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GiftLaw Note: Taxpayer desired to fund a two-life unitrust with appreciated property, sell the property and purchase an insurance policy. The Service permitted the use of an insurance policy as a unitrust investment. Taxpayer requested four rulings related to the trustee's investing in a life insurance policy:

1. Borrowing from the policy would not create debt-financed income;
2. Investing in the policy would not violate Reg. 1.664(a)(3) relating to investment restrictions on a trustee;
3. Investing in the policy would not violate Reg. 1.664(a)(4) relating to the payment of amounts, other than the unitrust amount, to any person other than a qualified charitable organization; and
4. Purchasing a life insurance policy would not automatically be considered a jeopardy investment.

First, the Service ruled that borrowing from the policy to create income would produce "debt-financed income." As to the second and third rulings, the Serviced ruled that investing in the policy would not violate either Reg. 1.664(a)(3) or (a)(4). Fourth, while a determination could not be made without reference to a specific policy, it is possible that insurance would not be a "jeopardizing investment" in violation of IRC Sec. 4944. Thus, this ruling suggests that it may be permissible for a trustee of a unitrust to purchase insurance.
DATE: August 7, 1987

This is in reply to your letter dated May 18, 1987, and previous correspondence, requesting rulings on certain transactions concerning X. The ruling requests will be answered consecutively.

X is a charitable remainder unitrust described under section 664(d)(2) of the Internal Revenue Code. The sole asset of X is non-income producing real estate which has appreciated in value over its basis. The trustee of X intends to sell the appreciated real estate and use the proceeds to purchase life insurance on the life of the recipients of the unitrust amount. The sole asset of X would then be the life insurance policy.

Ruling Request 1:


If the trustee borrows from the insurance policy and invests the proceeds to create income, acquisition indebtedness will not exist. Section 514(b) of the Code states that the term "debt-financed property" means any property which is held to produce income and with respect to which there is an acquisition indebtedness at any time during the taxable year. However, under section 514(b)(1)(A)(i), the term "debt-financed property" does not include any property substantially all the use of which is substantially related (aside from the need of the organization for income or funds) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption.

Section 514(c)(1)(A) of the Code states that the term "acquisition indebtedness" means, with respect to any debt-financed property, the unpaid amount of the indebtedness incurred by the organization in acquiring or improving such property. Section 514(c)(4) provides that the term "acquisition indebtedness" does not include indebtedness the incurrence of which is inherent in the performance or exercise of the purpose or function constituting the basis of the organization's exemption, such as the indebtedness incurred by a credit union in accepting deposits from its members.

In order for acquisition indebtedness not to exist with respect to debt-financed property, the indebtedness incurred must be inherent to the performance or exercise of the particular organization's exempt purpose or function. While a charitable remainder unitrust has an obligation to distribute the unitrust amount of the recipients of such amount, it is not inherent to the performance of the organization's [*3] exempt function to engage in borrowing to meet this obligation.

In the instant case, the unitrust amount is equal to the lesser of trust income for such taxable year or eight percent of the net fair market value of the trust assets. If there is no trust income in a particular year, it is possible for nothing to be distributed to the recipients of the unitrust amount. The trustee is not required to borrow funds from the insurance policy and invest such funds to create income. Consequently, if the trustee does borrow funds, it is an independent decision which is not inherent in the performance or exercise of the purpose or function constituting the basis of the organization's exemption. Accordingly, if the trustee borrows from the insurance policy and invests the proceeds to create income, acquisition indebtedness under section 514(c)(1)(A) of the Code will exist.

Ruling Request 2:


The transaction will not violate section 1.664-1(a)(3) of the Income Tax Regulations.

Under section 1.664-1(a)(3) of the regulations, a trust is not a charitable remainder trust if it includes a provision which restricts the trustee from investing the trust assets in a manner which could result in the annual realization of a reasonable amount of income or gain from the sale or disposition of trust assets. No such provision exists in the trust instrument. However, the trust instrument does include a provision which states that" [n]othing in this agreement shall be construed to restrict the Trustee from investing the unitrust assets in a manner which could result in the annual realization of a reasonable amount of income or gain from the sale or disposition of trust assets." Accordingly, the transaction will not violate section 1.664-1(a)(3) of the Code.

