Tax Implications of Using Life Insurance for Charitable Giving

Income Tax

A current income tax deduction is allowed for the transfer of a cash value life insurance policy to a qualified charity. The client will save an amount equal to the value of the deductible gift multiplied by the client’s effective tax bracket. For example, a $10,000 gift by a client in a 40 percent combined federal and state income tax bracket will yield a $4,000 tax savings. This means the cost of the gift is lowered to the amount contributed less the tax savings. In this example, the gift cost $6,000 ($10,000 – $4,000).

The deduction for a charitable gift of a life insurance policy is subject to the same limitations as other charitable gifts. One such limitation relates to the amount of a current deduction allowed based on a percentage of the donor’s adjusted gross income in that year.

A second limitation is that to be deductible the gift must be total and absolute. An outright gift of all of the incidents of ownership and all rights and benefits in a life insurance policy will be deductible up to the allowable percentage of the donor’s income. A gift of less than the client’s entire interest in a life insurance policy (or any other asset) will be deductible only if it constitutes one of the following interests:

  • A remainder interest in a qualified charitable remainder unitrust or annuity trust
  • A remainder interest in a pooled income fund
  • A charitable gift annuity
  • A remainder interest in a personal residence or farm
  • A qualified conservation easement
  • An undivided portion of the taxpayer’s entire interest in property
  • A guaranteed annuity interest or unitrust interest in a charitable lead trust

In other words, a client can usually deduct the value (as defined below) of a life insurance policy given to charity (or to an irrevocable charitable trust). Furthermore, after a complete and irrevocable gift of the policy, the client can deduct any premiums paid after the transfer of the policy to the charity (or to an irrevocable charitable trust). However, no deduction will be allowed for any portion of the gift unless the client donates to the charity either his entire interest or an undivided portion of his entire interest in the policy. A gift of an undivided portion of a policy would include a fraction or percentage of each and every substantial right in the policy. Alternatively, a deduction for a gift of a partial interest in property will be permitted if the partial interest is the client’s entire interest in the property.

A gift of the cash value will be considered a transfer of less than the client’s entire interest regardless of whether the client: (a) retains a continuing right to name some other party as the recipient of the net amount at risk (i.e., the pure death benefit); or (b) irrevocably designated the recipient of the death benefit before making the gift of the cash value to charity.

If a client creates a split-dollar plan with a qualified charity, under which he contributes to the charity the policy’s cash surrender value but designates a noncharitable beneficiary as owner of the death benefit, the IRS will not allow an income tax deduction.

Some flexibility is allowed where the client retains a very limited right that cannot be used for the client’s personal benefit. For instance, it appears a client can make a gift of a life insurance policy and reserve the right, exercisable only in conjunction with the donee charity, to add another qualified charity as beneficiary, change the portion of the proceeds one or more qualified charities will receive, or even shift all of the proceeds to another qualified charity. Technically, the IRS has reasoned in such situations that even though the donor shares with the charitable owner of the insurance policy the right to designate other qualified charitable recipients, the donor has still made a charitable gift of any rights he held in the policy and, therefore, the gift is not considered a gift of a partial interest.

Merely naming a charity as the beneficiary of a life insurance policy will not result in an income tax deduction, even if the designation is irrevocable. This follows the rule discussed above that the charity must be given the client’s entire interest in the policy. If the charity is named only as beneficiary, regardless of whether that designation is revocable or irrevocable, the policy proceeds will be includable in the client’s gross estate. But when the death benefit is paid to the charity, the client’s estate will be allowed an offsetting charitable deduction.

There is an important exception to this all or nothing rule: an employee who names a charity as the beneficiary of the total death benefit (or at least the entire amount in excess of the first $50,000) under a group term life insurance policy on his life for the entire tax year can exclude from income the value of the otherwise taxable coverage attributable to the charitable portion of the proceeds. This charitable technique can shield considerable amounts from income tax; yet, the client can retain the flexibility to change his mind the following year and name a personal beneficiary. The cost of this exclusion from income taxation is that the term coverage will remain in the client’s estate and, unless actually paid at death to the designated charity, will generate federal estate tax.

