More than Just Spaghetti: Exploring Differences in Life Income Gifts

If a researcher could travel back to the 1970s to ask average Americans about their pasta consumption, it is likely their responses would be fairly narrow: spaghetti and meatballs, American goulash, maybe even SpaghettiOs or Chef Boyardee Ravioli. Obviously, certain cities and regions boasted culinary scenes with fantastic, authentic Italian food, but much of the country had limited exposure to the exquisite variety of pasta dishes known throughout the world.

With easier access to information, people nationwide expanded their cultural and culinary awareness. Today, a pasta dinner might be angel hair cacio e pepe, spaghetti all’assassina, Portuguese pasta with linguiça and clams, or even Mentaiko pasta!

When it comes to estate and financial planning, many individuals maintain a limited awareness of charitable giving options and the personal planning benefits that come with those options. Clients may think immediately of gifts of cash or bequests but nothing beyond that. They may not even be aware that they can fulfill their charitable goals in a way that creates a lifetime income. This can be an extremely valuable planning option in certain situations—once they know about it and understand how it works.

This issue serves as important preparation for guiding client discussions and is written for ease of comparing the various facets of charitable gift annuities and charitable remainder trusts.

The basics

Life income gifts have been a part of charitable giving for many years. They are charitable gifts that include an income component in the form of regular payments to a non-charitable beneficiary. The purpose is twofold—to support a charity and secure an annuity for the donor and/or someone else. Though not every donor will want or expect an income stream to be part of a planned gift, the availability of this option makes certain charitable gifts possible and helps donors make effective planning choices.

There are two types of life income gifts: a charitable gift annuity (CGA) and a charitable remainder trust (CRT). Each has unique characteristics, meaning one or the other may end up being a better fit for a particular donor. Let’s start with the basics of each type of life income gift.

A charitable gift annuity is a contractual agreement made between the donor and the charity under which the donor agrees to make a charitable gift and the charity, in turn, agrees to pay a fixed amount periodically to the donor or the person designated by the donor.

A charitable remainder trust is an irrevocable trust that provides annual distributions to one or more non-charitable beneficiaries for a specified period (for life, joint lives, or a period up to 20 years), after which the trust terminates and the remainder interest is paid to a qualified charity.

There are two types of charitable remainder trusts:^[1]

• A charitable remainder annuity trust (CRAT) pays out a set amount every year, determined as a fixed percentage of the initial value of the trust assets. Since the trust is required to make distributions at least annually (including the year in which the trust is created), an illiquid asset that does not generate income may not be a good CRAT funding choice unless sufficient cash is also part of the gift.^[2] It is also important to note that a CRAT does not allow additional contributions after the initial contribution.^[3]
• A charitable remainder unitrust (CRUT) pays out a variable amount every year, determined as a specified percentage of the trust assets as revalued each year.^[4] This gives a CRUT much more flexibility than a CRAT, including allowing additional contributions. CRUTs offer further flexibility through four sub-varieties:
  1. A straight or fixed percentage unitrust.
  2. A net income (without makeup) unitrust (NICRUT). Beneficiaries annually receive the lesser of the trust’s net income or a unitrust payment.
  3. A net income with makeup unitrust (NIMCRUT). This is a net income trust in which the trust agreement is drafted to include a provision that if the annual payout is less than the specified percentage in one or more years, the accumulated “income deficits” will be made up in subsequent years in which income exceeds the specified percentage.
  4. A “flip” unitrust. Before a specified date or triggering event (called the “flip date”), the income beneficiaries receive payments from the trust that are net income only. After the flip date, the beneficiaries receive straight unitrust payments, as with a standard CRUT.

Formation

Charitable gift annuity

A qualified charity will typically provide the donor with a standard CGA contract—short and straightforward—that offers the donor choices depending on the type of CGA and what is permitted under state law.^[5] The regulation of charitable gift annuities varies from state to state. Some states require the issuing charity to maintain reserves, file draft annuity agreements, or submit annual filings, while others may require the issuing charity to register with the state in which it solicits gift annuities. The actual solicitation of charitable gift annuities may also be subject to state regulations. This should not be an issue for most donors who are working with a qualified charity, but it is always important to do all necessary due diligence.

When creating a CGA, the donor must make a number of decisions:

• How will the donor fund the CGA?
• Will the CGA be for a single life, two successive lives, or joint and survivor?
• Will the payments be immediate or deferred (beginning more than one year after the gift)?
• Will payments be made monthly, quarterly, semi-annually, or annually?
• Which applicable federal rate (AFR) will the donor use?

The AFR, also called the 7520 rate, applies to both charitable gift annuities and charitable remainder trusts. It is an interest rate published monthly by the IRS that is used to calculate the present value of future payments and, therefore, to determine the amount of the donor’s charitable income tax deduction. This discount rate is the annual rate of return that the IRS assumes the gift assets will earn during the gift term, and donors are allowed to choose the AFR for the month in which the gift is made or the AFR for either of the two months preceding the month in which the gift is made.

