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Charities Need to Cash Out Partial IRA Distributions

The most tax-efficient charitable bequest is generally a distribution from an IRA or qualified retirement plan:  Income tax and transfer tax savings resulting from charitable deductions and charity’s tax-exempt status can reduce the cost of such a bequest to just pennies on the dollar.  Charity can be named to receive the donor’s entire account, or just a fraction or percentage, with the rest passing to designated beneficiaries.

Most organizations want to receive IRA distributions as quickly as possible, but suppose an organization decides it likes the current investments and proposes to leave the account alone for several years.  If charity is the 100% beneficiary of the account, that approach should not produce adverse consequences.  But if charity is named as only a partial beneficiary, with the rest of the account going to family members or others, the designated beneficiaries will lose the option of stretching future distributions over their life expectancies.

The regulations suggest that a charity that is a co-beneficiary of a retirement account could “cash out” of the arrangement after the donor’s death, permitting the other beneficiaries to use their own life expectancies to calculate future distributions. If charity fails to cash out by September 30 of the year following the donor’s death, and the donor died prior to the required beginning date for distributions (April 1 of the year following the year in which the owner reaches age 70½), the account must be distributed within five years. If the donor died after the required beginning date, the account must be distributed within the donor’s theoretical life expectancy.

Bequests of Savings Bonds to Charitable Remainder Trusts

Clients sometimes are reluctant to cash in U.S. savings bonds (bonds that have reached full maturity) because they don’t want to pay tax on the accrued interest.  The bonds, sometimes worth six figures or more, end up creating income in respect of a decedent for the estate or beneficiaries.

Philanthropic clients might wish to establish a testamentary unitrust and specify that the trust will be funded with the savings bonds.  Tax results?  Elimination of income taxes on the savings bonds when they are redeemed by the trustee of the unitrust, which is tax exempt.  The interest on the bonds will be passed through to the trust beneficiaries as part of their annual unitrust payments, under the four-tier system, and taxed as ordinary income.  But there is no depletion of the trust corpus from tax.  Furthermore, the donor’s estate is entitled to an estate tax charitable deduction. 
Two words of caution: 

• If a client’s estate is subject to federal estate taxes, beneficiaries apparently will not be able to take advantage of a tax break usually available to recipients of IRD assets. The IRS has ruled unfavorably in a case involving retirement accounts where the account passes at death to a charitable remainder trust.  Heirs normally receive an income tax deduction for estate taxes that were owed on an IRA or other retirement account (IRC §691(c)(1)(A)).  Now, says the IRS, if the IRA passes to a CRT, the deduction will belong to the trust, not passed through to the income beneficiaries.  The result is to convert part of the trust’s income (IRD) to tax-free corpus – which the income beneficiaries may be unlikely ever to access, due to the four-tier system of CRT taxation (PLR 9901023, 10-8-98).  The same reasoning would also seem to apply to savings bonds bequeathed to a CRT. 


• Savings bonds can be transferred to a CRT only via will or revocable living trust, not by beneficiary designations on the bonds themselves.  Furthermore, existing co-owner or beneficiary designations generally would need to be removed (by having the bonds reissued), to enable the bonds to pass under the client’s will or revocable living trust.

Charitable Gift Opportunities with Corporate Bonds

Most articles on inter vivos charitable gift planning focus on the advantages of giving appreciated stocks, mutual funds and real estate, but many donors have corporate bonds in their portfolios as well, which may be just as appealing for making tax-wise contributions.

Generally, donors can deduct the full fair market value of any corporate bonds they give to charity and owe no capital gains tax on their paper profit.  The value of listed bonds is the average (mean) of the highest and lowest selling price quoted on the day of the gift (same rule as stock gifts).  If quotes for the high and the low are not available, then the value is the average between the closing value on the day of the gift and the closing value on the day preceding the gift.  If there were no sales on the day prior to the gift, then the value will be a “weighted average” between the close on the day of the gift and the nearest date before the gift date.  If there were no sales on the date of the gift, but sales occurred within a reasonable time period before and after the gift, then an “inverse weighted average” of selling prices before and after the gift must be calculated.

The deduction rules are different if a sale or redemption of the bond would result in ordinary income.  The amount that would have been taxable as ordinary income is not deductible.   Note that some bonds may generate a combination of capital gain and ordinary income upon a sale.  In many cases an accountant will need to be consulted to determine the tax results of sale or other disposition of a particular bond.  Bonds or other securities that have gone down in value should be sold and the proceeds contributed, creating both a charitable and capital loss deduction.  For more information on gift valuation of bonds and other securities, see pages 2-28(b) and 2-62 of the Charitable Giving Tax Service.

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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