Lipscomb University, a small religious school based in Nashville, Tenn., tells alumni on its website that they can arrange to give the school $50,000 at no cost to themselves through a “Lend Your Life to Lipscomb” initiative.
As the university outlines the plan, Lipscomb takes out a $1 million life insurance policy and an annuity policy on a donor. To finance the deal, the university borrows money from a lender. A combination of a low-interest rate loan, cheap cost of insurance and high annuity payments will give the university a $50,000 profit, according to the school's marketing copy.
Sound too good to be true? Don't let that stop you, says the website. In a description of the program, Lipscomb's director of gift planning, Scott Saunders, reassures would-be donors that the program “is a legitimate opportunity for those who love Lipscomb and want to support Christian education to make a significant donation without any cost to themselves.”
One hundred and fifty Tennessee residents, ages 75 to 90, have shown their love so far.
The mastermind behind this plan is Steve Church, a Class of 1975 Lipscomb graduate, who sold the deal to the school. He said he did so after being approached by an insurance broker. Church, president of the Nashville, Tenn. financial planning firm Creative Financial Concepts, says he also has presented the idea to “several” other nonprofits, which are considering similar plans.
Charity-owned life insurance (CHOLI) has been around for a long time, and industry experts say there's usually no problem when a single donor, especially a high-net-worth one, names a charity as the beneficiary of his life insurance policy. Such a move is analogous to a corporation taking out life insurance on a key executive.
But, as with corporations who take out policies on even their lowliest employees, the trouble for charities comes when they obtain polices on pools of donors — also known as “death pools.” And lately, insurance brokers throughout the country have been pushing death-pool CHOLI hard.
These plans vary in many details, but there is a common thread: Charities turn to a third-party investor for the funds needed to purchase insurance policies on the pool of donors. Sometimes the money comes in the form of a loan, sometimes as a partnership interest and sometimes the third parties simply purchase the donors' life insurance policies outright.
Many advisors are appalled. They see nothing but problems in financed CHOLI.
Insurance policies are not usually good investment choices — and this is even truer if the policies are purchased with borrowed money, requiring charities to pay back the loan with interest before seeing a dime in profit. There's also the possibility that charities might lose their tax-exempt status if they conduct too much unnecessary business with private parties — such as by taking on an investment partner to fund life insurance. Advisors also are turned off by the unseemliness of a charity gambling with the lives of its supporters. “They're in a position of hoping people die,” says Jerry McCoy, philanthropy guru and former chair of the American College of Trust and Estate Counsel's planned giving committee.
For donors, well, the value of their lives is put, literally, in someone else's hands — and it's hard to say whose. Sometimes the investment partner is an insurance company, sometimes a bank, sometimes it's a conglomeration of different financial companies; regardless, these investment partners have the right to sell their stake in the policies to anyone. Worse case scenario: A Tony Soprano-type buys the policies of well-meaning donors.
Most states guard against the dangers of the Soprano-scenario by requiring insurance beneficiaries to have a familial relationship with the insured. One of the very few exceptions to this rule is charities. But it's unclear whether this exception holds when the charity sells its interests. It doesn't, said the New York state insurance department in July.
That might change. Industry observers are nervous, because several states, including New York, are considering legislation to allow charities to finance insurance policies by any means necessary.
Lately, there seems to be an unofficial insurance industry campaign for financed CHOLIs. Craig Wruck, chair of the government relations committee of the National Committee on Planned Giving, a group of advisors and fundraisers, estimates that two-thirds of the members have been asked to weigh in on financed CHOLI recently. “The drumbeat started a year and a half ago and accelerated last year,” he says.
Wruck is heading a task force to study the matter. His preliminary thoughts? Charities are being told that they can create money out of nothing and “you just know intuitively that that's impossible.”
Lipscomb itself put the brakes on earlier this year, after signing up 150 potential donors. The school learned that another charity is seeking a private letter ruling from the Internal Revenue Service. The lawyer making the request, J. Leigh Griffith of the Nashville, Tenn. firm of Waller Lansden Dortch & Davis, PLLC, didn't return telephone calls.
Not everyone thinks financed CHOLI is a bad idea, however — and at least one is brave enough to go on the record saying so. Stephen Wolff of the Ashton Group in Irvine, Calif., says that the numbers can work to a nonprofit's advantage. “Charities can get a very, very nice economic result,” he says. Wolff recalls that he once helped put together a similar deal where the charity's rate of return came out to 4.3 percent — all of it on money fronted by a lender.
Still, trusts and estates lawyers claim that such wins are the exception, not the rule. Insurance companies, like casinos, are skilled at making sure they come out ahead over time. This means that pools of life insurance policies are not likely to be a winning investment. Better for the charity to simply take donor money and invest it, they say.
