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Charitable Gift Annuity Pitfalls: Tips for the Unwary

January 19, 2021
Charitable Gift Annuity Pitfalls: Tips for the Unwary

So maybe your charity is starting, or already running, a charitable gift annuity program.  Congratulations, and we hope it is successful!  This posting shares the benefits of some of our experience with such programs and identifies some common (and a few not-so-common) mistakes that can derail the charitable gift annuity enterprise.

Charitable gift annuity regulators are a savvy group.  There is a great deal of institutional experience in the federal and state agencies that concern themselves with charitable gift annuities.  These gift vehicles are hardly the new kids on the block.  As far as we know, the first gift annuity was issued by the American Bible Society in 1843.  (That organization must be doing something right – they’re still issuing them!).  So there are probably few things that the “CGA police” haven’t seen.

Bypassing Federal Regulations

There is so much emphasis on state regulation of charitable gift annuities that some charities fail to consider the pertinent federal rules, the bulk of which arose in the Philanthropy Protection Act of 1995 (PPA).  The most important of these provisions are the disclosure rules, which are different from the state mandates both in content and in timing.  For instance, potential annuitants must be informed in detail about the finances and governance of the issuing charity.  Most state regulations do not require that level of specificity.

Perhaps most important, the federal disclosures must be made prior to any deposit of money by the donor.  In our experience, that is the requirement most frequently overlooked by CGA-issuing charities, probably because state laws normally permit disclosures to be made in the annuity contract itself.  Federal enforcement action on charitable gift annuities is rare, but decisive.

For example, in 2013, the Securities and Exchange Commission (SEC) filed a fraud action against a Florida charity which alleged, among other things, noncompliance with the PPA.  Why the SEC?  Because CGAs are considered investment products by the federal government unless they meet precise requirements for exemption, including those imposed by the PPA.

Taking the “Home Field” View of Applicable Law

Some states have little or no specific charitable gift annuity regulations.  Charities in those states all too often take the view that any charitable gift annuity issued is subject only to the law of the charity’s state.  While that may be a way to escape the rigorous laws of a state like California, it is also an engraved invitation to enforcement action.

A charity transacting business with an out-of-state donor needs to follow the laws applicable in the donor’s location.  This is especially true when the laws exist primarily to protect consumers, as is the case with many CGA-related enactments.

Paying Higher Charitable Gift Annuity Rates

Virtually all charities peg charitable gift annuity rates to those recommended by the American Council on Gift Annuities (ACGA).  These rates are designed to be lower than those available in the commercial annuity market and to maximize the chance that there will be a significant sum left for the charity at the time of the donor’s death.

When a donor approaches a charity and offers to buy a large annuity if the rate can be “bumped” a point or two above the ACGA recommendation, the temptation to assent is overwhelming.  We believe that such a deviance is a mistake, even on a one-time basis.  There are at least three reasons for this:

  1. Rate competition poisons the charitable gift annuity marketplace. Gift annuities are, as the name implies, first and foremost donations.  If charities started “rate wars,” one likely effect would be that smaller CGA-issuing charities would be forced out of the market, as they could not compete.  That is certainly not the intent of CGA-related legislation.
  2. On the federal level, rate-hiking has the potential to transform a charitable gift annuity contract into the illegal sale of a regulated financial product. Repeated rate-hiking would only compound that problem and almost certainly lead to the “residuum” of the annuity being treated as unrelated business income for the charity.
  3. On the state level, charitable gift annuities providing in-excess-of-ACGA rates may well lose protection as “qualified” gift annuities. In that case, the instruments would become illegal securities or insurance policies, subjecting the issuing charity to nightmarish consequences and the donor to an unforeseen and unwelcome financial outcome.

Accepting Real Estate to Fund Charitable Gift Annuities

More than most charities realize, gifts of real estate are often in the equine family – Trojan horses.  In a forthcoming blog post, we will explore the risks of real estate gifts in more depth, but for now let’s limit ourselves to charitable gift annuities.

The reasons for caution when real estate is the “gift” part of a charitable gift annuity may almost be too obvious to belabor.  The issuing organization is accepting an asset that:

  1. Must be sold to realize its value;
  2. Will likely generate tax bills and other fees until sale;
  3. May well have maintenance and repair issues to be addressed before sale; and
  4. Is subject to fluctuating marketplace values.

Then, on top of all that, the charity is obliged to start making payments to the donor based upon a previously-agreed valuation.

Mortgaged Real Estate and Charitable Gift Annuities

An annuity funded by mortgaged real estate is subject to the listed cautions as well as two others:

  1. In most cases, the charity will have to start making mortgage payments (until the property is sold) at the same time it is making annuity payments. It may be possible to avoid that problem by having the donor agree to a deferred start date for the annuity.  (Note: using real estate to fund a deferred annuity may contravene the law of certain states.)
  2. In certain circumstances, a charity’s acceptance and subsequent sale of mortgaged real estate can lead to taxable unrelated business income. In the case of charitable gift annuity for real estate, that situation would seriously impair, if not destroy, any benefit the charity might have expected from the “gift” part of the arrangement.

Overenthusiastic Advertising

Only a fundraising ostrich would think that state regulators do not access and examine fundraising letters, advertisements, and web pages.  Gift planners know that many donors look at charitable gift annuities primarily as an investment and secondarily as a charitable gift.  That can lead to an over-emphasis on donor financial benefit in promotional materials.  In the worst-case scenario, such a lopsided advertisement could become Exhibit A in an enforcement action against the charity.

The situation would be even worse if the organization was promising higher-than-ACGA-rates or “guaranteed minimum” payouts, either or both of which would make the charitable gift annuity look dangerously like a commercial annuity.