An Interview with Michael D. Rybak and Michael D. Rybak, Jr.
The Community Foundation recently sat down with Northwest Connecticut attorneys Michael D. Rybak and his son, and Community Foundation Apolonia Stanulis Scholarship Fund recipient, Michael D. Rybak Jr. to discuss their work advising charitably inclined clients on planning well and giving locally.
An Interview with Michael D. Rybak and Michael D. Rybak, Jr.
The Community Foundation recently sat down with Northwest Connecticut attorneys Michael D. Rybak and his son, and Community Foundation Apolonia Stanulis Scholarship Fund recipient, Michael D. Rybak Jr. to discuss their work advising charitably inclined clients on planning well and giving locally.
NCCF: When does the conversation about charitable giving arise with clients?
MDR: When we do an estate plan we talk about the client’s objectives. Charitable giving often comes up with older people, those who have already provided for their family and those with no family. It’s increasingly common to have two professionals who don’t have children and would like to do some good with their money.
NCCF: How do you help clients plan for their charitable goals?
MDR: Some clients come in with a list of charities they want to support. I never influence them, but I do encourage them to do some research into where and how far their gift will go.
Some national charities are great, but if you give closer to home, you will have more information about how your gift will be used toward your charitable goals. Many clients have specific areas of interest. I have had, for example, clients set up a trust for the care of their dog or horse. After the animal passes, they want the remainder of the money to help other animals.
Others want to help people in the area, but they don’t know how. Most charitable goals can be best reached by working with a community foundation, in our area, the Northwest Connecticut Community Foundation, either by giving to an existing fund that works toward their goals, establishing a new donor-advised, discretionary, or field-of-interest fund specific to their wishes, or establishing a scholarship fund.
NCCF: How do you work with clients who want to give gifts in-kind, such as land?
MDR: Some people feel strongly about preserving their property, their land, woods or lake front. For some, I help them arrange a conservation easement. This gives them the benefit of using the property. By working with a local land trust the property is preserved forever. Alternatively, some clients choose to preserve their property through a bargain sale. They sell the property to a land trust at a low price. The land trust preserves the property, and they receive a charitable deduction on the difference between the appraised value of the land and its sale price.
There is typically a tax benefit to giving property to a nonprofit wholly through a bargain sale or through an easement rather than selling it at market value and donating the proceeds.
NCCF: What are some common misconceptions when it comes to giving through estate planning?
MDR: We all hear a lot about private foundations, often on public radio. Clients sometimes think that’s the best way to help their community.
People don’t realize how expensive and time-consuming private foundations are to establish and maintain. It’s almost never financially advantageous to establish a private foundation. It’s almost always better to create a donor-advised fund with an organization like the Northwest Connecticut Community Foundation. As donor-advisor to a fund, they can choose the nonprofits that benefit from grants and how grant money is spent. They can also leave that responsibility to a family member when they are no longer able to fulfill those duties.
Another misconception is that they can’t give until they have taken care of all of their and their family’s financial needs. Depending on their resources, clients can establish a charitable trust and receive an annuity payment for life from that trust with the remainder given to a specific charity or a fund.
Alternatively, annuity payments can be given to a charity or fund with the balance of resources given to family members or to a different charity or fund.
NCCF: You mentioned that there is a lot of value in giving locally. Please expand on that idea.
MDR JR: I think it’s worth saying that having a local charity or charitable component to estate planning is very important today in Connecticut and in Litchfield County, especially. Helping the local areas through nonprofits can help at least in some ways make up for state and local governments not being as generous as they used to be.
If clients give to a national charity because the nonprofit has a mission that they are particularly fond of, that’s great. But, it may not help in the local area. It may go to a central office somewhere.
NCCF: Why do you encourage your clients to work with the Northwest Connecticut Community Foundation as a partner in reaching their charitable goals?
MDR: The Community Foundation is local. They do a lot of good in our communities. We may not realize it, but we all know someone who has benefited from charitable giving through the Community Foundation, including a lot of young people who have received scholarships. They have benefitted, and our local communities have benefitted, because people established funds to help improve their communities.
Investor or Dealer?—Gifts of Real Estate and Donor Classification
Philanthropically motivated individuals increasingly understand the value of gifting appreciated real estate to charity. Donors are often able to claim a deduction for the property's fair market value while also bypassing capital gains tax that would otherwise be due if the donor sold the property. This is a win-win solution for the donor from a charitable and financial standpoint.
What is the result, however, when a donor is classified as a "dealer" of real estate and decides to make a gift of real property to charity? In that case, the property is considered an ordinary asset and, as such, the donor's deduction will be limited to cost basis. On the other hand, if the donor is considered an investor, he or she will be able to claim a fair market value deduction for the gift.
The distinction between dealer and investor is an important factor that advisors must take into consideration when guiding clients through the charitable giving process. While some cases may be clear-cut, other times, the line may be blurry.
