Taxes

Charitable Remainder Annuity Trust Opportunities Under Rising Interest Rates

For various reasons, the charitable remainder annuity trust has long been underutilized as a gift planning vehicle. At any given moment there may be somewhat over a hundred thousand split interest trusts in existence, but only about one in eight of these is a CRAT.

But with interest rates rapidly rising over the past year, this may begin to change. Income and remainder interests in a trust are valued with reference to a rate of return assumption, the so-called section 7520 rate, which is keyed to current yields on mid-term Treasuries. When current yields are low, a fixed annuity will tend to deplete trust principal, and this fact is reflected in the present value of the deductible remainder to charity.

When current yields are higher, the present value of the remainder, and thus the income tax deduction, increases.

Life or Term?

If the trust is to pay an annuity over the life of an individual, and the actuarial probability that she will outlive the period over which the annuity would exhaust the trust is more than “negligible,” IRS has taken the position [Rev. Rul. 70-452, 1920-2 C.B. 199] that the trust does not qualify, meaning no deduction at all is allowed for the present value of the remainder, and gain on the sale of appreciated property contributed to the trust is to be taxed to the settlor immediately, rather than spread out over some number of years.

But since 2016 [Rev. Proc. 2016-42, IRB 2016-34], IRS has acknowledged a workaround for this “probability of exhaustion” rule. If the trust instrument itself provides that the remainder to charity is to be accelerated if the next annuity payment would otherwise cause the trust corpus to fall below ten percent of its initial value, the trust will qualify.

The deduction will be limited to the present value of the remainder after the lesser of the annuitant’s table life expectancy or the term of years over which the annuity would exhaust corpus, but actually that was always true anyway [Reg. section 25.7520-3(b)(2)(v)].

But what this entire discussion actually points up is that it will often make sense to set up a CRAT for a term of years rather than for the life of the annuitant in the first instance.

What we are seeking is a fixed payout on the one hand and an immediate charitable deduction on the other. To achieve that we may need to limit the trust to a term of years. If we are looking for an “income” payout over one or more lives that might rise and fall with the markets, the more appropriate vehicle will usually be a unitrust.

On some other occasion we may explore why fluctuating section 7520 rates have very little effect on the present values of the income and remainder interests in a unitrust. For the moment, suffice it to say that in more than a few cases it may make sense to set up an annuity trust and a net income exception unitrust in tandem, to increase the charitable deduction while hedging the risk of a fluctuating “income” payout. And that this strategy is often overlooked.

Leveraging the Deductible Remainder

A rising section 7520 rate will ascribe less value to a fixed annuity and more to the remainder. The two numbers can only ever add to one hundred percent. At this writing in January 2023, the 7520 rate is 4.6 percent, off somewhat from a peak at 5.2 percent in December, but still up three hundred basis points from the January 2022 rate of 1.6 percent.

The comparisons can be quite dramatic. And in working through an example, we will assume that that the taxpayer would elect to take advantage of the two month “lookback” permitted by the tax Code to use the December rate in valuing the remainder gift.

The present value of the remainder of a CRAT paying the minimum 5.0 percent in quarterly installments over the maximum term of twenty years, assuming a 7520 rate of 5.2 percent, is about 38.7 percent, whereas if we had set up a similar trust back in January or February when the 7520 rate was still 1.6 percent, the present value of the remainder would have been just a fraction of that, at about 15.0 percent.

Or to look at it another way, assuming the “probability of exhaustion” test applied, if the 7520 rate were still at 1.6 percent, a five percent CRAT for the life of an individual aged less than 73 would not qualify, whereas with the 7520 rate at 4.6 percent, the minimum age drops all the way to 40.

With the section 7520 rate at 5.2 percent, we are assuming a return in excess of the payout, so there is no probability of exhaustion, and we are looking only at the requirement that the present value of the remainder to charity be at least ten percent. A five percent CRAT for the benefit of an individual aged 17 would qualify.

Since March 2020, the Federal Reserve has raised its benchmark lending rate seven times, going from nearly zero to 4.25 percent. This has been reflected at least indirectly in yields on mid-term Treasuries, and therefore the section 7520 rate. As noted, we have seen a modest easing in the 7520 rate in January, and it may soften a bit further.

But the Fed has indicated that it does not intend to cut the benchmark rate for at least another year. So, these higher 7520 rates may be with us awhile yet.

Just after the 2008 crash, as 7520 rates were still falling from six point something percent, but the eventual bottoming out near zero was still unthinkable, there was a lot of talk even at three point something about opportunities to use grantor retained annuity trusts for leveraging remainder gifts to children and grandchildren.

We now seem to be at a crest on an upward trend, and fresh opportunities for planning with charitable remainder annuity trusts are beginning to open up.

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