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Sunday September 19, 2021

Case of the Week

Dying to Deduct, Part 3


Abigail Green was a wonderful and spirited 80-year-old woman. Even in her advanced age, she worked in her garden, handled all of her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local homeless shelter. She believed that whenever you can lend assistance to your fellow neighbor it is your responsibility to do so. Because of this belief, she gave her time, love and money to the local homeless shelter. Abigail's normal practice was to give $5,000 each year to the homeless shelter. However, she wanted to make a more significant gift.

In January of last year, she decided to establish a $100,000 charitable gift annuity for herself and her sister. The payments would go to Abigail for life, then to her sister Mandy for life. She liked the high fixed payments, large tax deduction and simplicity of the arrangement. Because Abigail funded the CGA with cash, a large portion of each payment was tax free. This tax-free component is essentially a return of principal or investment, and it would last for the life expectancy of both Abigail and Mandy. But, of course, what Abigail loved most was the eventual gift to the shelter.

Sadly, Abigail suffered a heart attack a few weeks later and died soon after. To make matters worse, Mandy died the following year in a tragic automobile accident. It was a terrible loss to their family, friends and community.

Now several months have passed and Mandy's CPA is winding up Mandy's financial affairs. Mandy's CPA recalls that if a person who funds a gift annuity dies prematurely, he or she may claim an additional tax deduction for any unrecovered investment (See "Dying to Deduct, Part 1"). However, in this case, Mandy is not the donor and is only an annuitant. Thus, the CPA wonders if he can claim a tax deduction for the unrecovered investment on Mandy's final income tax return.


Since Abigail and Mandy died prematurely, who gets the "unrecovered investment" tax deduction?


The income from Abigail's gift annuity, as mentioned above, was partially tax free. This tax-free component is essentially a return of principal or investment, and it would last for the life expectancy of both Abigail and Mandy.

Normally, the premature death of a donor would trigger an additional income tax deduction on the decedent's final income tax return. See Sec. 72(b)(4). However, in this case, the annuity continued for the life of Mandy. The tax-free payments continued for Mandy as well. Mandy, in essence, stepped into Abigail's "shoes" and reaped the benefits of tax-free payments.

Consequently, there was no unrecovered investment in the annuity contract at the time of Abigail's death, because Mandy was still "recovering" it. This precluded Abigail's estate from claiming a tax deduction on her final income tax return, since Mandy continued to "recover" the initial investment. (See "Dying to Deduct, Part 2")

At Mandy's death, the amount of unrecovered investment is final, fixed and easily determined. It is merely the amount of remaining tax-free payments that have not been made. Since Mandy was entitled to receive the payments as the second life annuitant, it seems only appropriate for the tax deduction to flow to her final income tax return. This conclusion also makes sense because, in many cases, the second annuitant could die 5, 10 or even 15 years after the death of the first annuitant. It would be an administrative nightmare if the first annuitant were entitled to the tax deduction for the unrecovered investment. Furthermore, the time to file an amended return would likely have passed.

As a result, the most likely recipient of the tax deduction for the unrecovered investment is Mandy. The CPA feels comfortable with this treatment and files the income tax return accordingly.

Editor's Note: If an additional income tax deduction were applicable, it would not be a charitable income tax deduction, but rather an itemized deduction not subject to the 2% floor.

Published March 12, 2021
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Previous Articles

Dying to Deduct, Part 2

Dying to Deduct, Part 1

Living on the Edge, Part 6

Living on the Edge, Part 5

Living on the Edge, Part 4