Part I of this article will shed light on this important distinction between real estate investors and dealers, provide factors that advisors should take into consideration when making this determination and offer case examples to illustrate each factor. Part II will use the factors presented in this article to examine some hypothetical examples where a client makes a gift of real estate to charity. Part II will also provide charitable solutions for donors who want to make gifts of dealer-classified property. By understanding how these factors are used to determine whether a property owner is a dealer or investor, advisors can help guide their clients toward a strategy that will maximize their tax benefits while simultaneously fulfilling the client's philanthropic goals.
A taxpayer who is a "dealer" of certain assets recognizes ordinary income rather than capital gain on the sale of those assets. Thus, the starting point for understanding the distinction between a dealer and investor is IRC Sec. 1221, which, in part, explains that property will not be considered a capital asset in the hands of a taxpayer if the property is "stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."
Therefore, if an individual holds property for sale or as part of a trade or business, then he or she may be classified as a dealer. Alternatively, an individual who holds property for investment only is not a dealer, but is an investor. However, the line becomes blurred when determining at what point selling property changes from an "investment activity" to a "recurring business activity."
Again, this distinction is important because property held for investment purposes may be subject to more favorable capital gains tax treatment, while dealer property will be subject to less favorable ordinary income rates. While these categories are important for those buying and selling real estate, they also must be considered when an individual is planning to make a gift of real property to charity.
For example, if a donor is contributing real estate that has been held as investment property for many years, then the property is considered a capital asset in the hands of that donor and he or she will be entitled to a charitable income tax deduction equal to the property's fair market value. Capital assets include real estate that has been operated as a rental property or has been held as a management-free investment. If, on the other hand, the donor is in the business of flipping houses or developing real estate, then the real estate could potentially be classified as ordinary income in the hands of the donor. If the donor contributes this "dealer-type" property to charity, then the deduction will be limited to the donor's cost basis in the real estate. It is important to note that this status determination is made on a property-by-property basis, meaning that an individual could be classified as a dealer in the context of one property and an investor in the context of another.
The tax code and regulations do not provide clear guidance in making the dealer-investor determination. In fact, the Tax Court noted that there is an "indistinct line of demarcation between investment and dealership." Buono v. Commissioner, 74 T.C. 187 (1980). However, this classification issue has been litigated many times over the years and as such, advisors typically turn to case law when making this determination. There are five main factors that courts consider when classifying an individual as an investor or a dealer. The remainder of this article will examine each factor and provide case examples for further guidance. Advisors should consider all facts and circumstances in light of these five factors to ensure that they are providing their clients with accurate information and steering them toward a charitable gift that will maximize their tax savings.
The Dealer-Investor Factors
1. Frequency, Number and Continuity of Sales
The first factor, and perhaps one of the most important to consider, is whether the property owner has been frequently and continuously selling real property (see Biedenharn Realty Co., Inc. v Comr., 526 F.2d 409 (5th Cir. 1976) noting that the "the frequency and substantiality of taxpayer's sales" is the most important factor that must be considered). In Pool v. Commissioner, T.C. Memo 2014-3 (2014), the Tax Court explained, "Frequent and substantial sales of real property more likely indicate sales in the ordinary course of business, whereas infrequent sales for significant profits are more indicative of real property held as an investment."
The more regular and continuous the sales, the more likely it is that the donor will be considered a dealer. Thus, when analyzing this factor, advisors should consider the following questions: How many properties has the donor sold? What was the time frame of these sales? Were the donor's sale activities regular and sustained or intermittent and occasional?
For example, in Hancock v. Commissioner, T.C. Memo 1999-336 (1999), the Tax Court held that the property owner's sale of 47 unimproved lots over a nine-year period demonstrated "frequent, regular and substantial" sales. In contrast, in Buono v. Commissioner, 74 T.C. Memo 187 (1980), the Tax Court found that, despite the property owner's intent to zone and subdivide a particular piece of property, the property was not deemed "dealer property" when it was sold. The Tax Court emphasized the "isolated nature of the transaction" and noted that it considered the "lack of frequent sales to be the most important objective factor for purposes of characterizing the gain petitioners received." The fact that it was a single sale precluded a finding that the property owner "was engaged in substantial and frequent real estate sales over an extended period of time."
While, in many circumstances, the courts have found that a single sale will not result in dealer status, there have been cases where a property owner was classified as a dealer on the first transaction (see Allen v. US, 113 AFTR 2d 2014-2262, (DC CA) below). As such, all factors must be considered even if the donor has not engaged in frequent and continuous sales in the past.
Trouble often arises where the donor has engaged in more than a single sale but fewer than what would clearly be considered a substantial number. When the status of the property owner falls into this "gray area," the courts will dive deeper into the other factors to make an ultimate determination. If a client who is considering making a gift of real estate to charity falls into this area, the advisor should look to case law and carefully analyze the remaining four factors to determine whether the scales tip more toward classification as an investor or a donor.
