CHARITABLE GIVING

Jennifer J. Alby

Fair-Market-Value Deduction for Gifts of Publicly Traded Stock
to Private Foundations

What Was the Situation Before?

Gifts of highly appreciated securities to a private foundation have enjoyed favorable treatment in the past. For pre-1995 gifts of publicly traded long-term appreciated securities to private foundations the donor could deduct the securities’ full fair market value. The special treatment for pre-1995 gifts was available to the extent the contribution, along with all prior contributions of stock in the same corporation by the donor and the donor’s family, did not exceed 10 percent of the value of the corporation’s outstanding stock.¹ In 1995 Congress removed the fair-market-value deduction for appreciated stock gifts to private foundations, limiting the charitable deduction to the donor’s basis in the stock.

1. IRC Sec. 170(e)(5).

What Is the Nature of the Change?

Congress has temporarily restored the fair-market-value deduction for gifts of publicly traded stock to private foundations—but only for gifts made during the period of July 1, 1996, to May 31,1997.² By print, this news will be old. However, a bill currently in Congress, HR 519, would permanently restore this provision.

2. IRC Sec. 1206, Small Business and Job Protection Act of 1996.

What Should Be Done?

Financial service professionals must pay close attention to legislative developments regarding deductions for gifts of publicly traded stocks to private foundations so that they can inform clients of the tax consequences.

Where Can I Find Out More?

• PL 104-108. Small Business and Job Protection Act of 1996.

Charitable Gift Annuity Rates Raised

What Are Charitable Gift Annuities?

Charitable gift annuities (CGAs) are often promoted by charities as a useful way for a donor to make a charitable gift while retaining an income stream that will give the donor additional retirement protection. Nonprofit organizations are able to provide an annuity income to a donor in exchange for a gift under Internal Revenue Code Sec. 501(m)(5). How this technique works is that the donor and the charity form an agreement, whereby the donor makes a donation to the charity in exchange for a life annuity backed by the assets of the charitable organization. It is not a quid pro quo transaction because the fair market value of the gift exceeds the present value of the life annuity. Since the life annuity is not equivalent to the lump-sum gift, the charity will receive a benefit (that is, any funds remaining from the lump-sum gift above the cost of the life annuity) at the annuitant’s death. The donor is entitled to an income tax deduction at the time of the gift but must recognize income tax upon receipt of annuity payments pursuant to the annuity taxation rules.

According to the gift annuity agreement between the donor and the charity, the charity agrees to an annuity payment rate for the donor’s life. The American Council on Gift Annuities (ACGA) has prescribed a set of rates to which most charities adhere. These charitable gift annuity rates are actuarially determined based on the donor’s life expectancy and the applicable federal midterm rate for the current or previous 2 months (the donor can select the most favorable rate). This predetermined rate is not equal to what a commercial annuity would provide because the ACGA rates assume that the property that passes to the charity at the annuitant’s death is at least 50 percent of the amount of the donated property.

How Do They Work?

After the gift annuity agreement is signed and executed pursuant to state law, the donor contributes cash or property to the charity. The donor’s income tax deduction is the difference between the fair market value of the property given and the present value of the life annuity. The present value is determined by finding the annuity factor in IRS Publication 1457, Actuarial Values Alpha Volume. This amount is fully deductible within the percentage limitations of IRC Sec. 170.

Although the donor receives an income tax deduction upon transfer of the property to the charity, the donor must recognize income upon receipt of annuity payments. A portion of the payment will reflect a return of principal, which is determined by dividing the investment in the contract by the expected return. This results in an exclusion ratio, which shelters a portion of each annuity payment from tax. The investment in the contract is the lesser of the present value of the annuity or the fair market value of the property transferred. The expected return is the annual annuity amount multiplied by the donor’s life expectancy.

The annuity taxation rules provide for a portion of every payment to be excluded from income tax and the remaining portion generally to be included as taxable income. However, the character of the taxable portion of the annuity could result in both ordinary income and capital gains treatment if an appreciated capital asset is contributed to the charity.³ Although tax is avoided on any appreciation of capital gain upon transfer to the charity, a percentage of unrealized capital gain will be allocated to each annuity payment. The result is that each annuity payment may have parts that are nontaxable, parts that are taxable as ordinary income, and parts that are taxable as capital gain. If the annuitant lives beyond his or her life expectancy, each payment he or she receives will be entirely subject to ordinary income tax.

