PROBLEM SOLVING WITH GIFT ANNUITIES (Part 1)

Transcription

1 PROBLEM SOLVING WITH GIFT ANNUITIES (Part 1) VOL. IV, NO by David Wheeler Newman Creative charitable gift planning often focuses on charitable remainder trusts and charitable lead trusts while overlooking non-trust charitable giving techniques. These non-trust techniques include a charitable gift of a remainder interest in a personal residence or farm, a donor advised fund, a donor directed fund and a charitable gift annuity (CGA). This paper reviews the general federal income, estate and gift tax aspects of CGAs, and discusses opportunities to use charitable gift annuities to address common financial and estate planning problems. Attraction to Donors A CGA is often preferred by a donor over charitable giving vehicles utilizing a trust, such as a pooled income fund or charitable remainder trust, for two main reasons. First the donor doesn't need to read through a long and complicated trust agreement -- a CGA is usually documented with a very short (one or two page) contract. Second, unlike a trust, where the life income beneficiary depends on the assets of the trust and the yield generated from those assets for payment of the income stream, a CGA represents a direct obligation of a charitable institution which the donor knows and trusts. While trust principal may be exhausted if distributions to the income beneficiary exceed the yield derived from trust assets, an annuity by its very nature will not terminate earlier than planned, assuming the continued solvency of the issuing charity. Moreover, a CGA pays the annuitant a fixed annual amount. The annuitant need not be concerned with investment results obtained by the charity. Attraction to Charities The popularity of CGAs has increased over the past ten years in part because they are also very popular with charities. One reason charities like CGAs is because their donors like them. Another reason is economics -- charities have found that it is very expensive to develop and document a charitable remainder trust. For this reason, when charities propose charitable giving vehicles to their donors, trusts are often reserved for larger life income gifts. At one time it was thought that the demand for smaller life income charitable gifts could be filled by the pooled income fund, a charitable giving vehicle created along with the charitable remainder trust by the Tax Reform Act of However, inept management of pooled income funds by some sponsoring charities, and the disappointing yields from those funds which resulted, has caused the pooled income fund to become less attractive as a vehicle for smaller life income gifts, with a corresponding increase in the popularity of CGAs.

2 Mechanics A CGA is established by an inter vivos or testamentary transfer of assets to a charitable organization. In exchange, the charity issues an annuity contract specifying the payments to be made to the donor or other designated annuitant or annuitants. CGA payments are normally made monthly or quarterly. The amount of the payment is determined actuarially based on the age of the annuitant(s). While some charities undertake the actuarial analysis to create their own CGA rate tables, the majority of charities have traditionally used the recommended rates established through actuarial analysis performed by the American Council on Gift Annuities, an association of approximately two thousand charities issuing CGAs. State Regulation Many states regulate the issuance of gift annuities to their residents. For example, in California a charitable organization must obtain a Certificate of Authority from the Department of Insurance to act as a grants and annuities society before issuing CGAs. 2 General Tax Rules - Donor To effectively use the CGA as a planning device, one must begin with the general tax rules. From the perspective of the donor, the two most important issues are the availability and calculation of the charitable deduction and the manner in which annuity income is reported for tax purposes. Additionally, if a CGA is funded with appreciated property, the donor and his advisors must also consider how capital gain will be reported under the bargain sale rules, as discussed below. 3 The Charitable Deduction The charitable contribution income tax deduction is calculated by subtracting the value of the CGA from the value of the property transferred to the charity. 4 The value of the annuity is based on the charitable midterm federal rate of interest 5 in effect for the month of the gift and the life expectancy of the annuitant(s). These life expectancies are taken from tables in the regulations 6. The interest rate and life expectancy are combined in factors 7 which, when multiplied by the annual annuity, will yield the value of the annuity. Charitable deductions for gift tax 8 and the state tax 9 purposes are computed in the same manner. Reporting Annuity Payments The same rules applicable to commercial annuities to determine the portion of each annuity payment that an annuitant must include in his or her income also apply to CGAs. Gross income does not include that part of any amount received as an annuity which bears the same ratio to such amount as the investment in the contract bears to the expected return. This ratio is referred to as the exclusion ratio. 10

