CHARITABLE GIFT ANNUITIES
— WSJ Article, ACGA’S Response, Reinsurance

Wall Street Journal headline (May 21,2009): Donors Find Gift Annuities Can Stop Giving — Market Turmoil Saps Ability of Some Charities to Continue Paying Out Promised Yields.

That headline focused on two rare situations. The article has caused angst among myriad charities having sound and long-standing gift annuity programs. No doubt the article has also upset donors who already have gift annuities and will likely give pause to some individuals who are considering them.

The American Council on Gift Annuities’s Letter to the WSJ Editor responding to the article was in the May 21 Journal and is at the end of this article. Some charities are giving copies of that letter to concerned board members and others.

The Journal article also cast doubt on charities that reinsure their gift annuities: “Today, some charities are buying commercial annuities to back up declining reserve funds. It’s a legitimate technique, but one that carries its own risks, and it isn’t always communicated to donors. In such cases, the insurer generally makes payments to the charity, which then passes the money to the original donor. But if the insurer fails, the charity could be left without needed money to make promised payments.”

Simply put, that’s not so. A charity’s obligation to make the annuity payments is not limited to the assets transferred for the donor’s gift, reinvestments of those assets or reinsurance.

Gift annuities are backed by all of a charity’s assets — its endowment, buildings, land — down to its last pencil sharpener.

Two recent letter rulings deal with the tax implications of reinsuring gift annuities — consequences to the donor and to the charity. The letter rulings were obtained by a broker, an insurance company and a charity.

REINSURANCE (Letter Ruling 200847014*) — IMPLICATIONS FOR DONOR. Donor will transfer $10,000 to Charity in exchange for its agreement to pay him an annual annuity of $600, payable in quarterly installments, for his life.

The agreement provides: The annuity payments are a general obligation of Charity and are backed by all its assets; and the annuity is irrevocable and nonassignable, except that it may be assigned to Charity.

The agreement further provides: On the Donor’s death an amount equal to the residuum of the gift shall be used by Charity for its general operating purposes.

Enter reinsurance. Charity is authorized, but not obligated, to use Donor’s gift (or proceeds thereof) to purchase a commercial annuity with Donor’s life being the measuring life — the timing and amount of payments being substantially the same as the timing and amount of payments that Charity is obligated to pay to him. If reinsured, the portion of Donor’s gift that is not used to purchase the commercial annuity may be used by Charity immediately for its general operating purposes. Compare this with waiting until the donor’s death for the charity to use the residuum if reinsurance is not involved (above).

The Gift Annuity Disclosure Statement (attached to the agreement) states: The annuity payments are a general obligation of Charity and are backed by all Charity’s assets. Further, “[w]hile under no legal obligation to do so, Charity may elect to purchase an annuity with a commercial insurance company to fund a payment stream to Charity . . . [for] the duration of Donor’s life.” Also, for Charity’s administrative convenience and solely at its discretion and on its own behalf, Charity may elect to direct the commercial insurance company to make the quarterly payments generated by the annuity directly to Donor in fulfillment of Charity’s obligation to him under the gift annuity agreement.

Reinsurance — partial-refund feature. If the Annuitant dies before the total annuity payments received by the Charity equal or exceed the premium, then an amount of money equal to the initial premium minus the total of all payments made will be paid in a lump sum to Charity. An additional premium would be paid by Charity for this option.

Broker will receive a commission from Insurer and will not receive any compensation from Charity or Donor.

Ruling issue #1 — The income tax charitable deduction. Rev. Rul. 70-15, 1970-1 C.B. 20, concerned a situation in which a taxpayer purchased an annuity contract from a qualified charity. The amount paid by the taxpayer for the annuity exceeded its fair market value at the time of the purchase (as determined by the annuity rate tables in Rev. Rul. 62-137 and Rev. Rul. 62-216). Rev. Rul. 70-15 holds that the amount paid by the taxpayer for the annuity in excess of its fair market value at the time of purchase is a charitable contribution for the taxable year of the payment.

So, what’s the income tax contribution? “Pursuant to §1.170A-1(d)(1) . . ., the excess of the amount paid over the present value of the annuity at the time of purchase is generally treated as a charitable contribution.”

Query. Does this differ from the valuation of the charitable gift under the IRC §7520 rules? Read on.

Ruling issue #2 — gift tax charitable deduction. “. . . the amount of the gift tax charitable deduction will be equal to the . . . payment [to Charity] less the present value of the annuity payable to Taxpayer [Donor] under the [Annuity] Agreement determined under §7520.”

Comment. For the gift tax charitable deduction, IRS specifically says to use the valuation procedure under IRC §7520 even though reinsurance is involved. Why didn’t the IRS specifically say to use the IRC §7520 valuation procedure when ruling on the income tax charitable deduction (above)? If the gift annuity is reinsured, is the income tax charitable contribution the amount transferred to the charity by the donor minus the cost of the commercial reinsurance policy? The IRS didn’t say that, so the IRC §7520 rule should apply. But I thought that I’d raise the point.

Another comment. Although reinsurance is stated as being optional, it sure smells as if this baby will be reinsured.

Ruling issue #3 — split dollar. The IRC §170 income tax charitable deduction and the IRC §2522 gift tax charitable deduction are not barred by IRC §170(f)(10)(A) relating to split-dollar life insurance, annuity and endowment contracts.
Letter Ruling 200847014*

Not dealt with in this letter ruling (because the IRS was not asked):
• A donor who funds a gift annuity with appreciated property has a capital gain under the bargain sale rules (gain on the annuity element, not on the gift element). Presumably, that rule will apply for reinsured annuities.

