A Timely Strategy
Charitable Valuations Under Section §7520
by Robert L. Moshman, JD
Year-End Planning:
A review of traditional year-end planning strategies involving trusts and estates
Reforms Ahead:
A summary of proposed legislation affecting charitable giving, pensions, and the repeal of the estate tax
COLA 2003:
Projected Cost of Living Adjustments for 2003
he 4.2% October rate for the valuation of split interest charitable gifts under section §7520 is as low as the rate has gone since the adoption of §7520 in 1989. This presents an opportunity for a number of estate-planning strategies to be implemented.
Of particular interest, grantor remainder annuity trusts (GRATs) and charitable lead annuity trusts (CLATs) are more effective when rates are lower. A gift of a charitable remainder in a residence is also favorable under lower rates. However, there are other strategies that are negatively affected by lower rates. In fact, when rates are this low, it may be difficult to meet certain critical thresholds to qualify for charitable deductions.
A Context for §§7520
The value of annuities, life estates, term interests, remainders and reversions for estate, gift and income tax purposes is determined under Code Section §7520. The Applicable Federal Rate (AFR) or §7520 rate is the rate of return that the IRS assumes taxpayers will realize on an asset. If the actual return turns out to be higher, the additional income passes to heirs free of additional transfer taxes.
The IRS issues the rates on a monthly basis. Having the §7520 rate dip to 4.2% is remarkable. Five months earlier, in May, 2002, the rate was 6.0%. In fact, the §7520 rates remained above 6.0% from their inception in 1989 through the end of 1998. The highest the rates have ever gone was 11.6% in May, 1989. As an indication of how rates have fluctuated, here are rates from January of each year since the rates were established:
January 1989: 10.0%
January 1990: 9.6%
January 1991: 9.8%
January 1992: 8.2%
January 1993: 7.6%
January 1994: 6.4%
January 1995: 9.6%
January 1996: 6.8%
January 1997: 7.4%
January 1998: 7.2%
January 1999: 5.6%
January 2000: 7.4%
January 2001: 6.8%
January 2002: 5.4%
Sources: Tiger Tables at http://www.tigertables.com/§7520.htm. The IRS also posts rates at: http://www.irs.gov/tax_regs/fedrates.html.
Spotlight on CLTs
The charitable lead trust (CLT) never looked so good. A charitable lead trust makes a charitable gift up front in the form of an annuity or unitrust that is paid to a charity for a term of years. The remainder interest is a taxable gift that is valued when the trust is established.
When interest rates are low, the gift tax on the remainder is reduced. This is true even though the actual rate of return may turn out to be much higher than the assumed rate under §7520. A much larger remainder will reach the beneficiaries free of transfer tax. For the charitably inclined donor, this presents a great opportunity to accomplish multiple purposes:
Making a charitable gift that helps a charity immediately;
Keeping valuable property in the family for the future;
Minimizing transfer taxes on the remainder interest; and
Keeping all future appreciation on the transferred property out of the donor's taxable estate.
Note that there is no income tax deduction with the CLT. However, the income from the property goes directly to the charity and is not taxed as income to the donor in the first place.
Preferred Strategies
In addition to CLTs, the gift of a remainder interest in a personal residence, with a retained life estate, can be especially favorable while interest rates are low. Such an arrangement enables the donor to remain in the personal residence for the rest of the donor's life. The donor is entitled to an income tax deduction for the value of the remainder interest. The lower the §7520 rate, the higher the value of the remainder, and the higher the income tax deduction to the donor.
For example, a 70-year-old donor transfers a remainder interest in his personal residence to a charity. The property is worth $1 million. The land alone is worth $500,000 and the residence is worth $500,000. If the gift is made when the §7520 rate is 8%, the income tax deduction is $361,675. But if the §7520 rate is 4.2%, the income tax deduction jumps to $516,400. Source: Larry Katzenstein, commentator for Stephen Leimberg's financial website.
A Few Caveats
Rates will not remain low forever. As rates move higher, the relative merits of a given strategy must be reconsidered. Note that charitable giving arrangements can utilize the 4.2% October rates for gifts made during October, November and December.
In addition, note that while some strategies benefit from low interest rates, there are other strategies which suffer when rates are low. Some of these strategies may have to be postponed on a case by case basis. For example, a charitable gift annuity or a charitable remainder annuity will provide the donor with a smaller income tax deduction when rates are very low. Unitrusts, however, are not affected by changes in the interest rate.
Another issue to be aware of is the requirement that with charitable remainder annuity trusts, the charitable remainder must be at least 10% of the value of the assets transferred to the trust. There must also be no more than a 5% chance of the trust being exhausted before the remainder interest vests. And for charitable gift annuities, the value of the annuity must be less than 90% of the value given to the charity in return for the annuity. Low interest rates can make it difficult to meet these tests.
Year-End Planning Basics
Year-end planning is always a multi-faceted exercise, but this year the possibilities of a double dip recession and a potential war have entered the equation as well. Nevertheless, there are always new variables to speculate about, but real planning has to focus on the actual facts that exist and the nuts and bolts of the rules that actually apply. Here, then, are several traditional reminders pertaining to year-end estate and gift tax planning.
Gift Tax: The annual gift tax exclusion of $11,000 is available each year, but if it is not used by the end of the year, it is forfeited for that year. Taxable estates should not lose the opportunity to easily transfer out of the estate without transfer tax consequences. Gift splitting and multiple beneficiaries should be used to maximize tax-free gifts. Making such gifts years in advance also helps keep all future appreciation on such assets out of the transferor's taxable estate.
