A Potential Tax Trap for Married Couples Who Fund A Gift Annuity

A gift annuity funded by a married couple with their separate property can create unexpected tax issues. This article examines the tax consequences of such a gift, how to properly plan such a gift, and how to avert problems with this common gift structure.

Nature of Property Ownership

The title to property donated to fund a gift annuity will drive the tax consequences of a gift annuity for a married couple. There are three possible ways in which a married couple might own property used to fund a gift annuity.

  1. Separate property:  Separate property includes assets that are owned by only one of the couple and are not held in common.  An example of separate property is cash held in a bank account where only one spouse is the owner of the account.  Another example is stock held in the name of only one spouse. 
  2. Joint Property:  Jointly owned property includes assets owned by both spouses.  Examples are cash from a joint checking account and securities where the names of both spouses appear on the stock certificate or brokerage account.
  3. Community Property:  Ten states have some form of community property law: Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. In these states, property acquired during the marriage is considered to be owned jointly by the couple.  Marital property does not include property owned by a spouse prior to marriage or property that a spouse receives during the marriage by gift or inheritance, if kept separate from community property.

Separate property can be transformed into community property. For example, one spouse can make a gift of his or her separate property to the couple's community property. Even if the donors do not reside in a community property state, the property they contribute for a gift annuity may be community property if they acquired it pursuant to the law of one of these 10 states.

The Problem

When a gift annuity for a married couple is funded with one spouse's separate property, unexpected gift tax and capital gain tax issues may arise that are not a concern when spouses fund a similar gift annuity with jointly-owned or community property.
Gift Annuity Tax Trap

Transfer Taxes: Transfers of assets between spouses are entitled to an unlimited marital deduction. A gift tax problem can arise on transfers between spouses, however, because the marital deduction may not be claimed on certain transfers. For example, a transfer of a terminable interest, that is, an interest that terminates upon the death of the holder or on the occurrence or nonoccurrence of a certain event, will not qualify for the marital deduction.

Suppose a donor spouse uses his separate property to create a two-life gift annuity and names the non-donor spouse as the successor beneficiary. The donor spouse has made a taxable gift to his spouse because the annuity interest in the gift annuity transferred to his spouse is a terminable interest and therefore is not eligible for the marital deduction.  In addition, the donor spouse cannot use his annual gift tax exclusion to reduce his taxable gift to his spouse because this exclusion is available only for gifts of an immediate interest.  The annuity to be paid to his non-donor spouse is considered a gift of a future interest and not eligible for the annual gift tax exclusion.   Whether the donor will owe gift tax will depend on whether he has sufficient lifetime gift tax exemption, currently equivalent to $1 million, to offset the taxable gift.

Capital Gain Taxes: A popular tax benefit of gift annuities funded with appreciated property is that the donor can declare his reportable gain in installments over his life expectancy, as long as he is the primary annuitant. 

If the annuity is funded with a donor’s separate property, but is payable to the donor and then to the non-donor spouse, the gain is reportable over the donor spouse’s life expectancy only.  This is not the best tax result for the couple.  If the asset were held jointly, the gain would be reportable over the longer joint-life expectancy of the couple.  This would reduce the capital gain portion and increase the tax-free portion distributed by the annuity each year. 

Solutions 

There are two popular ways to avoid the tax issues discussed above.

  1. Re-title the Donated Asset: The easiest solution to the problem of separate property is simply to re-title the asset. If the donor intends to make the gift with cash, transfer the cash into a joint checking account. If the donor intends to make the gift with securities that are held in certificate form, he can instruct the transfer agent to reissue the securities in joint name. If the securities are held in a brokerage account, the donor can instruct his broker to transfer the securities into a jointly-held account.

  2. Revocation:  The donor-spouse can avoid making a taxable gift to the non-donor spouse by reserving the right, during life or under the will, to revoke the non-donor spouse’s annuity interest. Otherwise, any taxable gift reported at the time the annuity is established, like all other taxable gifts, will be included in the donor’s taxable estate.

Here are the tax implications in the typical situations where the donor-spouse retains the power to revoke the other spouse’s payments:

  • If the donor-spouse does not exercise his power and predeceases his spouse, the present value of the other spouse’s annuity, computed as of the date of the donor’s death will be included in the donor’s estate, but the value of the annuity will qualify for the estate tax marital deduction.

  • If the donor-spouse exercises his power, either during life or at death, and predeceases his spouse, nothing will be included in the donor’s estate, for his spouse's right to payments will have terminated prior to her receiving any.

  • If the donor-spouse outlives his spouse, nothing is included in his spouse’s estate, or subsequently in the donor’s estate, because his spouse was not a contributor, and her right to payments terminated prior to her receiving any.

If you use Planned Giving Manager to produce your gift annuity agreements, you can include revocation language in an agreement by answering Yes when asked Include revocation language? under Narrative Follow-up Questions.

A married couple that funds a gift annuity for themselves with separate property can face unnecessary gift tax and capital gain tax. To avoid paying these taxes, the donor-spouse should re-title the gift asset in joint name prior to donation. If the donor-spouse cannot be persuaded to put the asset in joint name, be sure to include revocation language in the gift annuity agreement.