2. Nature and Purpose of Holding or Purchasing the Property
The second factor focuses on the intent of the property owner. Here, the questions are: What was the donor's original purpose when acquiring the property and what was his or her intent at the time the property was transferred? Was the property purchased with the intent to hold it as an investment or was it purchased for the purpose of development and sale?
In Allen v. US, 113 AFTR 2d 2014-2262 (DC CA), a district court in California shocked many advisors who had long believed that a single transaction would not result in dealer status. In Allen, the court held that the one-time sale of land would be subject to ordinary income tax treatment. While the first factor — the frequency, number and continuity of sales — weighed in favor of the property owner, the court noted that the evidence clearly demonstrated that the property owner purchased the land with the intent to develop and sell it. This intent was further demonstrated by the property owner's efforts to sell the property. Ultimately, the court found that the property owner purchased and held the property with the intent to develop and sell it in the ordinary course of his trade or business.
It is important to note that the courts have recognized that intent can change over time. The most important intent to consider is that of the property owner at the time of transfer. For example, in Maddux Construction Co. v. Commissioner, 54 T.C. 1278 (1970), the property owner originally acquired a tract of land with the intent to subdivide it and construct homes. However, the Tax Court found that at the time the property was sold, the property owner had abandoned the "intention to subdivide the property for residential purposes and decided to hold the property for investment purposes, either as rental property or for eventual sale at a profit." The court noted that "intent is subject to change, and the determining factor is the purpose for which the property is held at the time of sale." Ultimately, the Tax Court found that while the property owner originally purchased the property to sell to customers in the ordinary course of business, this intent was abandoned and, at the time of sale, the property was held as an investment. As such, the property owner was entitled to report the gain as long-term capital gain.
Advisors should take intent into consideration when a donor is considering making a gift of appreciated real estate to a charitable organization. In order to ensure the donor receives a fair market value deduction, advisors should assist by analyzing the facts and circumstances to determine the intent of the donor with regard to the property in question at the time of the charitable transfer.
3. Nature and Extent of Taxpayer's Business
The third factor looks to the property owner's undertakings. Was the property owner actively engaged in managing, improving or developing the property? Activities like subdividing, grading, zoning and installing roads and utilities tend to favor dealer status rather than investor when analyzing this factor.
For example, in Pool v. Commissioner, T.C. Memo 2014-3 (2014), the Tax Court found that the property owner's act of developing a water and wastewater system was "more akin to a real estate developer's involvement in a development project than to an investor's increasing the value of his holdings." As such, this factor supported the Tax Court's ultimate holding that the property was not held for investment but was held primarily for sale in the ordinary course of the property owner's trade or business.
Again, it is important to note that this factor is analyzed in relation to the particular property involved. Thus, a property owner could be developing a residential neighborhood and be classified as a dealer for that particular tract of land and, at the same time, be holding a separate parcel of land for investment purposes. For example, in Pritchett v. Commissioner, 63 T.C. 149 (1974) the Tax Court granted investor status to a property owner who had historically held land for development and reported gain on properties he sold as ordinary income. The Tax Court found that the property owner had not made any effort to improve, subdivide or sell the property. Rather, he held it passively until he received an unsolicited offer to purchase the property. As such, the Tax Court held that the property owner was an investor in respect to this particular parcel. Therefore, the gain from the sale of the land would receive capital gain treatment.
Given the property-specific nature of this analysis, it is important that advisors analyze their clients' actions toward the property they intend to donate. If, prior to making a gift to charity, the client had been developing the particular property, a court may find that this factor supports classifying the client as a dealer, in which case the donor would have to limit the deduction to the property's basis. Advisors should consider all facts and circumstances involved and keep in mind that this factor is weighed in relation to the other factors involved. The greater the amount of development activity, the more likely that this factor will support a dealer-status finding.
4. Advertising, Solicitation and Sales Activities
The fourth factor considers the property owner's sales and marketing involvement with regard to the property. Here, questions to consider include: At the time of the transfer (either sale or charitable donation), was the property owner spending a great deal of time and effort attempting to sell the property? Was he or she personally trying to find buyers? Was he or she involved in negotiating sales? How engaged has the property owner been in marketing, advertising and solicitation?
The more time the property owner has spent either personally advertising the property or working with sales agents, brokers or marketing professionals, the more likely it is that the court will find an underlying business, rather than investment, motivation. In Biedenharn Realty Co., 526 F.2d 409 (5th Cir., 1976), the court pointed to a property owner's sales efforts as evidence of dealer-like real estate activities. The court explained that the property owner "hired brokers who, using media and on site advertising, worked vigorously on taxpayer's behalf." The court made clear that hiring real estate professionals does not protect a property owner from dealer treatment, noting, "We do not believe that the employment of brokers should shield plaintiff from ordinary income treatment."
