Author:
STEPHAN R. LEIMBERG AND ALBERT E. GIBBONS
STEPHAN
R. LEIMBERG is an attorney and CEO of Leimberg Information Services, Inc.
(http://www.leimbergservices.com), a provider of commentary on recent cases,
rulings, and legislation; CEO of Leimberg and LeClair, Inc., an estate and
financial planning software company in Bryn Mawr, Pennsylvania; and President
of Leimberg Associates, Inc., a software and publishing company. His e-mail
address is steve@leimbergservices.com. ALBERT E. GIBBONS is President of AEG
Financial Services in Phoenixville,
We are
entering a time when providing financial support to charitable organizations is
more important—and yet, because of the economic condition of our country, a
more difficult task—than ever. As estate planners, we need to consider the
highly useful and significant role that life insurance can play in providing charitable
support through the funding of major gifts, the building of endowment funds,
and the replacement of wealth otherwise lost to heirs. Life insurance, if
used properly, can provide unique leverage for accomplishing the dreams of the
charitably-minded client and the mission of the charity. 1 This first part of a
two-part column explores advantages and disadvantages of using life insurance,
valuation and tax ramifications, and traditional as well as new, creative
planning strategies.
Using life insurance both
creatively and ethically in charitable planning is not nearly as easy or simple
as it sounds. The combination of the life insurance product, its taxation, and the tax
implications of using life
insurance
in a charitable context create considerable complexity at a level seldom
encountered and not always appreciated by life insurance or other professionals.
State, as
well as federal, law must be taken into account. Issues of conflicts of
interest and abuse of the special tax treatment afforded to charities and
their donors constantly arise. 2 The IRS and the
various states' Attorneys General are ultra-sensitive to all dealings with charities where
there is—or may be—a motive other than detached, disinterested generosity,
and/or where the donor receives a benefit from the transfer that is more than
incidental and insubstantial. And the officials are rightfully watching
everyone involved. The consequences to both charity and donor—as well as to promoters,
advisors, agents or brokers or even insurers—can be quite severe if the
planning, the implementation, or the review process is flawed. 3 Great care must
therefore be taken both to use life insurance to its fullest potential as well
as to avoid misuse or abuse.
There are
many reasons why life
insurance
could be considered the "Ultimate Endowing Tool":
1. A life insurance policy
provides a guaranteed death benefit. So, assuming premiums are paid, the charity's receipt
of a given amount is certain. Compare this with a gift of real estate or
marketable securities that may be subject to wide fluctuations in value.
2. If the insurance policy
is owned by a charity,
assuming premiums are paid, the gift can't be revoked by the donor. So rather
than a "maybe someday" gift that might never be made, charity-owned life insurance is a
"right here, right now" gift.
3. Life insurance
provides an "amplified" gift. Incredible leverage is possible. A
relatively small amount of premiums can translate into a large and meaningful
gift. The leverage ratio of death benefit to premiums paid is extremely
favorable, usually many times more than the charity would otherwise receive
through a non-life
insurance
gift.
4. Life insurance can
legitimately be considered a way to obtain "immortality on the installment
plan": Almost anyone, regardless of economic station, can assure a
meaningful and significant gift, a larger gift to charity through life insurance than by
other methods.
5. A life insurance gift is
cost-efficient and provides "100 cent" dollars. There is no
"slippage" due to federal estate or state death taxes, state or
federal income taxes, administration or estate settlement costs, or any other
fees or charges.
6. Life insurance
involves none of the cost, delay, or uncertainty of probate.
7. The use of
life
insurance
involves a negligible risk of contest. Because of the contractual nature of life insurance and the
fact that it passes outside a person's probate estate, there is only a
scintilla of a chance the payment of life insurance owned by and payable to a charity could be
successfully contested by disgruntled heirs. Nor can a surviving spouse
intercept the policy proceeds payable to a charity. A spouse may elect against
the decedent's will without affecting a charity's claim to policy proceeds because
the insurance
money passes by contract to the charity outside the probate estate.
8. There is
no statutory limitation on charitable gifts of life insurance. Under so-called mortmain
statutes, in some states, gifts to charity made by will within a relatively
short period prior to death can be disallowed. But life insurance
proceeds are typically not subject to such restrictions or risk.
9. Life insurance is
generally accorded a greater level of protection against creditors than are
other assets under most states' creditor laws. 4
10. The
policyowner has the right to borrow or use policy cash values as collateral as
soon as they develop. If the charity is the owner of the policy, it can
use policy values for any reason whatever at any time. These cash values are
obtainable almost instantly once they accrue in the policy. If the donor is the
owner of the policy, he or she can use policy values for any reason at any
time.
11. Life insurance can be
publicity-free or can provide "leveraged" honor. The size and even
the existence of a life
insurance
gift can be completely confidential because of the contractual nature of life insurance. On the
other hand, amplified recognition is possible if publicity is desired. For
example, a "millionaire's club" can be formed to announce each
purchase of a policy with a "face value" (initial death benefit) of
$1 million or more. 5
12. Unlike
other installment-type gifts, the gift of life insurance can be
"self-completing." So, regardless of how few premiums the donor paid
prior to death, the amount the donor intended the charity to
receive (i.e., the policy's death benefit) is paid to the charity. Compare
this to annual gifts made by a "best intentions" donor who dies after
one or two years. Furthermore, if the insured becomes disabled, assuming a
"waiver of premium" feature was attached to the policy and the
disability meets the terms and conditions of the waiver of premium provision,
the insurer will keep the contract in force and pay all premiums on behalf of
the policyowner. Thus, such a charitable gift is, in essence,
"self-completing" in the event of the insured's disability. The charity can
choose to continue the policy—either out of income or capital or by using the
policy's own cash values and nonforfeiture options—if the donor starts to pay
premiums but for some reason is unwilling or unable to continue.
