As we embark on charitable gift planning for 2012, a look back at the events affecting philanthropy in 2011 can be helpful. At first glance, the events of 2011 may portend another year of uncertainty. But, when it comes to estate and financial planning, charitable giving opportunities now exist to complete gifts that yield benefits for donors and recipients that may not be available in 2013 and beyond.

Window of Opportunity

We began 2011 with the understanding that Congress had, through late 2010 legislation, opened a two-year window of opportunity that not only extended Bush income tax cuts, but also surprised planners with a provision for the reunification of federal estate and gift tax exemptions at $5 million per person (to be adjusted for inflation). This twist in the law, combined with lower interest rate assumptions used under Internal Revenue Code Section 7520 to determine the discount rate for valuing assets for tax purposes, resulted in a higher level of interest in a number of philanthropic planning tools. For example, many well-advised donors became interested in charitable lead trusts (CLTs), charitable remainder trusts and charitable gift annuities (CGAs) for the benefit of loved ones and transfers of real estate to charity with the donor retaining use of the property for life or some other period.1

Low Interest Rates

Low interest rates during 2011 made some charitable planning more difficult and certain types of tax-favored split-interest gifts impossible to complete. For example, under the November 2011 applicable federal midterm rate (AFMR) of 1.4 percent, a charitable remainder annuity trust (CRAT) that would pay a fixed income of 5 percent for the life of a person under age 75, failed to qualify for charitable income tax deductions and other favorable tax treatment.

That's because under the earning assumptions dictated by a low AFMR, the probability of corpus exhaustion would be greater than 5 percent (to qualify for a charitable deduction, the Internal Revenue Service requires that CRATs making payments for one or more lifetimes have less than a 5 percent chance of corpus exhaustion).2 The same was true for a couple who are both younger than age 77. Because it's not possible under federal tax law to compensate for low earnings assumptions by setting the payout rate at less than 5 percent, low interest rates effectively end the use of CRATs structured to last for the lifetime(s) of relatively young individuals. Donors under age 59 who wanted to create CGAs also couldn't qualify for favorable tax treatment because the anticipated charitable benefit was less than 10 percent.3 Individuals whose planning was negatively impacted by historically low discount rates could create CRATs instead, but those might not be practical for smaller amounts because of relatively high administrative costs and would need to be structured for a term not to exceed 20 years and with a mandated payout rate depending on how long the trust lasts.

Note, that because charitable remainder unitrust (CRUT) payments are based on a percentage of the trusts as valued annually, the 5 percent probability of exhaustion test doesn't apply and this factor in and of itself didn't act as a brake on the creation of these trusts. Other factors acted, however, to quell interest in CRUTs.

Low Capital Gains Tax Rates

Maximum federal capital gains tax rates of 15 percent for most real estate and other investments continued in 2011. This resulted in a reduced incentive to fund CRUTs as a way to bypass capital gains tax at the time of funding, while preserving the entire value of an asset to invest for future income based on anticipated growth of the trust corpus.

Investment Volatility

Continued investment market volatility also tended to discourage interest in CRUTs. Through November 2011, the high and low of the Dow Jones Industrial Average vacillated as much as 10 percent above or 9 percent below Jan. 1 values. This volatility, while stifling interest in gift plans that feature variable income based on asset performance, also increased interest in gift annuities among older donors, who were attracted to the higher predictable income for life and CRATs that paid income that could be determined for a period of years without running afoul of the 5 percent corpus exhaustion rules.

Charitable IRA Rollover Expires Again

The provision of the Pension Protection Act of 2006 that allowed individuals over age 70½ to make qualified charitable distributions directly to charity from a traditional or Roth individual retirement account expired on Dec. 31, 2011, after Congress had extended it for one more year in the fall of 2010. While further extension of this provision was included as part of a number of bills introduced in Congress in 2011, planners began this year without the benefit of this gift planning opportunity.

Tax Roulette

In addition to economic factors that created an air of uncertainty throughout much of 2011, an overlay of uncertainty regarding the nation's income, estate and gift tax laws further clouded the view of those advising charitably minded individuals.

With Congress' refusal in August to raise the debt ceiling without concurrent spending cuts or tax increases, a compromise was reached that called for a select “Super Committee” to hammer out recommendations to address deficit management by Nov. 23, 2011. Any package of recommendations this committee made wouldn't be subject to revisions on the floor of Congress and would succeed or fail on an up or down vote.

The ensuing period of negotiation made it even more difficult to engage in effective charitable gift planning as there was ongoing speculation about what the committee might do. A number of proposed tax changes were on the table, including reduction or elimination of the tax benefits associated with charitable gifts, mortgage interest and certain other longstanding deductions.

Rumors also surfaced about the possible reduction of estate and gift tax exemption equivalent amounts coupled with increased tax rates. Many began to seriously consider the possibility of the sunset of the increases mandated by 2001 tax legislation provisions that would return both the estate and gift tax exemptions to $1 million.

Others speculated that the gift and estate tax exemptions would once again be set at different levels, with the estate tax exemption maintained at $3.5 million or $5 million and the gift tax exemption reset at $1 million for transfers during life. This change might have taken place as early as 2013, with some predicting that the $1 million gift tax exemption would be retroactive to Nov. 23, 2011, the deadline for the Super Committee report and recommendations.

