The important, but complicated and sometimes scary role of life insurance in charitable giving
I am a bit of a spiritual seeker. Last summer, in search of the meaning of life, I trekked up one of the highest peaks in the Himalayas to seek the answer from two gurus who live in adjacent caves. The first guru told me that the key to the meaning of life is generosity. The second guru had a distinctly different point of view. She told me the key to the meaning of life is more life insurance.
Confused by what seemed to be conflicting answers, I struggled for days to reconcile the advice of the two gurus. After a great deal of soul searching, I came to the epiphany that “generosity” and “more life insurance” could be reconciled. I would buy a $1 million single premium paid-up life insurance policy and give it to my favorite charity, thereby obtaining the true meaning of life.
After being poked and prodded by the insurance physician and providing a tremendous amount of personal information to the insurance company, I obtained my policy and set off immediately to give the policy to my favorite charity. To my great disappointment, the charity refused to accept my offering. The charity's planned giving officer proceeded to tell me that the charity had adopted a written policy in recent years prohibiting the acceptance of gifts of life insurance because of abusive schemes involving charities and life insurance. Wasn't I aware of the dreaded charitable reverse split-dollar scheme in which participating charities could potentially lose their tax-exempt status? How about the charitable variation of stranger-owned life insurance, known as charity-owned life insurance or CHOLI, in which charities would lend the insurable interests of some of their older donors to private investors with the hope that the charity would receive the financial crumbs if the transaction succeeded (which was by no means guaranteed)? She also informed me of policies in which premiums were supposed to vanish after a certain number of years, only to mysteriously reappear later. “It's too much trouble, Dave,” she said. After I told her that I preferred to be called David, I left dejected.
Could the two gurus have been wrong? Maybe the thin air at such high altitudes had clouded their judgment. Or maybe I had misinterpreted their advice. What about the planned giving officer? Could her advice be trusted?
I decided to find out the answer for myself. I read everything I could about the confusing relationship between life insurance and charities. I ultimately concluded the gurus had generally been correct that life insurance could be a very effective way to show generosity to charity. I also learned that there had been serious abuses as well. But it was clear that with a little education, charities could avoid the abuses and there was no need to have a blanket policy rejecting all charitable gifts of life insurance.
Why Life Insurance?
Of all of the asset classes out there, why would a donor want to use life insurance for charitable giving? One answer is scale. There's approximately $11 trillion of life insurance currently issued and outstanding in the United States — that's about twice the value of all qualified retirement assets. Many individuals have large, valuable life insurance policies that they purchased for purposes that no longer exist. The kids have grown up, the business has been sold — but the policy remains. Cashing it in can have negative tax consequences, so why not make a gift of the policy to a favorite charity? Sometimes, donors want to make a large gift to charity but they don't have large assets they can part with without negatively impacting their families. Why not purchase (or better yet, have the charity purchase) a large life insurance policy that will pay proceeds to the charity at the donor's death? By paying small premiums each year, the donor can leverage his gift dramatically. Some commentators call this purchasing “immortality on the installment plan.” Life insurance allows donors with smaller assets to make large gifts, which many times are used to establish an endowment fund at a charity in the donor's name. Also, don't forget that the donor will typically get an income tax charitable deduction upon transferring the policy to charity and for any subsequent premium payments.
The challenge for both a donor and the charity is that life insurance is a very difficult asset to understand. The scope of the life insurance industry and the vast number and types of life insurance available make it difficult for anyone other than an expert to truly understand the alternatives and choose appropriately. Thus, both the donor and the charity are typically dependent on the expertise and integrity of an insurance professional. While the vast majority of insurance professionals are honest and well trained, a small number are not. This small minority of insurance professionals, who see charities and their donors as easy prey for high commissions on high risk insurance products, have burned many charities.
Although there is some federal regulation of life insurance, it's primarily regulated at the state level. Some states, like New York, are very aggressive in their regulation; some are less so. The state where the insured lives determines the regulation of a particular life insurance product. In the most egregious circumstances, such as if a large group of charities becomes involved with a widespread, packaged insurance technique like charitable reverse split dollar or CHOLI, state attorneys general (as the protectors of charitable gifts in their states), the Internal Revenue Service, and even Congress will get involved to shut down a particularly abusive strategy involving life insurance and charities.
Because abusive techniques can put a charity's tax-exemption at risk, it's no wonder many charities shy away from life insurance as a gift. But note that the insurance itself is not the problem. The problem is the way it's being packaged and sold. Plain vanilla gifts of life insurance and even some sophisticated strategies using charitable remainder trusts and charitable lead trusts can be completely valid. Donors and charities should, however, be very wary of charitable insurance strategies that appear too good to be true (particularly if those strategies involve premium financing and/or any benefit to an individual other than a donor's charitable deduction).
