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Computing the Deduction When a Gift Annuity Terminates

When a donor funds a gift annuity, he or she is, of course, eligible for an income tax charitable deduction.  But that may not be the last deduction that results from the gift.  Another income tax deduction may be available at the other end, when the last annuitant dies and the gift annuity terminates.

If a gift annuity’s last or only annuitant dies prior to the end of the applicable single or joint life expectancy, the annuitant is entitled to a posthumous income tax deduction on his or her final income tax return.  This rule applies to gift annuities funded on or after January 1, 1987.  See IRC Sec. 72(b)(3)(A). 

Determining the Deduction Amount
The deduction in this situation equals the undistributed investment in the contract.  Translation: the annuitant is entitled to an income tax deduction equal to the total of all unpaid tax-free amounts the annuity would have distributed had the annuitant(s) lived long enough to receive all of them.  The final annuitant is entitled to this deduction regardless of whether he or she funded the annuity.  See IRC Sec. 72(b)(3)(B).

Any capital gain that remains unreported at the death of the last annuitant is neither deductible nor taxed.  Rather, it simply becomes part of the residuum that belongs to the charity. 

Claiming the Deduction
The deduction for the undistributed investment in the contract may be claimed as a miscellaneous itemized deduction (not a charitable deduction) on the deceased annuitant's final income tax return.  This deduction is not subject to the 2% floor that applies to some other miscellaneous deductions.

Example
Here's an example of how the calculation works.

Imagine you have a donor, Mr. Johnson, who on 3/15/2002, at age 72, funded a 7.4% gift annuity with long-term capital gain property worth $10,000.  While the IRS tables predicted he would live another 14.5 years, he had the misfortune of dying a little over seven years later, in May 2009.  The last quarterly payment he received was for $185 at the end of March 2009.

The taxation schedule for the life of Mr. Johnson's annuity looks like this:

Mr. Johnson is entitled to a miscellaneous deduction on his final income tax return (filed posthumously) equal to all of the tax-free portions listed in the above schedule that he did not live long enough to receive.  This is the tax-free portion left undistributed in 2009 plus all of the tax-free portions that would have been distributed in 2010 through 2016.  The sum of these amounts is:

(3/4 x $171.08) + (6 x $171.08) + $121.13 = $1,275.92

Contributing the Annuity Interest to the Charity
There is a second way that a gift annuity can create an additional income tax deduction.  This is the instance where an annuitant voluntarily gives up his or her annuity interest by reassigning it to the charity.  This situation has been cropping up more frequently lately as some charities have actively encouraged some or all of their annuitants to consider making an additional gift in this way.

Ordinarily, the annuitant who reassigns an annuity interest is then eligible for a charitable deduction on his or her next income tax return.  Once the annuity interest has been reassigned, the charity’s obligation under the contract terminates and it is free to use the residuum.  

Determining the Deduction Amount
While from the charity's perspective the amount of the gift is the present value of the remaining annuity payments as of the date of assignment, the amount the annuitant can deduct typically is a lesser amount.

Although there are no Revenue Rulings or Private Letter Rulings specifically on point, most practitioners agree that the deduction is limited to the lesser of the present value of the remaining annuity payments computed using the standard IRS method and the annuitant's remaining investment in the contract.  The latter is the total of all tax-free and, if applicable,capital gain portions that would have been returned with future payments had the annuitant not reassigned his or her annuity interest to charity.  In most cases, the annuitant's remaining investment in the contract is the lesser amount and therefore determines the amount of the charitable deduction he or she can claim.

If the gift was funded with cash, the deduction resulting from a reassignment of the annuity should be subject to the 50% adjusted gross income limitation on contributions of cash.  If the gift was funded with long term appreciated property, this deduction should be subject to the 30% adjusted gross income limitation on contributions of long term appreciated property. 

Example
Returning to our previous example, imagine that Mr. Johnson did not die in May 2009, but rather reassigned his annuity interest to charity that month.

Assuming Mr. Johnson is 79 on the date of reassignment, the present value of his annuity is $5,680.  The sum of his undistributed tax-free and capital gain amounts from 2009 onward is:

(3/4 x $427.72) + (6 x $427.72) + $302.55 = $3,189.66

As is typical, the sum of the undistributed tax-free and capital gain amounts is less than the present value of the annuity stream, so Mr. Johnson will be able to claim a deduction of $3,189.66 on his next income tax return although the present value of his gift to the charity is $5,680.  Since his gift was funded with long term appreciated property, his deduction should be subject to the 30% adjusted gross income contribution limitation. 

Substantiating the Deduction Amount
When contributing an annuity interest results in a deduction of more than $5,000, the donor must secure a qualified appraisal, complete Part B of Form 8283, and file Form 8283 with the Form 1040 on which the deduction is claimed.  If the deduction exceeds $500 and is not more than $5,000, it can be reported on Part A of Form 8283, which does not require an appraisal.

Even though it is easy for you to calculate the value of the annuity interest in Planned Giving Manager, a donor who needs a qualified appraisal must retain someone independent of your charity to perform it and sign Form 8283.  Any professional who regularly determines present values of annuity interests and deductions for charitable gift annuities, who is unrelated to the donor and the charity, and who meets certain other criteria, could be a qualified appraiser.  PG Calc staff members Jeff Lydenberg and Bill Zook perform these sorts of qualified appraisals regularly.

Regardless of whether a donor must complete Part A or Part B of Form 8283, if the deduction is less than the present value of the annuity interest (again, the typical case), the donor should attach to Form 8283 a statement explaining how the deductible amount was determined.

New Function in Planned Giving Manager 6.2 Performs Both Calculations
One of the functions we have added to PGM 6.2 is called Deduction for Gift Annuity Termination.  This function, found in the Tools menu, makes it easy to compute the deduction for a gift annuity that terminates for either of the two reasons we have been discussing.  The screen below shows the calculation of our first example.  The deduction appears at the bottom of the screen.

Conclusion
There are two common situations where a gift planning officer may be called upon to determine the deduction amount available at the time a gift annuity terminates.  In the case of a final annuitant's premature death, the gift planner can determine the undistributed investment in contract that can be claimed on the annuitant's final income tax return.  In the case of an annuitant who voluntarily reassigns an annuity interest to charity, the gift planner can determine the present value of the reassigned annuity stream and the sum of all undistributed tax-free and capital gain amounts and inform the annuitant that the lesser of these two amounts can be claimed as an income tax charitable deduction.  However, if the deduction will be more than $5,000, the annuitant will need to secure an independent qualified appraisal to substantiate the deduction.

As always, encourage your donor to seek the advice of his or her own tax advisors before claiming a deduction.