead Trusts

If there is one planned giving vehicle that has taken advantage of low interest rates, it is the nonreversionary charitable lead annuity trust. The present value of the remainder interest is calculated by discounting the income interest paid to charity. The lower the discount rate, the higher the present value of the income interest (i.e., gift or estate tax charitable deduction) and, accordingly, the lower the present value of the remainder interest (i.e., the taxable transfer to noncharitable remainder beneficiaries).

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 used to calculate deductions was fixed at a relatively mere six percent.

With the discount rate so low in relation to market interest rates, many donors took advantage of this phenomenon to pass significant wealth to charity and their heirs at a highly discounted transfer tax cost.

Example 1: Based on a discount rate of six percent, an individual could have created a charitable lead annuity trust that paid a 12 percent annuity amount to charity for a period of 11 years, 7 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 amount to the noncharitable remaindermen was reduced to zero. Furthermore, with market interest rates in double digits, the trustee could easily satisfy the annuity obligation without taking undue risk by simply purchasing government-backed fixed income obligations.

Under the current method of monthly CFMR indexing, the possibility of such intense interest rate tax arbitrage has been eliminated. However, charitable lead trusts are not required to invest in debt instruments exclusively, but can invest in equities and other types of assets as well. Accordingly, as will be illustrated below, with the November, 2002 CFMR at 3.6%, gift planners should explore opportunities for donors to establish certain forms of charitable lead trusts.

How the CFMR Affects Charitable Lead Trust Deductions

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

For charitable lead annuity trusts, the CFMR is used as the discount rate for the purpose of determining the present value of the annuity interest. The lower the CFMR, 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 CFMR, is used as the discount rate for determining the present value of the unitrust interest. The CFMR affects only the payment frequency adjustment factor, which is relatively insignificant. As a result the CFMR has little effect on the computation of deductions for unitrusts.

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

Example 2: In this analysis, assume that $1,000,000 is transferred to two trusts -- a charitable lead annuity trust bearing a seven percent annuity rate and a charitable lead unitrust bearing a seven percent payout rate. One payment is at the beginning of each year (to eliminate the payment frequency adjustment factor) for a term of 15 years. The only variable is the CFMR, which begins at three percent and increases in one-percent increments through 10 percent.

CFMR   CLUT PVI   CLAT PVI
3%   66.3%   86.1%
4%   66.3%   80.9%
5%   66.3%   76.3%
6%   66.3%   72.1%
7%   66.3%   68.2%
8%   66.3%   64.7%
9%   66.3%   61.5%
10%   66.3%   58.6%

Figure 3. Comparison of present value of income (PVI) interests attributable to charitable lead annuity trusts and charitable lead unitrusts as a percentage of the fair market value of property transferred to the trust.

As would be expected, the PVI attributable to the unitrust is fixed whereas the PVI for the annuity trust is reduced as the CFMR increases. The theory behind the sensitivity of unitrusts and annuity trusts to the CFMR is quite logical. The unitrust, which determines its payment based on a percentage of its annual value, is self-adjusting. In other words, if due to prevailing market conditions the trust is unable to produce a return sufficient to satisfy its payout obligation, it will invade trust corpus to do so. Under such a scenario, on the next valuation date, the trust would 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 the same scenario to the annuity trust. The payment from the annuity trust is fixed from inception; therefore, a higher annuity rate in relation to the CFMR 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 CFMR is higher than the annuity rate, the calculation assumes that excess income will be added to corpus thereby increasing the remainder. Again, these assumptions may have little to do with the actual investment performance of trusts that invest in other types of assets.

Effect of CFMR on Payment Sequence Adjustment Factors of Charitable Lead Annuity Trusts

The CFMR also affects the Table J and Table K factors. These factors adjust the annuity rate based on the 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 one annual payment at the beginning of each year, the CFMR 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 CFMR.

Effect of CFMR on Payment Sequence Adjustment Factors for Charitable Lead Unitrusts

The only role the CFMR 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 year, the CFMR 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 CFMR.

From a planning perspective, the net effect of varying CFMRs on payment sequence adjustment factors for annuity trusts and unitrusts is negligible (a PVI variance of approximately 2.5 percent).

Effect of CFMR on Charitable Lead Trust Measuring Terms

Most nonreversionary charitable lead trusts are designed to accomplish specific gift and estate tax planning objectives.

Example 3: Suppose an individual desires to transfer real property worth $5,000,000 to her children via a charitable lead trust. The property can comfortably support an annuity or unitrust rate of seven percent. Her goal is to produce a $4,000,000 gift tax charitable deduction. This will leave a taxable gift of $1,000,000 that can eliminated by her gift tax credit.

The following graph compares the measuring terms (to the closest month) that would be required for an annuity trust verses a unitrust to produce a present value of remainder interest of $1,000,000 based on varying CFMRs. The trusts will make one payment at the beginning of each year (to eliminate the effect of the payment sequence on the computation):

CFMR   CLUT   CLAT
3%   22 years, 3 months   13 years, 09 months
4%   22 years, 3 months   14 years, 10 months
5%   22 years, 3 months   16 years, 02 months
6%   22 years, 3 months   17 years, 11 months
7%   22 years, 3 months   20 years, 05 months
8%   22 years, 3 months   24 years, 05 months
9%   22 years, 3 months   33 years, 05 months
10%   22 years, 3 months   Infinity

Figure 4. This graph compares the required measuring terms for charitable lead annuity trusts and charitable lead unitrusts that are required to accomplish a target deduction of $4,000,000 based on varying CFMRs.

