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Thursday April 24, 2014

Article of the Month

What Do Major Donors Want? Part One

Part One – Gift Annuity Tax-Free Payouts

Major donors have realized that they face higher taxes with the American Taxpayer Relief Act passed on January 1, 2013. Single persons must pay the Medicare tax at $200,000 AGI, may lose part of their itemized deductions at $250,000 of AGI and pay tax in the top bracket with $400,000 of taxable income. Married couples face the same tax increases at $250,000, $300,000 and $450,000 of income.

Major donor prospects who are age 75 and above would like to offset the new taxes and build tax-free income. A strategy with cash-funded gift annuities can reach that goal. Major donors will discover that a gift annuity produces a superior combination of both charitable deductions and substantial tax-free income.

Major Donor Mary Jones

Mary Jones has made substantial, regular gifts to favorite charities. To her charities, she is a "loyal donor." She has a significant estate, with $3 million in her IRA following a rollover after her husband John passed away two years ago. Mary also has $1 million in CDs and $2 million in realty, for a total estate value of $6 million.

Because Mary is now age 75, she is taking her IRA required minimum distributions (RMDs). Mary understands that the RMD levels will increase as she becomes older and she is concerned that within four years her required distributions will be over 5% and within eight years 6%. The 5% distribution would be $150,000 of taxable income and the 6% distribution will exceed $180,000 with anticipated growth of the account. All of these RMD payments are taxable at ordinary rates.

Because Mary has pension and investment income, she consistently is over $250,000 of AGI per year. Because she is very concerned about her high income taxes, Mary and her CPA Helen Wilson have sought tax-saving options.

Gift Annuity Plan

Mary decided to start a gift annuity funding plan. Her funding ages will be 76 through 80. The funding amounts, annuity payments, charitable deductions and tax-free percentages are reflected in the following table.

Annual Gift Annuity
Mary JonesAge 76

AgeCGAPaymentDeductionTax Free

Total PayoutDeductionTax Free

Gift Annuity Description

A current, or immediate, gift annuity is a contract between the charity and the donor. The donor transfers property to the charity and the charity promises to pay the annuity for one life or two lives. Sec. 514(c)(5).

As a contractual obligation, the annuity payments are secured by the assets of the charity. Most charities maintain an annuity reserve fund, which is required by some state insurance commissioners. However, the endowment and even all of the real property and other assets of the charity stand behind the promise to pay a gift annuity.

From the perspective of the donor, a gift annuity is a relatively simple agreement. He or she transfers cash, securities or other assets to the charity and receives a payment for one or two lives. The payment may be made monthly, quarterly, semiannually or annually. In addition, there is an income tax deduction and partially tax-free payout from the annuity contract.

When the gift annuity is created, part of the value represents a charitable gift and part is the amount exchanged for the annuity contract. There are several specific Treasury requirements for qualification as a gift annuity. A qualified gift annuity must be for one or two lives, there must be a minimum 10% charitable deduction, there can be no guaranteed minimum or maximum payments and the annuity may not be adjusted based on the income earned on the transferred property. Sec. 514(c)(5).

Gift Annuity Participants

There are four parties to a charitable gift annuity. First, there is a donor who transfers cash, securities or other assets to the charity. Second, a charity issues the contract and assumes the obligation to make the annuity payments. Third, the annuitant or annuitants receive the payments for life. The annuitant may be the donor, but could also be a relative or friend of the donor. Fourth, the State Insurance Commissioner is charged with responsibility to regulate gift annuities.

Tax Deduction – Bargain Sale

Only a portion of the amount transferred for a gift annuity qualifies as a charitable deduction. If a donor makes a gift to a charity and value is returned to the donor, the gift is described by Treasury as a "bargain sale." With the transfer of cash or other property to a gift annuity, the donor receives a deduction for only part of the transfer, since the charity has promised to transfer an annuity payout back to the donor. In effect, the donor has made a gift of part of the property and purchased an annuity contract with the balance. Reg. 1.1011-2(c).

Charitable Deduction

Mary will be progressively taking IRA distributions that will range from around $120,000 to eventually $150,000 or more. The charitable deduction will not offset all of the IRA distributions, but most of the IRA payouts will be covered by the deduction. Because Mary is contributing cash to fund each gift annuity, her charitable deduction may be used up to 50% of adjusted gross income.

In calculating the deduction, the prudent charitable gift planner uses the lowest AFR. While Mary desires a good current deduction, her primary goal is maximum tax-free return. Therefore, it is most important to use the lowest of the three available applicable federal rates for each calculation. A very beneficial result of the low AFR is that about 80% of payments from these cash gift annuities will be tax-free.

