Thursday April 18, 2024
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3.3.2 Current (Immediate) Gift Annuities
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Gift Annuity Description
A current, or immediate, gift annuity is a contract between the charity and the donor. The donor transfers property to the charity and the charity promises to pay the annuity for one life or two lives. Sec. 514(c)(5).
As a contractual obligation, the annuity payments are secured by the assets of the charity. Most charities maintain an annuity reserve fund, which is required by some state insurance commissioners. However, the endowment and even all of the real property and other assets of the charity stand behind the promise to pay a gift annuity.
From the perspective of the donor, a gift annuity is a relatively simple agreement. He or she transfers cash, securities or other assets to the charity and receives a payment for one or two lives. The payment may be made monthly, quarterly, semiannually or annually. In addition, there is an income tax deduction and partially tax-free payout from the annuity contract.
When the gift annuity is created, part of the value represents a charitable gift and part is the amount exchanged for the annuity contract. There are several specific Treasury requirements for qualification as a gift annuity. A qualified gift annuity must be for one or two lives, there must be a minimum 10% charitable deduction, there can be no guaranteed minimum or maximum payments and the annuity may not be adjusted based on the income earned on the transferred property. Sec. 514(c)(5).
Gift Annuity Participants
There are four parties to a charitable gift annuity. First, the donor who transfers cash, securities or other assets to the charity. Second, a charity that issues the contract and assumes the obligation to make the annuity payments. Third, the annuitant or annuitants who receive the payments for life. The annuitant may be the donor, but could also be a relative or friend of the donor. Fourth, the State Insurance Commissioner, who is charged with responsibility to regulate gift annuities.
Tax Deduction – Bargain Sale
Only a portion of the amount transferred for a gift annuity qualifies as a charitable deduction. If a donor makes a gift to a charity and value is returned to the donor, the gift is described by Treasury as a "bargain sale." With the transfer of cash or other property to a gift annuity, the donor receives a deduction for only part of the transfer, since the charity has promised to transfer a value annuity payout back to the donor. In effect, the donor has made a gift of part of the property and purchased an annuity contract with the balance. Reg. 1.1011-2(c).
Example 3.3.2A
Mary Johnson transfers $10,000 in cash to her favorite charity for a gift annuity. Based on her age, the charity agrees to pay her a 6.8% annuity, or $680 per year.
Using the life factor, located in IRS Pub. 1457, Table S, (based upon Mary's age and the Applicable Federal Rate under Sec. 7520), we multiply the adjusted factor times the annuity amount to produce an income tax charitable deduction of $4,908. Her contract value is $5,092 ($10,000 - $4,908). Her deduction is a cash-type charitable deduction and is deductible up to 60% of her adjusted gross income in the year of the gift.
Under Sec. 7520, it is permissible to use the current month AFR or an AFR from one of the two prior months. The low AFR of 2% was selected in this case, since Mary Johnson preferred to have a lower charitable income tax deduction and higher tax-free payments. If she had desired a larger charitable deduction, then the highest AFR for the three-month period would have been selected.
Charitable Deduction Rules
Most gift annuities are funded with cash, and the deduction may be taken up to 60% of adjusted gross income. If the annuity is funded with long-term capital gain property, the deduction may be used to 30% of adjusted gross income. Any excess over these amounts may be carried forward and deducted over as long as the next five years.
However, if short-term stock or an ordinary income asset is transferred to the charity in exchange for the gift annuity, the deduction will be reduced. Sec. 170(e). Property for which there will be a reduced deduction includes short-term capital gain securities, inventory, real property with recapture due to accelerated depreciation and tangible personal property put to an unrelated use by the charity. In all of these circumstances, the charitable deduction will be reduced proportionately by the short-term gain or ordinary income element.
A charity should not accept a gift of an encumbered asset in exchange for cash plus a gift annuity unless the annuity represents less than 90% of the value of the transferred property. Sec. 514(c)(5)(A). For purposes of this section, the term ?acquisition indebtedness? does not include an obligation to pay an annuity which is the sole consideration (other than a mortgage to which paragraph (2)(B) or this Section applies) issued in exchange for property if, at the time of the exchange, the annuity is less than 90% of the value of the property received in the exchange. Failure to follow this provision of the Code may subject the charity to unrelated business income tax for income generated from acquisition indebtedness.
Exclusion Ratio
A portion of the annuity payouts may be excluded from taxation as ordinary income. With a cash annuity, the value of the annuity contract is assumed to be paid out over the life expectancy of the individual. This amount is then tax-free return of basis.
