Case:

Abigail was a wonderful and spirited 80-year-old woman. She worked in her garden, handled all her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local 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 the shelter $5,000 each year. However, she wanted to make a more significant gift this year. 

In January, 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 for life. Abigail liked the 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. What she loved most though was the eventual gift to the shelter. 

Sadly, Abigail suffered a heart attack a few weeks later and died. It was a terrible loss to the community. Now several months have passed and Abigail’s family and CPA are winding up Abigail’s financial affairs. The CPA knew he could deduct Abigail’s charitable tax deduction on Abigail’s final income tax return. He also knew 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, Abigail’s sister is remaining on the gift annuity contract. Thus, the CPA wonders how this affects the unrecovered investment issue.

Question:

Since Abigail died earlier than expected, does she get another tax deduction? Does the fact that this is a two-life gift annuity affect the outcome?

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 lifetime of both Abigail and her sister. 

Normally, the premature death of an annuitant would trigger an additional income tax deduction on the decedent’s final income tax return. IRC Section 72(b)(4). However, in this case, the annuity continues for the life of Abigail’s sister. Furthermore, the tax-free payments continue for the life of her sister. Abigail’s sister, 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 Abigail’s sister is still “recovering” it. As a result, Abigail’s executor is not entitled to an additional income tax deduction on her final income tax return.

Editor’s Note: If an additional income tax deduction was allowed, it would not be a charitable income tax deduction but rather an “other itemized deduction” that can be claimed on Schedule A of Form 1040.