Friday April 26, 2024
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3.4.1 Appreciated Property Annuities
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Gift Annuity Description
A 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). Donors may choose between immediate payments to the annuitant or deferred payment schedules to the annuitant. Immediate gift annuities start making payments typically within one payment period from the funding date. Deferred gift annuities must delay payments at least one year from the funding date.
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. Most nonprofits who issue gift annuities have large reserves that assure gift annuitants the full payments will be made.
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 life of donor and spouse, 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 appreciated property, the capital gain on the gift portion is bypassed, while the capital gain prorated to the annuity portion will then be recognized over the life of the donor, 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 the donor is not the annuitant, and a child, nephew, niece or friend 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 3.4.1A
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 charitable gift annuity. Based on Mary's age, her charitable deduction is $4,908 and the annuity contract value is $5,092. The portion of the $8,000 capital gain allocated to the charitable gift is bypassed. However, the capital gain allocated to the annuity contract must be reported during her life expectancy.
Based upon the life expectancy and the exclusion ratio, she reports ordinary income of $138.04 annually. However, the remaining amount that is excluded from ordinary income is now divided between the long-term capital gain and the tax-free return of basis. Prorating the capital gain over her years of expectancy, the capital gain each year is $433.35 and the tax-free amount is $108.61. A few very senior persons may have a short life expectancy. For these gift annuity donors, 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.
It is possible for a gift annuity to be funded with long-term capital gain property and for the deduction to be based on the property's cost basis rather than fair market value. This option is helpful for a donor who desires to make a large gift of appreciated stock and has a reasonably high basis. The donor must elect to base the deduction on the property's cost basis and not the fair market value. Sec. 170(b)(1)(C)(iii). However, if the donor elects to deduct the cost basis as a cash-type gift, then all appreciated property gifts and carry forwards from prior years also must be treated as deductible at cost basis. Reg. 1.170A-8(d)(2)(i).
Appreciated Property Gift Annuity for Donor and Spouse
A donor may establish a charitable gift annuity with appreciated property for his or her own life and the life of his or her spouse. With joint or community property, the annuity pays jointly to the two spouses and then to the survivor. In community property states, 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 there is any question about title, the common practice is to document the transfer of the appreciated stock into joint or community property prior to funding the gift annuity. If a donor and spouse establish a joint and survivor annuity with joint or community property, no gift tax is due.
The capital gain on the appreciated property will be apportioned between the gift and the contract value. The contract value capital gain will be prorated over the joint life expectancy. If one spouse lives past that expectancy and all gain has been recognized, future payments will be ordinary income.
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 gift 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. The other half of 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 distributed. One 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 gain 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.
Successor Gift Annuity Interest
A donor also may establish a successor 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 revoke the interest of the surviving spouse 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, generally no tax-free income will be distributed until all of the capital gain income has been paid. If there is highly appreciated property, the payments to the first spouse may include no tax-free amounts. All tax-free payments may be to the surviving spouse.
Appreciated Property Gift Annuity for Spouse Created with 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 3.4.1B
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 rate and the applicable federal rate, the annuity contract is valued at $7,268, and the charitable gift is $2,732. Since Susan is relatively young, the total expected return equals $11,124. With an exclusion ratio of 68%, $115.20 of the $360 payment is ordinary income. The remaining value is the excluded amount, which may be either long-term capital gain or tax-free return of principal.
Since the property is separate property, the gain is reported over the lifetime of Mary Johnson. The full $244.80 is capital gain and there is zero tax-free payout during her lifetime. After Mary passes away, the balance, if any, of the capital gain will be reported by Sue. However, during the final years of Sue's expectancy, the full excluded amount will 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 directly for the child for one lifetime and is 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 3.4.1C
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 4% one-life annuity contract for Susan Smith. 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 on the annuity contact value, the prorated capital gain is reported by Mary Johnson for the tax year she establishes the annuity. Because the charitable deduction saves at ordinary income rates and the capital gain is taxable at a lower rate, the net result is often little or no tax payable by donor Mary Johnson.
Appreciated Ordinary Gain Property
Various types of property could be transferred that would produce ordinary income if sold by the donor. Inventory, tangible personal property transferred for 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 3.4.1D
Mary Johnson is a sole proprietor and 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. Mary's 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 adjusted expectancy, the ordinary income is $138.04. The tax-free amount is $108.61 and $433.35 is the gain taxed as ordinary income each year. If she survives beyond life expectancy years, all payments thereafter will be ordinary income.
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