Charitable Gifts Of Life Insurance

At a Glance

Charitable gifts of life insurance can enable a donor to substantially increase the potential amount of his or her gift while enjoying attractive tax advantages.

A donor has three basic choices in planning a gift of life insurance:

image\bullet.jpg The donor may give an existing policy to charity by assigning all incidents of ownership to the charity and the charity names itself as beneficiary of the policy.

image\bullet.jpg The donor may apply for a new policy on his or her life, with the charity as the original policyowner and beneficiary (subject to state insurable interest laws, as discussed later).

image\bullet.jpg The donor may designate a charity as the beneficiary of a policy that the donor continues to own, though no income tax advantages are accrued.

image\button1.jpg Click here for a graphic that shows one way a charitable gift of life insurance can work.

The donor also may wish to make annual gifts to the charity to enable it to pay premiums on a donated policy.

Simplicity is one of the major advantages of life insurance gifts. The donor executes a simple assignment and change of beneficiary formimage\emdash.jpgnaming the charity as the owner and beneficiary of the policyimage\emdash.jpgand files the form with the insurance company. This form will be provided by the insurance company that issued the policy.

Insurable Interest

To discourage speculation in human lives, state laws restrict who may apply for life insurance on a particular person's life. The insured is always deemed to have an insurable interest in his or her own life. The situation gets more complicated if a third party such as a charity is the policyowner and/or beneficiary.

Generally speaking, an applicant has an insurable interest in the life of the insured if the applicant is a family member or one who may reasonably be expected to suffer economic loss as a result of the insured's death. Examples of applicants with an insurable interest include:

image\bullet.jpg A spouse

image\bullet.jpg Children

image\bullet.jpg Business partners of the insured

image\bullet.jpg The business entity itself.

Nearly every state has enacted legislation to make it clear that a charitable organization has an insurable interest in the life of a donor. Legal counsel should verify a charity's eligibility to be the original owner of a policy on a donor's life under the insurable interest laws of any given state.

The question of insurable interest generally only arises when a policy is issued, not when some subsequent assignment occurs. Thus, even in a state in which a charity does not have an insurable interest in its donors, the donor (who always has an insurable interest in his own life) could apply for the policy and then transfer it to charity. Again, counsel should check the laws of a particular state.

Giving an Existing Policy

A simple, outright gift of an existing life insurance policy can qualify for the income tax charitable deduction. To do so, the donor should assign all rights to charity (naming charity as policyowner and beneficiary). If the donor retains any rights in the policy after the assignment, such as the right to borrow cash values or to change the beneficiary, the result would be a gift of a "partial interest" that would not qualify for the income tax (or gift tax) charitable deduction.

When an individual gives a life insurance policy to charity, the amount of his or her charitable contribution is deemed to be the lesser of:

image\bullet.jpg The value of the policy, or

image\bullet.jpg The donor's basis in the policy

The "value" of an existing policy is its replacement cost if the policy is paid-up (i.e., no further premiums are due). If further premiums are due, then the value of the policy is its interpolated terminal reserve, plus any unearned premium for the current period, plus any accrued dividends, minus any policy loan outstanding. Upon request the insurance company will provide this figure on IRS Form 712.

The fair market value of a newly issued policy is the initial premium that was paid to bring the policy into existence.

The cost basis is defined as aggregate premiums paid less the sum of dividends received in cash and amounts surrendered.

In an informational letter titled INFO 2009-0127, the IRS stated that an exchange of life insurance contracts in which one policy would be exchanged for two new contracts, and one of the new contracts would be donated outright to a qualified charity did not violate the partial interest rule for income tax charitable deductions.

Income Tax Consequences

Ordinary Income Limitation on the Income Tax Charitable Deduction

If a sale of the donated property on the date of the gift would have produced ordinary income, the amount of ordinary income reduces the charitable deduction allowable for the gift to charity. Because a transfer for value or surrender of a policy generally will produce ordinary income if the cash surrender value exceeds the basis of the policy, the income tax charitable deduction will be limited to the basis if there is a gain in the policy.

Thus, the amount of the contribution for a gift of a life insurance policy is the lesser of its value or its basis.

Percentage Limitations on the Income Tax Charitable Deduction

There is an overall percentage limitation on the income tax charitable deduction each year. Total cash contributions for the year, including life insurance policies, cannot be deducted in excess of 60% of the donor's adjusted gross income (AGI) for the year. If contributions surpass this limit, the excess is carried over and may be deducted the next year up to five succeeding years as subject to the percentage limitation in those years.

