U.S. charitable giving reached record levels during the pandemic, with Americans donating $484.85 billion in 2021.1 Unfortunately, all signs point to a dramatically different landscape in 2022, as challenging economic and market conditions threaten donors’ wherewithal to give. Personal and business balance sheets have suffered from steep market losses—the worst start to the year for stocks since 1970. What’s more, inflation has hit its highest level in 40 years, fueling the Federal Reserve’s ongoing campaign to raise interest rates.
Faced with tighter budgets and decreased purchasing power, donors may be wondering how to maximize a charitable gift’s impact. With this in mind, let’s look at several giving strategies best suited to withstand the current economic pressures while providing meaningful benefits to both donors and charitable recipients.
Contributions of Appreciated Stock
Despite recent market volatility, many investors still own stock with current value that exceeds its original purchase price—especially for securities held for a decade or longer. Donors who sell such shares and fund a charitable gift with the proceeds would owe capital gains tax on this built-in gain. However, those making a direct charitable gift of the appreciated stock may avoid this tax, essentially amplifying the gift’s personal benefit.
As a rule, not all charitable gifts offer the same tax savings. Consider a donor in the top (37%) tax bracket who deducts the value of a $100,000 cash gift to a qualified charity (See “Tax Savings,” p. 41). The gift will reduce the donor’s federal income tax liability by $37,000, thereby cutting the effective cost of the gift (the value of the gift minus the tax benefit) to $63,000 (See “Cash” column in “Tax Savings.”) For donors paying state and local income tax, the effective cost could drop even lower.
Now let’s assume the same individual gifted $100,000 in publicly traded stock that was originally bought for $50,000. Here, the donor could also avoid the 23.8% tax on the stock’s $50,000 gain. The extra tax savings would cut the effective cost of the donation to $51,100 (See “50% basis stock” column in “Tax Savings.”) What if this individual contributed $100,000 in publicly traded stock acquired at no cost—perhaps from a donor-created business? The gift’s effective cost falls to $39,200, thanks to the additional tax savings. (See “0% basis stock” column in “Tax Savings.”) Ultimately, low basis stock remains a compelling, tax-efficient candidate for charitable giving regardless of market fluctuations.
Charitable Remainder Trusts
In addition to outright gifts to charity, split-interest trust strategies may provide donors with both short-term and long-term tax benefits. For example, a donor with appreciated stock might consider creating a charitable remainder trust (CRT). The CRT will make annual distributions to one or more noncharitable beneficiaries (including the donor and the donor’s spouse) for a term of up to 20 years or the life of one or more individuals. The annual distribution can be structured as a unitrust—a percentage of the trust’s asset value determined each year—or as an annuity based on the trust’s original funding level. In each case, the payout must be at least 5%, but no more than 50% of the trust value at payment or funding, respectively. Further constraining the maximum payout rate, the remainder charity must receive at least 10% of the trust’s initial funding amount on an actuarial basis. At the end of its term, the trust’s remaining assets will pass to charity.
Two key factors make CRTs incredibly income tax-efficient giving vehicles. First, on funding the trust, the donor receives a charitable income tax deduction equal to the value of the trust’s remainder interest. To determine this figure, the Internal Revenue Service calculates the present value of the trust’s aggregate noncharitable payments by applying a discount rate equal to 120% of the mid-term applicable federal rate—known as the Internal Revenue Code Section 7520 rate (Section 7520 rate). As interest rates rise, so does the Section 7520 rate, resulting in an increase in the charitable remainder interest’s value and the donor’s corresponding income tax deduction. This makes CRTs one of the few interest rate-driven planning strategies that benefits from a rising rate environment.
In addition to the immediate income tax benefit, a CRT allows donors to diversify highly appreciated assets in a tax-efficient manner. Due to the trust’s structure, a CRT is treated as a non-taxable entity, which enables it to sell appreciated assets without triggering an immediate capital gains tax. Instead, capital gains recognized on the sale will pass to the trust’s noncharitable beneficiaries over time as they receive their annual trust distributions, offering them the benefit of tax deferral.
