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Gifts of Life Insurance
(Complete gift description)
Many graduates of the College are thoroughly familiar with life insurance products, but some may not be as familiar with their use in making charitable gifts. Here are a several options you may wish to consider:
Donate a Paid-Up Policy
If you donate all rights and incidents of ownership of a paid-up policy that you no longer need to the Foundation, you will qualify for a charitable deduction equal to the replacement cost of a comparable contract [Reg. § 25.2512-6(a), Ex. (3); see also U.S. v. Ryerson, 312 U.S. 260 (1941)]. This is the single-premium sum that the insurance company would charge to issue a policy on someone of the same age and sex as the insured. For a policy to be “comparable,” it must provide the same economic benefits as the gifted policy. Equivalent death benefits alone would not necessarily assure that the policies were comparable [Rev. Rul. 78-137, 1978-1 C.B. 280].
Your charitable income tax deduction is subject to a deductibility ceiling of 50% of your AGI [IRC §170(b)(1)(A)]. If the 50 percent ceiling is surpassed, any excess deduction may be carried over and deducted in up to five succeeding years, subject again to the annual 50 percent-of-AGI limitation in those years [IRC §170(d)(1)].
Donate a Partially Paid-Up Policy
You can donate a partially paid-up policy on which premiums remain to be paid. The value of your charitable deduction for such a gift is the sum of —
Typically, the interpolated terminal reserve value will slightly exceed the cash surrender value. You may continue to pay premiums on the policy after having assigned it to the Foundation. It may make a tax difference whether such premiums are paid directly to the insurance company versus being given to the Foundation as additional annual contributions.
If the premiums are paid directly to the insurance company, they may be treated as gifts “for the use of” charity. As such, these premium gifts would only be deductible up to 30 percent of your AGI [IRC §170(b)(1)(B)]. On the other hand, periodic transfers of cash or property to the Foundation in the amount of the premium would be considered gifts “to” charity, and as such, would be deductible up to the 50 percent-of-AGI limitation.
Gifts “for the use of” charity suffer another disadvantage. There is no five-year carryover for excess contributions that are nondeductible in the current year due to the percentage limitation [Reg. §1.170A-10(a)(1)].
HINT: You may want to consider transferring long-term appreciated property to the Foundation to pay the premiums. The full value of the property is usually deductible, including the gain that has never been taxed, and the Foundation will not pay capital gain tax when it sells the property because it is a tax-exempt entity. If this property happens to be tangible personal property related to the charity’s exempt purpose, you may be able to avoid a 28 percent capital gains tax. When the long-term capital gains rate on most other property dropped to 15 percent in 2003, tangible personal property did not enjoy this rate reduction, making it less attractive to hold purely from a tax standpoint.
Gift of a Newly Issued Policy
The U.S. Supreme Court has held that the value of a newly issued annual premium policy is the gross premium that was paid initially to bring the policy into effect [Powers v. U.S., 312 U.S. 259 (1941)].
If a newly issued policy is used to make a charitable gift, you may want to consider a second-to-die policy to reduce the premium cost. Of course, this will delay the Foundation’s receipt of the death proceeds until the second death and may be less attractive to you, as well as the Foundation, on that account.
Fund a Gift Annuity with Life Insurance Cash Value
A charitable gift annuity can be funded with the cash value of your life insurance policy. You can transfer your policy in exchange for a gift annuity, or surrender it and use the proceeds to fund a gift annuity. In either case, your charitable deduction can reduce or possibly eliminate the tax on the gain. You will receive lifetime payments from the gift annuity and enjoy the satisfaction of fulfilling your philanthropic commitment.
IRC Section 1035 generally permits the tax-free exchange of a life insurance policy for an annuity contract. However, a close reading of the Code indicates that the annuity contract must be issued by an insurance company [IRC §1035(b))1), (2)]. Thus, Section 1035 is not available to shelter the donor from any gain that may be recognizable on the transfer of a life insurance policy in exchange for a gift annuity.
Surrendering the policy and using the cash to set up a gift annuity results in all of the gain in the policy being taxed in the year of surrender (although the charitable deduction may offset most or all of the gain). If the policy itself is contributed for a gift annuity, the gain in the policy can be spread over the donor’s life expectancy, provided the donor names himself/herself as the annuitant.
Donate Excess Group Term Life Coverage
An employer may provide an employee with up to $50,000 of group term life insurance coverage without the cost of such coverage being included in the employee’s gross income [IRC §79(a)]. If the law of a state limits the amount of coverage an employee may receive under an employer’s group policy to less than $50,000, the employee is taxed on the excess coverage over the state law maximum. Further, the cost of such coverage is not based on Table I [Reg. §1.79-1(a)(2)] but on the actual premium paid [Reg. §1.79-1(e)].
If the employer-provided coverage exceeds $50,000, Table I prescribes the amount to be
included in gross income based on the employee’s age and the amount of the excess. However, if the employee names a charity as the sole beneficiary for the entire year of the coverage in excess of $50,000, the cost of the excess coverage is not imputed to the employee for tax purposes [IRC §79(b)(2)(B); Reg. §1.79-2(c)(3)].
