Planned and Endowment Giving: Gifts that Pay Income Philip M. Purcell, JD Ball State University Foundation ppurcell@bsu.edu Copyright 2012@All rights reserved. .

Planned Gifts that Pay Income or Provide Life Estate Charitable Gift Annuities Charitable Remainder Trusts Pooled Income Funds Remainder Interest in Personal Residence or Farm with Retained Life Estate

Partial Interest Rule No charitable income tax deduction for gifts of a partial interest in donated property. No deduction for a gift in which the financial interest in the donated asset is split between the donor (or others) and a charitable organization. Exceptions allowed for specific types of “split interest” gifts. You saw this slide earlier when we discussed charitable lead trusts as one type of a split interest gift. Split interest gifts are exceptions to a very important rule of the Internal Revenue Code. This rule requires that no charitable income tax deduction will be allowed for a gift in which the financial value of the gift is “split” between the donor and a charitable organization such as charity. There are some exceptions to this partial interest rule. Pooled income funds and charitable remainder trusts that we will discuss in this module are split interest gifts allowed by law.

Qualified Split Interest Gifts Charitable Lead Trust Charitable Gift Annuity Charitable Remainder Trust Pooled Income Fund Remainder Interest in Personal Residence or Farm with Retained Life Estate

Present Value Lead Trust: Gift tax reduced by present value of income payments projected to charity over term of lead trust per IRS formula. Gift Annuity, Charitable Remainder Trust, Pooled Income Fund, Remainder Interest: Income tax charitable deduction for present value of charity’s future interest per IRS formula.

Charitable Gift Annuity Let’s begin with a review of the basics of charitable gift annuities.

What is a Charitable Gift Annuity? A gift annuity is a contract between a donor and charity. The donor contributes cash or assets. The charity promises to pay a lifetime income to the donor or loved ones chosen by the donor. 1 or 2 annuitants per contract. Legally a gift annuity is a contract between a donor and charity such as charity. The donor contributes cash or assets. In exchange, a charity such as the charity promises to pay a lifetime income to the donor or loved ones chosen by the donor. By law, only one or two persons may receive payments per each annuity contract.

Key Definitions Donor: Contributes cash or assets. Payments: Made by charity to one or two annuitants per gift annuity contract. Rates: Payments based on rates recommended by American Council on Gift Annuities. Annuitant: Donor/others who receive payments. Residuum: Amount remaining when the final annuitant dies. It is very important that you learn definitions of some key words in order to understand gift annuities. First, a “donor” is one who contributes cash or assets to charity for a gift annuity. “Payments “ are then made by charity to one or two annuitants per gift annuity contract. The “rates” offered for gift annuities for these payments are based on rates recommended by American Council on Gift Annuities. An “annuitant” is the donor and/or others who receive payments as designated by the donor. Finally, the “residuum” is the amount remaining from the initial gift when the final annuitant dies. The residuum is used to serve the mission of your charity!

How a Charitable Gift Annuity Works 2. INCOME 3. RESIDUUM The payments to the donors are based upon their age. When they pass, the residuum is available for use by charity. Donors When annuitant(s) die, the residuum is available for charity’s use.

Recommended Rates ACGA formed in 1927. Rates at www.acga-web.org. Rates are voluntary. Rates are subject to change. Reasonable assumptions to assure a valuable residuum. Avoids competition. Most charitable organizations that offer gift annuities follow the rates recommended by a national nonprofit organization called the American Council on Gift Annuities which has been suggesting rates for gift annuities since 1927. The latest rates are available at the ACGA’s website. Following these rates is entirely voluntary and not required by law. However, time has proven the ACGA recommended rates to serve charitable organizations well. Valuable residuums may be possible based on reasonable assumptions used by ACGA to determine its recommendations. In addition, following ACGA rates avoids competition among charitable organizations. Donors should make decisions to establish gift annuities with charities whose mission they wish to support, rather than based on the highest offered gift annuity rate.

