Charitable Gifts of Life Insurance

Charitable Gifts of Life Insurance

Article posted in on 27 February 2008| 27 comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 23 April 2014
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Summary

A few years ago, insurance advisers Michael Brink and Bryan Clontz wrote an article for the Planned Giving Design Center that discusses ten creative charitable uses of life insurance and their tax implications in planned giving. It has now been updated for current law, so we thought you might enjoy taking another look.

by Michael Brink and Bryan Clontz

Revised: February 26, 2008

It seems like all the recent news about charitable uses of life insurance has only been one thing? BAD! From the 1980s version of vanishing premium universal life, which caused a substantial amount of planned giving expectancies to vanish, to the more recent charitable reverse split dollar fiasco that Congress chose to eliminate, life insurance has become the black sheep of planned giving vehicles. While the life insurance product itself is not inherently inappropriate, the flexibility of the product has allowed many to stretch the product to the edge. The many traditional uses for life insurance that can benefit both the charity and the donor are often lost in all the bad press.

Benefits

Life insurance is an excellent tool for making charitable gifts for a number of reasons. Life insurance provides an "amplified" gift that enables you to purchase immortality on an installment plan. Through a relatively small annual cost (the premium), a benefit far in excess of what would otherwise be possible can be provided for charity. This sizeable gift can be made without impairing or diluting the control of a family business or other investments. Assets earmarked for family members can be kept intact.

For example, a 50-year old committed to giving $5,000 annually for 10 years could leverage the $50,000 gift into a $360,000 gift. A second-to-die, or survivor life policy, adds even more leverage. A 50-year old couple could make a gift of $800,000 with the same $5,000 annual commitment. (Assumes 50-year old(s), preferred non-smoker(s) using variable life policy earning 10% gross return.)

Keep in mind that using a traditional permanent life insurance contract will generally yield a 6% to 7% internal rate of return to life expectancy on premiums paid.

Life insurance can be a self-completing gift. For a donor committed to making annual gifts, a portion of the annual gift can be directed to an insurance policy guaranteeing the continuation of that gift in perpetuity. If the donor becomes disabled, the policy can remain in force through the "waiver of premium" feature (if elected). This guarantees the ultimate death benefit to the charity and, in some cases, the same cash values and dividend build-up that would have been earned had disability not occurred. Even if the donor dies after only a few premium payments, the charity is assured a full gift. The death proceeds can be received by the designated charity, free of federal income and estate taxes, probate, and administrative costs, and without any delay, fees, or transfer costs.

Large gifts to charity are less subject to attack by heirs because of the contractual nature of the life insurance policy. The death benefit is guaranteed as long as premiums are paid. This means that the charity will receive an amount that is fixed (or perhaps increasing) in value, and not subject to the potential downside of volatile market risks as in securities.

10 Planning Ideas

There are a number of methods for including life insurance in a charitable gift plan.

  1. Make an absolute assignment (gift) of a life insurance policy currently owned, donate a new life insurance policy, or have the charity purchase life insurance on the donor's life and pay the annual premiums (assuming insurable interest and state law permits). Each of these allows a current income tax deduction.
     
  2. Use of dividends from existing policy. Assign all annual dividends to charity. This eliminates out-of-pocket contributions, yet still creates a deduction as dividends are paid. Amplify the gift by having these dividends purchase a new policy of which the charity is the irrevocable owner and beneficiary.
     
  3. Name a charity as the primary or contingent beneficiary of an existing or new life insurance policy. Although this will not yield a current income tax deduction, it will result in a federal estate tax deduction for the full amount of the proceeds payable to the charity, regardless of policy size. This can be particularly applicable in situations where there is only one logical beneficiary, or where insurance is used to fund a supplemental retirement benefit and the death benefit is of little importance to the insured.
     
  4. Group term life insurance can also be used to meet charitable giving objectives. By naming a charity as the beneficiary of the group term insurance for coverage over $50,000, a donor can not only make a significant gift to the charity, but also avoid any income tax on the economic benefit for the amount over $50,000 (Table I or P.S. 58 rates are IRS published schedules that specify the employee's "economic benefit" per $1,000 of coverage for employer-provided group term life insurance). While the initial $50,000 could also be given, no income tax deduction would be generated.