Types of Life Insurance.
Although it's possible to gift virtually every type of life insurance to charity, some types are more appropriate than others. Term insurance (sometimes known as temporary insurance) is the least appropriate for charitable giving because it's structured to end before a donor's life expectancy. So, if a donor lives until or past his life expectancy, there will be nothing for charity. Term insurance (which is also the least expensive of all of the types of life insurance) can either be purchased as an individual policy or can be provided under a group policy (typically for employees). Term insurance doesn't build up cash values, so there's little tax advantage of making an outright gift of a term policy to charity. The most typical way to use term insurance for charitable giving is for a donor to make the charity the primary or contingent revocable beneficiary of some or all of the proceeds from the policy.
Permanent life insurance, on the other hand, is the most appropriate form of life insurance to give to charity during a donor's lifetime. As its name reflects, permanent life insurance is expected to be in effect when the insured dies. Having said that, underfunded permanent life insurance policies (typically universal or variable life), may not have sufficient assets to pay the cost of insurance and may lapse before an insured's death. The key difference between term insurance and permanent insurance is that term insurance provides only a death benefit while permanent insurance provides both a death benefit and a cash accumulation account. Hopefully, the cash accumulation account will increase over time to offset the increasing mortality costs of the insurance as the insured grows older — so the life insurance remains in place until the insured's death. Permanent life insurance comes in a wide variety of choices and prices depending on the nature of the cash accumulation account and the guarantees provided in the particular policy by the issuing life insurance company.
Whole life insurance is the most traditional form of permanent life insurance as well as the most expensive. If an insured pays the required premium, the insurance company is contractually obligated to pay the death benefit. It's this guarantee that makes whole life insurance the most expensive. Whole life policies build up cash values that are invested in the insurance company's “general account.” Whole life policies sometimes pay dividends, which help to build up the policy's cash value over time.
Universal life is a form of permanent life insurance with fewer guarantees; it was developed as a response to the high cost of purchasing whole life insurance. In a typical universal life policy, there's an insurance account and a cash accumulation account that is credited with monthly interest based upon the insurance company's current crediting rate. There is a target premium set at the time the insurance is purchased, but the insured isn't required to make the target premium payment. In addition, even if the target premium is paid every year, the assumed interest crediting rates fluctuate with the market, and if interest rates go down over time, the insured will either need to pay a higher premium to keep the policy in place or let the policy lapse. Due to the risks to the insured of universal life, particularly in a situation in which a death benefit is necessary but the cost of whole life insurance is prohibitive, many insurance companies have created in recent years a form of universal life that reduces the emphasis on cash value growth in exchange for death benefit guarantees. Known as guaranteed universal life, this product has become extremely popular in the estate-planning context where the need for cash value is far less important than the need for a guaranteed death benefit.
The final type of permanent life insurance, and the most risky, is variable life insurance. Variable life insurance was developed in response to the tremendous returns generated by equities in the 1980s and 1990s. Like traditional universal life, variable life has two separate accounts — an insurance account and an investment account. But unlike universal life in which the investment account is invested conservatively in money markets and Treasuries, a variable life policy gives the insured the ability to choose to invest the investment account in a variety of mutual funds, some of which invest in equities. In a growth market the idea works well. In a down market like the one we've seen over the past decade, the strategy is a recipe for disaster because the investment account will not be able to keep pace with the increasing cost of insurance, and the insured will either have to significantly increase premiums or let the policy lapse. Because of this inherent risk of variable life policies, they have fallen out of favor to some extent in recent years.
Since virtually all permanent life insurance policies build up cash values, they are appropriate for lifetime gifting because the donor should be entitled to a significant income tax charitable deduction when transferring a permanent policy. How the deduction is calculated depends on the type of policy and also on whether the policy is considered paid-up or whether there are still premiums required to be paid.