Assumptions of ACGA Rates 50% of the initial gift remains at annuitant’s death. Invested assets earn 5.5%. Fees of 1%. Projected life expectancy based on standard mortality tables. The assumptions used by the American Council on Gift Annuities to recommend rates are subject to change, but currently include an objective that 50% of the initial gift remains as the residuum at the final annuitant’s death. This objective is based on an assumption that the invested assets from the gift annuity contributions grows at an average annual rate of 5.5%. In addition, fees are assumed to be 1%. Finally, the projected life expectancy of the annuitants is based on standard mortality tables.

Corporate Liability The obligation to make the annual payments is a corporate obligation. Be certain that donated assets can be sold! Residuum not guaranteed. Financial Statement: Payments are a liability. Financial Statement: Gifts are an asset. It must be understood that gift annuities represent a corporate obligation. The responsibility to make the annual payments is a corporate obligation of charity. This is important because the residuum not guaranteed since market fluctuations and other factors can impact the value of the residuum of the donor’s gift. As a result on the charity’s financial statement, gift annuity payments are a liability while the gifts from donors for an annuity are displayed as an asset. It should also be noted that many state regulate gift annuities and charity must assure compliance with applicable state laws where your donors reside.

State Regulations Must comply with applicable state laws where the donor resides States may regulate: rates, contract language, reserve requirement, investment restrictions Details for all regulating states at ACGA website: www.acga-web.org

Immediate Payment Charitable Gift Annuity Now that you understand the basics of gift annuities, let’s explore the first of two types of annuities: the immediate payment charitable gift annuity.

One Life Immediate Payment Rates Age 60 70 80 90+ Rate 4.4% 5.1% 6.8% 9.0% The pay-out rates recommended by the American Council on Gift Annuities is based on age. The older the donor, the higher the rate of payments back to him or her. Here are sample rates for a single life annuity. Of course, these rates are annually reviewed by the ACGA and subject to change. For the most recent recommended rates, you may visit the ACGA website at www.acga-web.org. (ACGA rates as of January 1, 2012)

Sample Two Life Immediate Rates Younger Age / Older Age 60/65 70 / 75 80 / 85 (ACGA rates as of January 1, 2012) Rate 4.0% 4.8% 6.1% Separate rates are recommended for gift annuity contracts making payments to two annuitants. As you can see, these rates are somewhat lower than the rates for single life annuity contracts at comparable ages.

Example of an Immediate Gift Annuity Mary Smith Age 70 Contributes $50,000 Annuity rate is 5.1% or $2,550 annually If fund earns as expected and If Mary dies as predicted then $25,000 residuum to charity To help understand how a gift annuity works, let’s consider an example. Mary Smith, age 70 contributes $50,000 for a gift annuity. Following the ACGA recommended rates, Mary will be paid 5.8% of $50,000 which equals $2,900 per year. The ACGA assumptions suggest that if Mary lives to her life expectancy, then the charity will receive the projected residuum of $25,000 which is 50% of her original gift of $50,000.

Risk of Gift Annuity Obligations If Mary dies sooner, then charity may receive more than a 50% residuum. But… If Mary outlives her expected life expectancy, then charity must continue her annuity payments. If Mary dies sooner, the charity may receive more than a 50% residuum. However, if Mary outlives her expected life expectancy, the charity must continue her annuity payments as its corporate obligation pursuant to the gift annuity contract. However, as we will discuss later, with the National Gift Annuity Program, charity Worldwide will assume this liability and not your local charity.

