14. Life Insurance in Charitable Planning, Part 3 of 4

14. Life Insurance in Charitable Planning, Part 3 of 4

Article posted in General on 20 July 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 20 July 2016

An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

14. Life Insurance in Charitable Planning, Part 3 of 4

Links to previous sections of book are found at the end of each section.

Charitable giving with a life insurance policy can be simple.  The owner of a life insurance policy can just name a charity as the beneficiary of the policy.  At the death of the insured, the charity will receive a check for the death benefit.  Although this transfer generates no estate taxation, it also – like other revocable gifts taking effect at death – generates no charitable income tax deduction.  In order to generate a charitable income tax deduction, the donor must make a completed gift during life.  Giving a policy to charity may constitute a substantial charitable gift, especially where the life insurance policy combines a death benefit (i.e., simple term insurance) with investment features.  These policies can become valuable assets over time.  Such policies may be particularly attractive candidates for donation when the original purpose for the life insurance no longer applies.  Despite this attractiveness, the rules for tax deductions, the policies themselves, and the proper post-gift management of the policies by the charity can be complicated.
Life insurance can address needs in a variety of circumstances.  As circumstances change, the original need for the life insurance may disappear.  This lack of need for an existing policy is a common motivation for a donor’s decision to donate the policy to charity.  A donor may have purchased life insurance to replace his or her income in the event of death as a way to protect his or her minor children.  Once the children are grown and independent, the original need for the policy no longer exists.  An insurance policy may have been purchased for a business buy-sell agreement.  For example, two partners in a business partnership may agree that at the death of one of them, the other will purchase the deceased partner’s ownership for an agreed price.  Each partner purchases life insurance on the life of the other so that, in the event of one partner’s death, the surviving partner will have the cash to purchase the deceased partner’s interest.  This provides cash for the heirs and prevents the difficulties inherent in sharing forced ownership in an operating business with a group of heirs unfamiliar with the business.  However, if the business relationship changes – perhaps due to the business closing or being sold – the need for the life insurance also changes.  These are just two examples of the variety of ways in which a policy owner may find that he or she has too much life insurance for current needs.  If, in combination with this lack of need for death benefits, the owner also wishes to forego the cash value of the policy in order to benefit charity, a gift of the life insurance policy may make sense.
When a donor gives a life insurance policy to charity it is important that the donor give up all rights to and benefits from the policy.  This means, for example, that the donor may not keep any rights to change beneficiaries, surrender, assign, or cancel the policy, pledge the policy for a loan, make withdrawals or loans from the cash surrender value, or hold any other reversionary interests.  Attempting to retain any rights will result in no completed gift.  This also extends to prohibit keeping indirect benefits for the donor, the donor’s family, or anyone else designated by the donor.  Not only does keeping some rights mean there is no charitable income tax deduction, but it also means that the life insurance policy will still be included in the donor’s estate, and thus subject to estate taxation.  Further, any additional premiums paid by the donor would not generate deductible gifts.
If the donor were to cash in a life insurance policy, any income generated would be treated as ordinary income, rather than as a capital gain.  The donation of an ordinary income property item is valued at the lower of fair market value or the donor’s basis.  (In contrast, some long-term capital gain property items can be valued at fair market value, even when such value is higher than basis.)  However, determining fair market value and even basis in a life insurance policy can be challenging.

What is the basis in a life insurance policy gifted to charity?  This is currently an unsettled question.  Basis clearly includes all premiums paid for the policy.  Also, any refunds or loans taken from the policy will reduce the basis.  The uncertainty surrounds the issue of whether or not the basis should be reduced by the “cost of insurance.”  The IRS argument for considering “cost of insurance” is that the policy owner has invested premiums, but in return has received the advantage of coverage in the event of death.  Thus, because the owner has already received this “peace of mind” benefit, his or her basis should be reduced by the value of this benefit.  This value received is what it would have cost the owner to purchase just the death benefit itself (i.e., the term policy) from the company. 

At present, it is clear that the basis is not reduced for this “cost of insurance” (a.k.a. “mortality charges”) when money is received from the insurance company, e.g., through withdrawals, distributions, or surrendering the policy for cash value.  (This is specified by statute in Internal Revenue Code §72.)  The IRS has taken the, somewhat controversial, position that basis is reduced by this “cost of insurance” when a policy owner sells the policy to someone else (Rev. Rul. 2009-13 & 2009-14).  There are no IRS examples specifically for calculating basis for a charitable deduction from a gift of a life insurance policy.  However, charitable gifts to third parties, just like sales to third parties, are not covered by Internal Revenue Code §72, which addresses only payments coming back from the insurance company.  It seems unlikely that calculating basis as reduced by the “cost of insurance” would apply to sales of policies, but not gifts of policies.  (Such inconsistency would certainly lead to an interesting calculation in the case of a bargain sale to charity.)  The most likely IRS position – absent any actual information at this point – appears to be that the basis rule for sales would also be the basis rule for gifts. 