The less time and effort the property owner has spent on attracting buyers, the more likely he or she is to receive more favorable investor treatment. For example, in Byram v. United States, 705 F.2d 1418 (5th Cir. 1983), the court found that a property owner who sold 22 parcels of real estate over the course of three years should be classified as an investor, despite the large number of sales in a short period of time. The court noted that the property owner "made no personal effort to initiate the sales; buyers came to him. He did not advertise, he did not have a sales office, nor did he enlist the aid of brokers." As such, despite the number of sales, the court found that the fourth factor, among others, weighed in the property owner's favor and that the properties were held for investment and not for sale in the ordinary course of his trade or business.
Advisors should consider the amount of time that a client has devoted to sale activities and actively participated in the sales process prior to making a charitable transfer in order to avoid dealer status and claim a full fair market value deduction. As the Biedenharn case explains, the use of brokers and third party sales agents does not shield a property owner from dealer status. Advisors should look at all the facts and circumstances involved when weighing this factor and understand that owning a sales office, working with brokers to find a buyer and using media and signage to advertise are activities that may add weight to the dealer side of the scale.
5. Extent and Substantiality of Transactions
The fifth factor looks at the overall level of the property owner's real estate activities. Questions to analyze here include: Is the property owner in the business of buying, selling, developing and improving real estate? If so, is it the property owner's full-time occupation? If the property owner is involved in multiple income-producing activities, what percentage of his or her income is derived from real estate activities?
While a property owner can be in the real estate business and still hold property for investment purposes (see Pritchett v. Commissioner, 63 T.C. 149 (1974) above), courts do consider the property owner's history with respect to his or her real estate transactions. In Galena Oaks Corp. v. Scofield, 218 F.2d 217, 220 (5th Cir. 1954) the court explained, "Congress intended to alleviate the burden on a taxpayer whose property has increased in value over a long period of time. When, however, such a taxpayer endeavors still further to increase his profits by engaging in a business separable from his investment, it is not unfair that his gain should be taxed as ordinary income."
When considering this factor, courts also look at the amount of income the property owner derives from his or her personal real estate activities in comparison to other income-producing activities. In Evans v. Commissioner, T.C. Memo 2016-7 (2016), the Tax Court found that even though the property owner, Jeffrey Evans, was employed by a real estate development firm, his personal real estate activities did not rise to the level of a trade or business. When classifying Evans as an investor, the court noted that Evans' "primary source of income was his full-time job" and that "any income he may have earned from developing properties accounted for an insubstantial portion of his income."
In contrast, in Gamble v. Commissioner, 242 F.2d 586 (5th Cir. 1957), the property owner, Harry Gamble, sold 70 parcels of land in a two-year period. During that time, Gamble was actively practicing law and earning money as an attorney and a notary. Gamble argued that since he did not have a license to sell real estate and because his legal practice was his only place of business, he was not in the real estate business. The court rejected his argument and classified him as a dealer with respect to the properties in question. The court explained that "a person may be engaged in more than one business" and that it was "significant that the petitioner's profits from his real estate ventures exceeded, during each of the two years in question, his earnings as a lawyer and notary."
Advisors who assist clients with charitable gifts of real estate should consider each client's current property dealings and past real estate transactions in addition to occupation, keeping in mind that even if a client's primary occupation is unrelated to real estate, it will not automatically prevent the client from being classified as a dealer. While a client can be in the business of buying, selling, developing and improving real estate and still hold property separately as an investor, the advisor will need to be prepared to present evidence that supports classifying the client as an investor with regard to the gifted property.
The classification of a donor as a dealer or an investor is an important, yet difficult, distinction that must be made in order to accurately report a charitable deduction where the property is gifted to charity. The process of making this determination, however, is not black and white. In Byram v. United States, 705 F.2d 1418, 1419 (5th Cir. 1983), the Fifth Circuit noted the difficulty and uncertainty that exists when it comes to this classification process, stating "[I]n that field of the law—real property tenure—where the stability of rule and precedent has been exalted above all others, it seems ironic that one of its attributes, the tax incident upon disposition of such property, should be one of the most uncertain in the entire field of litigation. But so it is..."
And so it is that advisors are faced with the task of guiding their clients through the somewhat murky waters that exist in the dealer-investor determination process. While there is no bright line, advisors can turn to the factors the courts have presented and the cases in which they are discussed. By understanding these factors and considering how courts have ruled in past cases, advisors can help guide their clients and determine the best charitable giving strategy, given the client's likely status as a dealer or investor.