    For example, a 60-year old executive with a combined state and federal income tax bracket of 40%, and who had $200,000 of coverage would save $842.40 each year (i.e., 40% of the $2,106 annual "Table I cost" that would be reportable as income). The advantage of this technique could be further enhanced by the introduction of higher Table I rates for individuals over age 65 who receive group term insurance.
     
  5. Most estate planning techniques become even more effective when coupled with other techniques. By giving appreciated long-term capital gain property to the charity (e.g., stocks, real estate, mutual funds, etc.), the donor avoids capital gains tax and receives a deduction for full-market value (with notable exceptions). Using this cash to then fund a life insurance policy provides even more leverage, creating an even larger gift.
     
  6. Perhaps one of the most popular ways to utilize life insurance in charitable planning more indirectly is through "wealth replacement." In this situation, life insurance makes it possible for a donor to make an immediate or deferred gift of land, stock, or other property while still providing an acceptable family inheritance.

    Qualified and non-qualified retirement plans are one of the best assets to give to charity because they are exceptionally inefficient in passing wealth to heirs. This is due to the fact that they face both income and estate tax, in some cases leaving only about 20% to 30% of the asset for the remaining family. Many families choose to leave the retirement plans directly to charity and then use life insurance as a way to "replace" the wealth contributed. Another option that may be considered is taking a distribution from the qualified or non-qualified plan and using it to purchase a life insurance policy in an irrevocable life insurance trust (ILIT); the donor can then give the remaining plan assets to charity. Not only does the charity receive a gift, but also the donor's heirs may receive more than they would have if the donor attempted to pass the retirement plan assets directly to them.

    A charitable remainder trust (CRT) is especially powerful for those who have highly-appreciated assets and a desire for increased income. These assets are often non-income generating and property tax-draining land or low-yielding stocks.

    A life insurance policy equal to the original gift, but owned in trust, allows the heirs to receive the full value of the assets without paying estate taxes. Properly structured, the premium can often be paid with the income generated from the tax deduction and/or a portion of the excess income, which results from the avoidance of capital gains tax.

    Bequests should also prompt one to consider using insurance to replace the assets. The donor may want to leave a gift by will to charity, but he/she may be concerned about disinheriting heirs. Since life insurance benefits can be received income and estate tax free if structured properly, the donor might choose to provide a death benefit equal to the charitable gift, or the amount the heirs would have received from the bequest after taxes.
     
  7. While life insurance is most commonly thought of only as a wealth replacement vehicle for CRTs, it can also be used as a funding asset inside the CRT in certain situations where it serves the following purposes.
    • The life insurance death benefit can substantially increase the remainder value of the trust, thus providing a larger gift to the donor's selected charities when the trust terminates.
       
    • In a two-life unitrust scenario, life insurance proceeds can "balloon" trust corpus when the first income beneficiary dies, creating a much larger income payout for the surviving income beneficiary.
       
    • The donor is able to make partially tax-deductible premium payments for a personal insurance need.

    For example, assume Mr. Donor establishes a net-income unitrust with a make-up provision (NIMCRUT) that will pay 6% per year for the lives of Mr. and Mrs. Donor. The trust is funded with property valued at $1,000,000 that is generating $60,000 of annual income. Under the typical CRT scenario, Mr. and Mrs. Donor will receive payments from the trust of $60,000 per year for life (6% of $1,000,000). Upon Mr. and Mrs. Donor's death, charity will receive the $1,000,000 remainder value.

    Now let us assume instead that the trustee invests some of the trust principal in a $1,000,000 life insurance policy on the life of Mr. Donor. When Mr. Donor dies, the trust is now worth $2,000,000, so Mrs. Donor receives 6% of $2,000,000 or $120,000 per year. So even though the life insurance is held in the CRT, it still serves its intended purpose, namely replacing income lost because of the untimely death of a breadwinner. In addition, charity will receive $2,000,000 upon Mrs. Donor's death instead of the $1,000,000 under the normal CRT scenario.

    In private letter rulings 9227017 (March 31, 1992) and 8745013 (August 7, 1987), the IRS approved the payment of premiums by the trust under the following circumstances.

    • The trust was established as an income only unitrust.
       
    • Premium payments would come from principal only, and never from trust income.
       
    • Cash value withdrawals or dividends would be treated as principal and not income.
       
