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Introduction

Commercial annuities are considered by many to be safe investments for individuals looking to secure a consistent source of income over extended periods, notably during retirement. A commercial annuity will typically provide financial security throughout an individual's lifetime, with the goal of alleviating concerns about depleting retirement savings.

Over time, however, an individual's finances may change, and their priorities may shift to philanthropic interests. Charitably minded individuals may consider transferring their commercial annuity to a charitable gift annuity as a way to combine their charitable goals and their desire for income security. Commercial annuities and charitable gift annuities are distinct from one another. Donors and their advisors should carefully consider the tax implications of commercial annuities.

In this article, we will provide insight into the mechanics of commercial annuities, Sec. 1035 exchanges and charitable gift annuities. We will also explore using a commercial annuity for a charitable gift. By understanding the rules that come with commercial annuities, its charitable giving options and its exit strategies, advisors can be prepared to assist clients with their charitable goals.

Commercial Annuities

A commercial annuity is an annuity, endowment or life insurance contract between a financial institution and an annuitant. IRC Sec. 3405(e)(6). These contracts promise fixed or variable income payments from a financial institution for the duration of the annuitant's life or a term of years. Certain commercial annuity contracts may also offer a death benefit.

To ensure adequate retirement income, individuals often purchase annuities. They may be acquired as part of a retirement account or with after-tax income. Typically, an annuity that is funded with pre-tax dollars is considered a qualified annuity and an annuity funded with after-tax dollars is considered a non-qualified annuity. For the purposes of this article, commercial annuities are assumed to have been created after April 22, 1987. IRC Sec. 72(e)(4)(C).

The Internal Revenue Service (IRS) taxes the annuity payouts depending on the type of annuity. In the case of a qualified annuity, the payouts are subject to taxation as ordinary income, and the annuitant is responsible for paying taxes on the entire distribution. For non-qualified annuities, the annuitant will pay tax on the earnings and interest portion of the distribution, not the principal.

Commercial annuities can be structured in various ways. A contract may include a minimum guaranteed payout or a minimum guaranteed duration, and payments can begin immediately or be deferred for several years. Withdrawals are generally allowed for non-annuitized deferred annuities; however, it is important to note that financial institutions will vary in their surrender and withdrawal policies. Because qualified annuities are considered retirement accounts, financial institutions often impose penalties to discourage annuitants from taking funds before retirement. In addition to the financial institution's penalty, a 10% penalty will be added by the IRS for most withdrawals from an annuity when an annuitant is under 59½ years of age.

Due to these penalties, an individual who withdraws or surrenders an annuity contract prematurely may have a significant loss of value in his or her initial investment. Additionally, the withdrawal will be subject to income tax and must be reported to the IRS on an individual's tax return. Annuitants who may feel trapped with their current annuity contract may not be able to avoid the surrender charge but can avoid the tax consequences of withdrawing an annuity early if it is exchanged for another commercial annuity that better aligns with their needs.

1035 Exchanges

Section 1035 allows individuals to exchange an existing annuity contract for a new annuity contract without paying tax on the income and investment gains in the current annuity account. IRC Sec. 1035. Section 1035 also allows this type of exchange for life insurance policies and endowments. To qualify, the exchange must involve the same contract owner or policyholder and be executed directly between the financial institutions.

An exchange under Sec. 1035 must adhere to the like-kind exchange requirement. The tax code allows tax-free exchanges from an annuity contract to another annuity contract, a life insurance policy to another life insurance policy or a life insurance policy to an annuity. The code does not allow the exchange of an annuity contract for a life insurance policy. While Sec. 1035 allows an exchange between commercial annuities, it does not permit exchanges of commercial annuities for charitable gift annuities.

Charitable Gift Annuities

A current or immediate gift annuity is a contract between the nonprofit and the donor. The donor transfers cash or property to the nonprofit and the nonprofit promises to pay the annuity for one or two lives. IRC Sec. 514(c)(5). The payments to the annuitant may be made monthly, quarterly, semiannually or annually. In addition, there is an income tax deduction and partially tax-free payouts from the annuity contract.

The annuity payments are a contractual obligation by the nonprofit and are secured by the full assets of the nonprofit. Most charities maintain a segregated annuity reserve fund, which is required by some state insurance commissioners. However, all the assets of the nonprofit (including the annuity reserve fund, the endowment and real property) stand behind the promise to pay the gift annuity.

