TAKEOVER TAX DODGE

Is an unwanted capital gain staring you in the face? Turn it into a Pomona charitable gift annuity.

Is an unwanted capital gain staring you in the face?

Turn it into a Pomona charitable gift annuity.

Two American pastimes: retirement planning and tax dodging. They come together in an investment recipe that you should consider if you are about to lose a stock in a cash merger.

The idea: Hand of your soon-to-beliquidated shares to a college, turning some of the money into a contribution and most of it into a retirement payout. The strategy is the most compelling for a woman who is in her peak earning years and fairly close to retirement. It also works, although not as powerfully, for investors who don’t quite ft that pattern.

The frst law of portfolio tax planning says that you should hold on to winners. But sometimes a sale is beyond your control. You behave yourself and then along comes an all-cash merger.

It’s a nice problem to have if the merger kicks up the price of the stock, but still it’s a problem. If you bought auto parts maker TRW at $3 a share six years ago, you are now threatened with liquidation at $105.60, as a German acquirer wraps up a tender ofer. State and federal tax on the gain will probably eat at least a fourth of this asset.

How to mitigate the damage? Sometime before the deal closes, transfer the shares to a college in return for a “charitable gift annuity,” a contract that gives you a fxed annual payout for life. The payout may be less than you’d get from a commercial annuity, but the shortfall goes to a good cause and the tax savings go to a very good cause—your bank account.

Many colleges with big endowments have CGA programs. Mostly these deals are aimed at grateful grads. One college, Pomona, has terms so attractive that well over half its participants are nonalumni. In the right circumstances a Pomona CGA beats out a commercial annuity purchased with the takeover proceeds.

Let’s suppose that Jane Doe is sitting on Acme stock that she bought years ago for $20,000 and that is soon to be acquired for $100,000. She’s a 60-yearold executive with a high salary. What with state income tax and the various enhancements to the 39.6% federal bracket, her marginal tax rate is 50% for ordinary income. For long-term capital gains, it’s 30%.

Jane is planning to retire at 70 and will be converting some of her savings into a fxed monthly payout that will last for her lifetime. At that point her income will be lower and she will be living in a state with lower taxes. Her tax brackets, we hypothesize, will go down by a third, to 33% and 20%.

Before the merger closes, Jane sends the shares to Pomona and takes back a deferred annuity. It will pay $11,120 a year, beginning when she is 70. If she dies before then, her heirs get nothing.

Calculations based on IRS actuarial tables and an interest factor put the present value of Jane’s future income stream at $90,000. This means that Jane is using only 90% of her Acme shares for her own beneft. The other 10% of them are being donated to Pomona. When she does her 2014 taxes she can claim a $10,000 charitable deduction.

When Jane retires she can amortize, against her $11,120 annual income, the $90,000 of capital she has invested in the annuity. The actuarial tables give her a 16-year life, so she can deduct $5,625 a year, leaving her with $5,495 of ordinary income.

A further breakdown determines that the capital being recovered consists 80% of gain and 20% of original cost of the Acme position. So, of the $5,625,

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$4,500 gets taxed at the long-term gain rates and $1,125 is not taxable at all.

On the bottom line is an aftertax annual income from the annuity of $8,407. After Jane turns 86 the capital investment in the annuity is fully recovered and the entire income stream is taxed. Her take-home at that point drops to $7,450 a year.

That charity deduction puts money in Jane’s pocket right away. If her income tax bracket is 50%, her deduction tax bracket is somewhere around 45%. (Why lower? Because charity deductions don’t protect you from either the Obamacare tax or a weird penalty related to adjusted gross income.) So, an upfront $4,500 goes into the plus column for the Pomona deal.

Now let’s see what happens if our heroine sits still while the IRS locomotive runs over her. The merger puts $100,000 in her hands, including a capital gain of $80,000, on which the tax is $24,000. That leaves her with $76,000. She puts $4,500 aside (to make the comparison fair with the charitable gift annuity) and has $71,500 left to buy a commercial annuity.

New York Life pays the same as Pomona—11.12%. But in this scenario Jane has less capital to put into the an- nuity, and so she gets only $8,018 a year pretax. After taxes she pockets $6,846 a year until she turns 86 and $5,372 a year thereafter.

This is a screaming win for Pomona’s annuity. How is that possible?

The essence of CGAS is timing. With help from the college Jane is able to postpone the Acme gain until later (as much as 26 years later). The deferral allows Jane to put more capital to work inside the retirement product, and when the government is eventually paid of, it’s at a lower tax rate. In this respect the annuity acts a lot like an IRA.

Two other things work in favor of the college annuity. One is that commercial annuity vendors have to compensate sales agents; colleges don’t. Another is that Jane is able to take a $10,000 deduction for a gift of Acme shares that cost her only $2,000; the $8,000 of appreciation on those shares is never taxed.

Jack Doe would get the same payout as Jane from the college, but at New York Life he’d get 10% more than Jane. (Commercial insurers often give nicer annuities to males on the assumption that they’ll die younger.) Still, Jack comes out ahead at Pomona, if we make the same assumptions about tax brackets and Acme.

A wealthy annuitant whose tax bracket is destined to stay high also wins with the college play, although not as much as Jane and Jack.

Is Pomona being too generous? Probably not. “Yale pays lower rates because its alumni are very philanthropic,” says Robin Trozpek, assistant vice president of capital giving at Pomona. Her college’s strategy gets the attention of investors who are not affiliated. Two recent transactions involved Covidien shares that were about to be acquired by Medtronic, and neither came from a Pomona grad.

Do you own any of the stocks in our takeover table? You have three choices. 1. You can take the cash and the upfront tax hit. If you buy a commercial annuity with what’s left, you’ll have this small advantage: If you die young, your executor might be able to get some tax beneft out of a deduction for the unrecovered portion of your annuity purchase price. 2. You can do a CGA with your alma mater. This makes a lot of sense if you are giving to the college anyway. 3. You can have a chat with the gift office at Pomona. Statistics research: Andrea Murphy.