Moving Beyond Securities to Fund CGAs & Into the Fun Stuff!

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Moving Beyond Securities to Fund CGAs & Into the Fun Stuff!

I. Funding a CGA with life insurance

a. Profile of a typical CGA donor with life insurance as the funding asset

After three months of discussing funding a $200,000 charitable gift annuity with cash, the donor says, ―I have this old life insurance policy that I don’t need for my family’s protection anymore. I’d like to give it to you. It’s worth about $500,000 and the cash value is $200,000. Can I use this for the CGA instead of writing a check?‖

The answer is maybe.

Where do you turn for help? First, look to your gift acceptance policy (assuming your organization has one; if it doesn’t, that’s a whole other presentation topic for another day). Look to the section on charitable gift annuities. Are there any prohibitions against using a life insurance policy to fund a CGA? If not, be sure to check the section on outright gifts of life insurance. If there are

restrictions on life insurance in the outright gift section, it may well be that your organization won’t want to accept life insurance for a CGA.

The next place to check if you are still unsure is with your organization’s gift acceptance committee, if you have one. Before you approach the committee (or whoever makes those decisions at your organization), do a little homework about what type of life insurance policy it is, how much it is worth, etc. Ask the donor to provide you with a copy of the actual life insurance policy, the last annual statement, and if possible, an up-to-date policy illustration.

b. Understanding the many types of life insurance

Life insurance policies come in many variations. The general categories are:

Whole life

This type of policy has guaranteed cash value growth and guaranteed death benefits. It pays dividends. Dividends can increase the cash value and eventually will increase the death benefit. Premiums are fixed and guaranteed not to increase throughout the life of the policy. Note, however, that if the whole life policy has term insurance mixed in with it, then all of the previous statements about whole life will probably not hold true when it’s mixed with term.

Universal life

Universal life is a variation of life insurance that came into place in the early 1980s. It is a ―cash value‖ type policy similar in some ways to whole life. Universal life, however, specifically declares to the policy owner at the beginning of each new policy year:

 the interest rate it will credit on the cash values,

 mortality charges and

 expense charges.

In contrast, a whole life policy does not specifically state these rates and charges; they are bundled together so the policy owner is not able to figure out each specific charge or expense—it’s just a lump sum premium amount. Neither the formula for the annual premium nor the dividend is disclosed.

With universal life, the amount of the specific charges can change each year, so the policy owner can never truly know how much the policy will cost in the future or if he/she will be able to afford the policy. What it states, however, are the maximum charges that can ever be assessed and the current rates and charges for the upcoming year.

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Variable life

This is a newer product than universal and whole life. It works much like universal life insurance in that the various expenses are specifically stated. It does not pay a specific rate of interest. Instead, the policy owner can invest the cash value in various subaccounts similar to mutual funds. It takes the investment risk to earn interest and moves it from the insurance company to the policy owner.

Term life

Term insurance is the most simple and straightforward type of policy. It generally has a fixed death benefit. An owner can purchase one-year term insurance that says for one year you can have $X amount of death benefit for $Y premiums. Every year thereafter the premium increases with age, but the death benefit remains at $X. Some term policies are called 10-year term in which the premiums are guaranteed to remain the same for a 10-year period, and, of course, so is the death benefit. After the 10-year period, the premiums can increase yearly. Likewise, a 20-year term policy guarantees a level premium/death benefit for the first 20 years.

Term life insurance has zero cash value which is its major differentiating feature from the cash value policies described above.

Are you thinking, “If term life insurance has zero cash value, how can a donor offer it in

exchange for a CGA?” Good question. Let’s just say your organization wouldn’t want to accept

that. There is no cash value so there is no gift amount of any kind today. Zero. There is only the hope that the term insurance will stay in force and pay a death benefit when the donor dies. It would be like accepting a revocable bequest in the future for a CGA today. Don’t do it. So for discussion sake, we aren’t talking about term life insurance in exchange for a CGA.

Equity indexed life

This is the newest of all types of life insurance policies and was first introduced between 1990 and 1992. It does not directly allow the policy owner to invest the cash value in subaccounts like variable life. Instead, it credits interest based on the performance of a third-party benchmark like the S&P 500 or other well known indices. The actual cash value is not invested in the S&P 500; the index is just used as a benchmark for how much interest the insurance company will add to the policy’s cash value. If the S&P 500 grows in value over the year, the same percentage of growth will be credited to the cash value (minus fees and expenses, of course). If the S&P 500 happens to decline in value over the year, the cash value probably wouldn’t decline, but it wouldn’t grow that year either.

c. Your charity’s risks of accepting life insurance for a CGA

There are several risks that your charity should consider beyond the normal risks associated with a CGA funded with cash. One is the fact that your organization will have to find another source for making the payments to the CGA annuitant since you would not want to access the cash value of the insurance policy to make the CGA payments. That would eventually cause the policy to lapse.

Another risk is the strength of the life insurance policy itself. If you plan to keep the policy as an investment (I’m not saying you should), then you have to look at how the policy has performed in terms of interest earnings and expenses and what it might earn in the future. Consider how much interest earnings you anticipate will be added to the policy until the time of the donor’s death, when the donor will die (how will you know this?), and how much it will cost between now and then to own this policy.

Another consideration is how well funded the policy has been until now. For any policy other than term and pure whole life, there is a range of premiums that can be paid; the thinner the premiums, the more the risk of the policy lapsing and vice versa. The worst-case scenario for your

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organization would be accepting a life insurance policy and then having to use your organization’s own funds to dump additional premiums into it just to keep it from lapsing.

