Dealing with a 1% IRS Discount Rate
The trend of the ultra-low IRS discount rate introduces some risk to charitable gifts – specifically, it increases the likelihood that some gifts won’t pass tests that have been deemed important. Additionally, the current 1.0% rate could pose a particular problem if it persists after September 30 and the 1.2% look back is no longer available.
Here are some tips on how to manage particular gift vehicles that fail to qualify as charitable gifts.
Charitable Gift Annuities
In the case of a gift annuity, if a charity issues an annuity in spite of the failure to meet the 10% test, the charity will be deemed to be issuing commercial insurance. Consequently, the annuity transaction will be a taxable arrangement to the charity subject to burdensome state regulation as commercial insurance.
Using ACGA rates adopted January 1, 2012 a one-life immediate CGA will fail if the annuitant is age 54 or younger. A two-life immediate annuity will fail if the annuitants are both age 60 or younger. If a CGA fails the 10% test, Planned Giving Manager will offer to recalculate the annuity rate so that it passes the test. This is the best solution if the donor wants to do an immediate annuity. You can also tweak out a bit higher deduction if you make the payments less frequent.
Another solution is to use a deferred annuity. For example, if a couple of two individuals both age 60 defer payments until they are both 68, the annuity will pass the 10% test with a 1% discount rate.
Charitable Remainder Trusts
In the case of a remainder trust, failure to meet the 5% probability test or the 10% test means that the remainder trust is not a tax-exempt entity and instead taxable as a complex trust. It also means the donor will not receive an income tax charitable deduction. If funded with appreciated property, the capital gain on sale of the donated property will be taxable to the donor.
The charitable remainder unitrust is relatively unaffected by the discount rate. A 5% CRUT fails the 10% test with two beneficiaries both age 39. It’s unlikely most donors or charities would consider a unitrust for such young beneficiaries anyway.
The low discount rate most seriously implicates the charitable remainder annuity trust. Keep in mind that there are less than 20,000 annuity trusts in existence. There are very few annuity trusts situations to deal with compared to gift annuities and unitrusts.
A 5% annuity trust will fail the 5% probability test with a 1% discount rate with one beneficiary age 75 or two lives age 77. The solution in these cases has historically been to use a fixed-term or a combination of lives or fixed-term. Unfortunately, a 5% annuity trust paying for a fixed term of 20 years generates a deduction that is only about 9.5% of the principal. A fixed term of 19.5 years (fractional years are permissible) passes the 10% with a deduction of a little over 11%.
Another solution for charities working with two lives is to use a combination of lives and fixed terms. For example, two lives age 77 fails the 5% probability test. A term that pays first to a beneficiary age 77 and then for a term of a second beneficiary age 77 or a term of 10 years, whichever is shorter, passes the 5% test. That means the trust will pay to the first beneficiary for life. On the death of the first beneficiary, the trust pays to the second beneficiary for 10 years or the second beneficiary’s death whichever comes first. The fact is the second beneficiary is unlikely to outlive the first beneficiary by 10 years so you essentially have a two life CRAT.
Charitable Lead Trusts
A 1% discount rate environment is perfect for a lead trust. In lead trusts, the lower the discount rate, the higher the lead trust deduction. A 1% discount rate means a non-grantor or a super lead annuity trust for a fixed-term of 20 years can pay 5.5416% and generate a 100% deduction. That means that so long as the trust earns 5.5416% for the 20 year term, the assets in the lead trust will be preserved and pass to the donor’s heirs completely free of gift and estate tax.