Assume that cash is used to fund a one-life gift annuity. The annuity amount is multiplied times the return multiple, adjusted if the annuity is not paid monthly. Reg. 1.72-9, Table V or VI. This total result is the expected return over the lifetime of the individual.
The exclusion ratio equals the annuity contract value divided by the total expected return. This exclusion ratio percentage is used to determine the tax-free portion of annuity payments for a gift annuity funded with cash.
Payout Taxation for a Cash Annuity
Based on the exclusion ratio, a portion of the payout will be tax free. The assumption behind the calculation is that the annuity contract value is invested. The earnings generate ordinary income. Therefore, a portion of the payout is ordinary income. However, the excluded amount, calculated using the exclusion ratio, is then tax-free payout for a cash gift annuity.
However, this exclusion is only applicable until the annuitant reaches his or her life expectancy. Should the annuitant live past life expectancy under Reg. 1.72-9, Table V or VI, all payouts will thereafter be reported as ordinary income.
Example 3.3.2B
Assume that Mary Johnson has funded a gift annuity with $10,000 cash. The charitable deduction is $4,908 and the contract value is $5,092. Based on her adjusted return multiple of the total expected return is $6,392 and the exclusion ratio is 79.7%.
Each year, she will receive $680, but $541.96 of this will be tax free. The ordinary income will be $138.04. If she should live more than 9.4 years, all future payments of the annuity will be ordinary income.
Payout Taxation – Appreciated Property Annuity
If a donor funds a gift annuity with appreciated property, the taxation of payouts will need to take into consideration the long-term capital gain. If the annuity is nonassignable, except to the issuing charity, and the annuity is written for the life of the donor, or lives of donor and spouse, then the capital gain in the annuity portion may be prorated. Reg. 1.1011-2(a)(4). In the case of a gift annuity funded with jointly held appreciated property, the capital gain on the gift portion is bypassed, while the capital gain prorated to the annuity portion may then be recognized over the life of the annuitant, or lives of donor and spouse.
If the donor is not the annuitant, the capital gain allocated to the gift portion is still bypassed. However, when a child, nephew, niece or friend, rather than the donor, is the annuitant, the capital gain on the annuity portion will be recognized and reported by the donor in the year of the contract.
Example 3.3.2C
Mary Johnson owns stock purchased four years ago for $2,000, with a current fair market value of $10,000. She transfers that stock in exchange for a 6.8% gift annuity. Her charitable deduction is $4,908 and the annuity contract value is $5,092. The portion of the capital gain allocated to the charitable gift is bypassed. However, the capital gain allocated to the annuity contract must be reported over her life expectancy.
Based upon the life expectancy of 9.5 years and the exclusion ratio of 79.7%, she once again reports ordinary income of $138.04, just as she would with a cash annuity. However, the remaining amount that is excluded from ordinary income tax is now divided between the long-term capital gain and the tax-free return of basis. Prorating the capital gain over her 9.5 years of expectancy, the capital gain each year is $433.35 and the tax-free amount is $108.61. It should be noted that for very senior persons with a short life expectancy, the prorated capital gain may not exceed the excluded amount. That is, all of the excluded amount may be capital gain. The tax-free return may be reduced to zero, but not below zero.
Appreciated Property Gift Annuity for Donor and Spouse Created with Separate Property
Joint and Survivor Annuity
A donor may establish a charitable gift annuity with appreciated separate property for his or her own life and the life of his or her spouse. (This type of gift is not as common in community property states because property held by one spouse may be considered community property if the property was acquired during the marriage or with income earned during the marriage.)
If a donor establishes a joint and survivor annuity with donor's separate property, no gift tax is due if the donor irrevocably gifts an interest to the non-donor spouse because the interest of the non-donor spouse qualifies for a marital gift tax deduction. In contrast, if the donor spouse retains the right to revoke the non-donor spouse's survivor interest, the gift is incomplete, and thus, there is no gift tax. Nor is any estate tax due because the non-donor spouse's interest qualifies for a marital estate tax deduction. Sec. 2523(f)(6). However, if the donor spouse's estate executor elects not to take the marital estate tax deduction, then estate tax will be due. Sec. 2056(b)(7)(C). (Note: The previous statements assume the spouse is a U.S. citizen.)
The capital gain on the appreciated property will be apportioned between the donor and the spouse. One-half of the capital gain will be prorated solely over the donor's expected life expectancy and no tax-free income will be distributed until all of the capital gain income has been distributed. The other half of the capital gain will be taxable to the donor in the year of the gift.
