Charitable Gift Annuity

<div class="Section1">The interest of a donee spouse in a joint and survivor annuity in which only the donor and donee spouses have a right to receive payments during the spouses’ joint lifetimes is treated as qualified terminable interest property (“QTIP”) for which the marital deduction is available unless the donor spouse irrevocably elects otherwise within the time allowed for filing a gift tax return.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 2523(f)(6).<br /> <br /> </div>

<div class="Section1">If an employee&rsquo;s annuity starting date was on or before July&nbsp;1, 1986, payments were taxed according to the three year cost recovery rule or the regular annuity rules.<a href="#_ftn1" name="_ftnref1">¹</a> The three year cost recovery rule was repealed for employees with an annuity starting date after July&nbsp;1, 1986.<a href="#_ftn2" name="_ftnref2">²</a> Certain premature distributions are subject to an additional tax ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3964">3964</a>). Excess retirement distributions were subject to an additional tax in&nbsp;years beginning before 1997.<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(d)(1), prior to repeal.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; TRA &rsquo;86, &sect; 1122(c)(1).<br /> <br /> </div></div><br />

<div class="Section1">A charitable gift annuity agreement is a contractual obligation undertaken by a charity to pay an annuity to an individual in return for an amount transferred by the individual, where the actuarial value of the agreed upon payments is usually less than the amount contributed (notwithstanding the fact that the payments might exceed the amount transferred if the annuitant lives long enough). The contractual obligation is backed by the charity’s assets. The typical charitable gift annuity can involve the transfer of appreciated property.</div>

<div class="Section1">Property transferred in return for a charitable gift annuity could fall into the general definition of “debt financed property” in IRC Section 514(b)(1) because the charity acquires the gift subject to the promise to pay the donor an annuity. This result would be problematic, because it could be treated as unrelated business taxable income and trigger an associated unrelated business income tax for the charity.</div><br /> <div class="Section1"><br /> <br /> However, in a private letter ruling, the IRS decided that issuing a charitable gift annuity will not result in income from an unrelated trade or business and that income earned by the charitable organization from investing the charitable gift annuity funds will not be considered unrelated debt-financed income.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> A charity’s obligation to pay an annuity will be exempt from the debt financed property rules of IRC Section 514 if the following conditions are met:<br /> <blockquote>(1)     the annuity must be the sole consideration paid for the property transferred;<br /> <br /> (2)     the present value of the annuity must be less than 90 percent of the value of the property received in exchange;<br /> <br /> (3)     it must be payable over the lives of one or two annuitants;<br /> <br /> (4)     the contract must not guarantee a minimum number of payments or specify a maximum number of payments; and<br /> <br /> (5)     the contract must not provide for adjustments to the amount of annuity paid based on income earned by the transferred property or any other property.<a href="#_ftn2" name="_ftnref2">²</a></blockquote><br /> Issuing charitable gift annuities does not affect the tax-exempt status of the organization if the annuity meets the requirements above and a portion of the amount transferred in return for the annuity is allowable as a charitable deduction.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Let. Rul. 200449033.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 514(c)(5).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 501(m).<br /> <br /> </div>

<div class="Section1">If an employee, whether a regular employee or a self-employed individual, has no cost basis for his or her interest in a plan, the full amount of each payment is taxable to the employee as ordinary income.<a href="#_ftn1" name="_ftnref1">¹</a> If an employee has a cost basis for his or her interest in a plan, the payments are taxed as discussed below, and depend on the employee&rsquo;s annuity starting date. To determine an employee&rsquo;s cost basis, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3968">3968</a>.<div class="Section1"><br /> <br /> The tax treatment is the same whether payment is made directly from a qualified trust or annuity plan or whether a trust buys an annuity and distributes it to an employee.<a href="#_ftn2" name="_ftnref2">²</a> Distribution of an annuity contract itself affects the tax on lump sum distributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="140">140</a>). If an employee has a cost basis for his or her interest, payments are taxed as discussed below, depending on the annuity starting date.