What's more, if charities finance group policies with loans, by the time the charity pays off the loan and interest, there might be little left, warns estate planner Vaughn Henry of Henry & Associates in Springfield, Ill. He adds, “It's very hard to make a profit with borrowed money.”
Even worse for the charity, if it borrows money to buy the life insurance policies, the charity will likely have to pay the IRS unrelated business tax income, says Laura Kalick, chair of an American Bar Association subcommittee on unrelated business income tax. That's because charities have to pay tax on debt-financed income.
Another tax problem for the charities is that involving themselves in financed CHOLI might risk their tax-exempt status. Charities who take on investment partners to finance life insurance are helping those partners turn a profit. This is problematic, because charities aren't usually allowed to help private individuals make money. The consequences of violating this rule can be severe, as charities stand to lose their tax-exempt status.
Even the donors can get hurt financially. The Lipscomb website boasts that donors make this gift “without any financial outlay, liability, reduction in estate value, impact on current life insurance, or any other cost.” But there is a hidden cost about which the unsophisticated may be unaware. Insurance companies tend to limit the amount of life insurance based on any one person's total net worth. For younger people, it's roughly seven times their annual income. If a donor worth $1 million lets Lipscomb take out a $1 million life insurance policy on him, he might not be able to leave any life insurance to his family.
Some advisors say they can't imagine why a charity would ever go with a plan like Lipscomb's. “I don't think I'd ever advise them to do it,” says McCoy.
For many observers, the main problem goes beyond using insurance as a money-making tool. The most serious concern is that charities are financing these initiatives by bringing in third parties, either as lenders or outright buyers of the policies.
Although donors can name charities as life insurance beneficiaries, when the charity allows a third party financier either to purchase those policies or lend money based on the policies, the result is a total disconnect between the donors and those who will profit by their deaths.
Such a setup carries obvious dangers. What if the ultimate policyholder is with organized crime? What if they're wiling to murder to “accelerate their interests,” asks renowned estate planning expert Steve Leimberg of Bryn Mawr, Penn.
Supporters of financed CHOLI say that critics are being overly dramatic. “People's visceral response is that a third party should not own life insurance,” says Wolff. “I'm hard-pushed to see why that's so unacceptable.”
For now, such plans are seen as violating at least the spirit of laws allowing charities to own life insurance on their donors. In New York, for example, the state insurance department's general counsel office issued an opinion last July nixing a charity's plan to finance insurance policies with bonds in which the policies served as collateral.1
The general counsel's office deemed the plan unlawful under New York law, noting that the “sponsors receive only a small portion of the economic benefit of the annuities and policies, and have, as a practical matter, a clouded ownership interest in the annuities and policies.”
A movement is now afoot to change the insurable interest laws in several states, including Florida, Louisiana, Maryland and New York. In New York, for instance, State Senator James L. Seward introduced S. 6678 on March 30, whose stated justification is to allow charities “to utilize funding vehicles or other entities to facilitate the purchase of life insurance,” according to the bill's supporting memorandum. It would allow charities to designate any “person, firm, association, trust or corporation” as beneficiary, provided the insured person consents. The bill is on hold for now, said a staffer in Seward's office. Seward introduced the bill after being approached by a “compilation of companies.” The staffer declined to name those companies, other than to say that they weren't charities.
Even if states decide to let charities get involved with financed CHOLI, the Treasury Department may have other ideas. For now, a Service spokesman says only that the IRS is aware of concerns regarding financed CHOLI and is looking into it.
Lately, though, the IRS has been cracking down on both life insurance schemes and charities. Just last month, the Service put charities on notice that they'll be considered as participants in listed transactions if they accept nonvoting shares of S Corporation stock in deals that help the corporation's shareholders avoid income tax (See “Charitable Giving,” page 14.) And using life insurance as an investment vehicle is exactly the sort of thing that attracts the department's attention. Just this February, the government killed two popular strategies using life insurance in executive compensation and estate planning that involved undervaluing policies (See “A Whole New Game,” Trusts & Estates, April 2004.)
Ultimately, some fear that Congress may rewrite the laws. “Life insurance in itself gets favorable tax treatment because of its beneficial nature to the community,” says Henry. That is, life insurance prevents widows, widowers and children from becoming paupers when the breadwinner dies. And for that reason, it isn't taxed. But, says Henry, that may change if Congress or the Treasury Department thinks life insurance has become nothing more than a wager. “I don't want the IRS swatting flies with sledgehammers.”
Others think the IRS need not go that far. After all, the Service can perform a surgical strike against financed-CHOLI. “If I were you,” McCoy tells a reporter, “I'd worry about being too fair and balanced about this. It's probably going to be illegal by the end of the year.”
- New York State Insurance Department, Opinion of the General Counsel, 03-07-39, issued July 7, 2003, www.ins.state.ny.us/rg030739.htm.