Friday April 26, 2024
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4.4.1 Valuing the Insurance Charitable Gift
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Transfer of Policy
Many individuals own life insurance at some time in their lives. A life insurance policy may provide peace of mind, financial liquidity, investment diversification or an inheritance for loved ones. As an individual's situation changes over time, however, the life insurance policy may no longer be needed for its original purpose. Individuals with philanthropic intent may decide to make a charitable contribution of the life insurance policy.
A donor who wants to make a gift of a life insurance policy must irrevocably transfer ownership of the policy to charity. With this transfer, the donor must relinquish all incidents of ownership and rights in the policy. Most states allow for such a transfer to charity; however, some may not. Therefore, it is imperative that a donor determine whether his or her state allows such a transfer before proceeding.
To effectuate a transfer, the donor will need to contact the insurance company and fill out the proper change of ownership forms. Once the charity owns the policy, it may hold or surrender the policy. In many cases, however, the charity will hold the policy until the donor's death. In this case, the charity should verify that it not only owns the policy, but is the designated beneficiary as well.
Value of Policy for Income Tax Purposes
An outright gift of a life insurance policy will produce a charitable income tax deduction equal to the lesser of the policy's value or the donor's basis in the policy. See Sec. 170(e) and Rev. Rul. 78-137. In general, the donor's basis in a policy equals the total amount of premiums paid by the donor. As a practical matter, the charitable income tax deduction will normally equal the donor's basis because, in most instances, the cost basis will not be greater than the policy's value, i.e., replacement cost or interpolated terminal reserve value (ITRV).
If the policy is paid in full, its value is generally equal to its replacement value. Replacement value is the cost of an identical policy given the donor's age and health. If the policy is not paid up, the policy's value will be based upon the ITRV plus any unearned premium. The insurance company provides the ITRV. The ITRV plus unearned premium is, in many cases, slightly higher than the policy's cash surrender value.
The rationale behind the "lesser of" rule is derived from the income tax reduction rules. See Sec. 170(e). Under the income tax reduction rules, a donor's charitable deduction is reduced by the contributed asset's ordinary income component. So a donor who surrendered his or her policy for cash would realize taxable income equal to the excess of the policy's value over the cost basis. This taxable income would be treated as ordinary income (not capital gain income), and the insurance company would report the income on IRS Form 1099. As a result, the contribution of a policy usually produces a charitable deduction equal to its cost basis only, with no increase for the ordinary income component of the policy. Keep in mind, however, that the charity would own the policy outright and could surrender it for the full value (minus any administrative or surrender charges).
Example 4.4.1A
John and Mary own a second-to-die whole life policy. After contacting the insurance company, they donors determine that the policy's value is $400,000. John and Mary have paid annual premiums of $10,000 for 25 years. Thus, their basis in the policy is $250,000 (25 x $10,000 annual premium). John and Mary contribute the policy outright to their favorite charity. Accordingly, they are entitled to a charitable deduction of $250,000, since it is less than $400,000. The reduction rules deny John and Mary a charitable deduction for the ordinary income component of $150,000 ($400,000 - $250,000).
The $250,000 deduction will be subject to the 50% AGI limitation (not the 30% limitation), because no capital gain element is involved in the charitable deduction. In other words, the gift is treated in a manner similar to a basis-type gift. Once the charity owns the policy, it can surrender the policy to the insurance company. Assuming no surrender or administrative charges, the charity will receive $400,000. As a tax-exempt entity, the charity has no income tax liability imposed at the time of surrender.
Example 4.4.1B
Joe owns a one life insurance policy. He has paid premiums of $2,000 per year for 10 years, or a total of $20,000. The policy is now paid up. The replacement value adjusted under the Rev. Rul. 78-137 guidelines requiring a determination of the "economic benefits" under the policy is $36,000.
Joe makes a gift of the policy to favorite charity. His deduction is the lesser of the $20,000 cost basis or the $36,000 policy replacement value, producing a deduction of $20,000.
Example 4.4.1C
Herbert purchased a life insurance policy and paid premiums of $2,000 per year for 10 years. The cost basis in the policy is $20,000, and it is now a "paid in full" policy.
Herbert plans to give the policy to favorite charity. He asked his CPA Helen to call the insurance company to check on the policy value. Because this was a very high cost policy, and the mortality tables have changed dramatically since the policy was first issued with annuitants now expected to live longer, the replacement cost is only $18,000 for a comparable policy. Under the "lesser of basis or policy value" rule, Herb's gift of this policy to charity produces a deduction of $18,000.
No Tax Recognition Upon Transfer
The transfer of a life insurance policy to charity should not trigger any income tax liability. However, this result may change in some rare instances, i.e., if there are loans against the policy in excess of basis. If this is the case, the donor must report and recognize the loan amount in excess of basis as an ordinary gain. Therefore, each situation must be reviewed prior to any transfer.
Viatical Settlements or Accelerated Benefits
Viatical settlements involve the sale of life insurance policies for lump sum cash payments. In a viatical settlement transaction, a person with a terminal illness assigns his or her life insurance policy to a viatical settlement company in exchange for a percentage of the policy's face value.
