Life insurance is an excellent tool for making charitable gifts for a number of reasons.
Life insurance provides an “amplified” gift that enables you to purchase immortality on an installment plan. Through a relatively small annual cost (the premium), a benefit far in excess of what would otherwise be possible can be provided for charity. This sizeable gift can be made without impairing or diluting the control of a family business or other investments. Assets earmarked for family members can be kept intact.
For example, a 50-year old committed to giving $5,000 annually for 10 years could leverage the $50,000 gift into a $360,000 gift. A second-to-die, or survivor life policy, adds even more leverage. A 50-year old couple could make a gift of $800,000 with the same $5,000 annual commitment. (Assumes 50-year old(s), preferred non-smoker(s) using variable life policy earning 10% gross return.)
Keep in mind that using a traditional permanent life insurance contract will generally yield a 6% to 7% internal rate of return to life expectancy on premiums paid.
Life insurance can be a self-completing gift. For a donor committed to making annual gifts, a portion of the annual gift can be directed to an insurance policy guaranteeing the continuation of that gift in perpetuity. If the donor becomes disabled, the policy can remain in force through the “waiver of premium” feature (if elected). This guarantees the ultimate death benefit to the charity and, in some cases, the same cash values and dividend build-up that would have been earned had disability not occurred. Even if the donor dies after only a few premium payments, the charity is assured a full gift. The death proceeds can be received by the designated charity, free of federal income and estate taxes, probate, and administrative costs, and without any delay, fees, or transfer costs.
Large gifts to charity are less subject to attack by heirs because of the contractual nature of the life insurance policy. The death benefit is guaranteed as long as premiums are paid. This means that the charity will receive an amount that is fixed (or perhaps increasing) in value, and not subject to the potential downside of volatile market risks as in securities.
10 Planning Ideas
There are a number of methods for including life insurance in a charitable gift plan.
1. Make an absolute assignment (gift) of a life insurance policy currently owned, donate a new life insurance policy, or have the charity purchase life insurance on the donor’s life and pay the annual premiums (assuming insurable interest and state law permits). Each of these allows a current income tax deduction.
2. Use of dividends from existing policy. Assign all annual dividends to charity. This eliminates out-of-pocket contributions, yet still creates a deduction as dividends are paid. Amplify the gift by having these dividends purchase a new policy of which the charity is the irrevocable owner and beneficiary.
3. Name a charity as the primary or contingent beneficiary of an existing or new life insurance policy. Although this will not yield a current income tax deduction, it will result in a federal estate tax deduction for the full amount of the proceeds payable to the charity, regardless of policy size. This can be particularly applicable in situations where there is only one logical beneficiary, or where insurance is used to fund a supplemental retirement benefit and the death benefit is of little importance to the insured.
4. Group term life insurance can also be used to meet charitable giving objectives. By naming a charity as the beneficiary of the group term insurance for coverage over $50,000, a donor can not only make a significant gift to the charity, but also avoid any income tax on the economic benefit for the amount over $50,000 (Table I or P.S. 58 rates are IRS published schedules that specify the employee’s “economic benefit” per $1,000 of coverage for employer-provided group term life insurance). While the initial $50,000 could also be given, no income tax deduction would be generated.
For example, a 60-year old executive with a combined state and federal income tax bracket of 40%, and who had $200,000 of coverage would save $842.40 each year (i.e., 40% of the $2,106 annual “Table I cost” that would be reportable as income). The advantage of this technique could be further enhanced by the introduction of higher Table I rates for individuals over age 65 who receive group term insurance.
5. Most estate planning techniques become even more effective when coupled with other techniques. By giving appreciated long-term capital gain property to the charity (e.g., stocks, real estate, mutual funds, etc.), the donor avoids capital gains tax and receives a deduction for full-market value (with notable exceptions). Using this cash to then fund a life insurance policy provides even more leverage, creating an even larger gift.
6. Perhaps one of the most popular ways to utilize life insurance in charitable planning more indirectly is through “wealth replacement.” In this situation, life insurance makes it possible for a donor to make an immediate or deferred gift of land, stock, or other property while still providing an acceptable family inheritance.
