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Monday February 24, 2020

Article of the Month

A Case for Charitable Gift Annuities


Individuals choose to interact with charities in various ways. Some will volunteer their time, others their talents and still more prefer to donate cash or other assets. Many donors live on a fixed income, but also have causes about which they care deeply. If a donor is contemplating a donation, but also likes the idea of receiving fixed payments for the donor or a loved one, a charitable gift annuity (CGA) is an option worth considering.

A strong CGA program will benefit charities and donors alike. Charities can enhance donor relations by offering CGAs. However, any organization that offers gift annuities will need to know how they work as well as best practices for gift annuity administration. This is the first article in a two-part series. This article will cover the basics of CGAs and threshold requirements to begin a CGA program. The next article will discuss the benefits of a CGA program for donors and charities.

Charitable Gift Annuity Basics


A CGA is a contract between a charity and a donor. The donor agrees to transfer cash or appreciated assets to charity and the charity agrees to pay fixed payments for the lives of one or two annuitants. Typically, the fixed payment is determined according to a suggested maximum payout rate based on the age of the annuitant.

The American Council on Gift Annuities (ACGA) was formed in 1927 to aid and educate charities regarding CGAs and other planned gifts. The nonprofit organization periodically publishes suggested maximum charitable gift annuity payout rates, which are followed by about 97% of organizations offering CGAs.

With a CGA, the donor can make a gift to a charitable organization, receive an income tax deduction in the year of the gift and receive fixed payments for life. The amount remaining at the end of the annuitant’s life, the residuum, then passes to charity. The ACGA suggested maximum rates target a 50% residuum to charity, thus making the standard ACGA rates popular with charities.

Types of Charitable Gift Annuities


The two major categories of CGAs are immediate and deferred annuities. Immediate gift annuities begin payouts within a year of the annuity’s funding date. Deferred CGAs begin payouts more than a year after the funding date. Deferred CGAs come in several varieties including flexible deferred and term of years deferred. Standard deferred CGAs simply have a predetermined fixed payout date that begins at a donor’s selected date that is at least one year after funding.

A flexible deferred CGA allows a donor to elect to begin the annuity payouts within a certain range of time at a future date. The donor will get a tax deduction in the year of the gift based on the target payout date. The annuity rate will also be determined according to the date on which the payouts begin. If the donor decides to take payments earlier than anticipated, the payouts will be lower; if he or she takes payouts at a later date than initially chosen, the payouts will be higher. This adjustment of the annuity payout rate allows the donor’s deduction to remain the same regardless of when the payouts begin.

In two private letter rulings, PLR 9042043 and PLR 9407008, the IRS allowed a deferred CGA to be commuted to a term of years. A term of years CGA must begin as a one or two life deferred CGA that is then elected to be taken over a term of years. This option for election must be written into the annuity contract at its creation and the annuity must be deferred for at least one year.

With a flexible deferred CGA, the annuitant must elect the term-of-years option prior to the annuity starting date. In such a case, the donor will receive the annuity payouts over the selected term of years. There is a 10% excise tax that applies to term payouts to beneficiaries under the age of 59 ½. As a result, the term of years CGA is utilized for individuals over that age. It is important to note that PLRs are only binding to the parties requesting the ruling. Still, PLRs may be helpful in understanding the probable position of the IRS.

State Law Considerations


Many states regulate gift annuities through the department of insurance. Each gift annuity contract is governed by the law of the state where the donor resides. Therefore, if a charity is located in State X, but desires to issue a CGA for a donor from State Y, the charity must make sure it is in compliance with State Y’s CGA requirements.

There are varying levels of state regulation of gift annuities. Generally speaking, there are four categories of state gift annuity regulation:

Registration states
A number of states require organizations to submit an application for a permit or license to issue gift annuities in their jurisdiction. These registration states require the charity to maintain a gift annuity reserve account. Reserve requirements vary by state. At the end of each year, registered organizations must provide an annual report on gift annuities held for annuitants in the state.

Notification states
These states have specific statutory requirements that must be met by organizations that wish to issue gift annuities. Once an organization meets these requirements and is ready to issue gift annuities in the state, it must notify the state, usually the insurance department, of the organization's intent to issue annuities in that state. These states usually require a specific number of years in existence for the charity and a specific amount of unrestricted assets.

Conditional exemption states
Some states require issuing organizations to meet their statutory requirements, but do not require notice to the state. As with notification states, there are usually requirements related to the charity’s time in existence and unrestricted assets.

Silent states
Certain states provide no express guidance or requirements at all. For these states, a charitable organization’s counsel will need to determine whether to move forward issuing gift annuities in the state.

Fixed Payments for Donors


The CGA is a general obligation of the charity and is backed by all of the charity’s assets. Because a CGA is a contract between the charity and the donor, the charity must make the annuity payments to the annuitant as agreed. The charity may be required to hold a certain amount in a segregated annuity reserve fund to pay its annuity obligations. This is required by law in some states, as mentioned above. Often, in states where there is not a reserve fund requirement, many organizations adhere to a best practice of investing a portion or all of the annuity funding value until the annuity contract ends.

If the charity’s annuity reserve fund is insufficient to pay the annuitants, the annuity amounts would be paid from the charity’s general endowment fund. All of the assets of the charity stand behind the annuity contract, including the buildings and land owned by the charity. This backing may give donors substantial peace of mind when deciding to create CGAs. Still, advisors should encourage their clients to research the financial stability of the organization with which they are considering establishing a CGA.

