Annuity Factors

An annuity is a series of payments that are of a fixed dollar amount (or presently determinable). When a person is entitled to receive annuity payments under a contract, from a retirement plan, or from a trust, it may be necessary to determine a present value of those payments for tax or other purposes.

Types of Annuities

Annuities can be payable for different periods of time:

• For a term of a specific number of years.
• While the person (or persons) entitled to the annuity is living.
• For a combination of a term of years and lives, such as the shorter of a lifetime or a fixed number of years, or the longer of a lifetime and a fixed number of years.

Present Values

Determining the present value of an annuity is usually based on two assumptions:

• An assumption about what income could have been earned by the payments if they were immediately receivable instead of received at a future date; and
• For annuities based on measuring lives, an assumption about the mortality of those lives (i.e., when they are likely to die).

For federal tax purposes, the income assumption is the average yield on federal securities with maturities of three to nine years (what is called the "applicable federal mid-term rate"), increased by 20%, and rounded to the nearest two-tenths of a percent. These rates are calculated each month by the Internal Revenue Service.

The federal mortality assumption is based on the most recent United States census, which is conducted every 10 years in order to determine the composition of the states in the House of Representatives.

These assumptions have been used by the IRS to construct tables of factors, and most annuities can be valued for federal tax purposes by multiplying those factors by the annuity amount.

Uses for Values

There are a number of different reasons why life estates and remainders might need to be valued:

• Values might be needed for estate, gift tax, or inheritance tax purposes;
• Values might be needed to settle litigation, or to sell property, if the defendant or purchaser wishes to pay the amount owed in the form of an annuity rather than a lump sum; and
• Values might be needed if there is already an annuity contract, or a trust paying an annuity, and there is a desire to sell the contract or terminate the contract or the trust.

The values computed by Webcalculators are most applicable to determine federal tax consequences, and other kinds of valuations may require different income or mortality assumptions.

Benefits/Costs of Grantor Trusts

A "grantor trust" is a trust which is considered to be "owned" by the grantor (or creator) of the trust (or a beneficiary of the trust) for federal income tax purposes. When the grantor or beneficiary of a trust is treated as the "owner" of a trust (or a portion of the trust), that grantor or beneficiary must include the income, deductions, and credits of the trust (or portion of the trust) on that person’s individual income tax return, and not on the tax return of the trust.

There are a number of different ways that a trust can be a grantor trust, and all of those different ways are too numerous and complicated to be described in detail, but they represent the judgment of Congress that a grantor who has retained a certain level of control over the income or principal of a trust should be treated as the owner of that trust for income tax purposes. The simplest example is a revocable trust. If the grantor of a trust can revoke the trust, then the trust should be ignored for income tax purposes. Similarly, a beneficiary who can withdraw the income and principal of a trust should be treated as the owner of that trust.

That a revocable trust is a grantor trust does not create any opportunities for estate or gift tax planning, because the creation of a revocable trust is not a completed gift, and the trust is still part of the gross estate of the grantor for federal estate tax purposes (and also subject to Pennsylvania inheritance tax). However, there are other powers that the grantor can retain to create a grantor trust other than the power to revoke, and the IRS has issued favorable gift and estate tax rulings on the use of those powers, so a trust can be a grantor trust even when the trust is irrevocable.

The most commonly used power to make an irrevocable trust a grantor trust is for the grantor of the trust to retain the power, exercisable in an individual and not a fiduciary capacity, to reacquire the trust principal (or corpus) by substituting other property of equivalent value. If the grantor creates an irrevocable trust and retains the power (in a nonfiduciary capacity) to require the return of property held in the trust in exchange for property of equal value, the trust is a grantor trust even if the grantor has no other interest or power in the trust. And the IRS has issued public rulings (on which taxpayers can rely) holding that the retention of a power of substitution does not cause the trust assets to be included in the grantor's gross estate, and so the trust is not subject to federal estate tax at the grantor's death.

Grantor Trust Benefit

The benefit of a grantor trust comes from who pays the tax on the trust's income and gains. The IRS has ruled that, when a trust is a grantor trust, the grantor is liable for the tax on the trust’s income. Therefore, because the grantor is paying his own tax liability and not the liability of the trust, the payment of the tax by the grantor is not a gift by the grantor to the trust or its beneficiaries.

The IRS ruling is not limited to any particular kind of income and applies to both capital gains and ordinary income. It also makes no difference whether the income or gains are distributed or accumulated. This means that the grantor of a grantor trust can pay the income taxes for income paid to children and grandchildren, or accumulated for their future benefit, without making a taxable gift.

So, if a trust has $20,000 of income and would otherwise have to pay $6,444 of federal income tax to accumulate that income (at 2017 rates), but the trust is a grantor trust and the grantor pays the tax on the income, the grantor has effectively made a $6,444 gift to the trust without payment of any gift tax. The trust will continue to earn income for which the grantor will have to pay additional taxes each year, so the grantor can indirectly add substantial sums to that trust during his or her lifetime by paying the income taxes for the trust.

Possible Income Tax Benefit (or Cost)

There may be a small income tax benefit to having income taxed to the grantor rather than the trust or its beneficiaries, because trusts reach the top income tax bracket very quickly (with only $12,500 of taxable income in 2017) and the grantor might not be in the top income tax bracket, in which case the income that would be taxed to the trust at the top rate is instead taxed at the lower rate that applies to the grantor.

In the alternative, there may be an income tax cost if the grantor is in the top income tax bracket, because then all of the income will the taxed at the top rate and the benefit of the lower income tax brackets of the trust will have been lost. However, this income tax cost is likely to be small in comparison to the gift and estate tax benefit, because the tax brackets that apply to trusts are much smaller than the tax brackets that apply to individuals, and so a trust reaches the top income tax rate very quickly. For example, in 2017, a trust reaches the top income tax rate with only $12,500 of income, and the difference between the tax on that income ($3,232.50) and the tax at the top income tax rate of 39.6% ($4,950) is only $1,717.50. So it doesn't take much of a gift tax benefit to overcome that income tax cost.

Further, if both the grantor and the trust are investing in securities that pay qualified dividends that are taxed as capital gains and not ordinary income, then the difference between the income tax payable by the trust as a separate taxpayer (non-grantor trust) and the income tax payable by the grantor will be even less.

An additional factor is that a trust accumulating income might also have to pay the 3.8% tax on net investment income under IRC section 1441, which the grantor might or might not have to pay because individuals have higher threshold amounts for that tax. So it is possible that the income tax paid by the grantor might be more than the income tax that would have been paid by the trust, while the tax on net investment income would be less, off-setting some (or all) of the income tax increase.

Comparing the Costs and Benefits

Webcalculators illustrates the gift tax benefit and income tax costs by calculating the income earned by a trust and comparing (a) the income taxes payable by the trust as a separate taxpayer (a non-grantor trust) and (b) the additional income taxes that would be payable by the grantor. The income tax cost is the difference between the cumulative difference in the income taxes paid by the two different kinds of trusts, plus the lost income, and the estate tax benefit is the difference between the compounded after-tax value of the two trusts.

Cost/Benefit of Lifetime Gifts

Gifts made during lifetime can help minimize (or eliminate) federal estate tax otherwise payable at death in a number of different ways. Gifts that use the annual gift tax exclusion are an obvious example, because the gifts are not subject to gift tax and not subject to estate tax. Gifts that use the applicable exclusion amount (currently $12,920,000 in 2023) are a less obvious example, because there is no gift tax to pay, but using the exclusion during lifetime means that there is less exclusion to apply for estate tax purposes at death. However, gifts that use the exclusion can nevertheless help to avoid estate tax if the gift is of appreciating property (such as common stock or real property) because the post-gift appreciation will not be subject to estate tax.

The disadvantage of lifetime gifts of property is that the donee (recipient of the gift) receives the property with the donor's income tax basis, while if the property had been held until death the property would have received a new income tax basis equal to fair market value at death (or at the alternate valuation date six months after death, if that would reduce the estate tax otherwise payable). So a lifetime gift of appreciating property has a possible estate tax benefit because post-gift apprecation is not subject to federal estate tax, but has a possible income tax cost because all pre-death appreciation (including pre-gift appreciation) may be subject to tax as capital gains.

One way to compare the income tax costs with the estate tax benefit is to project the future value of the property using an assumed rate of growth in value, then calculate both the possible estate tax on that post-gift growth and the possible income tax on the pre-gift and post-gift appreciation. The difference between the possible estate tax on the post-gift appreciation and the possible income tax on all of the pre-death appreciation is the net benefit of the lifetime gift.

Two additional calculations are possible:

• If the property has a basis that is less than current fair market value, then there is a current income tax cost but only a future estate tax benefit, and the net benefit will be negative if the donor dies soon after making the gift. There will be "break-even" point at which the estate tax benefit exceeds the income tax cost, and it is possible to calculate that break-even point and the probability of the donor living to that point, using the same mortality table used by the Internal Revenue Service for life estate and annuity calculations.
• By calculating the possible net benefit in future years, and the probability of the donor dying in each of those future years, it is possible to add those future probabilities together into a total net probable benefit for the lifetime gift.

The net benefit of the lifetime gift increases if the donor's basis in the property is nearer current market value, the assumed rate of growth is larger, or the donor is younger. The net benefit decreases if the property has a lower basis, the growth rate is lower, or the donor is older.

These calculations do not take into account the possibility that the property might not be sold for many years post-death, and so the tax on the capital gains might be deferred for many years (or avoided entirely if the beneficiary or beneficiaries who inherit the property should die before selling the property, so that the property receives a new income tax basis and the tax on the appreciation disappears). There is also the possibility of future tax law changes that would change the projected estate tax or income tax liabilities.

Charitable Lead Annuity Trust (CLAT)

A charitable lead annuity trust, or “CLAT,” is an irrevocable trust which pays to charity a fixed dollar amount each year for a period of time. At the end of the trust, the remaining assets of the trust go to the beneficiaries (such as children or grandchildren of the grantor) that are specified in the trust document.

Why Use It?

The usual reason for creating a CLAT is that the grantor wants to make a gift to charity of a certain amount, but also wants to increase the amounts that can pass to children or grandchildren free of federal estate tax. A CLAT can be set up so that the present value of the remainder for federal gift tax purposes is very small, or even zero, which means that at the end of the term of the trust, the remaining trust assets (if any) that pass to the beneficiaries are free of federal gift tax and federal estate tax.

In this way, a CLAT operates like a grantor retained annuity trust ("GRAT"), which pays an annuity to the grantor during the term of the trust, which means that the present value of the annuity is not a gift. In a CLAT, the annuity is payable to charity instead of the grantor, so there is a gift, but there is no gift tax (or estate tax) because the annuity is payable to charity and qualifies for a charitable gift tax or estate tax deduction.

Because a CLAT can qualify for either a gift tax charitable deduction or an estate tax charitable deduction, a CLAT can be created during lifetime (an "inter vivos" trust) or at death through a will or revocable trust (a "testamentary" trust). In both cases, the goal would be the same, which is to crate a gift for charity while also seeking to increase the tax-free amounts ultimately going to children or grandchildren.

Another reason to create a CLAT is to be able to claim an immediate charitable income tax deduction for the payments to be made to charity in the future. However, that immediate charitable income tax deduction comes with a cost, because a CLAT will not result in an income tax deduction unless the CLAT is a "grantor trust" for federal income tax purposes, meaning that all of the income and gains of the trust must be taxed to the grantor of the trust and not the trust itself. However, the income of the trust will be paid to charity and not the grantor, and the grantor will not get any income tax deduction for the income paid to charity, so the grantor will have to pay income tax on income and gains that the grantor will not receive. As a result, the benefit of the immediate charitable deduction will be reduced or eliminated (and perhaps exceeded) by the income tax that the grantor will have to pay during the term of the trust.

For that reason, creating a CLAT to obtain an income tax deduction will usually be beneficial only if the grantor is now in the highest income tax bracket and expects to be in lower income tax brackets in future years.

How Does It Work?

The gift tax value of the remainder is the present value of that future payment, and the present value of the remainder can be zero even though valuable trust assets may actually go to the remainder beneficiaries at the end of the term of the trust. This is because of the way the Internal Revenue Code and its regulations say that the remainder should be valued for gift tax purposes.

The present value of the remainder is based on an assumption that the CLAT will earn a certain rate of interest, so the present value of the remainder can be zero if the CLAT pays an annuity that exceeds that assumed rate of interest, because in that case the trust has to distribute principal along with income in order to make the annuity payments. Using the assumed interest rate, it is possible to calculate an annuity amount that will result in the distribution of all of the principal over the term of the trust, so that there is nothing left to distribute at the end of the term. However, if the CLAT actually earns more than the assumed rate of interest, then there will be money left over at the end of the term of the trust, which is how the remainder beneficiaries can receive money without the grantor making a taxable gift.

Benefits

The benefit of a CLAT is the possibility (but not certainty) that the beneficiaries selected by the grantor of the CLAT will receive money or property at the end of the term of the trust, free of federal estate and gift tax, as explained above. This benefit is only a possibility, and not a certainty, because the remainder beneficiaries will receive money or property at the end of the trust only if the trust investments produce income and capital gains in excess of the interest rate that is used to value the remainder when the CLAT is created.

As explained below, this benefit comes with very few costs, aside from the charitable gift itself.

Costs

As explained above, a CLAT should have no (or insignificant) gift tax cost if the trust document is prepared to conform to the applicable tax rules, if the annuity amount is calculated properly, and if the trust is funded properly, so that the present value of the remainder is zero (or nearly zero).

Because the creation of a CLAT has little or no gift tax cost, there is no loss if the CLAT is not able to earn more than the assumed interest rate, so that all of the trust assets are distributed to charity in order to make the annuity payments and the remainder beneficiaries receive nothing. There is, from that point of view, no "downside" to the creation of a CLAT.

There should be minimal federal income tax costs for a CLAT that is not a grantor trust (and so does not result in a charitable income tax deduction):

• The distributions of trust income (and gains) to charities in order to make the annuity payments should qualify for a charitable income tax deduction for the trust (but not the grantor), so the trust will pay income tax on trust income only if the income exceeds the annuity amounts payable.
• The distribution to the remainder beneficiaries of whatever is left in the CLAT at the end of the term of the trust should not result in any gain or loss, or any taxable income to the remainder beneficiaries.

Because there should be little tax cost for creating a trust, the only costs for the CLAT should be transactional:

• The legal fees or other costs in preparing the CLAT trust document. As explained above, the trust might be created during lifetime, or might be part of the grantor's estate plan for the disposition of his or her estate at death.
• For a CLAT created during lifetime, the costs of preparing any gift tax returns that will be needed to report the creation of the trust. The gift tax return would need to report the value of the assets transferred to the trust, the present value of the charitable gift of the annuity amount, and the resulting taxable remainder interests in the CLAT, so there may be costs of valuing the assets being transferred to the CLAT and costs of calculating the value of the annuity based on the federal interest rates that apply when the CLAT is created. If real property, closely held business interests, or other properties with no readily ascertainable market values are transferred to the CLAT, appraisals might be needed for those properties.
• For a CLAT created at death, the only additional costs would be the valuation of the charitable annuity interest and the funding of the trust from the grantor's estate, because the valuation of estate assets and the preparation and filing of an estate tax return would be required (or not required) whether or not the CLAT is created.
• The costs (if any) of administering the trust. The investment costs of the CLAT should be the same as what the grantor would have paid for investment advisors if the CLAT had not been created, so the creation of the CLAT should not cause additional administrative costs beyond what might be required for accounting for the receipts and disbursements of the CLAT and the preparation and filing of income tax returns for the trust.