<br /> <br /> If an employee had a cost basis for his or her interest, and the annuity starting date was after November&nbsp;18, 1996 and before January&nbsp;1, 1998 (or if the annuity is payable over one life and has a starting date after December&nbsp;31, 1997, as described above), the investment in the contract was recovered according to the schedule below. For purposes of this rule, the employee&rsquo;s investment in the contract did not include any adjustment for a refund feature under the contract.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> The excludable portion of each monthly payment was determined by dividing the employee&rsquo;s investment in the contract by the number of anticipated payments contained in the following table:<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <table border="1" align="center"><br /> <tbody><br /> <tr><br /> <td style="text-align: center;" width="140"><strong>Age</strong></td><br /> <td style="text-align: center;" width="233"><strong>Number of Payments</strong></td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">55 and under</td><br /> <td style="text-align: center;" width="233">360</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">56 &ndash; 60</td><br /> <td style="text-align: center;" width="233">310</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">61 &ndash; 65</td><br /> <td style="text-align: center;" width="233">260</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">66 &ndash; 70</td><br /> <td style="text-align: center;" width="233">210</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">71+</td><br /> <td style="text-align: center;" width="233">160</td><br /> </tr><br /> </tbody><br /> </table><br /> This table did not apply if the annuitant was age 75 or older unless there were fewer than five&nbsp;years of guaranteed payments under the annuity.<a href="#_ftn5" name="_ftnref5">⁵</a> It would appear that for an annuitant who was 75 or older and whose contract provides for five or more&nbsp;years of guaranteed payments, the rules for annuities with a starting date after July&nbsp;1, 1986 and before November&nbsp;19, 1996 would be applied.<br /> <br /> If a contract provided for a fixed number of installment payments, the number of monthly annuity payments provided under the contract was used instead of the number listed on the table.<a href="#_ftn6" name="_ftnref6">⁶</a> If payments under a contract were not made on a monthly basis, appropriate adjustments had to be made to the number of payments determined above to reflect the basis on which payments are made.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> The excluded amount remained constant, even where the amount of the annuity payments changes. If the amount to be excluded from each payment was greater than the amount of the annuity payment (e.g., because of decreased survivor payments), then each annuity payment would be completely excluded from gross income until the entire investment is recovered. As noted below, under earlier law, for distributees with annuity starting dates after December&nbsp;31, 1986, annuity payments received after the investment was recovered are fully includable in gross income. If two annuitants are receiving payments at the same time, each may exclude his or her pro rata portion of the amount provided under these rules.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> If a lump sum was paid to a taxpayer in connection with the commencement of the annuity payments, it was taxable as an amount not received as an annuity under IRC Section&nbsp;72(e) and treated as received before the annuity starting date. The taxpayer&rsquo;s investment in the contract was determined as if the lump sum payment had been received.<a href="#_ftn9" name="_ftnref9">⁹</a> Where a defined benefit plan required after-tax contributions and permitted participants to withdraw their aggregate after-tax contributions in a single sum at retirement in exchange for an actuarial reduction in their lifetime pension benefits, the IRS ruled that the single sum payment constituted a lump sum payment under IRC Sections 72(d)(1)(D) and 72(d)(1)(G).<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> The total amount that an employee could exclude was not permitted to exceed his or her investment in the contract, and if the employee died prior to recovering his or her full investment in the contract, any unrecovered investment will be allowable as a deduction on the employee&rsquo;s final return.<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> Special transition rules were provided for payors and distributees who continued using the simplified safe harbor contained in Notice 88-118 (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="617">617</a>), as revised by Notice 98-2, with respect to annuities with annuity starting dates after November&nbsp;18, 1996 and before January&nbsp;1, 1997.<a href="#_ftn12" name="_ftnref12">¹²</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&sect; 1.61-11(a), 1.72-4(d)(1); IRC &sect;&sect; 402(a), 403(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect; 402(a), 403(a)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect; 72(d)(1)(C), 72(c)(2); Notice 98-2, 1998-1 CB 266.