Compare the future estimated (projected) interest earnings to what your investment committee might be able to earn. Recall that CGAs should be invested with a 4.25% (net) per year earnings projection. Can your organization do better than the life insurance company?

Another risk to your charity is the strength (or lack thereof) of the insurance company that issued the policy. If the insurance company isn’t financially sound, the insurer could go under, leaving your policy exposed to bankruptcy. Be sure to perform due diligence on the insurance company if your organization wants to keep the policy as an investment.

Side note: Consider obtaining your due diligence information from unbiased or independent sources.

If the policy has a loan against it, your donor will need to extinguish the loan prior to any transfer to your organization. Any policy with a loan against it may result in a disallowance of the charitable deduction.

d. Should your institution keep the policy or surrender it for the cash value?

Life insurance isn’t an investment. It is insurance to protect against the risk of someone dying prematurely. If your donor dies before his/her life expectancy, you will probably make more net money on the policy if you keep it. However, if the donor lives beyond his/her life expectancy, your investment committee may easily do better financially if you surrender the policy right away and invest the cash from the surrender. The trouble is—you don’t know when the donor is going to die. Do you need insurance for a premature death? If so, keep the insurance. If not, your board should consider its ability to invest on their own.

Example: Should you keep the policy or cash it in

Bob is 74. He has a $500,000 insurance policy with a fair market value of $290,000. Do you keep the policy or cash it in? Well, if Bob dies in 6 years, you are better off keeping the policy. But you aren’t going to know at the beginning when Bob is going to die. If Bob lives to 104, you might have been better off cashing in the policy and investing the money on your own. Insurance makes sense when you need to insure Bob’s premature death.

Are there other options? Yes, another option exists besides surrendering the policy to the insurer: the option is a controversial segment of the life insurance industry, called life settlements, in which a policy owner sells a policy to a third party investor for more than the current cash value, but less than the face amount. The insured does not need to be terminally ill. If your institution is considering this, check into it thoroughly and consult independent sources to discover all the pro’s and con’s before proceeding.

e. How does your charity surrender the policy for cash?

If your charity has already accepted ownership of the life insurance policy (meaning the policy was transferred from the name of the donor to the name of your charitable organization), then your charity can surrender the policy for its current cash value. How? Your charity contacts the life insurance company and requests the appropriate paperwork necessary to surrender the life insurance policy for its current cash surrender value. Once this paperwork has been completed and signed by the appropriate official at your charity with authority to conduct the transaction, the insurance company could take weeks or even months to process your check. From the insurance company’s standpoint, they will want to take as long as possible to let go of the funds. You just need to be aware of this. They may also send you paperwork asking you to rethink your decision or they may send an agent out to pay you a visit in person. It’s called conserving the business.

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f. Life insurance valuation

The value of the life insurance ―asset‖ depends on the premium structure of the life insurance policy. There are three options:

1. The life insurance policy that is newly issued

2. The policy that has additional premiums to be paid in the future (most common) 3. Policies that are contractually guaranteed to be paid-up for the life of the policy or was

funded with a single premium (You will only see guaranteed paid-up with pure whole life policies without any term element whatsoever.)*

*Many people get confused between a policy in which future premiums are not anticipated and those in which it is guaranteed that no further premiums will be due, which is paid-up. In the 1980s, insurance companies said premiums had ―vanished‖ when they really hadn’t, which created class action law suits galore. If the policy comprises only whole life (and no term), the owner can pay enough premiums in advance to make the policy contractually paid-up, meaning no further premiums will ever be assessed. Universal life, variable life and equity-indexed policies can never truly reach paid-up status, regardless of what the donor tells you or his/her agent says.

Newly issued policy

The charitable deduction for an outright gift of a newly issued policy is the lesser of the premiums paid or the policy’s fair market value. The fair market value is defined as the first premium paid. So, in essence, the deduction is based on the premiums paid since policy inception. Therefore, use the premiums paid for a newly issued policy as the value of the donated asset to determine the ultimate deduction for the CGA.

Ongoing premiums

The deduction for an outright gift of this policy is the lesser of premiums paid or the fair market value of the policy. Fair market value is the interpolated terminal reserve amount plus unearned premium. It is similar to, yet different from the cash value. You can obtain the interpolated terminal reserve /unearned premium value from the life insurance company. Typically, the insurer will provide this number upon request on an IRS Form 712 Life Insurance Policy Statement.

Paid-up premiums/single premiums

The fair market value of an outright gift of a paid-up life insurance policy or a true single premium policy is the lesser of premiums paid or the fair market value. Fair market value is the replacement value of the life insurance policy. The replacement value is based on what a single premium would be for a new policy issued today based on the current age of the insured at the same face amount as the original policy.

g. Illustrations/tax issues

In our example at the beginning of this section, Bob had a premium paying, whole life policy with a fair market value of $290,000 and a death benefit of $500,000. His cost basis was $215,000. Let’s say you need to run a CGA illustration for Bob. What would you enter for the amount of the asset? Use fair market value. Do not enter the face amount of the life insurance policy.

When you enter that information into the computer program to calculate the deduction, be sure to enter Bob’s cost basis into the correct field. The cost basis is the total premiums paid to date, less any dividends the policy owner received in cash from the insurance company and less any partial surrenders (it is rare that policy owner’s take their dividends in cash). This does not include dividends that were used to increase the cash value.

There is no taxable event to the donor when he/she transfers the ownership of the life insurance policy in exchange for a gift annuity. This is unlike the situation where a commercial annuity is transferred to a charity.