Qualified and non-qualified retirement plans are one of the best assets to give to charity because they are exceptionally inefficient in passing wealth to heirs. This is due to the fact that they face both income and estate tax, in some cases leaving only about 20% to 30% of the asset for the remaining family. Many families choose to leave the retirement plans directly to charity and then use life insurance as a way to “replace” the wealth contributed. Another option that may be considered is taking a distribution from the qualified or non-qualified plan and using it to purchase a life insurance policy in an irrevocable life insurance trust (ILIT); the donor can then give the remaining plan assets to charity. Not only does the charity receive a gift, but also the donor’s heirs may receive more than they would have if the donor attempted to pass the retirement plan assets directly to them.
A charitable remainder trust (CRT) is especially powerful for those who have highly-appreciated assets and a desire for increased income. These assets are often non-income generating and property tax-draining land or low-yielding stocks.
A life insurance policy equal to the original gift, but owned in trust, allows the heirs to receive the full value of the assets without paying estate taxes. Properly structured, the premium can often be paid with the income generated from the tax deduction and/or a portion of the excess income, which results from the avoidance of capital gains tax.
Bequests should also prompt one to consider using insurance to replace the assets. The donor may want to leave a gift by will to charity, but he/she may be concerned about disinheriting heirs. Since life insurance benefits can be received income and estate tax free if structured properly, the donor might choose to provide a death benefit equal to the charitable gift, or the amount the heirs would have received from the bequest after taxes.
7. While life insurance is most commonly thought of only as a wealth replacement vehicle for CRTs, it can also be used as a funding asset inside the CRT in certain situations where it serves the following purposes.
- The life insurance death benefit can substantially increase the remainder value of the trust, thus providing a larger gift to the donor’s selected charities when the trust terminates.
- In a two-life unitrust scenario, life insurance proceeds can “balloon” trust corpus when the first income beneficiary dies, creating a much larger income payout for the surviving income beneficiary.
- The donor is able to make partially tax-deductible premium payments for a personal insurance need.
For example, assume Mr. Donor establishes a net-income unitrust with a make-up provision (NIMCRUT) that will pay 6% per year for the lives of Mr. and Mrs. Donor. The trust is funded with property valued at $1,000,000 that is generating $60,000 of annual income. Under the typical CRT scenario, Mr. and Mrs. Donor will receive payments from the trust of $60,000 per year for life (6% of $1,000,000). Upon Mr. and Mrs. Donor’s death, charity will receive the $1,000,000 remainder value.
Now let us assume instead that the trustee invests some of the trust principal in a $1,000,000 life insurance policy on the life of Mr. Donor. When Mr. Donor dies, the trust is now worth $2,000,000, so Mrs. Donor receives 6% of $2,000,000 or $120,000 per year. So even though the life insurance is held in the CRT, it still serves its intended purpose, namely replacing income lost because of the untimely death of a breadwinner. In addition, charity will receive $2,000,000 upon Mrs. Donor’s death instead of the $1,000,000 under the normal CRT scenario.
In private letter rulings 9227017 (March 31, 1992) and 8745013 (August 7, 1987), the IRS approved the payment of premiums by the trust under the following circumstances.
- The trust was established as an income only unitrust.
- Premium payments would come from principal only, and never from trust income.
- Cash value withdrawals or dividends would be treated as principal and not income.
- Nothing from the policy would ever be paid as income to the income beneficiaries.
8. The same double tax situation discussed for qualified plans also exists for non-qualified or supplemental retirement plans. These have become especially popular as a method of offsetting the limitations imposed on the more traditional qualified plans. Supplemental executive retirement plans (SERPs) are company paid plans while non-qualified deferred compensation plans (NQDC) are commonly used to allow executives to defer funds over and above the 401(k) limitations.
9. While many business owners and executives have accumulated significant amounts of money in these plans, most are unaware that due to the double taxation (income and estate) their family might only receive about 25% of this wealth.