    • Nothing from the policy would ever be paid as income to the income beneficiaries.
  8. The same double tax situation discussed for qualified plans also exists for non-qualified or supplemental retirement plans. These have become especially popular as a method of offsetting the limitations imposed on the more traditional qualified plans. Supplemental executive retirement plans (SERPs) are company paid plans while non-qualified deferred compensation plans (NQDC) are commonly used to allow executives to defer funds over and above the 401(k) limitations.

    While many business owners and executives have accumulated significant amounts of money in these plans, most are unaware that due to the double taxation (income and estate) their family might only receive about 25% of this wealth.

    For the executive in a position to forgo this supplemental income, the solution to this may be a SERP swap. Essentially this allows the executive to reposition this asset from an entity facing both income and estate tax to one that passes the entire asset to the heirs free of income, estate, and gift tax. This is accomplished by an exchange of the SERP or NQDC for a split dollar life insurance policy. Properly structured, this allows the executive to not only bypass both income and estate tax, but to take advantage of the leverage of insurance as well.

    Dollars Passed To Heirs Under Current SERP
    Estate taxes. 33%
    Dollars passed to heirs. 27%
    Income taxes. 40%
    Note: Values are based on a 40% individual
    income tax bracket and 55% estate tax rate on the after-tax benefit.

    Results Of SERP Swap
    Present value of employer's SERP costs. $1,494,546.92
    Wealth to heirs with SERP. 2,206,102.14
    Present value of employer's costs for alternative split dollar. 1,494,546.92
    Comparative wealth to heirs with alternative split dollar. 18,229,029.21
    Increased wealth to heirs with SERP swap. 16,022,927.07

    Because this is such a windfall for the executive, he or she may be willing to contribute a portion of the additional gain to a charity or family foundation.

  9. Purchasing life insurance for estate liquidity has been a standard life insurance technique for many years. Another option, however, has been gaining increased attention in recent years as a more exciting way to control assets your clients will not be able to keep: The "Zero-Tax Estate Plan." Properly structured, this can also allow the donor to assure that his or her heirs will become actively involved in philanthropy, and thus pass on family values as well as family wealth. Below are some simplified calculations to illustrate the concept.


      Option 1 Option 2 Option 3
    Gross estate after planning. $10 million $10 million $10 million
    Charitable contributions. None None $10 million
    Estate tax. $4 million $4 million None
    Life insurance purchased. None $4 million $10 million
    Total wealth--no control. $4 million $4 million None
    Total wealth--direct control. $6 million $10 million $10 million
    Total wealth--indirect control. None None $10 million
    Total wealth--controlled. $6 million $10 million $20 million

    Another variation on this theme is for the donor is to simply decide how much wealth he or she wants each heir to receive, purchase insurance policies in that amount, and donate all the remaining assets to charity.

  10. In the early to mid 1990s, many larger corporations offered a charitable board of directors program. This generally involved utilizing life insurance as the primary funding mechanism and the board members a directors' fees for premium payments (the company sometimes split costs or paid the entire premium directly). Board members could then choose their own preferred charities, or the corporation provided them with a short list of preferred options to receive the eventual benefit. The policy generally was designed to have the premium payment period correspond with the directors' term, and could potentially allow the corporation to recoup any employer funding on a present value basis at the time the charitable contribution was made. These plans are starting to come back in favor with mid-size and large private and public companies.

Tax Implications For Various Life Insurance Gifts

This section outlines the various income tax implications of partial interest gifts, annual deduction limitations, and various policy valuation rules. While the following charitable income tax issues of life insurance gifts may seem rather cumbersome, charitable deductions for transfer tax purposes are unlimited, and equal the full fair market value of the property.

Partial interest gifts. To receive a current income tax deduction, the donor must irrevocably transfer all incidents of ownership and control in the policy (though the donor's estate would likely receive an estate tax charitable deduction for the amount actually paid to charity). As an example, if the donor owns the policy and merely names the charity as beneficiary, no income tax deduction is allowed. To avoid violating the partial interest rules, the donor may not retain the right to:

  • change beneficiary(ies);
     
  • surrender or cancel the policy;
     
  • assign the policy or revoke assignment;
     
  • pledge the policy for a loan;
     
  • have any access to cash value via withdrawals or loans; and
     
  • hold any reversionary interests.

