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Monday, April 29, 2024
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Case Studies |
Planning Gifts of Life Insurance: Current, Deferred, Contingent & Split Interest, Part 4 of 6
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Case:
Many years ago when Dr. Mimms was just a budding young surgeon and father, he decided to purchase a life insurance policy on his life "just in case." At that time, he had two children and a very large mortgage. Therefore, he sought some financial protection should anything happen to himself, since he was the only income earner and his wife stayed at home to raise their children. Consequently, he purchased a $1,000,000 life insurance policy with annual premiums of $10,000.
Now the Mimms' financial picture is quite different. They have an estate of $4 million, which consists of a $1.25 million home, $2.5 million IRA, and $250,000 of various assets. Both of their daughters' schooling expenses have been set aside in education savings accounts. Finally, through the use of credit shelter trusts, bequests, and testamentary charitable remainder trusts, their estate plan was arranged so that no estate tax would be payable at either death. The Mimms are very philanthropic and want to make a substantial gift upon their death to their favorite charity.
Question:
Since the Mimms no longer seem to need the life insurance policy for estate tax or "just in case" reasons, can they designate their favorite charity as the beneficiary of the $1 million life insurance policy? What are the tax consequences of making such a designation? How can the charity count the gift?
Solution:
Under state law, a donor may transfer an existing life insurance policy to charity. Generally, the transfer is completed by the donor irrevocably designating charity as the beneficiary of the policy and assigning all the incidents of ownership in the policy to charity. However, in this instance, the donor wishes to maintain ownership over the policy and merely designate charity as the beneficiary of the policy. In other words, the Mimms will retain full control of the policy during their lifetimes and charity will receive the $1 million upon their deaths. This is a common situation for donors who wish to maintain utmost flexibility and control.
Unfortunately, the Mimms will not receive a charitable income tax deduction for this future gift, because they have not made an irrevocable charitable contribution in accordance with the tax code. Generally, the tax code requires an irrevocable transfer under state law of cash or property. Since the Mimms retained ownership of the policy and may elect to change the beneficiary, a charitable income tax deduction will not be allowed. However, in determining their estate tax liability, the Mimms' estate will be entitled to a charitable estate tax deduction for the amount transferred to charity (i.e., $1 million).
Even though this future gift does not qualify for a current income tax deduction, in many cases charities want to currently "count" this future gift. Some charities measure this gift by doing a "future value to present value" computation. In short, the charity takes the future value of $1 million and determines the present value of the $1 million using the life expectancy of the donors and an assumed discount rate (i.e., 3-4% for inflation). In this instance, the Mimms are both 65 and have a life expectancy of 25 years. Using a 3% discount rate, the present value of the $1 million policy is $477,606. Alternatively, some charities may use the applicable federal rate (AFR) to determine the present value. In this case, the present value of the $1 million policy using a 6.0% AFR is $232,999.
The Mimms love the flexibility and charitable benefits of this plan. As a result, they name charity as the primary beneficiary of their life insurance policy. This was accomplished by contacting the insurance company and filling out the proper change of beneficiary form provided by the insurance company. In the end, the Mimms' "just in case" plan provided peace of mind and a wonderful gift to their favorite charity.
Editor's Note: An outright gift of an insurance policy will produce a charitable income tax deduction equal to the lesser of the policy's value (i.e., interpolated terminal reserve value or replacement cost) or their basis in the policy (i.e., premiums paid). See Sec. 170(e) which deals with gifts of ordinary income property.
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