FEDERAL TAXATION

January 2000

CHARITABLE REMAINDER ANNUITY TRUST OR CHARITABLE GIFT ANNUITY

By Sonja Lepkowski, CFP, CPA, Yohalem Gillman & Company, LLP

Many public charities [as described in IRC section 170(c)] have established various gift-giving programs whereby individuals and their spouses can make a contribution to their favorite charity while securing cash distributions sufficient enough to meet their cash flow needs during their lifetimes. Arrangements that accomplish these goals include the charitable remainder annuity trust (CRAT) and the charitable gift annuity (CGA). After transferring the assets, such as cash, real estate, or appreciated securities to the trust, the donor (or some other trust beneficiary) collects income distributions and reports the taxable income and deduction items on personal income tax returns. No trust returns need to be filed by the donor when the charity acts as the administrator of the trust. But which of the two is better?

CRAT

The CRAT is a creature of the IRC. Under a CRAT, the donor makes an irrevocable transfer of certain assets to a trust, in accordance with the trust document. One or more noncharitable beneficiaries receive annual or more frequent payments for a stated term not to exceed 20 years or for the beneficiary's lifetime. The charity, as named in the trust document, receives the remainder interest in the trust property at the end of the trust's term.

The nature of income that the beneficiary will have to report depends upon the income earned by the trust. There are particular ordering rules as to how distributions are treated. Specifically, the beneficiary will be taxed on capital gains and ordinary income before receiving truly tax-exempt income.

The donor gets a current income tax charitable deduction under IRC section 170(f)(2)(A). The amount of the charitable deduction is based on the present value of the remainder interest of the trust's assets.

If the donor contributes appreciated assets, she generally is not required to pay a capital gains tax on such appreciation on personal income tax returns. However, a portion of the capital gain can be taxed to the beneficiary only to the extent that the CRAT sells the appreciated property and a portion of this capital gain is distributed to the noncharitable beneficiary.

Administrative costs for a CRAT are more burdensome than for a CGA, since the charity is required to file certain annual returns such as Form 5227, Split Interest Trust Information Return, and Form 1041-A, U.S. Information Return, Trust Accumulation of Charitable Amounts.

The annuity payout must be stated as a fixed dollar amount not to exceed 50% of the initial fair market value of the assets. Furthermore, this payout cannot be less than five percent of the initial net fair market value of all trust property. At least 10% of the initial fair market value of the property transferred must eventually pass to the trust remainderman, as explained in IRC section 664(d)(1)(D). Furthermore, a CRAT can lose its tax exemption for any year in which the trust has unrelated business income or debt-financed income.

If the donor retains an income interest for life or has retained the power to revoke the income interest of another, the full value of the CRAT will be included in her estate. But the full value will then also qualify for an estate tax charitable deduction. The value of any effective survivorship annuity will be subject to estate tax. However, if the surviving spouse is the only beneficiary, the value of the survivorship annuity will qualify for the unlimited estate tax marital deduction, and the trust will not be taxed in the estate of the surviving spouse.

CGA

The CGA is a creature of Treasury regulations. It is an outright gift to a charity under the bargain sale rules, created by an irrevocable agreement between the donor and the public charity. In turn, the charity promises to pay a fixed and guaranteed annuity from its own funds to the beneficiary or beneficiaries for life. The older the beneficiary, the greater the fixed income. The annuity payment, generally smaller than those paid by commercial insurance companies, is partially a return of principal and partially interest income taxable to the beneficiary, not necessarily the donor, as determined under IRC section 72.

In accordance with Regulations section 1.170A-1(d), the donor is entitled to a current income tax charitable deduction on the excess of the value of the transfer over the present value of the annuity payments, as determined by certain IRS tables. Furthermore, Regulations section 1.170A-13(f)(16) provides that if such a charitable deduction is $250 or more, the charity must make a contemporaneous written acknowledgement stating whether any goods or services were provided to the taxpayer in addition to the annuity.

If appreciated property is donated and the donor is also the beneficiary, the donor can recognize the capital gain over her life expectancy, as provided under IRC section 1011. Part of the annual tax-exempt portion of the annuity will become a long-term capital gain, and the net cash flow after taxes will be greater than the net cash flow under a CRAT. Administrative costs under this arrangement are modest, since there are typically no filing requirements associated with a CGA. Annuity rates are based upon the donor's age and actuarial life expectancy. If the annuity is for a term of years, it is an installment bargain sale, which gets special treatment under the tax law.

The CGA is typically structured so that the charity is entitled to approximately 50% of the assets. Because the charitable gift portion cannot be included in the donor's estate, her overall estate tax liability will be significantly reduced.

Gift Tax Consequences

In either case, to the extent the charitable gift exceeds the $10,000 annual exclusion (as adjusted for inflation), an annual gift tax return is required. However, the donor is entitled to a gift tax charitable deduction for the full amount of the taxable gift. If the beneficiary is other than the donor, the donor has made a taxable gift equal to the present value of the annuity as of the purchase date. The gift tax rules apply for an annuity commencing immediately, unless the donor retains a power to revoke the annuity interest. A gift tax marital deduction is allowed for a joint and survivor annuity and for a gift annuity where the donor's spouse is the sole beneficiary by reason of a special provision of IRC section 2523.

Weighing the Benefits

The benefits to a CGA beneficiary are generally greater than benefits to a CRAT beneficiary. The net tax cash flows will usually be greater with a CGA. It can accommodate smaller gifts, its agreement is more simply stated and understandable, and its capital gain component is distributed over the life of the annuity. If the beneficiary outlives her actuarial life expectancy by a substantial margin, the CGA makes a good choice.

On the other hand, the charitable deduction under a CRAT is generally higher than the amount that can be deducted under a CGA. Furthermore, a CRAT can last for a term of years, whereas a CGA can last for only one or two lives. The facts and circumstances of each situation must be thoroughly analyzed in order to determine which arrangement will provide the best result. *