What Donors’ Advisors Should Know About Charitable Gift Annuities

In a typical charitable gift annuity (CGA) transaction, an individual (the donor) transfers cash or appreciated marketable securities to a charity, and the charity agrees in return to pay the donor a life annuity. The annuity is called a gift annuity because the initial present value of the annuity (PVA) is less than the fair market value (FMV) of the asset transferred, and thus the transaction has a gift element.1

The CGA is a contractual arrangement that involves a current gift to the charity for federal tax purposes. The transaction is typically subject to state and federal laws, including regulatory, tax and securities laws.

CGAs are an old way of donating. Some were established before the Civil War. CGAs are generally regarded by fundraisers as 5-figure gift arrangements. I’ve worked on 7-figure and 8-figure gift annuities, although they’re not common.

Mechanics. The mechanics of establishing a CGA are usually that a gift officer employed by the issuing organization speaks with the prospective donor about: (1) the asset the donor plans to use to fund the annuity, (2) what the donor hopes to accomplish, and (3) possibly some tax considerations. Next, the gift officer may send a CGA application to the prospect. Such an application can be a good way to elicit key information, such as the identity, birthdate and Social Security number of the recipient, as well as who has legal title to the asset that will be used to fund the annuity.

Once the donor transfers the funding asset to the charity, the gift officer will transfer to the donor a CGA agreement and a disclosure statement (described below).

The CGA agreement may be subject to laws of the state where the donee organization or the donor is located. For example, the CGA agreement for a charity in New York must conform to a template previously approved by the Department of Financial Services (DFS).

The gift officer at this time also will routinely provide the donor with a detailed hard copy  showing the federal tax consequences of the gift transaction in which the donor has just participated.

Three CGA requirements. The CGA:

1. must be payable for life to one individual or two individuals;2
2. must be detailed in an agreement that doesn’t:
   • (1) guarantee a minimum amount or specify a maximum amount to be paid, or
   • (2) allow adjustment of the annuity amount based on what the charity earns on monies received for gift annuities;3 and
3. may not be assignable, except that a non-qualified charitable distribution (QCD)-funded annuity may be assignable to the payor charity.4

Payment rates. Most charities that issue CGAs abide by the payment rate schedule promulgated by the American Council of Gift Annuities (ACGA). ACGA payment rates are computed actuarially based on:

an assumed earnings rate on CGA monies held by a charity, an  expense assumption, and the requirement that the charity net, on average, 50% percent of the amount it receives for CGAs.5

“Payment Rates,” this page, is a snapshot of one-life ACGA immediate payment rates as of mid-2023. These rates are based on 5.25% earnings and 1% expense assumptions, which result in a 4.25% net earnings assumption.6

Federal Income Tax Considerations

An individual who establishes a CGA makes a charitable contribution. The contribution is equal to (FMV – PVA). Assuming the donee organization is a “public charity” as defined in Internal Revenue Code Section 170(b)(1)(A), the donor has the year of the gift plus five so-called carryover years in which to claim the contribution as a federal income tax charitable deduction.7

CGA payments. The federal income taxation of CGA payments depends on the asset used to fund the CGA.

Cash funding. If the CGA is funded with cash, it’s taxed partly as ordinary income and partly as a tax-free return of investment for the period of the CGA recipient’s life expectancy.8 Payments after that period are fully taxable as ordinary income.

Appreciated securities. If the CGA is funded with appreciated stock, gain is realized by the donor under the bargain sale rules.9 The gain is reported over life expectancy, but is reported each year only to the extent there’s a tax-free return of investment.10

IRC Section 72 deduction. Sometimes, the CGA recipient dies before receiving the entire “investment in the contract,” which is mathematically equal to PVA. In this situation, the donor is allowed a deduction under Section 72 in an amount equal to the unrecovered investment in the contract.11 This isn’t an income tax charitable deduction governed by Section 170.

