A charitable gift annuity is an agreement between a donor and a charity: the donor gives cash or property, and the charity promises to make payments to one or more annuitants at a payout rate determined by the age(s) of the annuitant(s). The donor’s gift is considered part gift and part annuity, much like a bargain sale to charity. The donor’s gift is the excess of the donated property’s fair market value over the present value of the annuity [See Reg. Sec. 1.170A-1(d)(1)].

Payout

The amount of the payout is determined according to the age based payout rates the charity offers. The American Council on Gift Annuities (ACGA) publishes recommended gift annuity rates for one and two lives, and most charities follow these rates. The ACGA publishes rates at least once a year (to become effective July 1st). However, a significant change in the economic and financial climate that affects asset values, interest rates, etc. may prompt the ACGA to revise the rates in the interim. For deferred gift annuities—charitable gift annuities with a payout start date that begins at least one year after the gift annuity contract is established—the ACGA publishes a formula to calculate deferred gift annuities for one and two lives.

Consult the American Council on Gift Annuities website for more information, including a policy statement entitled “Philosophy of Gift Annuities”.

Note that a charity can offer a payout rate that differs from its own established rates, though a charity will likely do so only under special circumstances. For instance, the donor offers real property in exchange for a gift annuity. A charity must begin payments to annuitants within the year, so the charity must be able to start making the annuity payments at the time the gift annuity contract is executed. However, a charity might depend on the gift itself to fund the annuity payments. There may be a risk to the charity offering the standard payout rate for a gift annuity that begins payment right away because the charity may not be able to liquidate the property right away. Instead, the charity might offer a lower payout rate, or a deferred gift annuity using an immediate gift annuity payout rate. But even in these special circumstances, the payments must be fixed and uniform once determined.

Charitable Deduction

The charitable deduction is equal to the value of the property transferred minus the present value of the annuity. For instance, if the present value of the gift annuity is worth $50,000 and the property is worth $110,000, then the charitable deduction is $60,000.

Factors that determine the present value of the gift annuity include:

• Payout Amount
• Age of Annuitant(s)
• Frequency of Annuity Payments (monthly, quarterly, semi-annually, or annuallly)
• Prevailing Applicable Federal Rate under Sec. 7520

The charitable deduction must equal at least 10% of the gift value in order for the arrangement to qualify as a charitable gift annuity [IRC Sec. 514(c)(5)].

If cash is transferred for the annuity, the percentage limitation on the charitable deduction is 50% of adjusted gross income (AGI). If long-term capital gain property is transferred, the percentage limitation is generally 30% of AGI. Any deduction in excess of the applicable percentage limitation may be taken in subsequent tax years (up to five years). Also, the donor may make the special election to reduce the amount of his contribution by the appreciation in the property in order to be eligible for the 50% limitation. The special election could make sense if (1) the appreciation element is small, or (2) the donor needs a larger deduction in the current year to offset a large income.

Income Taxation

How the annuity payment is categorized affects the rate of income taxation. The income can be classified in one of three ways:

Return of Principal

In order to calculate the amount of an annuity payment that will be characterized as a tax-free return of principal, the exclusion ratio is multiplied by the amount of each annual payment. The exclusion ratio is equal to the donor’s investment in the contract (present value of the annuity) divided by the expected return (as determined by consulting IRS Tables V and VI).

Capital Gains

If appreciated property is transferred for a gift annuity and the donor is the sole annuitant, gain on the sale portion is recognized over the donor’s life expectancy. If the donor outlives her life expectancy, the capital gain portion ends and all remaining payments are fully taxed as ordinary income.

If joint property is transferred by spouses for a two-life annuity for them, the gain may be spread over their joint life expectancy. If separately owned property is given by one spouse for a two-life annuity for both spouses, the gain is spread over the first life.

If the donor and a non-spouse third party are the joint annuitants, gain is recognized over the first life.

If the donor names a third party as the sole annuitant, all of the gain is recognized in the year of the contribution—even if the sole annuitant is the donor’s spouse.

Note, in order to spread out the gains over the donor’s lifetime, the gift annuity contract must require that the gift annuity interest is non-transferable except to the issuing charity.

Ordinary Income

Ordinary income is that income which is not characterized as a return of principal, nor as capital gain.

Gift Taxation

The creation of a gift annuity results in a gift to charity and to any third-party annuitant who may be named. If donors name themselves as annuitants, they do not, of course, make a gift to themselves.

The present value of the charity’s interest in a gift annuity is eligible for the gift tax charitable deduction. This deduction is unlimited in amount, unlike the income tax charitable deduction which is subject to percentage limitations that may cap the deduction in a particular year.