In most circumstances, the tax savings from the charitable gift partially or completely offsets the capital gains tax. The capital gain must be reported on the donor's Form 1040. The reported amount will depend on the amount of capital gain in the asset given for the gift annuity.
Successive Annuity
A donor also may establish a successive interest annuity for a spouse using the donor's separate appreciated property. Such an annuity provides an income stream to the donor for life, then to the non-donor spouse for life. In this case, there is no gift tax if the donor retains a right of revocation over the spouse's income stream. No marital deduction is allowed because the non-donor spouse does not have the immediate right to receive income from the annuity. Reg. 25.2523(f)-1(c)(2). To receive a marital estate tax deduction, the donor spouse should retain the testamentary right to revoke the non-donor spouse's income stream. If the donor spouse chooses not to exercise this right in his or her will, the estate may claim a marital estate tax deduction for the value of the income stream. Reg. 20.2056(b)-1(g).
The capital gain will be prorated solely over the donor's life expectancy and no tax-free income will be distributed until all of the capital gain income has been paid.
Appreciated Property Gift Annuity for Spouse Created with Donor Spouse's Separate Property
A donor also may establish a charitable gift annuity solely for a spouse with the donor's appreciated separate property. While this gift model may be appropriate for donors in separate property states, many community property states deem separate property as community property if the property was acquired during the marriage or with income earned during the marriage.
In the case of an annuity funded with separate property and payable only for the annuitant spouse's life, no gift or estate tax is due because of the unlimited marital deduction. Reg. 20.2056(b)-1(g), Example 3; Reg. 25.2523(b)-1(b)(6), Example 3. However, the donor will recognize a portion of the capital gain on the contributed property when the annuity is established. Although the gain allocated to the charitable gift is bypassed, the balance of the prorated gain will be taxable to the donor in the year of the gift. In most circumstances, the tax savings from the charitable gift will offset the tax payable on the capital gain, but the immediate taxation of the prorated capital gain will reduce the net tax savings. The capital gain must be reported on the donor's Form 1040.
Appreciated Property Gift Annuity for Parent and Child
If a parent creates a gift annuity with appreciated property that pays to the parent for life and then to the child for life, the capital gain must be reported during the life of the parent. With appreciated property, the portion of the gain allocated to the charitable gift is bypassed. However, the balance of the capital gain will be reported during the life expectancy of the parent. Once again, the amount reported is limited to the available excluded amount under the exclusion formula. With highly appreciated property, the parent may receive all ordinary income and capital gain, while the child may then benefit from ordinary income and tax-free return of basis.
Example 3.3.2D
Mary Johnson owns stock with a fair market value of $10,000 and a cost basis of $2,000. She creates a gift annuity payable to herself for life and then to her daughter, Susan Smith, for her lifetime.
Based on their ages, the annuity payout and the applicable federal rate, the annuity contract is valued at $7,268, and the charitable gift is then $2,732. Since Susan is relatively young, the adjusted return multiple for quarterly payments is 29.7 years and the total expected return equals $10,692. With an exclusion ratio of 68.0%, $115.20 of the $360 payment is ordinary income. The remaining $244.80 is the excluded amount, which may be either long-term capital gain or tax-free return of principal.
Since the stock is Mary's separate property, the gain is reported over the lifetime of Mary Johnson. The full $244.80 is allocated to capital gain and there is zero tax-free payout during her lifetime. After she passes away, the balance, if any, of the capital gain will be reported by Susan. However, during the final years of Susan's anticipated expectancy, the full $244.80 of the excluded amount will then be tax-free return. In effect, Mary reports the capital gain over her lifetime and Susan receives the tax-free payments that represent the basis allocated to the annuity contract.
Appreciated Property Gift Annuity for a Child
If the annuity is established for only the child for one lifetime and funded with appreciated property, a portion of the capital gain will be recognized immediately. While the gain allocated to the charitable gift is bypassed, the balance of the prorated gain will be taxable to the donor in the year of the gift. In most circumstances, the tax savings from the charitable gift will offset the tax payable on the capital gain, but the immediate taxation of the prorated capital gain will reduce the net tax savings.
Example 3.3.2E
Mary Johnson owns stock with a cost basis of $2,000 and a fair market value of $10,000. She transfers this stock to her favorite charity in exchange for a one-life annuity contract for Susan Smith. Based on Susan's age and the AFR, the charitable deduction is $2,271 and the annuity contract value is $7,729. The capital gain allocable to the charitable portion is bypassed, but not the gain allocated to the annuity portion. The capital gain allocable to the annuity portion ($6,183) is reported by Mary Johnson in the year of the agreement. Even though the charitable deduction saves at ordinary income rates and the capital gain is taxable at a lower rate, the net result is still a tax payable by donor Mary Johnson.