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With a life insurance policy as the funding asset for a CGA, there will be only two taxation tiers for the payments: ordinary income and tax-free return of principal. No part of the CGA payments is taxed as long-term capital gain for a CGA funded with life insurance.

h. Example: Bob’s life insurance to fund a CGA

Calculation values provided courtesy of PG Calc’s Planned Giving Manager software.

i. Should the donor surrender the policy for cash before funding the CGA?

Let’s look at Bob’s situation above. If Bob surrenders the life insurance policy, he will have a taxable event on the amount of its value over the cost basis, or in this case, $75,000. But, his income tax deduction is $33,228.75 higher with the cash gift ($128,484.50 - $95,255.75). His gift annuity payments will be taxed more favorably with the cash gift because of the higher cost basis with the cash gift than the life insurance gift -- he receives $3,188.69 more in tax–free income. He would need to live more than 13 years to receive enough tax–free income from the CGA to offset the taxable income from cashing in the insurance.

Bob’s date of birth

10/1/1935

Face amount of life insurance

$500,000.00

Cost basis

$215,000.00

Fair market value of life insurance (premium paying, whole life valued at interpolated terminal reserve plus unearned

premium)

$290,000.00 $215,000

CGA payment rate 6.1%

Income tax charitable deduction based on lower of fair market value or cost basis, quarterly payments and 3.4% CMFR

$95,255.75

CGA payment information

Income tax–free portion of payment Long-term capital gain income portion of payment

Ordinary income portion of payment

Total annual annuity payment

$9,141.15 $0 $8,548.85 $17,690.00

After 13.1 years, the entire payment is taxed as ordinary income.

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Example: Bob surrenders life insurance for cash to fund a CGA

j. Miscellaneous issues Appraisal

If the deductible portion of the gift is worth more than $5,000, an appraisal will be required for the life insurance policy. Where do you get a qualified appraisal? The IRS will not recognize an IRS Form 712 Life Insurance Statement from the issuing life insurance company as a qualified appraisal. Check third-party businesses that perform these appraisals for charitable gifts of life insurance, such as:

Bryan Clontz 3713 Pine Street Jacksonville, FL 32205 Phone: 404-375-5496 Fax: 435-603-4546 [email protected] www.charitablesolutionsllc.com Steve Briggs

Petra Life Insurance Consulting 200 Union Hill Drive, Suite 101 Birmingham, AL 35209 Phone: 205-414-9955 Fax: 205-414-9957 [email protected] www.petralife.com

Bob’s date of birth

10/1/1935

Cash

$290,000.00

Taxable event from surrender of the life insurance policy $75,000.00 $215,000

Income tax charitable deduction based on quarterly payments and a 3.4% CMFR

$128,484.50

$12,329.83 $0 $5,360.07 $17,690.00

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Alan Breus

The Breus Group, LLC 144 South 3rd Street, #104 San Jose, CA 95112 Phone: 408-297-6302 Fax: 408-297-6303 [email protected] www.thebreusgroup.com

Note that if the donor cashes in the policy to fund the CGA with cash, a life insurance appraisal is not required because it is a cash gift, not a gift of life insurance.

Receipt/IRS Form 8283

Provide the typical receipt for a charitable gift annuity, but describe the policy in detail. For example: A Prudential Life Insurance Company; whole life policy; policy #AJX738949; face amount of $500,000; cash value of $278,000; issued 9/1/1990; insured, John A. Doe; policy owner, John A. Doe. Be sure your receipt does NOT say, ―No goods or services were given in exchange for this gift.‖ It can say, ―No goods or services other than the charitable gift annuity payments will be given in exchange for this gift.‖ Also provide IRS Form 8283 where appropriate.

Campaign credits

What amount will you (soft) credit the donor if the gift is for a campaign? There is no standard rule or guideline for planned gifts in comprehensive or capital campaigns (some use cash surrender value, the deductible amount, the face amount, etc.). Check with your campaign counting guidelines that your organization put together at the start of the campaign. If you don’t have any, see the Partnership for Philanthropic Planning’s white paper, ―The Guidelines for Reporting and Counting Charitable Gifts.‖

II. Funding a CGA with real estate

a. Profile of a typical CGA donor giving real estate as the funding asset

Much like we’ve seen in the previous section with life insurance, a donor might come to you well into the gift cultivation process and bring up real estate as the funding asset. For example, say you’ve been working with a prospect to complete a $200,000 charitable gift annuity. You’ve discussed cash as the funding asset for the past three months. Then the donor might say to you, ―I have some real estate that has become more of a problem to me than it is worth. I’d like to use that to fund the gift annuity. It’s probably worth about $200,000 if I were to put it on the market today. I’m sure I could get that much for it although I haven’t had it appraised for about 10 years. Can I use this instead of writing a check for the charitable gift annuity?‖

The answer is maybe.

Again, as with the life insurance, first look to your gift acceptance policy’s section on CGAs—are there any prohibitions against using real estate to fund a CGA? If nothing is there, look to the section on outright gifts of real estate. Does your organization even accept gifts of real estate? If the answer is still unclear, check with your organization’s gift acceptance committee once you have a bit more information about the proposed real estate.

b. Your charity’s risks of accepting real estate in exchange for a CGA

Accepting real estate for a CGA is a huge risk. The risk is that you’ll get less for the real estate once you sell it than it was worth when you established the CGA. The main concern is, therefore,

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how much your institution can sell the land for and equally as important is how quickly you can sell it. Obviously, you’ll need to do the normal amount of due diligence on the real estate BEFORE accepting it: examining the property (both physically and legally), zoning issues and environmental checks just to name a few. You’ll need to know who owns it. Is there a mortgage— you’ll want to be sure the proposed real estate has no debt or mortgage encumbering it.

