Should Clients Contribute Commercial Annuities?

Suppose a client has a commercial deferred payment annuity and is considering making an outright gift of the contract to a charitable organization. How much can she deduct? Are there any adverse tax results?

It appears that, under Code §72(e)(4)(C), for contracts issued after April 22, 1987, a person who
transfers an annuity contract for less than full and adequate consideration (as in a gift) will be treated as receiving an amount of income equal to the cash surrender value of the contract, minus the value of the donor’s “investment in the contract” – generally, any amounts paid by the donor to the insurance company. So if the annuity contract is worth $50,000 and the donor paid in $20,000, she will have taxable income of $30,000 when she assigns the contract to an organization. On the other hand, the donor should be entitled to an income tax charitable deduction for $50,000, which would offset the $30,000 of extra income. (See Friedman v. Comm’r., 65-2 USTC, ¶9473 (CA-6, 1965).

If the donor transfers a deferred annuity contract prior to reaching age 59½, there is a risk that the income realized will trigger the 10% “early withdrawal” penalty. So our donor might owe an
additional $3,000 in tax (10% x $30,000) if she is underage. After 2010, the $30,000 of additional income could also result in reductions in both personal exemptions and itemized deductions if Code §68 is reinstated, and she may pay higher state income tax if she lives in a state where charitable deductions are unavailable.

Donors who give commercial annuity contracts would be better off if their deductions were simply reduced to basis, rather than report income when they make their gifts. That’s the rule with gifts of cash value life insurance policies, where donors generally deduct the lesser of a policy’s fair market value or their cost basis and aren’t required to report income.  For annuity contracts issued before April 23, 1987, donors are required to report income at the time the charity surrenders the annuity for its cash value (Rev. Rul. 69-102, 1969-1 C.B. 32). If charity “cashes out” in a year after the gift is made, the donor’s deduction may be limited to cost basis.  Furthermore, the donor’s deduction and recognition of income will occur in different years – an unfortunate result.  What about exchanging a commercial annuity for a charitable gift annuity? Code §1035 does permit tax-free exchanges of certain insurance policies, including exchanging one annuity contract for another annuity contract [Code §1035(a)(3)]. But charities do not appear to be eligible for tax-free exchanges under §1035.

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