Charitable Gifts of Commercial Annuities and Savings Bonds
Savings bonds and commercial annuities are considered by many to be very safe investments for individuals. Investors enjoy the guaranteed return these assets offer. Many individuals are concerned that they might outlive their nest eggs. Savings bonds and commercial annuities have been marketed as low-risk investments that can ease that fear.
Over the years, many individuals have invested in U.S. savings bonds or commercial annuities. Individuals who are charitably-minded may be interested in gifting savings bonds or commercial annuities to charity.
U.S. savings bonds are issued by the Department of Treasury and backed by the full faith and credit of the U.S. government. Because of this guarantee, savings bonds are generally considered a stable investment. The trade-off for the safety that these investment vehicles provide is a smaller investment return. The guaranteed return for a Series EE savings bond hovers at approximately 3.5%, while the rate for the Series I savings bond starts at 2.52% for bonds issued in mid-2018. Those returns are much lower in comparison to stocks, which have averaged a return of approximately 7% over the past decade.
The two most common savings bonds are Series EE and Series I bonds. Series EE and Series I savings bonds are subject to the same rules and tax treatment, despite their differences in structure. When savings bonds reach final maturity, all accumulated interest income must be recognized in the year the savings bond matures.
Series EE bonds are purchased at a discounted value. A Series EE bond is sold for half its face value and will accrue interest at a fixed rate. Series EE bonds will mature to face value after 20 years. After the maturity date, Series EE bonds continue to accrue interest for an additional 10 year period until reaching the final maturity date. The accumulated interest will be taxed on the final maturity date 30 years after its purchase, if not cashed in prior to that date.
Series I bonds, on the other hand, accrue interest at a variable rate. A Series I bond accrues interest at a guaranteed fixed interest rate plus the variable inflation rate as calculated in semiannual intervals. The potential benefit of the variable rate is that it allows Series I bonds to potentially appreciate at a higher rate than Series EE bonds.
The variable rate also means that Series I bonds carry more risk than Series EE bonds. Series I bonds accrue interest for 30 years, but the savings bond is not guaranteed to double in value by the 30-year maturity date. Because the fixed interest rate is added to the inflation rate, Series I bonds bear a risk that there will be little or no appreciation if the inflation rate is negative. Series I bonds will never be worth less than their purchase price because the combined variable rate cannot fall below zero.
A commercial annuity is an agreement between a financial institution, such as an insurance company or a bank, and an annuitant. Commercial annuity contracts promise fixed or variable income payments from the financial institution for the duration of the annuitant's life or a term of years. Most annuity contracts also offer a death benefit. The annuity contract is backed by the assets of the insurance company or bank. Thus, it is important that the annuity is purchased from a strong and reliable company.
Annuities are often purchased by individuals as a means of insuring adequate retirement income and may be acquired as part of a retirement account or with after-tax income. Lifetime transfers of annuities purchased on or before April 22, 1987 require recognition of ordinary income when the annuitant receives proceeds from the contract in excess of the cost basis. For the purposes of this article, after-tax funds are assumed to have been used to purchase a deferred commercial annuity after April 22, 1987 that has not been annuitized.
Commercial annuities can be structured in a variety of ways. The annuity can provide a minimum guaranteed payout or minimum guaranteed duration. An annuity can begin making payments immediately or can defer payments for a number of years. A flexible payout option is also available.
Commercial annuities grow on a tax-deferred basis and there is no limit to the amount of money that can be used to fund the contract. If the annuitant is younger than 59½, there is a 10% penalty for withdrawing funds from the annuity. When the annuity starts making payments, the distributions are taxed as ordinary income with a portion designated as tax-free return of principal. Commercial annuities typically offer a reasonably high payout.
Commercial annuities should be distinguished from charitable gift annuities. A charitable gift annuity is a contract between a donor and a charitable organization that makes payments for one or two lives. When the charitable gift annuity ends, the charitable organization receives the use of the remaining contract value. With a commercial annuity, the entire funds, minus fees, will be invested and are expected to be returned to the annuitant through the annuity payments. In most cases, a death benefit to a designated beneficiary is an additional option.
Lifetime Transfers of Savings Bonds
Many individuals may have held savings bonds for quite some time and desire an increase in their investment return. Investors may wish to make lifetime gifts of those savings bonds to charity. The owner of the savings bonds hopes to receive a charitable income tax deduction and bypass the interest income held in the bond.
Savings bonds can only be registered in the name of an individual. See 31 C.F.R. 315.6. Charities cannot be listed as owners, co-owners or beneficiaries on savings bonds. Due to these restrictions on re-issuing savings bonds, lifetime gifts of savings bonds to charity can only be accomplished by redeeming the savings bond and making a cash donation of the proceeds.
In general, transfers of savings bonds prior to the final maturity date will accelerate the accumulated interest in the year of the transfer. Reg. 1.454-1(c)(1). Rev. Rul. 55-278. No exception exists for charitable donations of savings bonds during life. PLR 8010082. The owner will be required to recognize the interest income on the difference between the amount paid for the savings bond and the redemption value of the bond.
