Charitable Remainder Annuity Trusts: Is Time Running Out?
January 19, 2024
Contributors: Holly Allen, Tax Senior Manager | Britanny Tubbs, Tax Manager
Charitable trusts have long been a powerful tool for estate planning, but some tend to be more effective at tax savings than others in certain interest rate environments. The Charitable Remainder Annuity Trust (CRAT) is one that tends to perform better in relatively high interest rate environments. With the Federal Reserve’s recent signaling in December of expected rate cuts starting in 2024, now may be the best time to lock in the benefits of a CRAT before rates drop.
How Do CRATs Work?
A CRAT is a type of split-interest trust with two sets of beneficiaries:
- A noncharitable beneficiary – the grantor or family member who receives a fixed stream of annuity payments during the trust term
- A charitable beneficiary – who receives the remainder interest in the trust property at the end of the trust term
The grantor is allowed a charitable contribution income tax deduction in the funding year, which is valued based on the expected charitable remainder interest as long as the trust meets the requirements of Internal Revenue Code (IRC) Section 664(d) and the related regulations.
The annuity must be set up to pay, at least annually, an amount between 5% and 50% of the initial fair market value of the trust property. The trust term can be no longer than 20 years or for the life of the individual beneficiary or beneficiaries. The value of the remainder interest must be at least 10% of the initial fair market value of the trust property.
Annuity distributions are taxable each year to the noncharitable beneficiary and reported on Schedule K-1 from the trust to the extent of income earned by the trust. Distributions are taxed first as ordinary income to the extent of the trust’s current and accumulated ordinary income from prior years. Then, taxed as capital gains to the extent of the trust’s current and accumulated capital gain income from prior years.
Why Do Interest Rates Matter?
Valuing the charitable remainder interest in a CRAT requires the use of the Section 7520 interest rate, published monthly by the Internal Revenue Service (IRS) and IRS Publication 1457 actuarial tables. The January 2024 Section 7520 rate is 5.2%, down from December 2023’s 5.8% rate, which is the highest the Section 7520 rate has been since 2007.
When interest rates are high, the computed asset values at the end of the trust term available to pass to the charity, and thus eligible for income tax deduction in the initial year, will be higher than in periods when interest rates are low. In periods of extremely low interest rates, it may be difficult or impossible for the remainder interest to meet the minimum 10% initial value requirement.
Example
Jane is in the 37% federal income tax bracket. She wants to provide a $100,000 annual income stream to her son for the next 10 years, with the remainder passing to her favorite charity at the end of the trust term. She makes a $1,000,000 gift to a CRAT, while the Section 7520 interest rate is 5.8%. The present value of the annuity interest is $743,030, which is treated as a taxable gift on Form 709 gift tax return. The present value of the remainder interest is $256,970, which is deductible by Jane on her current income tax return. This saves her $95,079 in current federal income tax. The charitable remainder interest also reduces her taxable estate for estate and gift tax purposes.
If the Section 7520 interest rate had been 3%, the present value of the annuity interest would be $853,020, leaving the present value of the remainder interest $146,980. Jane’s charitable contribution deduction would be $109,990 less, and the current gift amount on Form 709 would be $109,990 higher than in the 5.8% rate example.
Donation of Appreciated Property
One way to increase the tax benefits of a CRAT is for the grantor to contribute appreciated stock or other capital gain assets instead of cash to fund the trust. This can defer recognition of capital gains tax on the donated assets, while the grantor benefits from the relatively high market value of the donated assets in determining the current charitable contribution deduction.
Beware of strategy promoters who claim that capital gains can be completely avoided using a CRAT. This is generally not the case. The IRS has listed these strategies on its annual Dirty Dozen list of potential tax frauds.
CRATs vs. CRUTs
The Charitable Remainder Unitrust (CRUT) is another option to consider. CRUTs work similarly to CRATs, but instead of a fixed annuity payout over the trust term, a CRUT pays a percentage of the trust asset value (unitrust amount) each year. This means the payout amount is variable and must be recomputed each year as trust asset values change. Additionally, CRUTs are much more interest-rate neutral than CRATs. Changes in the Section 7520 rate have had much less of an impact on computed remainder values versus CRATs.
Ideal Time for a CRAT
While it appears that interest rates may have peaked and started trending downward in the current cycle, it may not be too late to lock in CRAT benefits if you act quickly. A grantor may elect under IRC Section 7520(a)(2) to use the Section 7520 rate for either of the two months preceding the month of transfer. Thus, a CRAT contribution made by February 29, 2024, could be valued using December 2023’s 5.8% rate if beneficial.
Your Guide Forward
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Related Guidance
2023 Year-End Tax Planning Checklist for Individuals
Controlling Income Recognition using a Charitable Trust