For the executive in a position to forgo this supplemental income, the solution to this may be a SERP swap. Essentially this allows the executive to reposition this asset from an entity facing both income and estate tax to one that passes the entire asset to the heirs free of income, estate, and gift tax. This is accomplished by an exchange of the SERP or NQDC for a split dollar life insurance policy. Properly structured, this allows the executive to not only bypass both income and estate tax, but to take advantage of the leverage of insurance as well.
10. Because this is such a windfall for the executive, he or she may be willing to contribute a portion of the additional gain to a charity or family foundation.
11. Purchasing life insurance for estate liquidity has been a standard life insurance technique for many years. Another option, however, has been gaining increased attention in recent years as a more exciting way to control assets your clients will not be able to keep: The “Zero-Tax Estate Plan.” Properly structured, this can also allow the donor to assure that his or her heirs will become actively involved in philanthropy, and thus pass on family values as well as family wealth. Below are some simplified calculations to illustrate the concept.
|Option 1||Option 2||Option 3|
|Gross estate after planning.||$10 million||$10 million||$10 million|
|Charitable contributions.||None||None||$10 million|
|Estate tax.||$4 million||$4 million||None|
|Life insurance purchased.||None||$4 million||$10 million|
|Total wealth–no control.||$4 million||$4 million||None|
|Total wealth–direct control.||$6 million||$10 million||$10 million|
|Total wealth–indirect control.||None||None||$10 million|
|Total wealth–controlled.||$6 million||$10 million||$20 million|
12. Another variation on this theme is for the donor is to simply decide how much wealth he or she wants each heir to receive, purchase insurance policies in that amount, and donate all the remaining assets to charity.
13. In the early to mid-1990s, many larger corporations offered a charitable board of directors program. This generally involved utilizing life insurance as the primary funding mechanism and the board members directors’ fees for premium payments (the company sometimes split costs or paid the entire premium directly). Board members could then choose their own preferred charities, or the corporation provided them with a short list of preferred options to receive the eventual benefit. The policy generally was designed to have the premium payment period correspond with the directors’ term, and could potentially allow the corporation to recoup any employer funding on a present value basis at the time the charitable contribution was made. These plans are starting to come back in favor with mid-size and large private and public companies.
Tax Implications for Various Life Insurance Gifts
This section outlines the various income tax implications of partial interest gifts, annual deduction limitations, and various policy valuation rules. While the following charitable income tax issues of life insurance gifts may seem rather cumbersome, charitable deductions for transfer tax purposes are unlimited, and equal the full fair market value of the property.
Partial Interest Gifts. To receive a current income tax deduction, the donor must irrevocably transfer all incidents of ownership and control in the policy (though the donor’s estate would likely receive an estate tax charitable deduction for the amount actually paid to charity). As an example, if the donor owns the policy and merely names the charity as beneficiary, no income tax deduction is allowed. To avoid violating the partial interest rules, the donor may not retain the right to:
- Change beneficiary(ies);
- Surrender or cancel the policy;
- Assign the policy or revoke assignment;
- Pledge the policy for a loan;
- Have any access to cash value via withdrawals or loans; and
- Hold any reversionary interests.
In situations where a donor divides an interest in property for the sole purpose of circumventing the partial interest rule, the deduction will still be disallowed. For example, a donor wants to transfer a death benefit interest in a life insurance policy to charity. This would be a transfer of a partial interest in property that is non-deductible. In order to get around this problem, the donor transfers the death benefit interest to his/her corporation. The corporation would then transfer its interest in the policy to charity. Since all the corporation owns is the death benefit, a transfer of the death benefit is an undivided interest of 100% of each and every right the corporation owns in the property, which should make the gift deductible. However, Treas. Reg. § 1.170A-7(a)(2)(i) denies a charitable deduction where “the property in which such partial interest exists was divided in order to create such interest and thus avoid § 170(f)(3)(A).”
Deduction Limitations. The maximum charitable deduction allowed each year is limited to 50% of adjusted gross income (AGI) for gifts to public charities and 30% of AGI for gifts to private charities. Like other charitable gifts, any excess deduction may be carried forward an additional five years. Deductions, however, may be further reduced by the method in which the policy or premiums are donated and by ordinary income property rules.