If the third-party annuitant is the donor’s spouse, or if the spouse is named as a concurrent and/or successor annuitant with the donor, the gift tax marital deduction may be taken for the life-income gift made to the spouse.

If the third-party annuitant is someone other than the donor’s spouse, a gift is made at the time the gift annuity is established which is equal to the present value of the individual’s lifetime annuity. This gift is of a present interest and qualifies for the gift tax annual exclusion.

However, if the donor retains the right to revoke the third party’s annuity interest at any time, then there is no immediate gift. Rather, each annuity payment is a completed gift in the year received by the annuitant. If the donor retains the power to revoke only in his or her will, then there is a completed gift at the time of the contribution. This gift is the present value of the annuitant’s life-income interest as measured by the donor’s life expectancy rather than the annuitant’s. The gift tax annual exclusion also would apply in this case.

If the annuity is payable to the donor for life, then to another (non-spouse), a power of revocation reserved by the donor will avoid a completed gift until the donor’s death—assuming that no actual revocation occurs and that the other annuitant survives the donor.

Estate Taxation

The federal estate tax consequences of a gift annuity generally depend on whether the donor names himself/herself or another individual as annuitant, and whether the annuity is for one or two lives.

Generally, the present value of any survivor annuity is included in the deceased donor’s gross estate. If there is no remaining annuity payable at the donor’s death, then nothing is includiable in the gross estate. Any taxable gift that the donor made at the time the gift annuity was set up —that is, the then-present value of a third-party annuitant’s interest—will come back into the donor’s estate tax base as an “adjusted taxable gift.”

If the donor designated himself as sole annuitant, the amount includiable in his gross estate at death is the value of any annuity payment due but unreceived at the time of death. If the donor designated a third party as sole annuitant, and did not retain the power to revoke the annuitant’s interest, then the remaining value of the annuity at the donor’s death is excluded from the donor’s gross estate. However, the taxable gift that resulted at the time the gift annuity was set up will be added to the donor’s estate tax base as an “adjusted taxable gift” [IRC Sec. 2001(b)].

Suppose the donor did retain a power to revoke a third-party annuitant’s interest to avoid making a taxable gift at the time the gift annuity was set up. The donor’s revocation power is a “string” that pulls the annuity back into his gross estate at death. The present value of the remaining payments under the annuity is the amount includiable. If and to the extent that the annual payments received by the annuitant during the donor’s life constituted taxable gifts as received, they will show up in the donor’s estate tax base at death as “adjusted taxable gifts.”

If the third-party annuitant is the donor’s spouse, the value of any remaining payments apparently qualifies for the estate tax marital deduction, according to tax regulations, even though this seems to be a terminable interest of the type usually disqualified for the estate tax marital deduction [see Reg. Sec. 20.2056(b)-1(g), example (3)].

An interesting “quirk” in the federal estate tax treatment of gift annuities is that the charitable gift portion of the original transfer is not included in the donor’s gross estate. This contrasts with the treatment of a charitable remainder annuity trust (CRAT)—a gift vehicle similar to the gift annuity—in which the full value of the trust is includiable in the donor’s gross estate if the donor retained a life-income interest in the trust or a power to revoke the income interest of another. Instead, the present value of the CRAT’s charitable remainder washes out of the estate tax base as an estate tax charitable deduction.

The Choice of Appreciated Property to Fund a CGA

Appreciated property is a natural choice to fund a gift in exchange for a charitable gift annuity.

The donor’s cost basis in appreciated property is divided between the gift and annuity portions of the transaction. The capital gain is the difference between the cost basis allocated to the annuity portion of the transaction and the value of the annuity.

Long-term capital gains tax normally owed upon the sale of such property is not due and owing at the time of the gift. Rather, if the donor names herself as an annuitant, the capital gains will be paid in part over her expected lifetime or the fixed annuity period.

Example: Herbert and Martha, ages 78 and 74 respectively, transfer jointly owned appreciated securities held for more than one year to XYZ charity in exchange for a two-life, immediate gift annuity. The securities are valued at $100,000 and have a basis of $35,000. XYZ uses the ACGA’s payout rates, which, at the donors’ ages, pay 6.1% or $6,100 per year. Assuming a 4.2% AFR and quarterly payments, the present value of the donors’ annuity is $62,954, leaving a charitable gift of $37,046. The donors will realize a long-term capital gain of $40,920 on the sale portion of the transfer after basis is allocated. Of their $6,100 total annual payments, $2,117 will be ordinary income; $2,590 will be long-term capital gain; and $1,393 will be income tax-free. If one or both of them outlive their assumed joint life expectancy of 17 years, the remaining payments will be taxed in full as ordinary income.

