The field of planned giving includes a variety of gift options. While bequests remain the simplest and most popular planned giving solution, many donors prefer to explore other opportunities. Charitable gift annuities, remainder trusts, lead trusts and gifts of remainder interests in certain types of real property are among the most popular charitable gift vehicles. Generally, each of these gift types allows the donor to take a charitable deduction. However, because the donor is retaining an income interest or portion of the gifted property, the full value of the donated property is not deductible. In each of these circumstances, the present value of the charity's interest in the property can be determined through the use of the IRS' prescribed calculation. The IRS requires the use of a specific discount rate in calculating the gift's present value.
This article will explore the rules related to the use of the applicable federal rates (AFRs) published under Sec. 7520 and their use in calculating charitable deductions. This is the second article in a two-part series. Part I discussed the AFR's effect on the present value calculation of several types of planned gifts and provided specific examples of these calculations. Part II covers the election requirements and provides sample AFR election letters.
Section 7520 of the Internal Revenue Code prescribes the rate that is to be used for calculating the present value of certain charitable gifts. This is known as the applicable federal rate (AFR). The rate is published each month by the IRS and is 120% of the federal midterm rate, compounded annually, rounded to the nearest two-tenths. When a present value calculation is performed for the purpose of determining a charitable deduction, the current month's rate or the rate from one of the two previous months may be selected.
Under Regulation 1.7520-2, if the donor wishes to use the AFR from one of the two previous months, he or she must make an election in writing. The election must identify the month for which the election is being made and must be attached to the donor's income tax return or amended return for that year. According to Reg. 1.7520-2(b)(1), this must be done within 24 months of the date the original return was filed or the date it was due, whichever is later. If the donor is using the AFR that corresponds to the month the gift was made, an election in writing is not required.
Joy funded a charitable gift annuity with her favorite charity during the month of May 2020. She transferred publicly-traded stock valued at $100,000 in exchange for a 5.8% annuity payout. When Joy funded the gift annuity, the May AFR was a mere 0.8%. Using that rate, her charitable deduction would have been $39,271. Joy's advisor explained that if she wishes to maximize her deduction, she should use the highest AFR available. While the May AFR is just 0.8%, April's rate is 1.2% and the March AFR is 1.8%. Joy decided to elect the March AFR of 1.8% and was able to claim a deduction of $43,482. Joy's advisor assists her in creating a letter to be attached to her income tax return for 2020. The letter includes a statement that Joy is electing to use the March 2020 AFR of 1.8%.
Although the code and regulations lay out the requirements for what should be included in the written election, a specific form is not required or prescribed. The donor should seek the counsel of a professional advisor to help the donor fulfill the requirements of Reg. 1.7520-2(b)(1). Many gift planners use charitable tax software to prepare gift proposals, the software typically will be capable of creating a worksheet demonstrating the donor's charitable tax deduction for funding the gift. One option a donor may choose is to attach the charitable income tax deduction worksheet from a tax software program to their tax return, which includes the AFR as well as the month that was elected. This worksheet shows the steps of the calculation to find the donor's charitable deduction. When applicable, it will include a line stating "Election: IRC Sec. 7520(a) election made using [month] [rate]% AFR."
Making the CGA Election
The charity receiving the gift may also send a letter to the donor. In the letter, the gift planner will describe the available AFRs and the benefits of choosing either the highest or lowest available rate.
Sample Gift Annuity Election Letter – From Charity to Donor
May 5, 2020
[City], [State] [Zip]
Thank you for your interest in a $100,000 gift annuity. Under federal tax rules, you may choose a month and interest rate for calculating your charitable deduction and your tax free payout amounts. With your funding date of May 13, 2020, the selected month and interest rate can be March 1.8%, April 1.2%, or May 0.8%.
A higher interest rate produces a larger income tax deduction. A lower interest rate provides you with larger tax free payouts. If you do not itemize deductions, you may want to select larger tax free payouts. Please select an option below -- greater tax deduction or larger tax free payouts. Thanks for your generous gift!
Please check one option -- larger charitable deduction or larger tax free payouts.