The only other cost of a CLAT is what might be described as an "opportunity cost," because the assets of the grantor that are used for a CLAT cannot be used for other estate planning steps, such as taxable gifts directly to children or grandchildren or trusts for their benefit. The benefit of a CLAT must therefore be weighed against the benefit of other steps that might have greater estate planning benefits.

Who Should Use It?

A CLAT is usually best suited to a person who has an estate that is more than his or her applicable exclusion amount (which can include both the base exclusion amount, which is $12,920,000 in 2023, as well as the unused exclusion amount of a deceased spouse) and who also wishes to make a large gift to charity.

Decisions

Before a CLAT is created, there are some decisions to be made:

• Who are the remaindermen (the noncharitable beneficiaries)?
• What charity (or charities) should receive the annuity payments? This should be decided in advance, and the grantor should not have the power to change the charitable beneficiaries. If the grantor has retained the power to change the charitable beneficiary (or beneficiaries) receiving the annuity, either directly through a power retained in the trust document or indirectly because the grantor is serving as trustee and the trustee has that power, the gift to charity is considered incomplete and the value of the annuity will be included in the grantor's gross estate at death, so that the trust will become subject to federal estate tax.
• What should be the term of the CLAT? Although a CLAT can be created for the lives of grantor, the grantor's spouse, or ancestors (or spouses of ancestors) of the remaindermen, it is better to use a term of years if the goal is to minimize the present value of the taxable gift to the remaindermen. The usual decision is to make the CLAT for a relatively long term, usually twenty years or more. This is because a longer term will produce a larger discount for the value of the remainder, which means that annuity can be smaller while still producing a remainder with a present value of zero, which increased the likelihood that the investments of the CLAT will be able outperform the assumed discount rate and produce a positive value of the remainder at the end of the term of the trust.
• Should payments increase over time? The annuity payments must be "determinable" in amount, which means that it must be possible to calculate the future amounts to be paid when the trust is created. The payments can therefore increase over the term of the trust if the increases can be calculated in advance. Having payments increase by each year (or remain low and then increase sharply in the end, something often called a "shark fin" CLAT) is usually considered desirable, because it increases the time that money will be held in the trust before it is paid out, which increases the discount and the likelihood of a positive value of the remainder at the end of the term of the trust.

Webcalculators can produce economic projections of CLATs so that the results of different payouts and investments assumptions can be illustrated.

Charitable Remainder Annuity Trust (CRAT)

A charitable remainder annuity trust, or “CRAT,” is an irrevocable trust which pays to the grantor (i.e., the creator or settlor of the trust), or beneficiaries selected by the grantor, or both the grantor and beneficiaries, a fixed dollar amount each year. At the end of the trust, the remaining assets of the trust go to one or more charities.

Why Use It?

The usual reason for creating a CRAT is that the grantor wants to make a gift to charity at his or her death, but wants a present charitable income tax deduction for the future gift. A CRAT can carry out that goal even though the CRAT is irrevocable because the grantor retains an income-like interest in the assets transferred to the trust, and so continues to have the benefit of the assets during lifetime.

Another reason for a CRAT is that the grantor wants to provide an income for a child or other relative, or a friend, but wants the trust assets to go to charity following the death of the beneficiary.

A third reason for creating a CRAT is that CRATs do not pay federal income tax, although income and gains that are earned by the trust become taxable to the beneficiaries of the trust when they are distributed. If a person who wishes to make charitable gifts has a valuble asset that has appreciated in value and is about to be sold, it may be advantageous to donate the asset to a CRAT before agreeing to the sale, so that the income tax on the capital gain is deferred until the gain is actually distributed in the future.

How Does It Work?

A gift to a CRAT results in a charitable deduction because section 170 of the Internal Revenue Code allows a charitable income tax deduction for the present value of the future charitable remainder in a trust described in section 664, which includes charitable remainder annuity trusts. The same present value is also a federal gift tax deduction, so only the noncharitable interests are subject to gift tax. If the CRAT is created at death, then the present value of the charitable remainder is a federal estate tax deduction, so only the present value of the noncharitable annuity payments is subject to estate tax.

Section 664 of the Internal Revenue Code also says that a CRAT is not subject to income tax, and that the income and gains of CRAT are taxable to the noncharitable beneficiaries of a CRAT only when they are distributed.

The present value of the charitable remainder is difference between the value of the property transferred to the trust and the present value of the annuity payments that must be distributed each year. When a CRAT is for a term of years, the future payments are discounted back to present value based on the income it is assumed the payments could have earned if received immediately. When a CRAT is for the life or lives of the noncharitable beneficiaries, the value of the future annuity payments is discounted for both interest that could have been earned and for the probabilities of the beneficiaries dying before the payments are to be made.

The Internal Revenue Code and regulations impose a number of restrictions on CRATs, the most signficant of which are the following:

• The payout percentage (the annuity amount as a percentage of the value of the property transferred to the trust) must be at least 5%, and cannot be more than 50%.
• The present value of the charitable remainder must be at least 10% of the contribution to the trust.
• The duration of the trust cannot be more than 20 years or until the deaths of the noncharitable beneficiaries.
• When the annuity payments are more than the assumed interest that would be earned by the trust, so that annuity payments will be made from principal as well as income and the trust might be entirely depleted by the annuity payments, the probability of the noncharitable beneficiaries outliving the principal of the trust must not exceed 5%.
• The trustees of CRATs are subject to many of the rules that apply to private foundations, such as the prohibition on self-dealing.

Benefits

The primary benefits of a CRAT are:

• The donor/grantor of the trust gets an immediate income tax deduction (or estate tax deduction in the case of a CRAT created at death) for the present value of the future remainder payable to charity.
• Because the distributions to the grantor or other noncharitable beneficiaries are a fixed dollar amount, the distributions will not go down even if the investments of the trust decrease in value.
• The income and gains of the CRAT are not subject to income tax until they are distributed to the noncharitable beneficiaries.

Costs

The primary costs of a CRAT are:

• There may be a gift tax (or estate tax) cost for the present value of annuity payments to be made to beneficiaries other than the donor/grantor. (Although the gift tax cost of payments following the death of the grantor can be postponed if the grantor retains the right to revoke the interests of those beneficiaries.)
• Because the payments to the grantor or other noncharitable beneficiaries are a fixed dollar amount and not dependent on future investments, the trust can be depleted if the payments exceed the income and gains of the trust, so that the charities named as beneficiaries receive nothing.
• Because the CRAT can only distribute the annuity amounts, and not any additional amounts, the grantor or other noncharitable beneficiaries will be unable to withdraw funds that might be needed for medical or other emergencies, or for other purposes which would be permitted for other kinds of trusts.
• There are also possible transactional costs:
• The legal fees or other costs of preparing the CRAT trust document.
• The costs of valuing the charitable and noncharitable interests in the CRAT for income tax and gift tax purposes, or for estate tax purposes, which costs would include the costs of valuing the assets being transferred to the GRAT and the costs of calculating the value of the remainder interests based on the values of the assets transferred to the CRAT. If real property, closely held business interests, or other properties with no readily ascertainable market values are transferred to the CRAT, appraisals might be needed for those properties.
• The costs of preparing any gift tax returns that may be needed to report the creation of the trust and the present value of the charitable noncharitable interests in the CRAT.
• The other costs (if any) of administering the trust. The investment costs of the CRAT should be the same as what the grantor would have paid for investment advisors if the CRAT had not been created, so the creation of the CRAT should not cause additional administrative costs beyond what might be required for accounting for the receipts and disbursements of the CRAT.

CRAT or CRUT?

There is another form of charitable remainder trust, and that is a charitable remainder unitrust, or "CRUT." A CRUT is similar to a CRAT, except that a CRUT pays out a percentage of the value of the trust assets, revalued each year, while a CRAT pays out a fixed dollar amount each year, regardless of the value of the trust assets.

A common question is, which is better, a CRAT or a CRUT? The answer depends on the goals and motives for creating the trust.

• The charitable deduction will be different for a CRAT and a CRUT even if they have what looks like similar payouts, so that the percentage payout from the CRUT is the same as the CRAT annuity as a percentage of the transfer to the CRAT. For example, there may be a significant difference between the charitable deduction for a $100,000 CRUT with a 5% payout and the charitable deduction for a $100,000 CRAT paying a $5,000 annuity, even though the annuity amount is 5% of the value of the CRAT. This is because of the differences in the ways that CRATs and CRUTs operate, and the different ways their charitable remainders are valued:
• The charitable remainder from a CRUT is valued based on the percentage payout, and the current and future assumed income yields, represented in other present value calculations by the §7520 interest rate, is almost irrelevant. So the remainder for a CRUT with a 5% payout may be pretty much the same regardless of whether current interest rates are 4% or 8%.
• The charitable remainder from a CRAT is valued based on the assumption that the trust will earn the current §7520 rate, and the present value of the remainder will vary greatly based on the difference between (a) the annuity payment and (b) the income that will be earned by a trust earning the §:7520 rate on investments. So the present value of the remainder for a CRAT that pays an annuity that is 5% of the initial value of the trust will vary a great deal depending on whether the §:7520 rate is 4% or 8%.
• The distributions from a CRUT will increase if the value of the trust increases, because the trust has been able to produce income and gains that are greater than the percentage payout, and the distributions will decrease if the investments yield less than the percentage payout. However, a CRAT will always payout the same amount until the trust ends, whether due to its terms or because the trust fund has been depleted by the noncharitable distributions. The choice between a CRAT and a CRAT may therefore depend on (a) expectations of future investment returns and (b) the grantor's goals for the noncharitable and charitable beneficiaries.
• Optimism about future investment yields, together with a desire to benefit the noncharitable beneficiary, might lead to the choice of the CRUT in order to give the noncharitable beneficiary the potential for an increasing income. However, if the goal is to maximize the future remainder to charity, and a fixed income for the noncharitable beneficiaries is acceptable, then a CRAT may be the better choice.
• Pessimism about future investment yields would lead to the opposite conclusions. A desire to benefit the noncharitable beneficiary would lead to the choice of the CRAT in order to give the noncharitable beneficiary the fixed income even though it might reduce (or eliminate) the future charitable remainder. However, if the goal is to preserve the future remainder to charity, and a reduced income for the noncharitable beneficiaries is acceptable, then the CRAT may be the better choice because the noncharitable distributions will decrease if the value of the fund decreases.

Other considerations:

• If the property contributed to the trust, or the initial trust investments, will produce little cash income (e.g., interest, dividends, or rents), a CRUT may be desirable because CRUT distributions can be limited to the actual net income of the trust, but the annuity payable by a CRAT cannot be limited to income.
• It may not be possible to create a CRAT for the entire lifetime of a relatively young noncharitable beneficiary (or beneficiaries), because the probability of the trust being exhausted by the annuity payments, and the charitable beneficiaries receiving nothing, can't be more than five percent. A CRAT must pay an annuity of at least 5% of the initial value of the trust, but the §7520 rate has been less than 5% since 2008, so it is assumed that a CRAT will have to distribute principal as well as income and will be depleted eventually. For beneficiaries below a certain age (the exact age will depend on the current §7520 rate), a CRAT will not be possible unless either (a) there is a term limit on the CRAT (i.e., the CRAT is not for the life of the beneficiary but for the shorter of a term or life), or (b) the trust document provides that the trust ends and distributes its assets to the charitable beneficiaries when the value of the trust assets fall to a certain level determined by a formula created by the IRS.

Webcalculators can produce economic projections of both CRATs and CRUTs so that the results of different payouts and investments assumptions can be illustrated for both kinds of charitable remainder trusts.

Decisions

Because the terms of a CRAT are restricted by the Internal Revenue Code and regulations, there are usually only a few decisions to be made when a CRAT is created:

• Who are the noncharitable beneficiaries?
• Who are the charitable remainder beneficiaries? Are they named now, or will the grantor name them in the future? Or can the trustees of the CRAT name the charities to receive the remainder at the end of the trust?
• What is the duration of the trust? A term of years? The lifetimes of the noncharitable beneficiaries? Or a combination of the two (such a trust for the lifetime of the grantor and the grantor's spouse, or a term of twenty years, whichever is shorter). It may be necessary to limit the number of noncharitable beneficiaries, or the number of years the trust can continue, in order for the present value of the charitable remainder to be at least 10% of the transfers to the trust, or for the probability that the trust will be exhausted to be less than 5%.
• What is the annuity amount to be paid by the CRAT? The payout percentage must be at least 5% of the transfer to the trust, but can be more than that (although larger percentages will reduce the present value of the charitable remainder). (Webcalculators can calculate the largest payout that will still result in a 10% charitable remainder and not result in a probability of exhaustion that is more than 5%.)

Charitable Remainder Unitrust (CRUT)

A charitable remainder unitrust, or “CRUT,” is an irrevocable trust which pays to the grantor (i.e., the creator or settlor of the trust), or beneficiaries selected by the grantor, or both the grantor and beneficiaries, a fixed percentage of the trust assets, the value of which is redetermined each year. At the end of the trust, the remaining assets of the trust go to one or more charities.

Why Use It?

The usual reason for creating a CRUT is that the grantor wants to make a gift to charity at his or her death, but wants a present charitable income tax deduction for the future gift. A CRUT can carry out that goal even though the CRUT is irrevocable because the grantor retains an income-like interest in the value of the assets transferred to the trust, and so continues to have the benefit of the assets during lifetime.

Another reason for a CRUT is that the grantor wants to provide an income for a child or other relative, or a friend, but wants the trust assets to go to charity following the death of the beneficiary.

A third reason for creating a CRUT is that CRUTs do not pay federal income tax, although income and gains that are earned by the trust become taxable to the beneficiaries of the trust when they are distributed. If a person who wishes to make charitable gifts has a valuble asset that has appreciated in value and is about to be sold, it may be advantageous to donate the asset to a CRUT before agreeing to the sale, so that the income tax on the capital gain is deferred until the gain is actually distributed in the future. This deferral of tax allows the pre-tax profit from the sale to be invested and produce future income, much like a retirement fund can defer income tax until retirement distributions are made. (When a trust is created to hold an investment producing very little current cash income, the CRUT can be created as an "net income" CRUT which later "flips" to require percentage distributions. See the explanation below of "NIMCRUTs" and "Flip CRUTs.")

Finally, a CRUT can be used as a kind tax-deferred retirement fund, which can accumulate and reinvest capital gains and defer the payment of any federal income tax until the capital gains are reinvested in income-producing investments and the income is distributed. (See the explanation of "NIMCRUTs" below.)

