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George F. Bearup, J.D. Senior Legal Trust Advisor

December 29, 2022

Philanthropy Today

Take-Away: The world of charitable giving is changing with inflation, rising interest rates, and changes in charitable giving trends. The amount of charitable giving may fall off due to a decrease in the donor’s available discretionary income caused by inflation. Moreover, the form of the charitable gift may change to reflect what works ‘better’ in a period of high(er) interest rates. But other trends or scheduled ‘events’ may encourage more individuals to give to charity.

Background: Currently there are three ‘trends’ that  affect charitable giving. It is no surprise that inflation takes a toll on the amount of philanthropy, and impacts  the form in which philanthropy takes place, or what asset are the source of the charitable gift. In addition,  future tax laws are about to change in another 3 years, and new (albeit volatile) assets are now being gifted to charities with more regularity, all of which makes philanthropy a dynamic topic. These are all touched on in the following paragraphs.

Inflation and Higher Interest Rates: Two of the 5 factors that normally affect the value of a donor’s charitable deduction are tied to inflation. The first factor is that as interest rate rise, donors will want a higher payout rate from their life income gifts, e.g. charitable remainder annuity trust; charitable gift annuities, to make up for the loss that inflation is causing to the donor’s discretionary income. The second factor is the IRC 7520 rate of interest that is used to value retained interests. This interest rate will rise along with inflation. As a generalization, the higher the income payment to the donor from their life income charitable gift, their lower their federal income tax charitable deduction. Yet, at the same time,  the higher the IRC 7520 rate that is used to value the donor’s retained interest will result in a higher federal income tax charitable deduction. As the IRC 7520 rate continues to creep upward, that change will affect each split-interest lifetime charitable gift a bit differently.

  1. Charitable Gift Annuities: The IRC 7520 rate affects a charitable gift annuity (CGA) in two ways. First, as the IRC 7520 rate increases, the donor’s charitable deduction also rises (a good thing!) Second, the  proportion of the annuity payments received by the donor that will be recognized as tax-free income over the donor-annuitant’s life expectancy as a return of principal will fall. This proportion of tax-free payments is substantial if the CGA is funded with cash. However, as the IRC 7520 rate increases, the proportion of tax-free income over the donor-annuitant’s life expectancy will decrease (a bad thing!)

Example: Don Donor wants to make a gift to his favorite charity, but he needs a steady stream of income to maintain his lifestyle. Back in January, 2022 when Don was first exploring a charitable gift annuity, the American Council on Gift Annuities recommended an annuity rate of 6.2%. If Bob had entered into  the CGA gift in January, 2022, 49.9% of the amount that Don paid in exchange for the CGA would have been income tax deductible by him. If Bob waited until October, 2022 in which to enter into the CGA, Don’s charitable income tax deduction would increase to 56.3% of the donated amount. Why the increase? January’s IRC 7520 rate was 1.6% while in October, that IRC 7520 rate increased to 4.0%. If Don had funded his CGA with cash, the proportion of the tax-free income of the annuity amount would have fallen from 81.6%, if the gift was made in January, to 71.2% if the CGA is entered into in October, 2022. This drop in the tax-free portion is because the higher the IRC 7520 rate allows for less of a return of capital to the donor.

External Factors: Two other recent factors have also impacted CGAs in 2022. First, the American Council on Gift Annuities increased the recommended maximum annuity rates in July. The Council increased its recommended maximum rate from 0.4% to 0.6% depending on the age of the donor-annuitant, effective 7/1/22. These higher income payments to the annuitant result in a lower income tax charitable deduction available to the donor. Second, the IRS published updated mortality tables back in January to reflect an increase in life expectancies for everyone. These new mortality tables will cause a CGA to pay income for a longer period of time to the donor, which results in a reduction of the donor’s current federal income tax charitable deduction when the CGA is initially funded.

  1. Charitable Remainder Trusts: Each form of charitable remainder trust (CRT) will have a different result with increases to the IRC 7520 rate.

CRUT: A charitable remainder unitrust (CRUT) will not change too much with a shift in the IRC 7520 rate. This slight impact is best demonstrated with the following example-

Example: Don Donor, age 72, creates a CRUT in January, 2022. Don funds the CRUT with $100,000. Don creates a 5% payout from his CRUT. The IRC 7520 rate in   January, 2022 is 0.4%. Don’s federal  income tax charitable deduction for the gift of the remainder interest to charity will be $55,101. If Don, instead, created his CRUT in October, 2022 when the IRC 7520 rate has increased to 4%, Don’s income tax charitable deduction would increase to $55,759, only $658 more.

CRAT: A charitable remainder annuity trust (CRAT) is more impacted by increases in the IRC 7520 rate. As that rate increases, so will the amount of the federal income tax charitable deduction. Another example demonstrates this impact-

Example: Don Donor, age 72, creates a CRAT in January, 2022 funding it with $100,000. His federal income tax charitable deduction will be $39,995. If Don waits until October, 2022 in which to create and fund his CRAT, Don’s federal income tax charitable deduction increases to $52,544, or a 31% increase in the income tax deduction amount.

Warning: One of the Tax Code conditions for a CRAT is that there must be a 5% or more probability that the charitable remainder beneficiary will actually receive its mandatory 10% remainder value of the initial transfer to the CRAT. It is probable that Don’s creation of the CRAT in January, 2022 would have failed this 5% ‘test.’ If that were the case, then Don would not have been eligible to claim any federal income tax deduction for his transfer to the CRAT in January 2022, since Don’s trust would have been to a non-qualifying CRAT.

