Saturday, April 20, 2024
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GiftLaw Note: Gift annuities under Sec. 514(c)(5) must be written for one life or two lives. However, after the gift annuity has been issued, it has been permissible to exchange the life interest for a term of years. For a young person, this potentially would permit a deferred payment gift annuity to be funded at a young age, with payments for one life to commence at age 18. However, the one-life gift annuity could then be exchanged for a term of years gift annuity with higher payouts during the college years.

This ruling discusses two specific issues with respect to the college annuity. First, since Congress in passing Sec. 501(m)(3) intended to make clear that charitable gift annuities were not "commercial type insurance," the gift annuity would not be subject to unrelated business taxable income (UBTI). Second, interest income from the annuity reserve fund would also not constitute UBTI. The issuance of a charitable gift annuity historically has been treated as the charity borrowing funds. The borrowing of funds is permitted under the exception to the debt-finance rules for charitable gift annuities. Therefore, interest income on annuity funds is also excluded from UBTI.
This is in reply to your request for rulings dated July 11, 1988, as supplemented and modified by subsequent correspondence. You are an educational institution exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code. You have been classified as not a private foundation by reason of sections 509(a)(1) and 170(b)(1)(A)(ii) of the Code.

You intend to engage in the sale of deferred gift annuities. Under your plan, individuals will make a payment of cash or property in return for a deferred gift annuity. The purpose of the annuity is to provide funds for education. Each donor will designate one recipient and may designate an alternate recipient. The recipient is entitled to a lifetime payout but has the option to sell or assign his or her annuity to you or to a third party in return for a lump sum payment or installment payments over several years. It is contemplated that recipients will use funds generated by the annuity to attend college at your institution. However, this is not required and recipients may in fact use the funds for any purpose.

You have requested a ruling that income derived by you as the result of the sale of these deferred gift annuities will not be considered income from an unrelated trade or business as defined in sections 511-513 of the Code. You have also requested a ruling that interest income derived by you from these annuities will not be considered debt-financed income within the meaning of section 514 of the Code.

Section 511 of the Code imposes a tax upon the unrelated trade or business income of tax-exempt organizations.

Section 513(a) of the Code states that the term "unrelated trade or business" means any trade or business, the conduct of which is not substantially related (aside from the need of an organization for funds) to the exercise or performance of such organization of its charitable, educational or other function which constitutes the basis for its exemption.

Section 1.513-1(d)(2) of the Income Tax Regulations provides that a trade or business is related to exempt purposes in the relevant sense, only where the conduct of the business activity has a causal relationship to the achievement of exempt purposes (other than through production of income) and is "substantially related" only if the causal relationship is a substantial one. The activity from which income is derived must contribute importantly to the accomplishment of exempt purposes.

Section 501(m) was added to the Code by the Tax Reform Act of 1986, Pub. L. 99-514 (1986). The section states that an organization described in section 501(c)(3) or section 501(c)(4) may be exempt from tax under section 501(a) only if no substantial part of its activities consists of providing "commercial-type insurance." Section 501(m)(3) sets forth a list of items deemed not to be "commercial-type insurance." Section 501(m)(4) provides that the issuance of annuity contracts shall be treated as providing insurance.

The Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647 (1988) amended section 501(m) by adding 501(m)(3)(E) which adds the term "charitable gift annuities" to the list of exceptions from commercial-type insurance. Section 501(m)(5) provides that for purposes of 501(m)(3)(E) the term "charitable gift annuity" means an annuity if (A) a portion of the amount paid in connection with the issuance of the annuity is allowable as a deduction under section 170 or 2055, and (B) the annuity is described in section 514(c)(5) (determined as if any amount paid in cash in connection with such issuance were property).

The legislative history accompanying the 1988 Act provides that "[t]he present-law exception to the debt-financed property rules had historically exempted from tax ANY income resulting from the issuance of charitable gift annuities." H.R. Rep. No. 795, 100th Cong. 2d Sess. 116 (1988) (emphasis supplied).

Section 512(b)(1) of the Code excludes interest income from the computation of the tax on unrelated trade or business income.

