Thursday April 25, 2024

6.1.4 Sec. 72 and Charitable Gift Annuities

Sec. 72 and Charitable Gift Annuities

Bargain Sale:  Sec. 72 of the Internal Revenue Code addresses the treatment of charitable gift annuity payments to an annuitant.

Return of Principal:  When a donor sells an asset such as stock, he or she will recognize gain on the difference between the amount realized and the cost basis.

Sec. 72 Tables:  In order to allocate the capital gain and tax-free amounts over the annuitant's life expectancy, a life expectancy table must be used to determine how long an annuitant will live and, therefore, how long to spread out those amounts.

Unrecovered Return of Principal:  An annuitant who passes away before his or her calculated life expectancy under the Sec. 72 tables is entitled to a posthumous income tax deduction on the final income tax return.

Bargain Sale
Sec. 72 of the Internal Revenue Code addresses the treatment of charitable gift annuity payments to an annuitant. (This same Code section also applies to commercial annuities, retirement annuities, and certain life insurance payments.) Under this section, only amounts received by the annuitant other than as a return of principal are included in the annuitant's gross income.

A gift annuity is deemed a bargain sale. In a bargain sale, the donor "sells" property to the charity. The amount that the donor receives in the sale is less than the fair market value of the property sold. In a gift annuity, the donor transfers property to the charity in exchange for the right to receive an income stream, payable over one or two lives. The value of the income stream payable to the annuitant or annuitants will always be less than the value of the asset that the donor transfers to the charity in exchange for the gift annuity. Because the value of income received by the annuitant is less than the value of the asset transferred to the charity, there is a gift to the charity, and thus, the donor receives a charitable deduction.

Example 6.1.4A

Dotty Donor transfers $100,000 of JCN stock to her favorite charity in exchange for a charitable gift annuity. Dotty receives a deduction of $40,000 based on her age, the rate of the month, the payment frequency, and her gift annuity funding amount. The $40,000 amount represents the present value of the remainder interest to charity. The difference between the $100,000 value transferred and the $40,000 charitable deduction is $60,000. The $60,000 represents the value to Dotty of receiving an income stream for her life. This transaction represents a bargain sale because Dotty is giving the charity stock worth $100,000, but receiving only $60,000 of value in return. As with any other bargain sale, the difference between the value given to charity and the value received by the donor is the charitable deduction.

Return of Principal
When a donor sells an asset such as stock, he or she will recognize gain on the difference between the amount realized (the sale proceeds) and the cost basis (what the donor paid for the stock). The difference between these two amounts is the gain. While the donor does have to pay taxes on the gain, he or she does not have to pay taxes on the funds that were used to acquire the asset (the cost basis). That is because those funds have already been taxed. To tax those funds again would result in double taxation. Therefore, when the donor sells an appreciated asset, the donor's cost basis is referred to as a return of principal. Only the growth in the investment is subject to tax.

This concept also applies to a charitable gift annuity. A gift annuity is a bargain sale, and thus, as the term indicates, there is a sale. In the sale the donor is likely to have both a gain and a return of principal. If the donor funds the gift annuity with cash, however, there will not be any capital gain and the entire gift annuity funding amount will also be the donor's cost basis.

Example 6.1.4B

Dotty Donor gives 10,000 shares of JCN stock to her favorite charity in exchange for a gift annuity. Each share of JCN stock is worth $10.00. Dotty purchased the stock 20 years ago for $1.00 per share. If Dotty were to sell the stock instead, she would recognize $9.00 of gain on each share for a total gain of $90,000. Dotty would have to pay capital gains tax on the $90,000 of gain. Her original investment of $1.00 per share, or $10,000, would not be subject to tax.
When a donor enters into a charitable gift annuity, because it is treated as a bargain sale, the donor must recognize the capital gain on the value of the lifetime income stream. So long as the donor is also the annuitant and the gift annuity is not assignable to anyone other than the charity, the gain will be spread over the donor's life expectancy. The donor also bypasses some of the capital gain. The capital gain recognized by the donor over his or her life expectancy is in the same proportion as the value of the donor's income interest in the gift annuity. The donor's return of principal also will be in the same proportion as the value of his or her income interest.

