9. Taxation of Charitable Gift Annuities, Part 1 of 4

9. Taxation of Charitable Gift Annuities, Part 1 of 4

Article posted in General on 3 February 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 3 February 2016
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VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

9. TAXATION OF CHARITABLE GIFT ANNUITIES, Part 1 of 4

Links to previous sections of book are found at the end of each section.

A donor makes a gift and in return receives annual payments for life from the charity.  This is the basic concept of a Charitable Gift Annuity.  Despite this underlying simplicity, understanding the tax implications of a Charitable Gift Annuity can be quite complex – so complex, in fact, as to warrant this separate chapter.  What causes this complexity in tax consequences for Charitable Gift Annuities?
The complexity begins with the reality that Charitable Gift Annuities generate potential tax consequences in five different ways.  The Charitable Gift Annuity is, at least in part, a charitable gift.  Because it is a charitable gift, it generates a charitable income tax deduction for the donor.  However, unlike other forms of charitable gifts, the Charitable Gift Annuity also generates a stream of payments to the annuitant.  This lifetime stream of payments produces its own set of tax results.  Some part of each payment will count as ordinary income to the recipient.  Some part of some payments may also count as tax-free return of investment.  If the gift given to the charity in exchange for the annuity was appreciated property, then some part of some payments may also be taxed as capital gain.  Finally, if the donor decides not to take the payments for himself, but instead provides a lifetime income for someone else (other than the donor’s spouse), then the donor has made a potentially taxable gift to the recipient.  Thus, this single gift vehicle can result in capital gain income, ordinary income, an income tax deduction, tax-free return of capital, and a taxable gift.  Let’s begin with the calculation of the income tax deduction generated by the purchase of a Charitable Gift Annuity.
A Charitable Gift Annuity is a form of a bargain sale.  As with other bargain sales, the charitable tax deduction is based on the value of what the donor contributed less the value of what the donor received.  Determining the value of what the donor contributed is relatively easy.  If the donor gave $10,000 in cash, then the value of the donor contribution is $10,000.  Determining the value of what the donor receives in exchange for the gift (i.e., the value of the annuity) can be a bit more challenging.
Let’s look at an example that we will return to throughout this section.  Suppose that a donor, age 55, gives $100,000 in cash to a charity, and in exchange, the charity agrees to pay the donor $4,000 per year for his life.  The charitable deduction will be the value of what the donor gave to the charity less the value of what the donor received from the charity.  Determining the value of what the donor gave to the charity is simple.  He gave $100,000.
But, how do we determine the value of the annuity that the donor received in return for his gift?  If the donor died immediately after making the contribution, then he would not have received any payments from the charity.  On the other hand, if the donor lived for 50 more years, then the donor would receive 50 X $4,000 (i.e., $200,000) from the charity in exchange for his gift.  Because it is impractical to wait 50 years to determine the donor’s charitable deduction, we must instead estimate the projected value of the annuity at the time that the gift annuity was purchased.  Thus, the value of the annuity will be based upon the idea that the annuitant will live to his projected life expectancy.  The reality of the annuitant’s actual life span will not affect either the initial valuation of the annuity or the charitable deduction.  In our example, the value of the annuity is the value of receiving $4,000 each year for the life expectancy of a 55-year-old.  The value of this payment stream will depend upon the prevailing interest rates.  Why?  Consider this.  Generating $4,000 each year when interest rates paid 4% would require a $100,000 investment.  If interest rates paid 1%, this would require a $400,000 investment.  And if interest rates paid 16%, this would require only a $25,000 investment.  Thus, the value of a $4,000 per year payment depends heavily on the prevailing interest rates.  Fortunately, the IRS has a prescribed process for determining the appropriate interest rate and calculating the value of annuities.  Let’s now walk through that process step-by-step.

The first step in valuing an annuity is to determine the appropriate interest rate.  For purposes of calculating the deduction for a Charitable Gift Annuity, the relevant interest rate is referred to as the §7520 rate.  This rate is published on the IRS website here. (It is also published on a variety of other planned giving websites.)

Once we know the appropriate interest rate, we can find the appropriate annuity factor in the actuarial tables posted here.

Multiplying this annuity factor by the annual payment gives us the value of the annuity for purposes of our income tax deduction.  Let’s now walk through each step for our example Charitable Gift Annuity.

