Best Practices: Matters of Trust
To Give and Receive
Lani Luciano
06/01/2005

Like many senior citizens, Warren Allen, 85, and his wife, Paula, 73, received ample unsolicited advice on how to combine their estate plans and philanthropic pursuits. They paid little attention to it. As patriarch of a family that has been giving generously for more than a decade, Warren knew exactly where and how he wanted to allocate his charitable dollars. Then, six years ago, the Allen family changed course.

“We support local causes,” explains Warren who, with his two late brothers, helped their father turn a small chicken hatchery in Seaford, Del., into the $500 million, 2,400-employee company it is today, Allen Family Foods. Since 1993 the family has poured roughly $9 million into community projects ranging from the Seaford Little League to a biotech lab at the University of Delaware, mostly through outright contributions to the Delaware Community Foundation and family donor-advised funds.

TOP VIEW
Charitable annuities can offer the best of both investment and philanthropic worlds. Annuities buyers are entitled to income tax deductions, estate tax reductions and even guaranteed income while their charities receive sizeable donations. But the various charitable annuities options require a buyer to choose carefully to meet his—and his heirs’—financial goals.
In late 1999, however, Warren took another look at some of the requests he had received to donate money through charitable gift annuities (CGAs). It was an epiphany of sorts, brought on by his distaste for the IRS and his search for tax breaks (it was too late in the tax year to do anything that would require advance planning). With this type of annuity, he could donate a lump sum—in either cash or equities—to a charity; in return the charity would pay him a fixed amount of interest, usually on a quarterly basis.

Since then, the Allens have funded nine CGAs, totaling more than $550,000, mostly in cash, for the Delaware Foundation. In addition to removing that money from their taxable estate, the couple has received roughly $200,000 in income tax deductions. The deduction a purchaser can claim for a charitable gift annuity is the present value of the amount that the charity expects to wind up with after paying out the interest to the beneficiary.

Charitable annuities are attractive to seniors because older annuitants receive higher payments. Indeed, the annuity provider sets the interest rate deliberately high to attract annuitants—either the investor or someone he names—who are older than 60, because the payments continue for the rest of that person’s life. “For people my age, the guaranteed annual interest rate was more than 9 percent,” Warren says. “That looked like a pretty good return compared to elsewhere in the investment market.”

Even with current efforts to abolish the estate tax, increased longevity and an uncertain investment climate can be powerful arguments for blending charitable donations with a guaranteed future payment stream. Gift annuities are just one option. Charitable trusts or even commercial annuities can further estate, tax and philanthropic goals, depending on the investor’s philosophy, circumstances and needs.

Charitable Gift Annuities
CGAs are popular last-minute tax savers because they are easy to set up, requiring little more than a simple legal contract and the transfer of the donated assets. They are not recommended, however, if you want to name a child or even a young or middle-age adult as the beneficiary.

While Allen could have earned 15 to 16 percent on his money with a commercial annuity (male seniors receive the highest rates of any annuity buyers), charities offered him lower rates to enable them to retain more capital when annuity payments end. But Allen enjoys significant benefits for his philanthropy. The difference between higher commercial and lower charitable interest payments constitutes a tax-deductible contribution for him. Additionally, if he dies earlier than mortality tables predict, his favorite charity (rather than a profit-making company) reaps the windfall of the money remaining in his annuity. “Two more good reasons to go with the charity,” he says with a laugh.

(Illustration by Jim Frazier.)
CGA interest payouts are backed by the assets of the charity, a fact that steers most buyers to large, stable nonprofits. Universities are among the most frequent recipients, followed by the Salvation Army and the Smithsonian Institution. More than 9 in 10 charities in the United States follow an investment model set by the American Council on Gift Annuities (ACGA), an educational and advocacy organization that recommends a conservative portfolio of 40 percent equities, 55 percent 10-year Treasury bonds and 5 percent cash. “When charities follow these guidelines, they wind up, on average, with 50 percent of the original donation retained after the annuity ends,” explains Betsy Mangone, an ACGA board member. “The bigger risk is that the charity will end up with less, not that the donor will.”

Still, CGAs are not fail-safe. Only 10 states (Arkansas, California, Hawaii, Maryland, New Jersey, New York, North Dakota, Oregon, Washington and Wisconsin) regulate charities offering CGAs under state insurance laws, and require them to put aside adequate reserves to cover their liabilities to annuitants. Each state has its own definition of what constitutes an adequate reserve, but the calculation is based on projected growth and liability potential, and the timeframe for the annuity.

CGA buyers can find out how tightly their state regulates these products, including the reserve requirements, by checking the ACGA website (www.acga-web.org). If regulation is loose in your state or the charity you are considering is small, new or little known, there are other annuity options that do not depend on the charity’s assets.

