Charitable Reverse Split-Dollar: Booby Trap or Bonanza?

Charitable Reverse Split-Dollar: Booby Trap or Bonanza?

Article posted in Insurance on 12 July 1999| comments
audience: Partnership for Philanthropic Planning, National Publication | last updated: 15 September 2012
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Summary

Charitable Reverse Split Dollar Life Insurance has been marketed for several years as a vehicle that provides benefits to both charity and donor. In this first contribution to Gift Planner's Digest, noted Charitable Tax Attorney Douglas K. Freeman, J.D., LL.M takes a critical look at the benefits and the potential risks of various CRSD techniques to donors and charities.

By Douglas K. Freeman, J.D., LL.M.

Charitable gift planners have been deluged, in recent years, with a variety of proposals that, in some fashion or form, utilize a concept known as "charitable reverse split-dollar", sometimes referred to as "CRSD". It is marketed to nonprofits as a no-cost, guaranteed gift for the institution. To the private clientele of the insurance agent, it is marketed as an income tax deductible method of purchasing insurance for the benefit of the family, without any estate tax consequences, while providing an additional gift to charity. Each comes with its own packet of attorney opinion letters and legal research, which appear to substantiate each of the claims of its sponsors.

This "new" concept is, in fact, a revised approach to a planning strategy that has appeared, from time to time, over 10 years. There are many packages in which the strategy is presented, with a variety of different design features. This article is not intended to review all of such programs, but merely to present the general concept, explain its basic format and authority, and analyze the prevailing arguments in support of and opposition to it.

What is "split dollar life insurance" and "reverse split dollar life insurance"?

Split-dollar life insurance is actually not life insurance at all, but a method of purchasing the insurance. Employment related split-dollar insurance involves the participation of an employer and employee, in which the parties agree to a sharing of the costs and benefits of the insurance on the employee. Typically, the employer agrees to advance all or some portion of the premium, in order to provide insurance for the heirs of the employee. The employer will be reimbursed its advances from the proceeds of the insurance upon the death of the employee (or from the cash value, if the policy is terminated early). The basic form provides for the death benefit to be owned by the heirs of the insured employee, subject to an obligation to reimburse the employer for its premium advances that is secured by policy cash values.

The tax consequences to the parties were initially outlined in Revenue Ruling 64-3281 and have been the subject of numerous rulings and court decisions. In essence, the IRS has determined that the economic benefit provided to an employee through the corporate funded purchase of insurance, under a split-dollar arrangement, is based on a table published by the IRS, known as the PS 58 rate, which was first promulgated in Revenue Ruling 55-747.2 This table reflected term insurance rates then in effect, but which are now outdated. In 1966, the IRS modified this measure of economic benefit by allowing the use of the insurance company's lower and generally available term insurance rates.

Through the years, a variety of forms and permutations of classical split-dollar have been created, including non-employment related or "private" split-dollar. Under this arrangement, one family member provides the funds so that another family member (or trust) will enjoy the benefits. The income and transfer tax consequences of private split-dollar are far less clear than those pertaining to employment related split-dollar. It is not certain that the measure of the economic benefit provided in private split dollar is the same as that utilized in employer/employee relationships. There is some authority in the estate tax area3 that supports the principle that both forms of split dollar are to be treated the same, but there are many commentators who have warned that the income and gift tax consequences may be based on the interest-free loan rules of IRC Section 7872.

Reverse split-dollar usually involves an arrangement in which the employer is named as beneficiary of all or a portion of the death benefit (the so-called "at risk" element) and the heirs of the insured are named as beneficiary of the cash value or remaining death benefit portion. This is the reverse of the classic split-dollar format.

What is "charitable reverse split-dollar life insurance"?

This is one of the newer forms of split-dollar insurance. There are a variety of styles and formats under which charitable reverse split-dollar is presented. Each shares certain common features -- a portion of the policy is owned by and payable to the charity, and a portion is owned by and payable to a third party, typically a trust for the benefit of the heirs of the insured. In some cases, the charity is assured of a minimum death benefit, while in others it has no long term guarantee, but a short term right to benefits as long as the program is in effect.

Each presumes there is no contractual obligation imposed on the charity to pay its share of premiums, although there is the clear expectation that this will be the case. The insured donor will be making gifts of cash or other assets to the charity to pay its portion of the premium, although, again, there is no contractual obligation to do so. The donor may, or may not, have a prior gifting or volunteer relationship with the charity. We'll examine a few of these plans, but this discussion is, by no means, inclusive of all the variations promoted.

