We frequently work to assist our clients in situations involving married couples. In some cases, the spouses are looking to establish a 2-life charitable gift annuity (CGA), whereby they will both be donors and they will both be beneficiaries (annuitants). There is no issue with potential gift tax consequences in cases where the couple’s marriage is recognized by federal law – such spouses may transfer unlimited amounts of wealth to each other without any possible gift tax. And if the CGA is funded with cash, there also is no issue with possible income tax, because there are no capital gains involved in the transfer of cash. If the gift annuity is funded with appreciated securities, however, there can be significant tax issues tied to the long-term capital gains inherent in the appreciated securities.
The charitable gift annuity is one of the legal arrangements known as “split interest gifts.” The donor contributes cash or something else to the charity, in exchange for a partial charitable tax deduction AND a stream of lifetime annuity payments. The charitable tax deduction is for the portion of the gift arrangement that the IRS deems to be a charitable gift. The other portion of the gift arrangement – known as the “investment in contract” or “value of the annuity” – is the present value of the estimated lifetime payments the annuitant will receive. Some gift planning professionals refer to this as the “noncharitable portion” of the split interest gift. The value of the charitable benefit (the deduction) plus the value of the annuity (the investment in contract) add up exactly to the total gift funding amount.
When a donor establishes a gift annuity with cash, and the annuity payments are to be made to the donor, the calculations are straightforward. There is a charitable deduction for a portion of the total funding amount, the amount of the annuity payment is fixed and will not change, and the payments will be made for the remaining life of the donor. The taxation of those payments is a combination of tax-free income and ordinary income over the donor’s life expectancy, and then the payments become fully taxable as ordinary income.
When a donor establishes a gift annuity with appreciated securities, however, with payments going to the donor, the taxation of the payments is different. A portion of the payments will be categorized as ordinary income, but another portion of the payments will be categorized as a distribution of long term realized capital gains. Depending on the amount of total appreciation (capital gain) inherent in the securities, there may or may not be a portion of the payments that is tax-free. But regardless of whether there is tax-free income, the amount of capital gains to be distributed will be spread out over the life expectancy of the donor. As long as the donor is the annuitant, the capital gains will be spread out over many years.
The situation can be quite different, however, when the donor is not the annuitant. If a husband, for example, establishes a charitable gift annuity with payments going to his wife, and the gift annuity is funded with appreciated securities owned solely by the husband, a portion of the capital gains must be reported and taxed right away, in the year of the gift. The reportable capital gain will NOT be spread over the annuitant’s life expectancy if the annuitant is NOT the donor. In our example, the husband would be taxed on the reportable capital gains all up front when he files his next tax return. Keep in mind that the problem does not exist if the husband establishes the gift annuity for the wife’s benefit and the funding asset is cash. There are no capital gains involved with a cash-funded gift annuity.
Now we get to the juicy part. Instead of situations involving just one annuitant, let’s imagine that both spouses wish to be named as the annuitants on a new gift annuity. They inform the gift officer that the gift annuity will be a “joint gift annuity” with payments going to them jointly (and then to the surviving spouse after the death of the first spouse). Generally speaking, the most favorable outcome for a two-life gift annuity is for both of the spouses to be named as DONORS – at least when the gift annuity is funded with appreciated securities. If both spouses are donors and annuitants, the reportable capital gain can be spread over their joint life expectancy. That means the capital gains are spread out over the greatest number of years. In the world of taxes, a tax deferred is a tax lessened.
But here’s the rub: both spouses can be donors but ONLY if they are both OWNERS of the stock. If the stock is owned by only one of the spouses, the other spouse simply cannot be a donor. You cannot be a donor if you are not an owner. You can’t give away something you do not own. It’s as simple as that. If the husband owns the stock by himself, for example, only he can be the donor. And likewise for the wife. They can BOTH be annuitants, but there may be negative tax implications.
When a gift annuity is funded with appreciated securities, but the stock is owned by only one of the spouses – and when both spouses are to be named as joint and survivor annuitants – the situation is a bit more complex. It’s almost as if there are two separate gift annuities being established. If there is one donor but two joint annuitants, 50% of the gift annuity is the situation where the donor is also the annuitant, and 50% of the gift annuity is the situation where the donor is NOT the annuitant. That means half of the reportable capital gain amount can be spread ratably over the husband’s life expectancy, but the other half of the reportable capital gain must be taxed up front. There can be just one gift annuity agreement, because the agreement doesn’t include any information about capital gains, but there have to be two separate gift annuity calculations.
For example, if a husband, age 75, funds a gift annuity for him and his wife, also age 75, with $100,000 in stock that he purchased years ago for $20,000, they will receive $6,300 in payments each year. They will need to report $53,454 of the husband’s $80,000 capital gain, half spread evenly over the first 13 years of payments ($2,038 per year) and half, $26,727, in the year of the gift.
The only way around this predicament is for the couple to transfer the securities from ownership by just one person to ownership by two persons – which is referred to as “joint ownership.” In the bad old days, when stocks were on paper certificates, it was an arduous and time-consuming process to transfer ownership from one spouse to both spouses. But nowadays, these transactions are executed at the click of a mouse. In most cases it is quite easy to transfer stocks into joint ownership and then proceed with charitable gifts. In many situations, the entire process can be done in one business day.
If there is a significant amount of reportable capital gain involved, it will probably be worthwhile for a married couple to transfer the securities into joint ownership prior to establishing the charitable gift annuity. There could be significant tax savings in taking these few extra steps. You may encounter some resistance on the part of older donors who do not realize how easy the process has become to transfer ownership in recent years. Be sure they understand transferring securities into joint ownership is easy and well worth the effort.
Returning to the case described above, if the husband transfers ownership of his stock into joint ownership by him and his wife, they won’t need to report any capital gain in the year of gift and the $53,454 they must report can be spread evenly over 16 years ($3,261 per year).
One last wrinkle to consider. What if the husband is the primary annuitant and the wife the successor annuitant, rather than joint and survivor annuitants, and the husband is the sole owner of the stock? In this case, all the capital gain must be reported over the husband’s life expectancy of 13 years ($4,076 per year) rather than the joint life expectancy of both spouses (16 years). No capital gain will be reportable in the year of the gift. If the spouses become joint owners of the stock first, then fund the annuity, half the capital gain will be reportable over 13 years ($2,038 per year), and the other half ($26,727) will be reportable in the year of the gift.