Ruling Request 3:


The transaction will not violate section 1.664-3(a)(4) of the regulations.

Under section 1.664-3(a)(4) of the regulations, no amount other than the unitrust amount may be paid to or for the use of any person other than an organization described in section 170(c). However, if the amount so paid is transferred for full and adequate consideration, the above described prohibition does not apply. In the instant case, the trustee is essentially exchanging one asset of the unitrust, real estate, for another asset, a life insurance policy. As long as it can be demonstrated that the value of the life insurance policy constitutes "full and adequate consideration," then the transaction will not violate section 1.664-3(a)(4).

Ruling Request 4:


The purchase of life insurance by X will not automatically be considered a jeopardy investment under section 4944 of the Code.

Section 53.4944-1 of the Foundation and Similar Excise Taxes Regulations provides that if a private foundation (as defined in section 509) invests any amount in such a manner as to jeopardize the carrying out of any of its exempt purposes, section 4944(a)(1) of the Code imposes an excise tax on the making of such investment.

Section 53.4944-1(a)(2) provides that an investment shall be considered to jeopardize the carrying out of the exempt purposes of a private foundation if it is determined that the foundation managers, in making such investment, have failed to exercise ordinary care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long and short term financial needs of the foundation to carry out its exempt purposes. The determination whether the investment of a particular amount jeopardizes the carrying out of the exempt purposes of a foundation shall be made on an investment by investment basis, in each case taking into account the foundation's portfolio as a whole. No category of investments shall be treated as a per se violation of section 4944. However, the following are examples of types of investments which will be closely scrutinized to determine whether the foundation managers have met the requisite standard of care and prudence: Trading in securities on margin, trading in commodity futures, investments in working interests in oil and gas wells, purchases of "puts" and "calls" and "straddles", the purchase of warrants, and selling short. The determination whether the investment of any amount jeopardizes the carrying out of a foundation's exempt purposes is to be made as of the time that the foundation makes the investment and not subsequently on the basis of hindsight.

It would appear that the purchase of life insurance by the trust will not automatically be considered a jeopardy investment under section 4944 of the Code. However, Rev. Rul. 80-133, 1980-1 C.B. 258, holds that each payment made by a private foundation for a premium on an insurance policy and the interest on a policy loan is a jeopardizing investment under section 4944 where the combined interest and premium payments exceed the amount the foundation would receive under the policy given the life expectancy of the insured-donor.

Consequently, the determination of whether the investment jeopardizes the carrying out of the foundation's exempt purposes can only be made on the basis of all facts and circumstances existing at the time of the investment.

Your ruling request concerning the characterization of gain under section 664(b) of the Code with respect to funds withdrawn from the life insurance policy will not be answered at this time. Without a specific life insurance policy in hand, a definitive answer is not available given the various adjustments possible under the policy. Upon our receipt of a proper life insurance contract, however, we will resume our consideration of this particular ruling request.

No opinion is expressed as to the federal tax consequences of the formation or operation of X under the provisions of any other section of the Code. No opinion is expressed as to any amendments to the provisions of X.

This ruling letter is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

Related Topics On Insurance Policy as Unitrust Investment

3.10.10  Investments of Unitrust Corpus:    One of the major decision points when creating a charitable remainder trust (CRT) is developing an investment strategy. Under the four-tier accounting rules, the type of income paid out of the trust is determined by the trust investments.


5.4.1  Jeopardizing the Charitable Interest:    Private foundations and charitable remainder trusts are subject generally to the rules on jeopardizing the charitable interest. If a foundation manager or trustee were to invest in highly risky ways, it is possible that the investments could result in the loss of the foundation or trust principal. In that case, there would be nothing available to charity.



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