Example 6.1.4C

In the Dotty Donor example, Dotty had a gain in her stock of $90,000. Dotty will have to recognize a portion of this gain over her life expectancy and the balance of the gain will be bypassed. To determine how much gain Dotty will bypass, we can divide the amount of the charitable deduction by the total amount given for the gift annuity. Dotty's deduction is $40,000 and the total amount given for the gift annuity is $100,000. Therefore, her charitable deduction represents 40% of the $100,000 amount transferred. That means the value of Dotty's income interest is 60%. Dotty will bypass 40% of the $90,000 capital gain. The remaining 60% will be allocated over Dotty's life expectancy.

A similar calculation is performed with the donor's cost basis to determine how much of the annuity payment will be tax free to the donor each year.

Example 6.1.4D

In the above examples, Dotty had a $10,000 cost basis in her JCN stock. Similar to the capital gain allocation, a portion of Dotty's cost basis will be allocated to the charitable gift and the remaining amount will be allocated over Dotty's life expectancy. The charitable gift represented 40% and Dotty's income stream interest represented 60%. Therefore, 40% of Dotty's cost basis, or $4,000, will be allocated to the charitable gift and 60%, or $6,000, will be repaid to Dotty over her life expectancy.

Sec. 72 Tables
In order to allocate the capital gain and tax-free amounts over the annuitant's life expectancy, a life expectancy table must be used to determine how long an annuitant is likely to live and, therefore, how long to spread out those amounts. GiftLaw Pro chapter 6.1.2 reviewed some of the different mortality tables used in charitable split-interest gifts. One of the tables described in that chapter was the mortality table that underlies the expected return multiples in Reg. 1.72. The tables published in Reg. 1.72 give the "expected-return multiple." The expected return multiple is the life expectancy over which the capital gain and tax-free amounts will be allocated. The tables published in this section must be used to determine the life expectancy of an annuitant for allocation of capital gain and tax-free amounts.

The mortality table used to determine the expected-return multiples was created prior to Table 90CM, which must be used for calculating the charitable deduction. Thus, the life expectancies used for allocating capital gain and tax-free amounts are different from those in the table used to determine the charitable income tax deduction.

Unrecovered Return of Principal
An annuitant who passes away before his or her calculated life expectancy under the Sec. 72 tables is entitled to a posthumous income tax deduction on the final income tax return. The amount of deduction is the difference between the tax-free income that the annuitant would have received if the annuitant had lived for his or her life expectancy and the amount of tax-free income already received by the annuitant. This amount is referred to as the unrecovered investment in the contract, or unrecovered basis. Sec. 72(b)(3)(A). The deduction for unrecovered basis is a miscellaneous itemized deduction not subject to the 2% floor. Sec. 67(b)(10).

Related Topics on Sec. 72 and Charitable Gift Annuities

3.3.2  Current (Immediate) Gift Annuities:    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).

3.3.3  Deferred Annuities:    A deferred annuity is similar in many respects to a current annuity. The deferred annuity is a contractual agreement between the donor and the charity. It is secured by all of the assets of the charity. The parties with interests in the agreement to the contract are the donor, the charity, the annuitant or annuitants and the insurance commissioner of the appropriate state.

3.3.8  Deduction for Unrecovered Basis:    Under the bargain sale rules, a transfer for a gift annuity produces a charitable deduction and a contract value retained by the donor. Reg. 1.1011-2(a). With a cash annuity, the contract value represents the donor's principal. This principal is returned on a prorated basis each year to the donor. Since it is a return of his or her principal, it is tax-free.

4.4.5  Insurance to CRT or CGA:    In some cases, a donor may not want to give a life insurance policy outright to charity, but instead may want lifetime income. It is generally permissible for a donor to transfer a life insurance policy to a charitable remainder trust (CRT) or charitable gift annuity (CGA). The issue will depend heavily upon applicable state law. Thus, if state law allows a charity to own a life insurance policy, then state law will likely also allow a transfer of a policy to a CRT or for a CGA. For a full discussion on the transfer of life insurance, see GiftLaw Pro 4.4.1.

Davenport:    In Estate of Sarah M. Davenport et al. v. Commissioner; T.C. Memo. 2006-215; No. 16060-04 (5 Oct 2006), the court determined that two commercial annuities would be includable in the estate and valued using the Sec. 7520 treasury tables.

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