Now let’s turn to donor considerations when creating a charitable remainder unitrust (CRUT). At the outset, the donor must initially determine how to structure the trust’s annual payments. With a traditional CRUT, the trust must pay out a set percentage of its asset value each year. Alternatively, a donor could consider a structure that pays out the lesser of net income and a set unitrust amount (such as a net income charitable remainder unitrust (NICRUT)), net income with makeup charitable remainder unitrust (NIMCRUT) or “flip” trusts that start as NICRUTs or NIMCRUTs and then convert to a traditional CRUT at a certain date or following an event. In each case, a higher payout would provide the trust’s noncharitable beneficiaries with a greater income stream while leaving less of a remainder for charity at the end of the trust term. As a result, there’s an inverse relationship between the payout amount and the donor’s upfront income tax deduction.
Next, the donor must identify an appropriate funding source for the trust. Highly appreciated public stock works well and is relatively straightforward. A donor might also consider contributing appreciated real estate. As interest rates continue to rise, the housing market may pull back, but at the time of this writing, real estate values remain elevated relative to historic norms. The aforementioned NICRUT, NIMCRUT or flip structures can ease payout pressures prior to selling a property. However, funding a CRUT with real estate may substantially complicate the transaction. Donors must obtain a qualified independent appraisal both at the trust’s creation and for each year of the trust’s term. They must also fund the trust with sufficient cash or marketable assets to underwrite the cost of maintaining the property. This holds particularly true if the property won’t generate rental income, although IRS rules do permit post-creation contributions. Further, the existence of a mortgage introduces a host of additional planning considerations. Donors should work closely with their tax and legal professionals to determine whether funding a CRUT with real estate makes sense for them.
How might a donor best evaluate these options and a CRUT’s likely impact over the long term? Consider a 65-year-old philanthropic couple based in New York City who wish to convert a capital asset into an income source for retirement (see “Which Can Create More Personal Wealth?” this page). The capital asset has a current market value of $5 million and zero cost basis. To achieve their goals, they could sell the asset outright, pay the associated taxes, invest the remaining proceeds in a diversified portfolio and then separately address their charitable aspirations. Alternatively, they can contribute the asset to a joint lifetime CRUT, diversify it inside the trust and defer the capital gains over time—all while supporting their charity of choice.
While exploring these scenarios, we evaluated annual payout rates of 5%, 8% and the maximum allowable rate of nearly 11.5%. We assumed a Section 7520 rate of 3.6% for purposes of the upfront charitable income tax deduction and that such deduction would be used to offset ordinary income in the first year of the illustration. Both the donors’ personal and CRUT portfolios were invested in 60% global equities and 40% bonds.
First, let’s examine the long-term outcomes as measured by both personal wealth and projected charitable benefit after 30 years. All three CRUT scenarios generated greater personal wealth than an outright sale—despite transferring funds to charity. Notably, this result largely stems from a “Goldilocks” scenario for CRUTs: use of a zero-basis asset, donors with high effective tax rates and a sufficient time horizon to capture a personal benefit from ongoing tax deferral.
We refer to the point at which the CRUT outperforms as the “crossover”—the moment when the donors’ personal wealth from the CRUT surpasses that from an outright sale. Here, the maximum payout scenario reached crossover first, at the 18-year mark. The 5% payout scenario took an additional four years, but simultaneously created substantially more wealth for charity (with a median charitable remainder of $5.3 million versus $0.7 million in the maximum income payout scenario). Importantly, this underscores a key trade-off for donors: whether to prioritize higher immediate income and an accelerated personal benefit or accept more modest income streams during life while creating greater overall wealth. Of course, donors needn’t pick one extreme or the other. As the 8% payout scenario shows, there’s a feasible middle ground.
Moving from CRUTs to charitable remainder annuity trusts (CRATs), donors contemplating the latter must choose a fixed annuity payment within the 5% to 50% range (while bearing the 10% remainder requirement in mind). Moreover, the terms of the CRAT must yield a less than 5% chance that the trust leaves nothing to charity—a constraint that may lower the maximum allowable payout rate. The CRAT structure also offers less flexibility than the CRUT, because the payout can’t vary over time or fluctuate with changes in the value of the trust’s assets, nor can the donor make additional contributions after the trust’s creation.
