July 23, 2010
Authored by: Kim Civins
The rate that the IRS uses to calculate the present value of an annuity has dropped to 2.6% for August. This is historically a very low rate, as just two years ago the rate was 4.2% and within the last decade the rate reached 8.2%. Clients are generally aware that such low rates present estate planning opportunities for vehicles such as Grantor Retained Annuity Trusts, where the ability of the trust to obtain an investment yield higher than 2.6% presents real family wealth transfer opportunities. However, clients with charitable intentions need to be aware that the same low interest rate is of substantial benefit in family wealth planning involving CLTs.
A CLT is both a family wealth transfer vehicle, as well as a charitable giving vehicle. A trust is established which pays an annuity to charity for a period of years, and at the end of that term of years, any left over assets belong to the client’s heirs. Usually, a CLT is structured so that the current fair market value of the annuity payments to charity substantially reduces or eliminates the gift tax upon formation, so that after the annuity stream is completed, the remaining assets belong free of gift or estate tax to the heirs. In this structure, the lower the IRS-assumed interest rate, the easier it is to achieve the desired gift tax result and the more likely it is that substantial assets will be left over after the required annuity is paid to charity. For an overview regarding the basics of lifetime CLTs, see A Primer on Lifetime Charitable Lead Trusts.
Here is an example of how a CLT would work at a 2.6% interest rate, as compared to a higher rate that is likely to prevail at some point in the future:An August 2010 funding of a 10-year $1 million CLT which is structured to have a zero present-value remainder for gift tax purposes would require annual charitable payments of approximately $115,000. If the CLT actually grows at the August 2010 7520 rate of 2.6%, the children receive $0 at the end of the term. However, if the actual rate of return on the $1 million is 5.0%, the children receive about $184,000 free of transfer tax. Of course, if the actual rate of return is even higher, the children directly benefit even more.
Compare this result to the 7520 rate for two years ago, August 2008, when the rate was 4.2%. In the same scenario, to obtain the $0 present value of the remainder interest upon funding (to eliminate gift tax consequence) the CLT required payment of about $125,000 to charity each year, and if the actual return on the CLT was 5%, at the end of the term the children receive only $63,000. We potentially almost triple the net effect to kids for an August 2010 CLT as compared to a 2008 CLT with all other variables constant.
And, just for kicks, we ran the numbers on the 8.2% rate which was in effect in March 2000. The annual payments to charity would have had to be about $150,000 to zero-out the remainder interest so no gift tax consequence would result. There is a good chance any CLT funded then would have failed, as you would have had to have exceeded a return of 8.2% for the CLT to ultimately pass any wealth to lower generations. But, if you achieved a 10% return over the last 10 years (and if you did, please call us, you’ve just become our new financial advisor), you would have transferred almost $200,000 to your children free of transfer tax.
In a nutshell, today’s low interest rate environment helps CLTs succeed.