Using the life factor, located in IRS Pub. 1457, Table S (based upon Mary's age and the Applicable Federal Rate under Sec. 7520), multiply the adjusted factor times the annuity amount to produce an income tax charitable deduction. Her deduction is a cash-type charitable deduction and is deductible up to 50% of her adjusted gross income in the year of the gift.

Under Sec. 7520, it is permissible to use the current month AFR or an AFR from one of the two prior months. The lowest AFR of 1.2% was selected in this case, since Mary preferred to have a lower charitable income tax deduction and higher tax-free payments. If she had desired a larger charitable deduction, then the highest AFR for the three-month period would have been selected.

Taxable and Tax-Free Payments

Each annuity contract is a separate agreement. As Mary becomes more senior, the rate on each new gift annuity contract will increase by 2/10 of a percent each year. The deduction will also generally increase, but that will change depending upon the applicable federal rate in subsequent years. Each year the gift planner will provide Mary with the updated calculation for the payout rate, deduction and tax-free percentage.

After five years, there is a total payout of $64,000 and a cumulative deduction of over $442,000. Mary will receive tax-free income of about $53,000 and ordinary income of $11,000. If all payment dates are the same, the charitable organization may issue one quarterly check for all of Mary's gift annuities.

Mary's CPA is especially pleased that the tax-free payouts are the equivalent of 5.3% of the $1 million that has been contributed. This is higher than she would receive with a very good quality portfolio with municipal bonds. To the CPA, the ordinary income is taxable, but that is simply icing on the cake since it is additional return.

The excellent news is that Mary now is able to maintain her total income payouts with lower taxes. She invests for growth rather than income with other parts of her portfolio. Mary has replaced part of her taxable investment income with the tax-free payments from the gift annuity. This plan has enabled her to achieve her goal of maintaining the total income stream while reducing her taxes for the rest of her lifetime. It also accomplished the transfer with minimal tax costs since the charitable deductions offset most of the taxable distributions from her IRA.

Will Low AFRs Last?

This five year plan is most attractive if the applicable federal rates remain below 2%. Is this a reasonable probability? Well, that depends on interest rates and they are notoriously difficult to predict.

There are two major economic factors with respect to interest rates and inflation. These factors might be described as a headwind and a tailwind. The headwind for inflation is the debt repayment process underway in the entire first world. In general terms, the first world historically had total corporate, personal and governmental debt levels of approximately 2.5 times the first world economy. Over a decade, the first world nations (United States, Canada, Europe and Japan) increased leverage to about 3.5 times GDP. For the past five years, there has been a process underway to reduce leverage, potentially back to 2.5 times GDP.

In summary, the first world nations collectively are attempting to reduce debt by approximately $30 trillion to $40 trillion over the next decade. This effort may or may not be successful, but debt repayment on this scale certainly is a deflation-oriented headwind. As long as this process is underway, it seems less likely that there will be significant inflation.

Central Bank Tailwind

In order to maintain their economies and avoid a deflationary recession, the first world central banks have all been printing money at a furious rate. Approximately $5 trillion to $7 trillion in new funds have been added to the first world economy during the past several years. The central bank in Japan was the last one to join the money-printing party, but now is enthusiastically printing money. For the past year, the U.S. Federal Reserve has been inserting approximately $85 billion per month into the economy.

Will all of this money printing lead to inflation? It may occur at some point, but there are two factors to consider. First, a majority of the new funds distributed to banks have not been loaned to individuals and businesses, but have been redeposited with the central banks. As a result of the 2008 financial failures, commercial banks must increase reserves maintained by the central banks. With the increased deposits and asset purchases, U.S. Federal Reserve banks have increased their collective balance sheet from $1 trillion to over $3.2 trillion. Other central banks are following the lead of the Federal Reserve and increasing their balance sheets.

Second, the U.S. Federal Reserve has stated that it plans to hold interest rates at low levels until 2015. Given this circumstance, it is quite possible that there will be low interest rates and low AFRs for three or more years into the future. If this scenario proves true, then the five year funding plan for the gift annuity with low applicable federal rates and high amounts of tax-free payments will be successful.


Major donors will be visiting with their CPAs this year to discuss reducing their taxable income. The ability for a series of cash contributions to gift annuities to build a significant level of tax-free payments is an excellent plan. The plan is particularly effective with the low applicable federal rates of the past year.

Published May 1, 2013

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