9. Taxation of Charitable Gift Annuities, Part 2 of 4

9. Taxation of Charitable Gift Annuities, Part 2 of 4

Article posted in General on 15 February 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 16 March 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.

Our first example was the simplest Charitable Gift Annuity case where the donor gives cash in exchange for lifetime payments.  However, married donors are frequently interested in payments that last for two lives, rather than just one.  Two-life annuities are allowed and there is no requirement that the annuitants be related.  (However, annuities for more than two lives are not permitted.) The actuarial tables used in the single life example will not work for a two-life annuity.  Consequently, we must slightly alter the process for valuing such annuities.
For two-life annuities, calculating the value of the annuity uses Table R, rather than Table S.  However, Table R looks different from Table S.  Where Table S has three numbers for each age (the annuity factor, the remainder interest, and the life estate), Table S has only one number for each age combination.  This one number is the remainder interest factor.  But, we don’t want the remainder interest factor; instead, we want the annuity factor.  Using Table S requires knowing that the annuity factor is calculated by subtracting the remainder interest factor from one and then dividing this amount by the current §7520 rate.  Thus, calculating the annuity factor for a two-life annuity will have one extra step.
As in the example for a single life annuity, once we know the value of the annuity given by the charity, we are able to calculate the tax deduction.  The deduction is the amount given by the donor to the charity less the value of the annuity given by the charity to the donor.
Knowing how to value the annuity allows us to calculate the charitable tax deduction resulting from purchasing the Charitable Gift Annuity.  However, the tax implications of a Charitable Gift Annuity do not end there.  Unlike other gifts, the Charitable Gift Annuity produces a lifetime income stream.  Each year (or quarter, month, or week) the annuitant receives a check from the charity.  How should the annuitant report this check to the IRS?  Let’s begin with the simple transaction where the Charitable Gift Annuity was purchased with cash.  In that case, each check will be reported as some combination of ordinary income and tax-free return of investment.
Some part of each annuity check given to a donor simply returns a part of the money paid for the Charitable Gift Annuity.  This part is a return of the donor’s original investment.  There are no income taxes on this portion of the annuity check, because this is not “new” earned money coming to the donor.  This is the donor’s own money being returned to him.  (Or, in the case of a gift annuity paid to someone other than the donor, this is a gift from the donor and is likewise not taxable income.)
The remaining part of each annuity check is taxable.  When the Charitable Gift Annuity is purchased for cash (i.e., not with appreciated property), this remaining part is taxed as ordinary income.  In this case, everything that is not tax-free return of investment is taxable as ordinary income.
Let’s look at an example that may help to explain the difference in tax treatment between earnings and tax-free return of investment.  Suppose you open an interest-bearing bank account and put in $1,000.
Further, suppose that each year you withdraw all of the interest earned in the account and some of your original $1,000 deposit.  For example, suppose that the bank account earns 5% interest per year.  At the end of the first year you withdraw the $50 of interest earned on your $1,000 deposit and you withdraw $100 of your original deposit.
Do you pay more taxes because you withdrew $100 of your original deposit?  Does removing $100 of your original deposit mean that you have $100 more of income this year?  No.  Removing money from an account does not cause you to have more income.  It simply shifts the location of your money.
Putting money into an account and then removing the same money from the account is no different than burying money in the ground and then later digging it up and taking it out of the ground.  This is tax-free return of investment.  The money was yours before you put it in the ground and is still yours after you take it out of the ground.  Neither of these actions changes your taxable income, even if they may change the amount of cash in your pocket.
Let’s return to the example of the bank account where you earned $50 in interest (on the original $1,000 deposit) and withdrew $150.  Do you pay taxes on the $50 of interest earned during the year?  Yes.  This $50 is not part of the $1,000 original deposit.  It is new.  This new money earned on the deposit is taxable income.  The idea of taking all of the interest and some of the principal each year from a bank account is similar to receiving an annuity.  Each annuity check represents all of the earnings during the year, plus some of the original investment.  The portion of the annuity check that represents a return of the original investment is not taxed.  The rest is treated as earnings and is taxed as ordinary income.

So long as the annuity was not purchased with appreciated property, each annuity check will consist of some combination of taxable earnings and non-taxable return of original investment.  Using the bank account analogy, the tax-free return of investment is like removing some of the original principle from a bank account, and the remainder of each annuity payment is like the taxable earnings from a bank account.

