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Archive for February, 2015

So far, this blogger has covered a variety of “level 101” charitable tools & techniques.  Today, we begin to take it up a notch to the “201” level – though, we’re not quite graduate students, we are upperclassmen, at least as far as split interest trusts go!  This week we will discuss a key limitation of the charitable remainder trust (CRT)

First, a quick review:  You want to give a sizeable donation to your favorite charity but, truth be told, you do not feel comfortable parting with the assets today because you need the income for living expenses.  In the right interest rate environment, the CRT can be a perfect tool.  The CRT is a tax exempt trust in which the donor or other noncharitable beneficiary retains the income interest from the trust for a period of years or for the life or lives of one or more individuals.  The donor transfers cash or other property into the trust and in return, receives periodic payments over the term of the trust.  For income tax purposes, in the first year, the donor can deduct the actuarial present value of the remainder interest as a current charitable contribution.   Upon termination, any assets remaining in the trust pass to one or more charities.   Its best use is for a donor who wants to make a large charitable gift but hold onto that annual income; it can also be used to monetize and diversify an asset or asset pool at little or no tax cost to the donor.

Generally speaking, however, it does not make sense to fund a CRT in a low interest rate environment.  Because there are a number of fences built around CRT’s designed to ensure that they do what they are supposed to do – get money to charity in a tax-efficient (but not too efficient) manner,  a transfer made to a CRT in a low rate environment may not even work!  Here’s why:

By law, the annual payout percentage from a CRT cannot be less than 5% nor greater than 50% of its  market value[1].  In addition, based on the published §7520 interest rate[2] in effect at the time of the transfer, the projected charitable remainder interest going to charity must equal or exceed 10% of the initial fair value of the trust.  In completely plain English, this means that you can’t use a CRT to avoid tax completely nor can you use it to cut out the charity completely.  Combining the two limitations means that the lower the published government rate, the more difficult it will be to meet the 10% rule.[3]  In addition, there is yet another stress test to be met – there has to be a less than 5% probability that the assets will run out before the trust terminates, either at term or at the death of the grantor(s).  Again, the lower that published government rate, the harder it is to meet this requirement; the only way around this is to let the grantor(s) season a bit (i.e. get older) before funding the trust or reduce the term over which the annuity will be paid.  The result?  All math, all painful, all the time.

Let’s compare a charitable remainder annuity trust (CRAT) set up in today’s low rate environment versus the higher rate environment of, say, 2008.  Except for the actual published government rates, we will hold all other assumptions between the two years equal.

Our hypothetical grantors are both 65 years old and wish to monetize their $1,000,000 portfolio using a CRAT, with the remainder interest earmarked for their favorite charity.  Per the trust agreement, they will take back the minimum allowable annual payout of 5% of the initial fair market value of the trust, or $50,000[4].  They structure the trust to run until the death of the second grantor.  The results are summarized in the following table:

Capture1

(Click to enlarge)

As you can see, from an income tax perspective, the CRAT is far less attractive today as the calculated charitable contribution is worth only 64% of what it would have been in the interest rate environment of 2008.  Of equal or even greater concern is the fact that contribution itself may be disallowed for tax purposes because there is a more than 5% chance that the trust will run out of money before its time.  Clearly this is a bad deal in today’s low interest rate environment.

As a planning tool the CRT may be on hiatus (or at least in hiding) for a bit because of today’s low interest rate environment, but, as we all know and expect, what is low now will eventually rise.  When that happens, all hail the triumphant return of the CRT!

[1] In the case of a charitable remainder annuity trust (CRAT), this would be the initial fair market value; in the case of a charitable remainder unitrust (CRUT) it would be the fair market value on the annual revaluation date for the trust.

[2] Let’s call it the “published government rate.”

[3] The §7520 rate for February 2015 is 2.0%.  When funding a CRAT, you are permitted to use the best (highest) rate in effect during the current month or the immediately preceding two months.  In our example, the January 2015 §7520 rate (2.2%) is best.

[4] Because this is an annuity trust rather than a unitrust, the annual payment is set in stone and does not change over time.

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