However, the ability to spread the capital gains treatment over time does not apply if the donor is not an annuitant or if the donor is a contingent annuitant that will receive payments only after the end of another life. Otherwise, the capital gains tax owed will be payable in the year the transfer is made.

If the donor dies before realizing all capital gains, the remaining capital gains will not be recognized unless annuity payments are received by a survivor.

Though appreciated property is a natural choice to fund a gift annuity, not all appreciated property is a good choice. The charity might not agree to accept illiquid property or property that will have a cost associated with its disposal. For instance, all 50 states permit the exchange of real estate for a charitable gift annuity. However, not every charity is willing or able to handle a gift of real estate in exchange for a gift annuity. The same reluctance to accept certain real estate gifts may also apply to collectibles.

Questions and Answers

What is the comparison between the gift annuity and regular commercial annuities?

An annuity offered by a commercial entity (i.e., an insurance company) seems similar to a charitable gift annuity. Annual payments are made to an annuitant at a rate based on the age of the annuitant. However, commercial annuities can be far more complex products; for instance, a commercial annuity can offer different features such as a guaranteed payout or variable investment options. And because the charitable gift annuity is part gift and part annuity, the payout rate can never be as high as the commercial annuity. Finally, the regulation of charitable gift annuities differs from the regulation of commercial annuities.

Who regulates charitable gift annuities?

Individual states regulate charitable gift annuities. If a charity offers gift annuities to donors residing in a particular state, the charity needs to comply with state laws concerning the solicitation and administration of charitable gift annuities. State laws might require the charity to:

• Obtain a license
• File regular reports
• Maintain reserves adequate to cover its gift annuity obligations
• Include specific language in annuity agreements
• Offer only the ACGA recommended payout rates

Are charitable gift annuities guaranteed?

The charity is contractually obligated to pay the annuity, and charitable gift annuities are considered an unsecured debt of the charity. As such, the annuitant has a contractual right to timely payments according to the gift annuity agreement. In the event of a bankruptcy, the annuitant stands as an unsecured creditor.

What effect does the applicable federal rate have on the gift annuity?

As noted above, the applicable federal rate, or Sec. 7520 rate, influences the exclusion ratio which determines what part of the transfer will be considered a gift and what part will be considered the annuity.

If the applicable federal rate is low, the annuitant will enjoy a greater tax-free component as the return of principal. However, the lower the rate, the smaller the income tax deduction will be for the donor.

What applicable federal rate can the donor choose?

The donor can choose the applicable federal rate for the current month, one month prior, or two months prior. For instance, in June, a donor wants to give $10,000 in exchange for a gift annuity. That donor can choose the rate for June, May or April—whichever rate is preferred (if there is a difference between rates).

Also, the IRS announces the upcoming applicable federal rate on the 20th of each month, so the donor has the option to wait for the rate available next month.

Example: On January 24, Penelope visits the development office of her favorite charity. She plans to give her favorite charity $10,000 in cash for a gift annuity. She understands her annuity payments will be part tax-free and part ordinary income. She would like the payment to be as tax-free as possible.

The planned giving officer looks up the most recent applicable federal rates:

Month	Rate
January	4.6%
December	4.6%
November	5.0%

The planned giving officer also tells Penelope the rate announced for February will be 4.0%. Based on this information, Penelope decides that she will wait the extra week in order to take advantage of a lower applicable federal rate, which equals a higher ratio of tax-free income on her gift annuity payout.

What happens if the annuitant dies before reaching life expectancy?

If an annuitant dies before reaching life expectancy, payments cease. However, the principal not returned as part of the gift annuity payments can be deducted by the annuitant’s final income tax return.

How many annuitants can there be?

The donor can name himself as the sole annuitant, another individual as sole annuitant, joint-and-survivor annuitants, or consecutive annuitants. A maximum of two annuitants is allowed.

What is a “college” charitable gift annuity?

Under IRC Sec. 514(c)(5), a charitable gift annuity must extend over one or two lifetimes. However, in Private Letter Ruling 9042043, the IRS specifically approved a variation on the charitable gift annuity that allows for future college education funding for a child. The inclusion of a commutation clause in the gift annuity agreement would permit the annuitant to sell or assign his or her annuity to the organization or a third party in return for a lump sum payment or installment payments over several years. The intention is that the donor names a child or grandchild as the annuitant for a deferred gift annuity issued by a college. At the appropriate time (usually age 18), the annuitant could use the funds to attend the college issuing the annuity. However, the annuitant could actually use the funds for any purpose.

What is the advantage of streamlining capital gains over several years?

