Tuesday February 20, 2024
Article of the Month
Charitable Gifts and Life Insurance Policies
Many individuals own life insurance at some point in their lives. Life insurance policies provide long-term financial protection to loved ones in the event of an unexpected death. Depending on the policy type, life insurance policies can also be a safe investment option. Over time, however, family circumstances and financial portfolios change, and the financial benefits of an insurance policy may no longer be needed. Individuals who are charitably minded may be interested in contributing unneeded life insurance policies to nonprofits.
This article will provide an explanation of the rules surrounding life insurance policies and discuss charitable giving methods including beneficiary designations, donations of new and existing policies and funding charitable gift annuities or trusts with policies. By gaining insight into the various options and tax consequences of gifting life insurance policies, advisors will be better equipped to guide their clients through the gifting process and help fulfill their goals and objectives.
There are generally two types of life insurance policies: a term policy and a permanent policy. A term life insurance policy provides coverage for a specified term or duration, typically ranging from 10 to 30 years. A term policy is not usually a good fit for charitable gifts because it ends after a certain number of years without paying any policy benefits or generating cash value. A permanent life insurance policy, such as a whole life or universal policy, stays in effect for the insured's lifetime as long as the premium payments are made. Since permanent policies can be valid for a donor's entire life and build cash value, they are a better option for making charitable gifts.
If a donor wishes to maintain ownership over a life insurance policy, he or she may designate a nonprofit as the beneficiary of the policy. This is a very simple way to benefit a nonprofit while maximizing a donor's flexibility and control. The donor retains full control of the policy during his or her lifetime and the nonprofit receives the insurance proceeds at the donor's death.
The donor will not receive a charitable income tax deduction for this future gift because he or she has not made an irrevocable charitable contribution. The tax code requires an irrevocable transfer of cash or property for a deductible gift. Since the donor retains ownership of the policy and may elect to change the beneficiary in the future, a charitable income tax deduction will not be allowed. Upon death, the proceeds are included in the donor's estate valuation. The donor's estate, however, will be entitled to a charitable estate tax deduction for the amount transferred to the nonprofit. IRC Sec. 2055(a). Accordingly, the value of the life insurance policy will not be subject to estate tax.
Example 1. Janice, 50, wants to donate $100,000 to her favorite nonprofit. After meeting with her advisor, she learns that she could use her $100,000 to fund a single premium whole life insurance policy and name the nonprofit as the beneficiary. When she dies, the nonprofit will receive a check for approximately $260,000 from the insurance company. Because Janice can change her beneficiary designation at any time, it does not constitute an immediate gift and, therefore, Janice will not receive a charitable deduction when she funds the policy. At death, her estate will receive a tax deduction for the value of the death benefits paid to the nonprofit. The nonprofit is pleased with this arrangement because they will receive the proceeds in a timely fashion following the death of the donor. Janice is also satisfied that her estate will qualify for an estate tax deduction upon her passing.
Nonprofit Ownership of New Policies
If the nonprofit would like assurance that a beneficiary designation will not be changed, the nonprofit could purchase a new policy on the donor's life that will be owned by the nonprofit. With this option, the donor usually donates cash or an appreciated asset to the nonprofit and the nonprofit, in turn, uses those proceeds to pay the premiums on the policy. The donor will receive a charitable deduction for the donated cash or assets but not for the policy itself. In addition, because the donor never owns the policy, the policy's death benefits are not included in the donor's estate at death.
Insurable Interest Requirement
One possible limit to this option is the insurable interest requirement. Most states require that someone applying for life insurance have an insurable interest in that person's life. An insurable interest is generally described as an interest on the part of the applicant or owner of the policy in the continuance of the life of the insured. The insured always has an interest in their own life. In addition, insurable interest is typically found in family relationships or when there is a reasonable expectation of deriving financial or economic benefits from the continuance of the insured's life. In some states, the statutory definition of insurable interests includes nonprofits. In other states, the donor may need some prior connection to the nonprofit to fulfill this requirement. Thus, state law and the circumstances of each situation determine whether the insurable interest requirement is met. If the requirement is not met, the donor could apply for the policy and then transfer ownership to the nonprofit. This option will be explored later in the section on Gifts of Existing Policies.