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(d)(1)(B).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(d)(1)(E).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect; 72(d)(1)(B)(i)(II), 72(c)(3)(B).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(d)(1)(F); <em><em>see</em> </em>Notice 98-2, 1998-1 CB 266, for two such methods.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp;&nbsp;&nbsp; Notice 98-2, 1998-1 CB 266.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(d)(1)(D).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp;&nbsp; Let. Rul. 9847032.<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp;&nbsp; IRC &sect;&sect; 72(d)(1)(B)(ii), 72(b)(2), 72(b)(3); Notice 98-2, 1998-1 CB 266.<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.&nbsp;&nbsp; Notice 98-2, 1998-1 CB 266.<br /> <br /> </div></div><br />

<div class="Section1">In the case of an annuity starting date before November 19, 1996, a simplified safe harbor method can be used if annuity payments depend on the life of the employee or the joint lives of the employee and a beneficiary. If an employee was age 75 or older when annuity payments commenced, this method could be used only if fewer than five years of payments were guaranteed.<a href="#_ftn1" name="_ftnref1">¹</a> Under this method, investment in the contract is the employee’s cost basis in the plan. No refund feature adjustment has to be made. Investment in the contract is divided by the total number of monthly annuity payments expected. This number is taken from the following table and is based on the employee’s age at the annuity starting date:<br /> <table border="1" align="center"><br /> <tbody><br /> <tr><br /> <td style="text-align: center;" width="140"><strong>Age</strong></td><br /> <td style="text-align: center;" width="233"><strong>Number of Payments</strong></td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">55 and under</td><br /> <td style="text-align: center;" width="233">300</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">56-60</td><br /> <td style="text-align: center;" width="233">260</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">61-65</td><br /> <td style="text-align: center;" width="233">240</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">66-70</td><br /> <td style="text-align: center;" width="233">170</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="140">71 and over</td><br /> <td style="text-align: center;" width="233">120</td><br /> </tr><br /> </tbody><br /> </table><br /> The same expected number of payments applies regardless of whether the employee is receiving a single life annuity or a joint and survivor annuity. The dollar amount excluded from each payment does not change, even if the amount of the payments increases or decreases.<a href="#_ftn2" name="_ftnref2">²</a> If an annuity starting date is after December 31, 1986, annuity payments received after the investment in the contract is recovered are fully includable in income.<br /> <br /> An employee makes the election to use the safe harbor method by reporting the taxable portion of the annuity payments received in the year, including the annuity starting date under that method, on the income tax return for that year and for succeeding years. An employee may change the method used to report the tax treatment of annuity payments (i.e., from the safe harbor method to the actual calculation of an exclusion ratio or vice versa) by filing an amended return for all open tax years, as long as the year containing the annuity starting date is an open year.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Notice 88-118, 1988-2 CB 450.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Notice 88-118, 1988-2 CB 450.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     Notice 88-118, 1988-2 CB 450.<br /> <br /> </div>

<div class="Section1">The tax consequences of a charitable gift annuity involve an immediate charitable gift (deductible within the limits of IRC Section&nbsp;170 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="739">739</a>)), income tax on a portion of the annuity payments, and a recovery of principal that will be made up of part taxable gain and part excludable adjusted basis if appreciated property is transferred for the annuity.<a href="#_ftn1" name="_ftnref1">¹</a> Each of these is discussed below.<div class="Section1"><br /> <blockquote>(1)&nbsp;&nbsp;&nbsp;&nbsp; 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&rsquo;s age at the date of the gift. See American Council on Gift Annuities&rsquo; 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="921">921</a>).<br /> <br /> (2)&nbsp;&nbsp;&nbsp;&nbsp; When an annuitant receives annuity payments, a&nbsp;percentage of each payment reflects a return of principal. This&nbsp;percentage (the &ldquo;exclusion ratio&rdquo;) 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&nbsp;years of life expectancy of the donor at the time of the gift. If the annuity starting date is after December&nbsp;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.