Immediate Payment Gift Annuity $50,000 $2,550 5.1% Payout 70 Year Old Donor To review, if a donor gives $50,000 to charity for a gift annuity, then charity guarantees payments back to the donors as a 5.3% annual payout. She will receive $2,900 annually from charity until they die. Plus there are more benefits. The donor avoids capital gains taxes by donating appreciated property such as stock AND a portion of their annual payout is considered tax-free return of principal. (Rates as of January 1, 2012)

Immediate Payment Gift Annuity Income Tax deduction = $16,769 $50,000 $2,550 5.1% Payout 70 Year Old Donor By giving a $50,000 gift to charity, a 70 year old donor will receive a current income tax deduction of $19,011 in addition to the annual lifetime payments of $2,900. In fact, the older the donor, the greater his or her current charitable deduction. Furthermore, of the $2,900 payment, $1,364 will be considered tax-free return of principal by the IRS. Many donors find these tax-free payments very attractive as they increase the “effective” payout rate. In this example, the effective payout rate is 7.5% once the tax-free component is added to the base payout rate of 5.8%. Finally, if appreciated property such as marketable securities is donated, then a portion of the $2,900 annual payment will be taxed at the capital gains tax rate which currently is 15%. The balance of the payments will be taxed at the annuitant’s ordinary income tax rate. $2,091 Tax Free Effective Payout Rate = 8.3%

Can Be Established During Life or at Death Also called “inter vivos”. Most charities require a minimum of $5,000-$10,000 for first annuity. Pays income immediately. Current income tax charitable deduction. Also called “testamentary”. Included in will. Pays income to surviving loved ones. Estate tax charitable deduction. All types of charitable remainder trusts are irrevocable and may be established during life or at death. Lifetime, or inter vivos, charitable remainder trusts are commonly at least $100,000 in size since they are usually funded with highly appreciated assets such as stock or land – and their purpose is to produce additional income for living and retirement. Lifetime trusts pay income immediately and qualify for an income tax charitable deduction that may be reported on the tax return for the year in which the gift to the trust is made. Trusts established at death are known as testamentary trusts and are often included in the terms of a will. These trusts may be funded with stock, real estate and even beneficiary designations of retirement plans. These trusts will pay income to loved ones who survive the donor. Testamentary charitable remainder trusts qualify for an estate tax charitable deduction.

Benefits of Gift Annuity for Donor Fixed payments for lifetime at attractive rates. Current income tax charitable deduction. A portion of payments is tax-free. Cash gifts increase tax-free payments. If capital gain property such as stock is donated, then portion of payments taxed at capital gain rate. Note: If anyone other than donor or spouse receives payments, then capital gains tax is immediately owed plus potential gift tax. Donation removed from taxable estate. To summarize, the benefits of a gift annuity for donors include fixed payments for lifetime at attractive rates as well as a current income tax charitable deduction. The donation is removed from the taxable estate and a portion of the annual payments is tax-free. In addition, if capital gain property such as stock is donated, then a portion of payments is taxed at the capital gain rate. If anyone other than the donor or donor’s spouse receives annuity payments, then capital gains tax is immediately owed and gift tax may be owed as well.

Deferred Payment Charitable Gift Annuity Now let’s compare the immediate payment annuity with the second annuity option: the deferred payment charitable gift annuity.

Deferred Payment Gift Annuity Donor elects to delay receiving income for a set period of time. Results in a higher annual payout rate once payments begin. A deferred gift annuity is similar to an immediate payment annuity, except the donor delays the payouts to himself or loved ones for a set period of time. The deferral allows the contribution to grow through investment, and in return the donor receives a higher payout. Individuals planning for their own or a loved one’s retirement may find deferred charitable gift annuities especially attractive. They may not need the extra income today, but can rely on the fixed payment they will receive down the road. This may give them greater financial freedom that is not dependent on market fluctuations.