Charitable Remainder Annuity Trusts
You can, in essence, become your own insurer for a charitable annuity by setting up a trust. Charitable remainder annuity trusts (CRATs) offer a number of tax advantages over charitable gift annuities if you want to donate highly appreciated assets, and they work well if you want to name a young beneficiary.

With this type of annuity, he could donate a lump sum—in either cash or equities—to a charity; in return the charity would pay him a fixed amount
of interest, usually on a quarterly basis.
With this vehicle, instead of giving the donation directly to the charity, you place the donated assets within an irrevocable trust, naming a charity as the ultimate beneficiary. You and the trustee—generally the charity—draw up an agreement that the trust will pay a fixed income for a stipulated period to someone you designate. You can name yourself or anyone else as income beneficiary and specify that payments continue for either a limited term of at least 10 years or the lifetime of the beneficiary, which is what makes a CRAT a viable choice for young beneficiaries. The trustee fulfills the agreement by managing the trust assets, generally by selling and reinvesting them. At the end of the prescribed period, the trust is dissolved and the charity receives all remaining assets.

The primary advantage of a CRAT lies in your ability to actually remove assets from your estate, reducing your estate tax liability. Of course, if annuity payments are set too high or the assets are poorly managed, a CRAT can conceivably run out of money.

Charitable Lead Annuity Trusts
Lead trusts (CLATs) have a few tax drawbacks, but work well as an estate planning tool if you have assets you wish to remove from your estate now, while enabling a charity and your heirs to reap the benefits of appreciation.

These trusts are, in one sense, a mirror image of CRATs. The charitable donation is derived not from the assets placed in trust, but rather a stipulated income derived from those assets. The assets belong to the trust, not the charity. As with a CRAT, the trustee, generally the charity itself, manages the assets to generate fixed payments for a specified period. When that period—at least 10 years, but often the donor’s lifetime—ends, the assets are returned to the ultimate beneficiary, either the donor or, more often, an heir or heirs.

If you, the CLAT buyer, are the ultimate beneficiary, the trust assets remain in your taxable estate. But if you name your heirs instead, they will likely have to pay little or no additional estate tax when the assets revert to them. Greg Johnson, senior vice president of the Delaware Community Foundation in Wilmington, points out that this strategy—known as an estate freeze—is most useful when trust assets are expected to greatly appreciate over time and are managed well enough to generate the income to satisfy the charitable payments without being liquidated. Profitable rental properties in growth areas or dividend-paying shares in a closely held and prosperous family business are two prime examples of assets well suited to a CLAT.

Commercial Annuity Plus Life Insurance
For donors drawn to the idea of supporting charitable causes at no net cost to themselves, a growing number of estate planners tout wealth replacement strategies that combine commercial annuities and life insurance. David Bardes, a financial advisor in Vero Beach, Fla., calls his method “reverse planned giving.” These bespoke plans vary according to individual circumstances, but, as one example, Bardes cites a 70-year-old, would-be philanthropist who has used up all of his gift tax exemptions. The hypothetical philanthropist has $4 million in municipal bonds yielding $140,000 in tax-free annual income. He would like to liquidate his bonds and donate $1 million to  charity, leaving $3 million (minus estate taxes) for his heirs. However, doing so would reduce his income, possibly causing him to spend down some of his savings earmarked for inheritance.

Bardes suggests he sell his bonds, presumably with no capital gains due, donate $1 million of the proceeds to charity and use the remaining $3 million to purchase a lifetime annuity on the commercial insurance market. “He can expect more than $250,000 a year in annuity payments, plus a large income-tax deduction for the $1 million donation,” Bardes explains.

This particular tactic will not work for everyone. To achieve painless philanthropy, a donor must be in good health so that he can purchase life insurance, and he needs a substantial reserve of liquid assets for emergencies. For others, Bardes vows, “there is a strategy for every situation.”

Nor can annuities themselves promise eternal youth and fitness, yet there is a curious statistic that neither charities nor insurance companies mention, lest it sound like a marketing ploy. Actuarial tables show that people with annuities live, on average, 18 months longer than people without them. “Sorry, no magic,” the ACGA’s Mangone says. “It’s just that they generally have better resources to take care of themselves.”

The Waiting Game: Deferred Gift Annuities
Whereas a charitable gift annuity (CGA) enables the purchaser to begin collecting payments right away, a deferred gift annuity, as the name implies, gives you the option to donate now for an immediate tax deduction, but delay payments until any specified future date, as long as it is at least one year after the date of the contribution. This arrangement can increase your overall tax deductions. Because the payments begin later than with a standard CGA, you will, according to actuarial mortality calculations, if not in fact, collect fewer payments. Thus, the charity gets to keep more of your assets.

Lani Luciano has written for Money, Barron’s and other magazines. lmluciano1@aol.com