Pooled Income Fund: While this form of charitable giving has not received much attention over the past decade with its lower interest rate environment, that might change with inflation. A pooled income fund (PIF) must be established by a charitable organization, so it is much different than a CRAT or CRUT. A PIF can define income on a total return basis, which allows for more flexibility in the PIF’s administration and determination of income that is paid to a contributor. [IRC 642.] In general, the federal income tax charitable deduction for a donor’s contribution to a PIF is based on the PIF’s investment return over the prior 3 years. If the PIF is ‘new’ without a 3-year earnings history, Treasury Regulations will assume that the ‘new’ PIF’s rate of return is the highest average annual IRC 7520 rate for the prior 3 years, reduced by 1%. Accordingly, this assumption creates a favorable income tax charitable deduction environment for ‘new’ PIFs over the past several years.

Example: A ‘new’ PIF that is created in 2022 will produce a percentage federal income tax charitable deduction between 69% for a 65 year-old donor and 91% for a 90 year-old donor. Those are higher rates of charitable deductions that can be achieved using more conventional CRTs.

Scheduled Tax Law Changes: The second impact is the scheduled tax law changes that return in 2026, when the tax law rates and tax deduction changes created by the 2017 Tax Act come to an end.

  1. Applicable Exemption Amount: It is hard to predict the impact of the scheduled 50% reduction in the applicable exemption amount on a deceased individual’s charitable giving. Some decedents might want to leave more to charities in the form of a charitable bequest in order to avoid the government’s flat 40% estate and generation skipping transfer taxes. Other decedents might decide to leave more assets to their descendants to make up for the federal estate tax ‘hit’ that those descendants will have to pay. If taxes drive charitable gifts, then more decedents may leave their retirement assets to charity via a beneficiary designation, and more non-retirement assets to their descendants. Some decedents may take a hard look at adopting a charitable lead annuity trust (CLAT) as part of their estate plan, since the amount that passes to charity is exempt from federal estate taxes and it is possible that if the CLAT’s assets grow faster than the IRC 7520 rate that is used when the CLAT is initially funded on the decedent’s death, the residual CLAT assets that pass to the decedent’s descendants as the CLAT’s remainder beneficiaries at the end of the charity’s annuity period, may pass estate and gift tax free.
  2. Standard Deduction: The 2017 Tax Act increased the size of an individual’s standard deduction. After the 2017 Tax Act was enacted, the Brookings Tax Policy Center noted that the number of households that claimed a federal income tax charitable deduction dropped from 37 million to 16 million. Starting in 2026, an individual’s standard deduction is reduced by 50%. Consequently, it is possible that with that scheduled reduction in the standard deduction, more individuals will begin to itemize their income tax deductions again which, in turn, may encourage more charitable gifts that can be claimed as a current federal income tax deduction.
  3. Tax Rates: If Congress does not act in the interim, come 2026 there will be a dramatic increase in the federal income tax rates. This scheduled change in the income tax rates ould drive more charitable giving because donors clearly understand that with the scheduled higher income tax rates that they face, those rates will be impacted more by larger income tax deductible gifts to charity.

Cryptocurrency: In 2021, Fidelity Charitable, one of the country’s largest grant makers, took in over $330 million in digital assets. For comparison purposes, Fidelity Charitable took in $30 million in digital assets in 2020, a ten-fold increase. Additionally, new intermediaries are being established to facilitate the receipt of cryptocurrency donations by tax exempt organizations- two examples- Endaoment and The Giving Block.  These charitable gifts of digital assets are not small, either. The Giving Block reported that the average size charitable donation of cryptocurrency that it handled in 2021 was $10,500. No surprise, many charities are leery of the extreme volatility of the cryptocurrency asset class, while others simply fear some damage to their reputation for their acceptance of such high risk-oriented assets as a charitable gift (Is it that desperate that it will even take cryptocurrency?)

  1. Avoid Capital Gains: Since the IRS treats digital assets as property, the donation of cryptocurrency to a charity will be treated as a gift of property to the charity. Cryptocurrency is otherwise subject to a 20% capital gain rate on its trade or sale by its owner. This may impact the amount that may be deductible by the donor depending on tax basis and holder period of the cryptocurrency. Which then leads to a question: If cryptocurrency is treated, and taxed, as property, will non-fungible tokens given to a charity be treated as collectible, which is subject to a 28% federal capital gain tax rate?  No one yet knows the answer to that question.
  2. Appraisals: Another problem associated with the gift of cryptocurrency to a charity is that since cryptocurrency is classified as property, it is subject to subject to a qualified appraisal requirement if the value of the charitable gift of cryptocurrency exceeds $5,000. Currently, there are not a lot of folks ‘out there’ who hold themselves out as qualified appraisers of cryptocurrency.
  3. Disclosures: In addition to the need for the submission of a qualified appraisal by a qualified appraiser for the gift of more than $5,000 in cryptocurrency to a charity, a gift of cryptocurrency in excess of $10,000 is subject to the federal anti-money laundering rules, which means that the donor’s name, address and social security number will be made available to the U.S. Department of Treasury

Conclusion: None of these ‘trends’ should come as a surprise. While some of them can in fact be destabilizing, others present new opportunities available to philanthropists who have an open mind.