A private foundation (PF), which can exist in perpetuity, extends a legacy of charitable work beyond the donor’s lifetime. And when a PF is buttressed with a life insurance policy, funding for that charitable work can continue without tapping other assets that the donor might wish to convey to heirs, including the family home, business and investment portfolio.
There are three key benefits for founders, heirs and PF board members of incorporating a life insurance policy into a PF.
Founders. A life insurance policy ensures that support for favorite charitable organizations and work on important issues continues long after one’s death.
Heirs. Because a life insurance policy can provide the PF with a dedicated source of funds, those funds need not come out of the estate’s other assets, preserving them for the donor’s heirs.
PF. Unlike the value of other assets that could be contributed to a PF, such as real estate, securities and private equity, the death benefit of some life insurance policies doesn’t fluctuate over time. Knowing the fixed dollar value of the policy helps the board plan and budget for future grantmaking and operations.
Benefits of Using a Life Insurance Policy with a PF
In addition to the benefits addressed above, PFs stand to reap these other significant advantages from the use of life insurance policies:
- High leverage. Relatively small premium payments can result in a large and significant future charitable gift. For example, the PF beneficiary would be assured the full death benefit even if the insured dies after only a few premium payments have been made.
- Certainty. The PF may be able to provide a more precise and reliable gift to charity through life insurance than through alternative methods, because the death benefit is certain and not subject to market fluctuations.
- Exemption from estate and income tax. Naming the PF as the beneficiary eliminates the cost, delay and uncertainty of probate. No portion of the benefit will be lost to federal estate or state death taxes, state or federal income taxes, administration or estate settlement costs or other charges.
- Exemption from excise tax. The death benefit portion of the amount payable to the PF on the insured’s death will not be subject to the usual excise tax on net investment income.
- No statutory limitation on charitable gifts. A few states have so-called “mortmain statutes,” which provide that gifts to charity made by a will executed within a relatively short period before the testator’s death can be disallowed. Life insurance payments, however, typically aren’t subject to such limitations.
- Stress-free gift. From the PF’s perspective, there’s much less administrative burden associated with maintaining a life insurance policy than for real estate or other similar assets. For example, there’s no complex or expensive valuation procedure nor is there concern about potential environmental liability.
Options for Using a Life Insurance Policy
There are several ways to provide the benefits of a life insurance policy to a PF:
- Designate the PF as the policy’s beneficiary. A PF can be designated as the beneficiary of a life insurance policy owned by the insured. At the insured’s death, the policy’s death benefit would pass to the PF, and the estate should be eligible to receive an off-setting charitable estate tax deduction. Note that it’s not possible to both own the policy and receive an income tax deduction—even if the PF is named as the beneficiary. Under the partial interest rules, the donor must part with all (not merely some) of the incidents of ownership in a policy to qualify for a charitable income tax deduction. If the insured continues to own the policy even partially, he wouldn’t be entitled to a charitable deduction.
- Donate a policy directly to the PF. Another option would be for the insured to both name the PF as the policy’s beneficiary and donate the policy to the PF, transferring all incidents of the policy’s ownership. The benefit for the insured donor is that on contributing the policy, he could claim a charitable income tax deduction that would be the lesser of the policy’s fair market value (FMV) at the time of donation and his basis in the policy. Of course, once the PF owns the policy, the policy’s donor may not retain the right to:
- Change the beneficiary
- Borrow against the policy
- Surrender the policy
- Cancel the policy
- Assign the policy
- Revoke the assignment
- Pledge the policy for a loan
- Obtain a loan from the insurer against the policy’s surrender value
- Have the PF purchase a new policy. A PF can purchase a new life insurance policy on its key officers and employees, assuming that the PF has an “insurable interest” in the insured under state law. Under this straightforward approach, the PF would be the policy’s sole and unconditional owner and beneficiary of the death benefits from the policy’s inception.
Financial Considerations and Best Practices
Although life insurance policies provide significant benefits for PFs, there are some important considerations.
- Maintaining liquidity. One potential area of concern is whether the PF has sufficient liquidity to cover the payment of the policy’s premiums. A PF may make these payments, provided that its board has concluded that doing so represents a prudent course of action. Such payments, however, aren’t typically treated as qualifying distributions (that is, they won’t count towards meeting the annual 5% minimum distribution requirement) because the ownership of a life insurance policy isn’t related to a PF’s administration or the carrying out of its exempt purpose. To offset the burden of paying for the premiums, the PF’s donor could make unrestricted charitable donations to the PF, which the PF could use to pay the policy’s premiums. To ensure sufficient liquidity, many wealth managers recommend that if a life insurance policy accrues value (for example, whole, universal, variable, etc.), that value shouldn’t comprise more than 20% to 30% of the PF’s investment portfolio.
- Valuation. For purposes of determining a policy’s FMV in connection with calculating a PF’s annual 5% minimum distribution requirement, any policy that accrues value over time should be valued once per year (at the same time every year) based on its cash surrender value.
- Gross investment income. Typically, investment-related fees or payments would reduce a PF’s gross investment income, thereby reducing its excise tax liability. However, premium payments made by a PF on a life insurance policy don’t qualify as a deduction from gross investment income because the death benefit payable on the insured’s death isn’t subject to taxation. The PF may be required to include in its gross investment income the amount by which the dividends credited to a life policy’s cash surrender value exceeds the premium payments made on that policy.
- UBTI and loans. A PF can take out a loan against a whole life policy’s cash surrender value and use the loan proceeds to purchase investment assets. However, in doing so, the PF may be required to report unrelated business taxable income (UBTI) in respect of the income generated by assets purchased with the loan proceeds. UBTI is taxed at for-profit income tax rates instead of the usual 1.39% excise tax rate and is reported on IRS Form 990-T.
- Alternate beneficiaries. The PF should consider designating one or more public charities as backup beneficiaries in the event that the PF no longer exists at the time the policy’s death benefit is paid. PFs are the charitable vehicle of choice for donors who want to make a strong philanthropic impact, reap substantial tax benefits and retain complete control of their assets. When used in conjunction with other wealth-planning instruments such as life insurance, the rewards of a PF are magnified for both the donor and worthy charitable causes. Combining these vehicles for synergistic effect can help fulfill philanthropic ambitions as well as financial objectives.
Important Compliance Cautions
The PF should ensure that it owns the life insurance policy free and clear of any obligation to repay funds borrowed against the policy.
If a PF’s insider (generally, its trustee, director, officer, substantial contributor and family members of any of those individuals) were to donate a policy against which the insider has borrowed funds outstanding at the time of the policy’s donation, a self-dealing violation likely would result. In such a case, the insider who donated the policy would be personally responsible for any resulting penalty even if he were unaware that the policy’s donation would result in a violation. Whether the policy is purchased by or contributed to the PF, the PF should further ensure that it’s designated as the policy’s sole beneficiary. If an insider were to be designated as a beneficiary under a policy owned by the PF and if such insider were to receive a death benefit on the insured’s death, a self-dealing violation likely would result. Assuming that the insured is an insider in respect of the PF, it may be appropriate to establish a special committee with exclusive authority over all decisions relating to the policy. To reduce the likelihood that the insured’s heirs or creditors could benefit from the policy, the insured could be expressly disqualified from ever serving on such a committee.
Jeffrey Haskell, J.D., LL.M. is chief legal officer for Foundation Source, which provides comprehensive support services for private foundations. Contact him at [email protected].