How Does It Work?

A gift to a CRUT results in a charitable deduction because section 170 of the Internal Revenue Code allows a charitable income tax deduction for the present value of the future charitable remainder in a trust described in section 664, which includes charitable remainder unitrusts. The same present value is also a federal gift tax deduction, so only the noncharitable interests are subject to gift tax. If the CRUT is created at death, then the present value of the charitable remainder is a federal estate tax deduction, so only the noncharitable interests are subject to estate tax.

Section 664 of the Internal Revenue Code also says that a CRUT is not subject to income tax, and that the income and gains of CRUT are taxable to the noncharitable beneficiaries of a CRUT only when they are distributed.

The present value of the charitable remainder is based on the precentage of the trust that must be distributed each year. So a CRUT for one year with a 5% payout would have a charitable remainder of 95% of the initial value of the trust, a CRUT with the same payout for two years would have a charitable remainder of 95% of 95%, or 90.25%, and so forth. When the CRUT is for the life or lives of the noncharitable beneficiaries, the value of the future remainders is based on the probabilities of the beneficiaries living or dying in the future years. When there is a delay between the annual valuation of the assets of the CRUT and the distribution of the percentage of that value, or the distribution is made in quarterly or other periodic installments, the valuation of the remainder is adjusted through a formula that takes into account the number of installments, the months from valuation to the first distribution, and interest on the delayed distributions.

The Internal Revenue Code and regulations impose a number of restrictions on CRUTs, the most signficant of which are the following:

• The payout percentage must be at least 5%, and cannot be more than 50%.
• The present value of the charitable remainder must be at least 10% of the contribution to the trust.
• The duration of the trust cannot be more than 20 years or until the deaths of the noncharitable beneficiaries.
• The trustees of CRUTs are subject to many of the rules that apply to private foundations, such as the prohibition on self-dealing.

NIMCRUTs and Flip CRUTs

There are variations on the regular CRUT known as "NIMCRUTS" and "Flip CRUTs."

"NIMCRUT" is an acronym for "Net Income with Makeup Charitable Remainder UniTrust." The Internal Revenue Code allows a CRUT to be created which distributes either (a) the specified percentage of the value of the trust assets or (b) the actual net income of the trust (e.g., interest and dividends, but not capital gains), whichever is less. The same trust can also provide for "makeup" distributions if trust income is less than the precentage amounts that could have been distributed, and the trust income later increases to more than the percentage amount, in which case the trust can distribute the amounts of excess income that will bring the total distributions up to what would have been the distributions if the percentage distributions had been made all along.

This net income limitation does not increase or otherwise affect the present value of the charitable remainder, but allows greater flexibility in planning the amounts and timing of distributions from the trust.

There are two principal uses for a NIMCRUT:

• As mentioned above, it might be desirable to transfer an appreciated property to a CRUT, so as to defer tax on the capital gains when the property is sold. However, there may be a delay before the property is sold, and the property might generate little (if any) income until it is sold, so the CRUT will be illiquid and unable to make cash distributions until the property is sold. Under those circumstances, it might be helpful to create the CRUT as a NIMCRUT so that distributions can be limited to actual income until the property is sold and the proceeds can be reinvested so as to create a larger income.
• As mentioned above, it might also be desirable to create a NIMCRUT and deliberately make investments that result in capital gains instead of ordinary income, or produce income that is not received until future years. Capital gains can be reinvested without immediate income tax liability, and income distributions can then be deferred to a future year, much like a retirement fund.

As taxpayers began using NICRUTs for these purposes, the Internal Revenue Service decided to make it easier (and not harder) by adopting regulations allowing a "flip CRUT," which is a NIMCRUT that can switch to being a regular CRUT upon the happening of a pre-defined event, or at a specified time. The differences between a NIMCRUT and a "flip CRUT" is that, after the Flip CRUT changes from a NIMCRUT to a regular CRUT, it (a) makes percentage distributions regardless of net income, and (b) cannot make any makeup distributions. So, for the examples described above:

• If a CRUT is created with a property that produces little or no current income, the CRUT document can direct that the trust will initially be a NIMCRUT, and then switch to become a regular CRUT once the property is sold.
• If the goal is to accumulate capital gains from trust investments until the noncharitable beneficiary retires and has less income, then the CRUT document can direct that the trust will initially be a NIMCRUT, and then switch to become a regular CRUT on the date that beneficiary reaches a specified age.

Benefits

The primary benefits of a CRUT are:

• The donor/grantor of the trust gets an immediate income tax deduction (or estate tax deduction in the case of a CRUT created at death) for the present value of the future remainder payable to charity.
• Because the distributions to the grantor or other noncharitable beneficiaries are a percentage of the value of the trust, which is revalued annually, the distributions can increase if the investment of the trust increase in value (or decrease if the investments decrease in value).
• The income and gains of the CRUT are not subject to income tax until they are distributed to the noncharitable beneficiaries.

Costs

The primary costs of a CRUT are:

• There may be a gift tax (or estate tax) cost for the present value of distributions to be made to beneficiaries other than the donor/grantor. (Although the gift tax cost of distributions following the death of the grantor can be postponed if the grantor retains the right to revoke the interests of those beneficiaries.
• Because the distributions to the grantor or other noncharitable beneficiaries are a percentage of the value of the trust, which is revalued annually, the distributions can decrease if the investment of the trust decrease in value (or increase if the investments increase in value).
• Because the CRUT can only distribute the unitrust percentage, and not any additional amounts, the grantor or other noncharitable beneficiaries will be unable to withdraw funds that might be needed for medical or other emergencies, or for other purposes which would be permitted for other kinds of trusts.
• There are also possible transactional costs:
• The legal fees or other costs of preparing the CRUT trust document.
• The costs of valuing the charitable and noncharitable interests in the CRUT for income tax and gift tax purposes, or for estate tax purposes, which costs would include the costs of valuing the assets being transferred to the GRAT and the costs of calculating the value of the remainder interests based on the values of the assets transferred to the CRUT. If real property, closely held business interests, or other properties with no readily ascertainable market values are transferred to the CRUT, appraisals might be needed for those properties.
• The costs of preparing any gift tax returns that may be needed to report the creation of the trust and the present value of the charitable noncharitable interests in the CRUT.
• The costs of revaluing the trust assets each year, and preparing the required income tax returns for the trust.
• The other costs (if any) of administering the trust. The investment costs of the CRUT should be the same as what the grantor would have paid for investment advisors if the CRUT had not been created, so the creation of the CRUT should not cause additional administrative costs beyond what might be required for accounting for the receipts and disbursements of the CRUT.

CRUT or CRAT?

There is another form of charitable remainder trust, and that is a charitable remainder annuity trust, or "CRAT." A CRAT is similar to a CRUT, except that instead of paying out a percentage of the value of the trust assets, a CRAT pays out a fixed dollar amount each year, regardless of the value of the trust assets.

A common question is, which is better, a CRUT or a CRAT? The answer depends on the goals and motives for creating the trust.

• The charitable deduction will be different for a CRUT and a CRAT even if they have what looks like similar payouts, so that the percentage payout from the CRUT is the same as the CRAT annuity as a percentage of the transfer to the CRAT. For example, there may be a significant difference between the charitable deduction for a $100,000 CRUT with a 5% payout and the charitable deduction for a $100,000 CRAT paying a $5,000 annuity, even though the annuity amount is 5% of the value of the CRAT. This is because of the differences in the ways that CRUTs and CRATs operate, and the different ways their charitable remainders are valued:
• The charitable remainder from a CRUT is valued based on the percentage payout, and the current and future assumed income yields, represented in other present value calculations by the §7520 interest rate, is almost irrelevant. So the remainder for a CRUT with a 5% payout may be pretty much the same regardless of whether current interest rates are 4% or 8%.
• The charitable reaminder from a CRAT is valued based on the assumption that the trust will earn the current §7520 rate, and the present value of the remainder will vary greatly based on the difference between (a) the annuity payment and (b) the income that will be earned by a trust earning the §:7520 rate on investments. So the present value of the remainder for a CRAT that pays an annuity that is 5% of the initial value of the trust will vary a great deal depending on whether the §:7520 rate is 4% or 8%.
• The distributions from a CRUT will increase if the value of the trust increases, because the trust has been able to produce income and gains that are greater than the percentage payout, and the distributions will decrease if the investments yield less than the percentage payout. However, a CRAT will always payout the same amount until the trust ends, whether due to its terms or because the trust fund has been depleted by the noncharitable distributions. The choice between a CRUT and a CRAT may therefore depend on (a) expectations of future investment returns and (b) the grantor's goals for the noncharitable and charitable beneficiaries.
• Optimism about future investment yields, together with a desire to benefit the noncharitable beneficiary, might lead to the choice of the CRUT in order to give the noncharitable beneficiary the potential for an increasing income. However, if the goal is to maximize the future remainder to charity, and a fixed income for the noncharitable beneficiaries is acceptable, then a CRAT may be the better choice.
• Pessimism about future investment yields would lead to the opposite conclusions. A desire to benefit the noncharitable beneficiary would lead to the choice of the CRAT in order to give the noncharitable beneficiary the fixed income even though it might reduce (or eliminate) the future charitable remainder. However, if the goal is to preserve the future remainder to charity, and a reduced income for the noncharitable beneficiaries is acceptable, then the CRUT may be the better choice because the noncharitable distributions will decrease if the value of the fund decreases.

Webcalculators can produce economic projections of both CRUTs and CRATs so that the results of different payouts and investments assumptions can be illustrated for both kinds of charitable remainder trusts.

Decisions

Because the terms of a CRUT are restricted by the Internal Revenue Code and regulations, there are usually only a few decisions to be made when a CRUT is created:

• Who are the noncharitable beneficiaries?
• Who are the charitable remainder beneficiaries? Are they named now, or will the grantor name them in the future? Or can the trustees of the CRUT name the charities to receive the remainder at the end of the trust?
• What is the duration of the trust? A term of years? The lifetimes of the noncharitable beneficiaries? Or a combination of the two (such a trust for the lifetime of the grantor and the grantor's spouse, or a term of twenty years, whichever is shorter). It may be necessary to limit the number of noncharitable beneficiaries, or the number of years the trust can continue, in order for the present value of the charitable remainder to be at least 10% of the transfers to the trust.
• What is the percentage payout from the CRUT? The payout must be at least 5%, but can be more than that (although larger percentages will reduce the present value of the charitable remainder). (Webcalculators can calculate the largest payout that will still result in a 10% charitable remainder.)
• If the property contributed to the trust, or the initial trust investments, will produce little cash income (e.g., interest, dividends, or rents), should distributions be limited to that trust income? If distributions are initially limited to trust income, should the trust "flip" upon the sale of the property (or other event) to require distributions of the full percentage the trust value? (Directing that the trust "flip" will eliminate any possibility of make-ups for past under-distributions caused by the income limitation.)

Contingent Remainders

It is possible to divide property between or among two or more people in a number of different ways, and one way is to separate the right to receive the current income of the property, or the right to use the property, from the right to own the property in the future after the income or use has ended (which is usually called the "remainder"). When property is divided that way, it may also be necessary to determine a present value for future income and remainder interests, for tax purposes or for purposes of a sale or separation of the separate interests.

Types of Interests

The types of interests that can be inconsidered "income interests" include the following:

• The right to the ordinary income (such as interest and dividends, but not capital gains) of a trust.
• The right to the rental income from a building, or the farming income from farmland.
• The right to use or occupy a residence or other property.

These rights can extend for different periods of time:

• For a term of a specific number of years.
• While the person (or persons) entitled to the income or use of the property is living. (This is usually known as a "life estate" or "life tenancy" and the beneficiaries receiving the income or use of the property are often known as "life tenants.")
• For a combination of a term of years and lives, such as the shorter of a lifetime or a fixed number of years, or the longer of a lifetime and a fixed number of years.

Regardless of how the length of the income or use of the property is measured, what is left at the end is known as the "remainder" and the person (or persons) who are ultimately entilted to the full ownership of the property is known as the "remainderman" (or "remaindermen").

When a remainderman must be living at the termination of a trust or life estate in order to be entitled to a share of the trust or property, the remainder is usually described as "contingent."

Present Values

Determining the present value of income and remainder interests is usually based on two assumptions:

• An assumption about what income will be earned by the property; and
• For income interests based on measuring lives, an assumption about the mortality of those lives (i.e., when they are likely to die).

For federal tax purposes, the income assumption is the average yield on federal securities with maturities of three to nine years (what is called the "applicable federal mid-term rate"), increased by 20%, and rounded to the nearest two-tenths of a percent. These rates are calculated each month by the Internal Revenue Service.

The federal mortality assumption is based on the most recent United States census, which is conducted every 10 years in order to determine the composition of the states in the House of Representatives.

These assumptions have been used by the IRS to construct tables of factors, and most income interests or remainders can be valued for federal tax purposes by multiplying those factors by the value of the property (or principal amount) subject to the income interest. Those tables cannot be used to calculate the present value of a remainder that is payable upon the death or deaths of one or more beneficiaries and that is contingent upon the remainder beneficiary surviving the income beneficiaries (or "life teant"), but the present value of contingent remainders can be calculated using the same kinds of assumptions that are used to calculate the factors found in the IRS tables.

Uses for Values

There are a number of different reasons why contingent remainders might need to be valued:

• Values might be needed for estate, gift, inheritance, or realty transfer tax purposes (although life estates and remainders are generally not recognized for federal gift tax purposes);
• Values might be needed if an owner of a property might want to sell a contingent remainder to a relative or third party; and
• Values might be needed if a property that is subject to a contingent remainder is sold, or a trust with a contingent remainder is terminated, and the sale price or trust property must be divided between or among the beneficial owners.

The values computed by Webcalculators are most applicable to determine federal tax consequences, and other kinds of valuations may require different income or mortality assumptions.

Credit Exclusion Gifts

Gifts made during lifetime can help minimize (or eliminate) federal estate tax otherwise payable at death in a number of different ways. Gifts that use the annual gift tax exclusion are an obvious example, because the gifts are not subject to gift tas and not subject to estate tax. Gifts that use the federal gift and estate tax unified credit applicable exclusion amount are a less obvious example, because using the exclusion during lifetime means that there is less exclusion to apply for estate tax purposes at death, so it might seem to be irrelevant whether the exclusion amount is used during lifetime or at death. However, gifts that use the exclusion can nevertheless help to avoid estate tax because future income or appreciation from the gift will not be included in the donor's gross estate, and so will avoid estate tax.

The estate tax benefit of credit exclusion gifts can be projected in two different ways:

• One way to project the benefit is to determine the donor's life expectancy (the average number of years the donor can be expected to live), calculate the possible future growth in the value of the gift based on either an assumed rate of capital appreciation or an assumed rate of after-tax income accumulation, and then calculate what the federal estate tax (and any state death taxes) would have been if the growth were still part of the estate.
• The other way to project the benefit is to calculate the future growth in each future year (using the same kind of assumed growth rate or income accumulation rate), and the possible estate tax on that future growth, but multiply those possible future estate tax savings by the probability of the donor dying in that future year. The sum of those possible benefits is the total probable benefit of the gift.

