16-Page Expanded Beach Reading Issue

Background. The valuation of charitable remainders (for unitrusts, annuity trusts, personal residences and farms), of charitable lead annuity trusts and lead unitrusts, and the gift portion of charitable annuities is determined by using the charitable mid-term federal rate (CMFR) for the month of the gift—or either of the two prior months at the donor’s election.

The CMFR is also used for determining the 10%-minimum-remainder interest (MRI) requirement for CRUTs and CRATs; also for determining whether the gift portion of a gift annuity is more than 10%.

Another also: For determining compliance with the 5% probability test (Rev. Rul. 77-374) for charitable remainder annuity trusts, the CMFR is also used.

Alert. If you plow through this stuff, you will see why I believe it could be dangerous to use the two-month lookback for determining whether the 10% MRI requirement is met.

Observation. Aren’t all these rules and the jargon beautiful to behold? And this is just the tip of the IRSberg.

Warning. This isn’t light reading. But if you want to know the ins and outs of valuing charitable split-interests and meeting the various requirements, read on.

Charitable Mid-Term Federal Rate—more background. Donors who create split-interest charitable gifts are allowed charitable tax deductions (income, gift and estate) for the value of the charity’s interest computed using Treasury tables. The tables’ interest assumption is pegged to the federal mid-term interest rate, based on the average market yield of U.S. obligations. Each month, Treasury announces an Applicable Federal Rate (AFR). The interest rate for computing charitable gifts—a figure we call the Charitable Mid-Term Federal Rate (CMFR)—is 120% of the annually compounded AFR for mid-term obligations, rounded off to the nearest 0.2%. See page 16 for the most recent rates.

Two-month lookback—more rules. For gifts that have no charitable component—e.g., giving a child a remainder interest in a house—the donor uses the applicable rate for the month of the transfer. However, donors whose gifts are partially charitable (e.g., a charitable remainder unitrust) can use the CMFR for the month of the gift or can elect to use the CMFR from either of the two previous months. The two-month "lookback" can actually give a donor four months to choose from, because IRS publishes the CMFR ahead of time—generally about the 21^st day of the previous month.

Example. Melvin plans to create a charitable remainder annuity trust in July. He can wait until toward the end of July to see what August’s CMFR will be; if it would yield a higher deduction, he can wait until August before funding the trust. Or, if he funds it in July, he can use the July rate or elect to use the CMFR for June or May.

Pooled income fund—valuation. For the short story, see page 16.

WHY YOU SHOULD WATCH THE CMFR LIKE A HAWK—BRIEFLY STATED. The CMFR—like most things financial—goes up and down. In May 2008, the CMFR was on the low end—3.2%. Only once before has that rate been lower.

First the ugly. With a low CMFR, the 10%-minimum-remainder-interest requirement—especially for charitable remainder annuity trusts—is easily flunked. Ditto for the 5% probability test governing charitable remainder annuity trusts. For charitable gift annuities, the requirement that the gift portion be more than 10% is also easily flunked.

Although charitable remainder unitrusts are affected by swings in the CMFR, for reasons known to the actuaries the effect is much less significant.

Consequences. Flunking the 10% MRI requirement for charitable remainder unitrusts and charitable remainder annuity trusts and the 5% probability test for charitable remainder annuity trusts means loss of income, gift and estate tax charitable deductions—and the trusts aren’t qualified. Furthermore, if a spouse is involved, the marital deduction will also be lost. And for charitable gift annuities (including deferred payment and flexible starting date gift annuities), if the gift portion doesn’t exceed 10%, the charities will be taxed under IRC §514(c)(5) and 501(m). Not a good thing.

Can the 10% MRI requirement be met by using the CMFR for either of the two months preceding the month a CRAT or CRUT is created, or must the valuation be made using the CMFR for the month the trust is created? IRC §7520 says you can use either of the two preceding months for computing any income, estate or gift tax charitable deduction. It doesn’t say you can use either of those two months for determining whether the 10% MRI requirement is met. Yet IRC §664(d)(1)(D) and IRC §664(d)(2)(D) say the values for meeting the 10% MRI requirement shall be "determined under section 7520," and those Code sections don’t carve out the "either-of-the-two-preceding months" election. Another yet. IRC §664(d)(2)(D) provides: "with respect to each contribution of property to the trust, the value (determined under section 7520) of such remainder interest in such property is at least 10% of the net fair market value of such property as of the date such property is contributed to the trust." [emphasis added.]

A splendid argument can be made that for purposes of meeting the 10% MRI requirement, the remainder can be valued using the CMFR for either of the two preceding months or the month of the transfer. But do you want to have to make that argument to the IRS, or to a court? The words of Justice Oliver Wendell Holmes, Jr., in U.S. v. Wurzbach, 280 U.S. 396, 399 (1930) are instructive: "Whenever the law draws a line there will be cases very near each other on opposite sides. The precise course of the line may be uncertain, but no one can come near it without knowing that he does so, if he thinks." So unless clarification comes from the IRS, cautious individuals will make sure the 10% MRI requirement is met for the month of the transfer.

