The charitable gift annuity is a favorite with donors: simple to execute and flexible enough to fit many personal financial plans. The charitable gift annuity generates both an income tax deduction and a lifetime payout for one or two annuitants selected by the donor. Planned Giving in Difficult Economic Times: Options to Consider

Charitable Gift Annuities

The charitable gift annuity is a favorite with donors: simple to execute and flexible enough to fit many personal financial plans. The charitable gift annuity generates both an income tax deduction and a lifetime payout for one or two annuitants selected by the donor. And, when the applicable federal rate or AFR is low, the charitable gift annuity can have another benefit—a comparably larger tax-free principal component of the charitable gift annuity payment. For a certain period of time, each annuity payment is comprised of a tax-free return of principal, interest taxed as ordinary income, and if the charitable gift annuity was funded with appreciated property, capital gain. The length of time for this income tax treatment depends on the age (or ages) of the annuitant(s). The determination for what part of the annuity payment is tax-free return of principal—interest income or, perhaps, capital gain is made using the exclusion ratio [IRC Sec. 72]. In order to calculate the amount of an annuity payment that will be characterized as a tax-free return of principal, the exclusion ratio is multiplied by the amount of each annual payment. The exclusion ratio is equal to the donor’s investment in the contract (present value of the annuity) divided by the expected return (as determined by consulting IRS Tables V and VI). Investment in the contract is not equal to the full value of the transferred property. Rather it is equal to the present value of the gift annuity on the annuity starting date (for the immediate gift annuity, this is the contract date and for a deferred annuity, this is the date of first payment). If appreciated property is transferred for a gift annuity and the donor is the sole annuitant, gain on the sale portion is recognized over the donor’s life expectancy. If the donor outlives her life expectancy, the capital gain portion ends and all remaining payments are fully taxed as ordinary income. Note, in order to spread out the gains over the donor’s lifetime, the gift annuity contract must require that the gift annuity interest is non-transferable except to the issuing charity. And, ordinary income is that income which is not characterized as a return of principal, nor as capital gain. The excess of the charitable gift annuity payment above the tax-free principal or capital gain is considered interest. For example, Benjamin (age 75) regularly volunteers at a local food pantry and donates cash as well. In 30 days, he has a series of bank certificates of deposit (CDs) that will mature. The available interest rates for CDs at this time are not what Benjamin would like. He recently read an article in the food pantry newsletter about the charitable gift annuity and the idea intrigued Benjamin. He especially liked the idea that part of each payment from the charity would be income tax-free. After speaking to his financial and tax advisors, Benjamin decides he will make a gift of $10,000 in cash to the charity’s gift annuity program. The applicable federal rate (AFR) at the time he makes his gift is 3% (the lowest rate in several months and the donor can select the AFR for the month of the gift or the two preceding months). The payout rate of the charitable gift annuity is 6.3%—$630 a year. The payment frequency is once a year. Under this scenario, the tax-free return of principal over the next 13.4 years (Benjamin’s life expectancy under the IRS Tables) is $461.79—an exclusion ratio of 73.3%. If Benjamin had made his gift when the lowest available AFR was 6%, the tax-free return of principal would be $379.89—an exclusion ratio of 60.3%.

Charitable Lead Trusts

One method of charitable giving that can have a distinct advantage during this time of an under-performing economy and low applicable federal rates is the charitable lead trust (CLT). A CLT is an irrevocable trust established to pay a charity an annual income consisting of a specified dollar amount or a percentage of trust assets as determined every year [Reg. Sec. 20.2055-2(e)(2)(vi)]. At the end of the trust term (either a term of years or as based on a measuring life or lives), the CLT assets are distributed to non-charitable beneficiaries. There are two types of qualified CLT: grantor CLT and non-grantor CLT [IRC Sec. 673(a)]. The grantor CLT distributes the assets (back) to the grantor at the end of the trust term. The non-grantor CLT distributes the trust assets to family members at the end of the trust term. A primary reason for the current viability of a CLT is the extremely low applicable federal rate (AFR). The AFR is published by the Treasury Department every month to value annuities, life interests, or interests for terms of years and remainder or reversionary interests [IRC Sec. 7520]. The AFR is important because a low AFR increases the present value of the charity’s income interest which reduces the value of trust assets expected to go to non-charitable beneficiaries.

Here are a few CLT approaches that might have particular appeal to donors.

