Strategies That Use Life Insurance as a Charitable Component
Any nonprofit organization would welcome a generous donation from one of your clients. Cash and marketable securities are often the most liquid assets used to help sustain an organization’s operations. Planned gifts, however, can be funded with many types of assets, including life insurance. While the general sentiment in the charitable community toward these types of gifts has been less than enthusiastic, there are many useful strategies for incorporating life insurance into a charitable estate plan.
To remind the staff of a charitable organization never to “look a gift horse in the mouth”—even one bearing a gift of life insurance—may be met with resistance. Their reluctance may be tied to the perception that life insurance is not a prudent investment. Indeed, life insurance is not an investment, but a risk-management tool used to provide a death benefit to the organization in case the donor-client dies prematurely.
Consider the example of the client who wanted to name a large charitable organization as the beneficiary of his insurance policy and asked his advisor to obtain the organization’s exact legal name for the insurance form. Simple, yes? No, the foundation’s planned giving officer proceeded to tell the advisor that the organization would only accept the designation (although at this point there is nothing to accept or decline) if the policy named the organization as owner and beneficiary of the policy. Even though the advisor explained that his client only wanted to name the organization as a beneficiary and wasn’t concerned about an income tax charitable deduction, the planned giving officer didn’t relent. In response, the client said, “Forget it.”
Why shouldn’t a charitable organization gratefully accept a donor’s offer to name it as either a primary or contingent beneficiary? It could be that the planned giving officer is unfamiliar with how gifts of life insurance are crafted; some give the organization ownership, others simply name the organization as beneficiary. Perhaps charitable organizations have been dissatisfied with over-aggressive agents touting insurance as a way to build an endowment, resulting in dollars being redirected into commissionable products with less immediate value. For these reasons, many charitable organizations would rather avoid insurance policies or insurance salespeople. Yet, naming a charitable organization as beneficiary on an insurance policy or a commercial annuity is perhaps the easiest deferred gift to effectuate. And these assets are commonly found in a client’s portfolio.
Charitable Giving Options
Legitimate uses of life insurance exist in charitable estate planning, making perfect economic and practical sense for a number of client situations. Depending on your client’s goals, existing assets and health status, one of the following three giving options may be most effective.
1. Purchase of a new policy. If your client is healthy and can pass an insurance physical, he or she may wish to purchase a new life insurance policy for the benefit of one or more charitable organizations. The death benefit could fund a special project or endow the donor’s lifetime gifts forever. Think of it in terms of “key person” insurance coverage on a valuable donor.
Does it make sense to buy a new policy solely for the use of a charitable gift? Maybe, if there’s a risk that the donor’s services and support would be lost to the charitable organization before typical mortality or before a traditional investment account could build up enough value to sustain itself. But there is a “crossover” point where the charitable organization’s own investments will eventually outperform the insurance policy.
The organization may prefer your client make annual gifts instead of purchasing an insurance policy, assuming its endowed investments will outperform the insurance company’s policy projections. To cut through the analysis, the first step is to ascertain whether this policy is being treated as an “investment.” Many insurance agents forget that the wealth-building tax advantages of an insurance-wrapped investment won’t apply to a tax-exempt 501(c)(3) organization. At a certain point, the tax-exempt charitable organization may be able to more efficiently invest the same premium dollars in its endowment fund and generate a greater impact.
If, however, the insurance policy is placed instead as key donor coverage, then the risk covered is that of the donor dying prematurely. In this case, the life insurance coverage is not an investment and becomes a practical charitable solution.
Few policies, however, actually perform as investment projections predict. Interest rates, crediting levels and mortality expenses change, and this variability is often forgotten after the policy is purchased. To avoid relying on the projections, annual reviews of a charitable organization’s insurance portfolio should be conducted by an objective analyst to ensure the policies are performing as designed. If they deviate significantly, then decisions can be made to preserve the value by reducing the death benefit or increasing the premium payments, or, if the organization chooses, to surrender the policy.
From an income tax perspective, a newly purchased policy should be owned from inception by the charitable organization, assuming any insurable interest issues have been properly addressed. Your client (and oftentimes his or her spouse) will be the insured(s). In most cases, the client will make the premium payment directly to the charitable organization, which then pays the premium to the insurance company. The client will be able to deduct the amount of the premium as an income tax charitable deduction, the ceiling for which is by most commentators thought to be 50 percent of AGI (although the old school of thought described this transaction as a gift “for the benefit of” a charitable organization instead of “to” the organization limiting it to a 30 percent ceiling).