The Philanthropy Protection Act of 1995 (PPP), a law designed to protect consumers by regulating stocks, bonds, annuities, insurance products and other securities, clarified that charitable gift annuities are not considered insurance products subject to federal regulation. Section 2(a) of the Philanthropy Protection Act exempts pooled income funds, funds set aside as reserves for charitable gift annuities, common remainder trust or lead trust funds and other irrevocable charitable trust funds from Sec. 3(c)(10) of the Investment Company Act of 1940. This means that charitable funds are not "investment companies" for purposes of the act. While it is not considered an investment, the PPP still requires the issuing charity to disclose the "material terms" of the gift annuity agreement to the donor.

Because charitable gift annuities cannot be issued by an insurance company and are not considered insurance, charitable gift annuities are not akin to commercial annuities. Consequently, they would not be eligible for treatment as a like-kind exchange with a commercial annuity under Sec. 1035.

Charitable Gifts of Commercial Annuities

While donors are unable to utilize Sec. 1035 for an exchange between a commercial annuity and a charitable gift annuity, donors can consider other alternatives for a commercial annuity.

Lifetime Transfers

Generally, deferred commercial annuities outside the surrender period may avoid surrender charges. If the commercial annuity has been annuitized, the transfer options may be limited or not permitted. A commercial annuity is deemed annuitized if the annuity contract has been converted to a specified payment schedule. If the contract is transferrable, a charitable transfer will require the recognition of any untaxed gain in the year of the transfer. However, the tax consequences may be offset in part by a charitable income tax deduction.

A commercial annuity is part investment and part ordinary income. The investment is the amount the annuitant paid for the annuity and the ordinary income is the amount of the tax-deferred earnings. With a lifetime transfer, if the annuity's value exceeds its initial cost, a portion of the distribution will be recognized as ordinary income. This means that while the original cost of the annuity is distributed tax-free, any amount in excess will be taxed as ordinary income. Therefore, a donor will recognize and must report any untaxed gain as ordinary income in the year that the transfer is made. Generally, the ordinary income will be equal to the difference between the surrender value of the commercial annuity and the donor's basis in the annuity.

If the commercial annuity contract is over $5,000 in value, the donor will be required to obtain a qualified appraisal. Although the annuity contract may have a value assigned to it by the insurance company, the IRS requires a qualified appraisal for all non-cash charitable gifts valued at more than $5,000. Reg. 1.170A-13(c). A 50% deduction limit applies because the donor must use the cost basis as his or her deduction. IRC Sec. 170(b)(1)(C)(iii).

In most circumstances, a donor may prefer to surrender the annuity contract and donate the cash received. If the donor makes the gift using the cash proceeds, he or she would be entitled to a deduction of up to 60% of adjusted gross income. Although the taxation of gain remains the same, the charitable deduction may be more advantageous as the deduction limit rises to 60% for cash gifts. Donors who use the cash proceeds are also not required to obtain a qualified appraisal. Therefore, if a donor is unable to avoid the surrender charges for making a gift of the annuity contract to a nonprofit, the donor may be better off surrendering the annuity contract and donating the cash proceeds.

Example 1

Leo wanted to make a gift of his commercial annuity contract to his favorite nonprofit. His insurance company confirmed that surrender penalties would apply. Despite the penalties, Leo decided to surrender his commercial annuity to make a gift to his favorite nonprofit. His annuity had a cash value of $75,000. Leo's original cost for the annuity was $50,000. Leo will recognize the $25,000 of untaxed gain as ordinary income at the 24% federal bracket. He will recognize about $6,000 in taxes from the surrender. Leo's adjusted gross income for the year was $125,000. His charitable deduction was limited to 60% of his adjusted gross income, as it is a cash gift. He can use all $75,000 of his charitable deduction in the year of the gift. The charitable deduction will produce a tax savings of $18,000, which offsets the tax realized from the surrender of the annuity.

The taxability of lifetime transfers of commercial annuities may dissuade some donors from making lifetime charitable transfers. However, the charitable income tax deduction resulting from the gift can be used to offset the ordinary income recognized from the transfer.

Testamentary Transfers

Commercial annuities are assets categorized as income in respect of a decedent ("IRD"). IRD assets refer to the amounts that a decedent earned or was entitled to as gross income but was not taxed as the decedent's income prior to the decedent's death. IRD assets represent untaxed ordinary income and are governed by Sec. 691. IRD assets are included in the estate of the decedent and may be subject to estate tax. Under Sec. 691(c), there is an offsetting deduction for estate tax paid on IRD assets.