Ordinary Gain Property
Various types of property that could be transferred would produce ordinary income if sold by the donor. Inventory, tangible personal property transferred and put to an unrelated use, commercial real property that has been depreciated under an accelerated method and depreciated equipment could all have an ordinary income element. These ordinary-income-type assets will result in a reduced charitable deduction. Sec. 170(e). In addition, a portion of the payouts represents ordinary gain. However, the bargain sale regulations specify that "any" gain may be prorated. Therefore, it should be permissible to prorate ordinary gain. Reg. 1.1011-2(a)(4)(ii).
Example 3.3.2F
Mary Johnson is a sole proprietor and she has inventory with a cost basis of $2,000 and value of $10,000. If she were to sell this inventory to customers, she would recognize $8,000 of ordinary income.
Mary transfers this inventory to a charity in exchange for a gift annuity. Her deduction is reduced to $982 due to the ordinary income property gifted. The 6.8% gift annuity for Mary makes a payout of $680 per year. Based upon her 10.2 year life expectancy and an AFR of 2%, the ordinary income is $138.04. The tax-free amount is $108.61. If she survives for more than 10.2 years, all payments thereafter will be ordinary income.
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Case Studies on Current (Immediate) Gift Annuities
The Annual Exclusion Gift Annuity:
Keith and Miriam Miller, ages 90 and 89 respectively, have one niece whose name is Joni. Joni has been the beneficiary of her aunt & uncle's generosity each year, receiving up to $28,000 in annual gifts.
Soft Markets and Low Interest Rates, Part 1 – CDs and Money Market Accounts:
Jeanne Henry, 77, is a very concerned American. Having grown up during the Great Depression, Jeanne developed certain attitudes towards money and savings. As a result, she saved consistently and conservatively during her entire life.
Marketing Ideas During Soft Markets and Dropping Interest Rates, Part 9 - Draft Testamentary CRUTs not CRATs:
Jeanne Henry, 85, is a very concerned American. Having grown up during the Great Depression, Jeanne developed certain attitudes toward money and savings. As a result, she saved consistently and conservatively during her entire life.
Rodeo Rider Life Estate Rollover:
Mac Swenson loved the great outdoors. He grew up in the Big Sky country of Montana. As soon as he could walk, Mac was on a pony.
CRAT vs. CGA – Which is the Better Choice?:
Frederick Fischer, a widower, purchased 1,000 shares of stock in a new pharmaceutical company in 1990 through an Initial Public Offering (IPO) for $100,000. The company has been very successful, having introduced a number of new drugs that have taken the market place "by storm." The stock in the company has skyrocketed and is now worth over $1,000,000, yet pays very low dividends, currently less than 1%. Mr. Fischer is very concerned that the market is due for a substantial correction and would like to sell the stock and reinvest in a more balanced portfolio. He would like more income as he anticipates cash needs for health care as he grows older. Applying a federal and state capital gains tax rate, he would owe about $180,000 in capital gains taxes on the sale of the stock. This leaves him $820,000 to reinvest for income in the range of 6%, or $49,200 per year.
Meeting the Needs of a Trusted Friend:
Melinda Carpenter Katharine Andrews have been trusted friends for the last 25 years. They have traveled together over the years, attend the same church, and share many of the same interests. Both are widows and have no children. Melinda has an estate of approximately $750,000 and receives income of approximately $75,000 per year, which includes a pension from her teacher's retirement fund. Katharine, on the other hand, has an estate of only $100,000, consisting of her home valued at $65,000 and liquid investments of $35,000. She has struggled financially over the years and Melinda has made it a point to give her $1,000 per month, which, along with her Social Security payments, allows her to live comfortably. Melinda has a block of Intel stock that she purchased several years ago for $100,000. The fair market value of that block of stock today is $160,000. Melinda has been considering making a contribution to the local Community Children's Home where she has done volunteer work over the years. However, she wants to make sure that Katharine continues receiving the $1,000 per month now and after Melinda is gone.
Meeting Mom's Retirement Home Needs:
George Johnson's mother is now age 90 and in a retirement home, the monthly cost of which is almost $3,000. His mother is able to provide only $2,000 per month toward the monthly cost through income on her investments and Social Security.
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