1. Plan One.

In the basic plan, the donor establishes an irrevocable insurance trust, which purchases a life insurance policy on the life of the donor. The trust then enters into a split-dollar agreement with a charity in which the two entities agree on a split of premium payments, rights and benefits in the policy. The trust then endorses or assigns over to the charity the right to name the beneficiary of a portion of the death benefit, which presumably would be the charity itself.

Thereafter, the donor makes cash contributions to the charity. The charity is not obligated to use the cash to pay its share of the insurance premiums, although its failure to do so will obviously jeopardize its continued participation in the program. The amount of the contribution is at least equal to the level term cost of the death benefit in the policy. The charity is given a variety of choices on the use of the premium.

(a) It may pay the increasing term costs, based on a specific death benefit, as determined by using the P.S. 58 tables.

(b) It may pay a level term cost, based on the average of such costs through life expectancy. Any excess premium paid in the early years will be allocated to an "unearned premium account", which will also be paid to the charity in the event of the insured's death or which will, in future years, be used to pay the increasing costs of the charity's share of the insurance.

(c) It may pay an annual amount that is necessary to guarantee the cost of premiums for a term of 15 years or until the insured attains age 65, whichever is later. In this case, the charity would receive the designated death benefit plus the account value for the insured, as determined by the insurance company.

(d) It may keep the cash contribution and pay nothing on the policy. If there are sufficient funds in the unearned premium account to continue the policy, the program will continue. Otherwise, the split-dollar arrangement will terminate and the charity would receive nothing further.

Under this program, the charity and the trust will split the policy benefits. The trust is entitled to the greater of (i) the premiums paid by it or (ii) the cash surrender value of the policy. The charity receives its share of the death benefit, and any excess passes to the trust. The plan also permits the insured to withdraw cash value as a policy loan, at some point after reaching a designated or agreed age.

As marketed, the charity is assured a minimum death benefit as long as it continues to participate in the program. This is the main attraction from the charity's perspective.

2. Plan Two

This plan is similar to the above arrangement, but instead of the individual insured making cash contributions to the charity, the insured's corporation will make such a contribution. Thus, the insured will be gifting some cash to the irrevocable trust, and the corporation will be gifting the balance to the charity.

Under some plans, the trustee is deemed the owner of the policy but subject to an assignment or endorsement of certain rights and benefits. In other plans, the ownership is divided between the charity and trustee. In all cases, the cash contributions to the charity are unrestricted, but part of a plan designed to fund the charity's share of the premium costs. The insured (or corporation) intends to deduct the cash gifts as charitable contributions. In some programs, the insured or trustee is authorized to withdraw cash value, or surrender portions of the policy dividends, or take policy loans, in order to distribute them to the insured, the grantor of the trust, or other family members. This is intended to be an income tax free distribution.

The plans are promoted on the basis of providing a supplemental and tax-free retirement benefit, estate tax free death benefits, current income tax deductions and the creation of a charitable endowment.

Will the insured be entitled to an income tax deduction for the cash contributions to the charity? The thrust of this discussion focuses on three specific issues.

1. Is the contribution non-deductible because the purchase of the insurance by the charity constitutes a partial interest?

Internal Revenue Code Section 170(a) is the governing provision that permits an income tax deduction for a charitable contribution made within the taxable year. A "charitable contribution" is a gift to or for the use of a charity, but only "if the contribution or gift is to be used exclusively for ... charitable... purposes"...4. A deduction is denied "in the case of a contribution (not made by a transfer in trust) of an interest in property which consists of less than the taxpayer's entire interest in such property..."5. This means that the general rule to qualify for a charitable contribution deduction is that the donor must give away his or her entire interest in the property.

There are several notable exceptions to this rule. Specifically, the Internal Revenue Code ("IRC" or "Code") provides that the "partial interest rule" does not apply to a contribution of a remainder interest in a personal residence or farm, or an undivided portion of the taxpayer's entire interest in the property, or a qualified conservation contribution.6 The restriction does not apply to contributions in trust that meet the requirements of IRC Section 664 (dealing with charitable remainder trusts) or IRC Section 642(c)(5) (pertaining to pooled income funds).7

These provisions are well known and each of the split-dollar plans attempts to address this issue. The basic argument proceeds as follows. The insured (or other third party) is making an unrestricted gift of cash to the charity. Such gift constitutes the donor's entire interest in the asset (cash) contributed. Further, it is the insurance trust that is making the split-dollar arrangement with the charity, not the insured. The endorsement of benefits or split ownership is between the trust and charity. The position of the plan sponsors is that the partial interest rule is inapplicable.

