Many older clients have little use for their life insurance policies, yet they never consider donating them to charity. In fact, more than 75 percent of all life insurance policies no longer meet their owners' original needs, and policy owners let them lapse or cash them in prior to death. Maybe it's time to get creative and think outside the box. Sort of like someone who designs a new and different use for an old auto engine: Its mission may be obsolete, but its efficiency is without fault. Indeed, that old auto engine (aka the life insurance policy) can be viable as a tangible gift and have enormous impact on a donor's current income and his estate.
Older clients who donate life insurance policies to charity can reap great rewards through large tax deductions and create extra cash flow that can be put towards retirement needs. Thus, monetizing this asset — typically seen as having little or no current value — actually creates many options, like supporting a favorite charity, adding directly to retirement funding, buying membership in a senior community or some combination of all three.
But here's the catch: To maximize the benefits of a client's donation of an insurance policy, trust professionals must be aware of several potential problematic issues. These issues include making sure an insurance policy is valued correctly and choosing an appropriate, qualified appraiser1 while actively shepherding the policy gift through the appraisal process. Here's a map to help you navigate the road for clients wanting to donate their life insurance policy to charity.
To understand life insurance appraisal, one must first redefine a policy's fair market value (FMV). In the ordinary course of business, FMV is defined as “the price that property would sell for on the open market. It's the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.”2 The value of the deduction for a gift of a life insurance policy, however, is its FMV reduced by the amount of gain that would have represented ordinary income to the donor, had he sold or surrendered the policy.3 Therefore, if the policy owner gifts the policy to a qualified charity, the amount deductible will be either the interpolated terminal reserve (for the most part, the cash surrender value) or the total net premiums paid, whichever is less. Separately, in dealing with a paid-up policy, FMV is the replacement cost that an insurance company would charge for a comparable contract with current dating.
Complicating this process is the fact that it's quite likely that among “seniors” (65 years and older), the gross FMV will be influenced by the potential selling price in the secondary market. This is the same secondary market activity as would be found in the resale of a home, an automobile or a piece of art. An average of $10 billion to $12 billion worth of life insurance has been sold in the secondary market each year from 2006 through 2009, ensuring its credibility as a market determinant before the Internal Revenue Service.
If a policy owner is a senior, the actual current market value may be determined by use of a medically underwritten life expectancy report. The result of this exercise might show a shorter than normal life expectancy which, by predicting that the benefit might be available sooner, would give it a higher internal rate of return, resulting in an enhanced current FMV that could exceed the net cash value and/or replacement cost. If this value does increase the “willing buyer/willing seller” value beyond the cash surrender value, then this value, in excess of the cash value, will be considered capital in nature. Thus, the older policy owner may be entitled to a deductible amount in addition to the lesser of net cost basis or the cash surrender value.
Because there are so many types of life insurance available, policies have been prone to inaccurate valuations. Valuation problems have emerged because of shifting ownership of policies or beneficiary issues. For instance, the IRS has denied deductions as “unsupportable” because there are revocable beneficiary designations. Preserving control of this right constitutes the retention of a partial interest and doesn't meet the test of complete divestiture of ownership as required by the partial interest rules.4 (More on partial interests, later.) Moreover, clients often misunderstand how to apply FMV principles, which may result in misguided valuations and egregious deductions. Historically, for example, donors have improperly used a policy's total death benefit, cash value or settlement value for a policy's FMV — without taking into consideration how the original cost basis affected the deduction. I've watched experienced professionals gasp when they learn that the cash value isn't the amount of the deduction!
Proposed Appraiser Qualifications
The second step is to contact a qualified appraiser who meets the requirements of the soon-to-be-enhanced appraiser credentials and understands the insurance industry and the secondary market. Because of a dramatic increase in tangible property deductions, the Congressionally authorized Appraisal Qualification Board (AQB) of the Appraisal Foundation on Oct. 26, 2010 issued its “First Exposure Draft of Proposed Personal Property Appraiser Qualification Criteria” (Criteria). The AQB last adopted criteria for personal property over a dozen years earlier on July 30, 1998; it anticipates ultimately adopting the bulk of these proposed 2010 revisions sometime this year.