To avoid any misunderstandings regarding payments and use of future premiums, it is recommended to have a written gift or pledge agreement in place between the nonprofit and the donor. The agreement will often include a promise from the donor to make the premium payments. The agreement should be careful not to restrict the nonprofit's use of the funds because that could reduce the donor's deduction.
For cash gifts, the deduction is normally allowed up to 60% of the donor's adjusted gross income (AGI). IRC Sec. 170(b)(1)(A). Gifts "for the use of" a nonprofit, rather than "to" a nonprofit, are deductible only up to 30% of the donor's AGI. Thus, if the agreement restricts the nonprofit's use of the donation or if the donor directly pays the insurance company, the donor is subject to the lower 30% AGI limitation. Reg. 1.170A-8(d).
Example 2. Spencer, 75, is a retired university professor with two independent adult children. With Spencer's consent, the university took a life insurance policy out earlier this year on Spencer. The policy will pay $500,000 upon Spencer's death. The policy's premiums each year are $15,000. Spencer wants the nonprofit to hold the policy and, upon his death, use the $500,000 to fund an endowment for scholarships at the university. While completely within its discretion, the university decides to keep the policy. However, it does not want to be responsible for the annual premiums. Thus, Spencer agrees that each year he will contribute an unrestricted gift of $15,000 to the university. As a result, the university feels comfortable holding the policy. In addition, Spencer will receive a $15,000 charitable deduction each year that he makes the contribution. If the gift is made in cash, it will be subject to the 60% AGI limitation.
Gifts of Existing Policies
Oftentimes, a donor wants to donate an existing permanent policy to a nonprofit. To qualify for a charitable deduction, the donor must relinquish all incidents of ownership and rights in the policy. If the donor retains any rights in the policy after assignment, the transfer is considered a partial interest gift that would not qualify for a charitable deduction. To effectuate a transfer, the donor will need to contact the insurance company and fill out the proper change of ownership forms. The nonprofit should verify that it not only owns the policy but is the designated beneficiary as well. It is also important to note that not all states allow for such transfers to nonprofits. Therefore, it is imperative that advisors help donors determine whether the applicable state law allows such a transfer before proceeding.
In situations discussed above where the insurable interest requirement cannot be met, a donor may apply for a new policy and then transfer ownership of that existing policy to the nonprofit. While this seems like a simple solution, there could be timing concerns about these transfers. One concern is the holding period for capital assets. The holding period is the amount of time that the donor owns an asset before disposing of it. Assets held for less than one year are not considered long-term capital assets. IRC Sec. 1222. Giving short-term capital gain property to a nonprofit produces only a cost basis deduction. Another timing concern is the three-year rule which provides that, if donors die within three years of the transfer, the policy proceeds will be included in their estate. IRC Sec. 2035(d). For donors whose estates could be subject to estate tax, advisors should be cautious about these transfers.
An outright gift of a life insurance policy will produce a charitable income tax deduction equal to the lesser of the policy's value or the donor's basis in the policy. IRC Sec. 170(e) and Rev. Rul. 78-137. The value is usually either the replacement cost (if no further premiums are owed) or the interpolated terminal reserve value (ITRV) with certain adjustments (if further premiums are still owed). For charitable deductions on assets using the cost basis as the value, the donor may use the deduction to offset up to 50% of the donor's AGI. Sec. 170(b)(1)(C)(iii). In general, the donor's basis in a policy equals the total amount of premiums paid by the donor. As a practical matter, the charitable income tax deduction will normally equal the donor's basis because, in most instances, the cost basis will not be greater than the policy's value. However, if the policy suffers investment losses, it is possible for the basis to exceed the policy's value and, thus, a donor will be limited to deducting the value of the policy.
