Case of the Week

Case:

Abigail Azah is a wonderful and spirited 80-year-old woman. To this day, she still works in her garden, handles all of her finances and plays golf each weekend. In addition to her busy schedule, she also makes time to help at a local homeless shelter. She believes that whenever you can lend assistance to your fellow neighbor it is your responsibility to do so. Because of this belief, she gives her time, love and money to the shelter. Abigail's normal practice is to give $5,000 each year to the homeless shelter. However, she wants to make a more significant gift to the shelter this year.

So, in January of this 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 she loved most was the eventual gift to the shelter.

Sadly, Abigail suffered a heart attack in March and died soon after. To make matters worse, Mandy died the following year in a tragic automobile accident. It was a terrible loss to the 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 but just an annuitant. Thus, the CPA wonders if he can claim a tax deduction for the unrecovered investment on Mandy's final income tax return?

Question:

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

Solution:

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 Section 72(b)(4). However, in this case, the annuity continues for the life of Mandy (the tax-free payments continue on to Mandy as well). Mandy, in essence, will step into Abigail's "shoes" and reap the benefits of tax-free payments.

Consequently, there is no unrecovered investment in the annuity contract at the time of Abigail's death, because Mandy is still "recovering" it. This precludes Abigail from claiming a tax deduction on her final income tax return, since Mandy continues 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. Logistically, 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 allowed, it would not be a charitable income tax deduction, but rather an "other miscellaneous deduction" (not subject to the 2% floor). This deduction can be claimed on Schedule A of Form 1040.