Webcalculators illustrates the probable benefit of making a lifetime gift using both methods.

A disadvantage of lifetime gifts of property is that the donee (recipient of the gift) receives the property with the donor's income tax basis, while if the property had been held until death the property would have received a new income tax basis equal to fair market value at death (or at the alternate valuation date six months after death, if that would reduce the estate tax otherwise payable). To compare the income tax cost of a lifetime gift of appreciating property with the estate tax benefit of excluding the appreciation from estate tax, see "Cost/Benefit of Gifts of Appreciating Property."

Gift Loans

Family members with assets or cash often consider making loans rather than gifts to other family members with financial needs, for one or more of several possible reasons:

• The financial need may be temporary, and the borrower may be able to repay the loan at a future date, so a gift is not necessary.
• The lender may expect to need the funds for his or her own financial needs at a later date.
• Although it is usually older family members who are thinking of providing financial support for younger family members, it is sometimes the other way around, and one or more children may be asked to provide financial assistance to a parent. In that case, a gift might not be not desired because the child providing the financial support might be one of several children and a gift might increase the inheritances of the other children (which is not what is intended), or because the child (or children) might have to pay estate or inheritance taxes when the parent dies and they inherit back the same money that was a gift to the parent.
• The lender might have already used up their federal estate tax or state estate tax exclusion, and may not want to pay any gift tax.

However, an intra-family or other gratuitous loan may have income tax and gift tax consequences if the loan is not made with a market rate of interest. This is because section 7872 of the Internal Revenue Code imputes interest to "gift loans" that have a rate of interest that is less than the "applicable federal rate," which is the rate of interest that can be earned on federal securities with comparable terms.

For loans for a stated term, the difference between the principal amount of the loan and the present value of the loan payment, calculated using the applicable federal rate, is a gift when the loan is made. For federal income tax purposes, the "foregone interest" (the difference between interest at the applicable federal rate and the interest actually payable) that is realized each year is considered to have been paid by the borrower and received by the lender in that year. (There are different rules for loans that are payable on demand and not for a stated term.)

There are exceptions and qualifications to these rules:

• These rules do not apply when the total amount of the loans between two people is $10,000 or less (but only if the loans are not used to purchase income-producing assets). For this purpose (and the purpose of the $100,000 limitation described below), a married couple is considered to be one person.
• When the loans between two people do not exceed $100,000, the foregone interest that is realized by the lender is limited by the borrower's net investment income (and net investment income of less than $1,000 is considered to be no investment income).
• If the making a loan results in a gift, the gift can qualify for the federal gift tax annual exclusion (which is $17,000 in 2023).

Therefore, before entering into a intra-family loan for a term, it is desireable to determine whether there will be a gift when the loan is made, and the amounts of foregone interest that may be realized each year.

Gift Tax on Net-Net Gifts

Net Gifts

Under the federal gift tax system, the donor pays the gift tax on a gift, and not the recipient ("donee") of the gift. In the classic "net gift," the recipient agrees to pay the gift tax on the gift. Because the recipient is paying an obligation of the donor, essentially paying money back to the donor, the value of the gift is reduced by the gift tax that must be paid by the recipient.

The classic net gift does not result in any actual tax savings, because the donor is simply making a smaller gift, and is usually done because the donor is making a gift of real property, a closely held business, or other assets that the donor doesn't wish to sell and the recipient has the cash necessary to pay the gift tax and is willing to pay the gift tax in order to get the property being given.

Net-Net Gifts

In a newer form of net gift, usually referred to as a "net-net gift," the recipient agrees to pay not only the gift tax on the gift, but the estate tax that might result if the donor dies within three years of making the gift. (If the donor dies within three years of the gift, then the gift tax that was paid on the gift becomes part of the gross estate for federal estate tax purposes and therefore subject to estate tax. Congress enacted this rule in order to treat gifts made shortly before death as in the same way as gifts made at death, because gift taxes paid on lifetime gifts are obligations of the donor and so reduce the donor's taxable estate while the estate tax does not reduce the taxable estate. See details for a more complete explanation.)

Unlike the classic net gift, the net-net gift produces an actual tax savings, because the value of the gift is being reduced by an amount that the recipients of the gift have not actually paid, and might never pay if the donor survives the three-year period after the death. And, even if the donor does die within the three-year period, the resulting estate tax is still less than it would have otherwise been because the gift tax that was paid was less than it otherwise would have been.

Based on a court opinion upholding the validity of a net-net gift, it would appear that the present value of the estate tax that might be paid should be valued in the same way as a contingent remainder (the present value of $1 payable upon the death of an individual, but only if the individual dies within the three-year period), applying the rules of I.R.C. section 7520, which generally controls the valuation of life estates, remainders, and annuities.

Semi-Net Gifts

It would also seem to be possible for the recipient of a gift to agree to pay the estate tax that might be owed on the gift tax even though the donor will pay the gift tax and not the donor. (In other words, the donor is willing to pay the gift tax, but wants the recipients to pay the estate tax on the gift tax.) This might be called a "semi-net gift." As explained above, the payment of the gift tax by the recipients does not produce any tax savings, but usually reflects a choice about who is best able to bear the burden of the gift tax that must be paid. A "semi-net gift" should be produce the same gift tax savings as a net-net gift in those cases in which the donor is the one best able to pay the gift tax.

Income Tax Considerations

A net-net gift also has income tax consequences:

• As with all gifts, the recipient receives the property gift with the same income tax basis as the donor, increased by any gift tax paid and by any other consideration paid by the recipient. So a net-net gift of appreciated property may later result in a capital gain that would not have happened if the gift had not been made and the property had received a new basis upon the death of the donor. (See the "Cost/Benefit of Lifetime Gifts" calculator for more information on this issue.
• A net gift or net-net gift is treated as part sale and part gift, and may result in taxable gain to the donor if the consideration paid by the recipient (the gift tax paid by the recipient and the present value of the agreement to pay the possible estaet tax on the gift tax) exceeds the donor's basis in the property.

Long-Term Grantor Retained Annuity Trust (GRAT)

A grantor retained annuity trust, or "GRAT," is an irrevocable trust from which the grantor (i.e., the creator or settlor of the trust) has retained the right to receive an annuity of a fixed (or determinable) amount during the term of the trust. At the end of the term of the trust, the remaining assets of the trust go to the beneficiaries (such as children or grandchildren of the grantor) that are specified in the trust document.

Why Use It?

A GRAT can be set up so that the present value of the remainder for federal gift tax purposes is very small, or even zero, which means that at the end of the term of the trust, the remaining trust assets (if any) that pass to the beneficiaries are free of federal gift tax and federal estate tax. There will be trust assets remaining at the end of the trust if the trust is able to earn more investment income and gains than are needed to make the annuity payments.

Usually, the GRAT is set up with a relatively short term, so that the grantor can survive the term of the GRAT, because if the grantor dies during the term of the GRAT, some or all of the assets of the GRAT will be included in the grantor's gross estate for federal estate tax purposes, and so subject to federal estate tax, under the same rules that require a trust to be included in the grantor's gross estate if the grantor has retained the right to receive (or control) the income from the trust.

A long-term GRAT would be set up for a term of 50, 100, or even 1,000 years (assuming that can be done under state law), which means that the grantor is certain to die during the term of the GRAT. That may be acceptable if current interest rates are low and likely to increase in the future, because if interest rates increase significantly then only part of the GRAT may be included in the grantor's gross estate. The GRAT will therefore get assets out of the grantor's taxable estate not because the grantor survives the term of the trust but because of an increase is interest rates.

How Does It Work?

The gift tax value of a GRAT remainder is the present value of that future distribution, and the present value of the remainder can be zero even though valuable trust assets may actually go to the remainder beneficiaries at the end of the term of the trust. This is because of the way the Internal Revenue Code and its regulations say that the remainder should be valued for gift tax purposes.

The present value of the remainder for gift tax purposes is the amount contributed to the trust less the present value of the annuity payments to be made to the grantor. The present value of the annuity is based on an assumed interest rate which is redetermined each month, and is usually known as the §7520 rate, that is based on the average yields of federal securities with maturities of three to nine years.

the calculation of the present value of the remainder is equivalent to assuming that the trust will earn the current §7520 rate for the entire term of the trust. If the present value of the remainder is zero, it is because the §7520 rate income will not be enough to pay the annuity amounts, so principal will be distributed and all of the principal will be distributed over the term of the trust. However, if the GRAT actually earns more than the §7520 rate, then less principal will need to be distributed, and there will be money left over at the end of the term of the trust. That is how remainder beneficiaries can receive money without the grantor making a taxable gift.

As explained above, a GRAT is usually set up with a relatively short term, so that the grantor can survive the term of the GRAT and the beneficiaries can receive any remainder free of both federal gift tax and estate tax.

In a long-term GRAT, for a term greater than the grantor's lifetime, the grantor is certain to die during the term of the GRAT and so at least part of the GRAT will be included in the grantor's taxable estate under the same principle that taxes a trust if the grantor creates a trust and retains the right to the income (or use) of the trust property. IRS regulations say that the part of the GRAT that is included in the taxable estate is the portion over which the grantor has retained the right to the income, which for an annuity trust is calculated by dividing the annuity payable by the trust by the §7520 rate that is in effect at the grantor's death. If the §7520 rate is relatively low when the trust is created, and the term of the trust is long, then the annuity that needs to be paid to create a remainder with a value of $0 will also be relatively small, not much more than the §7520 rate income that would be earned by the trust. If the §7520 rate goes up after the GRAT is created and before the grantor's death, it is possible that the value needed to produce an income equal to the annuity amount will be less than the value of the trust at the grantor's death, and so a portion of the assets in the trust will escape federal estate tax.

How much of the trust will be able to escape federal estate tax will depend upon:

• How much the trust has been able to earn in order to pay the annuity amount and maintain (or increase) the value of the trust. As explained above, a trust with a payout rate that produces a $0 remainder will need to distribute principal as well as income as part of the annuity payments. If the trust can earn more than the §7520 rate in effect at the time the trust was created, then not all of the principal will be distributed and some of the value of the trust will be maintained. If the trust can earn more that the annuity amount, then the trust will actually increase in value.
• How much the §7520 rate has increased from the time the trust is created until the death of the grantor.

Benefits

The benefit of a long-term GRAT is the possibility (but not certainty) that not all of the trust will be included in the grantor's taxable estate at death. This benefit is only a possibility, and not a certainty, because (as explained above) the portion of the trust that is included in the grantor's taxable estate depends on (a) how much the trust has been able to earn to make the annuity payments and how much the trust may have decreased in value by making the annuity payments; and (b) the §7520 rate in effect at death, and whether it is significantly higher than the rate that was used to establish the annuity amount when the trust was created.

As explained below, this benefit comes with very few costs.

Costs

As explained above, a GRAT should have no (or insignificant) gift tax cost if the trust document is prepared to conform to the applicable tax rules, if the annuity amount is calculated properly, and if the trust is funded properly, so that the present value of the remainder is zero (or nearly zero). (There may be an extremely small gift tax cost, perhaps $1, because many practitioners believe that the GRAT remainder should not actually be zero, but should have some value for gift tax purposes, so that a value is reported on a gift tax return.)

Because the creation of a GRAT has little or no gift tax cost, there is no loss if the GRAT is ultimately included in the grantor's gross estate, and so subject to federal estate tax, because the estate tax will not be any more than what would have been payable if the GRAT had not been created. There is, from that point of view, no "downside" to the creation of a GRAT.

There is a possible estate tax cost if (a) the grantor is married and would otherwise have used the federal estate marital deduction to avoid or defer the estate tax, (b) the GRAT does not pass to the surviving spouse or the interests of the grantor's spouse do not qualify for the federal estate tax marital deduction, and (c) the value of the GRAT assets, plus the total of the taxable gifts made by the grantor during lifetime and or at death exceed the federal estate tax exclusion amount (which is $12,920,000 in 2023). If the possibility of federal estate tax payable at the grantor's death is a concern, then steps should be taken to qualify the portion of the grantor's interests in the trust that are included in the grantor's gross estate for the federal estate tax marital deduction.

There are no federal income tax costs for a GRAT because:

• The transfer of property by the grantor to the GRAT is not a sale or other taxable disposition, so no gain or loss is realized when the trust is created.
• The GRAT should be considered a "grantor trust" for federal income tax purposes, so all of the income, gains or losses, deductions, and credits of the GRAT should be reported on the grantor's own individual income tax return, and not a separate return for the trust (where the income or gains might be subject to higher tax rates).
• If the GRAT needs to distribute assets of the trust "in kind" to make annuity payments (such as by transferring stocks or bonds back to the grantor), there should not be any taxable gain or loss because the GRAT should be a "grantor trust" for federal income tax purposes. (However, there could be gains or losses for state income tax purposes if the state income tax is different from the federal income tax and does not recognize the GRAT as a "grantor trust.")
• The distribution of whatever is left in the GRAT at the end of the term of the trust to the remainder beneficiaries should not result in any gain or loss, or any taxable income to the remainder beneficiaries.

Because there should be no tax costs for creating a trust, the only costs for the GRAT should be transactional:

• The legal fees or other costs in preparing the GRAT trust document.
• The costs of preparing any gift tax returns that will be needed to report the creation of the trust and the present value of the remainder interests in the GRAT, which would include the costs of valuing the assets being transferred to the GRAT and the costs of calculating the value of the remainder interests based on the values of the assets transferred to the GRAT and the federal interest rate that is applicable with the GRAT is created. If real property, closely held business interests, or other properties with no readily ascertainable market values are transferred to the GRAT, appraisals might be needed for those properties.
• If the GRAT needs to distribute assets of the trust "in kind" to make annuity payments (such as by transferring stocks or bonds back to the grantor), then those assets will need to be valued when they are transferred to the grantor, and there may be costs of valuing those assets. If the assets being transferred back to the grantor include interests in real property, closely held business interests, or other properties without readily ascertainable market values, then appraisals might be needed for each distribution.
• The costs (if any) of administering the trust. The investment costs of the GRAT should be the same as what the grantor would have paid for investment advisors if the GRAT had not been created, so the creation of the GRAT should not cause additional administrative costs beyond what might be required for accounting for the receipts and disbursements of the GRAT.

The only other cost of a GRAT is what might be described as an "opportunity cost," because the assets of the grantor that are used for a GRAT cannot be used for other estate planning steps, such as taxable gifts directly to children or grandchildren or trusts for their benefit. The benefit of a GRAT must therefore be weighed against the benefit of other steps that might have greater estate planning benefits.

Who Should Use It?

A long-term GRAT will usually be best suited to an unmarried person who has an estate that is more than his or her applicable exclusion amount (which can include both the base exclusion amount, which is $12,920,000 in 2023, as well as the unused exclusion amount of a deceased spouse) and who has securities or other easily transferrable assets which could produce an investment yield of income or capital gain that could exceed the assumed interest rate that is used to value the remainder of the GRAT.