13. A life insurance gift to
charity
is relatively "painless." From a cash flow perspective, the gift of
personally owned life
insurance
to charity
is not typically perceived as the loss of "a needed asset" because no
income-producing asset is being given away. From wealth transfer perspective, a
gift of life
insurance
to charity
doesn't affect the family business, home, or investment portfolio that the heirs
expect to receive.
14. The
transfer itself is simple and cost-efficient. Any size or type (e.g., term insurance,
ordinary, variable, universal, or combination) of policy can be used, and
absolute assignment forms are cost-free.
15. Upon
making the gift, the donor typically pays no ordinary income tax on any gain in
the policy, no matter how large the gain. 6
16. From the charity's
perspective, there is much less administrative responsibility for an insurance policy
than for real estate or other similar assets. Usually, there are no complex or
expensive valuation procedures nor is there concern about environmental
problems. If the value of the gift is $5,000 or less, the insurer—typically at
no charge—provides all the necessary information. (See below for further
discussion of valuation and documentation for tax purposes.) Compare the cost,
the degree of time and effort, and the complexity of a gift of life insurance to the
valuation of charitable gifts of closely held stock, real estate, or interests
in an FLP (family limited partnership) or LLC (limited liability company).
17. Annual
premium statements (request duplicate premium notices), coupled with annual
"thank you" notes, give the charity a continuing contact—and opportunity
to enhance its relationship—with the donor. It is very important that each
annual premium be considered by the charity as an opportunity to renew and
deepen the relationship and bond between the donor and the charity, and
recognize again the generosity of the donor. Whenever possible, those directly
affected by the gift (e.g., scholarship recipients or department heads) should
be introduced to the donor—perhaps giving the donor a "progress
report" and a further chance to see what each annual premium is helping
accomplish and sustain.
No tool or
technique is without cost or risk. Certainly, life insurance in a charitable context is
no exception to that general rule. A life insurance policy should be only one of many
types of assets in a charity's
investment portfolio and in the planner's tool kit. Therefore, like any other
asset, its appropriateness must not only be considered initially, but also be
reviewed annually. The charity must monitor premium payments, cash values, and
dividends as well as the financial health of the insurer. Gifts of life insurance should
not be sought by a charity
in place of the solicitation of outright gifts or an endowment program, but
should complement these. We shouldn't be asking, "What is the cost of
waiting for the insurance
benefits versus having dollars given currently to an endowment and compounded
over time," but rather, "How can we maximize both types of
gifts?" Most of the problems with respect to life insurance occur
not because of the product itself, but rather because it is misunderstood or
improperly used.
Contribution
of paid-up or single pay policy. The oldest, simplest, and most
appreciated way to use life insurance to benefit a charity is
through an outright contribution (absolute assignment) of all rights to an
existing "paid-up" or single premium policy. 7 However, the donor's
retention of any meaningful economic right in the policy or a loan against the
policy at the time of the gift—no matter how small—will bar a charitable
deduction. 8 Generally, the gift
of an existing paid-up or single premium insurance policy results in a current
deduction to the donor equal to the net premiums the donor has paid. 9
The gift of a
policy should have substantially greater value if the insured is terminally
ill. Reg.
25.2512-6(a) provides that "[i]f...because of the unusual nature of the
contract such approximation is not reasonably close to the full value, this
[interpolated terminal reserve plus unearned premium] method may not be
used." A client who is very ill—or even one who is paying a significant
rating or has unusual limitations on the policy—may be able to claim the gift
of that policy to charity
is worth more than it would be under normal circumstances. This is the same
argument the IRS would make upon the gift of a policy by such an insured to a
non-charitable donee.
Contribution
of `premium-paying policy.' A premium-paying policy is one for which
premiums remain payable. Typically, a charity is made the absolute owner and
beneficiary, and holds all ownership rights. The charitable organization must
have an insurable interest in the donor. Otherwise, all deductions may be lost.
State law must be checked. If the charity has an insurable interest, the charity can be
the original owner and beneficiary. Otherwise, the donor (or preferably donor's
spouse) can purchase the policy and make an immediate absolute assignment once
the policy is issued. (If the insured's spouse purchases the policy, the
insured never acquires incidents of ownership and consequently, there is never
a question of estate tax inclusion.) The deduction for a policy in
premium-paying status is usually the policyowner's basis—that is, the net
premiums paid. 10
As noted
above, the gift should have much greater value if the insured is terminally
ill. 11 Even a client who is
paying a significant rating or has accepted unusual limitations on the policy
may be able to prove that the gift of that policy to charity is worth
more than it would be under normal circumstances.
From the
donor's perspective, the drawback of an absolute gift of either a paid-up or
premium-paying policy is that the transfer is irrevocable. The donor can't
change his or her mind after making the absolute assignment. The charity has no
absolute assurance the donor will continue to make contributions, and the
policy may—or may not—be an appropriate investment for the charity to accept
or continue to hold.