Sample One Life Deferred Payment Gift Annuity Rates Age 50 Rate (10 Years) Rate (20 Years) 5.31% 9.2% The pay-out rate is influenced by age and the length of the deferral period as this slide reveal. The older the donor and/or longer the deferral period, the greater the rate of payments. (as of January 1, 2012)

Example of Deferred Gift Annuity Bob Boomer Age 50 Contributes $50,000 for deferred annuity that will begin payment in 20 years during his retirement at age 70. Annuity rate is 9.2% or $4,600 annually If fund earns as expected and If Bob dies as predicted then $25,000 residuum to Charity To illustrate, assume Bob Boomer, age 45, donates $50,000 for a deferred annuity that will begin payments when he reaches retirement at age 65. Due to his current age and twenty year deferral period, the rate recommended by the American Council on Gift Annuities is 11.7%, which would pay him $5,850 annually. The assumptions by ACGA would project at least $25,000 will ultimately be available to service the mission of your charity.

Benefits of Deferred Payment Gift Annuity for Donor Fixed deferred payments at attractive rates beginning at designated date for rest of lifetime. Current income tax charitable deduction. A portion of payments is tax-free. If capital gain property such as stock is donated, then portion of payments taxed at capital gain rate. Note: If anyone other than donor or spouse receives payments, then gift tax may be owed. Donation removed from taxable estate. To summarize, the benefits of a deferred payment gift annuity for donors include fixed payments for lifetime at attractive rates beginning at a date in the future designated by the donor. In addition, the donor receives a current income tax charitable deduction which increases the longer the deferral period. The donation is also removed from the taxable estate. A portion of the annual payments is tax-free. In addition, if capital gain property such as stock is donated, then a portion of payments is taxed at the capital gain rate. If anyone other than the donor or donor’s spouse receives annuity payments, then capital gains tax is immediately owed and gift tax may be owed as well.

Profile of Donor Desires fixed income for self and/or loved ones. Attractive rates for older donors or those willing to defer income. Needs tax savings. Desires tax-free payments. Can start with smaller gifts and donate for more and larger annuities over time. In light of what you have learned, the profile of a standard charitable remainder unitrust donor is one who desires income for himself or herself and/or for loved ones. Since a common initial gift size for a trust is at least $100,000, the donor must be able to make major gift. As the payouts are tied to long term market growth, these donors usually believe that the invested principal value will rise over time. Escaping capital gains tax means that commonly these donors own highly appreciated assets such as stock or real estate. In addition, these trusts may convert non-income producing property to a personalized investment portfolio that generates income. Of course, the attractive tax savings can be very valuable and helpful for trust donors too!

Charitable Remainder Trusts Charitable remainder trusts are very popular! In fact, over $100 billion has been donated to such trusts. There are many different types of charitable remainder trusts that we will explore in this module. We will begin with a review of the basic aspects of all these types of charitable remainder trusts.

Charitable Remainder Trusts Future Interest Gift TRUST Income Donors Charity To help explain the basics of charitable remainder trust, we will use the metaphor of an apple tree. A donor makes an irrevocable gift to a charitable remainder trust, represented here as the tree. For a defined period of time, annual payments are made to donors and/or other individuals named by the donors. Consider these payments as the apples produced by the tree. After a period of time defined when the charitable remainder trust is created, the principal of the trust – or tree - goes to charity for its charitable use and benefit. Income to donors or individuals named by donors

Can Be Established During Life or at Death Also called “inter vivos”. Commonly at least $100,000 initial gift. Pays income immediately. Current income tax charitable deduction. Also called “testamentary”. Included in will. Pays income to surviving loved ones. Estate tax charitable deduction. All types of charitable remainder trusts are irrevocable and may be established during life or at death. Lifetime, or inter vivos, charitable remainder trusts are commonly at least $100,000 in size since they are usually funded with highly appreciated assets such as stock or land – and their purpose is to produce additional income for living and retirement. Lifetime trusts pay income immediately and qualify for an income tax charitable deduction that may be reported on the tax return for the year in which the gift to the trust is made. Trusts established at death are known as testamentary trusts and are often included in the terms of a will. These trusts may be funded with stock, real estate and even beneficiary designations of retirement plans. These trusts will pay income to loved ones who survive the donor. Testamentary charitable remainder trusts qualify for an estate tax charitable deduction.