Gift of Policy Subject to Loan

Donors should be aware that donating a policy subject to a loan can be problematic. The loan will reduce the amount of the charitable deduction and pose other difficulties. The transfer to charity is technically a bargain sale because the charity has assumed the policyholder’s debt. So, the donor’s basis must be allocated between the gift transaction and the sale transaction.

For example, a donor contributes a policy with a cash value of $100,000. Her basis in the policy is $30,000. Her outstanding loan against the policy is $60,000. The donor’s basis should be allocated as follows:

Basis allocated to the charitable gift:

($40,000/$100,000) x $30,000 = $12,000

Basis allocated to the "sale":

($60,000/$100,000) x $30,000 = $18,000

A donor can take no more than the basis as a deduction (the basis or the fair market value, whichever is less), the donor’s charitable deduction would be $12,000. And, the donor would receive ordinary income of $42,000 (after allocating the $18,000 in basis towards the loan value of $60,000.)

Gift of Policy Dividends

Another approach using an existing policy is to give policy dividends to charity. Such dividends are taken in cash by the policyholder and then donated to the charity under the usual charitable deduction rules for cash gifts.

Tax Consequences

Estate Tax Consequences

If an individual gives an existing policy to charity, its value will be removed from the gross estate, provided he or she lives for at least three years after the transfer. But even if the insured donor dies within three years, the death proceeds would wash out of the gross estate as an estate tax charitable deduction (with no percentage limits as in the case of the income tax).

Gift Tax Consequences

If a donor transfers his or her entire interest in a policy to charity, a federal gift tax return will not have to be filed, regardless of the value of the policy at the time of the gift. The gift tax charitable deduction shelters the entire gift from tax (with no percentage limits as is the case of the income tax).

Gift Techniques

Premium Payments

Premium payments made by the donor after the policy has been transferred to charity may be treated as gifts "for the use of" charity if the premiums are paid directly to the insurance company. Gifts for the use of charity, rather than "to" charity, are deductible only up to 30% of the donor's adjusted gross income.

On the other hand, transfers of cash to the charity in the amount of the premium are considered gifts "to" charity (which then pays the premiums itself), and are deductible up to 60% of the donor's adjusted gross income.

Cash gifts to enable the charity to meet its premium obligations are usually made 20-30 days prior to the premium due date. In this way, the charity can assure that premiums are paid in time to prevent a lapse of the policy. This also gives the charity a chance to maintain ongoing contact with the donor.

The donor may want to transfer appreciated property to the charity rather than cash to provide payment on the premium. The full value of the property will be deductible, including the gain that has never been taxed, and the charity will not have to pay capital gains tax on the appreciation when it sells the propertyimage\emdash.jpgunlike the donor who would sell the property to raise cash for premiums.

Gift of a New Life Insurance Policy

The donor may apply for a new life insurance policy and name the charity as the owner and beneficiary. The value of the policy is the premium paid and this is the amount of the charitable deduction.

Another option is for the charity to apply for a life insurance policy on the life of the donor and pay the premium with funds provided by the donor. This approach does have the advantage that the donor never owns the policy so the donor never holds any incidents of ownership that could pull the policy death benefit into the donor’s estate. However, this approach could pose problems. The arrangement might violate state law regarding insurable interest, or jeopardize the donor’s deduction by restricting the charity's use of the funds. The charity might not believe that investing assets in an insurance policy would be a prudent choice. Different charities have different gift acceptance policies so it is always wise to consult the charity early in the gift planning process.

Insuring a Charitable Pledge

On occasion, a benefactor may make a substantial pledge to a charity. It may be the donor's intent to pay this pledge over a period of years. Such a pledge may be guaranteed by the donor. If the donor purchases a life insurance policy (naming a charity as beneficiary) in the amount of the total pledge, then it is certain the commitment will be paid in full.

Once the pledge is satisfied, the donor may choose to alter the beneficiary designation and leave the policy proceeds to his or her heirs, or to another charity.

Designating Charity as Beneficiary

If a donor does not desire to make an immediate gift with respect to an existing policy, the donor may retain ownership and control of the policy but name a charity as beneficiary. This will not produce any income tax charitable deduction at the time the beneficiary designation is made, but it will result in an estate tax charitable deduction for the death proceeds passing to the charity at the insured donor's death.