Zeroing out the Taxable Gift of a Charitable Lead Annuity Trust

A charitable lead annuity trust (CLAT) is a qualified CLT with the income interest in the form of a guaranteed annuity. A non-grantor CLAT can be designed so that the taxable gift to non-charitable beneficiaries equals zero. This is true even if the qualified income interest to charity actuarially exceeds the value of the total amount. For example, Eleanor decides to set up a charitable lead annuity trust to benefit the local art museum with the remainder to be split evenly between her two children. She has already used most of her lifetime gift tax exemption, so she would like the CLAT designed so the gift of the remainder interest does not generate any gift tax. She has decided to fund the CLAT with securities worth $1,000,000 and she would like the trust term to end in 20 years. The AFR for this month is 2.6%—the lowest AFR in several months. What can she do to ensure the taxable gift to her children is zero? She should choose a payout percentage for her CLAT which, when multiplied with the annuity factor (check under IRS Publication 1457, Table B for a 20 year term and an AFR of 2.6%) will equal at least 100% of the present value of the charity’s annuity interest. In this case, the annuity factor is 15.4429 so her payout percentage for the CLAT must be at least 6.475% so the present value of the remainder interest equals zero. Eleanor likes round numbers so she chooses a 7% payout percentage ($70,000 a year for 20 years). The likelihood is high that part of the trust principal will be eroded by the annual payments, but there is no estate or gift tax liability for Eleanor. Note that this approach is particularly good when the AFR is low in relation to expected growth and earnings of the assets in trust.

The Increasing Payment Charitable Lead Annuity Trust

A CLAT can be designed to increase payments over the term of the trust. In Rev. Proc. 2007-45, the IRS published its sample charitable lead annuity trust forms (a safe harbor for practitioners). Under the section entitled, Annotations for Paragraph 2, Payment of Annuity Amount, the IRS outlines how the payments can increase: “Alternatively, the governing instrument of a CLAT may provide for an annuity amount that is initially stated as a fixed-dollar or fixed-percentage amount but increases during the annuity period, provided that the value of the annuity amount is ascertainable at the time the trust is funded.” There are reasons why a donor might select an increasing payment over the life of the trust rather than a uniform level payment. Consider a CLAT created when the AFR is low—say 3%. The assets within the trust produce a consistent return of 7%. The benefit or accrual growth to the remainder distributed to non-charitable beneficiaries is 4% a year. If the trust instrument requires a level payout, the accrual benefit remains at that 4%. However, if lower payments are scheduled in the early years of the trust term, the CLAT has a chance to accrue greater value as compared to paying the level annuity. If the investments enjoy the greater compound growth in the early years of the CLAT, the non-charitable beneficiaries will have a larger remainder despite the somewhat larger payments scheduled later in the trust term.

Super Grantor Charitable Lead Trusts

A super grantor charitable lead trust (or intentionally defective non-grantor charitable lead trust) is a grantor trust for income tax purposes, but a non-grantor trust for gift and estate tax purposes. The super grantor CLT is designed so that the grantor retains a right that is enough to trigger grantor trust status, but not enough to pull the trust assets into the grantor’s estate [IRC Sec. 675(4)]. One option is for the grantor to reserve the power for a non-adverse party to reacquire trust assets from the charitable lead trust [IRC Sec. 675(4)(c)]. Though the grantor may be such a non-adverse party, this power must be exercised in a non-fiduciary role; it is possible that the grantor would violate the self-dealing rules of IRC Sec. 4941 if he were to use that power (though simply holding the power would be permitted under the incidental exception to the self-dealing rules under Reg. Sec. 53.4941(b)-3). A better choice might be for the grantor to choose a sibling to hold this power to reacquire the trust assets since a sibling is not considered a disqualified person under the IRC Sec. 4941 rules [PLR 200010036]. There are several benefits to creating a super grantor CLT including:

• The grantor can take an income tax charitable deduction for the present value of the charity’s income interest.
• The income tax attributed to the grantor CLT is paid by the grantor and not from trust assets, allowing the trust assets to grow at a greater rate. This could result in a relatively larger trust remainder left to go to non-charitable beneficiaries.
• The appreciation on the trust assets between the creation of the CLT and the end trust term is not subject to gift and estate taxation.