Section 514(a)(1) of the Code states that in computing the unrelated business income tax under section 512, income derived from debt-financed property should be included.

Section 514(c)(5) of the Code states that rules concerning debt-financed property should not be applied to annuities where 1) the annuity is the sole consideration issued in exchange for the property if, at the time of the exchange, the value of the property is less than 90 percent of the value of the property received in the exchange, 2) the annuity is payable over the life of one individual in being at the time the annuity is issued or over the life of two individuals in being at such time, and 3) the annuity is payable under a contract which does not guarantee a minimum amount of payments and does not provide for any adjustment of the amount of the annuity payments by reference to the income received from the transferred property or any other property.

Charitable gift annuities are a well established method for educational institutions to obtain contributions. Section 501(m)(3)(E) was added to the Code to make it clear that "charitable gift annuities" were not "commercial-type insurance." If they were classified as "commercial-type insurance" and a substantial part of an educational institution's activities consisted of issuing these contracts, the educational institution would lose its section 501(c)(3) exemption pursuant to section 501(m). If, as is far more likely, the issuance of charitable gift annuity contracts was not a substantial part of the educational institution's activities it would not lose its exemption but the provisions of these annuity contracts would be treated as an unrelated trade or business subject to tax pursuant to section 501(m)(2).

Since it is rather unlikely that a "substantial part" of an educational institution's total activities would consist of issuing charitable gift annuities, it is reasonable to assume that in enacting section 501(m)(3)(E) Congress was primarily interested in making it clear that the issuance of charitable gift annuities did not constitute an unrelated trade or business. This interpretation is supported by the legislative history of section 501(m)(3)(E) which indicates that under the law prior to the enactment of section 501(m) all income resulting from charitable gift annuities was exempt from tax. See H.R. Rep. No. 795, supra at 116. It is also supported by the fact that if the issuance of "charitable gift annuities" were to be taxed as an unrelated trade or business, section 501(m)(2) would provide a more favorable and more appropriate method for calculating the unrelated business income tax. Section 501(m)(2) would allow the educational institution to be taxed on this activity as an insurance company under subchapter L and it would get the benefit of deductions for reserves that would not be available under the general rules for taxing unrelated business income. Thus, if Congress had thought that the sale of charitable gift annuities were subject to unrelated business income tax, it would probably have allowed educational institutions to use the method of taxation described in section 501(m)(2) rather than specifically making it unavailable.

Historically it appears that the issuance of "charitable gift annuities" has been treated as a borrowing of money by the issuing organization and the sales aspect of the transaction has been ignored. Section 514(c)(5) specifically exempts "charitable gift annuities" from being considered "acquisition indebtedness" and thereby ensures that the interest, rents or dividends secured by the educational institution from the investment of the proceeds it receives from issuing these annuities will not be subject to unrelated business income tax. This exception from the debt-financed income provisions of the unrelated business income tax would be virtually useless if the proceeds themselves were subject to the unrelated business income tax. For these reasons, the present law exception to the debt-financed property rules has historically exempted from tax any income resulting from the issuance of charitable gift annuities.

Since in accordance with Donor Agreement III, the annuity is payable over the lifetime of one individual in being at the time the annuity is issued, and all other requirements of section 514(c)(5) of the Code have been met, the annuities will not be considered to be debt-financed property within the meaning of section 514. Therefore, interest income derived by you from the annuity is excludable from the computation of unrelated business income by reason of section 512(b)(1) of the Code.

Based on the above, we rule that:

1. Income from your sale of annuities is not subject to the tax on unrelated business income under sections 511-513 of the Code.

2. Interest income derived from investment of annuity funds is excludable from the computation of unrelated trade or business tax under the provisions of section 512(b)(1) of the Code.


Our holdings are contingent upon your meeting all the requirements under section 501(m) and 514(c)(5) of the Code, including the requirement that a deduction be allowed under section 170 or 2055.

Your ruling requests concerning deductibility of contributions and other matters have been forwarded to the appropriate offices within the Service. These offices will respond directly to you.

This ruling is directed only to the organization that requested it. Section 6110(j)(3) of the Code provides that it cannot be used or cited as precedent.



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