<a href="#_ftn2" name="_ftnref2">²</a></blockquote><br /> 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&rsquo;s adjusted basis. In this situation, the bargain sale rules apply. Under these rules, proportionate portions of the donor&rsquo;s basis are considered part of the charitable gift and part of the investment in the annuity contract. Thus, the donor&rsquo;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&rsquo;s adjusted basis and is excluded from the donor&rsquo;s income.<br /> <br /> The portion of the gain that is taxed is the&nbsp;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&rsquo;s life expectancy. After all the gain is reported, that portion of the donor&rsquo;s annuity payment is excluded from income as well as the return of basis portion, if the donor&rsquo;s annuity starting date was before January&nbsp;1, 1987. If the annuity starting date is after December&nbsp;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.<br /> <br /> 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&nbsp;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 <a href="javascript:void(0)" class="accordion-cross-reference" id="567">567</a>).<a href="#_ftn3" name="_ftnref3">³</a> 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.<br /> <blockquote>(3)&nbsp;&nbsp;&nbsp;&nbsp; The portion of each payment in excess of the return of principal element is ordinary income.</blockquote><br /> An example of these payment rules, classified as (1) a charitable contribution, (2) return of principal, and (3) ordinary income, is shown below:<br /> <blockquote><em>Example</em>. 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&nbsp;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&rsquo; Uniform Gift Annuity Rates at https://www.acga-web.org/current-gift-annuity-rates) is 5.7&nbsp;percent, and thus the annuity payment is $570 per year.<br /> <br /> (1)&nbsp;&nbsp;&nbsp;&nbsp; According to the applicable Estate and Gift Tax Tables ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="921">921</a>), the present value of the annuity for Mr. White is $6,261 (10.9031 [annuity factor] &times; 1.0074 [annuity adjustment factor for semiannual payments] &times; $570 [the donor&rsquo;s annual annuity]) (Mr. White elected to use an interest rate for a month as explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="921">921</a> with an interest rate that is assumed to be 3.0&nbsp;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&nbsp;years that is adjusted to 15.8 (16 &ndash; .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 &ndash;.2).<br /> <br /> (2)&nbsp;&nbsp;&nbsp;&nbsp; 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 &times; 15.8). Of this principal amount, $79 is gain ([$6,261 &ndash; ($6,000 &times; ($6,261 &divide; $10,000))] &divide; [15.8 &times; 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 &ndash; $79), as return of adjusted basis.<br /> <br /> (3)&nbsp;&nbsp;&nbsp;&nbsp; The balance of each annuity payment, $87, is the amount that Mr. White must report as ordinary income ($285 &ndash; $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.</blockquote><br /> 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.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> 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.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> In a private letter ruling, the IRS approved of &ldquo;reinsured&rdquo; charitable gift annuities.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect; 1.1011-2(c) Ex. 8.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(b)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(b)(3).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; Let. Rul. 200742010.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 80-281, 1980-2 CB 282; Let. Rul. 8045010. <em><em>See also</em></em> IRC &sect; 2522(a) and IRC &sect; 2503(a).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp;&nbsp;&nbsp; Let. Rul. 200847014.<br /> <br /> </div></div><br />

<div class="Section1">Other than punitive damages, any damages received on account of personal physical injuries or physical sicknesses are not includable in gross income. This is true whether the damages are received by suit or agreement or as a lump sum or periodic payments.<a href="#_ftn1" name="_ftnref1">¹</a> For this purpose, emotional distress is not treated as a physical injury or physical sickness.<a href="#_ftn2" name="_ftnref2">²</a></div><br /> <div class="Section1"><br /> <br /> The phrase “other than punitive damages” does not apply to punitive damages awarded in a wrongful death action with respect to which applicable state law, as in effect on September 13, 1995, provides that only punitive damages may be awarded in such an action.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> The rule regarding emotional distress does not apply to any damages that do not exceed the amount paid for medical care, as described generally in IRC Section 213, attributable to emotional distress.<br /> <br /> If a lump sum payment representing the present value of future damages is invested for the benefit of a claimant who has actual or constructive receipt or the economic benefit of the lump sum, only the amount of the lump sum payment is treated as received as damages and excludable. None of the income from investment of the payment is excludable.