608 / How are payments received under a charitable gift annuity agreement taxed?

(1)     A charitable contribution is made in the amount by which cash or the fair market value of property transferred to the charity exceeds the present value of the annuity. The American Council on Gift Annuities, a voluntary group sponsored by charitable organizations, recommends uniform annuity rates based on the annuitant’s age at the date of the gift. See American Council on Gift Annuities’ Uniform Gift Annuity Rates (https://www.acga-web.org/current-gift-annuity-rates). The uniform annuity rate is applied to the transfer and determines the amount of the annuity paid to the annuitant each year. The present value of a charitable gift annuity when issued is determined under Estate and Gift Tax Tables ( Q 921).

(2)     When an annuitant receives annuity payments, a percentage of each payment reflects a return of principal. This percentage (the “exclusion ratio”) is determined by the basic annuity rule, that is, by dividing the investment in the contract by the expected return. The investment in the contract in the charitable annuity situation is the lesser of the present value of the annuity or the fair market value of the property transferred to the charity. The expected return is the annual annuity amount multiplied by the years of life expectancy of the donor at the time of the gift. If the annuity starting date is after December 31, 1986, the return of principal portion is excludable only until the investment in the contract is fully recovered. Thereafter, that portion is included in income as ordinary income.²

If, however, the donor has transferred appreciated property to the charity, the donor has a gain (either a capital gain or an ordinary gain depending on the property) to the extent the fair market value of the property exceeds the donor’s adjusted basis. In this situation, the bargain sale rules apply. Under these rules, proportionate portions of the donor’s basis are considered part of the charitable gift and part of the investment in the annuity contract. Thus, the donor’s return of principal element of each payment consists of two segments: one represents return of gain that is taxed as capital or ordinary gain, and the other represents return of the donor’s adjusted basis and is excluded from the donor’s income.

The portion of the gain that is taxed is the percentage that the investment in the contract bears to the total amount transferred. As long as the annuity is nonassignable, the donor may take the gain into income ratably over the donor’s life expectancy. After all the gain is reported, that portion of the donor’s annuity payment is excluded from income as well as the return of basis portion, if the donor’s annuity starting date was before January 1, 1987. If the annuity starting date is after December 31, 1986, the IRC provides that amounts are not excludable after the investment in the contract has been recovered. Thus, it appears that once the annuitant has outlived his or her life expectancy, and recovered his or her investment in the contract, the entire payment is included in income as ordinary income.

If the donor dies before all of the gain is reported (and the donor is the sole annuitant), no further gain is reported. If the annuity starting date is after July 1, 1986, the IRC provides that if annuity payments cease by reason of the death of the sole annuitant before the investment in the contract has been recovered, the unrecovered investment in the contract may be deducted ( Q 567).³ Because the unrecovered investment in the contract where appreciated property has been given for the annuity includes the unrecognized gain portion, it is likely the deduction will be limited to the unrecovered basis.

(3)     The portion of each payment in excess of the return of principal element is ordinary income.

An example of these payment rules, classified as (1) a charitable contribution, (2) return of principal, and (3) ordinary income, is shown below:

Example. Ed White is a widower, age 70. He owns securities with an adjusted basis of $6,000 and a fair market value of $10,000. On June 1 he transfers the securities to ABC Charity in exchange for a life annuity, payable in semiannual installments. For purposes of this example, assume that the uniform annuity rate (see American Council on Gift Annuities’ Uniform Gift Annuity Rates at https://www.acga-web.org/current-gift-annuity-rates) is 5.7 percent, and thus the annuity payment is $570 per year.

(1)     According to the applicable Estate and Gift Tax Tables ( Q 921), the present value of the annuity for Mr. White is $6,261 (10.9031 [annuity factor] × 1.0074 [annuity adjustment factor for semiannual payments] × $570 [the donor’s annual annuity]) (Mr. White elected to use an interest rate for a month as explained in Q 921 with an interest rate that is assumed to be 3.0 percent for purposes of this example) The difference between the $10,000 fair market value of the property and the $6,261 value of the annuity, or $3,739, is the charitable contribution portion of the transfer. According to Table V, Mr. White has a life expectancy of 16 years that is adjusted to 15.8 (16 – .2) to reflect the frequency of payments (adjustment factor for semiannual payments with six months from the annuity starting date to the first payment date is –.2).

(2)     Of each $305 semiannual payment, 69.5 percent, or $198, represents return of principal. This percentage is found by dividing $6,261 (the value of the annuity, or investment in the contract) by $9,006 (the expected return: $570 × 15.8). Of this principal amount, $79 is gain ([$6,261 – ($6,000 × ($6,261 ÷ $10,000))] ÷ [15.8 × 2]). Mr. White must report the $79 as capital gain until all his gain is recognized, or until he dies, if that is earlier. Mr. White will exclude the balance of the principal, $119 ($198 – $79), as return of adjusted basis.

(3)     The balance of each annuity payment, $87, is the amount that Mr. White must report as ordinary income ($285 – $198). After all the gain and investment in the contract has been recovered (approximately 15.8 years), each payment is fully taxable as ordinary income.

The IRS has ruled that in the case of a deferred charitable gift annuity, no amount will be considered constructively received until the annuitant begins receiving payments.⁴

The gift portion of the transfer qualifies for a gift tax charitable deduction. With respect to estate taxes, a donor who designates an annuity only for himself or herself will not have any amount relative to the gift annuity transfer included in his or her gross estate.⁵

In a private letter ruling, the IRS approved of “reinsured” charitable gift annuities.⁶