As might be expected, the required measuring term for the unitrust remains fixed whereas the term required for the annuity trust varies from 13 years, 9 months to infinity. At a 10 percent CFMR, the present value of remainder never drops below $1,150,000.

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

Charitable Remainder Trusts

Like charitable lead trusts, the steps involved in calculating the present value of remainder interest for charitable remainder annuity trusts differ from those for charitable remainder unitrusts. Like charitable lead trusts, charitable remainder annuity trusts are highly sensitive to the CFMR whereas charitable remainder unitrusts are affected only to the extent of the CFMR's influence on the payment sequence adjustment factor. However, the effect the CFMR has on charitable deductions for CRTs is the inverse of its effect on CLTs.

Example 4: In this analysis, we will assume that $100,000 is transferred to a charitable remainder annuity trust and unitrust, each bearing a seven percent annuity/payout rate. Payments are made for the lives of two 65-year-old income recipients at the end of each annual period.

The only variable in this analysis is the CFMR, which begins at three percent and increases in one-percent increments through 10 percent:

CFMR   CRUT PVR   CRAT PVR   5% Probability Test
3%   22.9%   0.0%
  Fail
4%   22.9%   0.9%
  Fail
5%   22.9%   10.2%
  Fail
6%   22.9%   18.1%
  Pass
7%   22.9%   25.0%
  Pass
8%   22.9%   30.9%
  Pass
9%   22.9%   36.1%
  Pass
10%   22.9%   40.7%   Pass

Figure 5. Compares the present value of remainder interests (PVR) for charitable remainder annuity trusts and charitable remainder unitrusts based on varying CFMRs as percentage of the amount transferred to the trust. The five percent probability test is performed for charitable remainder annuity trusts.

Effect of CFMR on 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 the trust will exhaust its assets prior to charity receiving the remainder interest. The test does not apply to charitable remainder unitrusts or to charitable remainder annuity trusts measured by a fixed term of years.3

The five percent probability test is extremely sensitive to the CFMR. Referring back to Figure 5, the annuity trust deductions based on CFMRs of three, four and five percent failed the five-percent probability test. In addition, the annuity trusts with three and four percent CFMRs failed to qualify as charitable remainder trusts because the present value of the remainder interest was less than 10 percent.4 Conversely, none of the charitable remainder unitrusts failed the 10 percent test.

Charitable Gift Annuities

The effect of the CFMR on charitable gift annuities is similar to that of charitable remainder annuity trusts. A reduction in the CFMR causes an increase in the present value of the annuity payments and, therefore, a corresponding reduction in the value of the charitable gift. Whereas the charitable remainder annuity trust is subject to both the 10 percent minimum present value of remainder interest and five percent probability tests, organizations that issue gift annuities are subject to what are commonly referred to as the Clay Brown Rules:

When a charitable organization issues a gift annuity, it creates a liability equal to the expected return to the annuitant. Under IRC §514(c)(5), such acquisition indebtedness will cause the issuing organization to have unrelated business income to the extent of such liability unless it meets four conditions. One of those conditions is that the present value of the annuity must be less than 90% of the net fair market value of the property on the date of transfer. In other words, the donor's gross charitable deduction (prior to reductions under section 170) cannot be less than 10% of the amount transferred.

In essence, a declining CFMR increases the minimum age that individuals will qualify to obtain charitable gift annuities. For example, based on the November CFMR of 3.6%, a single life annuitant would have to be at least age 60 to qualify. Two joint and survivor annuitants would have to be, for example, 68 and 67 to qualify.

Fortunately, those making gifts in the month of December can apply the two-month lookback rule to elect to use the October CFMR of 4.6%. In such case, single life annuitants, age 47 or older, and joint and survivor annuitants, each age 62 or older will qualify. Of course, there are many other combinations of joint and survivor ages that will satisfy the test as well.

Reduced Annuity Rates

In response to rapidly falling interested rates, the American Council on Gift Annuities published new annuity rates effective January 1, 2003; however, the council suggested that organizations concerned about current rates could implement the suggested changes immediately.5

Lowering annuity rates lowers the age at which annuitants can satisfy the 10 percent test. In fact, based on the same 4.6% CFMR, we could not find a single instance when a single or joint and survivor annuitants failed the test regardless of age!6

Those purchasing gift annuities in January 2003 will not be able to use the October CFMR to calculate their deduction. Unless the January rate (to be published in the third week of December) exceeds the November rate of 4.0%, January gifts will be calculated at 4.0%.

The moral of the story is to always perform the test prior to the gift. As a rule of thumb, planner's antennas should go up when the CFMR drops below the annuity rate. In such case, the annuitant is in danger of failing the 10 percent test.