Amount of Deduction

When all incidents of ownership in an existing life insurance policy are donated to charity, the transfer is treated as a gift of ordinary income property in the year it is assigned absolutely to the charity. This means the donor must reduce his contribution amount by the gain that would have been realized had he cashed in the policy or sold it. The policy owner will be entitled to a current income tax deduction.

The amount of the deduction for a charitable gift of a life insurance policy is generally the lower of: (a) the fair market value of the policy; or (b) the donor’s cost basis. Stated another way, where the policy’s value at the date of the gift is greater than the net premiums the client has paid, the deduction will be limited to the client’s net premiums so in most cases, the donor’s deduction will be limited to basis.

Fair market value is dependent on the replacement cost of the policy. This depends on which of the following is involved:

Newly Issued Policy – Typically, the deduction for a policy transferred immediately after its issue or within its first year is based on the net (gross premium less dividends, if any) premium payments made by the date of the transfer.

Premium Paying Policy – The deduction value is for the sum of the interpolated terminal reserve plus any unearned premium at the date of the gift. The term “unearned premium” is defined as the unexpired payment to the insurer between the date of the gift and the premium due date after the gift. Dividends accrued to the date of the gift are also added. Any loans against the policy are subtracted.

Paid-up or Single Premium Policy – The deduction is based on the single premium the same insurer would charge for a policy of the same amount at the insured’s attained age.25

If the insured is in impaired health, it could be argued (by both the taxpayer in charitable giving cases and the IRS in noncharitable situations) that adverse health increases the value of the gift to charity. This argument is logical since impaired health to some extent must affect life expectancy. To this point, however, there are no rulings, nor is there a formal IRS position on the subject.

Deductions for Payment of Premiums

Premiums are generally deductible on policies contributed to or owned by charity. Once a policy is donated to or purchased on the donor’s life by the charity, subsequent premiums are deductible if: (a) paid in cash to the charity; or (b) paid directly to the insurer. Cash payments made directly to a qualified charity will qualify for a current deduction of up to 50 percent of the donor’s adjusted gross income. The current deduction for premium payments made to the insurer (but for the use of charity) may be limited to 30 percent of the donor’s adjusted gross income. The charity could, of course, use other money to pay premiums if the client decided to discontinue contributions.

It makes no difference whether premiums are paid all at once (such as in a single premium policy) or over just a few years (such as in a suspended premium arrangement). The deduction will, nevertheless, be allowed in the year the donor parts with dominion and control over the cash. Note that if the client merely collaterally assigns the policy to the charity as security for a note, premiums he pays on the policy will not be deductible. This makes sense because the charity is not the absolute owner of the policy and the policy could easily end up in the client’s hands if he pays off the note.

Gifts of Annuities

A charitable gift of an annuity issued after April 22, 1987, whether the gift occurs in the year of maturity or before it matures, will result in the immediate recognition of gain. When the donor gives the contract to charity, it is treated for income tax purposes as if he surrendered it. Reportable gain is equal to the excess of: (a) the cash surrender value at the time of the gift; over (b) the client’s investment in the contract. But in return, since the client must currently recognize the gain as ordinary income, that amount becomes part of the client’s basis and so the entire value of the annuity given to charity is fully deductible.

AMT Implications

The AMT is a tax designed to assure that individuals who pay little or no regular income tax, because they have taken advantage of certain exclusion, deduction, and credit obtaining techniques called “preferences,” will pay at least this minimum tax. Ironically, many of these preferences are in reality tax incentives designed to encourage taxpayers to take certain risks or make certain investments or contributions that are deemed to be in the public interest. So, on the one hand, Congress encourages the action and, on the other hand, it seeks to discourage the same pattern of behavior by diminishing the tax benefits for the same action.