What is the donor’s cost basis? Plus, your organization will need to have another source of liquid funds to make the gift annuity payments before you sell the real estate.

An organization cannot accept real estate for a CGA and delay making CGA payments until the charity sells the land. The charity can do a deferred CGA until a certain date, but not a date dependent upon when the land sells. In that scenario, a FLIP charitable remainder unitrust may make more sense.

c. Should your institution keep the real estate or sell it?

The answer to this question depends on whether or not the real estate is valuable to your

organization to use now or in the future. The location of the proposed real estate will have a large role in the answer to that question. Only your organization can answer that.

d. Valuation

Valuation is important because your organization hasn’t liquidated the real estate before it must begin making payments. The value of the land is the land’s current fair market value as of the date of the gift. An appraisal will tell you the value. Even if the donor has his/her appraisal (that he/she paid for), consider that proper due diligence requires your organization to obtain its own appraisal.

Use the appraised value to determine the income tax deduction and the amount of the gift annuity payments. Do not use the value of the land once it is sold. The value here is not a negotiated value between you and the donor. This is true even if you are deferring the payments for a year or more.

Provide the typical receipt for a charitable gift annuity, but describe the real estate gift in detail with the owner’s name and legal description of the property. Be sure your receipt does NOT say ―No goods or services were given in exchange for this gift.‖ It can say, ―No goods or services other than the charitable gift annuity payments will be given in exchange for this gift.‖ Also provide IRS Form 8283 where appropriate.

As stated under the life insurance section, you’ll need to determine the amount you will credit the donor (soft credit for donor recognition purposes). Will you credit them with the full amount of the real estate gift, or the present value of the future interest, or some other amount? There is no standard rule or guideline for planned gifts in comprehensive or capital campaigns. Check with your campaign counting guidelines that your organization put together at the start of the campaign. If you don’t have any, see the Partnership for Philanthropic Planning’s white paper, ―The

Guidelines for Reporting and Counting Charitable Gifts.‖

e. Should you adjust the land’s value to reduce your risk?

Let’s say your boss agrees to accept the real estate but at a value less than your institution’s appraisal shows. Should you arbitrarily establish a lower value of the land to reduce your institution’s risk that the land will not be sold for some time, or that it will bring a value much lower than the current appraisal states? In other words, if the donor’s appraisal states the real estate is worth $1,000,000, should you agree to do a gift annuity based on the land being worth $850,000? What you should do is negotiate a lower gift annuity rate with the donor (subject of course to any state law restrictions against it). So, if the normal rate for the donor/annuitant is 7.3%, you instead could negotiate a rate of say 6.5%, assuming your donor agrees to it.

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Take the current fair market value and reduce that amount by the expected selling costs and real estate agent commissions. Let’s say that totals 10%. In the above example, reduce $1,000,000 by 10% and you get $900,000. Determine the dollar amount of a current CGA payment based on $900,000. Then offer that payment amount (not the rate), but offer a 2-year deferred starting date for payments.

f. State law issues

Speaking of state law…check to see if there are any state law restrictions against accepting real estate in exchange for a CGA. New York comes to mind. In the best case scenario, the donor’s attorney will draft the deed giving the property to your organization. The attorney should be licensed in the state where the property is located to be able to identify any state law issues with the property or its transfer.

You’ll also want to be sure that if the particular state required your institution to submit or disclose its CGA rate schedule, that you have the ability to offer a gift annuity rate lower than what’s on the schedule.

g. Should both your organization and the donor obtain independent appraisals?

Your donor has to obtain an appraisal for the real estate to support the charitable deduction. If your donor wishes, he/she may voluntarily choose to provide a copy to you. However, this is

completely voluntary on the part of the donor. In other words, the donor doesn’t have to share the appraisal with you.

As mentioned earlier, regardless of whether the donor provides you with a copy of the appraisal, your organization should obtain its own independent appraisal.

h. What if the donor’s appraisal is higher than your organization’s?

If the donor’s appraisal is more than a little different than your organization’s, you’ve got some delicate dance moves to make, like diplomatically stating that your organization will need to use its appraisal, not the donor’s.

i. Illustrations/tax issues

Take the appraised value and use that as the fair market value of the donated asset. Obtain the cost basis from the donor. Determine whether the donor wants payments to begin immediately or if he/she will accept a deferred payment gift annuity.

j. An example

Mary who is age 65 gives you a $130,000 piece of real estate in exchange for a CGA. Her cost basis is $85,000. Her rate is 5.3% or $6,890. Assuming a CMFR rate of 3.4% and annual payments, Mary’s charitable income tax deduction will be $44,151.90. She avoids paying immediate capital gains income tax on the difference between $130,000 and $85,000. However, the capital gain will be spread ratably over the lifetime of the donor because she is the owner of the property and is the annuitant. In this case, the long-term capital gain of $29,716.65 is reported over 19.5 years, the expected lifetime of the donor/annuitant.

If you offer Mary a two year deferred CGA and offset the value based on 10% sales commissions and other costs, she would receive a rate of 6.0%, or $7,020, starting in two years.

