IRS INTEREST RATES & EFFECTS ON GIFT AND ANNUITIES
Annuities, life estates, property interests for a term of years, remainders and reversionary interests must all be valued according to an interest rate published by the IRS each month.
However, in valuing deferred gifts, donors can choose the tables using the most favorable Applicable Federal Rate (AFR- 120% of the midterm rate) from that in effect for the month of the gift or from either of the two months preceding the month of the gift.
You wish to elect the highest rate for
1. Charitable Remainder Annuity Trust
2. Charitable Remainder Unitrust
3. Charitable Gift annuity (For a large donation)
4. Gift of Remaining Life Estate in farm or personal residence
You would select the lowest rate available for
1. Charitable Lead Trust
2. Gift of Life Income Interest in Charitable Remainder Trust
3. Charitable Gift annuity (for large tax free payout)
4. Remainder Interest in farm or personal residence
When rates change a lot, the change can have a material effect on any
transaction. Basically, when rates fall, interests for life or term of years
lose value while remainder interests & annuities gain.
Grantor Retained Annuity Trusts gain in value as rates fall- the remainder
interest rises. The gift tax is determined at the time of transfer and therefore
the lower rates allows a transfer of more assets to the remainder beneficiary
without further tax.
Grantor Retained Income Trust can still be used to pass a personal residence
to children or nieces or nephews. However, lower rates increase the remainder
value and therefore increase tax.
Grantor Retained Unitrusts are charitable gifts that pay a FIXED income to
a beneficiary. They are not affected by rate changes.
Charitable Lead Annuity Trusts pay income to a charity and the remainder
goes to a non charitable remainderman. Lower rates decrease the remainder
interest and decreases tax.
Charitable Remainder Annuity Trusts pay an income based on fluctuating values
of the assets. The annuity interest becomes more valuable as rates drop and
hence the charitable reduction is reduced.
Charitable Remainder Unitrusts and Charitable Lead Unitrusts are unaffected by rate fluctuations.
Private Annuities cut the payments that the younger obligor must pay an older
annuitant. The private annuity costs less to implement now.
Gift Loans are also impacted since lower rates reduce the imputed interest that must be accrued to the borrower and received by the lender.
New Rules on Actuarial Tables for Annuity Valuations, Life Interests 2000
The Internal Revenue Services has issued final regulations relating to the use of actuarial tables in valuing annuities, interests for life or terms of years, and remainder or reversionary interests. These regulations will effect the valuation of inter vivos and testamentary transfers of interests dependent on one or more measuring lives. Section 7520(c)(3) of the Internal Revenue Code of 1986 directs the Treasury to revise the actuarial tables used in valuing interests dependent on mortality experience not less frequently than once each 10 years to take into account the most recent mortality experience available as of the time of the revision. This rule contains amendments to the regulations revising certain tables used for the valuation of partial interests in property under section 7520 to reflect the most recent mortality experience available. Effective date is June 12, 2000.
Interest rates and charitable gifting: ( Marc D. Hoffman, 2003)
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%
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]
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 invÄ!
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 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