3. This is different from the tax rules for commercial annuities, which do not include a capital gain element.

The following example illustrates the advantages of making a gift of appreciated property to a charity in the form of a charitable gift annuity:

Example: Sue has $500,000 worth of publicly held AT&T stock with a tax basis of $100,000. She wants to make a gift to The American College, but she needs a guaranteed income stream. Sue is 65 years old, and the American Council on Gift Annuities provides for a 6.5 percent annuity payout rate for her life expectancy. She decides to give the stock to the College in exchange for a charitable gift annuity for her life. Sue will receive an income tax deduction of $231,830, which will be limited to 30 percent of her adjusted gross income because appreciated property is being donated (under the percentage limitations in IRC Sec. 170); carryover rules are applicable. Sue will be paid an annual annuity of $32,500 for the rest of her life, of which $2,749.50 will be tax free and the balance taxable as ordinary income and capital gain.

Charitable gift annuities appeal to individuals like Sue who have charitable aspirations, wish to avoid tax, and need a guaranteed income stream without any worries.

What Is the Nature of the Change?

The American Council on Gift Annuities has recently raised the charitable gift annuity rates. The goal of these rates is to have at least 50 percent of the gift distributed to the charity and the other half paid to noncharitable beneficiaries in the form of annuity payments. The new ACGA rates are based on an interest rate of 6.25 percent (7 percent total minus administrative costs of .75 percent). The old rates were based on an interest rate of 5.5 percent. The new rates are also based on new mortality assumptions.

The following example illustrates the use of the new rates: 

Example: Assume the same facts as in the example above. Sue, who is 65 years old, has $500,000 worth of publicly held AT&T stock with a tax basis of $100,000. She wants to make a gift to The American College but needs a guaranteed income stream, so she decides to give the stock to the College in exchange for a charitable gift annuity for her life. Now the American Council on Gift Annuities provides for a 7.2 percent annuity payout rate for Sue’s life expectancy. In this scenario, Sue will receive an income tax deduction of $202,950, which is $28,880 less than it was using the old ACGA rates. This represents about $11,436 in tax savings. This deduction will again be limited to 30 percent of Sue’s adjusted gross income, and the carryover rules are still applicable. Sue will receive an annual annuity payment of $36,000 for the rest of her life; $3,045 will be tax free, and the balance will be taxable as ordinary income and capital gain. This annual payment is $3,500 greater than payments under the old ACGA rates.

As you can see, the tax deduction in this example is less than in the previous example. However, the income Sue receives each year is several thousand dollars greater, which will more than make up for the tax savings lost.

Charitable gift annuities are devices that require relatively little planning from the donor’s perspective, while providing a lifetime retirement benefit and ultimately making a gift to charity. The advantage of creating a CGA now is that the new rates enable CGAs to better compete with other fixed investment vehicles.

What Should Be Done?

Congress responded to challenges to charitable gift annuities with the Charitable Gift Annuity Antitrust Relief Act of 1995 (P.L. 104-63) and the Philanthropy Protection Act of 1995. These acts removed charitable gift annuities from antitrust scrutiny and limited the applicability of securities laws to charitable organizations.

Some states continue to have stringent rules for charities offering charitable gift annuities. These states regulate reserve limits, have investment requirements, and may require a permit to issue CGAs.⁴ These regulations make it difficult for the charity to provide even a moderate payout when chances are fairly good that investment performance will not yield much of a remainder interest. Since the charity backs the annuity payments with corporate assets, if the charity cannot earn enough to pay the annuity and principal is depleted, the charity may receive nothing at the donor’s death. Thus the risks to the charity are lower than expected investment returns and annuitants outliving their life expectancy.

4. See California Insurance Code Sec. 11420 et seq. and New York Consolidated Laws Sec. 1110 et seq.

Financial service professionals should familiarize themselves with both federal and state regulations on charitable gift annuities and monitor any changes in these regulations or in the ACGA rates.

Where Can I Find Out More?

• "New Rates for Gift Annuities," Planned Giving Today, January 1997, vol. 8, no. 1.
• Taxwise Giving, January 1997.
• NumberCruncher Software. (610) 527-5216.
• PG Calc Software. (617) 497-4970.

Charitable Planning with S Corporation Stock

What Was the Situation Before?

Many small corporations have opted to make the subchapter S election to take advantage of pass-through taxation while enjoying limited liability. Generally, in order to qualify as an S corporation, an entity must, among other requirements, have only individual shareholders (with some exceptions, not including a charity or charitable trust). If a charity is a shareholder, the corporation loses its S corporation status and becomes a C corporation. This presents a problem for owners of S corporation stock who wish to make a contribution to charity and avoid capital gain.

What is the Nature of the Change?

The Small Business Job Protection Act of 1996⁵ provides among other things that beginning in the year 1998, charities will be eligible owners of S corporation stock pursuant to IRC Sec. 1361 (c)(7). The good news is that this gives small business owners who own stock in such corporations the opportunity to make charitable contributions of S corporation stock. This stock is often the largest assets these shareholders own. The downside is that an S corporation’s income and losses will flow through to the charity shareholder, resulting in unrelated business taxable income. For a more detailed description of this change see chapter 3, "Business Planning."