Prospective donors who do meet minimum age requirements and desire the highest annuity rate should consider acquiring their gift annuities prior to year-end; after which, most organizations will implement the new lower rates. Some organizations, however, have already done so. Seeking the higher rate should also be done with the understanding that issuing organizations will realize a smaller residuary gift.

Planning Tips: Donors who cannot qualify under the 10 percent test for an immediate payment gift annuity should consider a deferred payment gift annuity. Deferring the annuity starting date will not only increase the donor's deduction, but will also increase the annual payments the annuitants ultimately receive.

Also, donors who desire to contribute real property and cannot obtain a gift annuity due to state law prohibitions, the issuing organization's internal policies, or failure of the 10 percent test could simulate a gift annuity via a bargain sale of the property to charity in exchange for an installment note.

Pooled Income Funds

The calculation of tax deductions for income, gift and estate tax purposes for pooled income funds is based on the fund's highest annual rate of return during the preceding three taxable years.

If a pooled income fund has existed for less than three taxable years immediately preceding the year in which a transfer is made, the highest rate of return is determined by first determining the average annual Applicable Federal Midterm Rate (rounded to the nearest 2/10ths) for each of the three taxable years preceding the year of the transfer.7 The highest annual rate is then reduced by one percent to produce the applicable rate. The rate for 2002, which is published each year along with the January CFMR, was 7.0%.

It may come as a surprise to many planners that the CFMR is not used in calculations for pooled income funds at all and, therefore, is immaterial.

Life Estate Agreements

In the case of a gift of a remainder interest in personal residence or farm, the CFMR is used to discount the value of the retained life estate. Accordingly, the lower the discount rate, the less the discount; hence, the greater the present value of remainder interest.

The computation of the present value of remainder interest is actually comprised of two separate computations--one for the nondepreciable (land) portion and the other for depreciable (improvements) portion of the property. The results are then combined to produce the overall present value.

The sensitivity of the calculation to the CFMR varies with each of these computations:

Giving the Farm: Assume a couple, each age 62, transfer a remainder interest in a farm, having no depreciable improvements, worth $1,000,000. Based on a 4.6% CFMR the present value of remainder interest factor is .34747. Reduce the CFMR to 3.6% and the present value factor increases to .43850, a relative increase of 26%.

Giving the Boat: As an alternative, assume the couple contributes a remainder interest in their yacht (yes, a vessel can qualify as a personal residence is considered entirely depreciable. Those who have ever owned a boat know this fact well). The vessel is worth $1,000,000, has a depreciable life of 25 years and a theoretical salvage value of $0.

Assuming a 4.6% CFMR, the remainder interest factor is .09567. Drop the CFMR to 3.6% and the factor increases to .11240, a relative increase of only 13%. In this case, the computation for the depreciable yacht was only half as sensitive to the CFMR as it was for the nondepreciable farm. Therefore, one can conclude the CFMR has less effect on the overall deduction as the depreciable portion of the property increases.

If the useful life of the yacht is increased from 25 to 40 years, the present value factors in relation to one another vary by 19%; therefore, lengthening the useful life increases the sensitivity of the CFMR to the computation. This makes sense because as the useful life is increased, it approaches that of nondepreciable property, which has an infinite useful life.

General Rules for Maximizing Life Esate Deductions: The highest deduction can be obtained with nondepreciable property. When depreciable property is involved, select the highest salvage value and longest useful life for which the property qualifies.

Summary

With the CFMR at the lowest rate in over 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.

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 CFMR.

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 and/or 10 percent present value qualification tests.

With respect to charitable gift annuities, although donors may want to take advantage of higher annuity rates that most organizations will be offering until year-end, some may, depending on their age, have to wait until next year when most organizations have lowered their rates in order to pass the 10% test.

And last but not least, consider a gift of a remainder interest in a personal residence or farm to take advantage of the substantial deductions that accompany lower CFMRs.

In a nutshell, CLATs, CRUTs and LEAs are in, PIFs are neutral, and while CLUTs, CRATs and CGAs while not being completely out, they are definitely less attractive purely from a deduction standpoint.


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

  2. IRC §7520; Rev. Rul. 89-34. 1989-1 C.B. 263; Notice 89-60, 1989-1 C.B. 700back

  3. Rev. Rul. 70-452, 1970-2 C.B. 199Rev. Rul. 77-374, 1977-2 C.B. 329back

  4. IRC §664(d)(1)(D)back

  5. The American Council on Gift Annuities is a private not-for-profit organization comprised of 25 volunteer members who represent over 1,000 member charitable organizations nationally. The Council deals with all matters pertaining to charitable gift annuities and meets periodically to establish suggested annuity rates that will result in issuing charities realizing a 50% actuarial residuum from the annuity agreements they issue. The rates are based on current mortality studies, prevailing and projected investment returns on invested reserves, and projected administrative costs.back

  6. Most issuing organizations maintain their own minimum age requirements. Also, annuity rates are banded (i.e., one rate can apply to annuitants differing in age by as much a four years). We did not run computations for every age combination, so sure to run your own computation.back

  7. Not 120% of the Applicable Federal Rate used to derive the CFMR.back

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