In situations where a donor divides an interest in property for the sole purpose of circumventing the partial interest rule, the deduction will still be disallowed. For example, a donor wants to transfer a death benefit interest in a life insurance policy to charity. This would be a transfer of a partial interest in property that is non-deductible. In order to get around this problem, the donor transfers the death benefit interest to his/her corporation. The corporation would then transfer its interest in the policy to charity. Since all the corporation owns is the death benefit, a transfer of the death benefit is an undivided interest of 100% of each and every right the corporation owns in the property, which should make the gift deductible. However, Treas. Reg. § 1.170A-7(a)(2)(i) denies a charitable deduction where "the property in which such partial interest exists was divided in order to create such interest and thus avoid § 170(f)(3)(A)."

Deduction limitations. The maximum charitable deduction allowed each year is limited to 50% of adjusted gross income (AGI) for gifts to public charities and 30% of AGI for gifts to private charities. Like other charitable gifts, any excess deduction may be carried forward an additional five years. Deductions, however, may be further reduced by the method in which the policy or premiums are donated and by ordinary income property rules.

Premium payments. If paid directly to charity, premium payments are deductible up to 50% of donor's AGI. If the payments are made to the insurance company on behalf of the charity, they may be deemed "for the use of" rather than "to" and could be limited to 30% of donor's AGI. Some recent cases have had positive rulings disputing this reduction, however.

Ordinary income property. Life insurance and annuities are considered ordinary income property, a group that also includes short-term capital gains property (capital asset held less than one year), inventory, depreciation recapture property, and accounts and notes receivable. For charitable gifts of ordinary income property, the deduction is limited to the lesser of adjusted cost basis or fair market value.

Policy valuations. The gift value of an existing life insurance policy (where premiums are still required) is the lesser of the interpolated terminal reserve (cash value + unearned premiums -- loans) or the donor's adjusted basis. The contribution is generally measured by cash value in the policy's early years and the donor's adjusted basis after "crossover" when the cash value is greater than the cumulative premium paid. For example, Mr. Donor pays $10,000 annually for an insurance policy. After two years, his cash value is $12,000. He gives the policy to charity and receives a $12,000 deduction (though his cost was $20,000).

Alternatively, Mr. Donor pays $10,000 annually for an insurance policy. After 10 years, he has $150,000 cash value. He gives the policy to charity and receives a $100,000 deduction (though it has a value of $150,000).

If the policy is "paid up" (contractually requires no further premiums), then the deduction is the lesser of the adjusted cost basis or the policy's replacement cost. The insurance company can provide the donor with the proper valuation for any type of permanent policy.

Policy valuation with outstanding loans. The type of gift would be treated as part sale/part gift, i.e., a bargain sale. The donor would incur income tax liability for the ordinary gain (if any) on the sale portion, and would obtain a charitable contribution deduction for the (lesser of) fair market value or adjusted cost basis for the non-sale portion.

For example, Mr. Donor contributes a policy subject to an outstanding loan to his favorite charity. On the date of contribution, the policy's fair market value equals $10,000, the donor's adjusted basis in the policy equals $4,000, and the outstanding amount of the loan equals $4,000.

  • Amount realized equals $4,000 (the outstanding amount of the loan).
     
  • Basis allocated to sale equals $1,600: $4,000 (basis) X [$4,000 (amount realized) ÷ $10,000 (fair market value)].
     
  • Gain recognized equals $2,400: $4,000 (amount realized) -- $1,600 (basis allocated to sale).
     
  • Amount eligible for charitable deduction equals $2,400: $4,000 (adjusted basis) -- $1,600 (basis allocated to sale).

Caution: Under charitable split dollar legislation, if the policy has any outstanding loan at the time of the contribution, the donor will not receive a charitable income tax deduction for the gift or any future premium contributions as it is deemed a private benefit transaction. See Stephen Leimberg's excellent article­ and summary under Problematic Transactions, Contribution of policy subject to loan.

Qualified appraisal. Gifts of property (other than publicly traded securities) that exceed $5,000 must have a qualified appraisal from a qualified appraiser. Thus, for any gift of life insurance where the value exceeds $5,000, a qualified insurance appraiser should be engaged to complete the appraisal and complete Form 8283 (the co-author is a qualified appraiser - (see http://www.charitablesolutionsllc.com/appraisal.html).

The Pension Protection Act of 2006 specifically modified Section 1219 170(f)(11)(E)(ii) to tighten qualified appraiser/appraisal requirements and specifically excludes the donor, donee, related party or party to the transaction (i.e., the insurance agent/broker or insurance company).