Not only has the employee made a gift to charity with no out-of-pocket cost, but the employer’s premiums remain fully deductible. Thus, if the employee is an owner-employee, he or she can view this as an opportunity to make a gift to charity without regard to the percentage limitations on the income tax charitable deduction.
Incidentally, the regs only say that charity has to be the sole beneficiary for the entire year, not that it has to be the irrevocable beneficiary. Presumably, the employee could elect in and out of the arrangement each year, incurring Table I gross income only in years in which charity is not the sole beneficiary.
Use Life Insurance to Replace Capital Donated to a Charitable Remainder Trust
Often donors would like to make a major gift to charity, but feel constrained by the fact that family members would be deprived of assets they might need in an emergency. The “wealth replacement” technique arose to address this concern.
This technique involves the use of a charitable remainder unitrust (CRUT), a life insurance policy, and an irrevocable life insurance trust (ILIT). The donor transfers property to the CRUT which provides for an annual payout to the donor for life or a term of years (up to 20 years maximum). The unitrust is used instead of a charitable remainder annuity trust because a CRUT can receive additional contributions after the initial contribution, and the payout amount can increase with the growth of trust principal.
There is no capital gain tax when appreciated property is transferred to the CRUT. And because the CRUT is tax-exempt, there is no capital gain tax when the trustee of the CRUT sells the property and reinvests the sale proceeds.
The trustee of the ILIT purchases a policy on the donor’s life with a face amount (at least) equal to the value of the property transferred to the CRUT. (This assumes, of course, that insurability is not a problem.) If the donor-insured were to purchase the life insurance policy and then transfer it to the ILIT, the proceeds would be included in his or her gross estate if death occurred within three years of the transfer [IRC §2035(a)]. But where a third party such as the trustee acquires the policy, even with funds provided by the insured, case law has made clear that the three-year rule does not reach the proceeds [see, e.g., Estate of Joseph Leder v. Comm’r, 90-1 USTC 60,001 (10th Cir. 1989); Estate of Eddie Headrick v. Comm’r, 90-2 USTC 60,049 (6th Cir. 1990)]. The IRS has indicated that it will not litigate the issue [AOD 1991-012].
The donor-insured uses part of the payout that he or she receives from the CRUT to make annual gifts to the trustee of the ILIT. The trustee, in turn, uses these gifts to make premium payments (after any withdrawal rights expire). This allows the donor to benefit charity — and to take an income tax charitable deduction immediately for the present value of the charity’s remainder interest in the CRUT — while using the life insurance proceeds to replace, for the family’s ultimate benefit, the property used to fund the CRUT. A “Crummey” withdrawal power, which gives the trust beneficiary(ies) the annual right to withdraw up to a certain amount from the trust, is used to qualify the annual transfers as present-interest gifts eligible for the gift tax annual exclusion [Crummey c. Comm’r, 397 F.2d 82 (9th Cir. 1968)].
Miscellaneous Tax Considerations
1) Revocable vs. Irrevocable Designations You can designate the Foundation as the beneficiary of your policy, but such a designation will not result in an income tax charitable deduction for the policy or subsequent premiums. This arrangement violates the partial-interest rule because the policy owner retains essential rights in the policy [IRC §170(f)(3)]. The partial-interest rule would also be violated if the donor-insured retained a right to borrow against the policy.
To assure an income tax charitable deduction for the policy gift, the policy should be absolutely assigned to the Foundation. Language such as the following could be used to execute the assignment:
2) Ordinary Income Reduction Rule Since the excess of a life insurance policy’s value over the policy owner’s basis is ordinary income if the policy is sold or surrendered, the practical effect of the reduction rule is to limit the deemed amount of the contribution to the lesser of (1) the policy’s value, or (2) the policy’s basis.
Practically speaking, the deemed amount of your contribution will typically be measured by the policy’s value in the early policy years (when its value is lower than its cost), but by the policy’s basis after the “crossover point” is reached and value overtakes cost.
3) Federal Estate Tax Life insurance proceeds are includible in the federal gross estate if payable to or for the benefit of the estate, or if the insured held incidents of ownership at death [IRC §2042], or within three years of death [IRC §2035]. If a policy is transferred to a qualified charitable organization more than three years before death, the proceeds usually will not be includible in the insured’s gross estate. Even if the proceeds are includible in the gross estate of the insured because he or she retained some incident of ownership in the policy, a full estate tax deduction is allowed for proceeds passing to charity [IRC §2055(a)(2)].
If a charity is designated the beneficiary of a policy which the insured continues to own — thus being disqualified for an income tax deduction under the partial-interest rule — the death proceeds nevertheless can qualify for the estate tax charitable deduction. And unlike the income tax charitable deduction, there are no percentage limitations on the estate tax charitable deduction.
For more information
Email us, complete the personal illustration form, or call us at 610-526-1425 so that we can assist you through every step of the process.
