Low Rates Make Lead Trusts, Gifts of Income Interests Attractive

The IRS discount rate used to value the charitable component of split-interest gifts dropped to 1.8% in December of 2011. After then climbing back to 3% in March, April, and May, it plunged again late in the summer and then hit an all-time low of 1.4% in October.

A low discount rate significantly increases the attractiveness of certain charitable-planning techniques, most notably the use of a nongrantor charitable lead trust. This vehicle directs a current income interest to a charity for a term certain or for a life or for a certain combination thereof, after which remaining trust assets pass to noncharitable beneficiaries. The present value of the income interest is subtracted from the total amount transferred to the trust to determine what portion of the transferred assets—if any—is subject to federal transfer tax.

When discount rates are low, the value of the income interest increases. For instance, assume a donor creates a nongrantor charitable lead annuity trust (CLAT) with $1,000,000 that will pay a charity $70,000 per year for the next 15 years and then distribute any remaining trust assets to the donor’s children. At a 1.4% discount rate the value of the charitable income interest is $941,170, while at a 5% discount rate it had been $726,580. If the discount rate is 1.4%, only $58,830 ($1,000,000 – $941,170) would be subject to federal transfer tax; but that amount would be $273,420 ($1,000,000 – $726,580) at a discount rate of 5%.

A nongrantor charitable lead trust can be a valuable planning tool for a person who intends to make significant annual charitable gifts and who anticipates having an estate that will be subject to federal transfer tax. Regardless of how much passes to the noncharitable beneficiaries at the end of the trust term, no additional amount will ever be subject to federal transfer tax. Because the grantor does not remain liable for tax on the income of a nongrantor charitable lead trust, such a gift does not generate an income-tax deduction.

Taxpayers can also make a gift of income interests they hold from both charitable and noncharitable sources. As a general rule, a taxpayer can take a deduction for the fair-market value of the income interest he or she gives to charity.

Example: Gene J, aged 80, decides to relinquish an income interest he holds in a charitable remainder annuity trust that pays him $7,200 each year. Based on a 1.4% discount rate, an income interest in that amount would have a present value of more than $53,500.

In Gene’s 35% federal tax bracket, a gift of the income interest could save him more than $18,500 in income taxes. The deduction for the annuity interest could be limited, though, to the projected amount the charity would actually receive if the value of the trust principal has dropped to the point at which it would not support a payout of the annuity for the balance of the life expectancy of the beneficiary.

If Gene’s interest is an income interest in a charitable gift annuity, the IRS takes the position that his deduction is limited to the lesser of the fair-market value of the annuity interest and the donor’s unrecaptured “investment in the contract”—that is, the value of the income interest at the time of creation of the gift. That amount is returned to the donor who is the beneficiary of the gift annuity ratable over the life expectancy of the annuitant.

Caution: Contribution of an income interest constitutes a gift of a noncash asset and obligates a donor to report the gift on IRS Form 8283; and if the claimed value of the noncash item is more than $5,000, the donor will also need to have a qualified appraisal to substantiate the gift. The taxpayer must complete Part B of Form 8283, and the form must be signed by the qualified appraiser.

Learn more

Find gift-planning articles and advice.