Reinsurance of CGA Not Commercial Insurance or UBI

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Jan

2009

Reinsurance of CGA Not Commercial Insurance or UBI

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Letter Rulings

The Service has ruled privately that a public charity's purchase of a commercial annuity to reinsure its payment obligation under a charitable gift annuity contract will not be treated as commercial insurance under section 501(m), nor will any benefits received by the charity under the contract (including any lump sum benefits under a guaranteed cash refund feature) be considered unrelated business income to the charity.

Ltr. Rul. 200852037

Full Text:

Contact Person: * * *

Identification Number: * * *
Telephone Number: * * *

SIN: 512.00-00
Release Date: 12/26/08

Date: September 30, 2008

Employer Identification Number: * * *

Dear * * *:

This is in response to your revised request for rulings under sections 501(m), 512 and 514 of the Internal Revenue Code.

FACTS

You are an organization described in section 501(c)(3) of the Code and a public charity. Your purpose is to operate two facilities, each of which serves as a home away from home for seriously ill children and their families. The houses are a haven for families who live too far away from the hospital to go home each night, while their children are receiving medical treatment.

Both of these facilities serve families of patients at a number of hospitals located in the area you serve. The programs offered in these facilities are supported by volunteers, staff and a wide base of community support.

Although other programs and facilities similar to yours exist throughout the United States, you are not controlled by any other outside entity. You are responsible for your own fundraising, and you support your programs and activities primarily by charitable gifts and contributions. In order to maintain your programs and activities, you are seeking new ways to increase charitable giving to support those programs.

As a means to increase funding of your programs, you have proposed to utilize a charitable gift annuity ("CGA") program. This program will be made available through an insurance broker and a major insurance company ("Insurer"). The Insurer is a highly rated affiliate of one of the leading international insurance organizations in the world.

You described the proposed CGA program as follows:

2. The CGA Contract will provide that each periodic annuity payment is payable from your general assets; however, Donor and Annuitant will be aware that you will purchase an annuity from Insurer to match your liability associated with the CGA Contract.

3. You will purchase an annuity policy from Insurer ("Commercial Annuity") based on the Annuitant's life and with the same periodic payment amount and frequency as specified in the CGA Contract. You will purchase the Commercial Annuity with a single premium and a payout starting date commencing no later than one year from the date the Commercial Annuity is purchased. The Commercial Annuity will pay you a series of substantially equal periodic payments (to be made not less frequently than annually), which will match your obligation to the Annuitant during the CGA Contract payout period. You may receive an additional payment upon the death of the Annuitant, as explained in paragraph 6 below.

4. The amount you receive from Donor as consideration for the CGA Contract will exceed the Insurer's market rates for a commercial annuity with the same payout period and periodic payment amount. The difference between the amount you receive from Donor for the CGA Contract and the premium you will pay to Insurer for the Commercial Annuity you will retain for your immediate and unrestricted use.

5. The broker will receive a commission from Insurer for the sale to you of the Commercial Annuity. You will pay no compensation to the broker for Donor's entering into the CGA Contract and will pay no fees to the broker, Insurer or to any other party.

6. At your option, and for additional consideration that you would pay to Insurer, the Commercial Annuity may provide that if Annuitant dies before the total annuity payments you receive from Insurer equal or exceed the original premium payment you made to Insurer, you will receive a guaranteed lump sum cash refund equal to the premium you paid to Insurer minus the total periodic payments you received from Insurer.

RULINGS REQUESTED

2. The following amounts will not constitute income from an unrelated trade or business within the meaning of section 513 of the Code:

b. The periodic annuity payments you will receive from Insurer; and

c. Any lump sum you will receive from Insurer upon the death of the last Annuitant under the guaranteed cash refund feature of the Commercial Annuity.

LAW

Section 72(a) of the Code provides that in general, gross income includes any amount received as an annuity under an annuity, endowment, or life insurance contract.

Section 102(a) of the Code provides that gross income does not include the value of property acquired by gift, bequest, devise or inheritance.

Section 501(m)(1) of the Code provides that an organization described in section 501(c)(3) shall be exempt from tax under section 501(a) only if no substantial part of its activities consists of providing commercial-type insurance.

Section 501(m)(2) of the Code provides that, in the case of an organization described in section 501(c)(3) which is exempt from tax under section 501(a) after application of section 501(m)(1), the activity of providing commercial-type insurance shall be treated as an unrelated trade or business as defined in section 513(a).

Section 501(m)(3)(E) of the Code provides that the term "commercial-type insurance" shall not include charitable gift annuities.

Section 501(m)(5) of the Code provides that for purposes of section 501(m)(3)(E), the term "charitable gift annuity" means an annuity if (i) a portion of the amount paid in connection with the issuance of the annuity is allowable as a deduction under section 170 or 2055, and (ii) the annuity is described in section 514(c)(5) (determined as if any amount paid in cash in connection with such issuance were property).