There is some question whether or not the courts will support this IRS position.  Why?  There is no statute directing this approach and this approach is not used in other contexts.  For example, if a taxpayer buys a car for $25,000 and sells it a year later for $25,000 she does not report a gain of $5,000 because it would have cost her $5,000 to rent a similar car for a year and she was able to enjoy the benefits of the car while she owned it.  The decision regarding whether or not to reduce the basis in a gift by the “cost of insurance” depends upon how aggressive the taxpayer wishes to be in this area of uncertainty.

For a taxpayer who wishes to reduce basis by the “cost of insurance,” determining this number may be a challenge.  Universal life policies typically report the “cost of insurance” component to policyholders, making this number easily accessible.  For term insurance, the “cost of insurance” is simply the premium.  However, for traditional whole life policies, the “cost of insurance” may not be reported or easily determined.  Death benefit coverage expenses can vary depending upon the age and health of the insured, interest rates, and the quality and rating of the company issuing the policy.  Consequently, determining what portion of a whole life policy represents “cost of insurance” can be complex.
Determining the fair market value of a gifted policy can also be a complicated procedure.  Of course, all property gifts of $5,000 or more require a qualified appraisal.  Consequently, the donor will not be the one to determine this valuation.  For a newly issued policy, the valuation can be determined by the premium paid for the policy.  For a paid-up policy (i.e., one in which no further premiums need be paid to keep the life insurance in force), the cost of a replacement policy for an insured of that age can be used as a basis for estimating fair market value.  Note that very few policies are truly paid up, meaning that no future payments will be due under any circumstances.  This is different than a policy that projects no future payments will be due depending upon the investment returns of a policy.  Most policies are neither newly issued nor paid-up.  For these policies where premiums payments are still required, valuation can be quite complex.  The approved valuation methods often approximate the cash surrender value of the policy.  A donor can use the greater of valuation allowed by the ITR or PERC methods.  The ITR method is based on the “Interpolated Terminal Reserve” plus any unearned premiums and a pro rata share of estimated dividends to be paid for the year.  There are, in fact, multiple possible methods to calculate the “Interpolated Terminal Reserve,” but the life insurance company will typically provide their estimation of this number to the policy holder.  However, this number – and, hence, this valuation approach – is not available for universal life or variable life policies.  An alternative valuation is the PERC method.  PERC comes from Premiums plus Earnings from the policy (such as interest, dividends, and withdrawals) minus Reasonable Charges (such as mortality charges).  The PERC number is often roughly equal to the cash value for universal life policies.  This PERC number is then multiplied by an “Average Surrender Factor,” approximating the charge incurred in surrendering the policy for its cash value.
These traditional valuation approaches do not apply in cases where they are not an appropriate estimation of the value of a life insurance policy.  This occurs when the insured has a terminal illness.  IRS gift tax regulations specifically prohibit using standard valuation approaches when the insured has a terminal illness.  In such cases, the “life settlement” market may provide a more appropriate, and much higher, valuation.  This market purchases life insurance policies on the lives of terminally ill individuals.  These policies are more valuable because the risk of death, and thus the likelihood of receiving the death benefit in the near future, is dramatically higher than for a typical insured.  These valuations, however, can be costly to obtain given the requirement to evaluate the health of a terminally ill individual.
Valuing a donated policy based upon its higher value in the life settlement market creates a more complex calculation for the charitable income tax deduction.  As mentioned previously, the typical tax treatment for a donated life insurance policy is to deduct the lesser of basis or fair market value.  This is because if the donor were to cash in a life insurance policy, any income generated would be treated as ordinary income rather than capital gain.  Ordinary income property is deducted at the lower of basis or fair market value.  This picture becomes more complex when selling a policy in the life settlement market.  In that case, the value received up to the cash surrender value would generate ordinary income, but the value above cash surrender value would generate capital gain income.  (This capital gain treatment is the most likely result although this is not settled law.)  This means the life insurance policy is in part ordinary income property and in part long-term capital gain property.  The gift of the ordinary income portion of the life insurance policy (i.e., the amount up to the policy’s cash surrender value) is valued at the lower of basis or fair market value.  However, the gift of any long-term capital gain portion of the life insurance policy (i.e., the amount above the policy’s cash surrender value) is valued at the greater of basis or fair market value.  This leads to different treatment depending on the relative value of the basis, the cash surrender value, and the life settlement value.  Consider the example of a policy with a $150,000 value in the life settlement market, a $50,000 cash surrender value, and a $20,000 basis.  Gifting this policy would generate a $20,000 deduction for the ordinary income part (i.e., the part represented by the cash surrender value of the policy), and a $100,000 deduction for the long-term capital gain part (i.e., the part represented by the value over and above the cash surrender value).  This, of course, assumes that the donor has not made a special election to value all long-term capital gain gifts during the year at the lower of basis and fair market value.  If the life settlement value were not greater than the basis, then the gift would be valued at the lower of its fair market value or basis as with a typical policy.  For example, if the basis was $200,000, the cash surrender value was $50,000, and the life settlement value was $150,000, then the deduction would be $150,000 (the lower of basis or fair market value).  If the life settlement was lower than the cash value, then the life settlement value would be irrelevant and the policy would be valued as normal.
As with all charitable property gifts of $5,000 or more, documenting a life insurance policy gift of this size will require a qualified appraisal.  In addition, the donor must complete IRS Form 8283, have reliable records of the gift, date, place, fair market value, and cost basis, and receive a note from the charity indicating the date of the gift with a description of the property and the magic phrase, “No goods or services were provided in exchange for these gifts.”
The required appraisal for documenting the charitable gift of a life insurance policy cannot come from the insurance agent or the insurance company.  They are parties to the transaction and are therefore disqualified.  Consequently, gifting a substantial life insurance policy will require the employment of a qualified outside appraiser.  Without such appraisal, the IRS will allow no deduction.