The first step in valuing the annuity is to determine the appropriate interest rate.  Because the §7520 interest rates change each month, we will have to set a date for our hypothetical transaction.  So, let’s assume that our 55 year old donor gave $100,000 in exchange for a $4,000 per year annuity on January 31 of the year 2015.  The IRS website for the §7520 interest rates shows that January had a 2.2% rate.  However, tax law allows the donor to choose the current or either of the prior two month’s §7520 interest rate for his calculation.  (In fact the next month’s rates are published several days early, so towards the end of the month, the donor also knows the interest rate for the upcoming month and could postpone the transaction in order to take advantage of a favorable rate change.) For a transaction on this date, the donor could choose the 2.2% rate from January or November or the 2.0% rate from December.  Which rate should the donor choose?
As discussed previously, the value of the annuity depends upon the current interest rates.  As interest rates rise, it takes a smaller and smaller investment to generate $4,000 per year.  Thus, the value of a $4,000 per year payment falls as interest rates rise.  So, if the donor selects the higher interest rate (2.2%), the annuity the donor receives from the charity will be valued at less than if the donor selected the lower interest rate (2.0%).  Does the donor want the annuity he receives to be valued higher or lower?  In most cases, the donor is interested in having the highest charitable income tax deduction.  Here, the donor’s deduction will be $100,000 minus the value of the annuity.  As the interest rate rises, the value of the annuity falls.  As the value of the annuity falls, the value of the donor’s deduction rises.  Consequently, the donor will choose the higher interest rate (2.2%) in order to generate the highest charitable income tax deduction.  (Choosing the higher interest rate is normally the “right” answer for a donor.  However, if the donor cannot make use of the income tax deduction, then the lower rate is preferable because, as discussed later, it will increase the amount of each payment considered to be tax-free return of investment.)
Because our donor wants the highest charitable deduction, he consequently wants the lowest valuation for his annuity.  (Remember that the charitable deduction is the value of what the donor gives to the charity less the value of what the donor receives back from the charity.  In this case, what the donor receives back is the annuity.) To get the lowest valuation for his annuity, the donor chooses the highest §7520 interest rate, in this case 2.2%.
After identifying the appropriate §7520 interest rate (2.2%), we next look at the relevant actuarial tables.  Going to the IRS webpage (www.irs.gov/Retirement-Plans/Actuarial-Tables) provides links for tables of single life factors and last-to-die factors.  In this case, the annuity pays for the life of the donor only and so we will use the table for single life factors (Table S).  Scrolling down through this table until we reach the section for a 2.2% interest rate reveals the annuity factor for each age at this interest rate.  Because our annuitant is age 55, we use the annuity factor of 18.6808.  (Of course, if the annuitant were a different age or if the interest rate were different, then this annuity factor would also be different.) This annuity factor of 18.6808 is multiplied by the annual payment amount of $4,000 to generate the value of the annuity for purposes of calculating the income tax deduction.

An annuity factor of 18.6808 multiplied by an annual payment of $4,000 generates a value for this annuity of $74,723.20.  (As a point of comparison, if the donor had chosen the lower interest rate of 2.0%, then the annuity factor would have been 19.1825 and the annuity would have been valued at $76,730.00.  The use of this lower interest rate would have reduced the donor’s tax deduction by over $2,000.)

Charities are allowed to make annuity payments more frequently than once per year.  This slightly modifies the valuation of the annuity because the donor does not have to wait as long to receive his payment.  (For example, if the annuitant is paid annually, he must wait 12 months to receive his first check, but if he is paid weekly he only waits 7 days.  In either case, the total payments in each year still sum to $4,000.  But, receiving the payments earlier in the year is more valuable than being required to wait until the end of the year.) This increase in value due to more frequent payments is calculated by multiplying the initial value by the frequency factor found in Table K.  Table K is found at the same webpage with the other actuarial tables.  The frequency factor for annual payments is simply 1.0, meaning that no valuation adjustments are made.  The frequency factor for semi-annual, quarterly, monthly, and weekly payments will be greater than one and will depend upon the current §7520 interest rate.  (The value of receiving the payment earlier depends upon how much interest that early payment could earn between the time it was received and the time the later payment would have been received.)

Having determined the value of the $4,000 per year lifetime payments to the donor, i.e., the value of the annuity, it is now easy to calculate the charitable deduction.  As with any bargain sale, the charitable deduction is simply the value of what the donor gave to the charity (in this case cash worth $100,000) less the value of what the donor received from the charity (in this case an annuity worth $74,723.20).  Thus, this transaction generates a $25,276.80 deduction for the donor.

Note that this calculation is based upon a $4,000 per year payout to a donor age 55 and corresponds with the suggested rates offered at the time of the transaction by the American Council on Gift Annuities.  Charities are always open to paying a lower annuity than the suggested rates.  It is good practice for charities to present a Charitable Gift Annuity proposal with three different payout rates, high (e.g., $4,000 per year as per the American Council on Gift Annuities suggested rate), medium (e.g., $3,000 per year), and low (e.g., $2,000 per year).  Remembering that the goal of the donor is, in part, to benefit the charity, the lower rates may more closely match the donor’s preferences and income needs while maximizing the benefit to the charity.  If a donor chose one of the lower payout rates, the value of the resulting annuity would be less and, consequently, the charitable income tax deduction would be greater.

In our example, the charitable deduction was approximately 25.3% of the $100,000 given by the donor.  Of course, if the charity had paid the donor more than $4,000 per year for life, then the charitable deduction would have been less.  There is, however, a limit on how much the charity can pay to the donor.  The IRS requires that the value of the annuity given to the donor must be less than 90% of the value of the gift the donor gives to the charity.  A quick way to see that this requirement has been satisfied is to make sure that the charitable deduction is greater than 10% of the amount given to the charity by the donor.  If this rule is violated the charity will be treated as if it is engaging in an unrelated (non-charitable) business and will be taxed accordingly.  Consequently, charities do not normally offer gift annuities that violate this rule.

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