IRD assets are typically viewed as "bad assets" to pass on to heirs due to the tax consequences. IRD assets are subject to tax at ordinary income rates on all distributions. Other appreciated assets, such as stocks and real estate, receive a step up in basis upon the original owner's death. In many cases, the beneficiary can sell assets that receive a step up in basis with little tax recognition.

Many financial planners suggest transferring "bad assets" to qualified nonprofits and "good assets" to heirs. A transfer at death provides a two-fold benefit. The nonprofit can receive the IRD assets tax free while heirs receive a generous inheritance from other assets in the estate.

In some instances, a commercial annuity may offer a death benefit to a beneficiary of the annuitant's choice. If an annuity has already been annuitized, a testamentary transfer may be the only option for a gift to a nonprofit. A commercial annuity is generally not controlled by an estate planning document. The annuity administrator will distribute the death benefit according to the beneficiary designation form on file.

Testamentary transfers of commercial annuities to family may result in the asset being subject to two tiers of taxation. The first tier of taxation would be at the estate level, as IRD assets would be included in the decedent's estate. Most estates, however, will not be subject to the estate tax as the lifetime exemption shields estates up to $13.61 million per decedent in 2024, with indexed increases thereafter and a sunset provision in 2025. The second tier of taxation is income taxation, which applies to the heirs when funds get distributed. With two tiers of potential taxation, a charitable contribution of a commercial annuity at death will often provide a more favorable outcome for individuals than lifetime transfers. Although many estates will not be subject to the estate tax due to the current large exemption, the income tax will apply to all non-charitable heirs on distribution. Testamentary transfers do not create an acceleration of the recognition of the taxable gain.

Methods for Testamentary Transfers

A beneficiary designation form is the controlling document that dictates how the account is distributed after the account holder's death. The beneficiary designation form can be obtained from the account administrator or custodian. It is a simple and easy way to change the beneficiary on an account.

The owner may designate a primary beneficiary, a contingent beneficiary or split percentage beneficiaries. Generally, distributions from the annuity contract will be subject to income taxation. The heir may often have options to choose from, including a lump sum, a five-year payout or to annuitize the payout. Heirs will be subject to income tax on the annuity proceeds regardless of the payout chosen.

A nonprofit may be listed as a designated beneficiary of a commercial annuity. If a qualified nonprofit is a beneficiary on the beneficiary designation form, any distribution to the nonprofit is tax free. The nonprofit will be able to use the entire proceeds for its charitable purposes.

Example 2

Linda listed her favorite nonprofit as the only designated beneficiary of her commercial annuity. Her annuity contract offers substantial death benefits for the beneficiary. Later in life, Linda creates a will. The will states that her entire estate is given to her niece Elizabeth. When Linda passes away, the commercial annuity will be distributed according to the beneficiary designation form she completed, not according to her will. Linda's favorite nonprofit will receive the proceeds from her commercial annuity tax-free and Elizabeth will receive the other assets from her aunt's estate.

Conclusion

Commercial annuities offer individuals a variety of options for managing their financial assets. An individual who owns a commercial annuity will benefit from a reliable source of income during retirement and Sec. 1035 will allow an owner to exchange his or her existing annuity contract for another without recognizing the gains in the contract. However, it is important to understand that a commercial annuity is distinct from a charitable gift annuity. This means that transferring a commercial annuity to a charitable gift annuity is not a tax-free exchange under Sec. 1035.

The tax implications for commercial annuity owners who are donating their annuities will vary based on whether the contribution is made during life or at death. Lifetime transfers, when permitted under the contract, will trigger the recognition of any untaxed gain in the year of the transfer but can be offset by the charitable deduction of the gift. Due to the recognition of untaxed gain upon transfer, it may be more cost efficient for commercial annuity owners to cash out their annuity and use the net proceeds for the charitable gift to take advantage of the more favorable deduction limit. Furthermore, testamentary transfers of commercial annuities may be attractive to donors and nonprofits because donor's heirs can receive tax advantages assets and the nonprofit liquidates the annuity tax-free.

When it comes to navigating an exit strategy for a commercial annuity, individuals should carefully consider the tax implications that may come from a charitable gift of a commercial annuity. Individuals should seek the guidance of financial advisors with experience in the commercial annuity sector to ensure they make a decision that aligns with their philanthropic goals and financial circumstances.