It’s generally imprudent to try to predict the course of future federal tax legislation, but clients who have contemplated making major lifetime charitable contributions might want to consider this:  The tax rewards of giving are unlikely to get any better than they are right now, in 2011, and incentives could become considerably worse under tax reform measures that may emerge as Congress grapples with deficit reduction.  If one were to assume the worst-case scenario – that 2011 turns out to be the last year for the income tax charitable deduction – many advisers would be telling clients some or all of the following:

• Accelerate several years’ worth of annual gifts into 2011, up to an amount that would be deductible under the contribution deduction ceilings (50% of AGI for gifts of cash, 30% of AGI for long-term capital gain property);
• Replace annual gifts with a large contribution to a donor advised fund from which they could direct annual grants in the future to the organizations they support;
• Consider establishing charitable remainder trusts or charitable gift annuities that create large deductions and minimize capital gains taxes;
• Create grantor charitable lead trusts that generate outsized income tax charitable deductions (thanks to rock-bottom §7520 rates) and make annual distributions to various charities.

What if absolutely nothing changes with respect to charitable giving incentives?  As a general tax-planning principle, it’s better to achieve tax savings sooner than later, so donors who make large gifts in 2011 should not be at a disadvantage.  And if Congress later adopts a flat (or “flatter”) tax, restricts a donor’s deduction tax savings to a low tax bracket, or caps tax savings with a charitable gift credit, clients who chose 2011 as the year to make large gifts could be dollars ahead.

In the absence of a spendthrift clause, the beneficiary of an income interest in a trust can assign a portion to charity, thereby reducing his or her future taxable income and qualifying for a charitable deduction.   Take the case of a 40-year-old life income beneficiary of a $1 million trust paying an average $50,000 annually.  The beneficiary would like to reduce taxes while also benefiting his favorite organization, so he assigns half of his income interest to the charity.  The value of the life income interest is $1,000,000 x .52127 (value of a life estate from Table S at the 2.0% federal midterm rate in effect for September 2011).  By assigning half of his interest, the beneficiary has made a deductible gift valued at $260,635, while reducing his future taxable income by $25,000 a year – a double tax benefit.  The gift of trust income is deductible up to 30% of the donor’s adjusted gross income, with a five-year carryover for excess deductions.

Note: This technique works well with complex trusts, since these can provide for distributions to charity and are therefore entitled to a charitable deduction for amounts passing to charity [Code §642(c)]. However, the IRS has ruled (TAM 8738007) that an assignment of income from a simple trust (one that does not provide for sums to be paid to charity), does not entitle the trust to a charitable deduction for the amount paid. While this does not prevent the beneficiary from making an assignment, the trust will be subject to a tax on that amount. The beneficiary will still be entitled to a charitable deduction on an individual return for the value of the gift. It appears from the IRS’s ruling that a simple trust may be entitled to a distribution deduction for the interest passing to charity if the trustee is required to pay income to charitable assignees of the beneficiary.   For more information on gifts of fractional interests in property, see Page 2-112(a) of the Charitable Giving Tax Service.

The persistence of low §7520 rates complicates the establishing of new charitable remainder trusts.   Annuity trusts for the lifetime(s) of one or more beneficiaries must pass a “5% probability test” – that is, the trust will be disqualified if there is more than a one in 20 chance that the trust assets will be exhausted when the trust ends (Rev. Rul. 77-374).  Low interest rates make it hard to pass this test.  Additionally, all charitable remainder trusts must produce a charitable remainder interest of at least 10%, which is especially difficult for annuity trusts when §7520 rates are low.

Charitable remainder unitrusts are generally preferred by donors over the fixed-income annuity trust, due to their greater flexibility.  But some older individuals are reported to be establishing 20-year charitable remainder trusts in lieu of trusts that last for their lifetimes.  These donors’ rationale is twofold:

• Mortality tables indicate they are unlikely to live more than 20 years, so the financial risk of outliving the trust is small;

• As a matter of fairness, they feel someone in their family should benefit from the CRT in the event they died a few years after the trust is established.    

A husband and wife, both in their late 70s, could establish a 5% 20-year annuity trust and know that their family will benefit for 20 years, no matter what.  It may be that no one actually depends on those payments financially; it’s just a more appealing arrangement psychologically. Futhermore, a term of years annuity trust is not subject to the 5% probability test, and the donors' CRAT passes the 10% minimum remainder test, even using the 1.4% October §7520 rate.

The majority owner of a corporation can sell shares owned at least three years to the ESOP and elect to defer tax on the gain by reinvesting the proceeds in shares of domestic corporations no earlier than three months prior to the sale and no later than 12 months after the sale (IRC §1042).  Following the sale, the ESOP must own at least 30% of the outstanding stock of the company.  The seller's basis in the "qualified replacement stock" (QRP) is the same as in the shares sold to the ESOP with gain deferred until the shares are sold.  Sale to an ESOP allows an owner to diversify a portfolio that may be heavily invested in the closely held company.   The QRP can also be used for gifts to charities, or to a charitable remainder trust.

Betty and Bill are shareholders of a corporation that maintains an ESOP.  They sold shares of the company's stock to the ESOP, reinvesting the proceeds in qualified replacement property (QRP).  The couple now wishes to create a unitrust, funding it with the QRP.  The trustee would be under no obligation, express or implied, to sell the QRP.  Betty and Bill asked the IRS if they would have to recognize deferred gain on the transfer of the QRP to the CRT.  The IRS told the donors not to worry:  Recapture rules contained in IRC §1042 do not apply to a transfer of QRP that occurs by gift, and the IRS further ruled that there will be no gain on transfer to the trust and no recapture (PLR. 9438012).

Another reported use of ESOPs is for owners to transfer closely held C stock to a charitable remainder trust, make contributions to the ESOP and – without any prearrangement – have the ESOP purchase the company stock from the CRT.