Wealth Replacement

At a Glance

Some potential donors would like to make a substantial gift to charity, but feel constrained from doing so by family financial security considerations. Many are concerned that a charitable gift could deprive family members of assets they might need for emergencies or unforeseen contingencies that suddenly require substantial funds. When such concerns forestall a charitable gift, donors lose the personal satisfaction of fulfilling their philanthropic objectives. Moreover, these donors lose the income tax and/or estate tax savings available to those who make charitable gifts and bequests.

"Wealth replacement" (a.k.a. "capital replacement") is a technique that addresses a donor's natural concern for family financial security. Wealth replacement involves the coordinated use of three instruments from the professional advisor's toolkit: (1) a charitable remainder unitrust, (2) a life insurance policy, and (3) an irrevocable life insurance trust. The general idea is to enable donors to fulfill their commitments to favored charities, while using the charitable deduction tax savings and income payout from the charitable remainder unitrust to acquire life insurance with a death benefit to replace the assets transferred to charity.

How Wealth Replacement Works

The wealth replacement technique involves the transfer of cash or long-term, appreciated property to a charitable remainder unitrust (CRUT). The trust provides for annual (or more frequent) payouts to the donor, and perhaps also to a surviving spouse, for life or a fixed term not to exceed 20 years. A CRUT normally is often preferred over a charitable remainder annuity trust (CRAT) because the CRUT can receive additional contributions subsequent to the initial asset transfer. An older donor might find a succession of charitable gift annuities preferable to a CRUT because of the relatively high payout rates as well as low implementation/administration costs.

If the donor's estate likely will be subject to federal estate tax, or if the donor wants to provide creditor protection to beneficiaries, the donor should also establish an irrevocable life insurance trust (ILIT). The trustee of the ILIT purchases a life insurance policy on the donor's life with a death benefit usually equal to the value of the property transferred to the CRUT. The donor has the option to use the income payouts from the CRUT, along with the tax savings from the charitable deduction, to make annual gifts to the ILIT in amounts sufficient to enable the trustee of the ILIT to pay the insurance premiums. If an ILIT is unnecessary because the donor does not expect to have an estate tax problem, this will reduce the implementation/ administration costs of wealth replacement, and make the technique more appealing to affected donors.

The present value of the charity's remainder interest is generally deductible as a charitable contribution in the year the property is transferred to the CRUT. If a sale of the transferred property on the date of the gift would have resulted in a long-term capital gain, the deduction is subject to the 30% of AGI limitation with a five-year carryover of any excess deduction. If cash is used to fund the CRUT, the deduction limitation is 60% of AGI. See, IRC Secs. 170(b) and (f) and the regulations thereunder.

There is no capital gain event when appreciated property is transferred to the CRUT. And because the trust is income tax-exempt, there is no capital gain event when the trust sells the property and reinvests the proceeds. However, capital gains realized inside the trust will be subject to the tier system, so the income beneficiary (donor or third party) may have to report capital gains realized inside the CRUT as income when trust distributions are received.

The donor makes annual gifts of cash or appreciated property to the ILIT to enable the trustee to purchase and pay the premiums on an insurance policy on the donor's life. "Crummey" withdrawal powers are used to qualify these gifts as present interests eligible for the gift tax annual exclusion [IRC Sec. 2503(b); Crummey v. Comm'r, 397 F.2d 82 (9th Cir. 1968); Rev. Rul. 73-405, 1973-2 C.B. 321]. Crummey powers give the beneficiaries of the ILIT a right to demand a distribution of these annually gifted amounts for a limited period each year, say for 30 days, after each addition is made to the trust. Provided the beneficiaries decline to exercise these powers, the trustee will have the funds to pay premiums until such time as the policy becomes self-supporting. At the donor's (or surviving donor's) death, the life insurance death proceeds are paid into the ILIT, where they are administered by the trustee in accordance with the terms of the trust instrument and eventually distributed to the donor's beneficiaries in accordance with the trust terms. Meanwhile, at the expiration of the income interest in the CRUT, usually upon the death of the donor and/or surviving spouse, the remaining balance of the trust is paid to the designated charitable remainderman. The result: the donor has provided a significant gift to charity while maintaining the size of the original estate for family members.

A Wealth Replacement Example

Charles and his wife Margaret, ages 67 and 68, own appreciated, long-term stock valued at $1,000,000. The stock has a cost basis of $300,000. In total Charles and Margaret have accumulated $14 million of assets.

They decide to donate this stock to a charitable remainder unitrust (CRUT), which will pay them five percent of the annually revalued principal in quarterly installments for their joint lifetimes, with remainder to a designated charitable organization. Based on the initial valuation, they will receive a trust payout of $12,500 quarterly during the first year, or a total of $50,000 during the first year.