3 A. Investment in the Contract The value of cash or other property transferred to the charity in return for the CGA, less the amount deductible as a charitable contribution (as calculated above) is the investment in the contract. B. Expected Return The expected return is the amount payable under the annuity each year multiplied by the life expectancy of the annuitant from tables in the regulations 11 equal to the total of all payments which the annuitant will receive if the annuitant lives to his or her exact life expectancy. Example One: Tom is 76 years old when he transfers $10,000 to Charity in July 1995 in exchange for an annual annuity of $790. Using the IRC 7520 CMFR of 8.6% in effect for July, 1995, and Publication 1457, we determine that the applicable factor is which, when multiplied by the annuity amount, results in a present value of Tom's annuity of $4, The charitable deduction is the amount transferred, $10,000, less this amount, or $5, The tables in Treas. Reg tell us that Tom has a present life expectancy of 11.9 years. The Expected Return from the Annuity is this figure, adjusted to 11.4 for annual payments as required by the Regulations, multiplied by the annual annuity amount of $790, or $9,006. The exclusion ratio is the ratio of the investment in the contract of $4, to the expected return of $9,006, or 51.2%. Of the $790 Tom receives each year, 51.2%, or $404.48, will be excluded from his gross income during his life expectancy. The balance is taxable each year as ordinary income. C. Software These calculations are thankfully performed with commercially available computer software, which is generally accurate. D. Annuitants Who Live Too Long The total amount excludable from income over the life of the annuity may not exceed the original investment in the contract. 12 An annuitant who lives longer than his or her life expectancy at the time the annuity was issued may no longer exclude any portion of the annuity from gross income -- the entire annuity payment is taxable as ordinary income after he or she has excluded the total investment in the contract. E. Annuitants Who Don't Live Long Enough

4 If payments under the annuity terminate with the death of the annuitant, and any portion of the investment in the contract has not been excluded because the annuitant did not live to his or her life expectancy, the unrecovered balance is a deduction on the final income tax return of the annuitant. 13 Transfer Taxes A. Gift Tax If annuity payments are to be made to anyone other than the donor or his or her spouse, the annuity interest is a taxable gift. If there is only one annuitant, and annuity payments begin immediately, the gift should be eligible for the annual $10,000 exclusion, 14 although this result is not entirely free from doubt. 15 A deferred CGA won't qualify for the annual exclusion because it is a future interest If a donor creates a two-life annuity, with payments to herself for life and then to a survivor for life, the value of the survivor's interest will not qualify for the annual exclusion because it is a future interest. 17 The donor can avoid creating a taxable gift by retaining in the gift instrument the right to revoke the survivor's interest. 18 Note that, unlike a charitable remainder trust, the donor may retain the right to revoke exercisable during the donor's life or at death through his will, not only the latter. A taxable gift results in any year the right to revoke is not exercised by the donor and the annuitant receives annuity payments. 2. If two donors create an annuity for their joint lives, each is making a gift to the other of his or her share of the survivor interest and should retain the right to revoke the income interest or the other in order to avoid gift tax. B. Estate Tax If a donor creates a one-life CGA for her own benefit, no amount is included in her gross estate. If the annuity is created during the life of the donor for another individual, no amount is included in the gross estate of the donor unless she reserved the right to revoke the interest of the annuitant, in which case the amount included in her gross estate will be the value of the annuity payments remaining at the donor's death. 1. An annuitant's interest in a CGA created in the donor's will is included in the donor's gross estate. 2. Any estate tax attributable to the annuity is allowed as an income tax deduction to the annuitant. 19