Insurable interest.The donor should confirm that his/her state would consider the charity to have an insurable interest in the life of the donor. If not, no income, gift, or estate deductions are allowed. However, most states have now adopted legislation granting insurable interest and have done so retroactively.

Estate tax considerations. Any charitable gifts of life insurance made within three years of death will cause inclusion in the donor's gross estate. However, with partial interest gifts, the estate would likely receive a full charitable deduction.

Conclusion Clearly, whether any of the aforementioned planning ideas will fit for a particular situation requires analysis on a case-by-case basis with the donor's and charity's respective goals being considered. As a well-placed planning tool, however, life insurance has many unique attributes that may enhance nearly any comprehensive charitable gift plan.

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Comments

Re: Charitable Gifts of Life Insurance

That said, it has become abundantly clear that life settlements are here to stay and additional regulations are needed to ensure a fair, transparent and efficient market place for no longer needed, wanted or affordable policies. Life insurance contracts in aggregate account for more than 15+ Trillion of potential payouts to policy owners.

Policy valuation with outstanding loans.

I'm confused if a donor would receive a charitable tax deduction if a life insurance policy with an outstanding loan was gifted. In one section of the article it mentions; "The donor would incur income tax liability for the ordinary gain (if any) on the sale portion, and would obtain a charitable contribution deduction for the (lesser of) fair market value or adjusted cost basis for the non-sale portion." But in another section it mentions; "Under charitable split dollar legislation, if the policy has any outstanding loan at the time of the contribution, the donor will not receive a charitable income tax deduction for the gift or any future premium contributions as it is deemed a private benefit transaction." Please clarify if a donor who transfers ownership of a life insurance policy with an outstanding loan would receive a charitable tax deduction based on the charitable portion of the gift. Thank you.

Life Insurance Inside CRT - More Flexible Than You Think

The PLRs cited regarding life insurance ownership inside a CRT do not give the full story. A CRT can be structured in such a manner that the death benefit and/or cash value can be accessed by the noncharitable beneficiaries - something that was not allowed under the facts presented in the PLR. The IRS has never denied this position. There has just never been a ruling on those specific facts. Just because a PLR recites certain facts does not mean those facts are necessary facts to achieve a certain result. The key issue here is whether or not the trust is a grantor trust. A trust that can pay life insurance premiums out of income is a grantor trust. One exception is the 677(a)(3) parenthetical language, cited by the PLRs above, in which the life insurance proceeds (death benefit, cash value, loans, dividends) can only inure to the benefit of charity. But that fact pattern ignores the even more basic issue. The easier solution is to stay outside the statute altogether simply by drafting the trust instrument to prohibit payment of life insurance premiums out of income and thereby avoid grantor trust status. The noncharitable beneficiaries could then access the life insurance policy or death benefits therefrom. There are lots of other hoops to jump through, but for grantor trust purposes, that simple step solves the grantor trust issue.

Charitable Gifts of Life Insurance

A very helpful and insightful update.

A bit off topic but - how about Vairable Annuity in a CRT?

Recent variable and fixed annunities have been developed that permit a "guaranteed" floor on income / principal amount in death if a portifolio of funds are selected that increase over a certain value established in the purchase of the annunity etc.This technique is being touted in media and is attractive to many in a difficult investment environment. USA Today 6/4/08 issue has such a plan advertised on page 8b Fidelity "No initial sales charge and 40% lower anunity costs"; (simple, deferred vairable annunity that provides guranteed income). What if a make up or flip trust is used? Individual buys annunity and gifts it to trust. If an immediate annuity is selected with the gurantee principal or a life insurance gurantee the charity and trust could reap a more reliable gift at termination of trust and still enjoy the upside, if any as available with the vairable advantage. Therefore, no downside only upside.

Variable Annuity in a CRT

The typical use of annuities in CRTs is to manipulate the amount of fiduciary accounting income so the CRT can act as a retirement account. The Service had stated that it will not rule on the qualification as a CRT one which uses annuities, limited partnerships, LLCs or other methods to manipulate fiduciary accounting income.

