By Sarah Kahl
There are two common charitable planning techniques that aptly illustrate the interrelation between interest rates and philanthropy.The first is a charitable lead annuity trust known as CLAT, which works better when interest rates are low. The second is a charitable remainder annuity trust CRAT, which works better when interest rates are high.
The key interest rate for many charitable planning techniques is the section 7520 interest rate pursuant to Internal Revenue Code 7520, which is used to value income interests, annuity interests, and remainders.
When charitable planning is involved, donors have the benefit of selecting the section 7520 rate for the month of the transaction or the section 7520 rate for one of the two immediately preceding months. Whether the highest rate or the lowest rate should be selected depends on the technique.
Many charitable planning techniques involve a split interest: that is, the charity shares the gift with someone else. The other person could be the donor or a third party. Often, one party receives an annuity. When the section 7520 rate goes up, the value of an annuity goes down. Therefore, the value of an annuity is likely to be lower in the future as interest rates rise.
With a CLAT, an annuity is distributed to charity, and when the annuity payments are completed, the rest of the trust property is distributed to an individual gift recipient. The value of the gift to the individual is equal to the value of the property transferred, reduced by the value of the charity’s annuity. The CLAT can be structured so that the value of the annuity is almost as high as the value of the property transferred, so that the gift is nominal. When interest rates are lower, the value of the annuity is higher. Therefore, a smaller annuity is necessary to generate a nominal gift, and more property can be transferred to the gift recipient when interest rates are low.
In contrast, a CRAT tends to work better when interest rates are high. A charitable remainder trust is a trust that pays an annual payment to the donor during the term, with the remainder passing to charity. The donor can get an upfront income tax deduction for the charitable portion of the transfer. The value of the charitable portion has to be at least 10 percent of the property contributed. Because the value of the donor’s retained annuity is lower when interest rates are high, the deductible charitable portion is higher when interest rates are high.
It is also easier to create a qualifying CRAT when interest rates are high. A CRAT is supposed to be structured so that there’s a less than 5 percent probability that the charity will be left with nothing. This test is known as the probability of exhaustion test. This test is in conflict with the requirement that the annuity be at least 5 percent of the contribution. With younger donors creating CRATs for their lifetimes, it’s impossible to satisfy both tests. The assumed low rate of return suggests that the CRAT’s earnings will be lower than the annuity, so the Internal Revenue Service model would show the CRAT value decreasing each year until it eventually depletes. The CRAT will fail the probability of exhaustion test if depletion is scheduled to happen too soon. As an alternative to passing the probability of exhaustion test, to qualify CRATs can distribute to charity early if the principal dips below 10 percent of the initial corpus. When interest rates are high, it will not be necessary to include the early termination language to create a qualifying CRAT.
Charitable gift annuities work much like a CRAT, except that donors don’t have to worry about maintaining a trust. Instead, donors transfer property to a favorite charity, retaining an annuity paid by the charity. Donors will get a better income tax deduction when interest rates are high, just as with a CRAT. In addition, the charity prefers higher interest rates to avoid unrelated business income tax. The charity will recognize unrelated business income tax when the gift portion of the transaction is not at least 10 percent of the property, and it’s easier for the gift to pass this test when interest rates are high.
As interest rates rise, finalize charitable lead annuity trusts sooner rather than later. Also, take a fresh look at charitable remainder annuity trusts and charitable gift annuities, which will be more attractive as rates rise.
Sarah Kahl is Counsel in Venable LLP’s Tax and Wealth Planning Group. For more information, visit www.Venable.com.