Wednesday October 4, 2023
Article of the Month
Golden Age for Gift Annuities
However, in 1946 the fifteen million Americans who served in the military during World War II returned home and started families. As a result, the Baby Boomer generation (born 1946 to 1964) has nearly double the number of individuals turning age 75 each year when compared with the Quiet Generation. Because the senior Baby Boomers are now age 76, during the next two decades there will be steady growth in the size of the primary gift annuity market. With greatly increased numbers of potential gift annuitants, the coming decade is likely to be a golden age for gift annuities.
Many donors fund a gift annuity with cash. However, with the growth of stock values the past decade, donors with appreciated stock may use that asset to fund an immediate gift annuity.
Current or Immediate Gift Annuities
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 on 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 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 expectancy of 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 contract portion will be recognized and reported by the donor in the year of the gift.
Mary Funds a Gift Annuity with Stock
Mary Johnson (age 80) owns stock purchased seven 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. 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 must also 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.
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 may also 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.
Mary Funds a Gift Annuity for Herself and Daughter Susan
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. Mary is age 80 and Susan is age 54.
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 Susan. However, during the final years of Susan'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.
Mary Funds a One Life Gift Annuity for Daughter Susan
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 contract value, the prorated capital gain is reported by Mary Johnson for the tax year she establishes the annuity. Because the charitable deduction saves tax 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).
Mary Funds a One Life Gift Annuity with Inventory
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 her projected life expectancy, all payments thereafter will be ordinary income.
Standard Deferred Annuity
Many Boomers with large IRAs and other qualified retirement plans desire a charitable deduction but may prefer to wait and later receive larger payments. These larger payments with a deferred or flexible deferred gift annuity give added security if the individual needs funds for long-term care.
With a standard deferred annuity, the payout is deferred for one or more years. However, there is a fixed date for payout. The disadvantage of the standard deferred annuity is that the annuitant is locked into a specific payment date and amount. He or she may desire to retire earlier or later. Deferred annuities would be more attractive to donors if there were greater flexibility, similar to the options available with a commercial annuity.
In PLR 9743054, the Service approved the use of a flexible annuity. (A private letter ruling is not permitted to be used as a precedent, but it does indicate the potential Treasury position on an issue.)
With a flexible deferred annuity, the donor selects a target date and age for retirement. However, the annuity contract permits the donor to take the annuity earlier or later than the target date. Since the income tax deduction is based upon the target date, if the donor decides to start the annuity in an earlier year there will be a reduced payout. The payout is reduced to the level that produces the same income tax deduction as the target year.
Alternatively, if the donor decides to wait until after the target date to receive annuity payments, the ACGA recommended rates are used for the longer deferral period. These rates are based on the rate for the age at which payment is commenced, adjusted for the period of deferral between the funding date and the annuity starting date. Since the rate is based on the ACGA payout rate, the tax-free amount will be adjusted accordingly.
Some flexible deferred annuity donors may choose to take the reduced rate at an earlier time. Others may decide that they do not need income and may choose a later starting date with a higher payout. Finally, some may not require the income at all upon retiring and may choose to give the contract back to the charity and receive an income tax deduction at that future date.
Mary Desires Fixed Income During a Future Retirement
Mary Wilson is age 55 and desires to benefit from a current income tax deduction. She also would like to have the option of receiving an income during retirement but is not certain at what age she will retire.
Mary transfers $100,000 cash to a charity to fund a flexible deferred payment gift annuity. She selects age 65 for the target date. The deferred annuity rate is 7.3% and the charitable income tax deduction is $38,291. Mary's contract allows her to start receiving payments at any age between 60 and 80. If she starts receiving payments prior to age 65, the annuity rate will be reduced accordingly. In addition, the tax-free amount may increase with the longer deferral period. With this flexible annuity, she may select a payout of $5,088 at age 60, $7,300 at age 65 or even $18,200 at age 80.
Mary Decides to Start Her Annuity Payments This Year
The annuitant must elect by written notice to commence payment of a flexible deferred annuity. If the annuity is a two-life annuity, the election may be made by either annuitant. The election must be made one payment period prior to the desired annuity start date. Below is a sample election letter and an example election.
Sample: Flexible Deferred Annuity Election Letter
Dear _____________("Gift Planner"),
On________("Date"), _______________("Donor(s)") signed annuity agreement No. ________________ ("Annuity No.") with ___________________ ("Charity"). In consideration for the property transferred, _________________ ("Charity") agreed to pay __________________ ("Annuitant(s)") for life/lives an annual annuity of the amount set forth in Schedule B of the annuity agreement in equal ______________ ("Frequency") payments with payouts at the end of each period.
The annuity agreement provided for the first payment to commence upon written election made by the Annuitant one payment period prior to the desired payout date. Under Paragraph 2 Flexible Annuity Election of the agreement, I make this election to commence gift annuity payments at the applicable Schedule B payment rate. I hereby irrevocably elect a starting date for payments on _____________________, __________.
Annuitant Name: _______________________________ Date:_____________
Flexible Annuity Election Made by John and Mary Stock
John and Mary Stock signed a two-life flexible deferred gift annuity agreement on April 29, 2030 with Favorite Charity, a qualified exempt charity. The gift annuity was funded with $100,000 in appreciated stock. Favorite Charity agreed to make quarterly payments to John and Mary for their lives and payments could commence as early as January 15, 2033, but no later than the year 2044. Payments would commence upon written notice by either John or Mary one payment period prior to their desired payout date. On October 14, 2034, John retired and elected to begin taking annuity payments as of January 1, 2035. John signed the following letter provided by the gift planner of Favorite Charity.
Flexible Annuity Election Letter
Dear Ms. Mueller,
On April 29, 2030, I, John Stock, signed annuity agreement No. 4229786 with Favorite Charity. In consideration for the property transferred, Favorite Charity agreed to pay John and Mary Stock for our lives an annual annuity of the amounts set forth in Schedule B of the annuity agreement in equal quarterly payments with payouts at the end of each period.
The annuity agreement provided for the first payment to commence upon written election made by the annuitant one payment period prior to the desired payout date. Under Paragraph 2 Flexible Annuity Election, I make this election to commence gift annuity payments at the applicable Schedule B payment rate. I hereby irrevocably elect a starting date for payments on January 1, 2035.
Annuitant Name: John Stock Date: August 14, 2034
With many Baby Boomers reaching their mid-70s in the coming decade, charitable gift annuities are entering a golden age. Donors will appreciate the fixed payments and generous fixed rates. Many donors will decide to become repeat gift annuitants after creating one gift annuity.