5 C. Marital Deduction If a donor creates a CGA to benefit his or her spouse, the type of annuity will determine the availability of a gift or estate tax marital deduction. 1. A CGA created solely for the spouse will qualify for the gift or estate tax marital deduction If an individual establishes a joint and survivor annuity with his or her separate property, naming the spouse as survivor annuitant, the interest of the nondonor spouse in the annuity automatically qualifies for a marital gift tax deduction under the QTIP rules unless the administrator of the donor's estate elects not to take the marital deduction. 21 Similarly, if there was no current gift when the joint and survivor annuity was created because the donor retained the right to revoke the survivor interest of the spouse, the interest of the spouse passing through the donor's estate will automatically qualify for a marital deduction under the QTIP rules unless the administrator of the decedent's estate elects not to claim the deduction If, instead of a joint and survivor annuity the donor creates successive interests in the annuity for herself and her spouse, the marital gift tax deduction will be jeopardized. For example, assume the wife uses her separate property to establish a CGA making payments to her for life, and then to her husband for life. The gift to the husband will not qualify for the gift tax marital deduction because the husband has not been give the immediate right to receive income. 23 To avoid this result, the wife should retain the right, exercisable by will, to revoke the husband's right to receive annuity payments. If she does not exercise this right, the interest of the husband will qualify for the estate tax marital deduction. 24 General Tax Rules - Charity In structuring a CGA to meet the planning objectives of the donor, the tax consequences to the charity of issuing a CGA must also be considered, since the consequences to the charity help define which CGA features are possible. Unrelated Business Income One variety of unrelated business tangible income is debt financed income arising from acquisition indebtedness. 25 The annuity obligation from the charity to the annuitant is a form of debt. Issues concerning encumbered property, discussed in V below, must be considered. In addition, for it not to be considered acquisition indebtedness, the annuity must meet the following criteria: 26 A. The value of the annuity must be less than 90% of the value of the property received by the charity.

6 B. The annuity must be payable over the life of one or two individuals living at the time of the gift. C. The annuity does not guarantee a minimum amount of payments or specify a maximum amount of payments. D. The annuity does not provide for adjustment of payments based on income received by the charity from the transferred property or any other property. Preserving the Tax Exemption A charity otherwise exempt from tax under Code Section 501(c)(3) can lose its tax exemption if a substantial part of its activities consists of providing commercial-type insurance. Even if the insurance activity is not substantial in relation to the overall activities of the charity, providing commercial-type insurance generates unrelated business taxable income, with the charity taxed under the rules applicable to insurance companies. 27 A. Exception for Charitable Gift Annuities For these purposes commercial-type insurance does not include a charitable gift annuity, defined to be an annuity if a portion of the amount paid for the annuity qualifies as a charitable deduction and the annuity is described in Code Section 514(c)(5) 28. For this reason, most CGAs meet the four criteria in Code Section 514(c)(5) described above. 1. P.L See IRC 642(c)(5) for the definition of a pooled income fund. 2. California Insurance Code to See paragraphs 103 and 104, infra. 4. Treas. Reg A-1(d). 5. IRC Treasury Regulation See IRS Publication 1457, Alpha Volume. 8. IRC See Revenue Ruling , CB IRC IRC Treas. Reg IRC 72(b)(2) 13. IRC 72(b)(3). 14. IRC 2503(b); PLR Estate of Miriam Kolker, 80 TC 58 (1983). 16. IRC 2503(b) 17. IRC 2503(b) 18. Treas. Reg (c) 19. IRC 691(c) 20. Treas. Reg. 2056(b)-1(g), Example 3; 2523(b)-1(b)(6)(iii). 21. IRS 2523(f)(6).

7 22. IRC 2056(b)(7)(C). 23. Treas. Reg (f)-1(c)(2). 24. Treas. Reg. 2056(b)-1(g). 25. IRC IRC 514(c)(5) 27. IRC 501(m) 28. IRC 501(m)(5)