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Example: Mary gives real estate in exchange for an immediate payment CGA

Calculation values provided courtesy of PG Calc’s Planned Giving Manager software. Valued of donated property $130,000.00

Cost basis

$85,000.00

CGA immediate payment rate (you can always negotiate a

lower rate with your donor) 5.3%

Income tax charitable deduction based on lower of fair market value or cost basis, immediate annual payments and a 3.4% CMFR

$44,151.90

CGA immediate payment information

$2,878.69 $1,524.02 $2,487.29 $6,890.00

Example: Mary gives real estate in exchange for an 2-year deferred payment

CGA

CGA 2-year deferred payment rate 6.0%

Income tax charitable deduction for 2 year deferred $48,758,58

2-year deferred CGA payment information

Payments based on 90% of $130,000 or $117,000

$2,896.80 $1,090.56 $3,032.64 $7,020.00

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III. Funding a CGA with the remainder interest in a gift of a personal residence/farm with a retained

life estate

a. See Section II

Please be sure you have read everything in Section II about the risks of accepting real estate before reading this section.

b. Additional risk of accepting the remainder interest in a personal residence/farm in exchange for a CGA

Even more risky than a gift of real estate in exchange for a CGA is the acceptance of the

remainder interest in a personal residence (could be a second home or a vacation home) or a farm (where a life estate is retained by the donor or someone else) in exchange for a charitable gift annuity. Why? Because with an outright gift of real estate your organization has the ability to sell the property at once and then have cash in hand to make the gift annuity payments. So, even if it takes two years to sell the real estate, you only have to come up with payments from another source for a two-year period.

But with the remainder interest in property, your charity cannot sell the real estate for quite some time because the donor (or someone else named by the donor) has retained a life estate (it can be a fixed term period instead of life) in that property. Therefore, your charity cannot take possession of the property or sell it until all the people holding the life estate are deceased or the term has otherwise expired. So it could be 20 or more years depending on the ages of the people holding the life estate. Sure, once the house is sold you can replenish the source that you tapped into to make the gift annuity payments, but in the meantime your CFO has had a heart attack. Hence, having to have another source of funds from which to pay a lifetime of gift annuity payments, plus the unknown of how much the property will sell for in the future can make this a huge financial risk to your charity.

The other risks are the basic risks associated with accepting a gift of a remainder interest in property, including the donor not maintaining the property during the life of the life tenant and any liability issues. Consider the problems created if your life tenant goes into a nursing home and lets the property deteriorate and is unwilling to sell his/her remaining life estate to your organization. After all, you aren’t putting out any of your own money or assets at much risk by accepting the retained interest in the property. The problem is you can only sell the property for what it is worth after the death, or term, of the life tenant, and if the tenant doesn’t keep up the real estate’s value, or if the market tanks, your organization gets a piece of property worth a lot less than you might have anticipated.

Your organization should have a separate agreement with the donor that covers:

 the identification of the life estate holders,

 the specific term,

 the responsibility of the donor to pay the real estate taxes and insurance,

 that the donor must properly maintain and repair the property, and

 what should happen to the property in the event the donor enters a nursing home or other such contingencies.

The deed itself will give title to the charity but it will be subject to a life estate in the donor (or other named individuals).

As stated earlier with gifts of real estate, the donor’s attorney should prepare the deed and be licensed in the state where the property is located to be able to identify any state law issues with the property or its transfer.

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c. Illustrations

Illustrating this type of gift is a two-step process. First, calculate the gift of the retained life estate; second, calculate the CGA funded with the remainder interest of the first gift.

d. Example: retained life estate

Helen who is age 78 gives you her $225,000 home subject to a life estate in exchange for a CGA. Her cost basis is $100,000. Assuming the gift was made in August 2009, and using a CMFR rate of 3.4%, if the house is worth $200,000 and the land $25,000, the charitable deduction is $146,667. This represents the amount of the future interest in the property; the difference of $78,333 represents the value of her life estate.

Helen doesn’t actually take the charitable deduction of $146,667, but instead uses this amount to fund a CGA. When illustrating the CGA payments, use this figure for the value of the asset being donated.

The amount of the charitable deduction she can actually take for this combination gift is the deduction calculated for the CGA or $72,520.96 (see Step 2) on next page.

Example: Helen funds a CGA with the remainder interest in her home

Cost basis

To determine the cost basis for the CGA, you take the total cost basis of the home and divide it by the total value of the home ($100,000 / $225,000 = .444).

Next take that number and multiply it by the amount used to fund the gift annuity (.444 x $146,667 = $65,120).

Next take this number and add $250,000 or $500,000 for the exclusion of capital gain on the home depending on the marital status of the donor ($65,120 + $250,000 = $315,120).

In this case, the capital gain is a non-issue because homeowners can avoid

any long-term capital gains tax on the first $250,000 of gain in a primary residence ($500,000 for married couples). So, because this is the donor’s primary residence and the capital gain is under $250,000 (assume our donor is single), capital gains tax in this example is not an issue. Hence, the taxation of the CGA payments falls under just two tiers: income tax–free and ordinary income.

Step 1: Value of Helen’s home

$225,000.00

Cost basis of Helen’s home

$100,000.00

Present value of the remainder interest based on a 3.4% CMFR

$146,667.00

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CMFR

For a retained life estate gift, normally the lower the CMFR, the larger the charitable deduction; for a CGA, the higher the CMFR, the larger the deduction. Do you need to use the same rate for both calculations? Can you use the lowest rate for the retained life estate and the highest rate for the CGA? For example, can you compute the retained life estate gift using let’s say the June 2009 rate of 2.8 and the CGA using the August rate of 3.4? Is there any authority for this? I’m not aware of any authority preventing this approach. However, the donor’s tax professional should make the final call.