The tax consequences of recognizing interest income on the savings bond will be offset by the charitable income tax deduction generated from the cash donation of the proceeds. Since this is a cash gift, the donor will be able to use the deduction to offset up to 60% of his or her adjusted gross income. The donor can carry forward any remaining deduction for up to five additional years.
Judy purchased Series EE bonds approximately 25 years ago. Her bonds were five years from the final maturity date. Judy went to her bank to have her bonds transferred to the name of her favorite charity. The bank informed her that she cannot have the bonds re-issued to the charity. Instead, Judy decided to cash in her savings bonds. She was required to report the accumulated interest from the savings bonds on her income tax return. Judy received a charitable deduction for the cash proceeds she donated to her favorite charity. She may use her deduction to offset up to 60% of her adjusted gross income.
Lifetime Transfers of Commercial Annuities
Some individuals may find they have retirement security and do not need any additional income from a commercial annuity. Others may find that the return from the annuity is not as substantial as they hoped and decide to terminate the contract. Typically, individuals will want to avoid surrender charges for early terminations of an annuity contract. Many hope that making a gift of an annuity contract to charity will meet that goal and provide a charitable income tax deduction.
Generally, deferred commercial annuities may be transferred to charity. 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. The tax consequences of the transfer may be offset at least in part by a charitable income tax deduction.
A commercial annuity is part investment, which is the amount the annuitant paid for the annuity, and part ordinary income, which is the amount of the tax-deferred earnings. A portion of the distribution will be recognized as ordinary income if the annuity is worth more than the original cost. The original cost of the annuity will be distributed tax free, but any amount in excess will be taxed as ordinary income. Therefore, a donor will recognize and be required to report any untaxed gain as ordinary income in the year that the transfer is made. The ordinary income would be equal to the difference between the surrender value of the commercial annuity and the donor's basis in the annuity. The donation of the annuity contract to charity may avoid surrender charges if the annuity is outside the surrender period.
The donor will receive a charitable deduction for the value of the annuity contract. If the 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 through the issuing organization, the IRS requires a qualified appraisal for all non-cash charitable gifts valued at more than $5,000. The donation of an annuity contract would be subject to a deduction limit of 50% of the donor's adjusted gross income, as it is a cost basis deduction. Donors rarely, if ever, structure their gift in this way.
In almost all circumstances, a donor will surrender the annuity contract and donate the cash received. If the donor makes the gift using the cash proceeds from the contract surrender, he or she would be entitled to a deduction of up to 60% of adjusted gross income. Although the tax consequences remain the same, the difference between the surrender value and the purchase price will be taxed as ordinary income in the year of the transfer, the charitable deduction may be more attractive because the deduction limit increases to 60% for cash gifts. An annuitant may be more inclined to donate the cash proceeds from the surrender of the annuity contract.
Xavier wanted to make a gift using his commercial annuity contract to his favorite charity. Xavier's insurance company confirmed that he was outside his surrender period. Xavier decided to surrender his commercial annuity to the insurance company in order to make a cash gift to his favorite charity. His annuity was valued at $100,000, with a cash value of $75,000. Xavier's original cost for the annuity was $50,000. He recognizes $25,000 as ordinary income. Xavier's adjusted gross income for the year was $125,000. His charitable deduction was limited to 60% of his adjusted gross income, since this was a cash gift. He was able to use all $75,000 of his charitable deduction in the year of the gift.
Generally, charitably-minded owners of commercial annuities hope to avoid generating additional taxable income and want to benefit from charitable income tax deductions. The taxability of lifetime transfers of savings bonds and commercial annuities may dissuade some of these donors from making lifetime charitable transfers. The tax treatment of lifetime transfers to charity is not dependent on whether the gift is made outright or through a life income gift, such as a charitable remainder trust or a charitable gift annuity. The charitable income tax deduction resulting from the gift can be used to offset the ordinary income recognized from the transfer. There may be additional options to explore when using savings bonds or commercial annuities to meet a donor's philanthropic goals.
Testamentary Transfers of Income in Respect of a Decedent Assets
Commercial annuities and savings bonds are assets categorized as income in respect of a decedent ("IRD"). IRD refers to the amounts that a decedent was entitled to as gross income, but was not received nor 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.
Some common examples of IRD assets include IRAs, U.S. savings bonds and commercial annuities. Generally, IRD assets are known as "bad assets" to pass on to heirs due to their 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 stepped-up basis upon the original owner's death and are considered "good assets," because they can be sold by the beneficiary without paying a large capital gain tax.
Many financial planners suggest transferring "bad assets" to qualified charities and "good assets" to heirs. This transfer at death provides a two-fold benefit. The charity can sell IRD assets tax free and heirs will avoid the negative IRD tax consequences, while receiving a generous inheritance from other assets in the estate.