Larger Charitable Deduction
____ March 1.8% with $43,481.90 deduction and $912.47 tax free payouts.*
Larger Tax Free Payouts
____ May 0.8% with $39,271.10 deduction and $977.21 tax free payouts.*
As the gift annuity donor, I select the checked option.
___________________________________________ Date: ____________________
* Full tax free payments until the end of 2031
This sample letter provides the donor with a breakdown of the results of selecting the highest and lowest available AFR. If the donor wishes to take the highest available deduction, she will simply select the highest available AFR on the letter. If, on the other hand, she does not itemize and wishes to maximize the tax-free portion of her payouts, she can select the lowest available AFR. The donor will need to attach a copy of the letter to his or her income tax return.
It should be noted here that the sample letter lists all three available rates, but only includes selections for the highest and lowest available. In nearly all circumstances, the donor will wish to maximize either the tax deduction or the tax-free portion of the payouts. While it is possible that a donor may wish to take a middle-of-the-road approach, the likelihood is very low. If Joy had selected to use the May AFR, she would not be required to include an election letter. The election in writing is only required where a donor is electing to use the AFR for one of the previous two months for purposes of calculating the present value of the gift.
A gift annuity is a contract between a donor and a charitable organization. As such, the format of the sample letter above works well for nearly all gift annuity circumstances. The gift planner for the charity will be involved in the process and can generate the charitable deduction worksheet and election letter for the donor in that circumstance. However, other types of gifts, such as charitable remainder trusts and lead trusts do not necessarily require the direct involvement of the charity in the process. Therefore, it may be necessary for the election to take a different form in circumstances where the charity's gift planner may not be closely involved in the creation of the planned gift.
Making the CRT Election
As with the gift annuity, the election is only required if the donor is choosing to use the AFR from one of the two previous months. If the donor wishes to use the AFR for the month in which the gift is made, no election is required. While the sample gift annuity election letter above can be modified to meet the election requirements for a charitable trust, a simpler format may better suit the circumstances. For instance, whereas the gift annuity donor may weigh the benefits of selecting either the highest or lowest available AFR, a charitable remainder trust donor will typically select the highest available rate. This is because there is no tax benefit to selecting the lowest available rate for a CRT like there is with a CGA.
As noted above, a donor electing to use an AFR from one of the two prior months may simply choose to attach the deduction worksheet from charitable tax planning software to his or her tax return so long as that worksheet includes the required election language. The attorney drafting the CRT or the tax professional assisting the donor may also wish to provide the donor with a sample form making the election along with instructions as to what information needs to be included and how it is reported to the IRS. It is imperative that if the advisor uses a separate form, he or she must ensure that the rate elected on the form matches the rate elected on the donor's deduction worksheet.
Sample Charitable Remainder Trust Election Form
May 13, 2020
[City], [State] [Zip]
It was a pleasure working with you to set up this trust. As we discussed, you are allowed to elect one of three available interest rates in calculating your charitable deduction. Please review and sign the form below, which indicates the month and rate you have selected. Once you have signed the form, please make a copy for your records. You will need to attach the completed form to your income tax return for this year.
On May 13, 2020, I contributed [cash/appreciated assets] valued at $100,000 to fund a charitable remainder trust. Under Sec. 7520 of the Internal Revenue Code, I may choose from one of three available rates for calculating the charitable deduction. The available rates are March 1.8%, April 1.2%, or May 0.8%.
Given that the highest available rate produces the largest charitable deduction, I hereby elect to use the highest available rate: March 1.8%.
___________________________________________ Date: ____________________
While the sample letters above use one-life examples, they may easily be modified to add a second signature line to allow spouses who jointly own property to both sign the same election form. The sample charitable remainder trust form may also be used as a template to build election forms for charitable lead trusts. However, with a lead trust, the lowest available AFR will produce the highest deduction.
It is vital for professional advisors not only to understand and explain the effects of the AFR to potential donors, but also to provide the tools to help donors reach the optimal outcome. Donors who are informed about how the AFR will affect their gift are able to maximize the financial benefit of the gift. This outcome can only be achieved by a donor properly electing the appropriate AFR under their circumstances. With rates that can fluctuate greatly from month to month, providing a donor with an election form can be a great service to provide, helping to ensure that all required information is included in the donor's election when necessary.