The conclusion by the plan sponsors is, at best, optimistic but unsupported, and, at worst, directly inconsistent with existing tax authorities. The basic partial interest rule is fairly clear. If the gift is anything less than 100% of the donor's entire interest, the contribution is not deductible. An undivided interest in real estate (e.g. 50% of the property, gifted to the charity as a tenant in common) would be permissible. Similarly, if an individual only owns a portion of or partial interest in an asset, a gift of such owner's entire, albeit partial, interest to charity would be deductible. The charity must receive a fraction or percentage of each and every substantial interest in the asset, and such interest must extend over the entire term of the donor's interest in the property.8

For example, if John owned securities and gave the right to the use of and income from these securities to Fred for his lifetime, and simultaneously gave the right to the securities after Fred died to Jane, Jane could make a charitable gift of her interest in the securities and she would be entitled to a tax deduction equal to the present value of that future interest. Jane had given all that she owned in the asset. Although it was only a partial interest in the entire asset, it was all that she possessed.9

This apparently straightforward rule is complicated by the step-transaction restriction. According to the Internal Revenue Service regulations, "if ...the property in which such partial interest exists was divided in order to create such interest and thus avoid Section 170(f)(3)(A), the deduction will not be allowed."10 The regulations proceed to give examples of the application of this restriction. If a taxpayer owned property and transferred the remainder interest to his son, and then immediately thereafter transferred the remaining income interest to charity, no deduction would be allowed. Conversely, if a taxpayer creates a life estate in securities and gifts this interest to his son, and thereafter gifts the remainder interest to charity, no deduction will be allowed. On the other hand, if the life estate were gifted to charity A, and the remainder gifted to charity B, the IRS will permit the deduction, since all of the taxpayer's interest in the property was gifted to charity.11

Unless the insured can overcome this problem, the basic premise on which each plan is designed is legally incorrect.

(a) Did the insured contribute all that he or she owned when cash was gifted to the charity without any contractual obligation by the charity to use the funds in connection with the purchase of insurance? The answer to this question must be seen in the context of the entire plan. The IRS will likely apply the "substance over form" principle in determining whether the funds gifted to charity and to the insurance trust were part of a plan in which the ownership of insurance would be split.12 The Government's case is made easier by the marketing materials of the promoters, which clearly describe the plan and its purpose.

If the insured had gifted an existing death benefit to charity, and cash surrender value to the trust, rather than cash which was used to purchase the same split ownership, the transaction would violate the partial interest rule. In Revenue Ruling 76-20013, a donor irrevocably assigned the cash surrender value of a paid-up insurance policy to a college, but retained the right to change the beneficiary of the policy, subject to the college's right to the cash value. It would also share in the death benefit to the extent of its cash surrender value one day prior to the insured's death. The college had the right to surrender the policy for its cash value, or borrow up to the amount of the cash value, without the donor's permission. The college was given possession of the policy. Nonetheless, the IRS concluded that this was a gift of less than the taxpayer's entire interest and did not constitute an undivided portion of the property. In this case, the taxpayer's gift tax deduction was denied under IRC Section 2522(c). In the companion ruling, Revenue Ruling 76-143, the Service denied the income tax deduction as well. Note that this is a Revenue Ruling, which has the force and effect of law on all taxpayers, and not a private letter ruling, which applies only to the taxpayer seeking the ruling.

In another Revenue Ruling, the IRS held that the owner of an annuity contract who exercised an option in the contract to purchase a separate term life insurance contract, at reduced rates, and who then transferred the annuity contract to a charity, was not entitled to an income tax deduction for the contribution.14 In this case, the right to buy the term insurance, at favorable rates, was a contractual right in the annuity contract. As long as the charity maintained the annuity contract, by making premium payments which were funded by gifts from the donor (though presumably not under any binding obligation to do so), the donor would be allowed to purchase the term coverage. The charity was the owner of the annuity, and enjoyed all ownership rights, including the right to assign, revoke an assignment, pledge the contract for a loan, surrender or cancel the policy, name a beneficiary or change the beneficiary and receive all annuity payments. The initial gift was made subject to the donor's retention of the right to purchase the term insurance, and the charity annually provided the donor with the right to renew the contract. The IRS focused on the pattern of conduct that effectively gave the taxpayer substantial economic benefits through the purchase of the term insurance.