Deduction
for gift of 'new' policy. For income tax deduction purposes, the value
of a charitable gift of a policy within its first year is the gross amount of
the premium paid at the time of application. 12 If the policy has
been in force "for a while," the donor generally will be limited to a
deduction of his or her basis. 13
Deduction
for gift of term insurance. Term insurance is an
unlikely and probably (for the reasons discussed below) an inappropriate gift
to charity
in most cases. Although the Regulations do not specify, in most cases the value
of term insurance
for purposes of computing a deduction will probably be the unearned premium as
of the date that ownership of the contract is transferred to the charity.
Premium
payments deductible. Premium payments made by the donor after the
gift of a policy or on a policy originally purchased and owned by a charity can
result in annual income tax deductions. 14 Although it is best
if the donor promises to support a policy he or she has given to charity, in most
cases the donor is under no legal obligation to continue premium payments. If
the donor discontinues payments, the charity has a number of options: It can (1)
continue premiums until the insured's death, (2) place the policy on
"paid-up" status at a lower "face amount" (death benefit)
with no further premiums payable, (3) surrender the policy for its cash value,
or (4) sell the policy to a "high net worth settlement company" or
viatical settlement company (assuming certain conditions are met).
Premiums
should be paid directly to the charity, and the charity should
then write its check to the insurer rather than the donor paying the insurer
directly. The reason for the donor to make contributions to the charity rather
than to pay premiums to the insurer is this: The donor potentially obtains a
higher current deduction for "gifts directly to the charity"
rather than for "gifts for use of a charity." 15 For instance, suppose
your client has $100,000 of adjusted gross income ("AGI"). If she
pays a $50,000 premium directly to the insurer, the IRS may limit her current
income tax deduction to $30,000 (i.e., 30% of $100,000) rather than 50% of her
AGI. If she wrote her check to the charity and the charity in turn
wrote its check to the insurer, her current deduction limitation would be 50%
of AGI (i.e., $50,000), a $20,000 difference. 16
As a
practical matter, it is generally suggested that the donor "round up"
the amount of each donation so that the charity can have the excess to defray the
costs of administering the program or add some money each year to its current
operating budget. And instead of paying cash each year, a more tax-smart
technique would be for the client to donate appreciated securities sufficient
in amount for the charity
to sell and net enough money to pay premiums and have a little extra for
administrative expenses.
Requirement
of absolute assignment of all rights. To obtain either a
gift or income tax deduction, the donor must assign all incidents of ownership
in the policy. If the donor assigns the policy cash value to charity but
retains the right to change the beneficiary or borrow the cash value, or
retains any other personally 17 beneficial economic
right, 18 no charitable gift or
income tax deduction will be allowed. 19
Stated
another way, if the gift is of a "partial interest," a charitable
gift tax deduction will be denied and the transfer of the policy becomes a
taxable gift. A donor must give all 20 of his interest—or an
undivided portion of each and every substantial interest—in the property to obtain
a deduction. 21 For example, suppose
Jo-Ann assigns the cash surrender value of a policy on her life to United
Cerebral Palsy. At the time of her gift, the cash value in the policy is worth
$10,000. The stipulation of her gift is that UCP will receive an amount equal
to the greater of $10,000 or the policy cash value on the day before her death.
The balance is to pass to Jo-Ann's son, John. Because she gave to charity less than
her entire interest in the policy, her income tax charitable deduction will be
denied. Furthermore, because this is a gift of a partial interest, no gift tax
charitable deduction will be allowed. That means Jo-Ann has made a taxable
gift.
If incidents
of ownership in the policy are retained, the policy proceeds will be included
in the donor's estate. Although there may be a corresponding estate tax
deduction for the amount actually received by charity, the inclusion could
possibly cause the estate to fail to qualify for benefits under Section
303 (partial stock redemption), 6166
(installment
payment of estate tax), or 2057
(deduction
for qualified family-owned business interest ("QFOBI")). Finally, if
the partial interest rule applies, the surviving spouse may argue that he or
she has a right to elect to receive a share of the policy proceeds on the
ground that the proceeds are part of the "augmented estate" 22 for purposes of the
spouse's elective share. It may therefore generally be more advantageous to
borrow cash from a policy and make a gift to charity of the cash than to make a
partial interest gift of the policy itself.
Name
charity as contingent beneficiary. Some clients have few
relatives and should consider naming a charity as a contingent beneficiary of a
policy. For example, the beneficiary designation might read, "To my wife
if living, otherwise to my children in equal shares or their issue, but if no
children survive, to The Boy Scouts of America, Troop 74, North Wildwood,
Name
charity beneficiary of all or a portion
of insurance proceeds. This is a very simple
procedure and will avoid probate. The donor retains flexibility and total
control over the policy and its cash values, and can remove the charity and name
a family member, friend, or trust at any time. Under this technique, the
donor's estate can deduct the amount of proceeds that actually pass to charity. The
proceeds will be included in the donor's gross estate because the donor has
incidents of ownership under Section
2042 , but this inclusion is offset by an estate tax charitable
deduction allowed under Section
2055(a) . Because the estate tax charitable deduction is unlimited, there
is no estate tax—no matter how large the death benefit.