All of that speculation is now behind us as the Super Committee failed to agree on a recommended course of action, assuring that, absent unlikely action by Congress in the meantime, the charitable tax law status quo will continue through 2012.

New Gift Annuity Rates

Another development that changed the playing field for charitable planning in late 2011 and into 2012 was the American Council on Gift Annuities' announcement of reductions in its recommended gift annuity rates effective Jan. 1, 2012. This relatively sudden change in rates was another result of an extended period of low interest rates coupled with investment market volatility. This led some charities to encourage donors to make gifts under the 2011 rates, which were from 8 percent to 15 percent higher than the rates taking effect in 2012.

Window of Certainty?

As a result of the fruitless Congressional negotiations in late 2011 and the upcoming presidential election that will end with a lame duck Congress, few believe there will be substantive change in federal income, estate and gift tax laws in 2012. It's possible that the Bush tax cuts may be allowed to expire, or there may be another extension bridging to 2013 and perhaps beyond. Few are predicting major changes in the economic landscape as well. So looking ahead this year, what appears relatively solid ground for effective philanthropic planning?

The charitable income tax deduction

As of today, there are no changes scheduled for 2012 that would limit the federal income tax benefits associated with charitable gifts. While no one can predict what Congress will do in the coming months, limits on the value of charitable and other income tax deductions for higher income taxpayers aren't scheduled to return until Jan. 1, 2013. These changes will require a reduction in charitable and other itemized deductions by 3 percent of the amount above certain income levels.4

The speculation surrounding the Super Committee deliberations made it clear that substantial bipartisan support exists for reducing tax benefits associated with charitable gifts, mortgage interest and other itemized deductions for higher income taxpayers.

For these reasons, financial and estate-planning professionals may advise higher income individuals who are considering making larger gifts that 2012 may be the best time to complete these gifts. For those who have significant amounts of cash earning very low rates of return, this cash can be used to fund charitable gifts and, thereby, yield tax savings of up to 30 percent or more.

If investment markets continue at or above late 2011 levels, planners may advise clients to consider using appreciated securities or similar assets to complete gifts, thereby bypassing capital gains tax on the appreciation element and using those paper profits to offset tax on other sources of income. They can then use cash that might have been donated to repurchase the same securities or diversify their holdings while enjoying a new, higher cost basis that will be welcome if sunset provisions return capital gains tax rates to higher 2001 levels.

Temporarily stable estate and gift tax exemptions?

After a decade of gradual changes in estate and gift tax rates and exemptions, Congress' inaction in 2011 on this front has provided a great degree of certainty that the high levels of exemption from federal estate and gift tax are likely to remain in effect in 2012. Under current law, it's possible for individuals to transfer a total of up to $5.12 million,5 free of federal estate and gift tax, to family or other loved ones.

Many individuals will be exploring ways to lock in the benefit of 2012 exemption levels by making various types of asset transfers — whether outright or in trust. Planners should be aware that there are a number of ways clients can transfer assets that qualify for the current exemption amounts, while also making significant near-term charitable gifts.6

Low interest rates are likely. It appears that national monetary policy and other factors will keep the interest rates underlying the AFMR at historic lows at the start of 2012. As a result, certain gift vehicles will continue to be especially attractive.

This phenomenon affects those of different wealth levels in various ways. As noted earlier, continued lower interest rates enhance the attractiveness of CLTs and certain other gift planning vehicles. Coupled with that is the usefulness of CLTs in particular to help leverage what may be temporary gift tax exemptions. This is one reason that, according to recently released IRS reports,7 the CLT has been the fastest growing type of charitable trust over the past decade — when tax laws and interest rates have interacted in ways that uniquely favor this charitable gift planning tool. For seniors of more modest means, CGAs should be especially popular in 2012 because, even under the new recommended payment rate structure for 2012, they provide a way to enhance income. At the same time, by accelerating a bequest from what may be a non-taxable estate in the future, those who make these gifts are also afforded income tax benefits that may never be greater.

Endnotes

  1. See Douglas Moore, “Charitable Remainder Trusts — Revisited,” Trusts & Estates (July 2011) at p. 40; Jonathan Tidd, “Charitable Giving at Death;” Trusts & Estates (October 2011) at p. CGS 5; Robert F. Sharpe Jr., “Planning For the Here and Now,” Trusts & Estates (September 2011) at p. 18.
  2. Revenue Ruling 77-374.
  3. Internal Revenue Code Sections 501(M)(5)(b) and 514(c)(5).
  4. The Pease Amendment, which limits the savings generated by charitable deductions by reducing by 3 percent of the income over a certain base amount, will reappear on Jan. 1, 2013. For example, if a taxpayer's income is $100,000 over the threshold, itemized deductions will be reduced by 3 percent of that amount, or $3,000.
  5. When Congress increased the gift and estate tax exemption to $5 million, it also provided that beginning in 2012, this amount would be indexed for inflation. On Jan. 1, 2012, the exemption amount was adjusted upward by $120,000, resulting in an exemption amount of $5.12 million.
  6. Supra, note 1.
  7. www.irs.gov/taxstats.

Robert F. Sharpe, Jr. is president of The Sharpe Group in Memphis, Tenn.