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> Where damages are to be paid periodically and the person injured has no right to the discounted present value of the payments or any control over investment of the present value, the entire amount of each periodic payment is excludable, including earnings on the fund.<br /> <br /> Thus, where a single premium annuity is purchased by a person obligated to make the damage payments to provide that person with a source of funds, and the person receiving payments has no interest in the contract and can rely only on the general credit of the payor, the entire amount of each periodic payment is excludable.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> Under proposed regulations issued in 2009, damages for physical injuries may qualify for the Section 104(a)(2) exclusion even though the injury giving rise to the damages is not defined as a tort under state or common law. In addition, the exclusion does not depend on the scope of remedies available under state or common law. In effect, the regulations reverse the result in <em>United States v. Burke</em><a href="#_ftn6" name="_ftnref6">⁶</a> by allowing the exclusion for damages awarded under no-fault statutes.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 104(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 104(a).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 104(c).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     Rev. Rul. 65-29, 1965-1 CB 59; Rev. Rul. 76-133, 1976-1 CB 34.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.     Rev. Rul. 79-220, 1979-2 CB 74; Let. Rul. 8321017.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.     504 U.S. 229 (1992).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.     Reg-127270-06, 74 Fed. Reg. 47152, 47153 (9-15-2009); Treas. Reg. § 1.104-1(c)(2).<br /> <br /> </div>

<div class="Section1">If an employee, whether a regular employee or a self-employed individual, has no cost basis for his or her interest in a plan, the full amount of each payment is taxable to the employee as ordinary income.<a href="#_ftn1" name="_ftnref1">¹</a> If an employee has a cost basis for his or her interest in a plan, the payments are taxed as discussed below, depending on the employee&rsquo;s annuity starting date. To determine an employee&rsquo;s cost basis, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3968">3968</a>.<div class="Section1"><br /> <br /> The tax treatment is the same whether payment is made directly from a qualified trust or annuity plan or whether a trust buys an annuity and distributes it to an employee.<a href="#_ftn2" name="_ftnref2">²</a> Distribution of an annuity contract itself affects the tax on lump sum distributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="140">140</a>). If an employee has a cost basis for his or her interest, payments are taxed as discussed below, depending on the annuity starting date.<br /> <br /> For an employee who has a cost basis for his or her interest, and whose annuity starting date is after December&nbsp;31, 1997, the investment in the contract is recovered according to one of two schedules set forth in the IRC. For purposes of this rule, the employee&rsquo;s investment in the contract does not include any adjustment for a refund feature under the contract.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> These tables operate in the same manner as the simplified safe harbor announced in 1988.<a href="#_ftn4" name="_ftnref4">⁴</a> If an annuity is payable over one life, the payments will be taxed as described below for annuities with a starting date after November&nbsp;18, 1996. If the annuity is payable over two or more lives, the excludable portion of each monthly payment is determined by dividing the employee&rsquo;s investment in the contract by the number of anticipated payments, as follows:<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <table border="1" align="center"><br /> <tbody><br /> <tr><br /> <td width="259"><br /> <p style="text-align: center;"><strong>If the combined ages of the annuitants are</strong></p><br /> </td><br /> <td width="141"><br /> <p style="text-align: center;"><strong>Number of payments</strong></p><br /> </td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="259">110 and under</td><br /> <td style="text-align: center;" width="141">410</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="259">111-120</td><br /> <td style="text-align: center;" width="141">360</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="259">121-130</td><br /> <td style="text-align: center;" width="141">310</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="259">131-140</td><br /> <td style="text-align: center;" width="141">260</td><br /> </tr><br /> <tr><br /> <td style="text-align: center;" width="259">141+</td><br /> <td style="text-align: center;" width="141">210</td><br /> </tr><br /> </tbody><br /> </table><br /> According to the Conference Committee Report for TRA &rsquo;97, this table applies to benefits based on the life of more than one annuitant, even if the amount of the annuity varies by annuitant. It does not apply to an annuity paid on a single life merely because it has additional features, such as a term certain. In the case of a term certain annuity without a life contingency, the expected number of payments is the number of monthly payments provided under the contract.