Example 1The taxability of lifetime transfers of commercial annuities may dissuade some donors from making lifetime charitable transfers. However, the charitable income tax deduction resulting from the gift can be used to offset the ordinary income recognized from the transfer.
Leo wanted to make a gift of his commercial annuity contract to his favorite nonprofit. His insurance company confirmed that surrender penalties would apply. Despite the penalties, Leo decided to surrender his commercial annuity to make a gift to his favorite nonprofit. His annuity had a cash value of $75,000. Leo's original cost for the annuity was $50,000. Leo will recognize the $25,000 of untaxed gain as ordinary income at the 24% federal bracket. He will recognize about $6,000 in taxes from the surrender. Leo's adjusted gross income for the year was $125,000. His charitable deduction was limited to 60% of his adjusted gross income, as it is a cash gift. He can use all $75,000 of his charitable deduction in the year of the gift. The charitable deduction will produce a tax savings of $18,000, which offsets the tax realized from the surrender of the annuity.
Linda listed her favorite nonprofit as the only designated beneficiary of her commercial annuity. Her annuity contract offers substantial death benefits for the beneficiary. Later in life, Linda creates a will. The will states that her entire estate is given to her niece Elizabeth. When Linda passes away, the commercial annuity will be distributed according to the beneficiary designation form she completed, not according to her will. Linda's favorite nonprofit will receive the proceeds from her commercial annuity tax-free and Elizabeth will receive the other assets from her aunt's estate.