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By Audrey L. Johnson
The possibility of creating a gift annuity that operates in a manner similar to an education trust is viable with the commuted payment gift annuity.
A commuted payment gift annuity (CPGA) is essentially a modified deferred gift annuity.
While a traditional deferred gift annuity provides fixed payments to one or two annuitants for life at least one year after the gift date, a CPGA agreement includes language that gives the annuitant the option to receive the payments over a compressed term of years instead of over a lifetime.
Often, donors use this type of annuity to pay for college tuition for a child or grandchild.
A commuted payment gift annuity is also called a “College Annuity,” “Tuition Gift Annuity,” or a “Tuition Assistance Plan.”
How it works
A donor establishes a deferred gift annuity and names the future student as the beneficiary with life payments to begin at age 18.
Before the annuity start date — at least one payment period prior to the first payment date — the annuity can be reduced to four or more installments to mirror the student’s years in college.
The annuitant, or annuitant’s legal guardian in the case of a minor, has the option of either accepting the annuity payments for life or electing the “commuted value” for the term detailed in the annuity agreement.
By commuting the payments, instead of receiving fairly small payments for life beginning at age 18, the annuitant receives large installments during the college years.
To commute the payments, the annuitant or the annuitant’s legal guardian must elect by written notice to exchange the right to receive an annuity for life for an annuity for a term of years.
The amount of the payments equal the present value of the life payments the annuitant would have received based on the starting date of the annuity payments and on the Charitable Midterm Federal Rate (CMFR) and mortality tables in effect at the time of the assignment.
Upon making the gift, the donor receives a charitable tax deduction and the annuitant receives income for the commuted period.
The payments are taxable to the annuitant as ordinary income, and partially tax-free at the student’s lower tax rate.
If the election is made after the annuity starting date, the payments are immediately taxable in full to the annuitant.
On July 5, 2006, Mr. Evans contributed stock having a fair market value of $100,000 and a cost basis of $30,000 for a CPGA for his granddaughter Paige, who is 3 years old.
The agreement states that Paige will receive semiannual payments for life beginning September 1, 2021.
It also contains a provision allowing the commutation of life payments. On July 13, 2006, Paige’s mother, as her guardian, assigned her annuity interest to the nonprofit in exchange for eight semiannual installments.
* Mr. Evans receives a charitable deduction of $63,587
* Mr. Evans’ realized capital gain is $25,489.10
* The taxable gift is $36,413. (Including language in the annuity agreement allowing Mr. Evans to revoke the annuity payments during his life or by will or testamentary instrument could postpone any taxable gift — IRC Reg.25.2511-2(c).)
* Paige receives $25,000 during each college year to be taxed as follows:
— Ordinary income: $15,896.75
— Tax-free portion: $9,103.25
Commuted payment gift annuities have only been approved by the IRS through Private Letter Rulings.
The State of New York does not permit this type of annuity per state law.
Although this type of annuity typically functions to provide tuition assistance, conceivably it could be used when a donor wants to give an annuitant, including himself or herself, the option of receiving term rather than life payments.
According to IRC Sec. 514(c)(5), gift annuities cannot guarantee a minimum number of payments or a term of years.
In PLR 9042043, the IRS ruled that the “option” to commute the annuity does not alter the fact that the primary obligation under the annuity is for the life annuitant.
The annuitant does not have to use the money for college tuition or education costs.
The donor will not avoid capital gains if the annuity is funded with appreciated securities.
Annuitants under the age of 59 1/2 are subject to the 10 percent excise tax per IRC Sec. 72 (q). This tax would be in addition to the ordinary income tax the student would pay on the installments.
It is important the annuitant or the annuitant’s legal guardian is aware of the gift in order to elect that the payments commute prior to the annuity start date.
Usually the annuitant or guardian exercises the commutation option soon after the annuity is funded. Exercising the commutation is what fixes the installments that will be paid when the annuitant enters college.
Delaying the commutation could cause the payments to be higher or lower depending on the CFMR and mortality tables at the time.
Given the longevity of the gift, there are more market variables that may ultimately impact the charitable residuum, positively or negatively.
Due to reduced ACGA rates for young annuitants, the commuted installments may not be as large as desired.
The CPGA is a lifetime annuity that allows the annuitant the option to elect payments over a compressed term instead of over a lifetime.
Commuted payment gift annuities allow a donor to receive an income tax charitable deduction, provide for a descendant’s education, and gift the residuum to a participating nonprofit.
Even though several private letter rulings have approved the commutation of gift annuity payments, only the taxpayer who filed for the ruling can rely upon it.
Therefore, filing for one’s own private letter ruling may be beneficial for a nonprofit planning to issue a CPGA to avoid tax consequences and ensure compliance with IRC Sec. 514(c)(5).
A working knowledge of commuted payment gift annuities may prove to be beneficial when discussing planned giving vehicles with potential donors.
There are a variety of education planning vehicles that should be considered and discussed with legal and tax counsel prior to establishing a CPGA.
For additional information, refer to PLR 9527033, 200233023, 9042043, 9407008 and 9108021 and GCM 39826.
NOTE: This communication is not a covered opinion as defined by Circular 230 and is not intended or written to be used, and cannot be used, or relied on, by the taxpayer, for the purpose of avoiding federal tax. This communication was written to support the promotion or marketing of the transaction(s) or matter(s) addressed in the written communication; and the taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
Audrey L. Johnson, MA is the Assistant Vice President, Planned Giving Advisor at Wachovia Nonprofit and Philanthropic Services.