Problem Assets for Charitable Lead Trusts

Remember that charitable lead trusts are treated as private foundations with respect to certain administrative restrictions under which they must operate. The trust agreement must contain specific prohibitions against the following:

• Excess Business Holdings [IRC Sec. 4943]
• Self-Dealing [IRC Sec. 4941]
• Jeopardy Investments [IRC Sec. 4944]
• Taxable Expenditures [IRC Sec. 4945]

In particular, the private foundation prohibition against excess business holdings will apply if the value of the charitable interest exceeds 60% of the value of the total trust assets, or if all the trust income is not paid to the charitable beneficiary. When a closely held business interest is transferred to a charitable lead trust, it is generally prudent to limit the charitable income interest to 60% or less of the total value of the trust through proper selection of the payout rate and trust term. Also, in order not to run afoul of the excess business holdings prohibitions, a CLT may not own any voting stock of a corporation in which the donor and other disqualified persons together own more than 20% of the voting stock. (Though there is an exception for a CLT that receives the stock in a closely-held business as a gift or bequest and disposes of that stock within five years.)

Generation Skipping Transfer Tax and Charitable Lead Trusts

The generation skipping transfer tax (GSTT) is imposed in situations where successive generations could otherwise avoid paying successive estate taxes as property passed to younger generations [IRC Sec. 2601]. If a non-grantor CLT is designed to distribute assets to grandchildren or more remote descendants, GSTT becomes an issue. A charitable lead unitrust or CLUT offers an opportunity to leverage the exemption because the GSTT allocation is made on the date the assets are transferred to the trust minus the charitable gift or estate tax deduction [IRC Sec. 2642—(a)]. However, a CLAT does not permit this same leverage to start, the charitable portion of the gift is not deductible for GSTT purposes. And, the exemption allocation for a CLAT is made on the date the assets are distributed to the grandchildren at the end of the trust term. As a result, it is that much harder to design a CLAT that shelters the transfer from GSTT if the assets are expected to increase in value during the trust term. Note that the amount of exemption allocated to the trust is increased annually by a percentage equal to the discount rate used in valuing the annuity interest.

Charitable Bequests

According to Giving USA, donors made charitable bequests that totaled $23.15 billion in 2007. One reason for the popularity of bequest giving is the traditional nature of giving to charity through a last will and testament. However, another compelling reason is that the donor continues to own the property to be distributed through a will. A bequest is a way to memorialize a commitment to charity, so it has a strong appeal to many donors. Even though it may be difficult to make a significant gift today, these donors can plan for a very significant gift from their estate.

Types of Bequests

A testator can choose among different types of bequests when outlining how she wants her property to be distributed from her estate.

Specific Bequest

A specific bequest bequeaths a certain dollar amount (e.g., $10,000) or certain other property (such as a home, art collection, etc.). This is the most popular form of bequest. Indeed, gifts of specific properties may be especially appropriate bequests both for tax and other reasons. During estate administration, specific bequests are the first type of bequest satisfied. Thus, if the estate cannot satisfy all of the bequests made in a will, recipients of specific bequests are more likely to inherit than other estate beneficiaries. The downside is that the testator may dispose of the specifically bequeathed property during life, in which case the intended recipient is out of luck. Note that a specific bequest of a certain dollar amount does not grow with an increase in the value of the estate during the donor’s lifetime. In addition, some specific bequests may be problematic. For example, a bequest of a certain number of shares of a specific stock may raise valuation questions if the stock’s value has changed dramatically since the donor’s death. Or, a specific bequest of real estate may require site inspection, or environmental reviews, or other vetting by the charity.

Percentage Bequest

A percentage bequest devises a set percentage (e.g., 5% of the value of the estate). A percentage bequest may be the best format for a charity to recommend since it lets the charity benefit from any estate growth during the donor’s lifetime. This is a good option for donors who have seen the value of their assets dramatically decline during the economic downturn. Including a percentage bequest in the will has no out-of-pocket cost but it shows the donor’s positive outlook and generosity. As the value of donor’s assets rebound, this charity will (eventually) share in the improving value.

Residual Bequest

A residual bequest distributes assets that remain after all other bequests, as well as any tax or administrative costs, have been satisfied.

Contingent Bequest

A contingent bequest devises property only when those named as primary beneficiaries predecease the testator or if the named beneficiaries waive or disclaim the bequest.

Charitable Bequests of Specific Forms of Property

Some property is better or more suitable than other forms of property as charitable bequests.