Additional consideration. Federal tax law provides that the obligation to pay a CGA must be the sole consideration for the asset used to fund the annuity, provided that the asset may be subject to a mortgage that’s more than five years old.12 This means, for example, that establishing a CGA may not be used to buy a seat at the issuing organization’s gala dinner. I’m aware that some years ago, a charity did allow a CGA to be used to buy a seat at a gala dinner.  That gift transaction was commercial insurance under IRC Section 501(m).

Acknowledgment of CGA

In general, the acknowledgment (gift receipt) for an inter vivos donation of $250 or more must state whether the donor received any goods or services from the donee in consideration of the gift.13 The agreement to pay a CGA is an agreement to provide the donor with “goods” (annuity payments). Accordingly, the tax law requires that an acknowledgment for a CGA state whether the donee has provided any goods or services in addition to the annuity.14 The donor’s tax advisor should take a close look at the gift receipt to make sure it conforms to the tax law.

Gift/Estate Tax Considerations

In establishing a CGA, a donor makes at least one gift, to charity, for federal gift tax purposes. This is a present interest gift that qualifies for the annual gift exclusion.15 To the extent the gift exceeds the annual gift exclusion, it qualifies for the unlimited gift tax charitable deduction. If a CGA is established post mortem (that is, by will), a gift is made to charity that qualifies for the unlimited estate tax charitable deduction.16

Naming another to receive annuity payments involves a transfer of financial value to the other for gift or estate tax purposes. Here are two of several patterns:

Inter vivos CGA for another. The donor sets up a CGA to benefit one other individual. The donor thereby makes a gift to the annuity recipient equal to the initial PVA. The main tax issue is whether this gift is a present interest gift that qualifies for the annual gift exclusion. Case law indicates clearly that the gift is of a future interest, which doesn’t qualify for the annual gift exclusion.17

Inter vivos annuity for self first and another second. The donor sets up a CGA that’s payable to the donor for life and then to a designated survivor for life. To keep from reporting a gift to the survivor, the donor retains the right, exercisable by will, to revoke the survivorship annuity.18 If the donor doesn’t revoke the annuity and the survivor is the donor’s spouse, the annuity payable to the spouse qualifies for the estate tax marital deduction.19

Stock-Funded CGAs

We’ve seen that when an inter vivos CGA is funded with appreciated stock, the donor realizes gain under the bargain sale rules, as illustrated in Treasury Regulations Section 1.1011-2(c), Example 8. If the stock has a value equal to FMV and a basis equal to B, the amount of gain realized is equal to: (FMV – B) x (PVA/FMV).

The quantity (FMV – B) is the stock’s total appreciation, and the quantity (PVA/FMV) is the ratio of the PVA to the value of the stock. Here’s how to determine the reported gain:

If the annuity is payable just to the donor, the gain is reportable ratably over the donor’s life expectancy. If the donor dies before reporting all the realized gain, the unreported gain is forgiven.20

If the annuity is payable to the donor and then to a survivor, and the donor dies before all the gain is reported, the survivor reports the remaining gain just as the donor would have if the donor had continued to live.21

If the annuity is payable just to an individual other than the donor, there’s no ratable spreading of the gain. The realized gain is reportable by the donor as a lump sum, up front.22 This means it’s important for the charity to determine up front who owns the  stock. A CGA application can be most helpful in this regard. If the stakes warrant, the “donor” can be changed to the owner, or the owner can be changed via a gift of the stock (which will be easy and painless if the gift is from one spouse to the other).

Note that gain-spreading as discussed here is possible only if the right to receive annuity payments is non-assignable except to the issuing organization.23

The mechanics. When appreciated marketable stock is used to fund a CGA, it’s commonplace in New York and other states for the donor’s broker to wire the stock to the bank that maintains the charity’s fund of monies received for CGAs. The bank will administer the CGA program, including handling tax reporting, making annuity payments and investing the monies in the fund.