5. Public Law 104-188 (August 20, 1996).

What Is Unrelated Business Taxable Income?

Generally, an exempt organization receives tax-exempt treatment only if its primary purpose is to engage in the type of activity that qualified it for the exemption. Exempt organizations may operate trades or businesses that further their exempt purpose. If the trade or business is outside the scope of its exempt purpose, however, the exempt organization may be subject to income tax for any income earned from the unrelated business.⁶

6. For an example of the devastating effect, see Newhall Unitrust v. Comm’r., Docket #95-7051 (9th Cir. 1/23/97).

The irony is that when a charity owns nondebt-financed real estate, any income earned on the real estate is not deemed to be unrelated business taxable income. However, if an S corporation owns real estate and the charity owns shares of the S corporation’s stock, the same income generated by the real estate will be unrelated business taxable income to the charity.

What Should Be Done?

Financial planners should be alert to the potential benefits of charitable deductions of S corporation stock, particularly in situations where the disadvantages to the charity, as described above, can be minimized.

Where Can I Find Out More?

• For more information contact The American College Development Division. (610) 526-1000.
• PL 104-188. Small Business Job Protection Act of 1996.

Charitable Planning with Qualified Plan Assets

What Was the Situation Before?

Prior to January 1, 1997, individuals who took distributions from qualified plans or individual retirement accounts were subject to a 15 percent excise tax on the amount in excess of the threshold distribution indexed for inflation. This 15 percent tax proved to be a disincentive for the people who wanted to take large distributions during life.

A qualified plan or IRA is also subject to a 15 percent excise tax on excess accumulations at death. The result is a double-edged sword. If an individual does not take distributions and recognize excise tax on excess distributions during life, he or she dies with the excise tax on the accumulation at death. The 15 percent excise tax applies even when the amount is given to a charity.

What Is the Nature of the Change?

The 3-year moratorium on the excise tax (effective for taxable years 1997 through 1999) for excess distributions from qualified plans or IRAs may entice some people to do some charitable planning. (See "The 15 Percent Excise Tax Moratorium—Should You Bite?" in chapter 5.)

What Should Be Done?

Financial services professionals should examine the options carefully. Also see "Estate Planning for Retirement Benefits, chapter 2, in which we examined the multilayer tax impact on qualified plans and IRAs includible in a decedent’s estate.

Suppose, in our example in chapter 2, Mrs. Adams named her children as beneficiaries of her $2 million IRA. The tax consequences on her $6 million estate result in the following taxes:

Federal estate tax State death tax Excise tax on excess accumulations Income tax (income in respect of a decedent) Total taxes Balance to heirs Percentage to heirs

$2,173,203 492,940 148,831 472,038 $3,287,012 $2,712,988 45%

In the above scenario, Mrs. Adams left the IRA to her children. The problem is that the children must recognize income tax because the property has income in respect of a decedent (IRD). Therefore, an alternative plan may be to leave a charity an asset with IRD and to transfer non-IRD assets to heirs. The charity will not recognize income tax because it is a tax-exempt entity. Likewise, the children will not recognize any income tax because they will receive assets that do not carry income in respect of a decedent.

Option 1. Assume that Mrs. Adams leaves her $2 million IRA to The American College and the balance of her gross estate of $6 million to her two children. The children will not recognize income tax and Mrs. Adams’s estate will receive a charitable deduction for the full value of the IRA passing to the College pursuant to IRC Sec. 2055. Unfortunately, the 15 percent excise tax on excess accumulations will still apply to the $2 million IRA left to the College (the 3-year moratorium applies only to excess distributions; excess accumulations continue to be subject to the 15 percent tax).

The taxes for her estate and her IRA are as follows:

Estate Tax Calculation
Gross estate Excise tax deduction Charitable deduction Taxable estate Tentative federal estate tax Unified credit State death tax credit Net federal estate tax	$6,000,000 148,831 2,000,000 $3,851,169 1,758,943 (192,800) (264,922) $1,301,221
Total Taxes
Federal estate tax Assumed state death tax Excess accumulations tax Income tax Total taxes Estate remaining after taxes Percentage of estate passing to heirs	$1,301,221 264,922 148,831 0 $1,714,974 $2,285,026 38%

Although less money will pass to Mrs. Adams’s heirs, less will also pass to the government. Thus, a philanthropically minded individual who plans on giving assets to a charitable organization at death may opt for this plan.

Option 2. Because the 3-year moratorium on the 15 percent excise tax applies only to excess distributions and not to excess accumulations, there may be a greater incentive to set up a charitable remainder trust (CRT) to begin removing the accumulation and thereby avoid both excise taxes. This planning opportunity involves taking a lifetime distribution from the qualified plan or IRA and making a net after-tax contribution to the CRT.