No income tax
deduction is allowed for merely naming a charity as beneficiary. But if that retained
interest is later assigned to a charity, the insured donor will be allowed
an income tax (and gift tax) deduction at that time. Similarly, the insured
receives no income tax deduction for future premium payments until and unless
the charity
is the policy's beneficiary and also owner of every economic benefit
represented under the policy. 23 The problem with this
arrangement is that it is difficult for the charity to plan on the ultimate
benefit since the donor can change his or her mind. And of course, there is no
current benefit for the charity.
Name
charity as beneficiary of policy rider. A "rider,"
as its name implies, is term insurance "riding on top" of the
basic policy. For instance, a client purchasing a $1 million permanent policy
for her family might at the same time buy an additional $200,000 term rider and
name a charity
(say, Villanova Law School) as the beneficiary. Designating a charity as the beneficiary
of a specified amount or percentage of the basic policy's death benefit or of
an additional term insurance
rider is simple and cost-effective. This strategy keeps the insured donor's
family's security intact and also provides a significant gift to charity. The
client continues to own and control the ownership of the policy and its cash
values—as well as the right to change or even eliminate the charitable
beneficiary.
No current
income tax charitable deduction is allowed because the insured has not made a
complete current and absolute gift of his or her entire interest to charity. An
estate tax charitable deduction will be permitted for 100% of the amount
actually received by the charity. So if a charity receives $100,000 out of a $300,000
policy or if charity
receives a $200,000 rider, the insured's estate is allowed a corresponding
estate tax deduction, effectively eliminating the tax on that amount.
Documentation
is important. All gifts of policies to charity must be documented and records
retained. IRS Form 8283 should be used and signed by an official authorized to
sign the charity's
tax return. 24 Failure to include
the Form 8283 could result in a disallowance of the charitable deduction.
If the
donated policy has a value of $5,000 or more, it is necessary to obtain a
formal appraisal from someone other than the insurer or the agent that sold the
policy. 25 Probably, an agent
other than the one that sold the policy would be accepted. The appraisal should
be performed not earlier than two months before the date of the gift of the
contract, and must be attached to the donor's return and filed before the
return's due date (including extensions). Exhibit 1 summarizes these
requirements.
If a policy
is donated to a charity
that becomes the owner and beneficiary, the proceeds are removed from the
donor's estate. However, Section
2035 must be considered. If the policy is transferred from the insured
to the charity
within three years of the donor-insured's death, the policy proceeds will be
included in the donor's gross estate. Section
2055 will, in most cases, provide an unlimited deduction for insurance
proceeds passing directly to charity (or to a charitable remainder
trust), and will generally eliminate any estate tax. Although the deduction
appears to "wash" the inclusion, it may not be a precise match: As
noted above, planners should compute the impact of the inclusion of life insurance upon
the estate's ability to qualify for the benefits of Sections
303 (partial stock redemptions), 6166
(installment
payment of federal estate tax), and 2057
(QFOBI
deduction) prior to its scheduled phase-out. 26
There are a
number of ways planners can help clients help charities through life insurance that
are both creative and within the spirit, as well as the letter, of the law. As
explained in more detail below, the use of these ideas must also fall within
the scope of an ethical and appropriate investment—not just for charities in
general but for the specific charity and donor in question. These
creative ideas may include the following.
Second-to-die
amplified gift. The death benefit otherwise payable is
greatly enlarged by the use of a second-to-die (survivorship) insurance policy.
The charity
purchases a policy on the donor's life or the donor contributes the policy to charity. Leverage
is enhanced through use of a survivorship type of contract. For example, a
couple can purchase a $1 million policy on their lives payable at
the death of the survivor of the two. The same premium purchases a larger death
benefit than ordinarily because no payment must be made by the insurer until
the later death and more premiums (i.e., for a longer time) must typically be
paid by the owners(s). Alternatively, the donor's outlay may be reduced. So the
same death benefit could be purchased using a lower premium, because the cost
of providing a death benefit is lower if no payment needs to be made by the
insurer until the death of the survivor of two individuals.
Matching
dollars. The client names the charity absolute owner and
beneficiary of a policy on his or her life. The charity's endowment fund pays
one-half the premiums. The donor commits to paying the other half. The donor's
fully deductible, no-strings-attached gift in essence doubles the rate of
return the charity
would otherwise enjoy. This greatly enhances the endowment fund.
The
`mass participation perpetual gift.' Also known as the
"forever endowment" technique, it works like this: The charity writes a
letter to its supporters. The letter invites them to purchase and then
contribute to—say,
Contributors
obtain a current income tax charitable deduction for their contributions. The
proceeds are not included in the donor's estate because the policy is owned by
the charity.
The gift is perpetual because it is assumed that the charity agrees to
invest the proceeds at an insured-owner's death and use only the interest on
the death proceeds. This arrangement works best where the charity
establishes and maintains a close relationship with the donor(s) and where the
policies are structured so that the payment process is completed in a
relatively short time (e.g., ten years). Thus, a ten-pay life contract
might be ideal. Once the policy is paid up, the charity is then assured it will
remain in force until the insured's death.