Stranger-owned life insurance. Recently, nonprofit organizations have been deluged with investment opportunities from life insurance agents and third-party investors to engage in plans known as “stranger-owned life insurance” or SOLI in which numerous policies are purchased on the lives of many elderly donors. The death benefits are unevenly split between the third-party investor and the organization. Although the intricacies of SOLI are beyond the scope of this article, note that Sen. Charles Grassley (Rep. Iowa) proposed legislation in 2005 to stop these arrangements from being solicited to charitable organizations. He said, “I’m very concerned about snake oil salesmen taking advantage of tax-exempt organizations to line their own pockets with life insurance schemes….The bill we’re announcing today will toll the bell on this scam.”
2. Donation of an old insurance policy. Donors who have old policies once acquired for other reasons (e.g., mortgage or debt risks, education for children, survivor income security or veterans’ policies) may no longer need the coverage and choose to transfer ownership to a nonprofit. If the donor transfers the ownership of the policy to a nonprofit organization, then besides removing the asset from the donor’s estate, it will often generate an income tax deduction equal to the lesser of cost basis or fair market value of the policy if all of the rights of ownership are completely transferred.
An often-unrecognized problem for an asset potentially worth more than $5,000 is the valuation of the policy. Some would argue that the insurance carrier can easily assess and report its value on an IRS form 712, but the agent and insurance carrier, as parties to the transaction, cannot perform the valuation and thus an outside appraiser is needed to perform the appraisal.
The fair market value of the policy is a function of the type of policy at hand. The section below shows the definition of fair market value.
Occasionally donors will have old life insurance policies with loans against the cash value. Donating such a policy, however, will not provide your client with a charitable income tax charitable deduction.
Gift of an Existing Policy Income Tax Charitable Deduction [IRC 170(e)(1)(A)]
- Contractually “paid-up”—the lesser of the cost basis or fair market value. The fair market value is the replacement value of a similar policy—meaning what the donor would have to pay for a new single premium policy with the same face amount at his or her age today. Note that very few policies fall into this category. Most policies are sold on the basis that premiums are paid for a limited number of years (e.g., 7–10 years), but are not contractually paid up at the end of the projected period. If interest rates are not credited as projected, the policy owner will indeed have to begin making additional premium payments.
- Contractually in premium paying status—the lesser of cost basis or fair market value (i.e., interpolated terminal reserve value).
3. Purchase of wealth replacement insurance. Another use of life insurance in an estate plan is to offset the gift of an asset by replacing the wealth so heirs aren’t unduly affected. These so-called “wealth replacement” plans are very popular when working with large bequests and charitable remainder trusts or gift annuities. It leaves the heirs their inheritance while still realizing the client’s dream of supporting his or her favorite organizations. Why shouldn’t the heirs simply inherit those assets and skip the insurance policy hassle? It might be more tax efficient to leave heirs an asset that always steps up in value at death. In contrast, commercial annuities or retirement plan proceeds come with an accompanying income tax as income in respect of a decedent and artificially inflate the taxable estate of the deceased donor. If the life insurance is properly structured and held outside of the estate (typically in an irrevocable life insurance trust with Crummey provisions or owned by a single heir), then the proceeds pass to heirs without income, gift or estate tax liabilities.
Approaching the Estate Planning Client
How can you approach your clients or potential donors concerning charitable donations of an insurance policy? Begin by finding out which policies are in place; don’t forget group plans provided by an employer. Review the ownership and beneficiary designations. Oftentimes clients discover ex-spouses or deceased beneficiaries are still listed, so it’s a great opportunity to suggest changes and introduce a charitable gift into the equation. If donors will consider naming a charitable organization for a portion of the death benefit, they may also consider transferring the ownership of the entire policy by absolutely assigning it and receiving tax benefits in the process. But you won’t know unless you ask, and because few donors realize that they can split beneficiary designations, they often don’t consider it.
Please call Tim Enstice at 757-962-8213, or e-mail us at email@example.com, for more information.