If the grantor is married, a GRAT might still be desirable, but it may also be desireable to take steps to try to qualify the portion of the grantor's retained interests in the GRAT that will be included in the gross estate for the federal estate tax marital deduction in order to avoid payment of tax at the death of the grantor.

Decisions

Before a long-term GRAT is created, there are some decisions to be made:

• Are interest rates in general, and the §7520 rate in particular, relatively low, and likely to rise in the future? The Internal Revenue Service usually announces the §7520 rate for the following month around the 16th of the current month, so it may be advantageous to wait to create a GRAT until the end of the month, when the next month's rate will be known, to decide whether to create the trust in the current month of the following month.
• What should be the term of the GRAT? The longer the term, the lower the annuity will be that will produce a $0 remainder, and the smaller the annuity the smaller the portion of the trust that will be included in the grantor's gross estate. However, the term should not be longer than is allowed under state law (which may have rules limiting trusts to lives in being or not more than 99 years). Even if there is no limit under state law, the term should not be unnecessarily long, and extending the term might not significantly reduce the annuity that will be payable.
• If the grantor is married, should an effort be made to qualify the portion of the trust that is included in the grantor's gross estate for the federal estate tax marital deduction?

Grantor Retained Annuity Trust (GRAT)

A grantor retained annuity trust, or "GRAT," is an irrevocable trust from which the grantor (i.e., the creator or settlor of the trust) has retained the right to receive an annuity of a fixed (or determinable) amount during the term of the trust. At the end of the term of the trust, the remaining assets of the trust go to the beneficiaries (such as children or grandchildren of the grantor) that are specified in the trust document.

Why Use It?

A GRAT can be set up so that the present value of the remainder for federal gift tax purposes is very small, or even zero, which means that at the end of the term of the trust, the remaining trust assets (if any) that pass to the beneficiaries are free of federal gift tax and federal estate tax.

How Does It Work?

The gift tax value of the remainder is the present value of that future payment, and the present value of the remainder can be zero even though valuable trust assets may actually go to the remainder beneficiaries at the end of the term of the trust. This is because of the way the Internal Revenue Code and its regulations say that the remainder should be valued for gift tax purposes.

The present value of the remainder is based on an assumption that the GRAT will earn a certain rate of interest, so the present value of the remainder can be zero if the GRAT pays an annuity that greatly exceeds the interest it is assumed that the trust will earn, because in that case the trust has to distribute principal along with income in order to make the annuity payments. Using the assumed interest rate, it is possible to calculate an annuity amount that will result in the distribution of all of the principal over the term of the trust, so that there is nothing left to distribute at the end of the term. However, if the GRAT actually earns more than the assumed rate of interest, then there will be money left over at the end of the term of the trust, which is how the remainder beneficiaries can receive money without the grantor making a taxable gift.

Benefits

The benefit of a GRAT is the possibility (but not certainty) that the beneficiaries selected by the grantor of the GRAT will receive money or property at the end of the term of the trust, free of federal estate and gift tax, as explained above. This benefit is only a possibility, and not a certainty, because the remainder beneficiaries will receive money or property at the end of the trust only if the trust investments produce income and capital gains in excess of the interest rate that is used to value the remainder when the GRAT is created.

As explained below, this benefit comes with very few costs.

Costs

As explained above, a GRAT should have no (or insignificant) gift tax cost if the trust document is prepared to conform to the applicable tax rules, if the annuity amount is calculated properly, and if the trust is funded properly, so that the present value of the remainder is zero (or nearly zero). (There may be an extremely small gift tax cost, perhaps $1, because many practitioners believe that the GRAT remainder should not actually be zero, but should have some value for gift tax purposes, so that a value is reported on a gift tax return.)

Because the creation of a GRAT has little or no gift tax cost, there is no loss if the GRAT is not able to earn more than the assumed interest rate, so that all of the trust assets are returned to the grantor in order to make the annuity payments and the remainder beneficiaries receive nothing. There is, from that point of view, no "downside" to the creation of a GRAT.

There is a possible estate tax cost because of the possibility of the grantor might die during the term of the trust, in which case the assets held in the GRAT should be included in the grantor’s gross estate for federal estate tax purposes. This is not necessarily a cost, because those same assets would have been part of the grantor’s estate if the GRAT had not been created, but it could result in more federal estate tax than would otherwise be payable if (a) the grantor is married and would otherwise have used the federal estate marital deduction to avoid or defer the estate tax, (b) the GRAT does not pass to the surviving spouse or the interests of the grantor’s spouse do not qualify for the federal estate tax marital deduction, and (c) the value of the GRAT assets, plus the total of the taxable gifts made by the grantor during lifetime and or at death exceed the federal estate tax exclusion amount (which is $12,920,000 in 2023). If the possibility of federal estate tax payable at the grantor’s death is a concern, then steps should be taken to qualify the grantor’s interests in the trust for the federal estate tax marital deduction.

There are no federal income tax costs for a GRAT because:

• The transfer of property by the grantor to the GRAT is not a sale or other taxable disposition, so no gain or loss is realized when the trust is created.
• The GRAT should be considered a "grantor trust" for federal income tax purposes, so all of the income, gains or losses, deductions, and credits of the GRAT should be reported on the grantor’s own individual income tax return, and not a separate return for the trust (where the income or gains might be subject to higher tax rates).
• If the GRAT needs to distribute assets of the trust “in kind” to make annuity payments (such as by transferring stocks or bonds back to the grantor), there should not be any taxable gain or loss because the GRAT should be a “grantor trust” for federal income tax purposes. (However, there could be gains or losses for state income tax purposes if the state income tax is different from the federal income tax and does not recognize the GRAT as a "grantor trust.")
• The distribution of whatever is left in the GRAT at the end of the term of the trust to the remainder beneficiaries should not result in any gain or loss, or any taxable income to the remainder beneficiaries.

Because there should be no tax costs for creating a trust, the only costs for the GRAT should be transactional:

• The legal fees or other costs in preparing the GRAT trust document.
• The costs of preparing any gift tax returns that will be needed to report the creation of the trust and the present value of the remainder interests in the GRAT, which would include the costs of valuing the assets being transferred to the GRAT and the costs of calculating the value of the remainder interests based on the values of the assets transferred to the GRAT and the federal interest rate that is applicable with the GRAT is created. If real property, closely held business interests, or other properties with no readily ascertainable market values are transferred to the GRAT, appraisals might be needed for those properties.
• If the GRAT needs to distribute assets of the trust "in kind" to make annuity payments (such as by transferring stocks or bonds back to the grantor), then those assets will need to be valued when they are transferred to the grantor, and there may be costs of valuing those assets. If the assets being transferred back to the grantor include interests in real property, closely held business interests, or other properties without readily ascertainable market values, then appraisals might be needed for each distribution.
• The costs (if any) of administering the trust. The investment costs of the GRAT should be the same as what the grantor would have paid for investment advisors if the GRAT had not been created, so the creation of the GRAT should not cause additional administrative costs beyond what might be required for accounting for the receipts and disbursements of the GRAT.

The only other cost of a GRAT is what might be described as an "opportunity cost," because the assets of the grantor that are used for a GRAT cannot be used for other estate planning steps, such as taxable gifts directly to children or grandchildren or trusts for their benefit. The benefit of a GRAT must therefore be weighed against the benefit of other steps that might have greater estate planning benefits.

Who Should Use It?

A GRAT is usually best suited to an unmarried person who has an estate that is more than his or her applicable exclusion amount (which can include both the base exclusion amount, which is $12,920,000 in 2023, as well as the unused exclusion amount of a deceased spouse) and who has securities or other easily transferrable assets which could produce an investment yield of income or capital gain that could exceed the assumed interest rate that is used to value the remainder of the GRAT.

If the grantor is married, a GRAT might still be desirable, but steps should be taken to qualify the grantor’s retained interests in the GRAT for the federal estate tax marital deduction in order to avoid payment of tax at the death of the grantor.

Decisions

Before a GRAT is created, there are some decisions to be made:

• What should be the term of the GRAT? The usual decision is to make the GRAT for a short term, usually two years. This is because the investments of a GRAT could increase suddenly in value, due to market or other conditions, but in a GRAT with a term of many years, that increase in a short term could be offset by decreases in value in a longer term.
• Should payments increase over time? The annuity payments must be “fixed” in amount, which means that it must be possible to calculate the amounts to be paid when the trust is created. The payments can therefore increase over the term of the trust if the increases can be calculated in advance, but increases of more than 20% from one year to the next will be disregarded for valuation purposes. Having payments increase by 20% each year is usually considered desirable, because it increases the time that money will be held in trust before it is paid out, which increases the discount.

Inclusion of Annuity Trusts and Unitrusts (GRATs, CRATs, CRUTs, and GRUTs)

Under § 2036 of the Internal Revenue Code, the property that is included in the gross estate for federal estate tax purposes and so subject to federal estate tax at a person's death includes not only the property that they own but also any property that they have given away but retained the right to the income or use of the property. (States that have their own death taxes have similar rules for the purpose of their taxes.)

When the grantor has retained not the right to the "income" of the trust, but an annuity amount or unitrust percentage payout, the same principle applies, but a different calculation must be performed to determine the portion of the trust that included in the gross estate and so subject to federal estate tax because the annuity or unitrust might be less than the income of the trust.

Annuity Trusts and Unitrusts

The kinds of annuity trusts and unitrusts that will most often be subject to these inclusion rules are GRATs, CRATs, CRUTs, and GRUTs:

• A grantor retained annuity trust, or “GRAT,” is an irrevocable trust from which the grantor (i.e., the creator or settlor) of the trust has retained the right to receive an annuity of a fixed (or determinable) amount during the term of the trust, which can be for life or a term of years, but which is almost always for a term of years. At the end of the term of the trust, the remaining assets of the trust go to the beneficiaries (such as children or grandchildren of the grantor) that are specified in the trust document, but if the grantor dies during the term of the trust then all or a part of the trust will be included in the grantor's taxable estate regardless of whether the trust ends or continues.
• A charitable remainder annuity trust, or “CRAT,” is an irrevocable trust which distributes an annuity of a fixed amount to one or more individuals. When the trust ends, either because the trust was for a term of years or because the indiviudal beneficiaries have died, the remaining assets of the trust go to one or more charitable beneficiaries. If the grantor has retained the right to all or part of the annuity distributions and the grantor dies before the trust ends, then all or a part of the trust will be included in the grantor's taxable estate regardless of whether the trust ends or continues.
• A charitable remainder unitrust, or “CRUT,” is an irrevocable trust which distributes a fixed percentage of the value of the trust (redetermined each year) to the grantor (i.e., the creator or settlor) or other individuals. When the trust ends, the remaining assets of the trust go to one or more charitable beneficiaries. If the grantor has retained the right to all or part of the unitrust distributions and the grantor dies before the trust ends, then all or a part of the trust will be included in the grantor's taxable estate regardless of whether the trust ends or continues.
• A grantor retained unitrust, or “GRUT,” is an irrevocable trust from which the grantor (i.e., the creator or settlor) of the trust has retained the right to receive an annual distribution of a fixed percentage of the value of the trust (redetermined each year) during the term of the trust. GRUTs are therefore similar to GRATs, but are rarely used because the way they are valued and make distributions will usually produce no tax benefit to the grantor or the grantor's beneficiaries.

Why Use It?

An inclusion calculation is needed when the grantor (creator or settlor) of an annuity trust or unitrust has died and a federal estate tax return (or state death tax return) is required, so the portion of the trust that is subject to federal estate tax or (or state death tax) must be determined.

How Does It Work?

As will be explained below, the general approach is to treat the annuity amount or unitrust distribution as an income, and then compare that income to the interest rate determined under I.R.C. §7520 for the month of the death of the grantor.

The §7520 rate is used for this purpose because it is the rate used to determine the present value of the income from a trust for a life or a term of years years. (The §7520 rate is 120% of the average yield on federal securities with maturities of more than three years but not more than nine years.)

Annuity Interests

Simple (Ungraduated) Annuity Interests

When the grantor has retained an annuity (such as an annuity from a charitable remainder trust) that is a fixed amount each year, and does not increase, the annualized annuity is treated as an income stream and divided by the §7520 rate to determine the amount of principal needed to produce that income. That principal amount is the portion of the trust that is included in the grantor's gross estate (but not in excess of the actual value of the trust, of course).

The "annualized annuity" is the total annuity amount payable each year, multiplied by an adjustment factor if the annuity amount is payable in installments that are more frequent than annual.

Increasing (Graduated) Annuity Interests

When the decedent has retained an annuity interst that is scheduled to increase in value each year (which is commonly done in GRATs), the calculation of the portion of the trust to be included in the grantor's gross estate is somewhat more complicated, because it is necessary to calculate the increasing amounts of principal needed to provide the income for the increasing annuity amounts and then discount those future principal amounts back to present value.

Unitrust Interests

When the grantor has retained a unitrust interest (such as a unitrust interest in a charitable remainder unitrust), the adjusted payout rate is converted to an equivalent income interest rate by dividing the adjusted payout rate by one minus the adjusted payout rate. The "adjusted payout rate" is the unitrust payout percentage multiplied by a factor when the unitrust distributions are not annual or are not made immediately after the annual valuation.

The equivalent interest rate is then divided by the §7520 rate to determine the percentage of the trust principal that would be needed to produce the income to pay the unitrust distributions without distributing any principal. That percentage of the trust principal (but not more than 100%, of course) is included in the grantor's gross estate.

Income (Life Estate) and Remainder Factors and Values

It is possible to divide property between or among two or more people in a number of different ways, and one way is to separate the right to receive the current income of the property, or the right to use the property, from the right to own the property in the future after the income or use has ended (which is usually called the "remainder"). When property is divided that way, it may also be necessary to determine a present value for future income and remainder interests, for tax purposes or for purposes of a sale of the separate interests.

Types of Interests

The types of interests that can be inconsidered "income interests" include the following:

• The right to the ordinary income (such as interest and dividends, but not capital gains) of a trust.
• The right to the rental income from a building, or the farming income from farmland.
• The right to use or occupy a residence or other property.

These rights can extend for different periods of time:

• For a term of a specific number of years.
• While the person (or persons) entitled to the income or use of the property is living. (This is usually known as a "life estate.")
• For a combination of a term of years and lives, such as the shorter of a lifetime or a fixed number of years, or the longer of a lifetime and a fixed number of years.

Regardless of how the length of the income or use of the property is measured, what is left at the end is known as the "remainder" and the person (or persons) who are ultimately entilted to the full ownership of the property is known as the "remainderman" (or "remaindermen").

Present Values

Determining the present value of income and remainder interests is usually based on two assumptions:

• An assumption about what income will be earned by the property; and
• For income interests based on measuring lives, an assumption about the mortality of those lives (i.e., when they are likely to die).

For federal tax purposes, the income assumption is the average yield on federal securities with maturities of three to nine years (what is called the "applicable federal mid-term rate"), increased by 20%, and rounded to the nearest two-tenths of a percent. These rates are calculated each month by the Internal Revenue Service.