Section 511(a) of the Code imposes a tax upon the unrelated trade or business income of tax-exempt organizations.

Section 512(a)(1) of the Code provides that the term "unrelated business taxable income" means the gross income derived by any organization from any unrelated trade or business regularly carried on by it, less allowable deductions which are directly connected with the carrying on of such trade or business, both computed with certain modifications.

Section 512(b)(1) of the Code provides an exclusion from unrelated business taxable income for all annuities and all deductions directly connected with such income.

Section 513(a) of the Code provides that the term "unrelated trade or business" means any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes from the profits derived) to the exercise or performance by such organization of its charitable or other purpose or function constituting the basis for its exemption under section 501.

Section 1.513-1(b) of the regulations states in part that where an activity does not possess the characteristics of a trade or business within the meaning off section 162, such as when an organization sends out low-cost articles incidental to the solicitation of charitable contributions, the unrelated business income tax does not apply since the organization is not in competition with taxable organizations.

Section 514(a)(1) of the Code provides that, in computing the unrelated business taxable income for any taxable year, a percentage of net income derived from debt-financed property should be included.

Section 514(b)(1) of the Code provides that the term "debt-financed property" means any property which is held to produce income and with respect to which there is an acquisition indebtedness at any time during the taxable year.

Section 514(c)(5) of the Code provides that the term "acquisition indebtedness" does not include an obligation to pay an annuity which:

(B) is payable over the life of one individual in being at the time the annuity is issued, or over the lives of two individuals in being at such time; and,

(ii) does not provide for any adjustment of the amount of the annuity payments by reference to the income received from the transferred property or from any other property.

The legislative history accompanying The Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647, H.R. Rep. No. 795, 100^th Cong., 2d Sess. 116 (1988), in adding section 501(m)(3)(E) to the Code, stated: "[t]he present-law exception to the debt-financed property rules had historically exempted from tax any income resulting from the issuance of charitable gift annuities."

ANALYSIS

Ruling No. 1

An activity that otherwise constitutes providing commercial-type insurance, within the meaning of section 501(m)(2) of the Code, will not constitute commercial-type insurance if it involves "charitable gift annuities." This term is defined in section 501(m)(5), and means an annuity if: (A) a portion of the amount paid is deductible under section 170, and (B) the annuity is described in section 514(c)(5).

You received a separate letter ruling from the Office of Associate Chief Counsel, Passthroughs & Special Industries that included the ruling that a charitable contribution deduction will be allowable under section 170 of the Code when a donor purchases from you a CGA Contract of the type described above. Thus, based on this letter ruling, the CGA Contract meets the first requirement of section 501(m)(5).

An annuity is described in section 514(c)(5) of the Code if it meets several requirements. For the following reasons, the annuity in the CGA Contract meets all of these requirements, and therefore the CGA Contract meets the second requirement of section 501(m)(5). Your obligation to pay Donor an annuity under the CGA Contract will be the sole consideration you will provide to Donor in return for the amount you will receive from Donor. The value of the annuity you will pay Donor will be less than 90 percent of the amount you will receive from Donor. Under the CGA Contract, you will make annuity payments to Donor based on the life or lives of one or two individuals at the time the annuity is issued. The CGA Contract does not guarantee a minimum or maximum amount of payments to the Donor. Finally, the CGA Contract does not provide for any adjustment of the amount of the annuity payments by reference to the income received from the funds transferred by Donor to you or from any other property.

Thus, the annuities under the CGA Contracts will meet both requirements for charitable gift annuities under section 501(m)(5) of the Code, and therefore, will constitute charitable gift annuities within the meaning of section 501(m)(3)(E). As a result, your sale of the annuities through the CGA Contracts will not constitute the provision of commercial-type insurance under section 501(m).

Ruling No. 2

Your principal purpose for selling CGA Contracts to Donors is to solicit charitable gifts to raise funds to finance your tax-exempt activities. A program that involves the issuance of charitable gift annuities has traditionally been treated as a borrowing of money by the issuing organization rather than a trade or business. Therefore, the provisions of section 511 through 513 of the Code are not applicable because this activity is not a trade or business under section 1.513-1(b) of the regulations.

Inasmuch as there is an underlying financial obligation, the property could be considered debt-financed within the meaning of section 514 of the Code. However, section 501(c)(5) states that the rules concerning debt-financed property do not apply to the sale of annuities that satisfy the requirements in that section of the Code. As stated above, you intend to structure your program in such a way so as to meet these requirements. Therefore, income derived from this program is not unrelated business taxable income.

Even if this activity constituted a trade of business, for the following reasons, the revenues you will receive from the sale of CGA Contracts would not constitute unrelated business taxable income under section 512 of the Code.