• A donor who wants to maximize the charitable income tax deduction will choose the highest available AFR.
• A donor who wants to maximize the tax-free portion of the annuity payments will choose the lowest available AFR.

Charitable remainder trust

A CRT is a legal entity created by the donor. It is much more complex than a CGA and its creation requires the assistance of legal counsel. The donor determines the terms of the trust based on their own unique planning needs. In order to qualify as a split-interest trust that generates an income tax deduction for the donor, the CRT has to meet criteria described under Section 664(d) of the Internal Revenue Code.^[6]

The CRT is a gift of a remainder interest (to the charitable remainderman) with a retained income interest (for the amounts in the trust paid to the income beneficiary). The gift qualifies for a charitable income tax deduction in an amount equal to the present value of the remainder interest in the year the trust is created.^[7]

As with a CGA, a donor who creates a CRT has a number of decisions to make:

• How will the donor fund the CRT?
• Who will the income beneficiaries be? Unlike a CGA, a CRT is not limited to two income recipients.
• How long will the trust term last?
• Which AFR will the donor choose? (See the AFR discussion in the previous section.)
• Who will serve as trustee, responsible for managing the trust?

Selecting the trustee is an important decision. The trustee can be a third party (such as a family member or the donor’s legal counsel or CPA), the charity (which is also the charitable remainderman), a financial institution with trust powers, or even the donor. The donor may retain the right to change the trustee. The donor should pick a trustee who is not only trustworthy but has sufficient estate and financial knowledge to manage the trust—if not, the donor must be prepared to incur extra expense when an unprepared trustee finds it necessary to hire counsel or accountants to assist with all aspects of the administration.

Funding

Charitable gift annuity

The minimum amount necessary to establish a CGA is determined by the charity and may be relatively modest—at IU the minimum is $10,000.

A donor may fund a CGA with cash (the most straightforward option) or another preferred asset. There are advantages to funding a CGA with a long-term appreciated asset—for example, stock or other securities held for more than one year. By using this type of asset, the donor avoids incurring capital gains tax on the gift portion of the CGA, and the long-term capital gain realized on the annuity portion of the CGA can be evenly spread across the annual payments over the span of the donor’s life expectancy.

It is important to advise a donor, however, that to qualify for this ratable recognition of long-term capital gain, the donor must be the only annuitant (or the donor and a designated survivor annuitant), and the annuity cannot be assignable to anyone but the charity itself.^[10] If the donor contributes appreciated property and the present value exceeds the basis of the gift allocated to the annuity, then the gain is immediately realized and recognized by the donor to the extent the present value of the annuity exceeds the basis of the appreciated property.^[11]

Property that cannot be easily valued or sold is not the best option to fund a CGA. Payments for an immediate CGA must begin within a year of when the gift is made, and the charity would be at a disadvantage if the funding asset cannot be quickly converted into an income-producing asset. The reality of charitable giving is that most (if not all) charities will not accept a gift that cannot be quickly converted into a liquid asset. A key factor in the charity’s acceptance of an illiquid gift is whether the state law of the charity’s home state permits the charity to count certain illiquid assets towards the state’s reserve requirements for charities. Additionally, most charities have adopted strict provisions in their gift acceptance policies that govern their acceptance of an illiquid gift.

Charitable remainder trust

A CRT is more complex and comes with more expenses than a CGA, so it is feasible only for gifts of $50,000 or more (depending on the type of CRT).

Like a CGA, CRAT payments must be made at least once a year, so an illiquid asset that does not generate income is not the best choice for funding unless sufficient cash is also part of the gift.

A CRUT is a different matter, though, as there are variations that permit flexibility in the annuity payout. For instance, a flip CRUT can begin as a net income CRUT holding a non-income-producing asset (and therefore making no payments), then “flip” into a straight CRUT when the trustee sells the asset.

Payout

Charitable gift annuity

The American Council on Gift Annuities (ACGA) publishes suggested CGA payout rates based on the annuitant’s age, updating these rates when appropriate. However, the charity can use the suggested rates or set their own payout rates for the CGA, keeping in mind that the offered payout rate must pass the 10% residuum to charity rule set forth in IRC §514(c)(5). The amount of the CGA annuity payment is set at the time the CGA is created and never varies—no adjustments to the payout amount are allowed based on investment performance, market performance, or any other factor.

The CGA will make set annuity payments for the life of one or two annuitants. However, the CGA agreement cannot specify that the annuitant will receive a certain number of payments.

Each income payment can be taxed in three ways:

• A tax-free return of principal. Part of the annuity payment is a tax-free return of principal until the assumed cost of the annuity (as determined by the IRS tables) has been recovered.
• Long-term capital gain. If the donor is the annuitant and funds the CGA with long-term capital gain property, part of the annuity payment will be taxed as long-term capital gain until that amount is recovered.
• Ordinary income. After the tax-free and capital gain portions of an annuity payment have been determined, the balance of the payment represents ordinary income.

Once the annuitant attains life expectancy, all principal attributable to the sale portion will have been recovered income tax free and all capital gain attributable to the sale portion will have been recognized. Thereafter, the entire annuity payment will be taxable as ordinary income.