The federal mortality assumption is based on the most recent United States census, which is conducted every 10 years in order to determine the composition of the states in the House of Representatives.

These assumptions have been used by the IRS to construct tables of factors, and most income interests or remainders can be valued for federal tax purposes by multiplying those factors by the value of the property (or principal amount) subject to the income interest.

Uses for Values

There are a number of different reasons why life estates and remainders might need to be valued:

• Values might be needed for estate, gift, inheritance, or realty transfer tax purposes (although life estates and remainders are generally not recognized for federal gift tax purposes);
• Values might be needed if an owner of a property might want to sell a life estate or remainder to a relative or third party; and
• Values might be needed if a property that is subject to a life estate is sold, or a trust with an income interest is terminated, and the sale price or trust property must be divided between or among the beneficial owners.

The values computed by Webcalculators are most applicable to determine federal tax consequences, and other kinds of valuations may require different income or mortality assumptions.

Income Tax Changes in 2018 for Individuals

The Reconciliation Act of 2017 (formerly known as the "Tax Cuts and Jobs Act") lowers most tax rates, but also denies or limits certain deductions, so whether any particular individual will see their federal income tax increase or decrease in 2018 depends on their level of income and what deductions will be claimed.

Changes in Rates

The most significant change in tax rates is the reduction in the top income tax rate from 39.6% to 37%, which means that taxpayers in the top income tax bracket will generally pay less tax.

The lowest income tax rate remains unchanged at 10%, but the intermediate rates have changed from 15%, 25%, 28%, 33%, and 35%, to 12%, 22%, 24%, 32%, and 35%. Because of changes in both rates and brackets, it's difficult to predict how much the tax has been reduced at any particular level of taxable income, but there is some decrease (or no increase) at every level of taxable income, with two exceptions:

• Heads of households with taxable incomes between $249,325 and $529,562 will pay slightly more tax under the new law than they would have paid under the old law. For example, a head of household with taxable income of $424,950 of taxable income will pay $123,030.50 of tax instead of $119,518, an increase of $3,512.50.
• Other unmarried taxpayers with taxable incomes $369,038 and $451,010 will also pay slightly more in tax under the new law, but only about $1,118 at most.

Changes in Deductions

Taxpayers who do not itemize deductions and have no dependents will generally be better off, even though personal exemptions have been eliminated, because the standard deduction has been increased. So, for example, under the old law a married couple with no dependents would have been entitled to a standard deduction of $13,800, and two exemptions of $4,450 each, for a total of $22,700 in reductions to taxable income. Under the new law, there will be no personal exemptions, but a standard deduction of $24,000.

For taxpayers with minor dependent child, the elimination of the deduction for personal exemptions may be offset by the increase in the child tax credit for dependent children under the age of 17, which has been doubled, from $1,000 to $2,000, and for which the threshold amounts at which the credit begins to be phased out has been increased from $110,000 to $400,000 for married taxpayers filing jointly, and to $200,000 for other taxpayers. (The threshold amounts had been $75,000 for unmarried taxpayers and $55,000 for married filing separately.) An additional credit of $500 is also allowed for dependents other than minor children.

Taxpayers who normally itemize deductions may see the benefit of lower tax rates entirely neutralized, or perhaps overwhelmed, by limitations on itemized deductions, such as the new limitation on deductions for state and local taxes.

The changes in deductions for the year 2018 can be summarized as follows:

All of the changes described above apply to the years 2018 through 2025 except for the change in medical expense deductions, which only applies to 2018 and 2019.

Other Changes

The base for calculating future inflation adjustments has changed from the consumer price index for all urban consumers (CPI-U) to what is known as the chained consumer price index (C-CPI-U). This may affect calculations for 2018 that use factors that have not otherwise been changed by the new law, but are adjusted for inflation.

Changes for individual taxpayers that are not incorporated into the calculations include the new deduction for qualified business income received through entities other than corporations (new IRC section 199A), as well as changes in the tax treatment of alimony, contributions to ABLE accounts, student loan discharges, casualty loss deductions, moving expenses, wagering losses, and the alternative minimum tax.

Income Tax on Estates and Trusts

Trusts and estates file income tax returns that are known as "fiduciary returns," Form 1041. (A "fiduciary" is a person who holds property for the benefit of other persons. Common types of fiduciaries are executors or administrators of decedent's estates, trustees of trusts, and guardians or conservators of the estates of minors or persons declared to be legally incapacitated.)

Estates and trusts are often described as "pass-through entities" because the beneficiaries of the trust are taxed on the income that is distributed to them and the trust is taxed on the income that is not distributed. The character of the income that is distributed generally has the same character that is received by the estate or trust, so if a trust that receives qualified dividends as income distributes all its income, the income received by the beneficiary is taxed as qualified dividends.

The taxation of estates and trusts is similar to the taxation of individuals in the following ways:

• Estates and trusts can claim deductions for some of the same things for which individuals can claim deductions, such as interest that is paid, and state and local taxes. And, like other taxpayers, the expenses of producing income must be allocated between taxable and tax exempt income and the expenses attributable to exempt income are not deductible.
• The undistributed taxable income of estates and trusts is subject to progressive tax rates that are similar to the tax rates that apply to individuals, and that are based on tax brackets that are indexed for inflation like the tax brackets of individuals, but there is no 10% bracket and the brackets are much smaller than those for individuals, with the top tax rate of 39.6% (37% for the years 2018-2025) applied to income in excess of $13,050 (for the year 2021).
• The long-term capital gains of estates and trusts are subject to a top tax rate of 20%, qualified dividends are treated like long-term capital gains, and the tax on capital gains is calculated in the same way as for individuals (but subject to different brackets).
• The capital losses of an estate or trust can reduce other taxable income by only $3,000.
• Estates and trusts are subject to the 3.8% tax on net investment income, just like individuals.

There are also a number of differences between the income taxation of estates and trusts and the income taxation of individuals:

• Estates and trusts can claim a charitable deduction, but only if the governing instrument (the will or trust document) requires the payment to the charity and only if the payment must be made out of the income of the estate or trust.
• The expenses of an estate or trust that are for the collection of income or the management or preservation of income-producing property (which covers most of the costs of administering an estate or trust) are deductible in full and not subject to the 2% limit on "miscellaneous itemized deduction" if the expense is not of a kind that would customarily be incurred by an individual holding the same property. So, for example, fiduciary fees are fully deductible, but investment management fees are subject to a 2% "floor" (or are not deductible at all in the years 2018 through 2025).
• As noted above, estates and trusts are entitled to a deduction for income distributions to beneficiaries (and the beneficiaries must then include the distributions in their own income), but the income that is distributed usually does not include any capital gains (except in the final year of the estate or trust, when capital gains are considered to be distributed along with ordinary income). In the final year of an estate or trust, the estate or trust can also distribute any capital loss carry-forward to the beneficiaries, as well as any deductions in excess of income for that year.
• Estates and trusts have a deductible exemption that is like the personal exemption for individuals, but it is much smaller, and not indexed for inflation.
• Estates are entitled to an exemption of $600.
• Trusts that are required to distribute all of their income each year are entitled to an exemption of $300. (Because all income is distributed currently, the exemption usually applies only to capital gains, which are usually not considered to be income and so not distributed.)
• Trusts that can accumulate income are entitled to an exemption of $100.

Last updated on 1/3/2021.>

Income Tax on Individuals

Although the federal income tax applies to "all income from whatever source derived," not all Americans pay the tax because the tax is calculated after deducting various kinds of expenses and exclusions which limit or eliminate the tax liabilities of many low-income people.

The federal income tax is "progressive," both because it does not apply to many low-income people, and because it applies that rates that are higher for larger incomes.

Some of the rules that determine what is or is not income and what is or is not deductible, as well as how to calculate the tax, can be somewhat complicated, but the the rules that apply to most Americans are not that difficult to understand, and are summarized below.

Gross Income

The starting point for calculating the federal income tax is determining "gross income" which, as noted above, is generally defined as "all income from whatever source derived." The most common kinds of gross income are the following:

• Wages, salaries, and other forms of compensation for labor or services.
• Interest, dividends, and other incomes from savings or investments.
• Gains from sales of property.
• Rents and royalties from the use of property.
• Annuities, pensions, and distributions from retirement plans.
• Alimony (but only before 2018)>

There are other kinds of receipts that are specifically excluded from gross income:

• Death benefits paid on life insurance policies.
• Gifts and inheritances (although distributions from estates and trusts may carry out income received by the estate or trust).
• Interest on state and local bonds.
• Gain on the sale of a personal residence (subject to limitations).
• Compensation received for physical injuries or sickness, and insurance received for injuries or sickness.
• Social Security benefits are generally not included in gross income, but up to 85% of benefits can be included (and taxed) if income from other sources exceeds certain thresholds.

These are only the most common kinds of receipts that are included (or not included) in gross income, and there are many other kinds of income that receive special treatment.

Deductions

There are two different kinds of deductions: Those deductions that can be claimed only as "itemized deductions" on a separate schedule, and those that can be claimed on the Form 1040 itself regardless of whether or not "itemized deductions" are claimed.

Deductions other than itemized deductions are used to calculated "adjusted gross income," which is a measure of income that is used in a number of calculations such as the taxation of Social Security benefits and the limits on charitable deductions.

The most common deductions that may be taken "above the line" to reduce adjusted gross income are:

• Trade and business expenses of self-employed taxpayers and sole proprietorships.
• Expenses of property held for the production of rents or royalties.
• Contributions to individual retirement accounts (IRAs) and other individual retirement plans.
• Contributions to health savings accounts and Archer medical savings accounts.
• Interest on education loans and certain higher education expenses.
• Half of the Social Security and Medicare taxes on self-employment income.
• Health insurance premiums paid by the self-employed.
• Beginning in 2020, up to $300 of charitable contributions for those who do not items deductions.

Itemized deductions are the deductions that are not applied to determined adjusted gross income, and the most common itemized deductions are:

• Medical expenses in excess of 7.5% of adjusted gross income (10% after 2020).
• State and local income taxes and property taxes, but the deduction is limited to $10,000 ($5,000 for married taxpayers filing separate returns) after 2017 and before 2026.
• Charitable contributions, but the deduction is limited to 50% of adjusted gross income for publicly-supported charities, with lower limits for private foundations and contributions of appreciated securities.
• A number of other kinds of deductions, known as "miscellaneous itemized deductions," had been deductible only to the extent that they exceeded 2% of adjusted gross income, and are not deductible at all after 2017.

Before 2018 and after 2025, some itemized deductions are also subject to certain limits for high-income taxpayers, and so the total amount of those deductions are reduced after adjusted gross income exceeds certain thresholds.

Taxable Income

Taxable income is adjusted gross income, less:

• Either the total of itemized deductions or the standard deduction;
• The deduction for personal exemptions (but only for years before 2018 and after 2025); and
• The 20% deduction for "qualified business income."

The amount of the standard deduction depends on the filing status of the taxpayer (married taxpayers filing jointly, married taxpayers filing separate returns, heads of households, and unmarried individuals other than heads of households). An additional standard deduction is available if the taxpayer (or spouse) is over 65, or blind.

Rates of Tax

There are different tax tables applicable to different kinds of taxpayers, specifically:

• Married taxpayers filing jointly;
• Married taxpayers filing separate returns;
• Heads of households (meaning an unmarried taxpayer with dependent children); and
• Unmarried individuals other than heads of households.

The same tax rates apply to all four groups of taxpayers, ranging from a low of 10% to a high of 37%, but the amounts subject to the different rates (the "rate brackets") are different in each case.

Capital Gains and Qualified Dividends

Different tax rates apply to long-term capital gains and qualified dividends, with some gains subject to a tax rate of 0%, some taxed at 15%, and so taxed at 20% for high-income taxpayers. There are also some kinds of gains that are taxed at 25% or 28%.

For this purpose, "capital gains" means the gain realized on the sale of securities and other investment properties, and gain is "long term" if the property had been held for one year or before it was sold.

A certain amount of gain (and qualified dividends) are taxed at 0%, depending on the type of tax return (married, single, etc.). The gains that would otherwise be taxed at the top tax rate (37%) is taxed at 20%, and everything in between is taxed at 15%.

Tax on Net Investment Income

As part of the Affordable Care Act, a new tax was enacted in 2010 that is 3.8% of the "net investment income" in excess of certain thresholds.

Interest on Federal Taxes

Underpayments and overpayments of federal taxes result in the imposition of interest that is compounded daily until the tax (and interest) is paid. This means that the annual interest rate is divided by 365 (366 in a leap year) to determine a daily interest rate, and then the daily interest rate is applied each day to both the tax that is owed and the interest has accrued.

Although this system might sound complicated, it actually simplifies the accounting for taxes and payments, because it lo longer makes any difference whether payments are applied to the tax or the accrued interest.

The interest rate on underpayments is calculated by the Internal Revenue Service and published quarterly, based on the applicable federal short-term rate for the first month of the quarter, rounded to the nearest whole percentage. (The applicable federal short-term rate for a month is the average yield on federal securities with a maturity of less than three years during the preceding three months.) In addition:

• The rate for overpayments of taxes by individuals (and estates and trusts) is the same as the rate for underpayments.
• The rate for overpayments of taxes by corporations is one percentage less than the rate on underpayments.
• The rate for overpayments by corporations in excess of $10,000 is 2.5 percentage points less than the rate on underpayments.
• The rate for underpayments by corporations in excess of is 2 percentage points more than the rate on underpayments.

The date on which interest begins to accrue on a tax (or penalty) depends on the type of tax (or penalty).

• When a tax is due with a return, interest on underpayments generally starts to accrue with the due date of the return, without regard to any extension of time. That is:
• For income tax returns of individuals, estates, and trusts, the 15th day of the fourth month following the end of the tax year (which is April 15th for calendar year taxpayers);
• For income tax returns of corporations, the 15th day of the third month following the end of the tax year (which is March 15th for corporations which file returns based on the calendar year);
• For estate tax returns, the date that is nine months after the date of death (or the last day of the month if the date of death was on the 30th or 31st and there is no 30th or 31st in the month the return is due);
• For gift tax returns, April 15th of the year following the year in which the gifts were made.
• In most cases, interest on penalties and additions to taxes (such as estimated tax penalties, penalties for failure to file, or penalties for failure to pay taxes) does not accrue until there is a notice to the taxpayer of the penalty or addition, and no interest is imposed if the penalty or addition is paid with 21 days of the date of the notice.
• For refunds, interest usually does not start to accrue until 45 days after the claim for the refund is filed or, in the case of a return that is filed before the due date of the return, 45 days after the return was due. (So, if an individual income tax return is filed claiming a refund before the April 15th deadline, interest on the refund does not begin to accrue until May 30th.

Interest on Pennsylvania Taxes

Underpayments and overpayments of Pennsylvania taxes result in the imposition of interest that is simple interest, and not compounded, regardless of how long the tax (and interest) remain unpaid.

This can complicate the accounting for taxes and payments, because it makes a difference whether payments are applied to the tax or the accrued interest. Generally speaking, payments are applied first to the tax owed, so payments will stop the accrual of additional interest even though the interest already imposed remains unpaid.