Charity as revocable
beneficiary of group-term life insurance. A client could name a
charity
the revocable beneficiary of group-term life insurance on his or her life in excess of
$50,000. 27 The advantage of this
technique is that it eliminates the need for the client to report Table I
income tax cost of the term insurance coverage in excess of $50,000, as
long as the charity
remains the beneficiary. No matter how much group-term insurance is
involved, the donor no longer has to report as income the excess coverage over
$50,000. 28 Nevertheless, if and
when the donor changes the beneficiary designation and names a non-charitable
beneficiary for amounts of coverage over $50,000, he or she must then again
report income. The insured receives no income tax deduction by naming a charity as the
beneficiary of the group-term insurance, but income tax is avoided on the
value of "premiums" required to provide protection in excess of
$50,000. To obtain this benefit, the charity must be the sole beneficiary of
amounts over $50,000 for the entire tax year.
Any question
about this being a partial interest gift can be avoided by naming the charity the beneficiary
of the entire proceeds rather than merely the excess coverage over $50,000. The
more aggressive position is that the excess coverage is probably a permissible
fractional interest in the insurance, so that the partial interest rule should not
apply. But prudence suggests the conservative course of action. The existence
of an insurable interest should not be a problem in most states, but should be
checked.
Example. Assume that a
55-year-old employee in a 28% income tax bracket is covered with group insurance equal
to his salary of $500,000. Exhibit 2 shows how to compute the income tax
savings of naming a charity
as beneficiary of the "excess" coverage.
Insurance as a wealth
replacement/enhancement vehicle. Also called an "inheritance
alternative," this technique can be impressively effective. Assume, for
example, that a client wishes to make a current gift to charity but feels
her children or grandchildren may want or need the financial security
represented by the asset she wants to contribute to charity. If she
does nothing, her beneficiaries will lose a percentage of her wealth (30% to
50% due to federal and state death taxes and estate settlement slippage) and,
if nothing is done, the charity receives nothing.
Instead, suppose
the donor makes a current gift of stock or real estate to a charity or to a
charitable remainder trust 29 ("CRT"),
and obtains an immediate income tax charitable deduction for a current gift of
"other property" to a charity or to a CRT. The donor then gives
all or portion of her current income tax savings from the deduction to her
children, using the gift tax annual exclusion, gift splitting, and/or the
unified credit. The children directly—or through a policy-owning entity such as
a trust—purchase and pay premiums on insurance on the life of the donor
and/or donor's spouse (often using a second-to-die type contract). The children
eventually receive the policy proceeds free of income tax, estate tax, and
probate. If the amount of insurance matches what they would have received, net
after all taxes and "slippage" had their mother made no lifetime
charitable gift, the wealth has been replaced. In many cases, the children
receive as much as—if not more (net after estate taxes and other estate
transfer "slippage") than—they would have received if the donor had
made no charitable gift. If the children actually receive more than they
otherwise would have received, their wealth has been enhanced.
From the charity's
perspective, this is a "right here, right now" rather than a
"maybe someday" type of gift. This technique can be leveraged using
second-to-die coverage. The major advantage of this technique is that a good
bit—if not all—of the wealth the family would have received had no gift been
made, is replaced and in some cases perhaps even enhanced. The technique can
work by making an immediate gift of appreciated property directly to charity or by
giving appreciated property to a CRT.
Purchase
of life insurance
inside a CRT. A charitable remainder unitrust 30 ("CRUT") is
tax-exempt. 31 It may be directly
funded with a life
insurance
policy. 32 The IRS has ruled
that the purchase and maintenance of life insurance by a CRT is not, per se, a
"jeopardy investment" that risks the charitable objectives of the
trust. 33 The CRUT can be named
owner and beneficiary of an existing insurance contract, or the trust can use its
assets to purchase a new policy. The donor's income tax charitable deduction
would be based on the present value of the remainder interest (i.e., the charity's
portion) of each premium payment. 34 In essence, the
donor-insured obtains a current income tax deduction for the increase each year
in the value of the charity's
remainder interest, even if premiums are paid directly to the insurer. 35 For example, assume
that Bob contributes to a CRUT $100,000 of stock and an insurance policy
on his life
with a $100,000 death benefit. The trust provides for a 6% annual distribution
(valued annually) to his grandson Able, for life. Bob also will contribute
$10,000 per year to the CRUT to pay the life insurance premium and to enhance the value
of the trust even more.
Bob will
receive a charitable deduction measured by the present (discounted) value of
the policy (using his basis as a starting point and ascertaining the discount
from the Section
7520 rate tables and using his age and the appropriate Section
7520 rate). Each time he makes a premium payment, he'll also receive a
deduction (again, discounted to take into consideration how long the charity must wait
to receive its remainder interest).
In this
example, the annuity stream preceding the charity's interest produces a gift to
the life
annuitant, his grandson Able. The younger the annuity beneficiary is, the
greater the gift Bob is making. His grandson's right to the annuity stream is
immediate and certain, which makes Bob's gift a present interest gift that
qualifies for the annual exclusion. The big advantage is that upon Bob's death,
the corpus of the trust is increased significantly by the life insurance
proceeds. Because the payment to the annuity beneficiary is based on the
annually measured value of the trust, the annuity increases after the grantor's
death—as does the amount eventually payable to charity.
A loan by the
CRT against the policy's cash values, if used to finance another investment,
would result in the income from that other investment being treated as debt-financed
income, which would be treated as unrelated business taxable income
("UBTI") and will result in the tainting of all the CRT's income for
the year. 36 The exemption of a
CRT from income tax applies only if—during the year—the trust has no UBTI for
that year.