Previously, the interplay between payout restrictions and low prevailing interest rates limited the pool of suitable donors for this strategy. When the Section 7520 rate is low, the IRS model faces a key challenge: It will assume a rate of return on the trust assets that’s unlikely to meet the 5% minimum payout requirement for the life of a younger donor, while simultaneously preserving sufficient property to satisfy the 10% remainder requirement and 5% exhaustion test.
As a result, in recent years, lifetime CRATs remained viable only for individuals well into retirement. Now, with interest rates rising, the potential donor pool has expanded. At the start of 2022, when the Section 7520 rate sat at 1.6%, an individual needed to be age 73 to successfully implement a single-life CRAT (see “Are CRATS Back?” this page). Just six months later, however, the Section 7520 rate climbed to 3.6% and lowered the eligible age to 61. We expect this strategy to become even more accessible should future interest rate hikes materialize.
Finally, donors considering a CRT—whether structured as a CRUT or a CRAT—must be mindful of certain external factors, including:
Timing. CRTs can provide a generous benefit to charity but only at the end of the trust’s term. In some cases, this timeline may not meet the remainder charity’s needs or the donor’s desire to make a greater charitable impact while living.
Asset limitations. The lower the donor’s basis, the less time required before the benefits of a charitable trust surpass those of an outright sale.
Effective tax rate. A CRT provides the greatest tax deferral benefit to donors subject to high state and local income taxes.
Charitable Lead Trusts
Unfortunately, not all split-interest trusts stand to benefit from a rising-interest-rate environment. Take charitable lead trusts (CLTs), which function in roughly the opposite manner as CRTs and therefore react to changes in the Section 7520 rate accordingly. More specifically, a CLT provides annual distributions (structured as annuity or unitrust payments) to a charity for a specified term—typically a set number of years or the life of one or more individuals. At the end of the CLT’s term, any remaining trust property may return to the donor or, more commonly, shift to other noncharitable beneficiaries free of transfer tax. Thus, the greater the difference between the trust’s charitable payout rate (sometimes referred to as the “hurdle rate”) and the trust assets’ rate of appreciation, the greater the tax-free benefit provided to the trust’s remainder beneficiaries.
That’s where interest rates factor in. As interest rates climb, so too may the CLT’s charitable payouts—undermining the trust’s overall tax benefit. For instance, when creating a CLT, many donors aim to avoid using their gift tax exemption by generating an upfront charitable deduction equal to the funding gift (that is, to “zero out” the gift). This deduction matches the value of the trust’s charitable interest, which is driven by the trust’s charitable payouts and the applicable Section 7520 rate. Keep in mind, the present value of a CLT’s charitable interest decreases as the Section 7520 rate increases (and vice versa). Thus, a donor looking to zero out a gift to a CLT must increase the trust’s charitable payouts in a high interest rate environment, which erodes the level of appreciation that can pass to the trust’s remainder beneficiaries—especially during periods of muted returns. Since these trusts typically require considerable cost and effort to implement, their usefulness for transfer tax planning may wane over time if rates continue to rise.
Interplay Between Rates and Giving
Donors will continue to enjoy many effective ways to meet their charitable giving goals in the months and years ahead. In deciding which strategy to implement, donors and their trusted professionals should consider:
- Whether the gift or strategy is sized appropriately given the donor’s “core capital” requirement. Put another way, will the donor retain sufficient funds to secure their own lifelong financial security?
- Is the strategy aligned with the donor’s giving patterns and desire to benefit charity during life, at death or both?
- Does the strategy maximize applicable tax efficiencies available to the donor?
Structuring a charitable giving strategy that incorporates the donor’s top values and priorities will help ensure giving success throughout fluctuating market cycles—particularly in light of widespread need and heightened potential impact amid rising rates.
Endnote
1. Giving USA 2022: The Annual Report on Philanthropy for the Year 2021.