IV. Funding a CGA with a commercial annuity

a. Profile of a typical CGA donor using a commercial annuity as the funding asset

People purchase commercial annuities from life insurance companies as investments for future retirement income. With the recent economy, many annuity purchasers have been disenchanted with low-interest earnings on their annuities. If they decide to cash in these poor performing assets, taxable events occur if the annuities are worth more than what they paid for them. Both of these situations lead to commercial annuities being frequently proffered as a charitable gift. Hence, gift planners need to know enough about commercial annuities to answer the following typical donor questions:

1. Should I give my commercial annuity to your organization now, and will I receive a tax deduction?

2. Is it better for me to use my annuity to fund a charitable gift annuity, or should I cash it in and use that cash to fund the CGA?

3. Can I do an income tax–free exchange from my commercial annuity to a CGA (under IRC Section 1035)?

Step 2: CGA payment rate (you can always negotiate a lower rate with your donor)

6.7%

Cost basis of the remainder interest $315,120 (capped at $146,667)

Income tax charitable deduction for the CGA based on annual payments and a 3.4% CMFR

$72,520.96

$7,340.54 $0 $2,486.15 $9,826.69

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b. Just what is a commercial annuity anyway?

A commercial annuity is an investment made via a contract between the annuity owner and the insurance company. Commercial annuities are investments usually made by those over the age of 50. There is no magic number about age 50. It’s just that the younger generations have little if any interest in purchasing retirement income products with after-tax dollars.

Commercial annuities can be categorized by whether the payments are in deferred status or whether the payments to the annuity owner have already begun.

 A deferred annuity is purchased when the owner wants to give the insurance company a

lump sum of money ideally, but not necessarily, for future retirement income. The owner expects his/her lump sum to grow every year as the insurance company invests it and credits it with interest earnings.

 An immediate annuity is also funded with a lump sum of money, but the payments to the annuity owner begin immediately. Interest is not credited each year. Instead the annuity owner receives a fixed amount for a period of time. The fixed amount doesn’t change from year to year. The owner merely has a right to a stream of payments with no cash value or ability to cash it in.

The deferred annuity can be turned into an income stream (an immediate annuity) at any point, including retirement. While this is the theory behind annuities, industry studies show that only about 1% of all deferred annuities are actually annuitized. The majority of deferred annuities are kept in ―deferred‖ status, allowing their values to continue growing, yet allowing the owner to annuitize whenever he or she wants or needs to.

The type of annuity your institution will be offered is the deferred annuity. This type of annuity has a cash value that can be booked as an asset on the charity’s books. Immediate annuities, however, are seldom, if ever, transferable by the annuity owner or commutable into a lump sum.

For purposes of this paper, the discussion of annuities is limited to non-qualified annuities. These are annuities funded with after-tax dollars. This paper will not address qualified annuities funded with IRAs, 401(k)s, 403(b)s, etc.

c. Annuity basics

Before we begin to answer the three main questions from Section IV(a), let’s begin with a general understanding of the various types of deferred annuities your institution may be offered.

One of the ways deferred annuities can be categorized is by how the insurance company determines the annuity’s interest earnings each year. Your donor may refer to it by one of the interest crediting techniques, so it’s good to have general knowledge of the lingo. The most popular methods of crediting interest are fixed interest, equity-indexed and variable interest annuities.

Fixed interest

This type of deferred annuity is the most basic variety. Once each year on the anniversary date of the annuity, the insurance company will declare what rate of interest it will pay for the upcoming year—for example, it might declare that it will pay 4%. The company does not explain how it determines the annual rate. As a consumer protection feature, each annuity contract will state a minimum amount of interest that can be credited each year, called a guaranteed interest rate—for example, 2%. Therefore, the insurance company’s current rate is 4% and the guaranteed rate is 2%. You don’t get both the current and the guaranteed rate. It’s just that the current rate the

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company offers cannot fall below the guaranteed rate. Approximately 20% of all annuities are fixed interest annuities.

Equity-indexed

The equity-indexed annuity is the newest of the three types of interest-crediting techniques. The annuity is still credited with interest earnings, but the insurance company looks to an outside source to determine the amount of interest credited. Common outside sources are the S&P 500 Index, Lehman Brothers Aggregate Bond Index, the Dow Jones Industrial Average, etc. Neither the annuity owner nor the insurance company actually invests the owner’s money in the particular index—this is a commonly misunderstood element of the annuity. The insurer simply uses the S&P 500 Index in a formula to determine the level of interest that the insurance company will credit to the annuity. Approximately 15% of all annuities are equity-indexed annuities.

Variable interest

Variable annuities are the third method for insurance companies to credit interest to a deferred annuity. A variable annuity offers the owner two major investment selections for the lump sum: a general account and a separate account. The general account offers guarantees of principal and interest, and the separate account offers many subaccounts that act similar to mutual funds. The purchaser of the annuity can select how he/she wants the annuity money invested in these choices. Since the purchaser takes on some of the investment risk by having the right to choose the various investment options—and incidentally he/she can actually lose money—this type of annuity is regulated more heavily than the prior two. Approximately 65% of all annuities are variable annuities.

Surrender

Annuities can be surrendered prior to retirement or prior to the maturity date (typically age 95) stated in the contract, allowing the annuity owner to receive the balance in the annuity. The amount of the balance depends on several variables, including whether the annuity is inside or outside of the surrender charge period.