RE Variable Annuity in CRT

No guarantee is free. Given a long enough time horizon and an investor/investment committee that is willing to be patient rather than swept along by the sentiments of fear and greed that drive short term market fluctuations, nothing beats direct ownership of stocks and bonds in a diversified portfolio. Everything else is "packaging". (Mutual funds and etfs provide needed diversification to pots of money of a certain size but additional 'wrapping' in the form of insurance guarantees is excessively expensive.) Further, ignoring the spread between ordinary income tax rates and the favorable rates on capital gains and qualified dividends is an expensive choice. Whereas selling product with guarantees in a short term situation may be wise, I believe that selling fear and then offering expensive guarantees to a long term investor, be it a charity or just anyone, is a cop out. If you can't educate the client on long term market philosophy, tax efficiency, and the advantages of low cost investing, you either aren't trying hard enough or they will not listen/learn and shouldn't be investing with you anyway.

Life Settlement

Eric, I appreciate your question concerning the taxation issues involved in using life settlement as a financial and planned giving tool. Please refer to my new article in the June issue of the Journal of Accountancy, www.aicpa.org/pubs/jofa/june2008/life_settlement.htm , which is peer reviewed by a notably prestigious panel of AICPA members and which does suggest a general consensus that past treatment by the Service is, in this case as in many others, a model for current action. Of course, tax law can change at any time, the various Reform Acts have not always grandfathered immoderate changes and so, even considering Thomas Jefferson

Bryan, thank you for the article and comments

Excellent comments, and an excellent article. Thank you again. As far as the life settlement aspects -- this can be a very slippery slope. While many may believe the IRS will treat ALL as they have treated ONE, SOME, or even MANY, I don't think there is a general consensus, or should I say it is generally accepted that the IRS will allow capital gains tax treatment in all life settlement cases. Yes, perhaps they should -- but that is another issue. I for one would not look to rely upon the Service's "silence" -- regardless of it being a cost-basis issue, a reduction in same, surrender vs. sale to a third party, etc. Let's remember that a policy owner is STILL getting payment, cash, consideration, etc. in excess of the cash value, ITR, 412i, or whatever pegged value you want to look at in comparison to the cash surrender value. I am sure there are people who would interpret this type of transaction differently, however, should we be relying on "interpretation" vis a vis what is generally accepted? We all understand the Phillips case, and nuances in situations and cases should of course dictate a case by case basis approach -- but ONE cannot be substituted for ALL. Aside from that, there are innumerable life settlement companies, investor groups, and related parties -- all with tax, legal, etc. positions and opinions, and for whatever their position is "oridinary income". I for one would like to see this landing in a place of "pro-insured" and have it be capital gain. I just think we should all be very careful. Eric

Deduction limitation for premium payment

In your article you allude to several recent cases that have ruled in favor of a 50% limitation, rather than 30% where the donor has made the premium payments directly to the insurance company. Can you give me some citations so that I can take a look at those cases? Thanks!

Code Section

IRC 170(b)(1)(A). This describes the reduction rules for gifts "for the use of" charity rather than "directly to charity." If a donor makes a premium payment as a cash contribution "to" the charity, it can choose to make the premium payment or not - it retains full dominion and control over the unrestricted gift. If instead, the donor sends the premium payment directly to the insurance company, it is indirectly "for the benefit of" the charity and the 50% to 30% reduction rules would apply. Hope that helps.

Life Settlement contracts

As I mentioned recently in a list-serve response, the question concerning life settlements is not as daunting as it may seem. I am writing with the experience of both being a qualified appraiser (Appraisers Association of America) and as having also both brokered and written about life settlements and appraisals (see the Jan.

Life Settlement Contracts

Mr Breus, What is the "affirming precedence that a life insurance policy has been treated as a capital asset"? Can you help us out with citations to that authority? Thanks