When a donor transfers appreciated property in exchange for a charitable gift annuity, the gain attributable to the exchange for the annuity does not have to be paid at that time. Instead, capital gains can be spread across many years. However, one might consider that the current capital gains tax rate of 5% or 15% is only in effect through 2011—at that time, they will revert to pre-2002 rates of 20%. Of course, Congress may change the capital gains taxation regime in the intervening years.

How long can one defer a charitable gift annuity?

The deferral period for a charitable gift annuity has no stated time limit. But for deferred gift annuities with longer deferral periods, the calculated payout rates may not pass the 10% test when the applicable federal rate is low.

What if the annuitant wants to make a charitable gift of the annuity back to the charity?

At some point in time, an annuitant may decide that he or she no longer needs the annuity payments or could use a deduction to offset current income. There is the option of making a gift of the annuity interest itself back to the issuing charity (essentially, the charity can stop making payments).

The question is how to measure this new charitable gift. The calculation of the value of the present interest in the annuity is based on the new gift date and the applicable federal rate effective at that time. However, the charitable deduction must be reduced by the amount that would be ordinary income if sold under IRC Sec. 170(e). And IRC Sec. 72(a) characterizes annuity payments other than the investment in the contract as ordinary income. So, the deduction is the lesser of the donor’s basis or the present value of the annuity interest on the date of its assignment back to the charity.

Can an IRA be used to fund a charitable gift annuity?

The question was posed by a donor seeking a private letter ruling from the IRS. A donor wanted to set up a testamentary gift annuity. Under the terms of the agreement, the donor would designate a charity as beneficiary of his IRA at death. In return, the charity would agree to pay an annuity to a third party if she survived the donor. The annuity would not be assignable, revocable, or commutable (except for no consideration to the charity). Should the annuitant predecease the donor, the charity would receive the IRA balance without obligation. The donor petitioned the IRS for a private letter ruling on the tax treatment of this arrangement.

The IRS ruled on several issues [Ltr. Rul. 200230018]. First, the charity would not lose its tax-exempt status as a result of the transaction, nor would it be in receipt of unrelated business taxable income (UBTI) from the IRA proceeds. While the value of the IRA would be included in the donor’s gross estate at death, his estate could claim an estate tax charitable deduction for the IRA’s value, decreased by the present value of the annuity. Finally, the IRA proceeds would be income in respect of a decedent (IRD) to the charity, and not IRD to the donor’s estate. Consequently, the IRA proceeds would not be taxed because of the charity’s exempt status.

The donor also asked the IRS to rule that the annuitant’s “investment in the contract” [IRC Sec.72(c)] is equivalent to the IRA proceeds conveyed to the charity, reduced by the estate tax charitable deduction. The IRS declined to rule on this “hypothetical” issue. The unresolved question is whether the annuitant would be entitled to the income tax deduction for estate tax paid on IRD [IRC Sec.691(c)]. If the answer is no, the annuity payments would be fully taxable, thereby discouraging testamentary gift annuities when the estate is subject to federal estate tax.

In a similar ruling involving an IRA bequest to a charitable remainder trust, the IRD deduction was only available to the trust, not the beneficiaries [Ltr. Rul. 199901023]. Because of the tier system applicable to charitable remainder trust payouts, this effectively delays, maybe indefinitely, the benefit of the IRD deduction to the trust beneficiaries. But since the tier system does not apply to gift annuity payouts, annuitants would appear to reap the benefit of the IRD deduction—unless the IRS eventually comes up with some theory to reach the same outcome as for CRTs.

Can a remainder interest in a personal residence or farm be used to fund a charitable gift annuity?

This question was posed by another donor seeking a private letter ruling. And, the IRS has approved the transfer of a remainder interest in a farm in exchange for a deferred gift annuity [Ltr. Rul. 8305075]. Under the facts of the ruling, the donor proposed to transfer his farm to charity, reserving a “life estate” of three years. At the expiration of the three-year period, full ownership of the property would pass to the charity, which in turn would pay a joint-and-survivor annuity to the donor and his spouse.

The value of the charity’s remainder interest was the fair market value of the farm, discounted to its present value to reflect the charity’s three-year wait. The amount of the charitable contribution was the value of the remainder interest, as just described, minus the present value of the deferred gift annuity payments to donor and spouse. The transfer would be a bargain sale that would trigger the reporting of gain on the sale portion of the transaction.

Charities may issue immediate gift annuities in exchange for the transfer of a remainder interest in a personal residence or farm, provided their gift acceptance policy permits them to make annuity payments well in advance of their receipt of the property—perhaps for as long as the joint lives of the donors.