Charitable gift plan deductions change monthly as the Sec. 7520 Applicable Federal Rate (AFR) is modified. Each month the IRS surveys hundreds of interest rates and publishes a revenue ruling with AFRs. The rate used for charitable deductions in Table 5 of the ruling is 120% of the Applicable Mid-Term Rate, rounded to the nearest 2/10 of 1%.

The Applicable Federal Rates since 1989 have varied from a high of 11.6% to a low of 3.0%. The AFR for May of 2008 is 3.2%.

How does an AFR that is near the historic low affect charitable gift planning? The answer is that it has major impact on many agreements. The most dramatically-affected agreements are the charitable remainder annuity trusts, charitable gift annuities, life estates and particularly charitable lead trusts. Indeed, this is probably a historic opportunity to set up charitable lead trusts with favorable AFR and investment parameters.

Annuity Remainder Trusts

Charitable remainder annuity trusts are fairly popular with senior donors who desire fixed payments. During times with lower AFRs, an annuity remainder trust for younger donors may not qualify. With a 3.2% AFR, even a 5% trust qualifies only if a couple is age 68 or older.

To protect the charitable remainder, the IRS requires an annuity trust to pass a 5% probability test. With a payout greater than the AFR and based on the ages of the donors, an annuity trust must not have a 5% or greater probability that the donors will live long enough to exhaust the trust. With a low 3.2% AFR assumption (adjusted for payment frequency), even the minimum 5% payout annuity trust fails the 5% probability test for a donor couple age 67 or younger.

Finally, an annuity remainder trust will have a deduction based upon the payout and the return. With a very low AFR, the remainder interest is reduced and there is a smaller charitable deduction.

Charitable Gift Annuities

A charitable gift annuity is a contract between the issuing charity and the donor-annuitant. It may be issued for one life or two lives. If the payout is deferred over one year, it is described as a charitable deferred payment gift annuity.

With low AFRs, gift annuity charitable deductions are reduced. However, because a portion of the annuity payout is tax-free, the low charitable deduction gift annuity produces a larger tax-free amount.

Since over 70% of individuals age 70 and above do not itemize, they will not benefit from a large charitable deduction. Rather, they benefit from the greater tax-free payout with a low AFR. Because the tax-free payout is a more important benefit for most gift annuitants, the lowest of the three permissible AFRs should usually be selected to maximize tax-free payouts to the individual.

Gift annuities are also subject to a 10% minimum deduction test. Under the American Council on Gift Annuity rates applicable until June 30, 2008, current gift annuities for individuals in their 50s and deferred payment gift annuities for individuals under age 60 may fail the 10% minimum deduction test. Therefore, it may be necessary to reduce the annuity payout in order to qualify for the minimum 10% charitable deduction.

The American Council on Gift Annuities recently announced that the rates on July 1, 2008 and thereafter will be reduced. However, with deferred payment gift annuities for individuals in their 50s, if the AFR remains low, they may still fail the 10% minimum charitable test after July 1. In that case, gift annuity payout rates should be reduced.

For flexible deferred payment gift annuities, there is a target payout date and a rate calculated for that date. The rates for earlier years are reduced and the rates for years after the target date follow the American Council on Gift Annuities schedule. Because the ACGA rates for individuals in their 40s and 50s may not provide a 10% minimum deduction for when the AFRs are 3.2% or lower, Crescendo permits an option to reduce ACGA rates.

Life Estates

A life estate reserved is an agreement that involves transfer of a home or farm to a qualified charity, with the life use reserved to the donor. There is a charitable deduction for the value of the remainder interest.

With a 3.2% AFR, the value of the remainder interest (the charitable deduction) is greater. In theory, with a life estate the remainder interest is discounted by the AFR over the anticipated life expectancy of the owner. Because the AFR is lower, there is less discounting and a larger charitable deduction.

Lead Trusts

Charitable lead annuity trusts are extremely favorable when the AFR is 3.2%. With a typical real estate or equities investment, it may be possible to earn 8% or 9% in the trust. Because the IRS is assuming that the trust is only earning 3.2%, there is a benefit of the growth to the family. With an assumed return of 9.2% and an AFR of 3.2%, there is 6% growth for the benefit of the family.

For example, a charitable lead annuity trust that pays 9% for 14 years can be transferred to family with zero tax. Whether the trust is $100,000 or $1 billion, there is no taxable transfer because the assumption by the IRS is that the trust is only earning 3.2%. Because the principal is assumed invaded to pay the annuity, in theory there is no remainder for family. However, if the trust is able to earn 9% and pay that amount to charity, then the full value of the trust is transferred to family with zero gift tax.

An even more favorable arrangement is to transfer real estate or other assets into a family limited partnership (FLP) and then transfer the FLP into the lead trust. If the FLP is assumed to have a discount rate of 35% and the payout again is set at 8.5% of the initial value, then a 9-year trust will be tax-free to the family.

But wait - even a shorter term annuity lead trust can be gift-tax free. The combination of the FLP, the lead trust and a $1 million gift exemption can permit the FLP to be shortened to as few as five years and still transfer very substantial assets tax-free to family.

A charitable lead unitrust is less affected by high or low AFRs. With a unitrust formula, only the adjustment for the payout rate is affected by the AFR. Therefore, with low AFRs, the preferred practice is to select a charitable lead annuity trust.

Unitrusts

Charitable reminder unitrusts are not dramatically affected by low AFRs. The charitable unitrust remainder is assumed to grow at a uniform rate and can be discounted at the same rate. Therefore, the unitrust is only affected to a very small degree by a change in the Applicable Federal Rate.

Will the Applicable Federal Rate Remain Low?

Because the Federal Reserve has recently reduced the federal funds rate to 2.0%, it is quite possible that the AFR may stay low for most of 2008. Assuming that the US economy recovers towards the end of 2008, it seems probable that the typical pattern of the AFR moving back into the 5% range will be the case by early 2009.

However, the current low rate presents unique planning opportunities, particularly for charitable lead annuity trusts. With a fair valuation for the equities market and real estate, combined with the 3.2% AFR, this is one of the best opportunities for charitable lead trusts in the past two decades.