Life Settlements

David, You're not the only one to question the statement. In order to give you some feel for my use of "precedence" first let me say that the common practice by the Service has been to allow capital gains treatment in all life settlement cases (I should have been more specific, thank you for keeping me honest). Your question, however, can be expanded upon. Please let me quote from an opinion letter addressed to me from a "major" accounting firm: Code Section 72(e)( 6) provides that aggregate premiums and other consideration paid less aggregate amounts received under the contract to the extent that such amounts were excluded from gross income (e.g., dividends and other prior distributions) is the cost basis for computing gain upon the lifetime maturity or surrender of a life insurance contract. No reduction in basis needs to be made for the cost of insurance protection. However, the Code is silent as to the cost basis when a life insurance contract is sold to a third party instead of surrendered to the insurance company. Character of Gain for Federal Income Tax Purposes on the Sale of a Life Insuriance Contract: If amounts received on the complete surrender, redemption, or maturity of a life insurance contract exceeds the cost of the contract, it is well established that such gain is treated as ordinary income, not capital gain (Code Section 72(e); Treasury Regulation Section 1.72-11(d); and Blum v. Higgins, 150 F.2d 471 (2nd Cir. 1945), among others). Several taxpayers in the past have attempted to convert such gain from ordinary to capital by selling a life insurance policy before maturity for its CSV. The courts have consistently ruled that gain under such circumstances is ordinary and not capital when the sales proceeds do not exceed the CSV. See for example, Arnfeld v. Us., 163 F.Supp. 865 (Ct. CI1958), cert. denied 359 U.S. 943, which involved an annuity; Phillips which involved an endowment policy; and Estate a/Crocker, which involved whole life insurance policies. The general rationale of these cases is that even though a life insurance contract is a capital asset, the tax law should not be read to allow the inside build up in a life insurance contract to be treated as capital gain when it really represents ordinary income (investment earnings). However, these cases differ from the circumstances at hand because the seller of the policy will be receiving a payment in excess of CSV. Prior to viatical settlement companies purchasing life insurance policies, it was unusual or exceptional for an owner to receive more than CSV upon the sale of a policy. Thus, there is very little in tax literature or tax litigation discussing the capital gain treatment of sales proceeds in excess of CSV. However, the subject is mentioned in footnote 3 of the Phillips case as follows: "On reargument, counsel for the Commissioner conceded that there may be exceptional circumstances requiring a modification of this rule. For example, if a policyholder had an amount receivable there under which was in excess of his cost, but policyholder was afflicted with a disease which would result in his death in the near future, he could, if in need of cash, assign his policy for an amount in excess of that receivable under the policy and, as to such excess, treat the same as a capital gain." The above statement in Phillips is consistent with the reasoning that a life insurance contract is a capital asset and capital gain should result except for the ordinary income portion of the CSV. Jules J. Reingold, BTA Memo, June 20, 1941, is another case that supports capital gain treatment for the excess of sales price over the higher of the CSV or federal income tax basis. This case dealt with the disposition of a life insurance policy by a subsequent purchaser subject to the provisions of Code Section 101(a)(2). Although the facts were quite unusual, the subsequent owner of the life insurance policy sold it for more than his cost and reported the income as capital gain. The court and the government agreed that a life insurance contract is a capital asset within the meaning of what is now Code Section 1221. The only points in dispute were whether the taxpayer owned the life insurance policy and whether a sale or exchange took place. This case is important primarily for the fact that it confirms the logical conclusion that a life insurance contract is a capital asset. Thus, one should expect capital gain treatment on the sale of a life insurance contract (except for the requirement that any inside build-up in the contract be treated as ordinary income). We are in agreement with these conclusions. It is our opinion that the sales proceeds in excess of the CSV of a life insurance policy or if greater, the federal income tax basis should be capital gain. I believe that this is the basis for most current accounting decisions. I hope that this helps. Regards, Alan

Selling a policy vs cashing it in

An advisor has suggested that investors might offer to buy the policy from the charity for more money than we would receive from cashing the policy in and receiving only the cash surrender value. Has anyone had experience with this approach and under which circumstances would it be attractive. Dennis Waller Director, Prospect Strategy American Cancer Society

Selling a policy vs cashing it in.

Dennis, A few questions are in order in this instance. I don't know if you have already done something in response to your initial question, but I wanted to get your feedback and also find what other advice you received. What was the purpose that the advisor gave for surrendering the policy or going the "Life Settlement" route? Was the donor not going to continue funding the policy? Was there a need for quick cash? What was the face amount and type of policy? These questions needed to be looked at prior to any decision on what to do, or not do with an existing policy that may payout many times what your immediate need is. What is the age, sex and health status of the donor and what was the intend when he donated the policy? Depending on whether the policy is one from a mutual or stock company, there may be dividends available to decrease premium payments, increase face amounts and cash value or both. Many advisors are not as aware of the benefits of permanent life insurance as a tool for charitable planning, estate preservation and wealth transfer in more technical terms. Some only look at the cost of the premium as a liability rather than an opportunity to utilize leverage and estate tax payment from a tax "exclusive" basis with dollars paying the tax from outside the estate (the insurance company) rather than from a tax "inclusive" basis (dollars taken out of the estate to pay the estate taxes). If you could let me know of the outcome of your dilemma, I would certainly appreciate it. Adrian Powell FIC, Advanced Planning & Financial Advice

