What's the Big Deal about the Donor's Cost Basis?

The question of why charities need the donor’s cost basis for long-term appreciated stocks funding charitable gift annuities (CGAs) comes up frequently in our client support calls. If the donor doesn’t provide the information up front, do they really need to pursue it? What if the donor says he doesn’t have the cost basis information? Can the charity simply assume zero for the cost basis and call it a day? What difference does it make anyway?

Why it matters

PG Calc’s Planned Giving Manager prompts the user to supply the dollar amount the donor paid for the stock when it was originally acquired – or, in the case of inherited stocks, the official value of the stock on the date of death of the previous owner (AKA the “stepped-up” cost basis).* This information is relevant and necessary because charitable gift annuities are split-interest gift arrangements. In each CGA, there is a benefit for the charity (the remainder or residuum), and a benefit for the annuitant (the value of the stream of annuity payments over time).

When the donor transfers the appreciated stock to the charity, IRS rules call for recognition and taxation of a certain proportion of the capital gain inherent in that stock. The capital gain attributable to the non-charitable part of the gift annuity is the gain that is reportable and taxable. The capital gain related to the charitable portion of the gift annuity, on the other hand, is not reported or taxed, because the charity is exempt from taxation.

If the donor doesn’t provide the cost basis information, the charity needs to request the information as part of the completion of the gift annuity arrangement. If the donor refuses to provide the information, or is unable to provide the information, the only solution for the charity is to assume the cost basis is zero. We can explain this by comparing a few different scenarios.

Let's look at an example

In all cases, let’s assume the donor is 69 and the stock is worth $10,000. Using the current ACGA payout rate, the donor would get a 5.0% annuity and the charitable deduction would be approximately $4,000 (based on February’s 2.4% discount rate).

 A deduction of $4,000 means that 40% of the gift annuity is considered to be a benefit for the charity and 60% is considered to be a benefit to the donor. Let’s see what happens when we assume different cost bases.

1. If the donor’s cost basis is $7,000, then the inherent capital gain – the long term appreciation built up in the stock – is $3,000. Given that 60% of the capital gain is attributable to the non-charitable portion of the gift, then $1,800 of the long-term capital gain is reportable. That gain would be reportable over the donor’s life expectancy if the donor named himself as the first (or only) annuitant.

2. If the donor’s cost basis, on the other hand, is only $2,000, then the inherent capital gain is $8,000. This means that $4,800 of the capital gain – which is 60% of $8,000 – is reportable over the donor-annuitant’s life expectancy. [Remember that if the donor is not the annuitant (or first annuitant), the reportable capital gain is taxable in the year the gift annuity is established.]

3. If the real cost basis is unknown, the calculations must assume zero, because assuming any other number could possibly understate the amount of capital gain that must be reportable. Using zero, the total inherent capital gain would be $10,000, but the reportable portion would still be only $6,000. In the worst case scenario – that of the donor being audited by tax authorities - it is without question better to risk overstating the reportable gain than to risk understating it.

Resist the urge to "help!"

Occasionally we hear the question regarding whether or not the charity can research historical stock prices to determine the donor’s cost basis. While we understand the desire on the part of the charity to be as helpful as possible to the donor in creating the gift annuity, there is considerable risk in following this approach. The charity can never be entirely sure of precisely when the original purchase was made, if the donor purchased any additional shares over the ensuing years, or if any shares were sold or donated along the way. Add to that the risk of looking up the wrong stock and the chance of doing the math incorrectly – we believe most tax professionals would concur that this extra effort is simply too dangerous for the charity to undertake.

The need for the donor’s cost basis information is a critical component of accepting appreciated stocks as funding for CGAs. The tax advantages to the donor are considerable, but since the establishment of the gift annuity is treated as a partial sale for tax purposes, we need to be steadfast in assuming zero when the true cost basis is unknown.

We hope this information is helpful. We realize this issue can be a difficult subject with donors, and we invite you to contact us if you have any additional questions or would like to discuss the matter further.

*Stocks inherited in 2010 may or may not have received a “stepped-up” cost basis – if the estate took advantage of the unique one-year hiatus from federal estate taxes, the cost bases for stocks passing through the estate would remain at the original amounts paid by the previous owner (decedent).