8. Introduction to Charitable Gift Annuities, Part 2 of 3

8. Introduction to Charitable Gift Annuities, Part 2 of 3

Article posted in General on 5 January 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 8 January 2016

An Introduction to the Law and Taxation
of Charitable Gift Planning

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


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

The previous statistics establish that Charitable Gift Annuities are quite popular in charitable planning.  Why?  The reason for their popularity is that they are a simple way to fill a need for donors in a variety of circumstances.  Let’s examine some of those situations.
It can often be the case that older donors have substantial assets and would like to make major charitable contributions, but they worry that a major gift could leave them without enough assets for their lifetime needs.  The worry is that he or she may outlive his or her assets.  This concern can prevent the donor from making the substantial charitable gifts that he or she would like to make.
A Charitable Gift Annuity is designed to overcome this worry about outliving one’s assets by providing a lifetime source of income.  Where a donor might regret having made a major gift of assets if she later lived “too long” and needed those assets for regular lifetime spending, such concerns are alleviated by giving through a Charitable Gift Annuity. 

The Charitable Gift Annuity may also be preferable to a simple charitable bequest because it generates an immediate income tax deduction.  Although understanding that annuity payment rates are not interest rates (because the donor loses the principal), if the donor is already planning to transfer the principal at death to the charity, then the Charitable Gift Annuity becomes exceptionally attractive.  For example, if a donor owns a $10,000 certificate of deposit, which he has already designated a charity to receive at death, then his payments from a Charitable Gift Annuity would be more directly comparable with his interest earned on the certificate of deposit, because in either case, the charity will receive the principal at death.  (Naturally, there are still differences that make this comparison inexact.  For example, the donor can later choose to immediately spend the entire certificate of deposit, but with a gift annuity the donor has only a lifetime income stream.)

The Charitable Gift Annuity is also attractive for the charity because, unlike a charitable bequest, a Charitable Gift Annuity is an irrevocable gift.  The charity need not worry about last minute changes to the donor’s plan by the donor or nefarious heirs, because the transfer is already complete.  Recent research shows that charitable plans become highly unstable in the years immediately prior to death (see James, R.N., 2013, American Charitable Bequest Demographics: 1992-2012).  Thus, it is particularly beneficial to a charity to be able to convert revocable bequest intentions into irrevocable planned gifts, such as Charitable Gift Annuities.

From a donor’s perspective, a Charitable Gift Annuity can be preferable to leaving the same amount as a bequest gift because a bequest gift generates no income tax deduction and no lifetime payments.  For a donor with the twin goals of generating lifetime income and making a post-mortem gift to a charity, the gift annuity works far better than alternative strategies such as investing and leaving a gift to the charity by will.  Simply purchasing an immediate annuity from a life insurance company provides lifetime payments, but doesn’t accomplish the donor’s charitable goals.  Similarly, writing a charity into one’s will generates no income tax deductions.  But, by converting that revocable bequest decision into an irrevocable Charitable Gift Annuity, the donor benefits the charity and generates immediate income tax benefits and lifetime income, making the gift annuity an attractive option.

Charitable Gift Annuities can also have advantages over more complex and expensive planned giving vehicles.  If a donor is specifically concerned about having lifetime income that won’t change or run out, the Charitable Gift Annuity can be an ideal charitable planning option.  A Charitable Remainder Unitrust can make payments for life, but the amount of each payment depends upon the return of the underlying investments.  This risk could be diversified using a Pooled Income Fund, but the payments will still vary with market fluctuations.  A Charitable Remainder Annuity Trust makes fixed payments for life.  However, if the investments in the Charitable Remainder Annuity Trust perform poorly, the trust can run out of money, causing the annual payments to stop.

In contrast, the Charitable Gift Annuity payments are a fixed obligation of the charity, which must be paid regardless of investment returns or market events.  So long as the charity continues to exist, the gift annuity payments must be made.