Charitable Remainder Trust Income Tax deduction = $50,607 CHARITABLE REMAINDER TRUST $100,000 $5,000 5.0% Payout 69 Year Old Donor Payout increases or decreases with value of trust

Benefits to Donors Income paid to the donor and/or loved ones for lifetime(s) or term of years (not to exceed 20 years). Charitable tax deduction. Escape of capital gains tax. Personalized investment portfolio can be adjusted over time as needs change. Donor selects trustee to manage the trust. Trust assets excluded from estate tax. Flexibility to change multiple charity designations. There are many benefits to donors of charitable remainder trusts. First of all, these trusts pay income to the donor and/or loved ones designated by the donor. This income may be paid for a lifetime or a term of years not greater than twenty years. Secondly, a gift to a charitable remainder trust qualifies for a charitable tax deduction. This deduction is for the current value of charity’s future interest in the trust. In fact, the law provides a mathematical formula that is required to calculate this deduction. A third benefit is that if appreciated property is donated to the trust – then is later sold by the trustee of the trust – there is no payment of any capital gains tax. Fourth, the trust principal may be invested in a portfolio that is personalized for the current and future income needs of the donor or those designated to receive income. In fact, this trust investment portfolio may change over time to respond to changing needs. Overseeing the trust management is a trustee selected by the donor that may include anyone authorized by law to serve as trustee, including the donor. A sixth benefit is that all donations to the trust completely escape estate tax. And finally, the donor may retain the right to name more than one charity as the remainder beneficiary of the trust – and can change these charitable remainder beneficiaries at any time.

Special Tax Implications of CRTs The income tax charitable deduction value must be at least 10% of the amount donated to the trust. The trust is tax exempt and pays no capital gains tax on the sale of donated appreciated property. Potential gift tax if anyone other than donor or spouse receives income. No estate tax owed on gifts to the trust. There are some special tax implications of the charitable remainder trust that you should remember. First, the income tax charitable deduction is not for the full amount given to the trust. Rather, similar to gift annuity contracts, it is calculated by an approved formula by law as the present value of charity’s future interest. In addition, the law requires that this charitable deduction value must be at least 10% of the total value of the gift when originally donated to the trust. Another tax result is that if appreciated property is donated to the trust and later sold by the trustee, there will be no capital gains tax owed by the donor or the trust since all charitable remainder trusts are tax exempt . In addition, if anyone other than the donor and/or his or her spouse receives income from the trust, then gift tax may be owed on the gift of an income interest depending on the circumstances. Finally, all gifts to a charitable remainder trust completely escape federal estate tax liability. Now, take a minute to make sure you understand some of the important information we’ve shared so far.

Wealth Replacement Life insurance replaces for children or other heirs the assets given to charitable remainder trust. At the end of the trust: Remainder of the trust passes to charity. Life Insurance distributed for benefit of children or other heirs. Another valuable planning technique often partnered with charitable remainder trusts is the concept of wealth replacement. Using the income payments and tax savings achieved by the trust, the donor may purchase life insurance that will provide a death benefit payment to children or other loved ones. This insurance death benefit can replace for these children or loved ones the value donated to the trust that will ultimately be received by the charity.

Types of Charitable Remainder Trusts 1. Charitable Remainder Unitrusts: Standard (most popular) Net Income Net Income with Make Up Flip Trust 2. Charitable Remainder Annuity Trust (least popular) There are many different types of charitable remainder trusts. Donors with the advice of their attorneys will choose which type is best for them. You should have a general understanding of the types of charitable remainder trusts so that you can basic conversations with your donors. The most popular are charitable remainder unitrusts. In fact, there are four types of unitrusts that will be explained in some detail: standard, net income, net income with make up and flip trusts. The charitable remainder annuity trust is the least popular of the types of charitable remainder trusts.

Standard Charitable Remainder Unitrust Now that you understand the basics for all charitable remainder trusts, let’s turn our attention to learn the differences between the types of charitable remainder trusts, starting with the most popular type for donors: the standard charitable remainder unitrust.