An appraiser's qualifications are extremely important because an appraisal that's poorly written or signed by an unqualified person will result in the IRS denying the deduction. It will no longer be acceptable to have an unqualified attorney, certified public accountant or insurance agent prepare an appraisal. In fact, the Criteria propose the following new requirements to ensure that an appraiser is qualified:
- Qualifying education (academic) — A minimum of an Associate degree or higher, from an accredited, degree-granting college or university. In lieu of the Associate degree, an applicant must successfully pass 21 semester credit hours from any one or more collegiate subject matter courses such as principles of economics, accounting or finance, statistics, business law and business administration;
- Qualifying education (specific) — A total of 135 creditable classroom hours, which includes 15 classroom hours on the “Appraisal Foundation's 15-Hour National Uniform Standards of Professional Appraisal Practice Course” (USPAP), or its AQB-approved equivalent. At minimum, applicants must complete and successfully pass a course examination for courses in valuation theory or principles of valuation (minimum of 30 hours) and the appraisal process, specific to the valuation of personal property. Experience may not be substituted for qualifying education;
- Qualifying education must include (no substitutions will be accepted) — USPAP, ethics, the appraisal process, types of appraisal and appraisal reports, practices and procedures, uses of appraisal reports, definitions of values and types of values, valuation theory and principles, definitions of markets, market research and analysis, methods of property identification, legal and regulatory considerations and report writing;
- Experience requirements — Seven hundred hours of personal property appraisal experience in areas of specialization and 1,800 hours of market-related personal property appraisal experience, of which 900 additional hours are in areas of specialization; or 4,500 hours of market-related personal property non-appraisal experience in areas of specialization; and
- Continuing education requirement — Every five years, the appraiser must fulfill 70 hours of instruction in courses and seminars, with a minimum of 20 hours of course work in valuation theory.
Current Appraiser Requirements
The proposed requirements aren't only significant, but also are particularly remarkable in that very few education or experience requirements now exist to qualify as an appraiser.
Considering the depth of the proposed requirements and the likelihood of their acceptance this year, it's appropriate to keep in mind the less stringent Treasury Regulations Section 1.170A-13(c)(5)(i) that currently defines a qualified appraiser as one who:
- Holds himself out to the public as an appraiser and performs appraisals regularly;
- Is qualified to make appraisals of the type of property being valued, as determined by the appraiser's background, experience, education and membership, if any, in a professional appraisal association;
- Is independent; and
- Understands that an intentionally false overstatement of the value of the appraised property may subject the appraiser to civil penalties.
Internal Revenue Code Section 170(f)(11) requires an appraiser to have earned an appraisal designation from a recognized professional appraiser organization or otherwise meet minimum requirements for education and experience specified by the Secretary of the Treasury. Under transitional terms of IRS Notice 2006-96, appraisers may meet minimum requirements by having successfully completed college or professional-level coursework relevant to the property being valued, plus two years of experience in the trade or business of buying, selling or valuing that type of property. Appraisers must describe this education and experience in the appraisal. They must also prepare their appraisal based on demonstrated competence in valuing the type of property in the appraisal. Relevant education in this field can be attained through the designation of Chartered Life Underwriter or Chartered Financial Consultant.
Understanding the Appraisal
You've learned the basics of life insurance policy FMV and helped your client identify an appraiser. Now what? The third and equally important task is to understand what information the IRS specifically requires in an appraisal. For the IRS to accept a deduction, an appraiser-signed Form 8283 that establishes the amount deducted, must accompany the tax return. Although there's no specific format for an actual appraisal of an insurance policy or any other tangible asset, a good starting point is IRS Notice 2006-96, “Guidance Regarding Appraisal Requirements for Noncash Charitable Contributions.”5 That Notice says that the IRS will treat an appraisal as having been conducted in accordance with generally accepted appraisal standards if it's consistent with the substance and principles of USPAP as developed by the Appraisal Standards Board of the Appraisal Foundation.6 If the amount of the deduction being claimed is $5,000 or more, the donor is required to obtain a written appraisal and fill out Section B of Form 8283,7 and if the deduction exceeds $500,000, or, as in the case of fine art, $50,000, the appraisal must accompany the return.8 Section B, Part I of Form 8283 contains information relating to the donated property itself. Part II is the signature declaration by the donor that identifies all donated items that have been appraised at a value of less than $500 each.
