The Highs and Lows of Rising Interest Rates

The rate of return that determines income earned on trust assets — term interests, life interests, annuities and remainders — is established through IRC Code Section 7520. Published each month by the IRS based on the previous month’s weighted average market yield for marketable treasure obligations of the same duration (short-term, mid-term and long-term), this rate is 120 percent of the “applicable federal rate” for mid-term obligations with semiannual compounding.

In recent years, the Section 7520 rates have been at historically low levels, but this could be a thing of the past as the rates have begun creeping up, and it’s likely they’ll continue to climb. Because transfer tax valuation rules are based, in part, on Section 7520 rates, certain charitable transfer tax planning techniques are directly affected by the prevailing rates. The impact is especially apparent with respect to annuity interests but also applies, albeit to a lesser extent, to unitrust interests.

As the Section 7520 rate increases, the present value of annuity or unitrust interest declines and the present value of the remainder interest increases. The opposite occurs when the Section 7520 rate decreases.

The annuity or unitrust interest will have a smaller present value, and the remainder interest a larger present value. The reason for the difference is that a higher Section 7520 rate presumes a higher rate of return that will be used to pay the annuity or unitrust interest and a less likely chance that principal will be needed for such payments.

Thus, charitable lead trusts are more advantageous when the Section 7520 rate is low. For example: A $1 million charitable lead annuity trust having a 5 percent payout to a charitable beneficiary for a 10-year period with the trust terminates and pays out to the donor’s child. If the Section 7520 rate is 5.4 percent, the present value of the charity’s right to receive $500,000 ($50,000 a year for 10 years) is $378,695. If the Section 7520 rate is 3.4 percent, the present value of the charity’s interest rises to $417,935. The increase in value of the charity’s interest reduces the present value of the remainder interest that will pass to the donor’s child in 10 years and, thus, lowers the value for federal gift tax purposes. In addition, any growth in the value of the trust assets in excess of the 5 percent annuity will pass to the donor’s child.