The typical result for donating property with an outstanding loan is that the donor is treated as both receiving income in the amount of the loan and making a charitable gift of the net equity in the property.  The first part of this typical result still holds in the case of a gift of life insurance.  The donor is treated as having received ordinary income in the amount of the loan, reduced by the applicable basis.  The applicable basis is the amount of the loan multiplied by the ratio of the policy’s basis to the policy’s fair market value.  For example, if a donor gifts a policy with a $100,000 fair market value, a $50,000 basis, and $10,000 of existing loans, the transaction will generate $5,000 of ordinary income for the donor [$10,000 loan x ($50,000 basis/$100,000 fair market value)].

However, because of special rules put in place to eliminate charitable split dollar transactions, the presence of a loan eliminates the tax deduction.  Thus, as the result of gifting a policy with outstanding loans the donor receives no charitable income tax deduction, but still reports ordinary income. 

The bottom line is that gifting policies subject to loans is unwise.  It would be better for the donor to pay off the loan first.  Then, the donor can gift the policy without loss of the charitable deduction due to the charitable split interest rules.  If this is not possible, then the donor may be better off to sell or cash in the policy, pay taxes on the gain, and then make an offsetting deductible charitable gift with the proceeds.  At a minimum, it is likely that there will be more tax advantageous assets for the donor to consider gifting instead of a life insurance policy with outstanding loans.

Upon receiving the policy, the charity may do anything with it that any other policy owner could do.  This includes surrendering the policy for its cash value, holding the policy until the death of the donor (if the policy is not paid up this will require the payment of premiums either by the charity or, if available, by the original donor), or selling the policy in the life settlement market.  Selling the policy in the life settlement market is rare because such markets require extraordinarily high rates of returns for investors.  Thus, if the charity is not in a desperate financial position, it is more appropriate for the charity to hold the policy and collect the death benefit.  Charities sometimes have an inappropriate tendency to automatically cash out any life insurance policies received, rather than considering the possibility of continuing to hold the policy until the death of the donor.  In many cases, the cash surrender value is well below the actuarial value of the policy.  By automatically taking the cash surrender value of policies, charities may often be making poor financial choices as compared with continuing to hold the policy, even if holding the policy may require payment of additional premiums.  Rather than immediately taking the cash surrender value, it would be more appropriate for charities to work with a life insurance professional to consider the relative financial value of continuing to hold the policy.
A donor may gift an annuity contract to a charity, but such gifts are usually not tax advantageous.  Gifting an annuity contract will cause all gain in the contract to be immediately taxed to the donor as ordinary income.  In contrast, continuing to hold the annuity would allow the annuity owner to recognize that income over many years, rather than immediately.  The donor may offset this immediate recognition of gain by the charitable deduction for the value the annuity contract (except for annuity contracts issued before April 23, 1987 that have not yet matured where the deduction is limited to the donor’s basis in the contract).  However, an alternative source for a charitable gift will often be more tax appropriate.  For example, gifts of long-term capital gain will generate no recognition of taxable gain.  Even gifts from cash may be better if they prevent the immediate recognition of gain resulting from giving an annuity contract.  Gifting an annuity at death does not create these same income tax problems, although this requires an annuity that still has value after the death of the donor.

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