The security provided by Charitable Gift Annuities can be more attractive in times of market volatility.  Traditionally, Charitable Gift Annuities have been considered primarily “small dollar” vehicles.  However, following substantial market drops during the most recent financial crisis, the number of multimillion dollar Charitable Gift Annuities increased notably.  The attraction of the Charitable Gift Annuity issued by a financially stable nonprofit is its ultimate security.  Considering that, historically, major universities and churches have outlived successive generations of businesses and governments, some gift annuities may provide an exceptional level of security.  Although other charitable planning vehicles, such as the Charitable Remainder Trust, provide opportunities for influencing investment choices, they are also exposed to investment risk.  When attention to investment risk is high (such as following a market crash) the attraction of the guaranteed gift annuity payments increases as compared with the risk of a Charitable Remainder Trust. 
Another reason Charitable Gift Annuities are so popular is that they are the simplest and easiest way to participate in charitable planning that produces both a tax deduction and income for the donor.  Charitable Gift Annuities are the simplest way for fundraisers to respond to the common statement from donors that “I wish I could do more, but…” Charitable Gift Annuities offer a way for donors to make a gift and provide a payment stream for other needs, such as college tuition or retirement income.  And yet the transaction can be as simple as writing a check and signing a one-page standard agreement from the charity.
If the enormous flexibility available with Charitable Remainder Trusts can be thought of as the paint palette of an artist, then the Charitable Gift Annuity is like the reliable number 2 pencil.  Charitable Gift Annuities are simple and cheap for donors.  There are no donor costs for setup or administration and the minimum investment amount is commonly only $5,000 or $10,000.  Each Charitable Gift Annuity agreement with a particular charity is typically identical except for the donor’s age, the payment rate, and the transfer amount.  In contrast, Charitable Remainder Trusts are usually hand-crafted documents specifically designed for the individual donor and his or her particular desires.  This enormous flexibility comes at a cost, both for the initial creation of the Charitable Remainder Trust and for annual administration.  Because of these costs, the minimum feasible amount for a Charitable Remainder Trust is normally 10 times that of a Charitable Gift Annuity.  Of course, there are significant potential advantages to using a Charitable Remainder Trust that are not available with Charitable Gift Annuities that can, in many cases, warrant the added expense for the donor.  One solution is not universally better than the other; both can fit the specific needs in different circumstances.

To this point we have been comparing Charitable Gift Annuities with leaving a charitable bequest.  This anticipates a scenario in which the charity holds the initial gift amount, makes payments to the donor for life, and then only after the death of the donor takes the remaining amount of the gift to use for charitable purposes.  However, the charity is not required to take this conservative approach (except in the State of New Hampshire).  A charity could instead calculate the share of the gift that would normally be needed to make the lifetime payments and immediately spend the remaining amount.  For a charity that chose to do this, the donor would be able to see the impact of his or her gift immediately.  For some donors, this could be an attractive feature, especially when compared to a bequest gift where the donor would not be alive to see its impact.

To make an immediate use of Charitable Gift Annuity funds, the charity spends the projected gift portion of the transaction.  Calculating this projected gift portion involves estimating the donor’s longevity and the charity’s investment returns.  Consequently, there is some risk involved if the projections are in error.  This risk explains why not all charities engage in this practice of immediately using the projected gift portion of Charitable Gift Annuity funds.  Nevertheless, it is an available option to charities in most states.

Note that in Florida, Tennessee, Washington, Hawaii, New Jersey, and Wisconsin the charity must hold the amount projected for the donor’s payments plus a 10% cushion.  In New York the cushion amount is at least 10%, and may be higher.  Even in these jurisdictions, however, making immediate use of part of the Charitable Gift Annuity is permitted.  In other jurisdictions, the charity could choose to immediately use even more than the projected “gift portion,” although this creates a future net liability for the organization.

To this point we have been reviewing some of the features and benefits of the Charitable Gift Annuity.  However, there are also some risks involved with the Charitable Gift Annuity.  First, let’s examine the risks for the donor.

