What is a charitable gift annuity? It is a contract with a charitable organization for a stream of payments in a fixed amount (payable in annual or other more frequent installments) over a period certain or for one or more lives (typically for life). The arrangement is a contract, not a trust.
In essence, the annuity is like a mortgage. The donor receives back his principal plus interest (at a modest rate) over the annuity period. However, unlike a traditional mortgage, if the donor-annuitant dies early, the payments stop. If the donor-annuitant outlives the annuity period, the payments continue.
The annuitant is relying on the general credit of the charitable organization to make the payments, not on the income generated by the contributed property as in the case of a charitable remainder trust. The annuity is only as good as the financial strength of the charity.
Since the charitable organization is undertaking a general obligation to make a stream of payments over an indefinite period of time (someone’s lifetime), it must reserve against the risk of a long lifetime. It does this by using conservative annuity rates. Guideline rates are published by an industry group called the Committee on Gift Annuities. These rates are intended to discourage competition among charities and to ensure a significant residual gift to charity.
A portion of the purchase price of the annuity represents the value of the annuity to be paid by the charitable organization and the balance of the purchase prices constitutes a gift to such charitable organization. If the rates published by the Committee on Gift Annuities are used, the gift will be at least 50% of the value of the contributed property. However, such conservative rates may discourage all but the most philanthropically minded.
The donor will receive a charitable income tax deduction for the value of the gift element of the contribution. If the donor has designated someone other than the donor as the annuitant, the value of the annuity will constitute a taxable gift.
If appreciated property is used to purchase the annuity, the transaction constitutes a bargain sale, i.e., part gift-part sale, with income tax consequences to the donor-purchaser (discussed below).
Taxation of a commercial annuity
Under IRC Section 72, each annuity payment is treated as part nontaxable recovery of the “investment in the contract”, i.e., what the annuitant paid for it, and part ordinary taxable income. Cost recovery is allowed ratably over actuarial life expectancy or the term of the contract. After that, 100% of the payments are taxable.
If appreciated property is used to purchase the annuity, there is immediate and full recognition of gain in the year of purchase.
Under IRC Section 2039 some portion or all of the value of the annuity at death is includible in decedent’s estate if the annuity continues after death, but if the annuity terminates at death, there is nothing to include in the estate.
Taxation of a charitable gift annuity
If cash or full basis property is used to purchase the annuity, there is no difference from a commercial annuity.
However, if appreciated property is used, the transaction is treated as a bargain sale. In other words, that part of the transaction which is in exchange for the annuity is treated as a taxable sale, the other part is nontaxable. If the annuity is nonassignable, the gain on the taxable portion is recognized ratably over the life expectancy of the donor rather than all in the year of purchase. Thus, there are three elements to every payment: nontaxable recovery of basis, gain recognition and ordinary income. After the life expectancy period, the payments are 100% taxable again.
If the donor dies before full recognition of the gain has occurred, the remaining gain need not ever be recognized. Moreover, the donor’s estate can claim a business loss in the year of donor’s death for any unrecovered basis in the property used to purchase the annuity.
Gift annuities versus charitable remainder trusts
The return on a charitable remainder trust (“CRT”) is tied to a percentage of principal or the actual earnings on principal, whereas the return on a charitable gift annuity (“CGA”) includes the return of principal plus a modest rate of interest. As the donor attains later age and the annuity period, based on life expectancy, shortens, the return on a CGA begins to exceed the CRT and can greatly exceed the return on a CRT.
The tradeoff for the higher return is most likely a lower income tax deduction. Because the return on a CGA includes the return of principal (indeed, the assumption is that all of the contributed principal will be returned over the annuity period), the size of the charitable gift and resulting income tax deduction may be much less than under a CRT. The deduction under a CRT is the present value of the remainder interest. The deduction under a CGA is the difference between the value of the annuity and the total property contributed.
Another tradeoff when appreciated property is being contributed is the recognition of gain in the case of the CGA but not the CRT.
From the standpoint of the charity, the immediately usable gift under a CGA but in a lesser amount than a CRT may be more desirable than a larger back end residual gift under the CRT.
As with CRT’s, the combination of the increased income generated by a CGA with a wealth replacement trust can be a powerful way of moving asset value estate tax free to the next generation.
See handout for a side-by-side comparison.
