The Highs and Lows of Rising Interest Rates

The rate of return that determines income earned on trust assets — term interests, life interests, annuities and remainders — is established through IRC Code Section 7520. Published each month by the IRS based on the previous month’s weighted average market yield for marketable treasure obligations of the same duration (short-term, mid-term and long-term), this rate is 120 percent of the “applicable federal rate” for mid-term obligations with semiannual compounding.

In recent years, the Section 7520 rates have been at historically low levels, but this could be a thing of the past as the rates have begun creeping up, and it’s likely they’ll continue to climb. Because transfer tax valuation rules are based, in part, on Section 7520 rates, certain charitable transfer tax planning techniques are directly affected by the prevailing rates. The impact is especially apparent with respect to annuity interests but also applies, albeit to a lesser extent, to unitrust interests.

As the Section 7520 rate increases, the present value of annuity or unitrust interest declines and the present value of the remainder interest increases. The opposite occurs when the Section 7520 rate decreases.

The annuity or unitrust interest will have a smaller present value, and the remainder interest a larger present value. The reason for the difference is that a higher Section 7520 rate presumes a higher rate of return that will be used to pay the annuity or unitrust interest and a less likely chance that principal will be needed for such payments.

Thus, charitable lead trusts are more advantageous when the Section 7520 rate is low. For example: A $1 million charitable lead annuity trust having a 5 percent payout to a charitable beneficiary for a 10-year period with the trust terminates and pays out to the donor’s child. If the Section 7520 rate is 5.4 percent, the present value of the charity’s right to receive $500,000 ($50,000 a year for 10 years) is $378,695. If the Section 7520 rate is 3.4 percent, the present value of the charity’s interest rises to $417,935. The increase in value of the charity’s interest reduces the present value of the remainder interest that will pass to the donor’s child in 10 years and, thus, lowers the value for federal gift tax purposes. In addition, any growth in the value of the trust assets in excess of the 5 percent annuity will pass to the donor’s child.

On the other hand, charitable remainder trusts offer more advantages when the Section 7520 rate is high. Using the same example of a $1 million charitable remainder annuity trust (CRAT) having a 5 percent payout to the donor’s child for a 10-year period, with the principal then paid to charity, if the Section 7520 rate is 5.4 percent, the value of the charitable remainder at the inception of the trust is $621,305 and the present value of the child’s right to receive $50,000 a year for 10 years is $378,695 ($1 million minus $621,305). However, if the Section 7520 rate is 3.4 percent, the value of the charitable remainder drops to $582,065 and the value of the gift to the donor’s child increases to $417,935.

Variances in the Section 7520 rate affect the values in charitable giving, making some techniques such as a CRAT more advantageous in times when the rate is high and others such as a charitable lead annuity trust (CLAT) more advantageous when the rate is low. It’s important to know how the rates will impact a potential donor’s charitable deduction.

New sample CRUT forms
The IRS has released eight new sample charitable remainder unitrust (CRUT) forms in Revenue Procedure 2005-52 through 2005-59, replacing sample forms issued in 1990. The following forms were issued:

* Inter vivos CRUT for one measuring life — Rev. Proc. 2005-52.

* Inter vivos CRUT for a term of years — Rev. Proc. 2005-53.

* Inter vivos CRUT with consecutive interests for two measuring lives — Rev. Proc. 2005-54.

* Inter vivos CRUT for concurrent and consecutive interests for two measuring lives — Rev. Proc. 2005-55.

* Testamentary CRUT for one measuring life — Rev. Proc. 2005-56.

* Testamentary CRUT for a term of years — Rev. Proc. 2005-57.

* Testamentary CRUT with consecutive interests for two measuring lives — Rev. Proc. 2005-58.

* Testamentary CRUT with concurrent and consecutive interests for two measuring lives — Rev. Proc. 2005-56.

These sample trust forms meet all of the requirements under the Internal Revenue Code for each specific type of trust.

While the forms are helpful and informative, the annotations to the forms are even more so. For example, the annotations include alternate language for testamentary additions to a CRUT and methods of computing the deferred payments. The annotations to the income-only type of CRUT deal with changes in state law definitions of income and provide that proceeds of sales of assets

may be allocated to income under the terms of the governing instrument, if not prohibited by local law. In addition, the trustee may be given discretionary power to make the allocation, provided the applicable state statute permits the trustee to make adjustments between income and principal to treat beneficiaries impartially. A “flip” CRUT can change from an income-only CRUT to a regular CRUT on a one-time basis. The annotations state that the change may not be discretionary with or in the control of the trustees or any other person.

It’s important (and disturbing) to note that all of the forms issued by the IRS are silent on the new spousal waiver requirement of Revenue Procedure 2005-24, which bars a charitable deduction for a charitable remainder trust unless a spouse waives his or her elective rights in the transferred property. This is a potential “trap for the unwary,” and unless the IRS changes the requirements of the spousal waiver, no matter what form is used to create the trust, a waiver must be added.

The annotations point out that if the trust is funded with unmarketable assets, the determination of fair market value that must be made at least annually must be made by an independent trustee or must be determined by a qualified appraisal from a qualified appraiser as defined in the regulations.

The language of the prior forms required the charitable reminder beneficiary to be an organization described in Section 170(c). Using this language could be a problem for an inter vivos CRUT, because such an organization could be a private foundation, which would then cause the donor to be subject to a lower income tax charitable deduction percentage limitation. The explanatory annotations include language in the event that the donor desires that a public charity be the charitable beneficiary.

Kathleen A. Stephenson is of counsel with the Philadelphia office of Pepper Hamilton LLP. Lisa B. Petkun is a partner in Pepper Hamilton’s tax department. They can be reached via www.pepperlaw.com.