Charitable remainder trust

While the donor can set the payout rate for the CRT, it must meet the IRC requirements, and at IU the offered rate is 5%, and the calculation for the proposed CRT at the given rate must provide at least a 10% remainder to charity.^[12] Once set, the payout rate to a non-charitable beneficiary generally cannot be changed, but an independent trustee may apportion trust income among beneficiaries if the trustee is given that power in the trust agreement.^[13]

The payment duration of a CRT is measured by a term of years (up to 20) or by the life or lives of the beneficiaries.^[14]

While a CRAT payout is fixed at the time of trust creation (as a percentage of the initial trust assets), the CRUT payout can vary from year to year because it is set as a percentage of the trust assets as revalued annually. A net income CRUT payout may vary depending on the income the trust has earned because the payout is the lesser of the net income earned or a percentage of the trust assets.^[15] In the case of a net income CRUT with a makeup provision, the trustee can pay a percentage of the trust assets as valued for the year plus any amount of trust income in excess of the percentage to the extent that the trust experienced income deficits in prior years.^[16]

A CRT payout is taxed according to a four-tier system that accounts for the nature of the income itself:

• Ordinary income
• Capital gain^[17]
• Other income (i.e., tax-exempt interest)
• Tax-free return of the trust principal^[18]

Distributions are made according to a “worst-in, first-out” system for each respective tier. The highest-taxed income in the top tier, ordinary income, is distributed first. If there is both ordinary interest income and qualified dividend income, the ordinary interest income is distributed first, followed by qualified dividends. After all ordinary income has been distributed, capital gains are distributed. Within the capital gains tier, net short-term capital gains are distributed before the net long-term capital gains.

Beneficiaries

Charitable gift annuity

The donor may choose one or two living persons (not a trust, corporation, LLC, or charity) as annuitants of a CGA.

Charitable remainder trust

The donor may choose any number of income beneficiaries for a CRT as long as at least one is not a charity. The donor can be a beneficiary. Any number of charitable remaindermen may receive the remaining trust assets once the term of the CRT has ended, but each charitable remainderman must be a qualified charity under the IRC and the regulations.^[19]The donor may choose to retain the power to change the charitable remainderman without compromising the tax-exempt nature of the CRT.

Administration

Charitable gift annuity

Once the CGA is established, the charity places the donor’s gift in its own reserve fund. The charity observes its own policies and state regulations for investment and maintenance of reserve funds. Every year, the charity makes one or more income payments (according to the schedule chosen by the donor) and issues a 1099-R form to the annuitants detailing the taxation of the CGA payout(s).

Charitable remainder trust

A CRT trustee must oversee several ongoing administrative issues:

• Managing investment of the trust assets
• Filing tax returns for the trust
• Making an accounting of trust income
• In the case of net income makeup unitrusts, tracking the makeup amount when the income is less than the payout rate
• Reporting and distributing income to the trust beneficiaries

Retirement planning

Charitable gift annuity

Donors looking to boost their income in retirement might consider a deferred CGA, which begins payments at least one year after the date the CGA is created. Compared to immediate CGAs, a deferred CGA has a higher payout rate and generates a larger charitable deduction. The donor receives the charitable deduction in the year the CGA is created, even though the payments do not begin until a future date.

Charitable remainder trust

A CRUT naturally fits the retirement model because the payout reflects the investment performance of the trust assets, which can provide a useful hedge against inflation. More specifically, the assets in a net income CRUT with a makeup provision can be invested, beginning payments at a future retirement date. The makeup provision units could then provide the beneficiary with an influx of cash at that later date.

IRS model agreements

In 2003, and with an update in 2016, the IRS issued model CRAT forms with preapproved trust language to conform to statutory and regulatory changes. These forms can be found in Rev. Procs. 2003-53 through 2003-60, released in IRB 2003-31, with the updates found in Rev. Proc. 2016-42, released in IRB 2016-34.

In August 2005, the IRS issued model CRUT forms with preapproved trust language to conform to statutory and regulatory changes since the prior model CRUT forms were issued 15 years earlier [Rev. Procs. 2005-52 through 2005-59, released in IRB 2005-34].

The life income gift: charitable giving with a bit extra

Would you like freshly grated parmesan on that?

There may be no question so highly anticipated by a cheese-loving diner in an Italian restaurant! As the server grates the cheese, the diner will look on expectantly, knowing that this “bit extra” will make the pasta that much better!

Making a gift to help a meaningful charity accomplish its mission is worthwhile in and of itself. But with a life income gift, the donor can help others and get a bit extra in the form of an income stream. CGAs and CRTs are both ways to give and first require a donor’s charitable intention. The payout rates of a CGA, even after considering the charitable income tax deduction, will almost never compare favorably to commercial annuity rates, nor will the time and donor expense required to create and maintain a CRT justify the income it produces if a charitable gift is not personally important to the client. Life income gifts are attractive to dedicated supporters because incorporating philanthropy into planning is essential. And for some donors, the little bit extra from the income makes the charitable gift that much better!