Similar results followed in a case in which the donor retained the right to the proceeds in excess of the cash value.15

Not all split ownership arrangements are likely to be denied favorable tax treatment. In Private Letter Ruling 9205012, the IRS examined an arrangement in which a parent corporation owned royalty interests in oil and gas properties. In 1984 and 1985, it "carved-out" the overriding royalty interests from the working interests in such properties and transferred the overriding royalty interests to a new subsidiary corporation. In 1992, the parent corporation sought to contribute the overriding royalty interests of the subsidiary to a charity. The issue faced by the Service was whether such partial interest was entitled to a charitable income tax deduction, or would be barred under the partial interest rule of IRC Section 170(f)(3)(A). The IRS had to examine whether the property was divided to avoid the restrictions on the partial interest rule.

First, it found that there was an independent business reason in 1984-85 to carve up the royalty interest from the working interest. It found substantial non-tax motivated reasons, including the creation of easily valued assets that could be used as collateral to finance business acquisitions. Second, it determined that the seven year delay between the splitting of the interests and the proposed charitable gift demonstrated the lack of intent to avoid Section 170(f)(3)(A). Attention should be paid to the focus of this decision. There were non-tax reasons for the split and time made the split "old and cold", thereby reinforcing the non-tax motivations of the donor.

(b) Is the action of the trust to enter into the split-dollar arrangement independent of the donor or will it be deemed an agent of the donor for this purpose? The analysis of this question is similar to the treatment of the donor's contribution of cash to the charity. If the purpose of the arrangement is to avoid the application of the partial interest rule, then using a third party, especially one established for this purpose, will not succeed. A taxpayer will not be permitted to do indirectly what one is prohibited from doing directly. The same rationale would likely be applied to the donor's corporation, if it is the source of the cash contribution to the charity.

The promoters of the plan argue that the split-dollar plan is separate and distinguishable from the partial interest rule and that the cash gifts to the charity and trust are separate and independent events from the purchase of the insurance. The marketing materials in which these plans are promoted themselves undermine this position. Each portion of the plan is integrated with the other and the benefits are summarized to the participants as if all elements were dependent upon the other. Asserting that the cash contribution is not conditioned on the purchase and continued payment of the insurance is unpersuasive, especially when these plans provide an economic incentive for the charity to continue to participate (usually by providing a guaranteed minimum death benefit).

2. Is the contribution non-deductible because it is part of a pre-arranged deal?

If, in fact, there is no partial interest in the arrangement, will the understanding of the parties nonetheless constitute a "pre-arrangement" such that the contribution will fail to be deductible? Supporters of this plan argue that the absence of a binding obligation by the charity to purchase the insurance satisfies the test set forth in Revenue Ruling 78-197.16 Of course, the underlying issue is still the partial interest rule. If the prearrangement was designed to avoid its application, it will fail even if there is no binding obligation. The Palmer case, on which the Revenue Ruling was based, dealt with a contribution of stock to a charitable remainder trust, followed thereafter by a redemption of the stock by the donor's privately held corporation. This case did not involve the provisions of the partial interest rule, but whether the contribution was a sale by the donor first, followed by a gift of cash.

The comfort provided by the Palmer case was muted by the decision in Blake v. Commissioner17, in which the Court held than an "understanding" between the charity and the donor was sufficient to ignore the form of the transaction and to tax the donor on the gain. This case is distinguished by plan supporters because of its outlandish facts and apparent implied obligation between the parties.

Other cases in this area all relate to a contribution of assets followed by redemption or sale. When an independent purpose exists for the contribution, that is unrelated to tax motives, the courts have given the taxpayer more latitude.18 It would be difficult to find a business purpose in most charitable split-dollar plans, although the issue may be more relevant when the corporation provides the cash to the charity.

Notwithstanding the difference in the fact patterns, between the contribution of stock, followed by corporate redemption, and the contribution of cash which is part of an overall plan to split the ownership of insurance, the promoters maintain that the thrust of Palmer should apply to charitable split-dollar.

Some of the programs rely on the reasoning of the Court in Crummey v. Commissioner19, which held that a donor to a trust for the benefit of children was entitled to the $10,000 annual exclusion for each beneficiary, provided that the beneficiary was given the power to withdraw the gift for some period of time during the year. Even though the donee beneficiary is never expected to exercise this right, the mere existence of the right is sufficient to qualify the gift as a present interest, and thus entitled to the $10,000 exclusion. So, according to the supporters of the plan, the absence of a binding agreement or legal obligation requiring the charity to use the proceeds to purchase the insurance will protect the tax deductibility of the gift.20

Again, however, the gift tax issues applicable here (IRC Sec. 2503(b)) are not the same as the rules applicable to split interest gifts to charity (IRC Sec. 2522(c)). It fails to address the issue of whether "the property in which such partial interest exists was divided in order to create such interest and thus avoid Section 170(f)(3)(A)". One has to be very confident that a gift of cash was not a partial interest, even though the purpose of the gift was to purchase a partial interest. If this assertion is wrong, and there is no authority to support it, the consequences for donor and charity are very unfortunate.