Contributing Life Insurance
There are many ways to use life insurance in charitable giving. A donor can contribute an existing permanent life insurance or term policy during his lifetime. In addition, a donor can leave the policy at death to charity by naming the charity as a revocable designated beneficiary. The charity can purchase a life insurance policy on the donor, and the donor can contribute the amount necessary to pay the premiums. Each of these techniques is subject to different federal tax and state law rules:
Contributing existing life insurance to charity — A donor can typically contribute an existing life insurance policy to charity and obtain an income tax charitable deduction. The amount of the income tax charitable deduction will depend on the nature of the policy. For a donor to receive an income tax charitable deduction for a contribution of life insurance to charity, a donor must relinquish all “incidents of ownership” that the donor has in the policy. If a donor doesn't relinquish all incidents of ownership, the income tax charitable deduction is disallowed as an improper partial interest gift (where the donor gives less than all ownership rights in a particular asset), and the donor will also be subject to gift tax on the transfer (because a gift of a partial interest in property also doesn't qualify for the gift tax charitable deduction). So what are the incidents of ownership that a donor must relinquish to be permitted a charitable deduction for a transfer of life insurance to charity? Incidents of ownership in a life insurance policy include (but are not limited to) the following rights and powers: (1) the right to change the policy beneficiary; (2) the right to surrender or cancel the policy; (3) the right to assign the policy; (4) the right to revoke the assignment of the policy; (5) the power to pledge the policy as collateral for a loan; (6) the power to borrow against the policy; and (7) the right to a reversionary interest in the policy or the policy proceeds, unless such reversionary interest is so remote as to be negligible.
Assuming the donor has relinquished all incidents of ownership when transferring the policy to charity, he should be entitled to an income tax charitable deduction and a gift tax charitable deduction. Calculating the value of the deduction depends on whether the contributed policy is a permanent or term policy. Life insurance is considered under federal tax law to be an ordinary income asset (that is, an asset that will not produce capital gain income upon sale). When a donor contributes a capital asset held long-term, the donor is typically entitled to a full fair market value (FMV) deduction for the contribution, particularly if the recipient is a public charity. That's why advisors suggest that contributions of low-basis capital assets are the most tax-efficient form of asset to give to charity, because the donor is not only entitled to a full FMV deduction for the contribution, but also is able to avoid any tax on the built-in capital gain. Ordinary income assets, like life insurance, are treated less favorably under federal tax law. The general rule for contributions of ordinary income property is set forth in Internal Revenue Code Section 170(e)(1)(A), which states that a donor of ordinary income property will only be entitled to an income tax charitable deduction for the lesser of: (1) the FMV of the contributed asset; and (2) the taxpayer's tax basis in the asset.
So, when a donor contributes life insurance to charity, he's entitled to a deduction for the lesser of his tax basis in the policy (generally total premiums paid as of the date of the gift less any dividends received in cash) and the FMV of the policy which, for policies that have been in place for a long time, can be significantly higher than the tax basis. This loss of deduction for the difference between the FMV and the tax basis can act as a disincentive for some donors to contribute life insurance to charity. In fact, under certain circumstances, it's more tax-efficient to first surrender the policy and contribute the after-tax proceeds to charity.
How FMV is determined for gifts of life insurance depends on the nature of the contributed property. If a permanent life insurance policy is fully paid-up (that is, no additional premiums remain to be paid), FMV is equal to the replacement cost for the policy which, according to Treasury Regulations Section 2512-6(a), example (3), is the cost of a comparable single premium policy. If the policy is not fully paid-up (that is, premiums remain to be paid), the policy's FMV is calculated using what's referred to as the policy's “interpolated terminal reserve.” Interpolated terminal reserve is a number you must request from the insurance carrier; it typically represents an amount that's slightly higher than the policy's cash surrender value. If premiums remain to be paid and the donor pays them, the payment entitles the donor to an income tax deduction for the full value of the payments; up to 50 percent of adjusted gross income (AGI) if the payment is first made to the charity, or up to 30 percent of AGI if the payment is made directly to the insurance company.
In certain cases, for both paid-up policies and policies in which premiums remain, if a donor's health is impaired, FMV may be higher because of the greater chance the donor will die within a short period of time. If a donor contributes a permanent policy to charity that the donor has purchased within one year of transfer to charity, the value of the charitable deduction is the gross amount of premium paid from the date purchased until the date of transfer. For contributions of term insurance policies (typically a bad idea), the value of the charitable deduction is considered to be the unearned premium as of the date the term insurance is contributed to charity.
Note that if a donor contributes an existing policy and dies within three years of the transfer, the value of the insurance will be brought back into the donor's taxable estate under IRC Section 2035, but there will be a full offsetting estate tax charitable deduction under IRC Section 2055(a).
If the value of the contributed insurance policy is $5,000 or more, a donor must obtain a “qualified appraisal” from someone other than the insurer or the selling agent. In addition, the donor must file (and the charity must sign) an IRS Form 8283, attaching an appraisal summary or the charitable deduction will be disallowed.
Designating a charity as the beneficiary of a policy — Although a donor doesn't receive an income tax charitable deduction, it's very common for a donor to name a charity as a revocable primary or contingent beneficiary of a life insurance policy. The donor can retain all of the incidents of ownership in the policy and can replace the charity at any time. At the donor's death, if a charity is still named as a beneficiary, the charity will receive the proceeds and the estate will receive an offsetting estate tax charitable deduction for the amounts passing to charity.