But if the broker wires the stock directly to the charity by wiring the stock to the charity’s account at its regular bank, a question may arise: What’s the date of gift? That is, as of what date is the CGA established?

The answer should be clear. A CGA is a contractual arrangement. Contract formation requires a meeting of the minds. There should be a meeting of the minds as to this particular date. But there may not be. Reason: The charity’s gift officer may never have encountered this situation before and may be perplexed because the charity has no written policy dealing with this sort of situation.

Here’s what such a written policy should provide and how the charity’s gift officer should behave. The policy should provide that the charity will treat the CGA as being established when it (which includes its agent bank) receives shares of stock intended to fund a CGA. And the gift officer should promptly convey this information, which is in the nature of a contract offer, to the donor so the donor can accept the offer. The policy should be more pointed, by the way. It should provide that the stock will be valued using the mean of the high and low trading prices on the day the stock arrives. This sort of provision ensures that no one—neither the donor nor anyone at the charity —receives an unexpected and unwelcome surprise.

QCD-Funded CGAs

Section 310 of the SECURE 2.0 Act allows the establishment of a CGA with QCD money.24 Here’s how it works:

1. An individual who’s an individual retirement account beneficiary and who’s at least 701/2 years old may cause up to $50,000 to transfer from the IRA to a charity to fund a CGA. 
2. The individual makes a one-time election to do this.
3. The QCD counts against the individual’s required minimum distribution (if any) for the year and isn’t taxable.
4. The individual isn’t allowed a federal income tax charitable deduction for the QCD.
5. No other asset is allowed to fund the CGA.
6. Annuity payments will be taxed entirely as ordinary income.
7. The CGA must be non-assignable.

Carefully handle the gift receipt for this arrangement.

Post-Mortem CGAs

I’ve encountered a post-mortem CGA just a few times. I don’t like the it for these reasons:

1. For a federal estate tax charitable deduction to be allowable, the PVA must be “presently ascertainable.”25 This means that the will must calculate the present value as of the date of death, which requires unusually skillful and knowledgeable drafting.
2. State law can pose a problem. For example, New York’s DFS requires the filing of a template by the charity that names the executor of the will as the donor. This requirement makes compliance with the federal “presently ascertainable” rule impossible.

In an ideal world, I’d advise that: (1) the donor and the charity enter into an inter vivos agreement that satisfies the “presently ascertainable” requirement, and (2) the donor bequeath a specific cash dollar amount to the charity pursuant to the agreement. This ideal world may exist in some states other than New York, which doesn’t allow such an agreement.

Securities Law Considerations

Statutory law. A charity isn’t considered an investment company for purposes of the Investment Company Act of 1940 merely because it maintains a fund consisting of monies it’s received for gift annuities.26 Nonetheless, an individual who solicits and obtains CGAs for a charity must be a volunteer or be engaged in the overall fundraising activities of a charitable organization and receive no commission or other special compensation based on the number or the value of donations collected.27

Disclosure requirement. A charity that maintains a fund of monies collected for CGAs, such as a charity located in New York, is required to provide a disclosure statement regarding the fund. The requirement exists in the Investment Company Act of 1940 Section 7(e):

(e) DISCLOSURE BY EXEMPT CHARITABLE ORGANIZATIONS. — Each fund that is excluded from the definition of an investment company under section 3(c)(10)(B) of this Act shall provide, to each donor to such fund, at the time of the donation . . . written information describing the material terms of the operation of such fund.

Note that the required disclosure is limited to “the material terms of the operation of such fund.” Virtually all charities provide CGA disclosure statements that disclose matters not required to be disclosed and that fail adequately to disclose what’s required.

Are CGAs securities for federal securities law purposes? One court looked into this question. In Warfield v. Alaniz,28 the Mid-America Foundation, located in California, recruited financial planners and life insurance agents to sell Mid-America CGAs to individuals living in and around Phoenix. Mid-America paid these planners and agents a commission for each CGA obtained. And Mid-America also armed them with promotional materials that included catchy language (such as “Maximizer Gift Annuity”) that emphasized tax and financial benefits. Leonard Bestgen was one of those who sold an annuity and received a commission from Mid-America. Lawrence Warfield was a receiver who sued Leonard to recover the commission. Lawrence was appointed receiver after Mid-America’s founder basically made off with all of Mid-America’s CGA money, and Mid-America went bust.