3. Is a portion of the contribution non-deductible because of an economic benefit derived by the insured?

If a contribution to a charity is in exchange for an economic or other material benefit to the donor, all or some portion of the contribution will be non-deductible, under the quid pro quo rules. The value of the benefit provided to the donor must be determined by the charity and reported to the donor.21 These rules are difficult to apply in many circumstances, not the least of which would be charitable reverse split-dollar.

Is there any economic benefit provided by virtue of this gift arrangement? Under the facts described in Revenue Ruling 76-200, in which a discounted premium for term insurance was available as a part of the annuity contract gifted, it would be easier to assess the economic benefit derived. The plan supporters argue that the payment of the P.S. 58 costs by the charity is the measure of its benefit in the policy and the payment by the trust constitutes the balance, thus there is no additional benefit provided by the charity to the donor.

To understand the nature of the economic benefit provided, one would have to examine the relationship between the premium paid by the charity (based on the P.S. 58 table most frequently used in these plans) and the actual insurance premium payment. On analysis, it becomes clear that the deduction is substantially greater than the premium necessary for payment of the related death benefit.22 Where does the excess go? Is there a benefit created to the non-charitable co-owner by the nature and extent of the charity's payment of premiums? What if the actual cost of the term portion of the insurance could have been measured by the insurance company's lower annual term rate? Why would a charity pay the P.S. 58 cost, instead of the lower term rate? The rates used in the P.S. 58 table have been outdated for many years, making the actual cost of the insurance substantially less than is indicated. This means that the charity is overpaying for its share of the policy, and a substantial benefit is flowing to the family of the insured.

In a newsletter produced by a major insurance company for its agents, the spread between the actual term cost of the insurance and the government's P.S. 58 table was illustrated. (See Exhibit 2).23 The case reflects premiums for a 50 year old male, with dividends purchasing additional insurance. The initial death benefit is $500,000, with a total premium of $14,555. The P.S. 58 cost, paid by the employer (or charity in a reverse split dollar arrangement) begins at $4520, and grows to $12,952 over 15 years. Total premiums paid by the employer, using the tables, would be $119,656. The same company's term rates for similar coverage is $520 in year 1, and grows to $3317 in year 15, for a total of $21,000. The total premium for the same period of time is $192,825, of which the employer's portion is $119,656. The employer would receive this amount at the employee's death, but there would be a total death benefit of $537,664, and cash value of $246,743, most of which would be owned by the insured's family or irrevocable trust. In CRSD, the charity would receive a death benefit that is more than just a return of its premium, but not nearly equivalent to the proportion of the premium that it has paid.

One of the promoters of this type of plan used the following pattern to demonstrate the economic benefit to the insured. Husband is age 65 and wife is age 60. They wish to acquire a $4 million death benefit for their one child. The cost of such coverage was $67,000 per year for 10 years, or $112,000 per year on a pre-tax basis. They could only utilize $20,000 of annual gift tax exclusions to fund this gift. Under the proposed split-dollar plan, the donors would gift $20,000 each year to a trust for the benefit of the child, and gift $80,000 per year for 10 years to the charity. The two recipients would utilize the cash gifts to purchase a $5 million policy, with $950,000 allocated to the charity, and the balance to the trust. Because the amount of the charity's share of the premium was substantially greater than needed, there was an excess premium account that would grow to a maximum of $735,000. If the donors died at that point, the charity would receive $1,735,000. The excess premium would eventually decline, but the charity would never receive less than $950,000. The trust's benefit was a minimum of $4 million, growing to $5 million over time. By utilizing the charitable split-dollar program, according to the promoters, the clients would be able to fund the cost of the family's insurance needs for $20,000 per year, plus the net after-tax cost of the gifts to charity of $48,000 per year. This was substantially less than the $112,000 pre-tax cost of the non-split-dollar plan and avoided any utilization of the parent's lifetime exemption.

It would be hard to argue that an economic benefit did not flow to the child by virtue of the charity's contribution of excess premium during the 10 year period of contributions. Should this value be applied on an annual basis to reduce the charitable contribution deduction? Should the charity acknowledge the quid pro quo by reporting the economic benefit to the donors?

The IRS has concluded that there is an economic benefit when equity is created under a split-dollar plan. This can occur when the employer's interest in the policy is limited to its premium advances. Excess policy values will accumulate for the benefit of the insured or third party owner, rather than for the employer. The IRS has indicated that such benefit will be deemed taxable income to the employee.24

If the insured's corporation contributes the cash to the charity, which is used to pay the insured's premium, will this constitute additional income to the insured instead of a charitable contribution deduction?