Charles and Margaret will receive an income tax charitable deduction in the year the CRUT is established, based, among other things, on the applicable federal interest rate (AFR) at the time of the transfer, and subject to the 30% limitation and the five-year carryover. If we assume an AFR of 4.0%, their deduction will be $376,810, which is the present value of the charity's remainder interest in the CRUT. A $376,810 deduction will save them $139,419 in federal income taxes in their 37% marginal bracket if they itemize. Moreover, they will not pay the capital gains tax that would be levied on a current sale of the appreciated stock, and will pay tax on the gains realized inside the CRUT only as it is deemed to flow out to the beneficiaries under the tier system.

With the tax savings from the charitable deduction and the income payout from the CRUT, Charles and Margaret expect to have more than enough left to pay the annual premiums on a $1,000,000 second-to-die life insurance policy on their lives, depending on the issuer and specific product, with income left over to augment their retirement income. (In a second marriage situation, it will often be desirable to use a single-life policy.)

The $1,000,000 second-to-die policy will be applied for and owned by an irrevocable life insurance trust (ILIT) which they have established for the benefit of their three children. Since they have never held any incidents of ownership in the policy, it should be excluded from their gross estates for federal estate tax purposes. More wealth likely will be available for the benefit of their children than would have been the case if the stock had been held and passed under their wills—and taxed in the survivor's estate.

Charles and Margaret will donate cash or stock annually to the ILIT for the premiums on the second-to-die policy held in trust. The children, as ILIT beneficiaries, hold Crummey withdrawal powers, which qualify the annual gifts to the trust for the gift tax annual exclusion ($17,000 in 2023). And, keep in mind that a married couple can effectively double the gift tax annual exclusion for each beneficiary through gift-splitting. Thus, Charles and Margaret can avoid making a string of taxable gifts as each transfer is made to the ILIT.

Crummey powers are sometimes limited to $5,000 per donee per year. It may be necessary to take additional steps to use the entire gift tax annual exclusion amount.

Upon the death of the survivor of Charles and Margaret, the income interest in the CRUT will terminate and the trust principal will be paid to the charitable remainderman. At the same time, the life insurance proceeds will be paid into the ILIT and will be disposed of for the benefit of the children as provided in the trust instrument.

Summary of Advantages

Let's review what Charles and Margaret have accomplished with the wealth replacement technique. They were able to:

image\bullet.jpg Fulfill their dream of making a major gift to charity without reducing the inheritance of their children;

image\bullet.jpg Use the untaxed appreciation in their stock to generate a current economic benefit in the form of a charitable deduction;

image\bullet.jpg Qualify for an immediate federal income tax deduction of $376,810 in the year the stock is transferred to the CRUT. Subject to the 30% limitation, this deduction will save $139,419 in their 37% tax bracket if they itemize. This federal income tax deduction can be carried over for five additional years in the event the entire deduction cannot be used in the year the CRUT is established;

image\bullet.jpg Use the income tax savings and the annual payouts from the CRUT to pay the annual premiums on the life insurance policy, with income left over to supplement their retirement income;

image\bullet.jpg Avoid the federal gift tax on the annual transfers to the ILIT through the strategic use of Crummey withdrawal powers;

image\bullet.jpg Remove both the property transferred to the charity and the life insurance proceeds from their gross estates for federal estate tax purposes; and

image\bullet.jpg Provide creditor protection for their three children by having the life insurance proceeds paid to an ILIT for the children's benefit.

One more important point: The life insurance death proceeds usually will be received federal income tax-free by the ILIT.

Some Pitfalls to Avoid

image\bullet.jpg Purchasing the Policy. The donor could purchase the life insurance policy, then transfer it to the ILIT. But, under this scenario, the death proceeds would be includible in the donor's gross estate if he or she died within three years of the transfer [IRC Sec. 2035(a)(2)] or if the donor retained some string on the policy that was an incident of ownership [IRC Sec. 2042(2)]. The safer course is to have the ILIT apply for, own, and pay the premiums on the policy.

image\bullet.jpg Jeopardizing the Validity of the Crummey Powers. There are various ways in which the validity of Crummey powers can be jeopardized. For example, if the trust beneficiaries are given only a very brief time in which to exercise their withdrawal powers, the IRS may view such powers as illusory. Some authorities recommend a minimum 30-day period before the powers lapse. Also, some authorities believe the ILIT trustee should give formal, written notice of withdrawal rights to the beneficiaries each year.