Income and Deductions: The timing of income and deductions can be adjusted based on the circumstances. For example, where income is very high in the current year, it would generally make sense to postpone some of the income and accelerate any deductions. Bunching deductions in a particular year so as to have deductions exceed the 2% of income threshold can be useful as well.
Income and Estates: The income tax liabilities of estates and the beneficiaries of estates should also not be overlooked. When beneficiaries are in lower tax brackets than the estate, it may be possible to have distributions of income to beneficiaries so that the estate gets a deduction for the current year even though the income is not reported by beneficiaries until the following year. Distribution of certain capital gains to beneficiaries who have offsetting losses can also be effective. To be in a position to utilize such strategies, however, an executor would first have to determine the cash needs of beneficiaries, and project taxable income (and tax brackets) for the estate, trusts, and heirs.
Capital Gains: Accelerating the recognition of a loss can offset capital gains. Coordinate the payment of state and local capital gains taxes with those years when the alternative minimum tax does not apply so that the AMT won't diminish the available deductions.
Investment Techniques: Selling under-performing stocks is one way to convert a paper loss into a loss that can be used to offset gains. It is even possible to replace losing positions with similar assets, thus recognizing the loss but maintaining the portfolio mix that is preferred. "Wash sale" rules must be observed however. One must not purchase a stock or bond that is substantially the same within 30 days before or after the sale.
Reforms Ahead
Charitable Giving Legislation
Prospects may be improving for a bill that would expand tax incentives for charitable giving. Senate Majority Leader Thomas Daschle (D-S.D.) indicated in mid-September that he hoped to reach an agreement to limit debate on the bill. The Senate's version of the bill would provide about $8 billion of charitable giving incentives. One potential change that will get a great deal of attention involves a two-year deduction for charitable donations by individuals who do not itemize their deductions. Other key provisions would permit individual retirement account rollovers for charitable purposes with no tax penalty and individual development accounts that allow for the establishment of tax-deferred savings accounts for charitable purposes. Additional provisions limit certain corporate tax shelters. A variety of amendments are being considered. One would increase the limit on a private foundation's direct holdings in a corporation from 2% to 5%. Duplicate reporting requirements were also addressed. The House of Representatives has previously passed their own version of the bill, the Charity Aid, Recovery, and Empowerment (CARE) Bill of 2002 (HR 7).
Estate & Gift Tax Return Phone Line
The Estate and Gift Tax Department of the IRS has a new toll-free customer service phone line. Estate and gift tax return filers may contact the IRS at the Cincinnati processing center by calling (866) 699-4083. This number is intended to assist taxpayers with account-related calls regarding Form 706 (Estate Tax) or Form 709 (Gift Tax) returns. Thus, inquiries on the status of an estate tax return filing, claims, amended returns or extensions would be appropriate. General inquiries on estate and gift tax law should be directed to the general assistance number: (800) 829-1040. Note that there is also a new estate and gift tax section with frequently asked questions on the IRS website: http://www.irs.gov/. Assistance is available Monday through Friday from 7:00 am until 7:00 pm.
Make Repeal Permanent
A sense of the House resolution to make the repeal of the estate tax permanent was supported by a 242 to 158 vote in the House of Representatives on September 19, 2002. The House previously voted to make the repeal permanent when it passed the Permanent Death Tax Repeal Bill of 2002 (H.R. 2143) on June 6, 2002, by a vote of 256-171. President Bush has also favored making the repeal permanent. However, the vote fell six votes short in the Senate on June 12 and it is not likely to reconsider this issue until 2003.
Pension Reform Legislation
Pension reform legislation is moving ahead. A pension reform package was presented by President Bush in February 2002. The House of Representatives passed a version of this legislation in April. In July, the Senate Finance committee approved the National Employee Savings and Trust Equity Guarantee Bill (S1971). This legislative initiative is intended to provide protection of pension plan participants in the wake of the Enron scandal. Provisions address the diversification of plan assets, worker protection during plan blackout periods, information assistance to plan participants, expanded disclosure of insider trading and executive compensation. There is also a moratorium on the collection of employment taxes on the exercise of incentive stock options or under employee stock purchase plans. Senate Majority Leader Tom Daschle expects the Senate to approve a modified version of the bill before the end of the current session.
COLA Projects for 2003
The Department of Labor's release of the Consumer Price Index for August 2002 was the last figure needed to compute inflation-adjustments for 2003 tax rates, deductions, and credits. Commerce Clearing House has projected the inflation-adjusted figures for 2003, including the following:
Gift tax exemption: Remains at $11,000.
Generation-skipping tax exemption: Up from $1,100,000 to $1,120,000.
Estate tax interest: estate tax interest reduction (also up from $1,100,000 to $1,120,000).
Special use valuation: Up from $820,000 in 2002 to $840,000.
Attorneys fees: Attorneys' fee awards remain capped at $150 per hour.
Charitable organizations: In 2003, allowable de minimus benefits are up from $7.90 in 2002 to $8.00 before unrelated business income is triggered. A contribution of the lesser of $79 or 2% is fully deductible in 2002; this rises to the lesser of $80 or 2% in 2003.
Qualified funeral trusts: For contracts entered into for qualified funeral trusts to cover burial expenses, the maximum contribution is $7,800 (up from $7,700 in 2002).
Expatriation presumptions: Tax avoidance is presumed for expatriates with average annual net income tax liability for the five year period before the loss of citizenship of $122,000 in 2003 (up from $120,000 in 2002); or net worth exceeded $608,000 (up from $599,000 in 2002).
More Reforms To Follow
Vice President Cheney said that President Bush was considering a tax reform package for next year as a means of strengthening the economy. Among the potential areas are a capital gains tax cut and the elimination of the double taxation of dividends.
© MMII.10 K.S.
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