The annuity payments come from the charity.  The charity is required to make these payments and they are a general obligation of the charity.  So long as the charity survives, the donor need not be concerned with market crashes and other investment worries. 
However, if the charity goes bankrupt, the donor payments may cease or be reduced.  Thus, the primary risk for the donor is that the charity would be unable to make its payments in the future.  As a general obligation of the charity there may be no specific assets that can be attached in the event of a bankruptcy.  Although some charities have, and a few states require, segregated reserve funds, this segregation may not be sufficient to prevent other creditors from having a claim on the funds.  Additionally, such segregated funds may also deplete due to poor investment decisions.
Compared with the field of commercial annuities issued by insurance companies, Charitable Gift Annuities are remarkably unregulated.  As shown by this map, the majority of states have no reserve requirements for nonprofits issuing Charitable Gift Annuities.  This means that a charity operating in one of the states working with a donor in one of these states could choose to immediately spend 100% of the amount given for the Charitable Gift Annuity and simply leave the payments as an unfunded obligation for the future.  Several states have operating requirements such that a charity issuing Charitable Gift Annuities must have been in operation for a minimum number of years and have a minimum amount of unrestricted cash (or cash equivalents such as publicly-traded securities).  Unrestricted cash, however, does not mean that there are no creditor obligations on the cash.  Unrestricted cash means only that it is money that has not been temporarily or permanently restricted by a donor.  Further, these requirements for unrestricted cash are fixed dollar amounts that do not vary, regardless of the number or amount of Charitable Gift Annuities being issued by the nonprofit.  In essence, these operational requirements simply limit gift annuity issuance to charities that are not brand new and have at least a little money in the bank.  Note that in states like Indiana, Kansas, Kentucky, Louisiana, Massachusetts, Michigan, and Minnesota, there are neither operational requirements nor reserve requirements.  This means that a nonprofit could be created one day, start issuing Charitable Gift Annuities the next day, and then immediately spend 100% of the amount given for all Charitable Gift Annuities.  Obviously, such a scenario entails substantial risk for the donor.  At the same time, Charitable Gift Annuities issued by large stable nonprofits may be among the most secure lifetime payment streams available.  However, the lack of regulation in some areas creates a “Wild West” scenario in which the donor must do some investigation to understand the risks involved.

One way to investigate the financial condition of a charity is to examine the IRS form 990 for the charity.  The IRS form 990 contains financial information about the charity, including assets, liabilities, income, and expenditures.  Charities are required to provide these forms to anyone who requests them.  Additionally, these forms are available from a number of websites for no charge.  Some of the websites that currently post IRS form 990s are

Given the complexity of reading and understanding financial statements, this is an area where a financial advisor could be particularly helpful to a donor.