How Standard Charitable Remainder Unitrusts Work Charitable remainder unitrust document created by donor’s legal counsel. Donor selects the trustee and charitable remainder. Trust document specifies a payout percentage which by law must be no less than 5%. The trust pays from income and/or principal the stated percentage of the principal as the principal is revalued once each year (usually December 31). A charitable remainder unitrust document must be created by the donor’s legal counsel. The donor selects the trustee and the charitable organizations such as charity that will ultimately benefit from the trust, called the charitable remainder. Of course, the trust will pay income for the lifetime or a term of years not greater than twenty years to one or more income beneficiaries named by the donor. The trust document specifies a payout percentage which by law must be no less than 5%. The trust pays from income and/or principal the stated percentage of the principal as the principal is revalued once each year, usually on December 31.

Market Adjusted Payouts The actual dollar amount paid from the trust is dependent on performance of the invested trust assets. As market value goes down or up, so does the annual payment. Can provide a hedge against inflation over the long term. The payout from the standard charitable remainder unitrust is tied to the investment performance of the underlying assets. If markets return a higher growth than expected, the underlying trust value grows and the annual payments increase. In addition, the charitable remainder for charity is greater – a real win-win scenario! Conversely, if the trust’s investments decrease, the trust principal shrinks in value and the income beneficiaries receive lower annual payments. This means that the beneficiaries may receive more or less annually depending on market performance. If a donor elects to have a lower percentage payout, then the market value of the principal may grow the trust assets and the income beneficiaries could receive higher value payments in future year than initially. Many donors choose to have a lower percentage payout in order to receive higher dollar value payouts in future years, providing a hedge against inflation in the long run. This also allows for a greater remainder value for charity!

Profile of Donor Desires income for self and/or loved ones. Able to make major gift. Believes principal value will rise. Owns highly appreciated assets . Wishes to convert non-income producing property to a personalized investment portfolio. Needs tax savings. In light of what you have learned, the profile of a standard charitable remainder unitrust donor is one who desires income for himself or herself and/or for loved ones. Since a common initial gift size for a trust is at least $100,000, the donor must be able to make major gift. As the payouts are tied to long term market growth, these donors usually believe that the invested principal value will rise over time. Escaping capital gains tax means that commonly these donors own highly appreciated assets such as stock or real estate. In addition, these trusts may convert non-income producing property to a personalized investment portfolio that generates income. Of course, the attractive tax savings can be very valuable and helpful for trust donors too!

Remainder Interest in Personal Residence or Farm with Retained Life Estate

How it Works Donor retains life estate. Irrevocable gift of remainder. Includes principal residence. Vacation home, condo, co-op. Includes fixtures - not equipment, furnishings or crops. Remainder value is discounted to reflect depreciation and salvage value is factored.

Example Donor age 65 $500,000 property value 1% AFR rate (August 2012) $318,884 income tax charitable deduction Retained life estate Removed from taxable estate

Adjusted Federal Rate (AFR Rate) A factor in the formula used to calculate the tax benefits of any split interest gift Changes monthly At an historic low December 2012: 1%

When AFR Decreases Gift Annuity income value increases but deduction decreases. Charitable Remainder Annuity Trust tax deduction decreases. Minimum impact on CRUTs. Increase in tax deduction for Remainder Interest in Residence or Farm. Reduction in gift or estate tax liability for Charitable Lead Trust.

Planning Considerations Income tax charitable deduction for present value of remainder interest. Deduction increases as AFR rate drops. Escape of capital gains tax and estate tax liability. Useful if charity needs the specific real estate or if the property value sustains until ultimate receipt and sale by charity. Remainder Interest Agreement required.

Remainder Interest Agreement Signed by Donor and Charity Liability for Property Taxes Payment of Property Insurance Obligation for Maintenance Costs Right of Charity to refuse future leases, major changes to property that may diminish value, etc.