Computing the Charitable Income Tax Deduction for a Single-Life CRAT

Editor:

Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from "Guide to Tax Planning for High Income Individuals," 2nd Edition, by Anthony J. DeChellis, Douglas L. Weinbrenner, Catherine A. Roeder and Patrick L. Young, published by Practitioners Publishing Company, Fort Worth, Tex., 2001 ((800) 323-8724; www.ppcnet.com ).

Facts: Harry, age 70, established a charitable remainder annuity trust (CRAT) when the Sec. 7520 rate was 7.4%. He transferred property worth $2 million to the trust, and will receive a $140,000 annuity payable annually on December 31 for life. Issue: How is the remainder interest valued?

Analysis

The IRS provides valuation tables for valuing annuities payable for life or a term of years (Sec. 7520(a)). These tables are based on a floating interest rate equal to 120% of the Federal midterm rate rounded to the nearest 0.2% (i.e., the Sec. 7520 rate) for the month in which the valuation date falls. These rates are published monthly in the same revenue ruling that provides the applicable Federal rates (AFRs) for that month.

The tables used in the valuation of annuities are located in IRS Pub. 1457 (Rev. 7/99), Actuarial Values, Alpha Volume. The following is a short description of each table:

1. Table S provides the factors for determining the present worth of an annuity payable for an individual's life.

2. Table B provides the factors for determining the present worth of an annuity payable for a term certain.

3. Table K provides the adjustment factors for annuities payable semiannually, quarterly, monthly and weekly.

4. Table J provides the adjustment factors for annuities payable at the beginning of annual, semiannual, quarterly, monthly and weekly periods for a term of years. (Table J is located in Regs. Sec. 20.2031-7(d)(6).)

The following is a step-by-step approach for determining the value of a remainder interest in a CRAT.

Computation

Step 1: Determine Sec. 7520 rate. The first step in determining the value of the annuity is to determine the Sec. 7520 rate for the month in which the valuation date falls. For inter vivos transfers, the valuation date is the date on which the property is transferred to the trust. However, the donor may elect to use the Sec. 7520 rate for either of the two previous months. The interest rate for each of the two months previous to Harry's transfer was 7.6%. The Sec. 7520 rates are found in the AFR tables issued monthly by the IRS. The appropriate actuarial factor used to value an annuity payable for life is located in IRS Pub. 1457 (Rev. 7/99), Table S. The table corresponding to the Sec. 7520 rate should be used; for example, if the Sec. 7520 rate is 8.2%, Table S (8.2) should be used. The appropriate actuarial factor used to value an annuity payable for a term certain is in IRS Pub. 1457 (Rev. 7/99), Table B.

Step 2: Locate appropriate annuity factor. The second step in the process of calculating the value of the remainder interest in a CRAT is to determine the appropriate factor for valuing the annuity interest from the IRS valuation tables. The table containing the appropriate factor varies, depending on the trust's term (i.e., term of years, life of one individual or joint life).

Note: If IRS Pub. 1457 is not readily available, the required annuity factor for a term of years or the life of one individual can be derived from Table B or S in Regs. Sec. 20.2031-7(d)(6). The annuity factor is calculated by subtracting the remainder factor (that corresponds to the applicable 120% midterm AFR and annuity column) in Table B (for term-certain annuities) or in Table S (for one-life annuities) of the regulation from 1.00 and dividing the result by the 120% midterm AFR expressed as a decimal (Regs. Sec. 20.2031-7(d)(2)(iv)). The result should be carried to five decimal places.

Step 3: Determine unadjusted value of annuity. The annuity's unadjusted value is determined by multiplying the amount payable annually by the factor determined in Step 2.

Step 4: Adjust for annuities payable at beginning or end of period. The value of the annuity determined in Step 3 assumes the annuity is paid annually at the end of the year. Thus, the value determined in Step 3 must be adjusted if the annuity is paid (1) at the end of a semiannual, quarterly, monthly or weekly period or (2) at the beginning of an annual, semiannual, quarterly, monthly or weekly period. The factor to be used is the one that corresponds to the Sec. 7520 interest rate and frequency of payment (e.g., monthly). Table K is used for annuities payable either for life or for a term of years if the payment is at the end of the period. Table J in Regs. Sec. 20.2031-7(d)(6) is used only for annuities payable at the beginning of the period for a term of years. If an annuity for an individual's life is payable at the beginning of a period, the value of the annuity is the sum of the first payment plus the present value of a similar annuity, payment of which is made at the end of a period (Regs. Sec. 20.2031-7(d)(2)(iv)(C)).

Step 5: Calculate present value of remainder interest. Once the present value of the annuity has been calculated (see Steps 14), the value of the remainder interest is determined by subtracting the value of the annuity from the entire fair market value of the property contributed to the trust.

Note: Practitioners who decide to use the IRS valuation tables (Pubs. 1457 and 1458) should be sure to use the most recent edition (Rev. 7/99), released Nov. 3, 1999.

Valuing Harry's Remainder Interest

Harry contributed $2 million to a CRAT that pays him $140,000 for life. His charitable deduction is computed at Sec. 7520 rates of 7.4% and 7.6%. As noted, the taxpayer can elect to use the Sec. 7520 rate for either of the two months preceding the month of transfer for purposes of valuing the remainder interest.

The annuity factors from IRS Pub. 1457 (Rev. 7/99), Table S, for age 70 using 7.4% is 7.7270 and using 7.6% is 7.6266. Age 70 is used because this is Harry's age (to the nearest whole year) at the time the trust is funded (Regs. Sec. 1.664-4(e)(5)). Therefore, the value of the annuity interest is:

The charitable income tax deduction (which equals $2 million less the value of the annuity interest) is $918,220 for the 7.4% rate and $932,276 for the 7.6% rate. Accordingly, Harry will use the prior month's 7.6% rate, as it will give him a larger charitable income tax deduction.