For tax years beginning before 1993, the major preference item in terms of charitable giving was a contribution of appreciated property. Specifically, the unrealized gain inherent in a gift of long-term capital gain property was considered a preference item for purposes of the AMT. However, for taxable years beginning after 1992, a charitable contribution of appreciated property is no longer treated as a tax preference. As a result, if a taxpayer makes a gift to charity of long-term capital gain property that is real property, intangible property, or tangible personal property, the use of which is related to the donee’s tax-exempt purpose, the taxpayer is allowed to claim a deduction for both regular tax and AMT purposes in the amount of the property’s fair market value (subject to applicable percentage limitations).

Since life insurance is an ordinary income type asset and a donation of life insurance is not considered a preference item, and since the receipt of insurance proceeds will not be taxable in any way to the charity, it does not present AMT problems in and of itself.

Gift Tax Implications

Regardless of the size of the gift of life insurance, no federal gift taxes are payable on transfers to qualified charities, but there is an important qualification, especially where life insurance policies are involved. A gift tax charitable deduction is allowed without limit for an outright transfer of a new or existing life insurance contract but, except in certain defined situations, any deduction will be denied if the transfer is of less than an entire interest in the policy.

For instance, your client would not be allowed a gift tax charitable deduction for a gift of a split-dollar policy between an individual and a charity. In such situations, the insured’s gift of the right to the cash surrender value of the policy is a gift of a partial interest, less than the donor’s entire interest in the property and, consequently, does not meet one of the exceptions that will qualify the gift for a charitable deduction. Note that this disallowance cannot be avoided by having the client make an irrevocable designation of a personal beneficiary before making the gift to the charity.

In addition, if a policy is donated to a charity in a state where the charity has no insurable interest in the insured’s life, and the lack of such an interest is deemed to give the insured’s estate some rights to control the ultimate disposition of the proceeds, the IRS will disallow the deduction on the grounds that the insured retained an incident of ownership. It would seem that if the charity was the original policy purchaser, even where statutory law gives the insured’s estate some right over the ultimate disposition of the proceeds, it could not be said that the insured retained some right since he never had it. But smart planners will avoid the issue and check state law to be sure that insurable interest in the life of the insured is not a problem.

Estate Tax Implications

If a client holds any incident of ownership in the policy at death, regardless of whether the charity owns the policy or whether a charity has been irrevocably named as the beneficiary of the proceeds, the entire amount of the payment made by the insurer at the insured’s death will be subject to federal estate tax in the insured’s gross estate.

If a client assigns all incidents of ownership in a life insurance contract to a charity, and survives for more than three years after the transfer, the policy should be excludable from the donor’s estate for federal estate tax purposes.

Gifts of life insurance made at death to a qualified charity (as well as those made prior to death to charity that for some reason were brought back into the client’s gross estate) are includable in a client’s estate, but will receive a federal estate tax charitable deduction. This deduction is unlimited. The policy proceeds could amount to millions of dollars or more and, regardless of how large, could be left to a qualified charity and the estate tax charitable deduction would eliminate the federal estate tax the proceeds would otherwise have generated.

However, even though the estate tax on the insurance paid to charity may be entirely eliminated, there may be a cost. The inclusion of the life insurance may adversely affect the estate’s ability to qualify for the benefits of: Section 303 partial stock redemptions; Code section 6166 (installment payments of estate tax); and (before 2004) Code Section 2057 deduction for Qualified family-Owned Business Interest, (QFOBI).

Once again, however, there is an important qualification. As is the case with both the income and gift tax laws, for estate tax purposes the deduction will be disallowed if the entire interest in property is not transferred to the charity. This is due to the fact that if the insured has not given up each and every incident of ownership he owns, he continues to hold a property interest in the policy. This is sufficient to cause estate tax inclusion of the entire proceeds no matter how seemingly small that incident is.

Tax Implications for the Charity

No tax is paid by the charity upon receipt of either a lifetime gift of a life insurance policy or a bequest of a policy at death. Likewise, the payment of premiums by a charity on a policy it owns and is the beneficiary of will not generate a gift tax to the original donor of the policy.

Income earned by a charity on assets it owns generally will not be subject to income tax. But as noted below, if a charity borrows policy cash values to finance the purchase of income producing investments, the income produced by these investments may be considered unrelated business taxable income and result in a tax to the otherwise tax-exempt charity.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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