Premium Payments. If paid directly to charity, premium payments are deductible up to 50% of donor’s AGI. If the payments are made to the insurance company on behalf of the charity, they may be deemed “for the use of” rather than “to” and could be limited to 30% of donor’s AGI. Some recent cases have had positive rulings disputing this reduction, however.
Ordinary Income Property. Life insurance and annuities are considered ordinary income property, a group that also includes short-term capital gains property (capital asset held less than one year), inventory, depreciation recapture property, and accounts and notes receivable. For charitable gifts of ordinary income property, the deduction is limited to the lesser of adjusted cost basis or fair market value.
Policy Valuations. The gift value of an existing life insurance policy (where premiums are still required) is the lesser of the interpolated terminal reserve (cash value + unearned premiums — loans) or the donor’s adjusted basis. The contribution is generally measured by cash value in the policy’s early years and the donor’s adjusted basis after “crossover” when the cash value is greater than the cumulative premium paid. For example, Mr. Donor pays $10,000 annually for an insurance policy. After two years, his cash value is $12,000. He gives the policy to charity and receives a $12,000 deduction (though his cost was $20,000).
Alternatively, Mr. Donor pays $10,000 annually for an insurance policy. After 10 years, he has $150,000 cash value. He gives the policy to charity and receives a $100,000 deduction (though it has a value of $150,000).
If the policy is “paid up” (contractually requires no further premiums), then the deduction is the lesser of the adjusted cost basis or the policy’s replacement cost. The insurance company can provide the donor with the proper valuation for any type of permanent policy.
Policy Valuation with Outstanding Loans. The type of gift would be treated as part sale/part gift, i.e., a bargain sale. The donor would incur income tax liability for the ordinary gain (if any) on the sale portion, and would obtain a charitable contribution deduction for the (lesser of) fair market value or adjusted cost basis for the non-sale portion.
For example, Mr. Donor contributes a policy subject to an outstanding loan to his favorite charity. On the date of contribution, the policy’s fair market value equals $10,000, the donor’s adjusted basis in the policy equals $4,000, and the outstanding amount of the loan equals $4,000.
- Amount realized equals $4,000 (the outstanding amount of the loan).
- Basis allocated to sale equals $1,600: $4,000 (basis) X [$4,000 (amount realized) ÷ $10,000 (fair market value)].
- Gain recognized equals $2,400: $4,000 (amount realized) — $1,600 (basis allocated to sale).
- Amount eligible for charitable deduction equals $2,400: $4,000 (adjusted basis) — $1,600 (basis allocated to sale).
Note: Under charitable split dollar legislation, if the policy has any outstanding loan at the time of the contribution, the donor will not receive a charitable income tax deduction for the gift or any future premium contributions as it is deemed a private benefit transaction.
Qualified Appraisal. Gifts of property (other than publicly traded securities) that exceed $5,000 must have a qualified appraisal from a qualified appraiser. Thus, for any gift of life insurance where the value exceeds $5,000, a qualified insurance appraiser should be engaged to complete the appraisal and complete Form 8283 (the co-author is a qualified appraiser.
The Pension Protection Act of 2006 specifically modified Section 1219 170(f)(11)(E)(ii) to tighten qualified appraiser/appraisal requirements and specifically excludes the donor, donee, related party or party to the transaction (i.e., the insurance agent/broker or insurance company).
Insurable Interest. The donor should confirm that his/her state would consider the charity to have an insurable interest in the life of the donor. If not, no income, gift, or estate deductions are allowed. However, most states have now adopted legislation granting insurable interest and have done so retroactively.
Estate Tax Considerations. Any charitable gifts of life insurance made within three years of death will cause inclusion in the donor’s gross estate. However, with partial interest gifts, the estate would likely receive a full charitable deduction.
Conclusion Clearly, whether any of the aforementioned planning ideas will fit for a particular situation requires analysis on a case-by-case basis with the donor’s and charity’s respective goals being considered. As a well-placed planning tool, however, life insurance has many unique attributes that may enhance nearly any comprehensive charitable gift plan.