<a href="#_ftn6" name="_ftnref6">⁶</a> In the case of payments made other than monthly, an adjustment must be made to take into account the period on the basis of which payments are made. Two methods of making such an adjustment are set forth in Notice 98-2.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> For purposes of this rule, if an annuity is payable to a primary annuitant and more than one survivor annuitant, the combined ages of the annuitants is the sum of the age of the primary annuitant and the youngest survivor annuitant. If an annuity is payable to more than one survivor annuitant but there is no primary annuitant, the combined ages of the annuitants is the sum of the age of the oldest survivor annuitant and the youngest survivor annuitant. Any survivor annuitant whose entitlement to payments is based on an event other than the death of the primary annuitant is disregarded. For an explanation of the basis recovery rules under IRC Section&nbsp;72(d), see Letter Ruling 200009066.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&sect; 1.61-11(a), 1.72-4(d)(1); IRC &sect;&sect; 402(a), 403(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect; 402(a), 403(a)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect; 72(d)(1)(C), 72(c)(2); Notice 98-2, 1998-1 CB 266.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(d); Notice 98-2, 1998-1 CB 266.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(d)(1).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp;&nbsp;&nbsp; Notice 98-2, 1998-1 CB 266.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp;&nbsp;&nbsp; 1998-1 CB 266.<br /> <br /> </div></div><br />

<div class="Section1">If an employee has no cost basis for an interest in a plan, each payment, regardless of amount, is fully taxable as ordinary income. An employee&rsquo;s cost basis generally consists of any nondeductible contributions the employee has made to the plan and any employer contributions that have been taxed to the employee, other than excess deferrals ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3760">3760</a>) not timely distributed ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3968">3968</a>).<div class="Section1"><br /> <br /> When an employee has a cost basis for an interest in a plan and the annuity starting date is after June&nbsp;30, 1986, payments are taxed under the annuity rules as expressly applied to variable payments ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="550">550</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="552">552</a>). Thus, the amount excludable from an employee&rsquo;s gross income each year is determined by dividing the cost basis, adjusted for any refund or period-certain guarantee, by the number of&nbsp;years in the payment period. If an annuity is payable for a life or lives, the payment period is determined by the IRS annuity tables.<br /> <br /> For annuities with a starting date after December&nbsp;31, 1986, the present value of any refund feature is not to be taken into account in calculating the unrecovered investment in the contract, but these amounts still are taken into account in calculating an individual&rsquo;s exclusion ratio.<a href="#_ftn1" name="_ftnref1">¹</a> The unrecovered investment in a contract affects only those annuitants who die before the annuity payments end (i.e., the amount of their deduction on their final year return) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="567">567</a>) and the annuitant&rsquo;s cost recovery date (i.e., the date upon which the annuity holder recovers his or her investment in the contract).<br /> <blockquote><em>Example</em>. Mr. Mounger retired on August&nbsp;31, 2025 when he had reached age 65. He became eligible to receive monthly variable annuity payments for life under an earlier contributory pension plan of his employer. In the event of Mr. Mounger&rsquo;s death before receiving payments for at least five years, payments on the same variable basis will be continued to his beneficiary for the remainder of the five-year period. Mr. Mounger contributed $6,000 to the plan ($5,000 representing investment in the contract before July&nbsp;1, 1986; $1,000 representing investment in the contract after June&nbsp;30, 1986). Payments for the first year began in September, and during the last four months of the year, Mr. Mounger received a total of $640. Mr. Mounger elects to determine his excludable amount by making separate calculations for his pre-July&nbsp;1986 and post-June&nbsp;1986 investment in the contract. The value of the refund feature determined under Table VII of &sect;&nbsp;1.72-9 is not more than 50&nbsp;percent, and Mr. Mounger had only life annuity options available. On the basis of these facts, Mr. Mounger&rsquo;s annual exclusion from gross income will be $343.60. The first step is to adjust the investment