In some variations of this arrangement, the corporation provides the premium payment, claiming the charitable contribution deduction. This is intended, presumably, to further separate the insured from the charitable contribution, and the implications of the partial interest rule. The corporation functions, in this regard, in a manner similar to the irrevocable trust. It also adds a layer in the relationship.

The question, of course, is whether the action of the donor's corporation, over which he or she has direct or indirect control, will be treated independently from the donor in connection with a plan that attempts to avoid the partial interest rule.

If the corporation cannot deduct the premium payment as a charitable contribution, it is likely that it will be treated as property transferred in connection with the rendering of services and taxable to the employee under IRC Sec. 83. It might even be treated as a corporate dividend, to the extent of corporate earnings and profits. This could have serious repercussions, if the entity is an S corporation, especially if there is more than one shareholder, since such dividends might be deemed a selective dividend and result in loss of S status.25

Will the insured be entitled to a gift tax deduction for the cash contributions to charity?

The gift tax rules parallel the income tax rules. As discussed in Revenue Ruling 76-200, a contribution to a charity of an asset that violates the partial interest rule will not be entitled to the gift tax deduction provided in IRC Section 2522. What happens if a donor makes a non-deductible gift to charity? The results are the same as if the gift were made to a taxable entity or individual. The donor will be entitled to the annual $10,000 exclusion, and thereafter must apply the available applicable exclusion amount (formerly "exemption equivalent"). This is the lifetime amount that may be gifted without payment of tax, by utilizing the unified tax credit. It is unlikely, however, that a donor would want to apply the unified credit to gifts made to charity.

In other words, a gift to charity that is not deductible is taxable.26

Will the proceeds of the policy be excluded from the insured's estate?

Most of the split-dollar programs are designed so that the insured has gifted away all incidents of ownership and control, either through an irrevocable insurance trust, or by outright ownership by the heirs. However, where the program involves the use of a corporation or other business entity, in which the insured/donor retains ownership or control, the right to a portion of the policy or any other incident of ownership (including the power to borrow, change beneficiaries or pledge as security) will likely cause the proceeds to be includible in the insured's estate.27 This risk would seem to exist if the insured received or expected cash from the policy through "loans", especially those marketed as "tax free retirement income".

Since the charity is receiving a free gift, why would it complain or worry?

Each of the various charitable reverse split-dollar plans promoted state that the charity will be enticed or eager to participate in this program, provided that they receive a minimum benefit that is sufficiently attractive to merit their efforts. Furthermore, establishing a new relationship with a substantial donor is always in the charity's best interest. This simplistic conclusion, while possibly accurate with some organizations, fails to recognize the serious risks to the charity, as well as the development staff that has committed the charity to participate.

1. Should a charity utilize its name and reputation to endorse or validate a program that could result in an adverse tax result to its donors?

Phrased in this manner, it is unlikely that a reputable organization would do so. Of course, a donor is free to engage in conduct that, upon the advice of his or her tax counsel, is permissible under the law, even if there is a measure of risk involved. But, for many potential donors, it is the participation of the charity that reinforces or supports the opinion of the promoters. After all, so the implication goes, the charity would never knowingly engage in improper conduct, so it must have done its own due diligence and concluded that the technique was acceptable.

The charity must recognize that the donor could lose the income tax deduction, be required to pay a gift tax, and even have the proceeds includible in the estate. These risks are not insubstantial. If the public acceptance of the program is enhanced by the reputation of the charity, is there some responsibility that the charity should bear if the program fails on audit or in court? Should the development staff that places the organization in this position be held responsible in such an event?

2. Will the participation of the charity in a program that provides substantial benefit to a third party constitute private inurement or private benefit?

Section 501(c)(3) of the Internal Revenue Code states that, to remain qualified as a charitable organization, no part of the net earnings may inure to the benefit of any private shareholder or individual. The regulations define "private shareholder or individual" as "persons having a personal and private interest in the activities of the organization."28

The scope of this provision includes not only founders, trustees, directors, officers and significant donors, but all employees of the organization, such as physicians employed by a hospital.29 "Inurement" can occur through payments from the gross earnings of the entity, and are not limited to "net earnings" or "profits".30 This is an absolute prohibition. Even a small amount of inurement may result in excise tax on the individuals involved or even loss of exempt status for the organization.31

Can split-dollar insurance create this problem? In John Marshall Law School v. U.S.,32 the charity lost its exempt status because its earnings inured to the benefit of private individuals, as a result of numerous inappropriate activities, including, according to the Court of Claims, a split dollar plan (though unlike the plans discussed in this article). Death benefits were paid to the insured's heirs, but the court held that the policies were not justified as compensation. The Court expressed additional concern about why dividends earned by the charity's premium payments were used to purchase additional insurances for the benefit of the key officer's spouse and children. The facts and circumstances are quite different in the typical CRSD case, but the potential consequences cannot be ignored.

