For various reasons, the charitable carryover annuity trust has long been underused as a gift planning vehicle. At any given time, there may be just over a hundred thousand split interest trusts in existence, but only one in eight of these is a CRAT.
But with interest rates rising rapidly over the last year, this may start to change. Income and remaining interest in a trust is valued by reference to an assumed rate of return, the so-called section 7520 rate, which is related to current medium-term Treasury bond yields. When current yields are low, a fixed annuity will tend to deplete the principal of the trust, and this fact is reflected in the present value of the charitable deductible remainder.
When current returns are higher, the present value of the remainder, and therefore 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 of surviving the period during which the annuity would deplete the trust is more than “negligible,” the IRS has taken the position [Rev. Rul. 70-452, 1920-2 C.B. 199] that the trust does not qualify, meaning that no deduction is allowed for the present value of the remainder, and the gain on the sale of the appreciated property contributed to the trust must be taxed to the settlor immediately, rather than spread among a number of years.
But since 2016 [Rev. Proc. 2016-42, IRB 2016-34], the IRS has recognized a workaround for this “probability of exhaustion” rule. If the trust instrument itself states that the remainder to charity will be accelerated if the next annuity payment would cause the trust 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 annuity beneficiary’s table life expectancy or the period of years during which the annuity would exhaust the corpus, whichever is less, but in reality that was always true of anyway. [Reg. section 25.7520-3(b)(2)(v)].
But what all of this discussion really points to is that it will often make sense to establish a CRAT for a period of years rather than for the life of the beneficiary in the first instance.
What we are looking for is a fixed payment on the one hand and an immediate charitable deduction on the other. To achieve this, we may need to limit the trust to a period of years. If we are seeking an “income” payment on one or more lives that could rise and fall with the markets, the most appropriate vehicle will generally be a trust.
On some other occasion, we can explore why the fluctuating rates of section 7520 have very little effect on the present values of income and interest remaining in a trust. For now, 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 trust in tandem, to increase the charitable deduction while hedging the risk of an “income” payment. fluctuating. . And that this strategy is often overlooked.
How to take advantage of the rest of the deductible
A rising section 7520 rate will place less value on one fixed annuity and more on the rest. The two numbers can only add up to one hundred percent. As of this writing in January 2023, the 7520 rate is 4.6 percent, slightly below the December high of 5.2 percent, but still three hundred basis points higher than the 1 rate, 6 percent from January 2022.
The comparisons can be quite dramatic. And working through an example, we’ll assume that the taxpayer would choose to take advantage of the two “lookback” months allowed by the Tax Code to use the December rate when valuing the remainder of the 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 rate of 7520 of 5.2 percent, is approximately 38.7 percent, whereas if we had established a similar trust in January or February, when the 7520 rate was still 1.6 percent, the current value of the remainder would have been only a fraction of that, around 15.0 percent.
Or to look at it another way, assuming the “probability of exhaustion” test applied, if the 7520 rate was still at 1.6 percent, a CRAT of five percent for the life of an individual under age 73 would not qualify, while with the 7520 rate of 4.6 percent, the minimum age drops to 40 years.
With the section 7520 rate at 5.2 percent, we assume a return in excess of payment, so there is no probability of depletion, and we only consider the requirement that the present value of the remainder to charity be at least ten percent. . A five percent CRAT benefiting a 17-year-old would qualify.
Since March 2020, the Federal Reserve has raised its benchmark interest rate seven times, from near zero to 4.25 percent. This has been reflected, at least indirectly, in medium-term Treasury yields and therefore the 7520 section rate. As noted, we have seen a modest easing in the 7520 rate in January, and it is possible that it will soften a little more.
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 for a while yet.
Right after the 2008 crash, when 7520 rates were still falling from 6.9 percent, but an eventual bottoming out near zero was still unthinkable, there was a lot of talk, even 3 point something, about opportunities to use trusts. of annuities retained by the grantor to take advantage of Other gifts to children and grandchildren.
It now appears that we are at the top of an upward trend, and new opportunities for planning with charitable remainder annuity trusts are beginning to open up.
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