The interest rate on underpayments and overpayments is the same as the interest rate on underpayments of federal tax, but is only updated annually, in January, even though the federal rates can change quarterly. In addition:

Interest-Only Long-Term Note

Family members often make loans to other family members for non-tax reasons. In a period of low interest rates, there may be tax reasons to make loans as well and, to maximize the tax benefits, the loan is most likely to be in exchange for an interest-only note for a term of years.

Why Use It?

When the lender has an estate that is likely to result in federal estate tax or state death taxes, an interest-only note can allow assets to be transferred to family members with no gift tax cost and with a reduced value for federal estate tax and state death tax purposes.

How Does It Work?

An intra-family loan may have income tax and gift tax consequences if the loan is not made with a market rate of interest. This is because section 7872 of the Internal Revenue Code imputes interest to "gift loans" that have a rate of interest that is less than the "applicable federal rate," which is the rate of interest that can be earned on federal securities with comparable terms.

However, a note paying interest at the applicable federal rate may have estate tax advantages, for the following reasons:

• The interest rate that may be applied to value the note for estate tax purposes may be higher than the interest payable on the note, in which case the future interest payments will be discounted and the fair market value of the note will be less than its face amount. The interest rates used to value the note at death may be higher than the interest rate payable on the note for at least two different reasons:
• Interest rates may have risen since the note was issued. (This is why making loans may be advantages during a time of lower than normal interest rates.)
• The applicable federal rate payable by under the note is a rate of interest paid by the federal government, which is an extremely highly rated borrower and so pays the lowest interest rates. The market rate of interest used to value the note should be a rate commonly paid on personal loans by individuals, which is typically a higher rate of interest. The value of the note may therefore discounted at death even though interest rates have not changed significantly.
• The estate tax value of the note may be further discounted due to lack of marketability and other factors.
• The borrower may have been able to invest the money represented by the note and earn more than is required to pay the interest on the note, resulting in a net profit. That net profit represents income that could have been earned by the borrower with that same money, and so the net profit has been effectively transferred from the borrower to the lender without any gift or estate tax.

Benefits

The benefit of an interest-only note for a term of years is the possibility (but not certainty) that the note will be discounted to less than the face amount of the note at the death of the lender, and the possibility (but not certainty) that the borrower will be able to invest the loan amount and be able to earn investment income in excess of the interest payable on the note.

Costs

Because a promissory note is relatively easy to prepare, there are few transactional costs to making an interest-only loan.

The primary "costs" to the lender is a possible reduction in income if the interest payable on the note is less than the current investment income received by the lender on the amount of the loan, and the risk that the loan will not be repaid when it is due, or that the lender will need some of the funds for his or her own support before the note is due.

Decisions

Before a interest-only loan is made, there are some decisions to consider:

• Are interest rates relatively low, and likely to rise in the future? The Internal Revenue Service usually announces the applicable federal rates for the following month around the 16th of the current month, so it may be advantageous to wait to make a loan until the end of the month, when the next month's rate will be known, to decide whether to make the loan using the current month's rates or the following month's rates.
• What should be the term of the loan? A loan of nine years or fewer can be made using the federal mid-term rate, which is typically less than the long-term rate, which applies to loans of more than nine years. A loan of fewer than nine years might therefore seem to be better because it can be at a lower rate, but it might be less certain how much interest rates will rise over the next nine years and, once the term of the note ends, so does any valuation benefit. So it might be better to "lock in" a slightly higher rate for a longer term.

Note Valuation

A promissory note that provides for a fixed rate of interest and regularly scheduled payments of interest and principal must often be valued for the purpose of the federal estate tax, federal gift tax, state death taxes, distribution from an estate or trust, or other transactions.

Typically, a note is valued by comparing the rate of interest payable on the note to a "market" rate of interest, and the determination of a market rate of interest usually includes two considerations:

• The time value of money, without regard to any risk of the borrower's ability to pay. The securities of the federal government are considered to be the safest investments in the world, and so the yield on federal securities is the rate that would ordinarily apply without considering any risk factor. The yield on federal securities is codified in the Internal Revenue Code as the "applicable federal rate," and those rates are one possible measure for valuing a promissory note.
• The risk of repayment, which is dependent on the credit wothiness of the borrower and the borrower's ability to pay. Bonds of municipalities and corporations are frequently rated for the borrower's ability to pay, and lower credit ratings require higher interest yields in order to balance the reward with the risk. For individual borrowers, the risks include the risk of death and the possibility that the assets of the decedent's estate may be insufficient to repay all debts.

Once a market rate of interest has been determined, the payments on the note can be discounted by that market rate of interest and the fair market value of the note can be determined.

If the rate of interest payable on the note is less than the market rate, then the value of the note will be less than the principal balance of the note, and the difference in values will be a discount. If the rate of interest payable on the note is more than the market rate, then the value of the note will be more than the principal balance of the note, and the difference will be a premium.

A complete explanation of the possible tax consequences of valuing a note with a premium or discount is beyond the scope of this overview, but if a note is transferred on death and as a result has a tax basis equal to its value at death, payments of principal on the note may result in gain or loss if the note is valued at a premium or a discount.

Pennsylvania Inheritance Tax

Pennsylvania imposes an inheritance tax on the transfer of property at death by will or intestate succession, as well as certain other transfers at death or within one year before death.

Taxable Transfers

The inheritance tax is imposed on a number of different kinds of transfers of property at death, the most common of which are the following:

• The transfer of property will or intestate succession (the laws governing how an estate is distributed when there is no will), which generally means all of the property in the name of the decedent at death.
• Gifts made within one year before the death to the extent that the total of the gifts to any one person exceeded $3,000 during a calendar year.
• Any lifetime transfer of property for which the decedent has retained the right to the income or use of the property, the right to amend or revoke the transfer, or the power to decide who shall possess or enjoy the property. This would include revocable ("living") trusts, bank and broker accounts that are "in trust for" or payable to named beneficiaries, as well as transfers of houses or other properties while retaining a life estate in the properties or the explicit or implicit right to use or occupy the properties.
• Individual retirement accounts and other retirement benefits, unless the decedent did not have rights of ownership. (Generally speaking, IRAs and retirement benefits are taxable when a decedent is 59-1/2 years of age or older.)
• Joint bank and broker accounts and other properties held as joint tenants with right of survivorship, other than accounts and properties in the joint names of a married couple (see below). Under Pennsylvania law, bank and broker accounts in two or more names are presumed by the held as joint tenants with right of survivorship.

Except for gifts within one year before death, these assets and transfers are all valued as of the date of death.

Some things that are not taxable:

• Transfers to the United States, the Commonwealth of Pennsylvania, political subdivisions of Pennsylvania, and charities.
• Property owned jointly by a married couple with right of survivorship. Property passing to a surviving spouse is subject to a 0% tax rate (see below), but jointly held property is not even considered a transfer subject to tax and so bank accounts and houses joint names are not even reported on an inheritance tax return.
• Life insurance, even if payable to the estate.
• Retirement benefits payable through the pension system of the Commonwealth of Pennsylvania.
• Real and tangible property outside of Pennsylvania, and intangible property (such as stocks and bank accounts) owned by a decedent who was not domiciled in Pennsylvania.
• Propery over which the decedent held a power of appointment, such as property in a trust created by someone other than the decedent but which the decedent had the right to withdraw or direct the distribution of.
• Certain kinds of agricultural property and closely held business interests.

Deductions

From the gross value of assets and transfers subject to tax, there is deductible:

• Funeral expenses, compensation paid to executors or administrators of the estate, attorney fees, and other costs of administering the estate.
• Debts of the decedent, and mortages and liens imposed on property subject to tax.

Rates of Tax

The rate of tax that is imposed on each transfer depends on the relationship between the person receiving the transfer and the decedent.

• Transfers to a surviving spouse are taxed at 0% (i.e., there is no tax).
• Transfers to children, grandchildren, and other descendants and step-descendants, the spouse, widow, or widower of a child, and parents, grandparents, and other ancestors are taxed at 4.5%. However, transfers by a minor decedent to a parent are taxed at 0%.
• Transfers to siblings (i.e., brothers and sisters) are taxed at 12%.
• Transfers to all other persons, such as aunts, uncles, nieces, nephews, as cousins, as well as friends and persons who are unrelated, are taxed at 15%.

There is no exemption or exclusion amount, so a net transfer of $100 to a child will result in a tax of $4.50.

Returns and Payment of Tax

Inheritance tax returns are due, and the tax is payable, nine months after death. So, for example, if death occurs on April 3, the tax return and payments are due on the following January 3.

There is a discount of 5% for tax paid within three months of death, so it is usually advisable to estimate the tax that will be due and pay the tax within the three month period.

Unless a will (or revocable trust) directs otherwise, the burden of the tax is allocated as follows:

• The tax on gifts under a will (or revocable trust) of specific amounts of cash or specific property is payable from the residue (if any) of the estate (or trust).
• The tax on each share of the residue under a will or revocable trust, or each intestate share of an estate, is payable from the share.
• The tax on all other transfers is paid by the beneficiary of the transfer.

All returns are filed with, and tax payments are made to, the Register of Wills, and tax returns must be filed in duplicate. However, the tax returns are examined by the Department of Revenue, which also assesses the tax.

Private Annuity

A private annuity is a contract between one or two persons (the "annuitant" or "annuitants") and a person (individual, corporation, partnership, or trust) that is not in the business of selling annuities (the "payor"). Under the contract, the annuitants transfer money or property to the payor in exchange for the payor's unsecured promise to pay a fixed amount of money for the life or lives of the annuitants. If the annuity amount is calculated properly, the present value of the annuity payments will equal the value of the cash or other property transferred in exchange for the annuity, so that the transfers are not gifts.

Upon the death of the annuitant (or the last to die of two annuitants), the payments end and there is nothing included in the taxable estate of the annutant other than the accumulated payments already received.

Why Use It?

A private annuity can be a way of transferring property between family members without making a gift when the persons transferring the property do not need or want it any more but need or want a steady income, and are willing to rely on the ability of the payor to make the annuity payments. So, a family member owning real property, or closely held business interests, can transfer those kinds of properties to another family member (or another family controlled business or trust) in a private annuity transaction. The transaction can result in a net estate and gift tax benefit if the annuitants do not live out close to their normal life expectancies, or if the property transferred (or reinvested) is able to generate a net income that exceeds the interest assumption used to calculate the annuity payments.

If a property is about to be sold and capital gain realized, a private annuity transaction is a way of getting the benefit of installment sale treatment for the gain while keeping the financing costs (and risks) within the family. In a private annuity transaction, any capital gain is realized (under current law) over the life expectancy of the annuitant. But the person receiving the property and paying the annuity has an initial basis equal to the present value of the future annuity payments, which will be near to the market value of the property if the private annuity is properly calculated, and so a sale by the transferor should result in little or no taxable gain. The original owner (the annuitant) will therefore realize any gain ratably over his or her life expectancy while the payor of the annuity will be able to sell the property will little or no taxable gain.

Any capital gain for the annuitant can be eliminated if the private annuity transaction is with a trust of which the annuitant is considered the grantor for federal income tax purposes, because Internal Revenue Service rulings have established that transactions between a grantor and a "grantor trust" do not result in gain or loss. (But a later sale of the property by the trust to a third party would most likely result in taxable gain.)

How Does It Work?

The present value of an annuity can be calculated using actuarial factors in tables published by the Internal Revenue Service. The the annuity amount is multipled by a factor (and a second factor if the payments are more frequent than annual) and the result is the present value of the annuity payments. In order to create a annuity with a value equal to the value of a specific property, all that is needed is to run the calculation in reverse, dividing the desired present value by the appropriate factors to get the amount of the annuity to be paid.

Although a private annuity can be a convenient way of transferring property and serving the non-tax goals of the parties, a private annuity can also result in a net transfer of value between the annuitants receiving the annuity payments and the payor making the payments in the following ways:

• If the annuitant dies prematurely, then the payor gains because the payor acquired valuable property while making fewer payments than expected, but if the annuitant outlives his or her life expectancy then the payor loses because the payor has to make more payments than expected.
• The present value of the annuity is based on an assumption about interest rates and investment incomes. If interest rates rise, then the future annuity payments are worth less and the payor benefits. If interest rates fall, then the future annuity payments are worth more and the payor loses because the future payments will effectively cost more.
Regardless of whether interest rates rise or fall, if the property transferred by the annuitant(s) to the payor actually produces an income in excess of the interest rate assumed to apply at the beginning of the annuity contract, then the payor will be able to gain by making more of each payment out of the property's income than was originally expected, but if the payor's actual investment income is less than the initial assumed interest rate, then the payor will lose money by having to make more of the payment from other financial resources.

Although the annuity must be a "fixed amount," the amount can change from year to year, as long as the amount to be paid in any future year can be calculated in advance. So, for example, an annuity can increase by a fixed percentage each year, so as to keep pace with anticipated inflation or increases in costs of living, but it cannot be increased based on the Consumer Price Index because future increases in that index are not known at the beginning of the contract.

It is also possible to defer the beginning of the annuity payments for a fixed number of years. So, for example, if a person age 60 wants to tranfer property, but doesn't need or want the annuity payments until age 65, when he or she expects to retire, the start of the annuity payments can be deferred for five years. However, the payments cannot be deferred until actual retirement because that would allow the annuitant to decide in the future when the annuity payments will begin, and so the payments will not be fixed amounts payable at known times.

Because the payor of the annuity would benefit if the death occurred early, tax regulations do not allow the annuity to be valued using the usual mortality table if the annuitant is terminally ill and is likely (at least 50% probability) to die within one year. (However, if the annuitant survives for at least 18 months, there is a presumption that the annuitant was not terminally ill.)

Benefits

The possible benefits of a private annuity are:

• There may be non-tax benefits because the transaction may allow younger family members to use property they need or want while older family members can receive cash they may need for their support.
• The property may produce an income (or be invested to produce an income) that exceeds the income represented by the annuity payments, so that there is a net transfer from the annuitant(s) to the payor and a possible saving in death taxes.
• The annuity payments end at the death of the annuitant, and if the annuitant were to die before his or her normal life expectancy, there may be a net reduction in his or her estate (and a nontaxable benefit for the payor) that results in a death tax savings.

Costs

There are several possible costs to a private annuity:

• If the property being transferred has an income tax basis that is less than fair market value, capital gain will be realized that might not be realized if the property were held until death (when it would receive a new basis equal to fair market value).
• Part of each annuity payment will be ordinary income to the annuitant, but the payor will not be entitled to any income tax deduction, and so the combined net taxable income of the family may increase, resulting in a total net increase in income taxes.
• If the annuitant outlives his or her life expectancy, his or her estate may be increased, which may result in an increase in death taxes.
• If the annuitant were to die prematurely, there may be death tax savings (see benefits described above), but the payor's basis in the property that is acquired for the private annuity will have a basis equal to the total of the payments made, so a later sale of the property may result in capital gains.
• There may be transactional costs:
• The legal fees or other costs of preparing the private annuity contract.
• If real property, closely held business interests, or other properties with no readily ascertainable market values are being transferred, appraisals might be needed to be sure that the property is being transferred for fair market value.
• For transfers of real property, there may be costs of preparing and recording deeds, as well as possible realty transfer taxes.