The private benefit rule is broader than private inurement and is not limited to insiders. A charitable organization must demonstrate that it is organized and operated exclusively for charitable purposes. Thus, the organization must establish that "it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests."33 There can be private benefit without private inurement.34

The Supreme Court has held that an organization is not operated exclusively for charitable purposes if it has a single noncharitable purpose which is substantial.35 What is substantial is a question of facts and circumstances; there is no percentage test applied by the courts.36

The promoters of the plan maintain that private inurement can be avoided by carefully selecting non-insiders to participate. In addition, these plans dispel the notion that there is any private benefit at stake here, because the charity is purchasing its own benefit with cash that has been gifted to it without restrictions or conditions and the third party (insurance trust or heir) is paying its own fair share of the cost of the insurance.

To understand the issue, however, the question must be phrased differently. Is there a substantial economic benefit provided to the donor (or the donor's family) because of the premium paid by the charity in excess of what would be required to purchase the same benefit independently of this arrangement? The economics of every program must be examined to determine this, but the answer seems apparent, otherwise the donor would not be motivated to utilize the split-dollar plan to fund the family's personal insurance need. The marketing materials utilized to encourage prospects for these programs make it clear that there is a benefit to making a gift to charity that is applied to split ownership of insurance, beyond the income tax deduction available.

In a recent Private Letter Ruling dealing with private split dollar, the IRS found no gift by the taxpayers in a circumstance in which a trust, created for the children of the Taxpayers, paid the lesser of the PS 58 costs or the insurer's published annual term rates, and the Taxpayers paid the rest. The Trustee owned the policy and paid the lower term rates. The Taxpayers (and insureds) paid the balance of the premium. At the surviving taxpayer's death, the Taxpayer's estate will receive an amount equal to the cash surrender value.

According to the Service, "since the Taxpayer (if living) or the estate of the last Taxpayer to die will be reimbursed by the trust for the portion of the premium payments made by the Taxpayers, the portion of the premium payment made by the Taxpayers will not constitute gifts to the trust for gift tax purposes."37

In this case, unlike CRSD, the Taxpayer is paying the bulk of the premium, while the trust is paying the lower term rates, not the higher PS 58 rates. This reduces the taxable gift made by the Taxpayers to the trust for their children. It is good estate planning, but not analogous charitable planning. .

In this private split dollar plan, the Trust will receive everything it paid for, namely the mortality portion of the policy, while the Taxpayers have retained, and will ultimately receive, the savings portion, or cash value. In CRSD, the charity has overpaid for its share of the death benefit, and this excess payment ultimately enhances the cash value and excess death benefit owned by the Trust. This is the private benefit prohibited by IRC Section 501(c)(3) and Treasury Regulation Section 1.501(c)(3)-1(d)1(ii).

3. Will the charity be violating the Uniform Management of Institutional Funds Act by investing the "gifts" in the insurance program?

If the dollars "gifted" to the charity are not part of a prearranged plan, then they can be invested in any fashion. When you compare the economic benefit to the charity from the programs that are promoted to even modest projected returns from the stock or bond markets (unless the Donor dies prematurely), a serious question arises as to the charity's prudent management of its investments.

Final thoughts and suggestions. Charitable gift planning requires a grasp of the technical and an appreciation for the intangible. Tax implications are important for the donor and the charity. Gifts may be deterred or lost if the cost to the donor is too great. However, tax motivation is rarely sufficient to make a major gift to charity. Deal makers are generally poor donors. Conversely, charities that participate in an arrangement that could result in financial harm to a contributor, or to the institution itself, are likely to bring serious repercussions to all the parties involved. A bad gift from a good donor is not worth receiving.

Charitable reverse split-dollar is a strategy that creates serious risks to both the contributor and charitable recipient. There is no credible or reliable authority on point that substantiates the claims of its sponsors, notwithstanding the opinions presented by various attorneys and commentators. While CRSD may prove valid, upon review by the Internal Revenue Service or federal court, until that time, it would seem imprudent and inappropriate for gift planners to recommend the concept or for charities to participate in its promotion.