The transfer of a life insurance policy to a nonprofit can be a transformational gift. While the deduction may be limited to cost basis, the nonprofit is able to realize the full death benefit if it retains the policy. Any gain inside the policy at the time of transfer will be excluded from the deduction. The donor must also report and recognize any unpaid loan amounts in excess of basis as ordinary gain.
Example 3. Oscar and Maria purchased a second-to-die whole life policy that has a cash value of $400,000. Oscar and Maria have paid annual premiums of $10,000 for 25 years. Their basis in the policy is $250,000 (25 x $10,000 annual premium). Oscar and Maria contribute the policy outright to their favorite nonprofit. Accordingly, they are entitled to a charitable deduction of $250,000 since their basis is less than $400,000. The reduction rules prohibit a charitable deduction for the ordinary income component.Substantiation Rules
The $250,000 deduction will be subject to the 50% AGI limitation (not the 30% limitation), because no capital gain element is involved in the charitable deduction. Once the nonprofit owns the policy, it can surrender the policy to the insurance company. Assuming no surrender or administrative charges, the nonprofit will receive $400,000. As a tax-exempt entity, the nonprofit has no income tax liability imposed at the time of surrender.
If a taxpayer makes a noncash charitable contribution greater than $500, then IRS Form 8283 must be included with the tax return. If the property is not publicly traded stock that may be valued on an exchange and exceeds $5,000 in value ($10,000 for closely held stock), a qualified appraisal is required. The qualified appraisal will determine the donor's charitable contribution value. The appraisal must be made no earlier than 60 days prior to the gift and not later than the date the return is due with extensions.
Finding an appraiser can be a challenge. While the insurance company itself may be in the best position to determine the value, the rules require an independent appraiser and IRS rules do not address whether the insurance company is considered an "independent" appraiser. When the policy is transferred, the donor can request that the insurance company calculate and complete IRS form 712 which will report the value of the policy and other related information. However, a qualified appraisal will still be required.
The transfer of a life insurance policy subject to a loan will be an immediate taxable event to the extent that the loan exceeds the cost basis. In addition, the amount of the charitable deduction will be reduced. A donation of a policy with a loan is treated as a bargain sale since it is a part-gift and part-sale transaction. A bargain sale occurs when a nonprofit purchases property from a donor for less than fair market value. IRC Sec. 1011. With a bargain sale, the gift amount is the fair market value of the property less the sale price. Loan forgiveness is deemed to be a bargain sale because any debt relief is a benefit to the donor. Here, the sale price is the amount of the loan forgiveness. The basis is allocated between the taxable sale portion and the gift portion. Since the charitable donation is limited to the lesser of cost basis or fair market value and the fair market value is reduced by the loan, the deduction could be negligible.
Example 4. Ali took out a life insurance policy many years ago which has a cost basis of $50,000. The policy is now worth $100,000. Ali took a loan out against the policy for $80,000. Ali no longer needs the policy since her children are grown and she would like to donate it to her favorite nonprofit. If Ali donates the policy, her basis will be prorated between the charitable gift and the sale (i.e. the loan forgiveness). Thus, her basis will be $10,000 ($20,000/$100,000 x $50,000). Because she is limited to the lesser of her basis or value, Ali's deduction will be $10,000. In addition, Ali will be taxed on ordinary income of $40,000 ($80,000 "loan forgiveness" less $40,000 allocated basis).Life Settlements
Donors or nonprofits may also want to consider a life settlement option. Life settlements involve ownership transfer of a life insurance policy to a third party, known as a life settlement provider, in exchange for a lump sum cash payment greater than the policy's cash surrender value. Donors or nonprofits can locate a reputable life settlement provider to obtain bids for a life settlement contract. Once a purchase agreement is reached, the life settlement provider then assumes the responsibility of paying the ongoing premiums and collects the death benefit. The life settlement amount could be much larger than the ITRV. If the policy is owned by the donor at the time of transfer, the donor may owe ordinary income or capital gains tax upon transfer which is offset by the charitable deduction. If the nonprofit is the owner of the policy, the donor's deduction is based on the value determined by the qualified appraisal, the nonprofit receives the cash directly for its immediate use and is relieved from paying further premiums.