Combination of a CGA with a commercial annuity
A charitable organization that is not in the habit of issuing and servicing charitable gift annuities should consider purchasing a commercial annuity on the donor’s life as a means of reinsuring its risk. Thus, the charity changes the nature of its risk from that of having to reserve for a long lifetime and poor investment performance to that of whether the commercial annuity company will continue in existence. This should give the charitable organization much greater freedom both to offer higher annuity rates than those suggested by the Committee on Gift Annuities and to use the gift portion of the CGA for its charitable purposes immediately.
The commercial annuity belongs to the charity and is simply an investment, internally earmarked for the payment of the donor’s annuity. The donor acquires no interest in the commercial annuity and still looks to the general credit of the charity for payment of the annuity.
See overhead for a simplified illustration of how this works.
Valuation of a CGA
Under Regs. 1.1011-2(a)(4) the gain on appreciated property used to fund a CGA can be reported ratably over the life of the annuitant provided that the annuity is nonassignable (or assignable only to the charity) and that a charitable contribution deduction is allowable under IRC Section 170. If no charitable contribution deduction is allowable, then there is no bargain sale in the first place and the transaction is the equivalent for tax purposes of a fully taxable purchase of a commercial annuity.
Whether a charitable contribution deduction is allowable depends on whether the amount transferred to charity exceeds the value of the annuity. Under Regs. Section 1.170A-1(d), the value of an annuity is determined under Regs. Section 1.101-2(e)(1)(iii)(b)(2), which used to refer to the cost of a comparable contract purchased from an insurance company but since 1994 refers to IRS tables. Under Regs. Section 1.101-2(e)(1)(iii)(b)(1), which was not amended in 1994, if the annuity is paid “by an insurance company or by an organization (other than an insurance company) regularly engaged in issuing annuity contracts with an insurance company as coinsurer or reinsurer of the obligations under the contract,” the value of the annuity can be determined using the insurance company’s discount rates and mortality tables. This would appear to give the charitable organization an alternate way of valuing an annuity if it meets the “regularly engaged” test. (See also Rev. Ruls. 70-15 and 55-388 with respect to prior law before Regs. Section 1.101-2(e)(1)(iii)(b)(2) was amended.)
If the present value of an annuity is to be determined in accordance with government valuation techniques, IRC Section 7520 and Regs. Section 1.7520-1 control, which require the use of IRS tables and the use of an interest rate equal to 120% of the federal midterm rate under IRC Section 1274(d)(1) for the month in which the valuation date falls, rounded to the nearest 0.2%. The table is found in Regs. Section 20.2031-7(d)(6).
If the charitable organization issues the annuity based on IRS tables, no problem arises. However, if the charity reinsures its risk by purchasing a commercial annuity and if the commercial annuity pays at a higher rate than under IRS tables, a problem can arise, as described below.
A rated annuity is one based not solely on the annuitant’s age but also on his or her health. Unlike many life insurance products, an annuity can usually be obtained for a would-be annuitant in very poor health. The effect of this is to shorten the projected life expectancy and thereby increase the payout, sometimes very significantly.
The problem with valuation arises if a charitable organization commits to paying a much higher payout than would be justified under IRS tables, based on having reinsured its risk with a high payout commercial annuity. Unless the charitable organization meets the “regularly engaged” test in Regs. Section 1.101-2(e)(1)(iii)(b)(1), the annuity must still be valued for tax purposes using the government formula. Applying the expected return multiple produced by government tables times the higher payout can result in a value for the annuity that exceeds the value of the property transferred to the charity. In that circumstance no charitable contribution deduction would be allowed and the bargain sale rule for recognition of gain would not apply.
It is not clear what “regularly engaged” requires, but from other contexts in the Internal Revenue Code and Regulations one can reasonably conclude that it involves a substantial and ongoing practice of issuing annuities with an insurance company coinsuring or reinsuring the specific risk of the life involved. There are probably not many charities out there that can presently meet this test, but it would seem that many could and should put themselves in a position to qualify once this opportunity is better understood.