image\bullet.jpg Manufacturing Beneficiaries. When the premium payment is substantial, there may not be enough beneficiaries to shelter the annual transfers to the trust under the gift tax annual exclusion. Grantors have tried to get around this by "manufacturing beneficiaries" who have no rights in the trust except the Crummey powers. The IRS has attacked this practice in letter rulings. But the IRS received something of a setback in Estate of Maria Cristofani v. Comm'r [97 T. C. 74 (1991)]. The Tax Court ruled that the unexercised rights of withdrawal by several beneficiaries allowed additions to the trust to qualify for the gift tax annual exclusion. The IRS later acquiesced in the result in Cristofani [Action on Decision 1992-09, 1992-1 C.B. 1 and Action on Decision 1996-10, 1996-2 C.B. 1], but has indicated that it will continue to press the issue. Specifically, the IRS will seek to deny exclusions when (1) the Crummey power holders have no other interests in the trust, (2) there is a prearranged understanding that the powers will not be exercised, or (3) the withdrawal rights are not in substance what they purport to be in form [TAM 9628004, Action on Decision 1996-10]. To be safe, beneficiaries should have some other interest in the trust besides their Crummey withdrawal powers, such as being in the class of beneficiaries eligible to receive distributions under the trustee's sprinkle power.

image\bullet.jpg Serving as Trustee. It can be fatal to the arrangement for the donor to serve as trustee of the ILIT. The control the donor could exercise over the beneficial enjoyment of the trust, even though exercisable only in a fiduciary capacity, will jeopardize a key part of the ILIT strategy: to keep the life insurance proceeds out of the gross estate of a donor who expects to be subject to the estate tax.

The wealth replacement technique is not a panacea for all client situations. For example, if the donor is a substandard insurance risk, premium rates on the life policy may be higher than the CRUT payout. The efficacy of the arrangement hinges on supporting the policy from the income paid out by the CRUT.

image\button1.jpg Click here for a graphic on the wealth replacement technique.

Charity-Owned Life Insurance

Charity-owned life insurance (CHOLI) typically begins when a promoter approaches a charity and recommends the purchase of life insurance policies on consenting donors. Then the charity borrows money from an outside lender or the life insurer to pay premiums on these policies. Upon an insured's death, the life insurance proceeds pay off the loan, and any remaining funds go to the charity.

So does the charity have an insurable interest in donors or employees? How substantial must contributions have been for a charity to have an insurable interest in a particular donor? How far up the hierarchy must an employee be? Answers to these questions may vary from one state to another.

There is also the issue of whether the arrangement is for the exclusive benefit of charity. Some arrangements reportedly provide a death benefit to the insured's beneficiaries as well as charity. If charitable dollars are used to provide a personal benefit, does this violate the prohibition against private inurement?

Some estate and financial planners fear that CHOLI will attract unfavorable legislative or regulatory attention and/or litigation by unhappy heirs, which has plagued company-owned life insurance and stranger-owned life insurance.

To this end, the Pension Protection Act of 2006 installed a temporary reporting requirement with respect to acquisition of certain life insurance contracts by exempt organizationsimage\emdash.jpgcomplete the tax return to list the organization and the insurer and any other information as the Treasury wants.

Charitable Split Dollar

A 1999 federal law prohibits federal income tax deductions for contributions made to charity under "personal benefit contracts" under which there is a payment, or expectation of a payment, of the premium on any life insurance, endowment, or annuity contract that directly or indirectly benefits the donor, his family, or other related entities. This law was designed to eliminate "charitable split dollar," and followed similar regulatory action by the IRS.

Under the typical charitable split-dollar arrangement, the taxpayer created an irrevocable life insurance trust that applied for a policy on the taxpayer's life. The trustee entered into a separate split-dollar agreement with a charity which specified the proportions in which the premiums and death proceeds would be shared. The trustee designated as beneficiaries of the policy both the charity and members of the taxpayer's family, as called for in the split-dollar agreement.

The donor gave cash or property to the charity each year with the understanding that the charity would use such assets to pay its share of the premiums. The advertised benefit of this plan--before the IRS and then Congress lowered the boom on it--was that the donor's annual transfers to charity were deductible as charitable contributions, even though his family benefited.

However, the law also imposes an excise tax on charities participating in such arrangements. The tax is levied in the amount of any premium payments; that is, a 100% tax. Charities are required by the law to report annually all such payments.

Further, the IRS has indicated that a charity's federal income tax exemption could be jeopardized by participating in charitable split dollar since it is deemed to be providing a private benefit rather than carrying out its public purposes.



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