Whether these possible costs are less than or more than the possible benefits should be considered under the circumstances of each case.

Who Should Use It?

A private annuity is often appropriate for an unmarried person who has real property, closely held business interests, or other assets that he or she wants to transfer to other family members, but he or she wants or needs a continuing income from the property transferred.

A private annuity is particularly suited to someone whose estate may be subject to federal estate tax or state death taxes, such as an estate that is more than the federal applicable exclusion amount (which can include both the base exclusion amount, which is $12,920,000 in 2023, as well as the unused exclusion amount of a deceased spouse), and is in poor health (but not terminally ill) and not expected to survive to normal life expectancy.

A private annuity should also be considered if a property needs to be sold, because a private annuity transaction with a family member (or trust for a family member), followed by a sale to a third party, can allow deferral of the realization of capital gain similar to an installment sale.

Required Minimum Distributions

Qualified retirement plans and individual retirement accounts (IRAs) were intended by Congress to help support the plan participant or account owner during retirement, and not as a tax-deferred investment account for the benefit of future generations. Therefore, § 401(a)(9) of the Internal Revenue Code, and the regulations that have been adopted for that section, require distributions from retirement plans during the account owner's lifetime and, after the owner's death, complete distribution either within five years after the owner's death or, if there is an "eligible designated beneficiary," within that beneficiary's lifetime.

The minimum distribution requirements were changed by the SECURE Act, and the requirements that apply after 2019 can be summarized as follows:

• The owner must begin taking distributions following the year in which the owner reaches age 72, and the first distribution must be made by April 1 of that following year. (Before 2020, the required beginning age was 70-1/2.) Required distributions for the years after the year in which the owner turns 72 must be made before the end of the year (i.e., by December 31).
• During the owner's lifetime, required distributions are (a) the value of the account at the end of the previous year, divided by (b) the distribution period. The distribution is based on life expectancies calculated based on ages at the end of the year, as follows:
• If a spouse is named as a designated beneficiary and the spouse is more than ten years younger than the account owner, the distribution period is the joint-and-survivor life expectancy calculated from the owner's age and the spouse's age.
• In all other cases, the distribution period is taken from the "Uniform Lifetime Table," which is the joint-and-survivor life expectancy based on the account owner's age and a second age 10 years younger.
• Following the account owner's death:
• If there is no designated beneficiary, all distributions must be completed within five years if the account owner died before the required beginning date (i.e., before April 1 following the year in which the owner reached 72), or may be made over the owner's remaining life expectancy if the owner died on or after the required beginning date.
• If the designated beneficiary is the surviving spouse, the required minimum distributions may be made over the life expectancy of the surviving spouse, redetermined each year, or over the remaining life expectancy of the account owner.
• If the beneficiary is an "eligible designated beneficiary" other than the surviving spouse, meaning a minor child (but only while a minor), a disabled or chronically ill individual, or an individual not more than 10 years younger than the account owner, then the required minimum distributions may be calculated based on the beneficiary's life expectancy. However, when the beneficiary is a minor child, the distributions must be completed within 10 years after the child reaches the age of majority. (The Internal Revenue Service has not yet issued guidance on what is the age of majority for this purpose.) If the owner died on or after the required beginning date, the beneficiary can elect to take distributions over the owner's remaining life expectancy.
• If there is a designated beneficiary who is not an eligible designated beneficiary (e.g., the beneficiary is an adult child of the account owner), the account must be distributed within 10 years regardless of whether the death was before or after the required beginning date.

A "designated beneficiary" must be either an individual (or group of individuals) or a trust which meets certain requirements (in which case the beneficiary or beneficiaries of the trust are considered the designated beneficiaries). When there is more than one designated beneficiary, the age of the oldest beneficiary is used to calculate required distributions. Following the death of an account owner, the identity of the designated beneficiary must be determined before the end of September of the year following the death of the owner, so accounts and plans can be divided into new accounts among multiple beneficiaries and the required distributions can be calculated for each beneficiary's separate account.

Future distributions can be calculated from the current value of the retirement fund by increasing the value of the fund each year based on an assumed investment yield and using the future life expectancies to determine the future retirement distributions.

Sole Use Trust Election

Pennsylvania inheritance tax law allows a trust for the “sole use” of the surviving spouse to be taxed entirely at the death of the surviving spouse, rather than having to pay tax on the present value of the taxable remainder upon the first death, when the trust is created. However, the estate can elect to pay the tax on the present value of the remainder, essentially prepaying the tax, and there are sometimes a benefit to making that election.

Benefits of Prepaying Tax

When a trust is for the sole use of the surviving spouse, the executor has a choice: pay tax now on the present value of the remainder interests (the present value of what is likely to remain in the trust at the death of the surviving spouse), or pay no tax now and pay tax on the full value of the trust at the death of the surviving spouse.

In theory, prepaying the tax is beneficial, because determining the present value of the remainder acts as a discount on the rate of tax.

For example, take the case of a $1,000,000 estate which is to be held in trust for the benefit of a surviving spouse, paying income to the spouse for his or her life. If the executor does not elect out of section 2113, then there is no tax payable now, but the entire value of the trust will be taxed at the spouse’s death. If there is no change in the value of the trust, and the remaindermen are all children (or grandchildren or other lineal descendants), then the tax at the spouse’s death will be $45,000 (4.5%), and the beneficiaries will receive $955,000.

If the executor elects out of section 2113, then there is tax payable immediately on the present value of the remainder interests, and the value of the remainder is determined by factors which are based on mortality (the likelihood of the spouse dying in any particular year) and an assumed interest rate (which is used to discount the value of the future remainder back to present value). The Internal Revenue Service has published tables of life estate and remainder factors for different ages and interest rates, and those factors are used to determine the present value of life estates and remainders.

In the case of a $1,000,000 trust that pays the income to a surviving spouse for life, the present value of the income interest might be 40% of the current value of the trust, and the present value of the remainder might be 60% of the present value of the trust, depending on the age of the spouse and interest rates in effect when the trust is created. In that case, the remainder would have a present value of $600,000, and the inheritance tax would be 4.5% of $600,000, or $27,000, leaving $973,000 in the trust. There would be no additional tax payable at the death of the surviving spouse so, assuming no change in the value of the trust during the surviving spouse’s lifetime, the remaindermen will receive $973,000 instead of $955,000, an increase of $18,000.

Benefit of Paying the Tax on the Remainder

There is value to tax deferral, but that's only when the tax is on income. When the tax is on the principal (i.e., the investment itself rather than the income from the investment), then the timing of the tax payment is economically irrelevant, and the most important issue is the rate of tax.

To illustrate, assume that the investments of the trust could increase by 30% during the surviving spouse's lifetime, so that a $1,000,000 trust would be worth $1,300,000 at the death of the spouse. The tax at 4.5% on $1,300,000 would $58,500, leaving $1,241,500 for the remaindermen.

If the tax of 4.5% were paid at the first death instead of being deferred until the second death, and the tax were paid on the original $1,000,000 (without any remainder discount), then the trust would have only $955,000 to invest during the lifetime of the surviving spouse. If that $955,000 increased by then same 30%, then it would be worth $1,241,500 at the death of the surviving spouse, which is the exact same value that results when the tax is paid at the death of the survivor.

Because the timing of the payment of the tax is economically irrelevant, and only the rate of tax is significant, the prepayment of the tax is beneficial because, as previously stated, the remainder discount acts like a discount to the rate of tax.

Benefit of Deferring the Tax on the Remainder

Despite the economic benefit of prepaying the inheritance tax, there are practical reasons why deferring the payment of the tax may produce the better result, mainly because changes in circumstances could reduce (or eliminate) the inheritance tax payable at the death of the surviving spouse, making tax deferral the better choice. For example:

• If the spouse needs to spend principal of the trust, reducing the value of the trust (or perhaps even exhausting the trust), then prepaying the inheritace tax may lead to a bad result, because tax will have been paid on money that the remaindermen (children or grandchildren) do not receive.
• If the spouse moves out of Pennsylvania and dies as a resident of another state, then there will be no inheritance tax payable and (once again) the prepayment of tax will have cost money instead of saving money.
• It is always possible that the Pennsylvania legislature will amend or repeal the inheritance tax, reducing or eliminating the tax that would otherwise have been payable at the death of the spouse.

Perversely, there is a trade-off between the remainder discount and the risks of changes in circumstances that could undermine the discount, because there is a greater remainder discount for younger spouses with longer life expectancies, but the longer life expectancy increases the opportunities for (and likelihood of) changes in circumstances that might reduce or eliminate the inheritance tax payable at death on the value of the trust.

If the financial needs of the surviving spouse can be determined with some certainty, then the first possibility, the possible decrease in the value of the trust, can be calculated.

Summary

Although payment of inheritance at the first death, on the present value of the remainder, should reduce the ultimate tax burden in theory, there are practical circumstances which might make tax prepayment inadivisable. Prepayment of tax should always be considered, but will probably only be advisable in larger estates, when the surviving spouse will have more income than will be spent, and in cases in which the spouse is elderly or in ill health and has a relative short life expectancy.

Unitrust Factors and Values

A "unitrust" is a trust that pays out a percentage of the value of the trust each year, based on a revaluation of the trust assets each year, instead of income (e.g., interest and dividends, rents, and royalties) or an annuity (a fixed dollar amount). The right to receive the trust assets when the unitrust interest ends is called the "remainder." When a trust is divided that way between present and future interests, it may also be necessary to determine a present value for the unitrust and remainder interests, for tax purposes or for purposes of a sale or termination of the separate interests.

Uses of Unitrusts

Unitrusts are usually formed or created for one of the following reasons:

• A person wishing to make a gift to charity, but also wishing to retain income-like distributions for his or her life, or the life of another beneficiary, might create a charitable remainder unitrust so that the present value of the remainder passing to charity when the unitrust ends will qualify for a current income tax (and estate and gift tax) charitable deduction. (This calculator should not be relied upon for the valuation of the remainder in a charitable remainder unitrust because there are special rules that apply to that valuation. See instead the separate calculator for charitable remainder unitrusts.)
• Many states now allow trustees to elect to convert the "income" that is payable from a trust to a unitrust. This may be advantageous because the trustees may then follow an investment strategy that maximizes the total yield, regardless of whether that yield is capital gains or ordinary income, without adversely limiting the distributions to the income beneficiary.

Like income interests and annuities, unitrusts can extend for different periods of time:

• For a term of a specific number of years.
• While the person (or persons) entitled to the unitrust interest is living. (This is similar to a "life estate.")
• For a combination of a term of years and lives, such as the shorter of a lifetime or a fixed number of years, or the longer of a lifetime and a fixed number of years.

Regardless of how the length of the unitrust is measured, what is left at the end is known as the "remainder" and the person (or persons) who are ultimately entilted to the full ownership of the property is known as the "remainderman" (or "remaindermen").

Present Values

Determining the present value of a unitrust interest and unitrust remainder is different from determing the value of an income interest or an annuity, because the assumption about what income will be earned by the trust is relatively unimportant. The most important consideration is the percentage to be paid out each year, usually referred to as the "payout rate." However, there are still two assumptions:

• If there is a delay between the valuation of the trust and the first distribution based on that valuation, whether because distributions are made more frequently than annually, or because the annual distributions are not made immediately after the valuation, then an assumption about what income will be earned by the trust, and that assumption is used to calculate an "adjusted payout rate" that is comparable to annual payouts immediately following the annual valuation.
• For unitrusts based on measuring lives, there must be an assumption about the mortality of those lives (i.e., when they are likely to die).

For federal tax purposes, the income assumption is the average yield on federal securities with maturities of three to nine years (what is called the "applicable federal mid-term rate"), increased by 20%, and rounded to the nearest two-tenths of a percent. These rates are calculated each month by the Internal Revenue Service.

The federal mortality assumption is based on the most recent United States census, which is conducted every 10 years in order to determine the composition of the states in the House of Representatives.

These assumptions have been used by the IRS to construct tables of factors, and most unitrusts can be valued for federal tax purposes by multiplying those factors for the appropriate payout rates by the value of the principal amount of the trust subject to the unitrust.

Uses for Values

There are a number of different reasons why unitrusts might need to be valued:

• Values might be needed for estate, gift, inheritance, or realty transfer tax purposes (although as explained above charitable unitrusts are subject to special rules for which this calculator might not be appropriate);
• Values might be needed if a trust with a unitrust distributions is terminated, and the trust assets must be divided between or among the beneficial owners.

The values computed by Webcalculators are most applicable to determine federal tax consequences, and other kinds of valuations may require different income or mortality assumptions.

Value of Income and 'Five and Five' Power

A common feature of a trust that gives liberal benefits to a beneficiary is to give the beneficiary all of the income and, in addition, the power to withdraw each year either five percent of the value of the trust or $5,000, whichever is the greater amount. (Those limits are intended to conform with a provision of the Internal Revenue Code that states that, if the beneficiary does not exercise the withdrawal right, and the right lapses, the lapse is not a gift by the beneficiary to the trust.)

These "5&5" powers must sometimes be valued for tax purposes, and this calculator determines the value of the combined income and principal withdrawal rights in accordance with section 7520 of the Internal Revenue (which applies to the valuation of life estates, remainders, and annuities). Valuations under section 7520 rest upon two assumptions: (a) a rate of interest that is applied to discount future amounts back to present value, and (b) a mortality table that is used to determine the probability that a person with survive to a particular age, or die before reaching that age.

The valuation of a 5&5 power is done in the following steps for each possible future year:

• The income of the trust is assumed to be the principal of the trust times the 7520 rate.
• The withdrawal right is either 5% of the principal of the trust or $5,000, whichever is greater.
• The present value of the income and withdrawal right is the sum of those rights multiplied by a factor that represents the present value of $1 to be paid only if the beneficiary is living, and so discounted by both the interest the $1 could have earned at the 7520 rate and the probability the beneficiary could die before receiving those interests.
• Those present values, for all years from year one to the year in which the beneficiary would reach 110 (which the mortality table considers to be the oldest possible age), are added up, and become the total present value of all future income and withdrawal rights.

Weighted Average Maturity

In order to select an "applicable federal rate" that might apply to a promissory note or other debt instrument for federal income tax, estate tax, or gift tax purposes, it is necessary to determine the term of the note, because the choice of applicable federal rate depends on the term of the note. For this purpose, the "term" of the note is not the number of years until the last payment is made, but is the "weighted average maturity" of the note, which is the average number of years until each dollar of principal is paid.

Webcalculators determines the weighted average maturity of a note by following the procedure described in federal regulations. The future principal payments for the note are calculated, and the percentage of the total principal balance of the note represented by each payment is multiplied by the number of whole years that will elapse until that payment is made. The sum of those weighted maturities is the weighted average maturity for the note.