(b) Section 512(b)(1) of the Code provides that various items of income, including annuities, are excluded from unrelated business taxable income. Thus, the periodic annuity payments you will receive from Insurer under the Commercial Annuity will be excluded from unrelated business taxable income.

(c) In some situations, if Annuitant dies before the total annuity payments you receive from Insurer equal or exceed the original premium payment you made to Insurer, you will receive a guaranteed lump sum cash refund equal to the premium you paid to Insurer minus the total periodic payments you received from Insurer. We have been advised by the Office of Associate Chief Counsel, Financial Institutions & Products that the presence of this refund feature in the Commercial Annuity will not adversely affect the status of CGA Contracts as an annuity under section 72 of the Code. Thus, based on this advice, any lump sum you receive from Insurer upon the death of the last Annuitant under the guaranteed cash refund feature of the Commercial Annuity will constitute an annuity. As a result, it will be excluded from unrelated business taxable income under section 512(b)(1) of the Code.

Under the CGA Contract, the annuity is payable over the lifetime of one or two individuals in being at the time the annuity is issued. In addition, the CGA program will meet all the other requirements in section 514(c)(5) of the Code. Therefore, the annuities under the CGA Contracts will not be debt-financed property within the meaning of section 514. Therefore, interest income you derive from the annuity will be excludable from unrelated business taxable income under section 512(b)(1).

RULINGS

Accordingly, based on the information furnished, we rule as follows:

2. The following amounts will not constitute income from an unrelated trade or business within the meaning of section 513 of the Code:

b. The periodic annuity payments you will receive from Insurer; and

c. Any lump sum you will receive from Insurer upon the death of the last Annuitant under the guaranteed cash refund feature of the Commercial Annuity.

This ruling will be made available for public inspection under section 6110 of the Code after certain deletions of identifying information are made. For details, see enclosed Notice 437, Notice of Intention to Disclose. A copy of this ruling with deletions that we intend to make available for public inspection is attached to Notice 437. If you disagree with our proposed deletions, you should follow the instructions in Notice 437.

This ruling is directed only to the organization that requested it. Section 6110(k)(3) of the Code provides that it may not be used or cited by others as precedent.

This ruling is based on the facts as they were presented and on the understanding that there will be no material changes in these facts. This ruling does not address the applicability of any section of the Code or regulations to the facts submitted other than with respect to the sections described. Because it could help resolved questions concerning your federal income tax status, this ruling should be kept in your permanent records.

If you have any questions about this ruling, please contact the person whose name and telephone number are shown in the heading of this letter.

In accordance with the Power of Attorney currently on file with the Internal Revenue Service, we are sending a copy of this letter to your authorized representative.

Sincerely,

* * *
Manager, Exempt Organizations
Technical Group 1

(16)
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Mr. Henry thinks it would be a bad idea writes: "The charity still has a legal obligation to service the annuity contract. While insurance companies rarely default, and the state insurance funds usually pick up those contractual obligations, the charity is not technically off the hook"

Firts, what Mr. Henry may fail to realize is that a commercial insurance company is forced to set up reserves to guarantee the payment of these annuities. The likelihood of a failure on the part of a charity to meet its obligations is substantially greater than that of an insurance company. Second, the insurance company has substantially more experience in dealing with the risk management. Third, Mr. Henry did mention the State Insurance Guarantee Associations. If an insurance company really screwed up, the state association might guarantee all or part of the liability, yet if the charity were not reinsuring and they "goofed", the client would be out the money.

The next point made by Mr. Henry ("Charities that live hand to mouth never properly develop an endowment, which a CGA is usually solicited as a part of its creation") is on its face contradictory. If the charity, due to insuring the annuity commercially, were able to have free access to the residual balance immediately, the prudent ones would use a significant portion of those funds for their endowment. The good news is that if they put the endowment portion into a balanced portfolio, it could create immediate, unrestricted income to assist with their current operating budget. What charity do you know that wouldn't like to have more spending money today?

As for Mr. Henry's third point, "A CGA is a long-term commitment, and spending the uncommitted dollars immediately is imprudent, especially in today's financial climate. I equate that mindset with those charities that solicit a CGA, receive the funds and immediately spend the proceeds and on a wing and a prayer, in the hope that the charity can service the contract out of annual budget expenses. Short term thinking with long-term obligations is dangerous.", I don't understand.

The commercial annuity solves the problem of the irresponsible charity that is not reserving enough money to meet their CGA obligations. Furthermore, if the charity sets it up with the payment going via direct deposit from the insurance company directly to the annuitant, they can relieve themselves of a significant amount of service. Finally, whether the charity spends the uncommitted dollars now or in the future will most probably be determined by the management of the charity. As noted above, the prudent ones will capitalize a substantial portion of the money in their endowments. Those that don't are probably the ones who would have defaulted on their obligation anyway!!

Stephen N. Mathieu, President Legacy Financial Solutions, Inc. Manchester, NH 03101 (603) 647-7166

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