Insurance and Charitable Gift Annuities
A charitable gift annuity (CGA) is a contract between the nonprofit and the donor. In a CGA funded with a life insurance policy, a donor gives all ownership of the policy to the nonprofit in exchange for a promise to pay a set percentage of the initial funding amount to one or two annuitants for life. The charitable deduction for a CGA is based on the present value of the charitable remainder at the time of the gift.
Once the nonprofit owns the policy, it can hold the policy or elect to surrender the policy and reinvest the funds. If the death benefit is substantial, the nonprofit may elect to keep the policy. In some cases, a fully paid policy can make its own premium payments. Another option is for the nonprofit to dispose of the policy by cashing it in, selling or surrendering it. The value of the policy will not fluctuate greatly like other assets so the nonprofit can thoroughly weigh its options before proceeding.
Ordinary Income Recognition
If the donor is transferring the policy to a CGA, the issue arises of whether the ordinary income can be spread out over the donor's lifetime instead of triggering immediate recognition. IRC regulations state that any gain realized upon funding a gift annuity is spread out over the lifetime of the donor if the donor is the only annuitant or the donor and a successor annuitant are the only annuitants. Reg. 1.1011-2(b)(1). In addition, gifts of other types of ordinary income property exchanged for gift annuities such as inventory will spread ordinary gain over the donor's lifetime. Congress also added provisions to the Tax Code in 1986 specifically requiring immediate recognition of ordinary gain for some transfers of certain assets but did not include life insurance. IRC Sec. 72. Based on this legal framework, it is likely permissible to spread ordinary income gains over the donor's life expectancy when funding a CGA.
Example 5. Robin owns a $250,000 life insurance policy with a current value of $100,000. Robin pays annual premiums of $11,000 and the total amount of premiums paid so far is $33,000. Robin wants to transfer the policy to a nonprofit in exchange for a gift annuity. Since the current value of the policy is $100,000 (not $250,000), the nonprofit agrees to a one-life $100,000 gift annuity for Robin who is 59.
Pursuant to Sec. 170(e), the charitable deduction is based upon the lesser of cost basis or policy value. Robin's cost basis is her premiums paid thus far, which amounts to $33,000. Because this amount is less than the policy value of $100,000, the $33,000 cost basis is used to determine Robin's charitable deduction. Based upon this lower figure, Robin's charitable deduction is approximately $11,000. In addition, each annuity payment will include a tax-free return of principal, which is based upon the $33,000 cost basis.
To accomplish this calculation in Crescendo's software, there are a couple of adjustments. First, the property value and cost basis will be $100,000 and $33,000, respectively. Second, on the "options" screen, one must enter 100% for "ordinary gain" and 0% for "long-term capital gain." As a result, Crescendo's software will produce the appropriate calculations.
Insurance and Trusts
While the IRS has not issued a private letter ruling approving a transfer of an insurance policy to a CRT, another option for donors is to transfer the policy to a charitable remainder trust (CRT). A CRT is a tax-exempt irrevocable trust that is funded by a donor and makes income payments to the donor or other beneficiaries for life, lives or a term of years. There are two types of CRTs. A charitable remainder annuity trust (CRAT) pays out a fixed percentage of the initial funding amount each year. A charitable remainder unitrust (CRUT) pays out a fixed percentage of the trust, with revaluations each year. The donor receives a charitable income tax deduction in the year the trust is funded, based on the present value of the charitable remainder. After all payments have been made, the remaining trust assets are transferred to one or more designated nonprofits. There are many benefits to transferring appreciated assets to a CRT, including an income tax deduction, bypass of capital gain and an income stream.