Unlike some commercial annuity products, Charitable Gift Annuities do not offer payments for a fixed term of years or a minimum guaranteed number of years.  Instead, Charitable Gift Annuity payments are for life only.  This is not due to the lack of willingness of charities.  Rather, the IRS tax code penalizes charities for offering other varieties of gift annuities, even though these may be available from commercial annuity providers.
One risk in purchasing a gift annuity that makes payments for life is that the annuitant could die immediately after purchasing the annuity.  Unfortunately for the annuitant, there are no refunds for early death, nor are charities allowed to offer gift annuities with guaranteed minimum payment amounts or with a fixed number of payment years.  From a financial perspective, there is a clear risk in that the donor may receive very few benefits prior to death.  However, if the donor’s goal was to make a large gift to charity (but not risk outliving his or her assets), then the risk of receiving few payments is of less concern as the donor’s goal will still be achieved.
To this point we have been considering the simplest and most common form of a gift annuity where the donor makes a gift and in return receives lifetime payments from the charity.  Although a charity is not allowed to offer annuities with a guaranteed return in the event of premature death or annuities paying for a set number of years, the tax code does permit a few other gift annuities variations.  (Note that if a charity were to offer gift annuities with terms outside of approved variations, the charity would be required to pay taxes on income earned from the gift annuities as unrelated business income tax, thus making them highly undesirable charitable giving vehicles.)
The most common variation on the traditional gift annuity is the gift annuity that pays for two lives.  This means that the annuity payments will continue to be made until the death of the last of the two individuals to die.  (The payment is not reduced at the death of the first to die of the two annuitants.) Most commonly, these gift annuities pay for the lives of the donor and the donor’s spouse.  However, there are no requirements that either annuitant be related to the donor.  A gift annuity cannot, however, pay for more than two lives.  Nor, can it pay for the life of someone who is not yet born (e.g., “pay for my life and the life of my first child if he or she is born before my death”).
The American Council on Gift Annuities also issues suggested rates for these two-life annuities.  As before, these rates vary depending upon prevailing interest rates and the ages of the two annuitants.  The full table is much larger than for single life annuities, given the wider range of age combinations possible.  This excerpt provides a few examples from that table.
One particularly attractive variation of the standard gift annuity is the deferred gift annuity.  If the donor does not need the income payments to begin immediately, the donor may choose to postpone the start of the annuity payments.  Each year that the donor postpones the start of the annuity payments will increase the size of the remaining payments.  This may be helpful for donors who wish to make an immediate transfer, receive an immediate tax deduction, but postpone income until some future year, such as the start of retirement.  The donor can either establish in advance when the annuity will begin or can decide each year whether or not to begin the annuity in that particular year (this is sometimes called a “flexible annuity”, see PLR 9743054).
The essence of a deferred Charitable Gift Annuity is that if the donor postpones the start of the annuity payments, each remaining payment will become larger.  The American Council on Gift Annuities suggests a compounding rate which incorporates current interest rates and the reduced longevity of the annuitant.  If a compounding rate is so high that it increases the overall value of the annuity beyond the simple immediate annuity, it will reduce the available tax deduction.  For example, in 2015 the payout rate would be the current rate in effect at the age the payout begins multiplied by 1.0325n where n is the number of years the payout was delayed after the initial gift (i.e., a 3.25% compound annual increase in the remaining payment size).
The deferred or flexible gift annuity also creates the opportunity for a donor to make a gift, but retain an “emergency” right to receive payments.  This can be helpful with a donor who does not anticipate ever needing the payments, but who nevertheless feels insecure about making the gift because of unknown possibilities.  The donor can choose to postpone the payments indefinitely and, at death, the charity would receive the entirety of the initial gift.  Although the amount transferred to the charity is the same as could have been transferred through a bequest, this transaction allows for an immediate income tax deduction and also allows the charity to make immediate use of a portion of the initial gift.
If a donor purchased a gift annuity and then later found that he or she no longer needed the annuity payments, the donor could gift the rights to all future payments to the charity and potentially receive an income tax deduction for that gift.  This could be more tax efficient than receiving each check (which counts, at least in part, as income) and then gifting it back to the charity (which creates a deduction that may or may not completely offset the income, depending upon a variety of factors such as the amount of other itemized deductions, adjusted gross income level, and so forth).
The typical Charitable Gift Annuity makes lifetime payments to the donor.  However, the donor may instead select someone else to receive payments as the annuitant.  This is a potentially taxable gift if given to a non-spouse, so for a donor whose estate is large enough to be concerned with estate taxes, such gift tax considerations must be considered.  (Although, as discussed later, such gift taxes can be reduced by the annual present interest exclusion because gifts of immediate annuities are considered to be gifts of present interests.)
One creative variation on a Charitable Gift Annuity allowed a donor to name his grandchild as the life annuitant with the lifetime payments to begin at age 18.  This particular annuity had an additional provision that allowed the grandchild to trade the lifetime income for an equivalent lump-sum tuition payment at the donor’s alma mater.  Because the annuity was issued by the donor’s alma mater, this created an attractive incentive for the grandchild and a potential double benefit for the university.

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