• When an annuity is for the life of the donor or the lives of a donor and another individual, the capital gain under the bargain sale rules is reported ratably over the donor’s life expectancy if the annuity is nonassignable (except it can be assigned to the issuing charity).

Some questions:
• Suppose reinsurance is required. Even though the annuity is nonassignable (except to the charity), will the gain computed under the bargain sale rules qualify to be reported ratably over the donor’s life expectancy — or will it all be reportable in the year of the transfer for the annuity?

In Letter Ruling 8322068, the Charity was required to reinsure the annuity for the donor’s spouse. The bargain sale rules were held to apply — with the nontaxable portion being the difference between the transferred stock’s fair market value and the cost of the commercial annuity. The “ratably” issue was not discussed — presumably because the donor was not the annuitant or one of two annuitants.

Reg. §1.1011-2(c) Example 8 deals with a donor who transferred appreciated securities “to a church in exchange for a promise by the church” to pay the donor a nonassignable annuity for life. The example shows how to compute the capital gain and shows how the ratably rule applies. The example doesn’t deal with reinsurance.

Note. IRS made the above rulings contingent on receipt by the Charity of favorable rulings on how reinsurance would affect Charity. And Charity did receive favorable rulings, as you shall now see.

REINSURANCE (Letter Ruling 200852037*) — IMPLICATIONS FOR CHARITY. Charity, to increase funding of its programs, wants to use a charitable gift annuity program to be made available through an insurance broker and a major insurance company.

The details. Charity will offer a charitable gift annuity to an individual (Donor), based on the life or lives of one or two individuals (Annuitant) living when the annuity is issued. The value of the Annuity Contract will be less than 90% of the amount of cash or the value of other property received from Donor and will specify the amount of each periodic payment — but will not guarantee a minimum number or specify a maximum number of periodic payments to the Annuitant; nor will it specify a minimum or maximum aggregate amount of payments the Annuitant will receive. Further it will not provide for any adjustment of the amount of the annuity payments by reference to the income received from the property transferred by Donor or from any other property.

More facts. The Annuity Contract will provide that each periodic annuity payment is payable from Charity’s general assets; however, Donor will be aware that Charity can purchase an annuity from Insurer to match Charity’s liability under the Annuity Contract.

Charity will purchase a Commercial Annuity based on the Annuitant’s life and with the same periodic payment amount and frequency as specified in the Annuity Contract. Charity may receive an additional payment upon the death of the Annuitant, as explained soon.

The amount Charity will receive from Donor as consideration for the Annuity Contract will exceed the Insurer’s market rates for a commercial annuity with the same payout period and periodic payment amount. The difference between the amount Charity receives from Donor for the Annuity Contract and the premium Charity will pay to Insurer for the Commercial Annuity will be available for Charity’s immediate and unrestricted use.

Broker will receive a commission from Insurer for the sale to Charity of the Commercial Annuity. Charity will pay no compensation to the Broker for Donor’s entering into the Annuity Contract and will pay no fees to the Broker, Insurer or to any one else.

One more fact. At Charity’s option, and for additional payment by Charity, the Commercial Annuity may provide that if Annuitant dies before the total annuity payments received from Insurer equal or exceed the original premium payment Charity made to Insurer, Charity will receive a guaranteed lump sum cash refund equal to the premium paid to Insurer minus the total periodic payments received from Insurer.

IRS rules:
• Charity’s sale of annuities through its reinsurance program will not constitute the provision of commercial-type insurance under IRC §501(m).

• The following amounts will not constitute income from an unrelated trade or business within the meaning of IRC §513:

– The difference between (i) the premium Charity will receive from Donor for the Annuity Contract and (ii) the premium Charity will pay to Insurer for the Commercial Annuity;
– The periodic annuity payments Charity will receive from Insurer; and
– Any lump sum Charity will receive from Insurer upon the death of the last Annuitant under the guaranteed cash refund feature of the Commercial Annuity. Letter Ruling 200852037*

Comment. The favorable ruling was given because the transaction met all the requirements of IRC §§501(m) and 514(c)(5).

Query. If the identical requirements of those two sections aren’t satisfied, can the charity be taxed twice on the same transaction?

CHECKLIST ON REINSURING GIFT ANNUITIES
For Charity:
• Confirm that state law allows reinsurance of gift annuities.
• Meet state law reserve and investment requirements.
• Prudent for charity to keep the “gift portion” of the commercial annuity in reserve until the annuitant’s death. See the American Council on Gift Annuities recommendations regarding maintaining reserves at: www.ACGA-web.org/
• Meet the tests of IRC §501(m) and 514(c)(5) so that the charity is not taxed on its gift annuity program and possibly lose its tax-exemption.
• Make written disclosure of possible reinsurance to potential donors before accepting payment for an annuity and include that language in the annuity agreements.
• Annual reporting to the donors should be exactly the same as if the annuities had not been reinsured.
• Highly preferable: The payments should be made to the annuitants by the charity and the payments made by the insurer to the charity (rather than the payments being made directly to the annuitants by the insurer).

For Donor:
• Donor should believe in the charity’s mission and have confidence that the charity will wisely use the donor’s gift.
• Naturally, the donor should determine that the charity is sound.
• The donor should be aware of how the income and gift tax charitable deductions will be computed if a gift annuity is (or might be) reinsured. (The first letter ruling in this article — not a precedent — deals with this.) *A letter ruling is not a precedent. See page 12.

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