Surrender charges occur if the annuity owner surrenders the annuity within the surrender charge period (which could be any length of time usually from seven years to 15 years). The charge is a penalty assessed against the amount the owner would receive. For example, if Jack’s annuity value was $55,000 and the company had a 10% surrender charge, then Jack would receive $55,000 minus $5,500, or $49,500.

But, if Jack transfers the annuity to your institution instead of surrendering it for cash, the surrender charge would not be assessed upon transfer. In other words, your institution would receive the annuity with an accumulation value of $55,000. Now, it is important that if your institution decides to surrender the annuity, then your proceeds would be subject to surrender charges. In this example, if Jack transferred the annuity to your institution and within the same policy year your CFO asked the annuity company to surrender it, your institution would only get the $49,500 because of the surrender charges.

Example: Surrender of a commercial annuity

An annuity is 9 years old and the contract states that there is a 4% surrender charge in the ninth year. The annuity owner surrenders the annuity. The accumulation value is $100,000. The surrender value is $96,000. The annuity owner will receive $96,000, which is equal to the accumulation value minus (the accumulation value multiplied by the surrender charge), or $100,000 – ($100,000 x .04).

If the annuity is worth $16,000 and the cost basis is $10,000, when the owner surrenders, he/she will have $6,000 of ordinary income. If the owner is under age 59½, a 10% IRS penalty tax may also apply.

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IRS 10% penalty tax

If the annuity owner is under age 59½, a 10% IRS income tax penalty applies against taxable amounts. If Jack was age 55 and he surrendered his annuity worth $55,000 and a cost basis of $30,000, he would not only have to pay income tax on $25,000 of ordinary income, but he would also have to pay the IRS another $2,500 for the tax penalty. This would be true if Jack surrendered the annuity for cash or if he transferred the ownership to your institution.

d. Question No. 1: Should I give my commercial annuity to your organization now, and will I receive a tax deduction?

Let’s quickly walk through how an outright gift of a commercial annuity works, and then when the discussion begins about using a commercial annuity to fund a CGA, it will make more sense.

Lifetime gifts to charities

From a purely tax standpoint it is not a good idea for an annuity owner to give the annuity to charity during his/her lifetime because it becomes a taxable event to the donor. It makes much more tax sense to leave the annuity to charity at death through a beneficiary designation.

 Annuity contracts issued before April 23, 1987

If the annuity in question was issued prior to April 23, 1987, and it is given either to a charity or a charitable trust, the transaction will cause a taxable event to the donor. The donor will have to recognize ordinary income in the year the charity or trust cashes in the annuity or receives the proceeds from it. The taxable amount is the excess of the surrender value over the cost basis.

If the pre-April 23, 1987, annuity is not surrendered in the same year as the gift (which would be uncommon), the donor’s income tax charitable deduction is the lesser of fair market value or basis.

Example: Gift of Annuity issued before April 23, 1987

If a deferred annuity worth $100,000 that was originally purchased in 1984 for $25,000 was given to a charity, the owner would incur $75,000 of ordinary income in the year in which the charity surrendered the annuity.

If the charity surrendered the annuity in the same year as the donor’s gift, the donor’s deduction would be based on the fair market value, not the lesser of fair market value or cost basis. Therefore, the owner would be able to deduct $100,000.

If the organization does not surrender the annuity until year two, the donor can deduct only the $25,000 cost basis in the year of the gift (year one) and would recognize $75,000 of ordinary income in year two, with no further charitable deduction available. It appears to make more sense for the donor to cash in/surrender the annuity and contribute a $100,000 cash gift. The donor would still recognize $75,000 of income, yet deduct $100,000 in the same year.

 Annuity contracts issued after April 22, 1987

If the annuity in question was issued after April 22, 1987, and it is given to a charity, the donor has a taxable event. The donor is taxed on the excess of the surrender value at the time of the gift, over the cost basis. See Reg. §1.170A-4(a)(3).The taxable event is in the same year as the gift,

regardless of when the charity cashes in the annuity or receives the proceeds from it.

Because the timing of the taxable event is linked to the year of the gift, the donor’s charitable income tax deduction is based on fair market value. See Reg. §1.170A-4(a)(3).

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Example: Jack’s outright gift of a commercial annuity

Jack, age 75, has a commercial deferred annuity currently worth $55,000 for which he originally paid $30,000 in 1990. If Jack gives your institution ownership of the annuity (he does this by getting both change of ownership and change of beneficiary forms from the insurance company and naming your institution as the new owner and beneficiary), Jack will have a taxable event for the difference between $55,000 and $30,000. In other words, Jack will have to report $25,000 of ordinary income on his income tax return just for giving the annuity to your institution.

What is Jack’s income tax deduction? It is $55,000, but because he has to declare $25,000 of additional income that diminishes the true tax benefits of making this type of gift. Also, most donors aren’t aware that this type of taxation occurs with commercial annuities, so often it can become the beginning of a sore subject with donors.

It’s important to note how gifts of commercial annuities are very different than appreciated stock or real estate where the gain is avoided upon making a gift to charity.

What if the annuity has been exchanged under IRC Section 1035?

Annuity owners frequently move commercial deferred annuities from one insurance company to another for various reasons. The owner is allowed to move his or her annuity values on an income tax–free basis under IRC Section 1035. When this 1035 exchange transaction has occurred in the past, the new annuity succeeds to the status of the prior annuity with respect to computing taxation. Therefore, in these situations it is important not just to validate the date on which the annuity was issued, but also to determine the issue date of the previous company’s annuity if the proffered annuity had been previously with another carrier.

e. Question No. 2: Is it better for me to use my annuity to fund a charitable gift annuity, or should I cash it in and use that cash to fund the CGA?