Part 2 of
this column, which will appear in the next issue of Estate Planning, will
suggest additional planning strategies, will examine the effect of state law,
and will explain how to handle troublesome transactions.
Value and Form of Gift Deduction Disallowed Unless---------------------- ---------------------------$250 or Greater Charity provides Donor with contemporaneous written acknowledgment of contribution stating amount of cash or noncash property received and value of any consideration provided by Charity to Donor in return for gift.More Than $500 but Less Than Same as above, plus Donor must$5,000 complete IRS Form 8283 which provides Charity's name, address, description of property, how and when Donor acquired property, basis, FMV, and method by which property was valued.$5,000 or More A "Qualified Appraisal" is obtained. Reg. 1.170A-13(c) provides that neither the Donor nor the insurance agent (or insurer who issued the policy) can perform this appraisal.
Example Actual ------- ------Input: Coverage in Excess of $50,000 $450,000 $_________Input: Age of Donor: End of Calendar Year 55 _________Input: Cost per Month per Thousand Dollars .43 _________Compute: Excess Coverage/1,000 $450. _________Compute: Reportable Income From Excess Coverage (Units of Excess Coverage × Cost per Month) $193.50 _________Compute: Reportable Income From One Year's Coverage (Monthly Reportable Income × 12) $2,322 _________Input: Donor's Income Tax Bracket 28% _________Compute: Income Tax Savings for Naming Charity (Tax Bracket × Reportable Income) $650.16 _________
For detailed commentary, see Tools and Techniques
of Charitable Planning (National Underwriter, 800-543-0874); Tax
Planning With Life
Insurance
(800-950-3055); and The Tax Economics of Charitable Giving (13th
Edition, Arthur Andersen, 800-775-5730).
See Bohannon and Huston, "Should Charities Accept
Gifts of Life
Insurance?,"
3 J. Gift Planning 26 (1st Quarter, 1999).
For instance, it is essential that the payment of
premiums by the charity
is a "prudent" course of action and that charity has
"insurable interest," as defined under state law.
See
It is important from the charity's
perspective that lifetime recognition of the donor be commensurate with the
ultimate gift. This means that the charity should keep in contact with the donor
and "make a big fuss not only upon the donation of the policy but each
year as premiums are paid."
Beware of contributions of policies with loans,
particularly where the owner has borrowed against the policy to pay premiums.
This issue is discussed in more detail in Part 2.
This assumes the existing insurance is no
longer needed or has served its purpose.
Policy loans may also subject the policy to the
bargain sale rules. Reg.
1.1011-2(a)(3) ; Rev.
Rul. 80-132, 1980-1 CB 255 . As a result, the donor would have some
reportable gain but, because of the rules enacted to bar charitable
split-dollar, no deduction—no matter how seemingly insignificant the loan
against the contract at the date it is donated.
Technically, the deduction is generally limited to
the lower of (1) "replacement cost" (cost of comparable single
premium policy), or (2) the policyowner's basis (net premiums paid to date of
gift). Reg.
25.2512-6(a), Example 3 , and Section
170(e)(1)(A) . See Ryerson, 25
AFTR 1164 , 312 US 260 , 85 L Ed 819 , 41-1 USTC
¶10014 . Replacement cost is defined as the single sum an insurer would
charge to issue a policy on a person the same age and sex as the insured.
Comparability requires that the hypothetical policy have the same economic
value; i.e., a merely equivalent death benefit is not sufficient. Rev.
Rul. 78-137, 1978-1 CB 280 .
Technically, the deduction is generally the lower of
(1) the interpolated terminal reserve plus unearned premium (less outstanding
loans) at the date of the gift, or (2) the policyowner's basis. Reg.
25.2512-6(a) and Section
170(e)(1)(A) . In the early years of a policy, its value is typically lower
than the policyowner's cost, and so value is used. After the
"cross-over" point when cost is less than value, the taxpayer is
forced to use cost as the deductible limit. The gift will qualify for the
50%-of-adjusted-gross-income ("AGI") ceiling if the gift is to a
public charity.
A five-year carryover is allowed for any excess.
Reg.
25.2512-6(a) provides that "[i]f...because of the unusual nature of the
contract such approximation is not reasonably close to the full value, this
[interpolated terminal reserve plus unearned premium] method may not be used."
Powers,
25
AFTR 1168 , 312
Technically, the value of the gift is the sum of the
interpolated terminal reserve plus the unearned premium less policy loans. The
unearned premium is that portion of the premium that carries the coverage
beyond the date of the gift. Reg.
25.2512-6(a) . But if the donor's basis in the policy is lower, the deduction
is limited to basis. Hence, in most cases, the deduction is the donor's basis
in the policy.
Awrey,
25
TC 643 .
Gifts "to" the charity are
deductible up to 50% of the donor's contribution base (essentially AGI) while
gifts "for the use of" charity are currently deductible only up to
30% of the donor's contribution base. Sections
170(b)(1)(B) and 170(b)(1)(A)
.
See Slavutin, "Life Insurance and Charitable
Giving—Important Tax Rules," ALI-ABA Course of Study, Uses of Insurance in
Estate and Tax Planning, which suggests that premium payments made to insurance
companies will be considered gifts "for the use of" charity rather
than "to" charity.
