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

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

Article posted in General on 16 March 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 16 March 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 4 of 4

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

The final area of potential tax consequences for a Charitable Gift Annuity relates to gift taxation.  When discussing gift taxation, we are not referring to any charitable gift or charitable gift portion of the annuity.  Instead, we are considering gift transfers to non-charitable recipients.  Gift transfers are taxed as part of the estate and gift taxation system.  In 2015, the exemption amount for gift and estate taxes was $5.43 million (or $10.86 million for a married couple).  Thus, for the vast majority of donors, estate and gift tax considerations will be irrelevant.  But, for those where estate tax considerations are important, it is useful to understand the gift tax implications of purchasing a Charitable Gift Annuity that pays to someone other than the donor.
If the donor names an annuitant other than himself, the donor has made a gift to that person.  If that person is not the donor’s spouse, then this gift is a taxable gift.  The value of the gift is simply the value of the annuity as calculated previously.
However, the value of the taxable gift made to the annuity recipient will be reduced by the annual present interest exclusion for gifts if the Charitable Gift Annuity is the typical immediate annuity interest.  For example, in 2015, the annual present interest exclusion for gifts was $14,000 per donor per donee.  Thus, if a donor named another person as the beneficiary of a Charitable Gift Annuity where the annuity portion was valued at $100,000, the amount of the taxable gift would be $100,000-$14,000, or $86,000.  This present interest exclusion would not apply if the gift annuity purchased was a deferred gift annuity, because the exclusion only applies for present interests.  An immediate annuity is considered to be a present interest, but a deferred annuity is not.
A transaction as straightforward as a Charitable Gift Annuity can result in a wide range of tax consequences, including a charitable income tax deduction, recognition of ordinary income, tax-free return of investment, recognition of capital gain (either immediate or deferred), and gift taxation.  This same set of tax consequences also applies to other transactions such as a Charitable Remainder Trust, but in slightly different ways.

We have examined the taxation rules for Charitable Gift Annuities.  However, certain scenarios can create unusual cases where the application of these rules may not be immediately obvious.  Next we turn to some of these tricky examples to see how the taxation rules operate in these circumstances.

We have already examined the rules for capital gain resulting from purchasing a Charitable Gift Annuity with appreciated property.  However, there is a separate tax rate for long-term capital gain for collectibles.  Collectibles are items such as artwork, antiques, stamps, coins, and jewelry.  Capital gain on these items is taxed at a maximum rate of 31.8%.  What taxation would result if a Charitable Gift Annuity were purchased in exchange for appreciated collectible items?
The initial calculations are identical to those used for any other item of capital gain property.  Thus, the same amount of capital gain would be recognized from each check as in the previous example where the donor gave appreciated stock rather than appreciated collectibles.  The only difference is that when the donor recognizes the capital gain, the donor must recognize the capital gain as capital gain for collectibles. 

The general principle here applies to all forms of capital gain.  The nature of the capital gain income does not change when it is later recognized by the donor.  The result of the gift annuity transaction is to simply defer the recognition of the capital gain, but not to change the character of the capital gain.  Although we know in advance how much and what type of capital gain will be recognized in future years, we cannot say with certainty what the tax rate will be for that type of capital gain in a future year.  Even if current tax rules do not change, the donor’s future income levels may change, which will cause the tax rate to change.  Purchasing a Charitable Gift Annuity with appreciated property produces the clear advantage of paying capital gains taxes later, rather than today.  However, if the donor is in a higher income bracket today, but will be in a lower income bracket in the future (e.g., after retirement), then the gift annuity transaction may result not only in tax deferral, but also in tax reduction (or even complete tax avoidance if the donor’s future income is low enough).  For the donor who is in a high income tax bracket today, but expects to be in a lower income tax bracket after retirement in the future, the Charitable Gift Annuity purchased with appreciated property generates the “double bonus” of an immediate income tax deduction today (when income and tax rates are high) and deferral of recognizing capital gain until future years (when income and tax rates will be low).  The use of a deferred or flexible Charitable Gift Annuity which postpones the initial payments for some years can generate even longer tax deferral.

Given the higher tax rate (31.8%), the deferment of recognizing capital gains taxes with appreciated collectible items may be even more attractive than with the use of appreciated stocks.  A key challenge in such transactions is that the charitable tax deduction may be limited to the share of basis applied to the “gift” portion of the transaction unless the charity plans to make use of the collectibles in its charitable purpose, rather than simply selling them.  Let’s examine how this might work with a tangible personal property gift.
Suppose that a donor gives a work of art (or any other tangible personal property) to a charity in exchange for a gift annuity.  The charity plans to immediately sell the art in order to provide funds for making the annuity payments.  As in our previous examples, assume that the donor purchased the art for $60,000 more than one year ago, making this long-term capital gain, with a $60,000 basis.  What is the charitable deduction for such a transaction?  If the donor were giving $100,000 of cash, the deduction would be the difference between the $100,000 transfer and the $74,723.20 value of the annuity (i.e., 25,276.80).  The same deduction would apply if the donor were giving $100,000 of long-term capital gain appreciated securities with the same $60,000 basis.  However, in this case, the deduction will be lower.  Why?  The critical distinction here is that the gift is of “unrelated use” tangible personal property, because the charity intends to sell the artwork, rather than use it in its charitable purposes.
Because this is “unrelated use” tangible personal property, the deduction is limited to the lower of basis or fair market value.  Of course, this rule applies to all gifts of “unrelated use” tangible personal property, regardless of whether or not those gifts are given in exchange for a gift annuity.  Can we simply deduct the $60,000 basis as a gift?  No.  Because part of the basis is used to purchase the gift annuity (i.e., the “sale” part of this bargain sale), and only part of the basis applies to the charitable gift portion (i.e., the “gift” part of this bargain sale).
To calculate the share of cost basis used for the gift portion, we follow exactly the same process as before.  The only difference here is that this calculation focuses on the gift portion of the basis, rather than the sale/annuity portion of the basis.
Just as before, the first step is to divide the property value into the gift portion and the annuity/sale portion.  The annuity/sale portion is 74.7232%.  This is because, as before, the IRS valuation of the annuity is $74,723.20.  The remaining amount from the $100,000 transfer is the gift portion.  Thus, the gift portion is 25.2768%, representing $25,276.80 of the $100,000 transfer.  If the transfer from the donor was cash or appreciated securities held for more than one year, then this $25,276.80 would be the deductible gift.  However, we cannot deduct this full amount, because for this type of property gift only the basis can be deducted, not the higher fair market value.
In order to calculate the deduction, we must divide the cost basis between the gift portion and the sale/annuity portion.  The cost basis will be divided in exactly the same way that the property value (or total transaction amount) was divided.  Thus, 25.2768% of the $60,000 basis (i.e., $15,166.08) will apply to the gift portion of the transaction.
This $15,166.08 of the basis is the deductible charitable gift resulting from the transaction, because only basis may be deducted when giving “unrelated use” tangible personal property (such as artwork that the charity intends to sell).
Although the Charitable Gift Annuity is a relatively simple transaction (typically documented with a standard one or two page agreement used for all annuity sales from a particular charity), the tax results are as complex as those found in more advanced instruments such as the Charitable Remainder Trust.  The taxation of Charitable Gift Annuities can become complicated, but it is often important to present them to prospective donors or clients in a simple, intuitive fashion, rather than burying the client with details.  As with other forms of charitable planning, successful planning can generate a range of tax benefits, but should only be considered for clients who have a real charitable interest in advancing the work of the charity.

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