Fine hairs: For CRUTs and CRATs, the remainder interest (gift portion) must be at least 10%. But for gift annuities, the gift portion must be more than 10%. Oh, what fun.

Note: The 10%-minimum-remainder-interest rule doesn’t apply to pooled income funds.

Now for the beautiful. Charitable lead annuity trusts are treated most favorably when the CMFR is low. The value of the charity’s lead interest under a low CMFR is much greater than under a high CMFR. That makes the value of the remainder interest in the lead trust— that typically goes to family members—much smaller. Result: A charitable lead annuity trust can pass assets on to family members down the line at greatly reduced or no gift or estate tax. You’ll want to take the generation-skipping tax considerations into account.

Is a charitable lead annuity trust when the CMFR is low an abusive arrangement? The topic came up at the April 3, 2008 U.S. Senate Finance Committee estate tax hearing. In a statement that I prepared for the American Council on Gift Annuities and the National Committee on Planned Giving for the record of the hearing, ACGA and NCPG pointed out that the CMFR is a two-edged sword. Although it can now be highly advantageous to create charitable lead annuity trusts, the charitable deduction is especially low for charitable remainder annuity trusts. And there are many, many more charitable remainder annuity trusts than charitable lead annuity trusts. Back reference. For ACGA’s and NCPG’s statement to the Senate Finance Committee, see Charitable Lead Trusts, Taxwise Giving, May ‘08, pages 1 - 8.

Silver lining for gift annuities. With a low CMFR, the charitable deduction is now smaller than it had been. So what’s so good about that? For donors who create charitable gift annuities and take the standard deduction, the size of the charitable gift portion is irrelevant. However, a low CMFR means that the part of each payment excluded from income by the annuitant (under IRC §72) will be larger. Depending upon the circumstances, it may be preferable to choose (under the month of the gift and two-month lookback rule), the CMFR that has the lowest valuation of the charitable gift. On the other hand, if appreciated assets are used to fund the gift annuity, the capital gain—computed under the bargain sale rules—will be larger if the value of the charitable gift is smaller. Thus weigh the charitable deduction (whether it can be used or not), the exclusion ratio and the capital gains implications. Piece of cake!

How and when to make the lookback election. You make the election by: (1) stating to do so on the return for the year of the transfer; and (2) identifying the elected month. The election is generally made on a timely filed return, but it may be made or revoked on an amended return that’s filed within 24 months after the later of: (1) the date the original return was filed; or (2) the due date for filing the return. Reg. §1.7520-2(b)(1) through (3).

Information required with the tax return whether or not the lookback election is made. To claim a charitable deduction for a split-interest gift, the tax return must contain: (1) a description of the interest that is transferred, including a copy of the instrument of transfer; (2) the valuation date of the transfer; (3) the names and identification numbers of the beneficiaries of the transferred interest; (4) the names and birthdates of any measuring lives; and (5) a computation of the deduction showing the interest rate used to value the transferred interest. Also, if a measuring life is of a person who is terminally ill, that should be stated and explained. For a definition of terminally ill, see Reg. §1.7520-2(a)(4).

Valuation date. If you elect the two-month lookback, the month you look back to is the valuation date for purposes of determining the interest rate. Reg. §1.7520-2(a)(2). Donors who transfer more than one interest in the same property at the same time must use the same interest rate for each interest in the property transferred. Donors who transfer more than one interest in the same property in two or more transfers at different times value each interest by using the interest rate in effect during the month of the transfer, or either of the two months preceding the month of the transfer. Reg. §1.7520-2(a)(3). What is IRS driving at? I think the following example illustrates what the IRS has in mind:

Example. A donor funds her charitable remainder unitrust with securities. The trust pays income to her son for life with the remainder to charity. The donor must use the same month’s rate to value both the son’s and the charity’s interests. If the donor uses an undivided half-interest in real estate to fund the just-described trust (and assuming the IRS doesn’t believe that doing so would violate the self-dealing rules), she must still use the same month’s rate to value the son’s and the charity’s interests. But, if six weeks later, she transfers the other half interest to create another unitrust, that transfer has nothing to do with the first transfer. So the second trust’s interests are valued in the month of that transfer—or either of the two preceding months at the donor’s election. In short, the donor doesn’t use the month’s rate selected for the first trust to value the interests in the second trust.

Charitable remainder trust payout dates. If the governing instrument of a charitable remainder trust doesn’t specify when the distributions are to be made during the period, they’re presumed to be payable on the first day of the specified period. Reg. §1.664-4(a)(3).