The issue was whether the CGAs were securities for federal securities law purposes. If they were, Lawrence was on solid ground relative to Leonard, because Leonard wasn’t licensed to sell securities and therefore wasn’t entitled to a commission for selling Mid-America CGAs. The court held that the CGAs were investment contracts (securities) because they were promoted heavily on the basis of tax and financial incentives, and potential buyers were given reason to believe they might reap a financial profit while making a charitable contribution.

It’s important to understand this case. It treats the CGAs, not merely the sort of “reserve fund” California law requires for CGAs, as unregistered securities fully subject to federal securities laws.

CGA marketing. Charities routinely turn to for-profit vendors for assistance in marketing CGAs. The vendors often use catchy language that emphasizes the financial aspect of CGA. This sort of emphasis attracted the attention of the court in Warfield. Gift officers, by and large, are under pressure to secure gifts and thus have an incentive to ignore Warfield. An individual who may have a strong incentive to pay attention to this case is one whose close family member set up a sizable CGA, thereby depriving the individual in question of a large inheritance.

State Law Regulation

About one-half of the states regulate CGAs in some fashion. The regulation takes several forms:

1. The least stringent state regulation consists of threshold requirements, such as number of years in existence and amount of unrestricted assets.
2. Next are states such as Pennsylvania, which require certain disclosure type statements in the CGA agreement.
3. Most demanding are states that require the charity to obtain a permit to issue CGAs and to maintain a reserve fund to back them.

Some states, such as New York, regulate CGAs through their insurance law. Connecticut, on the other hand, requires the charity to disclose in the CGA agreement that the annuity isn’t insurance and isn’t protected by an insurance guaranty association.29

Compliance. Compliance with state law regulation varies. Many charities are meticulous in their compliance. Others flout compliance requirements.

Some years ago, compliance was difficult for some charities. A Massachusetts university might have had a large number of New York CGA prospects, for example. To issue CGAs to these New York residents in compliance with New York law, the Massachusetts charity would have had to establish a fund (what New York calls an “admitted asset account”) and invest assets of the fund in accordance with New York law, which formerly required investment largely in bonds. Bonds were relatively safe over time but produced poor returns in some years compared to stocks. The Massachusetts charity might have viewed New York’s CGA regulation with aversion and sought to avoid it. Massachusetts, doesn’t now regulate, and never has to my knowledge regulated, CGAs.

In some years, it would have been relatively easy for the Massachusetts charity to avoid New York compliance. In those years, the U.S. Supreme Court took the view that a state could exercise jurisdiction over a foreign corporation only if the corporation was doing business in the state or had a presence in the state.30 All the Massachusetts charity would have had to do to avoid New York jurisdiction was avoid doing business in New York.

In 1957, the U.S. Supreme Court employed a relatively new minimum contacts test for jurisdiction in McGee v. International Life Insurance Co.31The facts of McGee are important. Lowell Franklin was a California resident who owned a policy of insurance on his life issued by a certain Arizona insurance company, which was later acquired by International Life, a Texas insurance company. International Life, which had no agents or other presence in California, mailed a new reinsurance certificate to Lowell offering to insure him, which Lowell accepted. Thereafter, International Life received checks as premium payments that Lowell mailed from California.

