The important section 7520 rate

This month, the section 7520 rate that the IRS uses to value certain charitable interests in trusts is only 3.4%, making this April, May and June a good opportunity for moving assets outside of your taxable estate if it is appropriate for your overall wealth planning situation.

The section 7520 rate is very important because most estate planning strategies are designed to minimize what you "give" to the government (as opposed to beneficiaries you choose, such as causes you care about and members of your family), and the 7520 rate plays a key role in assessing how much of an asset gifted to an irrevocable trust will be exposed to estate taxes and gift taxes.

The IRS sets the section 7520 rate each month using the Federal Midterm Rate, which is determined using an average of the yields of government securities with terms of more than three years and less than nine years. The rate represents a rate of return by which assets in a trust can be reasonably expected to grow in future years, and so the section 7520 rate is basically the rate of return that the IRS projects onto those assets.

In the diagram above, for example, which depicts a charitable lead trust, a wealthy family has created a trust which will donate an annual payment to a charity (such as a college) for a certain number of years and then at some future time give the remainder to non-charitable beneficiaries (such as children or grandchildren). The IRS will use the section 7520 rate for the month in which the trust was established to determine the net present value of the (non-taxable) gifts to the charity, and how much would theoretically be left over for the remainder beneficiaries (a taxable gift). If the assets in the trust grow at a rate of return which is greater than the section 7520 rate, then the amount beyond the calculated "taxable gift" passes to those beneficiaries (the children or grandchildren in this example) free of estate taxes and gift taxes.

Therefore, the lower the section 7520 rate is in the month in which you establish the trust, the better it is for your non-charitable beneficiaries, because there is a greater chance that the trust assets will outperform the rate that the government foresees, growing outside of the tax system and not subject to estate and gift taxes.

Even better, you actually get to choose the most favorable (i.e. the lowest) of the section 7520 rates for the month you establish the trust or the two prior months. The lowest the section 7520 rate has ever been since it was established in 1988 was in July of 2003. The second-lowest was the following month, August of 2003, in which the rate was 3.2%. This month, April of 2008, is the next-lowest after that, at 3.4% (the two months previous to this one were 3.6% and 4.2%).

To see just how powerful the section 7520 rate is, consider the charitable lead trust described above and add some numbers. If a wealthy individual (the grantor of the trust, indicated by the figure on the left of the diagram) establishes an irrevocable trust into which he grants $1,000,000 (indicated by the first green arrow going into the trust), and the terms of the trust dictate that it will gift $75,000 per year to a certain charity (represented by the green arrow with vertical arrows on top of it) for a period of twelve years, then the IRS would use the section 7520 rate to determine the net present value of the original million dollars minus those twelve years of gifts, which would be the amount of the trust that is subject to estate and gift tax when it passes to the remainder beneficiaries.

At 3.4%, the amount subject to gift and estate taxes is $270,965.93. This is over a hundred thousand dollars less than if the trust had been established under a section 7520 rate of 6.2%, which is what it was as recently as August of last year.

By increasing the gift size or duration of the gift stream to the charity, the amount subject to gift and estate taxes can be brought to zero. Any remainder would then pass to the remainder beneficiaries completely free of estate and gift taxes. There would only be a remainder if the growth rate exceeded the section 7520 rate, of course. However, the lower the 7520 rate, the better chance to do so. And obviously, the lower the 7520 rate, the less you need to increase the gifts to the charity in order to leave the taxable gift at zero (at 3.4% in our example above, you could zero out the taxable gift by increasing the annual charitable gift to $100,000 and extending it to thirteen years).

Other types of irrevocable trusts, such as Charitable Remainder Trusts and Grantor Retained Annuity Trusts, also use section 7520 and benefit similarly from a lower 7520 rate.

Because the trust uses the lowest section 7520 rate of the current and prior two months, it seems logical that this June would be an even better month to establish this type of trust (because the rate may continue to go down, but if it doesn't you can still use the April rate of 3.4%). However, the stock market is also down right now, meaning that if you grant assets to the trust that are stocks and they are valued at a lower price right now, that will also work to lower the amount that ends up being potentially subject to estate taxes. There is no telling whether stock assets will still be low in June.

The combination of low asset prices and a historically low section 7520 rate makes this a potentially valuable confluence of events for drafting these types of trusts, if it is appropriate to your situation.

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