Previously, as part of our series of articles, The 2020 Estate Planning Trifecta and Sprints, Marathons and Hurdles: Estate Planning Techniques for 2020, we explored short-term and long-term estate planning strategies as well as the development of appropriate trust governance that would benefit from the current environment of historically low interest rates and highly-favorable tax laws. This combination, along with thoughtful planning, can allow for potentially significant wealth enhancement for multiple generations.

In this final article of our series, we take a look at the impact and benefit of low interest rates on planning strategies to accomplish philanthropic legacies while maintaining the opportunity for generational wealth to benefit future generations of your family.

Interest Rates and Their Impact on Philanthropic Strategies
Each month, typically in the middle of the month, the Internal Revenue Service (IRS) issues a Revenue Ruling setting out the following month’s Applicable Federal Rate (AFR) and the § 7520 rate. These rates have reached historic lows in recent months as a result of the economic slowdown associated with the COVID-19 pandemic. In October, the rates ticked up slightly but remain very low as can been seen in the accompanying chart showing the October 2020 rates.

The § 7520 rate, calculated as 120% of the mid-term AFR rate and currently at .4%, is used for valuing the transfers to split-interest trusts often used in philanthropic strategies such as a Charitable Remainder Trust or Charitable Lead Trust. Split-interest trusts provide an income benefit for an initial period of time to the income beneficiary, which is the charity or family member depending on the strategy utilized, followed by a remainder interest that upon the expiration of the income period is distributed to the ultimate beneficiaries, again either a family member or charity depending on the strategy utilized.

Charitable Remainder Trusts
Charitable Remainder Trusts (CRTs) are designed so that the grantor of the trust receives income each year from the trust as either a fixed annuity payment or as a percentage of the annual trust assets. The charity at the end of the income term will then receive the remainder of the trust assets.

CRTs are tax-exempt and often utilized as a way to minimize capital gains taxes upon the sale of a highly-appreciated asset. However, a deal so sweet comes with a dose of bitter. In this case, the lemons are the requirements under the code for qualifying a trust as a CRT and the impact of low AFR rates on the likelihood of that success.

For a trust to qualify under the tax code as a CRT, it must be designed to survive an actuarial calculation that ensures that at least 10% of the initial contribution would be available for the charity as the remainder beneficiary. The calculation takes into account the term, the proposed payout percentage or annuity amount and the § 7520 rate.

The payout percentage must be a minimum of 5% and not more than 50%. The term selected, which may be for life or a period of years, also impacts the qualification. If a fixed number of years is selected, it can be no more than 20 years. The longer the term, the smaller the percentage remaining at the end of the term for charity. Unfortunately, during periods of low AFR rates, it is often difficult to qualify as a CRT under the rules.

For example, a married couple, both age 70, propose creating a CRT. They want to fund it with $1,000,000, use the October 2020 rate of 0.4% and have the proposed CRT pay to them an annuity payment of $60,000 each year during each of their lives. Under those terms, the proposed CRT would not qualify.

If they decreased the annuity payment to $50,000 a year during each of their lives, the proposed CRT would then qualify. However, as an additional example of how severely the low AFR rates impact the ability of a proposed CRT to qualify, if all other things remain the same, simply proposing a CRT when our married couple are both age 69, would cause the proposed CRT to not qualify.

Charitable Lead Trusts
Charitable Lead Trusts (CLTs) are the opposite of a CRT. A CLT is designed so that the charity receives income each year from the trust during the trust term. The CLT must state whether the amount paid to the charity is to be calculated as either a fixed annuity payment or as a percentage of the annual trust assets. The remainder beneficiaries, typically children, will then receive the balance of the trust assets at the end of the income term.

CLTs are not tax-exempt and are more often used as a means of reducing the gift/estate exemption allocated to the value of the interest of the remainder beneficiaries. It is possible to reduce the gift or estate amount to zero; therefore using none of the gift or estate exemption. Jacqueline Kennedy Onassis famously used a CLT in her will to provide for benefits initially to charity and ultimately to her family.

Using a CLT allows us to turn the lemons of low AFR rates into lemonade. The amount of gift or estate exemption necessary to cover the remainder interest of a qualified CLT decreases when AFR rates are low.

To qualify as a CLT, the trust must:

• Be irrevocable;
• Have either a set term of years, be measured by the lives of one or more persons living at the time of the trust creation or a combination of the two. Example, for the joint lives of husband and wife but for a minimum period of 10 years;
• Direct that during the trust term the guaranteed payment of either an annuity or unitrust interest be made to a charity.

Unlike with a CRT, there is no minimum payout percentage. In addition, there is no minimum charitable interest required.

To show how a lifetime CLT might benefit both charity and beneficiaries, let’s bring back our married couple, both age 70. They propose creating a CLT with $1,000,000, using the October 2020 rate of 0.4% and paying to charity an annual annuity payment of $60,000 until the death of the survivor of the two of them, at which time the remaining balance will be distributed to their children. In addition, let’s assume that the trust assets grow at a rate of 6%.

Using the CLT, the value of the gift of the remainder interest to the children is approximately $115,000. However, the children would actually receive $1,000,000 based on the assumed growth rate at the termination of the CLT.

If, instead of their lifetimes, the trust term was fixed at 20 years, our couple would avoid using any of their gift exemption simply by reducing the assumed annual annuity payment to the charity to $52,130. In addition, at the end of the 20 years, assuming the same 6% growth rate of the CLT assets, the children would receive a distribution of approximately $1,289,000.

Conclusion
Both Charitable Remainder Trusts and Charitable Lead Trusts can be excellent strategies for achieving an affluent family’s twin goals of philanthropic legacy and multi-generational wealth enhancement. However, the interest rates at the time of creation greatly impact the decision of which strategy is a lemon and which is lemonade. Under the current low interest rate environment, many families are choosing to drink from the Charitable Lead Trust pitcher.

The impact of interest rates on these decisions, as well as your goals and objectives, should be discussed with your Oxford team of advisors, who are available to coordinate the optimal solution for you and your family.

The information in this presentation is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. The opinions expressed are those of Oxford Financial Group, Ltd. The opinions are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Oxford Financial Group, Ltd. is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Carmel, Indiana. Registration does not imply a certain level of skill or training. OFG-2010-14