Part III contains the appraiser's binding declaration that reflects all of the changes made by the Pension Protection Act of 2006 — specifically, an acknowledgment that the appraiser or anyone acting as the appraiser may be subject to a gross valuation misstatement penalty and that there's no longer a reasonable cause exception to a valuation misstatement. For appraisals that result in a substantial tax valuation misstatement causing an undervaluation (within the meaning of IRC Section 6662(g)) or gross valuation misstatement (within the meaning of IRC Section 6662(h)), the appraiser or signatory of Form 8283 may be liable for a penalty. The penalty amount is the lesser of (1) the greater of $1,000 or 10 percent of the amount of an underpayment attributable to the misstatement, or (2) 125 percent of the gross income received by the appraiser for preparing the appraisal.9
Generally, the IRS will disallow a charitable contribution if a taxpayer contributes less than his entire interest in donated property. This is known as the partial interest rule. (Remember the valuation problems mentioned above of keeping the right to change the beneficiary!) So the question is, consistent with the partial interest rule, can a taxpayer holding a term or cash value life insurance policy convert a portion of his old policy and in exchange, receive two brand new policies, one of which he'll donate to charity? The IRS says “yes.” In its General Information Letter,10 the IRS states that:
If a taxpayer exchanges an insurance policy for two new, separate and distinct insurance policies, and donates one to charity, that contribution would generally not violate the partial interest rule. Likewise, if a taxpayer has his or her insurer reduce the old policy's death benefit in exchange for the insurer issuing a new policy that is then contributed to charity, that contribution would generally not violate the partial interest rule.
But the next question is, how do you design and value a multifaceted policy for donation? That's where an appraiser fits in. A qualified appraiser who's properly credentialed will certainly be sensitive to all contractual options available to the insured, such as partial conversion or IRC Section 1035 exchanges, and will address any option that will enhance all or part of the value of the policy. That is, a qualified appraiser will use all of the tools available to him for the insured (including, as previously noted, the secondary market) and will incorporate all of the benefits he accumulated during the development of his appraisal document.
- At its organizational meeting on Jan. 30, 1989, the Appraisal Standards Board (ASB) unanimously approved and adopted the original Uniform Standards of Professional Appraisals Practice (USPAP) as the initial appraisal standards promulgated by the ASB. The purpose of the USPAP is to establish requirements for professional appraisal practice, which includes appraisal, appraisal review and consulting, as defined. The intent of the USPAP is to promote and maintain a high level of public trust in professional appraisal practice.
- Internal Revenue Service Publication 561, p. 2.
- Under Internal Revenue Code Section 170(e)(1)(A), there won't be a federal income tax deduction for appreciation that represents unrealized ordinary income or short-term capital gain.
- 26 C.F.R. 1.170A-7.
- “Guidance Regarding Appraisal Requirements for Noncash Charitable Contributions,” Notice 2006-96, Internal Revenue Bulletin 2006-46 (Nov. 13, 2006), www.irs.gov/pub/irs-drop/n-06-96.pdf.
- The Appraisal Foundation bases the USPAP on the original USPAP developed in 1986-1987 by the Ad Hoc Committee on Uniform Standards and copyrighted in 1987. Prior to the establishment of the ASB in 1989, the USPAP had been adopted by major appraisal organizations in the United States and had become recognized as the generally accepted standards of appraisal practice.
- See www.irs.gov/pub/irs-pdf/f8283.pdf.
- See www.irs.gov/instructions/i8283/ch02.html.
- See www.irs.gov/irm/part20/irm_20-001-012.html.
- Info 2009-0127 PLR-P-101523-09 (April 9, 2009), www.irs.gov/pub/irs-wd/09-0127.pdf.
Alan Breus is the managing partner of The Breus Group, LLC in San Diego, Calif.