See also Schlesinger, "Charitable Giving: Using Life Insurance in
Charitable Planning," 25 ETPL 387 (Oct. 1998) .
No five-year carryover is available for any contributions "for the use
of" charity
in a given year in excess of this limit. Reg.
1.170A-10(a)(1) . See Kirschten and Neeley, Charitable Contributions:
Income Tax Aspects, 521 Tax Mgm't (BNA), p. A-92. Conversely, if the donor
makes a cash contribution "to" charity, the donor's current income tax
deduction is subject to a limit of 50% of AGI; any excess of the gift over the
current year's deduction limit can be carried forward for up to five years. Rockefeller, 76
TC 178 49
AFTR 2d 82-1140 , 676 F2d 35 , 82-1 USTC ¶9319 , and Rev.
Rul. 84-61, 1984-1 CB 39 , seem to imply that the donor's payments
directly to an insurer would be considered a gift "to" rather than
"for the use of" charity. However, neither the IRS nor the courts have
ruled on this specific issue. See also Kirschten and Neeley, Charitable
Contributions; Income Tax Aspects, 281-3rd T.M. (BNA), p. A-10, n. 102, and
Zaritsky and Leimberg, Tax Planning With Life Insurance (RIA, 800-950-3055). A
30%-of-AGI limitation applies to gifts to private foundations regardless of
whether the check is made directly to the charity or directly to the insurer.
C corporations may deduct up to 10% of net income contributed to charity. See Section
170(b)(2) . S corporations are not subject to this limit.
The prohibition is against the retention of a right
that does or might benefit the donor. However, it is permissible for the donor
to retain the right, exercisable in conjunction with the charity, to
change and add new charitable beneficiaries. Ltr.
Rul. 8030043 .
Nor can the donor expect a current income tax
deduction if he buys an annuity that is coupled with an option to purchase term
insurance
at special rates if he gives the annuity to charity but keeps the rights to buy
term insurance
at special rates. See Rev.
Rul. 76-1, 1976-1 CB 57 .
Rev.
Rul. 76-143, 1976-1 CB 63 .
For example, a donor can't obtain a current income
tax deduction by giving charity the cash value portion of a policy but keeping
policy proceeds in excess of cash values. See Rev.
Rul. 76-143 , supra note 19; Rev.
Rul. 76-200, 1976-1 CB 308 .
Sections
170(f)(3)(A) and 170(f)(3)(B)(ii)
.
See Uniform Probate Code (UPC) section 2-202.
Rev.
Rul. 76-143 , supra note 19.
See Ross, "Gift Taxation of Life Insurance After
TAMRA," ¶5503, Successful Estate Planning Ideas and Methods (Prentice
Hall Law and Business).
See Reg.
25.2512-6 and Rev.
Rul. 59-195, 1959-1 CB 18 , for gift tax valuation procedures. The charity should
provide the donor with a receipt for the policy. That receipt should spell out
the donor's name, date of the gift, description of the policy including face
amount, name of the insurer, serial number, and "quid pro quo"
statement that the donor received no goods or services in return (i.e.,
received only an intangible charitable benefit).
See Tools and Techniques of Estate Planning
(12th Edition, 800-543-0874).
Usually, the cost of up to $50,000 of group term life insurance
coverage is not reportable as income but the cost of coverage in excess of
$50,000 of coverage is taxable to the employee under so-called Table I rates.
(Note TD
8821, 6/3/99 , revising group-term rates downward.)
See Section
664 .
A charitable remainder annuity trust
("CRAT") can't be used because only one contribution can be made to a
CRAT.
The CRUT's receipt of life insurance might be considered a
jeopardy investment if the proceeds of the policy are allocated by the trust
document, or by default pass, to the annuity beneficiaries.
See Millard, "Using Life Insurance to Fund
a Donor's Charitable Gifts," 22
ETPL 297 (Sept./Oct. 1995) , and Schlesinger, supra note 16.
Ltr.
Rul. 8745013 and Reg.
1.664-1(c) . See also Leila G. Newhall Unitrust, 105 F.3d 482, 79 AFTR2d
97-547 (CA-9, 1997).
©
Copyright 2005 RIA. All rights reserved.
Author:
STEPHAN R. LEIMBERG AND ALBERT E. GIBBONS
STEPHAN
R. LEIMBERG is an attorney and CEO of Leimberg Information Services, Inc.
(http://www.leimbergservices.com), a provider of commentary on recent cases,
rulings, and legislation; CEO of Leimberg and LeClair, Inc., an estate and
financial planning software company in Bryn Mawr, Pennsylvania; and President
of Leimberg Associates, Inc., a software and publishing company. His e-mail
address is steve@leimbergservices.com. ALBERT E. GIBBONS is President of AEG
Financial Services in Phoenixville,
This second
part of a two-part commentary suggests additional planning strategies, examines
the effect of state law, and explains how to handle troublesome transactions.
Creating
a DAG (Director's Amplified Gift). Suppose, in lieu of
all or a portion of a director's fee, one or more members of a company's board
of directors request that the corporation make a contribution to a specified charity. That
gift would be reportable as income by the director. It would also be considered
a gift by the director to the charity and would be deductible. Now,
suppose that no money was never owed to the director but the corporation
nevertheless made a gift to charity in the director's name. The
corporation's gift to the charity would be income tax-free to the director and
deductible by the corporation.
