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Wednesday, May 8, 2024
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Case Studies |
Sailing with the Rate of the Month
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Case:
Robert and Mary Smith, 78 and 76, respectively, are both retired engineers. In addition to their work careers, both Robert and Mary have participated significantly with charities. Robert was a long-time lover of ships and sailing. In fact, he actually sailed across the Atlantic at one point in his life. His passion for sailing resulted in his active involvement on the board of a sailing preservation society. Mary, on the other hand, loved the arts. While Robert was off sailing to Europe, she flew ahead and used her extra time to explore all of the major art museums in Europe. Her passion for art led her to join the board of a regional art museum.
At this point in their lives, Robert and Mary truly enjoy the time they spend together and the time they spend involved with their charities. Wanting to help financially with the expansion of their beloved charities, they decided to fund a charitable remainder annuity trust (CRAT) with $1 million of appreciated stocks. The CRAT would pay 6% annually ($60,000) for Robert's and Mary's lifetimes. In addition, the trust would generate a very large income tax deduction. Upon viewing the proposal, the Smiths quickly questioned the use of a particular interest rate or rate of the month used in computing their charitable deduction.
Question:
What is this rate, why is it used, and how is it determined?
Solution:
A gift to a charitable remainder trust or for a charitable gift annuity is deemed a split-interest gift because the donor gives an interest in the property, yet, at the same time, retains an interest in the property (in the form of an income stream). Not surprisingly though, donors desire a charitable income tax deduction today for the interest they gifted to charity. Fortunately, the tax code does allow for such a deduction. See I.R.C. Sec. 170. However, the next logical question is "How much did I give to charity?"
How much a donor gives begins with the fair market value of the property (determined, when appropriate, by a qualified appraisal). Here, the Smiths gave $1 million of stock to a CRAT but retained a two-life income stream. Therefore, we must calculate the present value of a 6% CRAT based upon the ages of the Smiths, 78 and 76. In other words, we must determine what the Smiths did not give away to charity. Once we have that figure we can subtract it from the $1 million transfer to arrive at the charitable contribution.
The valuation of an annuity, any interest for life or a term of years, or any remainder interest shall be determined under tables provided by Treasury. See I.R.C. Sec. 7520. The issued tables are based upon life expectancies recomputed approximately every 10 years. When calculating the value of an annuity under the mortality tables, we are required to discount the future annuity payments at the interest rate in effect when the gift is made. This is where the Applicable Federal Rate ("AFR") (a.k.a. Rate of the Month, Sec. 7520 Rate, Discount Rate, and Federal Mid-term Rate) comes into play.
The Treasury Department issues this rate every month. The rate represents 120% of the interest rates paid on medium term (3-9 years) government securities. To add flexibility, Sec. 7520 allows donors to elect either the AFR in effect for the month in which the gift was made or for either of the two preceding months. This option allows donors and their advisors to do some planning since the choice of AFR can have a significant effect on the charitable deduction. For example, the Smith's charitable deduction with a 6.2% AFR was $476,000. If they had chosen an AFR of 5.8%, their deduction would have been only $463,000. This difference of $13,000 was caused merely from choosing among three possible AFRs. As a general rule, a higher AFR will produce a higher deduction for charitable remainder trusts and charitable gift annuities. Conversely, a lower AFR will produce a higher deduction for charitable lead trusts and life estates.
Feeling fully educated (and maybe a little sorry for asking), the Smiths proceeded to create their CRAT with their block of stock. They wisely chose the highest AFR. Lastly, since Robert and Mary each had a favorite charity to benefit, the CRAT remainder value at the end of their lives (approximately $1.5 million) will be divided equally between the sailing preservation society and the arts museum.
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