in the contract for the value of the refund feature, as follows:</blockquote><br /> <table border="1" align="center"><br /> <tbody><br /> <tr><br /> <td colspan="3" width="484">Pre-July 1986 adjustment:</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Unadjusted investment in the contract</td><br /> <td style="text-align: right;" width="72">$5,000</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Allocable part of amount to be received annually (($5,000 &divide; $6,000) &times;</td><br /> <td width="72"></td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">$1,920)</td><br /> <td style="text-align: right;" width="72">$1,600</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Duration of guaranteed amount (years)</td><br /> <td style="text-align: right;" width="72">5</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Guaranteed amount (5 &times; $1,600)</td><br /> <td style="text-align: right;" width="72">$8,000</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Percentage in Table III for age 65 and 5 years</td><br /> <td style="text-align: right;" width="72">7%</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Present value of refund feature rounded to nearest dollar</td><br /> <td width="72"></td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">(7% of $8,000)</td><br /> <td style="text-align: right;" width="72">$560</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Adjusted pre-July 1986 investment in the contract ($5,000 &ndash; $560)</td><br /> <td style="text-align: right;" width="72">$4,440</td><br /> </tr><br /> <tr><br /> <td colspan="3" width="484">Post-June 1986 adjustment:</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Unadjusted investment in the contract</td><br /> <td style="text-align: right;" width="72">$1,000</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Allocable part of amount to be received annually (($1,000 &divide; $6,000) &times;</td><br /> <td width="72"></td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">$1,920)</td><br /> <td style="text-align: right;" width="72">$320</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Duration of guaranteed amount (years)</td><br /> <td style="text-align: right;" width="72">5</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Guaranteed amount (5 &times; $320)</td><br /> <td style="text-align: right;" width="72">$1,600</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Percentage in Table VII for age 65 and 5 years</td><br /> <td style="text-align: right;" width="72">3%</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Present value of refund feature rounded to nearest dollar (3% of $1,600)</td><br /> <td style="text-align: right;" width="72">$48</td><br /> </tr><br /> <tr><br /> <td width="11"></td><br /> <td width="401">Adjusted post-June 1986 investment in the contract</td><br /> <td style="text-align: right;" width="72">$952</td><br /> </tr><br /> </tbody><br /> </table><br /> Once the investment in the contract has been adjusted by subtracting the value of the period-certain guarantee, an excludable amount is determined by dividing the adjusted investment in the contract by the life expectancy taken from Table I or V. Taking the example above, the excludable amount is determined as follows:<br /> <table border="1" align="center"><br /> <tbody><br /> <tr><br /> <td width="443">Pre-July 1986 investment in the contract (adjusted for period-certain guarantee)</td><br /> <td style="text-align: right;" width="72">$4,440</td><br /> </tr><br /> <tr><br /> <td width="443">Life expectancy from Table I (male age 65)</td><br /> <td style="text-align: right;" width="72">15 years</td><br /> </tr><br /> <tr><br /> <td width="443">Excludable amount ($4,440 &divide; 15)</td><br /> <td style="text-align: right;" width="72">$296</td><br /> </tr><br /> <tr><br /> <td width="443">Post-June 1986 investment in the contract (adjusted for period-certain guarantee)</td><br /> <td style="text-align: right;" width="72">$952</td><br /> </tr><br /> <tr><br /> <td width="443">Life expectancy from Table V (age 65)</td><br /> <td style="text-align: right;" width="72">20 years</td><br /> </tr><br /> <tr><br /> <td width="443">Excludable amount ($952 &divide; 20)</td><br /> <td style="text-align: right;" width="72">$47.60</td><br /> </tr><br /> <tr><br /> <td width="443">Amount excludable from gross income each year ($296 + $47.60)</td><br /> <td style="text-align: right;" width="72">$343.60</td><br /> </tr><br /> </tbody><br /> </table><br /> In the case of an annuity starting date before November&nbsp;19, 1996, a simplified safe harbor method may be available ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="616">616</a>).<br /> <br /> With respect to annuities with starting dates prior to July&nbsp;1, 1986, payments are taxed under the annuity rules or under the three-year cost recovery rule ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>).<br /> <br /> Certain early (premature) distributions are subject to an additional tax ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3964">3964</a>).<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 72(b)(1), (2).<br /> <br /> </div></div><br />