Tangible Personal Property

Tangible personal property (e.g., artwork, collections, antiques, etc.) may be given to a charity by bequest. Generally, bequests of tangible personal property qualify for the estate tax charitable deduction for the current full appraised value without regard to whether the charity puts the property to a “related use” as is required for the income tax charitable deduction [IRC Sec. (e)(1)(B)(i)]. However, the artwork itself and its copyright are two interests in the same property. It is possible to make a charitable gift of the physical artwork and a separate charitable gift of its copyright so that both gifts qualify for the gift tax and estate tax charitable deduction (as a whole) but only if the following rules are met:

• The gift property must be tangible personal property with existent copyright protection under federal law,
• The charity is either a public charity or a private operating foundation, and
• The use of the property by the charity must be related to the organization’s exempt purpose. [IRC Sec. 2055(e)(4), 2522(c)(3)]

Ordinary Income Property

Ordinary income property given by bequest is also deductible at the current full appraised value for purposes of the estate tax charitable deduction. The reduction of the deemed amount of the contribution to cost basis required for the income tax charitable deduction does not apply for estate tax purposes.

Income in Respect of a Decedent

Income in respect of a decedent (IRD) is inherited property that would have been taxable income to the decedent if the decedent had received it before death. Since the earnings have never been taxed, IRD is subject to federal income tax. And, if the estate of the decedent is subject to federal estate tax, IRD is an estate asset and is also subject to federal estate tax. Donating IRD assets to a charity through a bequest can both create an estate tax charitable deduction and eliminate the negative income tax component because a qualified charity that receives the IRD assets is exempt from federal income tax. For instance, a donor might want to set up a testamentary charitable gift annuity using an individual retirement account (IRA): The donor would designate a charity as beneficiary of his IRA at death. In return, the charity would agree to pay an annuity to a third party if she survived the donor. The annuity would not be assignable, revocable, or commutable (except for no consideration to the charity). Should the annuitant predecease the donor, the charity would receive the IRA balance without obligation. In PLR 200230018, a donor sought out IRS approval for this plan. The IRS noted that while the value of the IRA would be included in the donor’s gross estate at death, his estate could claim an estate tax charitable deduction for the IRA’s value, decreased by the present value of the annuity. And, better yet, the IRA proceeds would be income in respect of a decedent (IRD) to the charity, and not IRD to the donor’s estate. Consequently, the IRA proceeds would not be taxed because of the charity’s exempt status. The donor also asked the IRS to rule that the annuitant’s “investment in the contract” [IRC Sec.72(c)] is equivalent to the IRA proceeds conveyed to the charity, reduced by the estate tax charitable deduction. The IRS declined to rule on this “hypothetical” issue. The unresolved question is whether the annuitant would be entitled to the income tax deduction for estate tax paid on IRD [IRC Sec.691(c)]. If the answer is no, the annuity payments would be fully taxable, thereby discouraging testamentary gift annuities when the estate is subject to federal estate tax. In a similar ruling involving an IRA bequest to a charitable remainder trust, the IRD deduction was only available to the trust, not the beneficiaries [PLR 199901023]. Because of the tier system applicable to charitable remainder trust payouts, this effectively delays, maybe indefinitely, the benefit of the IRD deduction to the trust beneficiaries.

Charitable Gift of the Remainder of a Qualified Terminal Interest Property

A qualified terminable interest property (QTIP) is property in a decedent’s estate that, even though the surviving spouse’s interest is subject to certain restrictions, can still qualify for the estate tax marital deduction (also includes property given to a spouse during life that qualifies for the gift tax marital deduction) [IRC Sec. 2056]. And the QTIP can be utilized to first provide for a surviving spouse, then for a charity, and not incur estate taxation. It is true that the future value of the QTIP remainder interest to charity itself does not qualify for an estate tax charitable deduction when the decedent dies. However, the value of that remainder interest is shielded from the estate tax nonetheless because the entire transfer qualifies for the marital deduction in the decedent’s estate. Upon the death of the surviving spouse, the value of the remainder interest will be included in the now deceased spouse’s estate, but the charitable gift of that remainder interest qualifies for an estate tax charitable deduction.

In Conclusion

Historically speaking, Americans have proven to be generous givers to charities, even in challenging economic times. It is important to know different options for charitable giving available to your clients. With help from professional advisors, donors can fulfill their charitable goals in a way that best meets their personal plans as well.