Sometimes a charity will offer to give a donor credit in a capital campaign for a bequest of life insurance if the donor makes the charity the irrevocable designated beneficiary of the insurance. This is a very bad idea because the donor has not parted with all of his incidents of ownership in the policy and therefore runs afoul of the partial interest rule, whereby the donor will have made a taxable gift to charity.
Purchases by charity of insurance on donors — Although there have been abusive situations, like CHOLI, in which a charity purchases insurance on a group of donors, most situations in which a charity purchases insurance on a key donor or group of donors are totally legitimate. Typically, a charity will purchase a policy at the request of a key donor (although the charity can also suggest the purchase) and the donor will make the premium payments, for which the donor will receive an income tax charitable deduction. Often, the purpose of the insurance is to enable the donor to make a larger gift than he would otherwise make by paying the premiums over time. The insurance proceeds are typically used to create a special fund named after the donor or an endowed chair in his honor. The goal of the charity is to convince the donor to come up with new money to pay the premiums, rather than cannibalizing his existing giving. Although the purchase of life insurance by charities is typically done on a one-off basis, sometimes it's part of a packaged transaction to attract a group of donors to pay the premiums on insurance on their lives owned by their favorite charity. Even packaged transactions can be completely legitimate as long as the only entity benefiting from the insurance proceeds is the charity.
Charities, under virtually every state law, have what is known as an “insurable interest” in their donors. That's why charities can purchase insurance on a donor. Not everyone has an insurable interest on everyone else — and for good reason. The justification for the insurable interest rule is that it discourages people from wagering on the lives of others and discourages committing murder to collect insurance proceeds. Therefore, only people who are likely to either receive a financial benefit while the insured is alive or who would incur a financial loss if the insured died are entitled to purchase insurance on the insured. Typically, only family, business partners and charities are entitled to buy life insurance on an individual.
A few years back, some clever investors decided that they could profit from the fact that a charity has an insurable interest in its donors. This technique became known as CHOLI. The charity would lend these investors their insurable interest in certain elderly donors, and the investors would then purchase significant amounts of life insurance on those donors using a variety of structures that typically involved premium financing. While the private investors would walk off with large transactional fees and significant upside if an insured died, there were typically no guarantees of any amounts going to the charity and if there were, they were de minimis. In 2006, Congress mandated a study by the Treasury to address whether these transactions were improper tax shelters. In the interim, Congress required that the participating charity disclose such transactions to the IRS.
The Treasury released its report1 to Congress on April 2, 2010. The report raises issues about whether benefiting these private investors could somehow put the charity's tax-exempt status at risk. The report also recommends legislation that would make the insurance proceeds taxable to the private investor (typically life insurance proceeds are income tax free). The net effect of the report should be to put an end to all CHOLI transactions. In addition, charities should run, not walk, away from any insurance strategies that include a private benefit as such transactions could put a charity's tax exemption at risk. If the technique sounds too good to be true, it probably is. Charities that are approached by promoters of insurance strategies should either say no, or if the strategy looks legitimate, have their outside advisors vet the transaction and issue a written determination as to its viability. There are, however, several sophisticated estate-planning techniques involving charities and life insurance that are safe. Insurance can be owned by both charitable remainder trusts and charitable lead trusts, sometimes with some very exciting results. In addition, it's very common to use life insurance as a wealth replacement technique for an asset otherwise passing to charity.
With this knowledge in hand, I re-approached the planned giving officer to explain what I had learned about the intersection of life insurance and charities. My knowledge didn't fall on deaf ears — she was able to get board approval to accept my gift of a $1 million paid-up life insurance policy. Although I wasn't certain that I had found the meaning of life, I did feel good about the fact that I had not only been able to make a gift to my favorite charity, but also had helped their fundraising in the long run: Now they understand that life insurance under the right circumstances and with the right intentions can be a very effective type of charitable gift.
David Thayne Leibell is a partner in the New York and Stamford, Conn. offices of Wiggin and Dana, LLP
Spring Into Action! Liu Ye's print “A Composition for Mondrian & Dreaming of Mondrian,” (2 works) about 31 inches by 80 inches, sold for U.S. $20,119 at Sotheby's “Contemporary Asian Art” auction in Hong Kong on April 5, 2010.
Spring Into Action! Yue Minjun's oil on canvas “On the Lake,” about 71 inches by 182 inches, painted in 1994, sold for U.S. $1,887,691 at Sotheby's “Contemporary Asian Art” auction in Hong Kong on April 5, 2010.