How much of each annuity check is taxable income?  We calculate this indirectly by determining how much was simply a return of the money originally invested.  The rest is taxable income.
The formula for determining the amount of each annuity check that qualifies as tax-free return of investment divides the part of the transaction used to purchase the annuity by the annuitant’s original life expectancy.  Note that the part of the transaction used to purchase the annuity is not the entire cost of the Charitable Gift Annuity.  Part of the cost of the Charitable Gift Annuity is a charitable gift.  That is the part which generates the charitable income tax deduction.  The rest of the money used to purchase the Charitable Gift Annuity (i.e., not the deductible gift part of the transaction) is the money used to purchase the annuity part.  It is this part of the transaction that is the investment part (i.e., not a gift).  Consequently, this is the part of the transaction that can become tax-free return of investment.  The gift part of the transaction cannot become tax-free return of investment, because it was given to the charity as a deductible charitable gift.
Let’s return to our original example where a 55-year old donor gave $100,000 of cash to the charity and the charity, in return, agreed to pay the donor $4,000 per year for life.  The amount of each annual $4,000 annuity check that is tax-free return of investment is determined by dividing the dollars used to purchase the annuity part by the annuitant’s life expectancy when the Charitable Gift Annuity was purchased.
In this case we have previously calculated the value of the annuity as $74,723.20.  Thus, this is the portion of the $100,000 transfer that was used to purchase the annuity.  The remaining amount from the $100,000 was not used to purchase the annuity.  Instead, it was used to make a charitable gift (and was thus deductible as a charitable gift).  Dividing this $74,723.20 annuity part by the annuitant’s 21.7 year original life expectancy results in $3,443.46.  Thus, $3,443.46 of each $4,000 annuity check will be tax-free return of investment until all of the donor’s original investment has been returned.  How do we find the annuitant’s life expectancy?  The life expectancy used for this calculation is called an “expected return multiple” and is identified in the table found in the Code of Federal Regulations Title 26 §1.72-9.  (Several free websites show the Code of Federal Regulation such as www.law.cornell.edu/cfr/) This factor is called an “expected return multiple” because it is the period that payments are actuarially expected to be received.  In this case, the “expected return multiple” for a 55 year old male is 21.7 years.
As a result of this calculation, we can now say that out of each $4,000 annuity payment, $3,443.46 will be treated as tax-free return of investment.  This is how each annuity check will be treated until the entire $74,723.20 of the investment in the annuity portion has been returned.  Note that the charity is required to send each annuitant an IRS Form 1099R which indicates what portion of each payment is tax-free return of investment, which part is taxable income, and (if the gift annuity was purchased with appreciated property) which part is capital gain.
The tax free return of investment is divided among each expected payment.  If an older annuitant had a life expectancy (“expected return multiple”) of five years at the creation of the charitable gift annuity, then each year for five years 1/5th of the donor’s original investment in the annuity portion of the transaction would be returned to the donor.  But what happens once the entire original annuity portion cost has been returned?  (In other words, what happens if the annuitant outlives his or her “expected return multiple”?)

Once the entire original investment (in our example, $72,797.20) has been distributed to the annuitant, there is no part of the original investment left.  Consequently, after that point, no part of the subsequent annuity payments will be tax-free return of investment.  Thus, once an annuitant has lived past his or her life expectancy (“expected return multiple”), the entire annuity payment will be treated as ordinary income.

Returning to our example, $3,443.46 of each $4,000 annuity check will be treated as tax-free return of investment for 21.7 years.  (For the check in the 22nd year, the tax-free return of investment would be $3,443.46 X .7, or $2,410.43.) After that point, however, every additional $4,000 check will be treated entirely as ordinary income.
If the donor dies prior to reaching his original life expectancy (“expected return multiple”), then the donor fails to receive his entire original investment in the annuity portion of the transaction.  In this case, the donor’s last tax return can deduct the portion of the original investment not yet returned to the donor.
For a donor who wishes to benefit a charity that does not offer a Charitable Gift Annuity, a similar transaction would be to use part of the money to purchase a commercial immediate annuity from an insurance company and then simply donate the remaining amount to the charity.  This accomplishes roughly the same goals as a Charitable Gift Annuity.  However, there are two tax disadvantages that make this substitute transaction less advantageous. 
The deduction generated by the substitute transaction (purchasing a commercial annuity from the insurance company and donating the remaining cash to the charity) will be lower than the deduction generated by a comparable Charitable Gift Annuity.  With a Charitable Gift Annuity, the charitable deduction is the amount transferred less the value of the annuity as determined by the IRS tables.  In the substitute transaction the charitable deduction will be the amount given to charity, in other words, the total original amount less the price of the commercial annuity.  However, a commercial annuity will inevitably be more expensive than the IRS valuation of a similar annuity from a charity.  This occurs for two reasons.  First, the commercial annuity product must incorporate the salaries and profit of the insurance company into its pricing.  This margin must be above and beyond the value of the expected payout based upon current interest rates.  Additionally, the IRS valuation for an annuity from a charity will be lower because the IRS uses standard life expectancy tables.  However, people who buy annuities, on average, live longer than others of the same age.  (As discussed in the previous chapter, this is because people who are sick or dying or poor do not purchase annuities.  The exclusion of these groups means that those who purchase annuities will, on average, live longer than others of the same age.)  Thus, the insurance company must price its annuity based upon the longer life expectancy of annuity purchasers, and not the generic life expectancy used by the IRS.  This expectation of a longer life means that the insurance company must charge more for its annuities as compared with the IRS calculation.

The second tax disadvantage of the substitute transaction is that it cannot be used to shelter capital gains taxes when contributing appreciated property.  Despite these disadvantages, if a donor wants to purchase a Charitable Gift Annuity with cash to benefit a charity that does not offer Charitable Gift Annuities (or perhaps does not offer them in the donor’s state of residence), this substitute transaction might be suggested as a possible alternative.  Having just mentioned sheltering of capital gains as a potential advantage of Charitable Gift Annuities, let’s now turn to a discussion of capital gains taxes.

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