Necessary Disclosures


When a charity issues a gift annuity, it is required by the Philanthropy Protection Act of 1995 (PPA) to provide the donor “written information describing the material terms of the operation of [charitable common] funds.” The purpose of the PPA is to exempt charitable common funds, such as the reserve fund for CGAs, from the full requirements of securities regulation required by the Investment Company Act of 1940, but to still require an appropriate level of disclosure to the donor.

The “material terms” which must be provided to a donor are not clearly specified by the statute. However, the charity’s disclosure should enable a donor funding a CGA to know certain information related to the CGAs continued health. This information includes the amount of the charity’s endowment and the amount the charity holds in its gift annuity reserve fund. Because the CGA is a general obligation of the charity, the security behind a gift annuity is different from the structure and risks associated with an investment fund. However, gift annuities are specifically mentioned in Sec 2(a)(B)(iii) of the PPA, so good faith compliance with the letter and spirit of the Act is necessary.

Federal Income Tax Deduction


A CGA is a type of bargain sale. Regs. 1.170A-1(d)(3) and 1.1011-2(a)(4)(i). A bargain sale is comprised of a partial gift to charity, with a partial return of value to the donor. The donor receives a charitable income tax deduction for the value of the gift to charity. The donor transfers a sum of money or an appreciated asset in exchange for payments spanning the course of one or two lives. While the exact amount of the benefit to the donor and charity cannot be determined with certainty, because the annuitant’s lifespan is unknown, a present value calculation is done for the purpose of determining the amount of the donor’s deduction.

The present value calculation must adhere to IRS requirements, using the actuarial factors prescribed in Publication 1457. The calculation involves the Sec. 7520 applicable federal rate, the age of the annuitant, payment frequency and the annuity payout percentage to determine the present value of the remainder interest. This is the value of the donor’s deduction.

It is important to distinguish the residuum of the gift annuity from the present value of the remainder interest. While the present value of the remainder interest can be calculated at the time of the gift, the actual residuum depends on how long the contract exists.
Example:

Twins Steve and Sally each set up $100,000 gift annuities today. They each receive a charitable deduction of $40,000, the present value of the remainder interest. Steve passes away next week, before his first annuity payment is made. The charity withdraws the residuum of $100,000 from its annuity reserve account. Sally lives to the age of 95 and the charity receives a $35,000 residuum.

Starting an Annuity Program


An organization may choose to manage its gift annuity program in-house, use an independent provider such as a bank or other financial institution for investments and administration, or arrange for a community foundation to manage its program.

To start a CGA program, an organization must have sufficient financial strength, the right personnel who are able to dedicate time to the CGA program as well as a sufficiently deep pool of potential donors. If a charity is struggling financially, it may not be the right time to begin an annuity program. Annuitants count on the charity to make the agreed-upon annuity payments. If the issuing organization cannot make those payments, it could lead to hardship for annuitants as well as hard feelings toward the charity.

If a charity is unsure of whether to start an annuity program in-house, it could begin by partnering with a local or national community foundation that does issue CGAs. Due to the varied state regulations, it may prove to be a wise choice to use an established organization for issuing CGAs. Many charities will also outsource the administration of their CGA pool to allow a financial institution to take on the risk of investment and handle the administration, including payments and tax forms.

Ideal Donor Candidate


Charitable gift annuities are a great tool for charitably-inclined donors who desire fixed payments. The CGA rates may prove to be most attractive for donors in retirement and beyond. A younger donor may not qualify for a charitable gift annuity with the IRS due to the minimum deduction rules. The IRS requires that at the creation of the CGA, the charitable deduction is at least 10% of the funding value. Deferred annuities may be useful for younger donors.

Many charities have minimum age requirements for CGA annuitants. Charities should evaluate their donor demographics and look at the potential pool of annuitants before beginning a CGA program. According to the ACGA, young donors creating CGAs may be troublesome for both the donor and the charity. The fixed payouts to the donor will not increase over time, despite the rate of inflation, and the length of time the charity is required to make payouts could cause depletion of the original gift. In cases like these, a deferred annuity may fit the needs of the donor and pass the IRS rules.

The ACGA recommends that charities establish a minimum age for immediate and deferred gift annuities. According to the ACGA’s sixth national survey of charitable gift annuities in the past 24 years (2017 ACGA Survey), the average age of annuitants establishing immediate CGAs is 79, while 82% of donors funding immediate CGAs are 75 and above. In funding a two-life CGA, the minimum age should apply to the younger donor. Similarly, for deferred CGAs, the ACGA recommends that at the time payouts begin, the donor should meet the nonprofit’s minimum age for the annuitant of an immediate CGA.

According to the 2017 ACGA Survey, 25% of charities require an annuitant to be 60 years or older, 32% require the annuitant to be 65 or above and 6% require an annuitant to be at least 70. In this period of low IRS applicable federal rates, many younger donors will not pass the IRS requirements for their CGAs to qualify as charitable gift annuities.

Minimum Annuity Thresholds


Some charitable organizations require a minimum funding amount for CGAs. One popular threshold for funding a CGA is $10,000. In the past this amount was closer to $5,000. However, newer charities should take into account costs to manage CGA administration. These costs include paying someone to oversee the program, investing the funds, cutting the checks to annuitants and tracking the annuities’ growth. According to the 2017 ACGA Survey, 59% of charities have a minimum funding amount of $10,000 to $24,000, 13% require $25,000 or more and 28% allow for funding a CGA with less than $10,000.

Conclusion


Charitable gift annuities may be an attractive option for a donor who wishes to make a charitable gift, but also wants to ensure a fixed stream of payments over his or her lifetime. A charitable gift annuity involves a relatively simple and straightforward contract between the donor and a charity. There are many ways to manage a CGA program, and charities would be well-advised to consider the benefits offering CGAs may provide to their organization and to donors as well.

Published February 1, 2020
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