Selling a policy vs cashing it in

Hello Dennis, Adrian and all, I am pleased to see planned giving professionals and advisors exploring the charitable life settlement scenario. There have been many different reports published on the statistics of life settlements and it is difficult to distinguish what is accurate. That said, it has become abundantly clear that life settlements are here to stay and additional regulations are needed to ensure a fair, transparent and efficient market place for no longer needed, wanted or affordable policies. Life insurance contracts in aggregate account for more than 15+ Trillion of potential payouts to policy owners. What most people don

Selling Vs. Cashing it in

Peter; I agree with you that life settlements are here to stay; it is my hope that the majority of those that choose to use it as a funding mechanism will have an advisor with your sense of ethical concern and interest in "well-doing", rather than a purely pecuniary attachment to the practice. It has been my experience (limited though it is), that many individuals do seek to "Do The Right Thing" by thinking of funding a charitable gift of life insurance while they are relatively healthy, at modest rates, thinking that it will provide more bang for the buck. But, as is often the case, as they age, their health declines or they attempt to get a policy for another term of years upon the expiration of the initial period they find that the re-entry premium far higher than they believed it would have been, and frequently higher than the premium they would have paid for a whole life or UL policy during the initial phase. In these cases, it may in fact be the best for all parties involved to look at a life settlement option prior to the expiration of the term period and the conversion privilege. The best advice, as the sage once said, is the advice that is followed. Adrian D. Powell, FIC www.advancedplanningfinancialadvice.com

NIMCRUT

I am confused. In your example of a NIMCRUT funded with $1 mil, how can you guarantee or assume a NIMCRUT will actually pay out the 6% ($60,000) per year? The payout would be the lesser of net income or 6%. Would a diversified portfolio (or even a total fixed income portfolio) generate 6% net income in today's low interst rate environment? And if part of the principal is used to purchase a $1 mil policy, the principal available to generate a min of $60,000 in net income each year would be decreased. And what if Mrs. Donor dies first? Mr. Donor would not share in the additional income generated from the payout. What am I missing?

NIMCRUT

I am a trustee of a NIMCRUT which purchased life insurance from the proceeds. The CRT is also funded with variable annuities and a REIT. The purpose of the NIMCRUT would be to defer gains, hopefully capital and liquid enough to take money out when needed. Would the above assets meet these needs. Havn't read the above aritcle but hope it answers your and my questions. Any helpful comments ron@carlsbergmt.com 10/2/08

Katherine, These are very

Katherine, These are very good questions and unfortunately relate to the fact that we did not update this specific example since the article was first published in 2001. But, generally, the hypothetical situation would still hold over time - though not in this current interest rate environment. But, a few modifications, like suggesting a payout rate of 5% and perhaps defining capital gain as income might still make this scenario palatable in some client situations. And as to the question about who dies first, a first-to-die policy might be more appropriate where the timing would indeed be an issue. So this hypothetical example, while not pefectly matched in today's environment, hopefully is still illustrative regarding how life insurance might be beneficial as a trust asset in some, albeit likely limited situations.

Who pays for the appraisal and is it deductible?

I am wondering if it is appropriate for the charity to pay for the appraisal.  My gut says it would not be a good idea, since the appraisal is required by law in order to substantiate the deduction.  I think it is a personal expense of the donor and is not something the charity should pay for.  Also, the PPA seems to be mandating independence on the part of the charity, donor, and insurer where the appraisal is concerned.  Any thoughts?

The charity should not pay

The charity should not pay for the appraisal unless they show the cost as consideration received for the gift. I think most CPAs would suggest issuing a 1099 to a donor if this is the case. All things being equal, it is just better for the donor to hire the appraiser separately but I have done it both ways.

Charitable Gifts of Life Insurance

This was helpful, maybe even the basis for a presentation to our donors.  I am wondering if Life Settlements will ever become an easy step to charitable gifts.

Charitable Life Settlements

Life Legacy Trust has developed and is currently successfully implementing a charitable life settlement program accepted by several major national non-profits. For more information please visit www.LLTrust.com or contact Peter Coroneos at peter@lltrust.com or call 866 551 1223.

charitable gifts of life insurance

excellent explanation and great review for me. 

Chartible Gifts of Life Insurance

Helpful!!

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