A charitable remainder trust is an irrevocable trust that will be income tax exempt if drafted properly pursuant to IRC Sec. 664. The donor will receive an immediate income tax charitable deduction for the present value of the remainder interest that will eventually pass to charity. This will help offset the income tax on the distribution from the plan. With the 3-year moratorium on the excise tax on excess distributions, an individual can take distributions without being subject to the excise tax. This option may be a good one for a person who is at or near age 70 1/2 and will not be able to take advantage of additional deferrals.

A charitable remainder trust can be an annuity trust or a unitrust. The main difference between the two is that annual payments in an annuity trust must be at least 5 percent of the initial value of the trust, while in a unitrust payments must be at least 5 percent of the value determined annually. The unitrust percentage is based on the increase in corpus due to investment growth.

The donor of the charitable remainder trust may retain the right to receive income for life or for a term of years not to exceed 20, and he or she may also designate others as income beneficiaries. The trustee of the CRT will make distributions of the payout amount to income beneficiaries, who will have to recognize income tax on those distributions. Distributions made to beneficiaries are taxed under a tier system pursuant to IRC Sec. 664. Essentially, a distribution to a beneficiary is taxed as ordinary income to the extent that the trust has ordinary income in the current year and undistributed ordinary income from prior years. Thereafter, the distribution is taxed as capital gain to the extent the trust has realized capital gains form prior years. Any excess amount of the distribution is tax free to the beneficiary.

Suppose that instead of naming The American College as the beneficiary of the qualified plan, Mrs. Adams decides to fund a charitable remainder unitrust (CRUT) by taking a $2 million lump-sum distribution from her IRA. She recognizes income tax of $688,000 on the distribution, but she does not recognize excise tax because of the 3-year moratorium. She makes a contribution to the charitable remainder trust of the net after-tax amount of $1,312,000. This contribution to the trust generates an income tax deduction for the present value of the remainder interest of $769,134, which passes to the College at her death. Mrs. Adams will receive an income payout of 6 percent from the trust.

Assume for purposes of the following calculation that Mrs. Adams dies in the year of the distribution and does not have the advantage of receiving any income from the CRT. The taxes for her estate and her IRA are as follows:

Tax on Distribution from IRA
Income tax on the IRA (assume 34.4% income tax rate on lump-sum distribution of $2 million due to 5-year averaging) Excise tax on excess distribution	$688,000 0
Tax Deduction for Transfer to CRUT
Net after-tax amount contributed to a CRUT Income tax charitable deduction (assume the entire amount is deductible in current year)	$1,312,000 $769,134
Estate Tax
Gross estate (includes $304,577—the income tax saved by the charitable deduction) Tentative federal estate tax Unified credit Credit for state death tax Federal estate tax	$4,304,577 2,308,317 (192,800) (313,713) $1,801,804
Total Taxes
Federal estate tax Assumed state death tax Excess accumulations tax Income tax Total taxes Estate remaining after taxes Percentage of estate passing to heirs	$1,801,804 313,713 0 688,000 $2,803,517 $3,196,483 53%

(Note: This calculation assumes death occurs in the year of distribution. If Mrs. Adams survives additional years, the estate will appreciate. Likewise, Mrs. Adams will receive annual income payments from the CRUT that will be subject to income tax in accordance with the four-tier system.)

Option 3. Now suppose that Mrs. Adams wants to give her children additional income at her death but also wants to benefit The American College. She decides to name a testamentary CRT as beneficiary of her IRA at death. Her children will be the income beneficiaries for their lives, and The American College will receive the remainder interest. The trust will pay out 6 percent of the income it earns to the two children for the rest of their lives. Assume that one child is 51 years old, and the other is 46. The College will receive the remaining principal at the death of the surviving child.

The tax consequences are as follows:
Estate Tax Calculation
Gross estate Excise tax deduction Estate tax charitable deduction Taxable estate Tentative federal estate tax Unified credit State death tax credit Federal estate tax	$6,000,000 148,831 291,140 $5,560,029 2,698,816 192,800 458,003 $2,048,013
Total Taxes
Federal estate tax Assumed state death tax Excess accumulations tax Income tax Total taxes Total reduction of estate ($6,000,000 minus $291,140 minus all taxes) Percentage of estate passing to heirs	$2,048,013 458,003 148,831 0 $2,654,847 $3,054,013 51%

Option 3 saves the estate $160,127 in federal estate and state death taxes over the initial plan. What’s more, there will be no income taxes on the IRA until Mrs. Adams’s children receive their annual payments from the CRT. The present value of the payments they will receive during their lifetimes is $1,708,860.

Where Can I Find Out More?

• Charitable Giving and Solicitation, October 16, 1996.
• Leimberg’s Pension and Excise Tax Calculator. (610) 527-5216.
• PG Calc Software. (617) 497-4970.
• NumberCruncher Software. (610) 527-5216.

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