Charitable Giving Strategies for Not-as-Wealthy Donors

Dave Smith, CEO and founder of Heaton Smith Group, writes in Giving USA 2022 that charitable giving declined in 2022 when adjusted for inflation. He intimated that the current 40-year-high inflation rates may adversely affect charitable gifting for years. The last comparable inflationary period was in the 1970s, when charitable giving fell almost 9%, in inflation-adjusted terms, over a four-year period.

These kinds of observations are sounding an alarm among charitable giving experts that their tactics to attract and retain charitable donors may need to change.

It’s possible that many dependable donors will be less generous in the coming years. Some may worry that the U.S. economy has entered a prolonged recession, and others may view the recent spike in inflation as a precursor to a “stagflation” decade like the 1970s. But most will simply react to the profound and sudden erosion of their spending power.

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Charities are well versed in the strategies that benefit charitable donors, both the relatively wealthy and those with less excess income or fewer resources. They need to give these people confidence that they can continue giving to charity, and even increase their level of generosity once they are educated on the related financial benefits.

Community foundations have offered continuing education seminars for decades. They do so precisely to evoke a genuine interest among legal and financial advisory professionals to develop expertise in charitable gifting strategies for the average investor, simply because there are so many more of them than the usually targeted multimillionaires facing eventual estate tax liability. Community foundations and charities generally espouse the benefits of charitable remainder trusts, charitable lead trusts and charitable gift annuities.

How a Split-Interest Gift Works

A donor who funds a charitable trust shares the benefit of investment growth with the charity through a split-interest gift. The tax code allows the donor (the asset owner and his or her loved ones) and the charity (public charities, private foundations and other entities for which donations qualify for a tax deduction to the donor) to form a fiduciary relationship for mutual benefit. The trust vehicle is designed to provide income to either the donor or the charity, with the remainder of the assets delivered to the other party. The donor may choose to qualify for a charitable income tax deduction at the time of the donation. The amount of that charitable income tax deduction is critical to the efficacy of the donation.

The donor will select the assets to be gifted, prove the market value, select the retained benefit from the donation in the form of periodic payments back to the donor or a lump-sum paid to the donor’s loved ones and calculate the related income tax deduction. The income tax deduction is based on the charity’s benefit in today’s dollars, called the present value, and not on the total amount that charity eventually receives.

The present value of the donor’s retained interest is not deductible. There are strict rules that control whether and how much income tax deduction may be taken and in which years. However, once the original market values are proven (sometimes through an independent appraisal) and the initial discount rate is applied, the IRS has a limited time or reason to audit the transaction.

What Is the Charitable Federal Midterm Rate?

That discount rate is the key to calculating the donor’s income tax deduction and the amount of the payments. It is used to calculate the present value of future periodic payments for a term of years or the donor’s life. The rate is published by the IRS as the Charitable Federal Midterm Rate, often called the “§7520 rate” (authorized under 26 U.S. Code §7520), and represents 120% of the one-month average of the market yields from domestic marketable debt obligations that mature between three and nine years.

Before May 1989, the §7520 rate was fixed at 10%. After IRC §7520 was amended to tie the monthly discount rate to the monthly market rates of domestic debt obligations, the §7520 rate fell over several years. The low rates greatly benefitted planning that used intra-family loans, installment sales to a grantor trust, grantor retained annuity trusts (GRATs), charitable lead annuity trusts (CLATs) and charitable gift annuities (CGAs).

Since 2020, the discount rate has doubled three times and, over the past six months, rose another 162% to 5.2% for December 2022, the highest rate since November 2007.

As the discount rate remains high, donors should strongly consider charitable gift planning using a charitable remainder trust (CRT).

How the Charitable Remainder Trust Works

The CRT is a contender for charitable gifting when §7520 rates are high. The donor (or donors, if a married couple) funds the trust and retains annual payments for life or a term of years at a set rate; the charity receives the entire remaining trust corpus at the end of the term. The donor’s income tax deduction is determined by the §7520 rate published on the day the CRT is funded. A higher §7520 rate ensures that the CRT qualifies and meets the minimum payment requirement. A CRT may be structured to pay an annuity that does not fluctuate (known as a charitable remainder annuity trust, or CRAT) or a unitrust amount that does fluctuate (known as a charitable remainder unitrust trust, or CRUT).

For example: A donor decided to give $100,000 in cash to a new CRAT on Dec. 1, 2022, in return for an annuity for 20 years, with the remainder going to the donor’s chosen charities. Based on the December 2022 discount rate of 5.2%, the donor’s annual payment is $7,115. Assuming the total annual average return on the underlying investments is 6%, the charity may receive $49,171 after 20 years, and the donor would definitely receive $142,300. The charitable gift tax deduction available in 2022 is $10,000.

Because this is an annuity, the donor’s annual payment is guaranteed and unchanged unless the trust terminates due to very poor performance (which would have to be worse than a 3.9% average annual total return). However, the donor gains nothing from greater investment performance. A donor who wants a share of that growth potential can use a CRUT, so his payments fluctuate with the performance of the underlying assets.

Using the same example, a $100,000 CRUT that experiences a 6% average total return may also qualify for a charitable gift tax deduction of $10,000. The initial annual payment to the donor would start out at a whopping $11,224, but the principal would suffer over the years from the disparity between the discount rate and the actual performance. After 20 years, the total received by the donor and the charity would be just $138,946 and $32,684, respectively.

If the investments performed much better, say 8% on average, the donor and the charity could receive about $163,393 and $49,013, respectively. However, a donor who needs a dependable annual payment every year for part of his support might prefer the CRAT.

The donor’s payments from a CRT are taxable to the extent of the taxable earnings paid out to the donor each year. If the donor funds the CRT with an asset with a low-cost basis, so the CRT is the owner of the asset when it is sold, then the capital gain on that sale is not recognized by the CRT.

For example, the same CRT is funded with shares of company stock with nearly zero income tax basis that are sold the year following the gift. Not only may the donor take an income tax deduction for the $10,000 present interest gift, but he also defers the federal capital gains tax he would have owed if he had sold the shares himself.

In addition, a CRT can be structured to limit payments back to the donor until illiquid assets, like company stock, are sold. He can even “make up” the lost payments during the time before the trust begins making full payments. The administrative costs for a CRT can be low if the donor can serve as trustee; some charities offer to serve as administrator at an attractive cost.

Give With Confidence

Please note that the 5.2% §7520 rate is still a low rate. Even though the benefits of a CRT are on the rise, there are personal circumstances that still warrant the use of CLATs and CGAs.

Consult your attorney and a professional charitable giving expert to learn about these opportunities to continue your charitable giving with confidence.