2011 Planned Giving Year-In-Review

In the wake of the dramatic changes to the federal gift and estate tax laws brought about by the enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the "2010 Tax Relief Act"; P.L. 111-312) at the end of 2010, 2011 was relatively quiet. It brought few statutory changes on the charitable giving front, aside from the expiration of certain tax provisions noted below. Nevertheless, new case law, Internal Revenue Service rulings and economic trends have provided more than a few topics for discussion in this update. Meanwhile, with the 2010 legislation set to expire at the end of 2012, we anticipate more excitement on the horizon.

Expiration of Tax Laws Relating to Charitable Gifts

The following charitable giving incentives, which had most recently been extended by the 2010 Tax Relief Act, expired on December 31, 2011:

Tax-free distributions from IRAs for charitable purposes Favorable basis adjustment to stock of S corporations making charitable contributions of property Increased contribution limitations and carryover periods for charitable contributions of qualified conservation property Enhanced charitable deductions for contributions of food inventory, book inventories to public schools, and corporate contributions of computer equipment It is currently unclear whether Congress will act this year to retroactively extend or make permanent any of the above provisions.

Also as a result of the 2010 Tax Relief Act, the Pease limitation on itemized deductions, which effectively reduces by 3% a taxpayer's total itemized deductions to the extent that his or her adjusted gross income exceeds a designated level, is ineffective for 2012. The Pease limitation is set to return in 2013.

Historically-Low Interest Rates Impact Planned Giving Options

Market interest rates have dropped significantly since 2007 and are currently hovering at historic lows. This reduction in rates has led to a corresponding reduction in the Section 7520 Rate ("7520 Rate"), which is used to value the charitable and non-charitable interests created by certain planned giving arrangements, such as charitable lead trusts, charitable remainder trusts, charitable gift annuities and gifts of a remainder interest in real estate. The 7520 Rate for both February and March 2012 is 1.4%. A low 7520 Rate makes some planned giving structures more advantageous, and makes others less attractive or even unavailable to some donors.

Charitable Lead Annuity Trusts (CLATs): A low 7520 Rate makes CLATs particularly attractive to donors. The value of the charitable interest, and the corresponding income, gift or estate tax deduction for the donor, is equal to the present value of the annuity stream the charity expects to receive. This value, and hence the donor's charitable deduction, increases as the 7520 Rate decreases. The other impact of a decreasing 7520 Rate is that the value of the non-charitable interest decreases. Therefore, if the donor provides that the non-charitable interest will benefit someone other than herself, the value of the donor's gift for gift tax purposes would be lower in a low-interest rate environment, potentially resulting in gift tax savings for the donor.

To illustrate these points, consider a donor who funds a $1,000,000 10-year CLAT providing for a 10% payout to charity with the remainder payable to the donor's children at the end of the term. If the CLAT's investments earn 6% annually over its 10-year term, the following table depicts the results based on the 7520 Rate in effect at the time of contribution:

7520 Rate

2%

4%

6%

Tax Deduction

$898,300

$811,000

$736,000

Amount of Taxable Gift

$101,700

$189,000

$264,000

Amount Passing to Charity

$1,000,000

$1,000,000

$1,000,000

Amount Passing to Children

$472,800

$472,800

$472,800

Although in each of the above examples the charity and the children receive consistent amounts from the trust, in the lowest interest rate environment the donor will obtain the largest gift tax charitable deduction and thus can transfer property to her children at the lowest gift tax cost.

Charitable Remainder Annuity Trusts (CRATs): Conversely, a lower 7520 Rate will result in a smaller income tax charitable deduction for a donor who establishes a CRAT. More importantly, CRATs have been significantly impaired by low 7520 Rates because of the "5% exhaustion test." This test provides that there must be a 5% or lower probability that the CRAT's assets are exhausted before a distribution is made to charity at the end of the term. For purposes of this test, the 7520 Rate is the CRAT's assumed annual investment return over its term. Accordingly, if the 7520 Rate is below the CRAT's annuity rate, which must at a minimum be 5% of the initial value of the trust regardless of market conditions, this results in some possibility of exhaustion. If the difference between the two rates is small, the CRAT may still be able to pass the 5% exhaustion test. However, at the 7520 Rate's current level, which is well below the CRAT's minimum 5% annuity rate, this test is difficult to pass. Thus, only a CRAT with a short term will satisfy the test. For example, if the 7520 Rate is 2%, a 5% CRAT cannot be designed to make annuity payments for the lifetime of any person who is younger than 72 years old. Likewise, a 7% CRAT cannot be designed to make annuity payments for the lifetime of any person who is younger than 82 years old.

Charitable Gift Annuities (CGA): All other factors being equal, a low 7520 Rate will reduce the actuarial value of the charitable gift associated with a CGA, as well as the corresponding income tax charitable deduction available to the donor. Because charitable organizations set their CGA annuity rates based on prevailing market interest rates, a CGA purchased when interest rates, and hence the 7520 Rate, are low will also generally pay a lower annuity rate than one purchased when rates are higher. (See the discussion below regarding the ACGA's downward adjustment to its recommended annuity rates.) The silver lining is that the donor's contribution for the annuity contract is higher relative to what the annuitant receives, thereby increasing the investment in the contract and reducing the income tax...