A CRT could be an option for donors who would like to generate an income stream. It is important to remember, however, that the funding amount of the gift is the cash value of the policy, not the death benefit. Consequently, the charitable deduction will also be lower compared to other appreciated assets. If the donor does not need an immediate income stream from the CRT, a FLIP payout may be appropriate. When the policy is transferred to a FLIP unitrust, the trust will only pay the lesser of the net income generated in the trust or the unitrust percentage until a designated FLIP trigger event occurs. On January 1, following the trigger event, the trust flips to a standard unitrust payout and begins making the regular unitrust payments.
Example 6. Pat owns a $1 million life insurance policy with a current value of $400,000. Pat pays annual premiums of $10,000 and the total amount of premiums paid so far is $250,000. Pat wants to transfer the policy to a charitable remainder trust but does not need income until retirement in 10 years. Pat's advisor explains that donating to a FLIP unitrust could provide a deduction and delay income payments. Since the current value of the policy is $400,000 (not $1 million), the initial trust value will be $400,000. Therefore, Pat creates a one-life, 5% payout FLIP CRT with a trigger date in 10 years and transfers the policy to the CRT. The trustee elects to surrender the policy and conservatively reinvest the funds.Gifts and Irrevocable Life Insurance Trusts
Pursuant to Sec. 170(e), the charitable deduction is based upon the lesser of cost basis, $250,000, or the policy value, $400,000. Here, the $250,000 cost basis is lower and, based upon this figure, Pat's charitable deduction is approximately $87,000.
To accomplish this calculation in Crescendo's software, there are a couple of adjustments. First, the trust value and cost basis will be $400,000 and $250,000, respectively. Second, on the "options" screen, one must click on "reduce deduction to basis." As a result, Crescendo's software will produce the appropriate calculations.
A charitable gift to a CRT paired with an irrevocable insurance trust can be an effective option for donors who would like to make a gift to a nonprofit but also want to provide financial security to loved ones. In these situations, the donor is creating two separate trusts, a CRT and an irrevocable life insurance trust (ILIT).
An ILIT is an irrevocable trust designed to use insurance as the principal trust investment. In the case of an ILIT created to provide inheritance for family members, the ILIT will receive one or more gifts of cash from the grantor and will use those gifts to pay the premiums on an insurance policy. The grantor can fund these premium payment gifts with income from the CRT or the tax savings from the CRT deduction.
It is essential that an ILIT is irrevocable, since a key goal is to avoid inclusion of the life insurance proceeds in the estate of the grantor. To avoid inclusion, the proceeds must be payable to the ILIT, and the grantor cannot retain any "incidents of ownership" to the policy. Sec. 2042(2). Incidents of ownership include the right to designate beneficiaries under the policy, to borrow against the policy or to control the policy in any manner.
When a payment is made to the ILIT, beneficiaries must have "Crummey" powers in order to have a present interest and completed gift that is covered by the annual gift exclusion. Without a "Crummey" power, a beneficiary would not benefit from the trust until sometime in the future so it would not be considered a present gift and, thus, the lifetime exemption would be used to cover the gift value. The "Crummey" power states that the beneficiaries of the insurance trust will have the right for a reasonable period, typically 30 to 45 days, to withdraw the donor's contribution. If they do not exercise that right, the power of withdrawal lapses at the end of the period. After the period ends, the trustee may then use the contributed asset to make premium payments. If the amount available for withdrawal exceeds $5,000 or 5% of the trust principal, the excess amounts could be deemed a gift to the other beneficiaries. Careful consideration and drafting should be used to avoid this result. Donor's counsel can best determine how to structure the trust and any gift tax implications.
Given that many donors have life insurance policies, it is important to understand the various methods for making donations to nonprofit organizations. Outright gifts to nonprofits have the same tax deduction limits as gifts that fund charitable gift annuities or charitable remainder trusts, which is 50% for cost basis election type gifts. Transfers to charitable gift annuities or charitable remainder trusts may also be attractive since donors will receive lifetime income payments and defer gain over their life expectancy. By understanding the options and strategies that are available for transferring these policies, advisors can better serve their clients and provide creative solutions that will benefit the client and achieve their personal and financial objectives.
Published February 1, 2024