Let’s say Jack would like to give his commercial annuity in exchange for a charitable gift annuity. What are Jack’s tax consequences? Jack will complete the change of ownership and change of beneficiary forms with the insurance company holding the commercial annuity. The insurance company will reissue the commercial annuity with your institution as the new owner and beneficiary. The insurance company will send Jack an IRS Form 1099-R, which will indicate his $25,000 taxable event of ordinary income.

The effective date of the gift is normally the date the donor signs the change of ownership forms with the insurance company. Therefore, for processing a gift annuity, that will be the gift date.

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Example: Jacks funds a CGA with a commercial annuity

The key is that the cost basis has been increased by the amount of ordinary income taxed as part of the transfer—in other words, the CGA payments are based on a cost basis of $55,000.

It really doesn’t make any difference if Jack decides to cash in the commercial annuity and give you the cash proceeds in exchange for the gift annuity. In fact, it is probably much simpler if Jack does it this way. If Jack surrenders the commercial annuity (he completes a surrender form from the insurance company and they will issue a check for the surrender value to Jack), he has a taxable event equal to the difference between the cash surrender value and his cost basis—in this case, $25,000 of ordinary income. The taxation of the gift annuity payments remains the same. Cash value of commercial deferred annuity $55,000.00

Cost basis

$30,000.00

Taxable event for transferring ownership of annuity to charity

in year of gift; taxed as ordinary income

$25,000.00 $215,000

Charitable deduction calculated for CGA based on quarterly payments and a 3.4% CMFR

$24,683.45

Amount of commercial deferred annuity used to calculate CGA payments

$55,000.00

$2,446.29 $0 $1,018.71 $3,465.00

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Example: Jacks funds a CGA with cash from surrendering a commercial annuity

When a gift of the commercial annuity might be favored over a surrender/gift of cash

One situation exists in which it may be acceptable for an annuity owner to give an annuity contract instead of surrendering it and giving the cash proceeds: If the annuity is subject to surrender charges, surrendering the annuity will force the donor to receive a smaller value than the annuity’s cash value (also called an accumulation value). By making a gift of the annuity contract instead of surrendering it, the donor can make a larger charitable gift by avoiding the surrender charges. Although, when your charity surrenders the annuity, it will only receive the annuity’s surrender value. So, in the end, you receive the same amount of money if the donor had cashed in the annuity, he/she just received a larger tax deduction.

Note that as previously mentioned, changing the ownership will subject the donor to a taxable event equal to the gain in the annuity. If the owner is younger than age 59½, the 10% IRS penalty tax may also apply.

Appraisal

If the deductible portion of the gift is worth more than $5,000, an appraisal will be required for the deferred annuity. Where do you get a qualified appraisal? Since it rarely, if ever, makes sense to give the annuity policy instead of cashing it in for a gift, I’m hard pressed to find an appraiser that’s experienced in annuity appraisals. See Section I(j) for the list of life insurance appraisers if you absolutely must find one.

Note that if the donor cashes in the annuity to fund the CGA with cash, an appraisal is not required because it is a cash gift, not a gift of an annuity.

Cash donated in exchange for CGA $55,000.00

Taxable event for cashing in the annuity worth $55,000 and a

$30,000 cost basis; taxed as ordinary income

$25,000.00 $215,000

Charitable deduction calculated for CGA based on quarterly payments and a 3.4% CMFR

$24,683.45

$2,446.29 $0 $1,018.71 $3,465.00

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If you do accept the commercial annuity, provide the typical receipt for a charitable gift annuity, but describe the annuity in detail. For example: American Equity Insurance Company; deferred annuity #D83839398390; accumulation value $120,840; surrender value $108,756; issued 5/18/1999; owner, John A. Doe; annuitant, John A. Doe. Be sure your receipt does NOT say ―No goods or services were given in exchange for this gift.‖ It can say, ―No goods or services other than the charitable gift annuity payments will be given in exchange for this gift.‖ Also provide IRS Form 8283 where appropriate.

As mentioned before in the section on life insurance gifts, there is no standard rule or guideline for soft credit for planned gifts in comprehensive or capital campaigns (some use cash surrender value, the deductible amount, etc.). Check with your campaign counting guidelines that your organization put together at the start of the campaign. If you don’t have any, see the Partnership for Philanthropic Planning’s white paper, ―The Guidelines for Reporting and Counting Charitable Gifts.‖

f. Question No. 3: Can I do an income tax–free exchange from my commercial annuity to a CGA (under IRC Section 1035)?

No. Under IRC Section 1035, an owner of a commercial annuity can transfer the annuity to another insurance company without having a taxable event. This applies when moving from one annuity to another or when moving from one life insurance policy to another. However, it does not apply when moving from an annuity to a life insurance policy or when moving from a commercial annuity to a charitable gift annuity.

g. If your institution accepts a commercial annuity to fund a CGA, should your institution keep the annuity in-force or surrender it for the cash value?

That depends. Your CFO should look at the amount of interest that has been credited to the commercial annuity since it was purchased by the original owner (i.e., the performance of the annuity). If the CFO feels he/she can do better than that investing the money, it may make sense to surrender the annuity. Determine if any surrender charges will apply that could lower the amount of the proceeds. Most nonprofits don’t wish to hold commercial annuities as assets, particularly because commercial annuities are tax-deferred retirement investments and nonprofits don’t need the benefit of income tax deferral.

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Moving Beyond Securities to Fund CGAs & Into the Fun Stuff!

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