In 1997, Sec. 101(g) of the Tax Code was amended so that proceeds from accelerated benefits and viatical settlements are tax-exempt as long as the settlor's life expectancy is less than two years and the viatical settlement company is licensed (if the settlor lives in a state that requires licensing). Many states also have declared that payments of accelerated benefits or viatical settlements are exempt from state taxes. However, given the complexity of this area of law and the different state laws, a professional advisor should be consulted prior to any sale.
If the donor is age 70 or above and is willing to consent to a life settlement, there may be increased benefit to the charity. Several major financial services companies selectively purchase policies. The purchase price depends upon the policy face value, the age of the insured, and his or her health. In cases with very senior insured persons who have health concerns, the life settlement amount may be two or three times the cash value of the policy. If there is a potential life settlement donor, then it is essential to obtain a qualified appraisal. The policy has basis equal to premiums paid, ordinary income for the difference between basis and cash surrender value, and long term capital gain for the excess of the life settlement proceeds over the greater of basis or cash value. The charitable deduction equals the capital gain plus the basis.
An outright gift of a life insurance policy generally will produce a charitable income tax deduction equal to the lesser of the policy's value or the donor's basis in the policy. Usually the donor's basis in a policy equals the total amount of premiums paid by the donor. As a practical matter, the charitable income tax deduction will normally equal the donor's basis because, in most instances, the cost basis will not be greater than the policy's value, i.e., replacement cost or Interpolated Terminal Reserve Value (ITRV).
Life Settlements
Life settlements involve ownership transfer of a life insurance policy to a third party, known as a life settlement provider, in exchange for a lump sum cash payment greater than the policy's cash surrender value. Donors or nonprofits can locate a reputable life settlement provider to obtain bids for a life settlement contract. Once a purchase agreement is reached, the life settlement provider then assumes the responsibility of paying the ongoing premiums and collects the death benefit. The life settlement amount could be much larger than the ITRV. If the policy is owned by the donor at the time of transfer, the donor may owe ordinary income or capital gains tax upon transfer which is offset by the charitable deduction. If the nonprofit becomes the owner of the policy and the donor's deduction is based on the value determined by the qualified appraisal. The nonprofit sells the policy to the life settlement provider and receives the cash directly for its immediate use and is relieved from paying further premiums.
Life Insurance Contract Reporting by Charities
A number of charities have been involved in acquisition of insurance contracts on trustees. After the insurance is in place, the charity sells the insurance contracts to a group of investors. In theory, because the contracts are purchased at a price based on a substantial lapse rate and the investors will not allow the policies to lapse, the investors will receive a substantial return on the policies.
This strategy has been criticized as a method for violating state insurable interest rules, which ordinarily would preclude an investor group from buying policies on unrelated individuals. The Service issued Notice 99-36, which states that the transactions will not produce the tax benefits advertised by the promoters. "Furthermore, promoters of these transactions, and taxpayers and organizations participating in them, may be subject to other adverse tax consequences, including penalties." The Service found that no charitable contribution deduction is permitted when a taxpayer assigns a partial interest in an insurance policy to a charity.
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Case Studies on Valuing the Insurance Charitable Gift
Get a Life (Insurance Policy) and Give it Away:
Dr. Eleanor Crane, 55, has been director of research at a local hospital for the past 16 years. She is the first woman director in the hospital's history and was honored several times by her colleagues for outstanding medical research. During her tenure as director, she and her spouse, August, raised two wonderful daughters, Denise and Laura. In fact, both of her daughters are medical students and wish to follow in the prestigious steps of Dr. Crane (a.k.a. Mom).
Planning Gifts of Life Insurance: Current, Deferred, Contingent & Split Interest, Part 1 of 6:
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."
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Private Letter Rulings
PLR
200017051 No Gain Recognized on Asset Transfer to FLP:
In this ruling, Husband and Wife had created a fairly complex set of entities. Trusts one and two were created to hold insurance and possess three insurance policies. Trust three was an earlier trust and the assets from trust three were transferred to trust one and two through a series of notes in order to pay premiums on the insurance policies.
PLR
200209020 Gift of Life Insurance Policy Produces Deduction Equal to Premium Paid:
Taxpayer intends to buy a single premium whole life insurance policy from Company. At the time of purchase, Taxpayer will designate Charity as the irrevocable beneficiary of the policy and will transfer to Charity any and all privileges in the policy. Charity has an insurable interest in Taxpayer's life under state law and is an organization described in Sec. 170(c) of the Code.
PLR
200232036 Foundation May Own and Pay Premiums on Life Insurance Policy Contributed by Donor:
Donor created a private foundation and an irrevocable trust during his life. Donor now wishes to have his trust transfer a term life insurance policy to his foundation. The term life insurance policy requires annual premiums, is convertible into a whole life policy, has no cash value and is not subject to a policy loan. Because the policy has no cash value, no one can possibly borrow against it.
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