EXHIBIT 2 YEAR TERM COSTS PS-58 COSTS 1 520 4,520 2 539 4,794 3 615 5,190 4 691 5,627 5 779 6,111 6 888 6,548 7 1,016 7,024 8 1,170 7,540 9 1,338 8,097 10 1,533 8,718 11 1,750 9,411 12 2,009 10,174 13 2,321 11,016 14 2,694 11,934 15 3,317 12,952

$21,000 $119,656

Reprinted from The Journal of Gift Planning, a quarterly publication of the National Committee on Planned Giving. The Journal is available to members of an NCPG affiliated council for $22.50 per year -- $45 for nonmembers. The publication is intended to facilitate and encourage the education and training of the many different professionals in the planned giving community. For subscription information, contact NCPG at its website: www.ncpg.org


Footnotes


  1. 1964-2C.B. 11back

  2. 1955-2 C.B. 228back

  3. PLR 9636033; see also Rev. Rul. 79-129, 1979-2 C.B. 306back

  4. IRC Sec. 170(c)(4)back

  5. IRC Sec. 170(f)(3)(A)back

  6. IRC Sec. 170(f)(3)(B)back

  7. IRC Sec. 170(f)(2)(A)back

  8. Rev. Rul. 79-9, 1979-1 C.B.1back

  9. Treas. Reg. Sec. 1.170A-7(a)(2)(i)back

  10. Treas. Reg. Sec. 1.170A-7(a)(2)(i)back

  11. Treas. Reg. Sec. 1.170A-7(2)(ii)back

  12. See: Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945), in which the Supreme Court held that the tax consequences "are determined on the basis of the substance of the transaction and not its form".back

  13. 1976-1 C.B. 308. See also: Rev. Rul. 76-143, 1976-1 C.B. 63back

  14. Rev. Rul. 76-1, 1976-1 C.B. 57back

  15. Rev. Rul. 76-143, 1976-1 C.B. 63back

  16. 1978-1 C.B. 83, acquiescing in Palmer v. Commissioner, 62 T.C. 684 (1974), aff'd 523 F.2d 1302 (8th Cir. 1975).back

  17. 697 F.2d 473 (2nd Cir. 1982), aff'g 42 T.C.M. 1336 (1981)back

  18. See: Caruth v. U.S., 865 F.2d 644 (5th Cir. 1989)back

  19. 397 F.2d 82 (9th Cir. 1968); see also Cristofani Estate v. Commissioner, 97 T.C. 74 (1991), acq. 1992-1 C.B. 1back

  20. See PLR 9729005, where the IRS held that gifts funneled through a spouse in order to avoid the gross-up rule IRC Sec. 2035(c) will be ignored.back

  21. IRC Sec. 6115back

  22. See: Horowitz, Scope & Goldis, "Tax Planning with Life Insurance: The Myths of Charitable Split-dollar and Charitable Pension", J. of the American Society of CLU and ChFC. (Sept. 1995), p.96, 99back

  23. Connecticut Mutual Life Insurance Company, The Advanced Underwriter, Vol. XLIX, No. 3 (March 1995)back

  24. PLR 9604001back

  25. Johnson v. Commissioner, 74 T.C. 1316 (1968)back

  26. IRC Sec. 2522(c)(2)back

  27. IRC Sec. 2042back

  28. Treas. Reg. Sec. 1.501(a)-1(c)back

  29. G.C.M. 39670 (June 17, 1987); G.C.M. 39498 (Jan. 28, 1986); G.C.M. 39598 (Dec. 8, 1986)back

  30. Harding Hospital, Inc. v. United States, 505 F.2d 1068 (6th Cir. 1974); People of God Community v. Commissioner, 75 T.C. 127 (1980)back

  31. IRC Sec. 4958; McGahen v. Commissioner, 76 T.C. 468 (1981), aff'd 720 F.2d 664 (3rd Cir. 1983)back

  32. 81-2 USTC para 9514back

  33. Treas. Reg. Sec. 1.501(c)(3)-1(d)(1)(ii)back

  34. American Campaign Academy v. Commissioner, 92 T.C. 1053, 1068 (1989)back

  35. Better Business Bureau v. United States, 326 U.S. 279 (1945); see also Treas. Reg. Sec. 1.501(c)(3)-1(c)(1), which states that "an organization will not be so regarded (as operated exclusively for exempt purposes) if more than an insubstantial part of its activities is not in furtherance of an exempt purpose".back

  36. See: World Family Corp. v. Commissioner, 81 T.C. 958, 967, (1983); Church in Boston v. Commissioner, 71 T.C. 102, 108 (1978)back

  37. PLR 9745019; See also PLR 9636033back

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