Transfers at death, known as testamentary transfers, of savings bonds and commercial annuities to heirs may result in the assets being subject to two tiers of taxation. Typically, IRD assets are included in the decedent's estate for estate tax purposes and distributions to heirs will be subject to income tax. Testamentary charitable gifts of savings bonds and commercial annuities may provide a more favorable outcome. Most estates will not be subject to the estate tax because the lifetime exemption shields estates up to $11.18 million per decedent in 2018, with indexed increases thereafter and a sunset provision in 2025. Charitable solutions can alleviate some of the tax burdens associated with IRD assets and advisors can better serve their clients by understanding the challenges associated with these assets.
Testamentary Transfers of Savings Bonds
The regulations restricting the re-issue of savings bonds will prohibit a charity from being named as a co-owner of the savings bonds. If an individual wants to use a savings bond to benefit his or her favorite charity at death, the best option is to leave a specific bequest of the savings bonds to charity in a will or trust. If a specific bequest of the savings bonds is not included in the estate plan, there are two possible outcomes. If there is no will or trust directive to use IRD assets to fulfill charitable bequests, the estate may be required to recognize the interest income held within the bonds. As a result, the estate would be required to realize ordinary income before the proceeds are passed on to charity. The reduced after tax amount would pass to charity.
Alternatively, if the executor or trustee has the authority under local law to make non-pro rata or in-kind allocations, the estate may be able to avoid tax on the savings bonds. PLR 9537011. If local law is silent on the matter, the estate document may specifically provide that the savings bonds can be used to satisfy charitable gifts from the estate and the estate will avoid income taxation on the interest accumulated in the bond. If savings bonds are used to satisfy pecuniary bequests or bequests of specific dollar amounts, savings bonds may be subject to income tax within the estate. PLR 9507008.
If a qualified charity receives savings bonds, it may be able to redeem the bonds tax free. If the savings bonds were not subject to income tax at the estate level, they will escape taxation completely because the charity will not be taxed on the redemption. Savings bonds will avoid income tax at the estate level if the testamentary transfer was either a specific bequest of the savings bonds or there is authorization under local law that permits the executor to satisfy charitable bequests with IRD assets. The estate will avoid the estate tax on the savings bonds and the charity is exempt from taxation. This is a great result for the estate and the charity.
Linda was the executor of her mother's estate. Her mother left the residue of her estate to charity in her will. The will provided that IRD assets were to be used to satisfy charitable gifts. Linda used the savings bonds to satisfy the charitable bequest. The estate avoided paying estate tax and the heirs avoided income tax on the savings bonds. The charity did not owe income tax on the savings bond received and was able to use the entire value for its charitable purpose.
Testamentary Transfers of Commercial Annuities
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 charity. 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.
A beneficiary designation form is the controlling document that dictates how the account is distributed after the accountholder's death. The beneficiary designation form can be obtained from the account administrator or custodian. It is a fairly 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 choose 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 charity may be listed as a designated beneficiary of a commercial annuity. If a qualified charity is the beneficiary on the beneficiary designation form, any distribution received from the commercial annuity will be estate and income tax free. The charity will be free to use the entire proceeds for its charitable purposes.
Edward listed his favorite charity as the designated beneficiary of his commercial annuity. His annuity contract offered substantial death benefits for his beneficiary. Later in life, Edward created a will. The will stated that his entire estate was to be given to his niece Elizabeth. When Edward passed away, the commercial annuity was distributed according to the beneficiary designation form he completed, not according to his will. Edward's favorite charity received the proceeds from his commercial annuity and Elizabeth received the other assets from her uncle's estate.
Transfers of savings bonds and commercial annuities generally have similar tax treatment. Outright gifts to charity have the same tax deduction limits as gifts to fund charitable gift annuities or charitable remainder trusts. The unrealized ordinary income will be recognized at the time of transfer. Lifetime transfers of cash proceeds from savings bonds or commercial annuities may generate large charitable deductions, which can be used to offset the tax consequences of the transfer.
Testamentary transfers may be more attractive to donors. If the gift is structured correctly, the asset will avoid estate and income tax. The charity is able to cash in the asset tax free, as well. The estate will receive an estate tax deduction, however, most estates will not reach the threshold for taxation. A testamentary transfer to charity will allow heirs to avoid recognizing taxable income from the IRD asset and allow the entire proceeds to be gifted to charity.
Individuals may have commercial annuities or savings bonds that have been held for many years and may be interested in using those low-yield assets to make gifts to charity. By understanding the options and strategies that are available for transferring these low-yield investments, advisors can better serve their clients and provide creative solutions that will benefit the client and achieve their personal and financial objectives.