After Lowell died, a dispute arose concerning the policy’s death benefit, and Lulu McGee (Lowell’s mother and policy beneficiary) brought suit against International Life in a California court, which applied California law and held for Lulu. International Life argued California lacked due process jurisdiction. The Supreme Court found that International Life had sufficient minimum contacts and a substantial connection with California, so that due process was satisfied.32

This case is profoundly important as a matter of constitutional law and in terms of state law regulation of CGAs. If a Massachusetts charity today mails a CGA agreement to a New York resident, after receiving a funding check from the resident, and sends annuity payments to the New York resident, I believe the Massachusetts charity has sufficient minimum contacts with New York to justify New York’s imposing its compliance scheme as to the CGA.

In the five states in which I’ve been admitted to practice law, it’s unethical for a lawyer to advise a client to flout the law. Therefore, I believe it would be unethical today for a Massachusetts lawyer to advise a Massachusetts charity to flout New York law in the hypothetical situation we’ve been considering. Not being a Massachusetts lawyer, however, I would leave the matter to the Massachusetts Bar.

Endnotes

1. Federal tax law requires that the present value of the charitable gift annuity (CGA) be less than 90% of fair market value. Internal Revenue Code Section 514(c)(5)(A).

2. IRC Section 514(c)(5)(B). A CGA for a term of years isn’t permitted, although in Private Letter Ruling 8429075 (April 18, 1984), the Internal Revenue Service approved a CGA that was payable for 10 years or life, whichever was shorter.

3. Section 514(c)(5)(C).

4. But see Treasury Regulations Section 1.1011-2(a)(4)(ii), discussed further in connection with stock-funded gift annuities.

5. The 50% residuum target corresponds to New York law.

6. As of mid-2023, American Council of Gift Annuities payment rates satisfy New York law.

7. See IRC Section 170(b)(1)(B) and (b)(1)(C).

8. As to life expectancy, see Treas. Regs. Section 1.72-9, Table V (expected return multiples).

9. See Treas. Regs. Section 1.1011-2(c), Example 8.

10. Treas. Regs. Section 1.1011-2(8)(c).

11. The deduction is allowed to the donor even if the annuity recipient is another individual.

12. See Section 514(c)(5)(A). To be completely safe, a charity is well advised not to accept any mortgaged property as a funding asset for a CGA.

13. Treas. Regs. Section 1.170A-13(f)(1).

14. Treas. Regs. Section 1.170A-13(f)(16).

15. IRC Section 2503(b)(1).

16. IRC Section 2055(a).

17. SeeEstate of Miriam R. Kolker, 80 T.C. 1082 (1983), in which the Tax Court held that the right of a grandchild to receive a fixed $3,000 yearly payment from a trust was a future interest, because the right was created approximately six months before the first payment was made.

18. Treas. Regs. Section 1.1011-2(a)(4)(ii).

19. See IRC Section 2056, and note that the surviving spouse’s right to receive annuity payments isn’t a terminable interest. When the spouse dies, nothing passes to the charity; the charity received the funding asset when the first spouse established the CGA.

20. Treas. Regs. Section 1.1011-2(a)(4)(iii).

21. Ibid. That is, the gain is spread over just the “life expectancy” of the donor as determined when the CGA is established.

22. See supra note 18.

23. Ibid.

24. The SECURE 2.0 Act may be cited as the “Securing a Strong Retirement Act of 2022.”

25. Treas. Regs. Section 20.2055-2(a).

26. Investment Company Act of 1940 Section 3(10)(B)(iii).

27. Securities and Exchange Act of 1934 Section 3(e)(2).

28. Warfield v. Alaniz, et al., 569 F.3d 1015 (2009).

29. CGS Section 38a-1032.

30. See, for example, Lafayette Insurance Co. v. French, 59 U.S. 404 (1855).

31. McGee v. International Life Insurance Co., 355 U.S. 220 (1957).

32. McGee, ibid., wasn’t an outlier when it was handed down in 1957. It was a natural outgrowth of International Shoe Co. v. Washington, 326 U.S. 310 (1945), which held:

due process requires only that, in order to subject a defendant to a judgment in personam, if he be not present within the territory of the forum, he have certain minimum contacts with it such that the maintenance of the suit does not offend traditional notions of fair play.