Another problem arises with respect to high value annuities. If the value of the annuity equals or exceeds 90% of the value of the transferred property, the property transferred will be considered “debt financed property” under IRC Sections 514(b)(1) and (c)(5) and any income subsequently generated by that property will be treated as unrelated business taxable income to the charity. Also, under IRC Section 501(m)(1) a charitable organization engaged in “substantial commercial-type insurance” activities runs the risk or losing its tax exempt status, but CGA’s that meet the definition in IRC Section 514(c)(5) are not treated as commercial-type insurance. Regs. Section 1.514(c)-1(e)(2) states that the value of an annuity for purposes of this test is again to be determined under Regs. Section 1.1011-2(e)(1)(iii)(b)(2) [this is an incorrect cross reference, Section 1.101-2(e)(1)(iii)(b)(2) must be intended, as there is no Section 1.1011-2(e)(1)(iii)(b)(2)] (but this is an old Regulation and the reference is to Regs. Section 1.1011-2(e)(1)(iii)(b)(2) prior to its amendment).
Clearly there is some confusion as to how to value an annuity in the situation of a charity which chooses to exceed the guideline annuity rates set by the Committee on Gift Annuities and which meets the test of being regularly engaged in issuing CGA’s. Even though some of the pertinent Regulations have been amended and some have not, it would probably be safe to assume that the amended Regs. Section 1.101-(2)(e)(1)(iii)(b)(2) will govern all future valuation questions. That is, such a charity must also specifically reinsure its CGA’s with an insurance company in order to be able to use the insurance company’s discount rates and mortality tables.
It might not be a bad idea to seek a private letter ruling for the first CGA to be issued as a rated annuity if the application of the government tables yields a value for the annuity in excess of 90% of the value of the transferred property.
Mrs. Jones is 87 years old and in poor health. A commercial insurance company is willing to issue an annuity on her life as if she only had 3 years to live when in fact her actuarial life expectancy is more like 7-8 years. She has $2,000,000 to invest in the annuity. It will pay her $800,000 a year, or 40% a year, for the rest of her life.
Mrs. Jones also desires to make a gift to her favorite charity. She offers to transfer the $2,000,000 to charity in exchange for an annuity based on $1,700,000. The charity gets the other $300,000.
The charity purchases a $1,700,000 annuity from the insurance company in question, which will pay to the charity the $680,000 a year which Mrs. Jones expects the charity to pay to her. The charity then has immediate use of the other $300,000 for its charitable purposes and Mrs. Jones has a charitable contribution deduction of $300,000. Or does she?
The issue is, how is the annuity contract between Mrs. Jones and the charity to be valued? If the charity is regularly engaged in this kind of CGA issuance, presumably Mrs. Jones will get her deduction and report any gain on the transfer ratably and the charity will stay out of trouble with the UBTI rules. But if the charity is not so engaged, the annuity will have to be valued under IRS tables. The expected return multiple for a person aged 87 under current interest rates will be around 3.8. This multiple times $680,000 a year produces a value for the annuity of almost $2,600,000, well in excess of the $2,000,000 of property initially transferred. In that event, Mrs. Jones gets not deduction, must report all gain immediately and the charity will have UBTI in the future.
A solution would be to reduce the annual payout to around $500,000 a year and increase the gift portion to $1,250,000. Another solution is to simply buy the commercial annuity directly and pay $300,000 to the charity. Mrs. Jones would then get her deduction and the charity would stay out of trouble with the UBTI rules, but Mrs. Jones would not get to report her gain ratably. The value of ratable reporting will depend on the amount of gain and the availability of other sources of cash flow for payment of tax, as well as the potential for gain avoidance by early death.
A CGA becomes much more attractive as a substitute for a CRT if the proportion of the property transferred in exchange for the annuity is much higher than the recommended 50%. A charity will probably only be willing to accommodate a higher payout annuity if it can reinsure its risk.
If the assets available for the purpose are appreciated, a CGA for an older person can produce significantly greater income than a CRT. Gain recognition will not be avoided but can be reported ratably with a chance for some tax avoidance if early death intervenes.
To maximize the benefit of a CGA, it is desirable to minimize the gift portion, but not to 10% or less. Fifteen percent would be safer, or the charity may not be willing to risk a mistake in valuation.
If a rated annuity is available, it may be preferable to purchase a commercial annuity and pay the immediate tax on the gain and make a separate gift to charity. That will depend in part on the underlying charitable motivation of the donor.
If a charitable organization meets the “regularly engaged” test, the purchase of a rated annuity from the charity may be the best way to go, with a minimal gift to charity. A private letter ruling may be advisable.
As always, there is no substitute for crunching the numbers and doing the research.