TCJA and Charitable Remainder Trusts
The Tax Cuts and Jobs Act (TCJA) was the most comprehensive change in tax law since 1986. While there have been voluminous comments and articles on the business and personal tax effects of TCJA, the bill also has potential impact on charitable remainder trust accounting.
In an article titled "Impact of the TCJA on Trust and Estate Income Taxation," American University Professor Donald T. Williamson discussed the potential impact of Sec. 199A and the repeal of miscellaneous tax deductions on charitable remainder trusts (CRTs).
A CRT is generally exempt from income tax. If it has unrelated business income (UBI), 100% of that UBI is forfeited as an excise tax. Sec. 664(c)(2). Therefore, the CRT does not need or qualify for a Sec. 199A deduction. Prop. Reg. 1.199A-6(d)(3)(5).
The accountant for the CRT must track the four-tier amounts for ordinary income, capital gain (with sub-tiers for short term gain, tangible personal property gain, straight line depreciation gain and long term gain), other income (tax-free payments) and return of principal.
However, a CRT beneficiary may qualify for a Sec. 199A deduction. The "taxable recipient of a unitrust or annuity amount from a CRT may take into account the CRT's qualified business income (QBI), real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income to determine the recipient's Section 199A deduction."
Assume a CRT has investment income of $500 and qualified REIT dividends of $1,000. The CRT distributes $1,000 as a unitrust amount to a beneficiary. The $1,000/$1,500 ratio is 66.67%. The beneficiary receives that percentage of income taxed at the same rates, or $333 of investment income and $667 of REIT dividends.
The CRT also distributes a proportionate amount of the Form W-2 wages and unadjusted basis immediately after acquisition (UBIA). If the QBI, REIT dividends or PTP income are unrelated business taxable income (UBTI), they are subject to the 100% excise tax.
TCJA also repealed the miscellaneous deductions for trusts. However, "Sec. 67(e) provides that estate and nongrantor trusts may continue deducting costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate."
Examples of the deductible fees are fiduciary attorney or accounting fees. Therefore, "all ordinary and necessary expenses attributable to the production of income from real property remain deductible."
Editor's Note: CRTs generally invest in securities with a goal of avoiding UBTI. The combination of the Sec. 664 four-tier and the Sec. 1411 Medicare tax accounting rules create substantial complexity. If the CRT also has QBI that is not UBTI, the process is even more complex. CRT accounting in the future will continue to be a very specialized field.
Representative Opposes SALT Charitable Deduction Limit
On April 1, 2019, Rep. Josh Gottheimer (D-NJ) sent an open letter to IRS Commissioner Chuck Rettig. Gottheimer opposed the IRS limits on state tax credits for charitable gifts.
In REG-112176-18 (effective August 27, 2018), the Service published Proposed Regulations to limit the benefits of state tax credits for charitable gifts. The Tax Cuts and Jobs Act limited state and local tax (SALT) deductions to $10,000. Sec. 164(b)(6). Because several states with higher tax rates had many affected taxpayers, a number of states passed new tax credit plans in an attempt to replace the lost SALT deductions.
Under the proposed regulations, a state tax credit is "quid pro quo" and reduces the federal charitable deduction by the amount of any state or local tax credit received for the donation. Thus, if a state resident gives $20,000 to a state charity and receives a $20,000 state tax credit, the federal charitable deduction is zero. Prop. Reg. 1.170A-1(h)(3)(i).
The "reduce the federal deduction" rule also applies to a state deduction that exceeds the charitable gift amount. An exception applies for a state tax credit that is not more than 15% of the gifted amount. Prop. Reg. 1.170A-1(h)(3)(vi). Gifts with a state credit at or below 15% qualify for a full federal charitable contribution deduction.
Gottheimer noted that the Tax Cuts and Jobs Act "includes no reference to new limitations on the charitable deduction that you have proposed in this regulation. There are over 100 programs that permit a state tax credit for charitable gifts. Under the proposed regulation, the state tax credits over 15% are considered 'quid pro quo' gifts and reduce the federal deduction. The 'quid pro quo' rule effectively eliminates the benefit for state programs that were designed to bypass the federal $10,000 SALT deduction limit."
The state credits support many social programs, rural hospitals and schools. These charitable programs need support because they are "crucial funding mechanisms for families, entities, and communities. Such a significant change requires explicit congressional action, particularly as this represents a significant tax increase on many Americans in at least thirty-three states."
In the view of Gottheimer, the proposed "quid pro quo" rules are arbitrary and capricious. The IRS "suddenly wants to reverse decades of precedent and court cases."
Editor's Note: Many tax professionals had hoped the IRS would publish final regulations on the charitable deduction limits connected with state credits prior to the April 15 filing deadline. Most tax software companies calculated the charitable deduction using the "quid pro quo" principal specified in the proposed regulations. The tax preparation community awaits the final regulations.
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