Funding CGAs with Mutual Funds – Is This Still a Problem?

Americans have extensive holdings of mutual funds representing significant portions of their investment portfolios, and many invest exclusively in mutual funds. This makes sense – mutual funds are easy to purchase, simple to understand, and they allow for continuous reinvestment of dividends and income earned by the mutual fund shares. As donors review their financial assets to determine which ones to use to fund charitable gift annuities, mutual funds present an obvious choice. The share price of a mutual fund is determined daily and published as the “Net Asset Value (NAV).” A donor uses this share price to value a gift of mutual fund shares. In contrast, a gift of publicly traded securities must be computed as the average of the high and low trading prices on the date of the gift.

But gift planners should be aware of some particular aspects of mutual funds that can cause significant complications in the process.

Capital Gains Can Be an Issue

When a donor is considering a charitable gift annuity, shares of mutual funds that have appreciated considerably over time are good candidates for funding the gift. As with investments in stocks, the current value of the mutual funds can be considerably higher than the total historical cost – the amount the donor paid for them. And, as with appreciated stocks, donors can be liable for significant capital gains taxes when appreciated mutual funds are sold.

If a mutual fund is donated as an outright gift to a charitable organization, the donor’s cost basis transfers to the charity along with the shares, just as it would with a gift of stock. However, because non-profit organizations are tax-exempt, there are no taxes due when the organization sells the security. If the donor cannot produce the historical tax accounting information, the charity can simply declare that the cost basis was zero; there is no need to delve any further into the matter because there is no capital gains tax due on either the gift to the charity or the subsequent sale by the organization. However, when an appreciated mutual fund or stock is used to fund a charitable gift annuity, precise accounting of the amount of capital gains becomes important.

Cost Basis Complexity

With a gift annuity arrangement, the donor’s obligation to pay taxes on long-term capital gains is reduced, following IRS rules, to what is known as “reportable capital gain.” Reportable capital gain is only a portion of the total capital gain that would be taxable in an ordinary sale transaction; further, in most cases the tax due on reportable gain may be spread ratably over the donor’s life expectancy. However, automatic dividend reinvestment programs popular with most mutual funds can make it difficult to determine the cost basis of a particular share. Essentially, each time the mutual fund reinvests a dividend instead of paying it out, a new fractional share is acquired with its own separate cost basis.

With publicly traded stocks, the initial purchase of a particular corporation’s shares is frequently the only purchase of that security the investor will make. If a subsequent purchase is made, it will be a deliberate investment decision increasing the owner’s holdings. A person who has 100 shares of a company that is healthy, strong, and growing over time may purchase another 100 shares at a later point in time because it makes good financial sense. It’s worth noting that each purchase of the stock – any stock – creates what is called a “tax lot” – a group of shares purchased at a specific point in time at a specific price. The computation of realized gains and losses is applied to each tax lot separately.

Here’s a general example: If an investor purchases 500 shares of a particular stock in February of 2022, and then another 500 shares of stock in February of 2023, he will have two tax lots of 500 shares each, and each tax lot will have a separate cost basis. If the investor sells all 1,000 shares in April of 2023, he will have to report 2 separate transactions for tax purposes. The sale of the first tax lot of 500 shares will be considered a realization of long-term gains because those shares were held for more than one year. The sale of the second lot of 500 shares will be considered a realization of short-term gains. These two sale transactions will be taxed differently.

Mutual Fund Transactions and Tax Accounting

Similar transactions occur with mutual funds – a new tax lot is created every time a purchase is made. Mutual funds usually make periodic distribution of dividends and income, typically on a quarterly basis, paid per share for all shares in registered ownership as of a particular date. Mutual fund dividends are frequently retained within the owner’s account at the mutual fund company and used to purchase additional shares of the fund. This purchase creates a new tax lot for a fractional number of shares purchased at a particular price at a specific point in time. The tax lot created by the reinvestment of the March dividend will be separate and distinct from the tax lot created by the reinvestment of the June dividend, and so on. With this pattern, there will be at least four new tax lots for each calendar year. If a donor owns a mutual fund for 30 years, and all of the dividends over time are reinvested, there could be 120 or more separate tax lots for tax accounting purposes!

Here is a more detailed example of how the purchase of a mutual fund and the subsequent dividend reinvestment process might look like over a period of just one year:

 [Note: These are fictitious prices for a fictitious mutual fund and do not reflect historic losses in the investment markets in 2022]

So, at the end of 2022, thanks to the automatic dividend reinvestment process, our donor would have a total of 1,037.097 shares, made up of five separate tax lots, each with its own cost basis, as follows:

Funding a Gift Annuity

Now what if the donor decides to fund a charitable gift annuity with all those shares on February 15, 2023? The current price is $15.293, making the shares worth $15,860.32. The total gain on the holdings is $1,452.84, which is the difference between the current value of $15,860.32 and the total historical cost basis of $14,407.48. But here’s the tricky part: the IRS requires the donor – and the charity – to break out the short-term and long-term gains separately in the case of a sale, and, under the bargain sale rules, a charitable gift annuity is considered a partial sale and a partial gift.

For the creation of the gift annuity arrangement, the charity has to determine exactly how many shares are short-term, how many shares are long-term, and the cost basis associated with each portion. To calculate this example in Planned Giving Manager (PGM), the charity would need to select “Multiple Property Types” as the “Property Type” in the “Principal Value – Cost Basis” screen, breaking the shares down as follows:

How is this information used in the tax accounting and reporting for the charitable gift annuity? So long as the donor is the annuitant, or the first of two annuitants, a portion of the long-term capital gain is permanently forgiven. The rest, the “reportable gain,” is spread ratably over the donor’s life expectancy. Short-term capital gains are distributed as a part of the regular gift annuity payments, and are included as ordinary income, since short-term capital gains are taxed as ordinary income.

The breakdown between short-term and long-term capital gains is necessary not only for the tax accounting of the gift annuity and for the tax reporting of gift annuity payments, but it is also required for calculation of the charitable deduction for the gift annuity. The charitable deduction for the portion of the gift annuity that is funded with long-term appreciated property is based on the current market value of the property, but the charitable deduction for the portion of the gift annuity that is funded with the short-term appreciated property is based on the cost basis – not on the market value. The deduction can be presented as one amount, but it must be computed separately.

Conclusion

In most respects, using mutual funds to establish a charitable gift annuity is similar to using appreciated stocks, but the calculations and tax reporting can be much more challenging. Automatic reinvestment of dividends is an excellent way to increase ownership and accumulate greater wealth, but it leads to a proliferation of individual tax lots that greatly complicate the accounting process for transactions that are considered as sales by the IRS.

In summary, mutual funds that have appreciated over time can indeed be used successfully as the funding assets for the establishment of charitable gift annuities, but gift planners should be aware of the need for the donor’s full tax accounting history. The donor will need to provide all of the historical cost basis information for the total number of shares used in the creation of the gift annuity. Without those details, the IRS could assume zero cost bases for both long- and short-term portions, thereby greatly exaggerating the amounts of reportable gains and reducing the charitable deduction available to the donor.

While not the subject of this article, it should be noted that details on all of the tax lots are also required when funding charitable remainder trusts with mutual funds. The same need to distinguish between short-term gains and long-term gains exists with CRTs as well. We focused on funding CGAs with mutual funds because it is an area about which we receive many questions related to cost bases and capital gains.

We hope you found this article helpful. Please feel free to contact us if you have any questions or if you would like to discuss the subject matter more fully.