Assume that
we enhance this concept and call it a DAG, or Director's Amplified Gift. The
corporation would allow each of its directors to select one or more charities. The
corporation would purchase a limited pay life insurance policy on each director's life. The policy
would be owned by and payable to the corporation. The cash values would
therefore be available to the business for an emergency or opportunity.
At the death
of a director, the corporation would receive the death proceeds income tax-free
(except for any alternative minimum tax (AMT) imposed on "large"
corporations). After the corporation receives the policy proceeds, it pays the
promised amount to the charity selected by the director. The corporation can
take a charitable deduction for the payment, so that if the promise was to pay
$1 million, and the policy proceeds are $1 million, the corporation can use its
income tax savings to pay out much more than $1 million—or it can pay out $1
million and add any balance (after AMT) to surplus. Because a C corporation's
current deduction is limited to 10% of its adjusted taxable income, the
corporation may pay out the insurance proceeds over a period of years to
take full advantage of the income tax deduction.
The
corporation's payment of cash to the charity is income tax deductible. The
directors are never subject to income or estate tax. Both the corporation and
its directors receive immediate and favorable publicity. If the director
leaves, the company can keep the policy, cash it in, or replace it with a term
or paid-up whole life
contract that will pay a reduced amount.
Director's
Amplified Gift—Type II. Suppose the corporation wants an immediate
income tax deduction. It could create a Type II DAG that works like this: The
policy would be owned by and payable to the charity specified by the director.
This would make cash values—as soon as they begin to develop—immediately
available to the charity
for an emergency or opportunity. The death benefit will be received income
tax-free by the charity.
The donor
corporation will receive an immediate income tax deduction for its annual cash
contributions to the charity
(subject to its annual limitation). The director will never be subject to
income taxation, and no portion of the policy proceeds will be included in the
director's estate. Both the corporation and the director receive immediate and
favorable publicity. The charity can keep the policy in force until the
director's death, cash it in, or replace it with term insurance or a paid-up
whole life
policy with a reduced death benefit.
Under a
variation on this theme, the charity owns and receives the policy
proceeds but the premium check paid by the corporation is treated as income to
the director. In this scenario, the director-donor reports income and then
deducts payments made by the corporation to the charity.
Using
life insurance
to perpetuate the charity's income
stream in a charitable lead trust. A charitable lead
trust (CLT) can be established during the donor's lifetime or at the donor's
death. In a traditional CLT, the trust pays an annuity (liquidation of
principal and interest over time on a fixed or variable basis) to one or more
specified charities
for a fixed number of years. At the end of that term, the trust pays the then
remaining principal—if any—(together with any income earned beyond the amount
payable to charity
and any growth in trust assets) to noncharitable remaindermen selected by
donor.
The problem
with the traditional CLT—from the charity's perspective—is that the annuity
eventually runs out. To help solve this problem, the charity uses a
small portion of each year's annuity from the trust to purchase insurance on the life of the donor
and/or the donor's spouse. At the donor/donor's spouse's death, the charity receives
sufficient insurance
proceeds to replace all or a portion of the income stream it was enjoying and
to perpetuate the annuity.
At the same
time, the donor gives his/her children/grandchildren (or trust or FLP or LLC in
which they hold an interest) sufficient cash to purchase insurance on the
donor/donor's spouse's life. At the donor's death, the children don't have to
wait until the charity's
annuity ends to achieve financial security or to purchase assets from donor's
estate. So the charity
receives a sizable annuity for many years from the CLT, and then the annuity is
eventually replaced by insurance proceeds on the life of the
donor/donor's spouse. The donor's estate receives a significant federal estate
tax deduction that can shelter a substantial amount of wealth.
Key
person protection. A charity can purchase insurance on the life of a major
regular contributor, a particularly valuable board member, or a key employee to
provide an "Economic Shock Absorber" to the charity to
compensate for that person's loss.
Using
life insurance
inside a charitable remainder trust. It is permissible to
purchase and maintain life
insurance
inside a charitable remainder unitrust (CRUT). For instance, suppose Jo-Ann
makes annual contributions to a CRUT that will last for her life and the life of her
handsome spouse. The CRUT purchases a policy on her life. When she
dies, insurance
proceeds are paid to the trust and "swell" the value of the trust so
that at its next valuation, the trust has a much higher value than previously.
In other words, her husband's annual unitrust payments will be based on a much
larger amount and so will be significantly greater than if the policy had not
been purchased.
For example,
assume Greg and Tiana create a CRUT for United Cerebral Palsey. The trust
provides both spouses an annuity for life equal to 6% of the trust's value, as
revalued each year. If Greg is insured for $1 million by the trust, the size of
the trust will "balloon" by $1 million at his death. Although Tiana's
annuity percentage payout remains the same, 6%, her actual annuity payment
increases the first year of revaluation by $60,000, 6% of $1 million! Of
course, the charity
also benefits because it receives the remainder interest in the $1 million. If
the donor lives
to a normal retirement age, the independent trustee 1
of the CRUT can surrender the policy and invest the proceeds to increase the
annuity available for payout. The donor or others could make continuing
contributions to the CRUT.
In a slight
twist on this theme, the IRS concluded in Ltr.
Rul. 199915045 that, because the insurance contract is owned by the CRUT and
is irrevocably payable for a charitable purpose, neither the existence of the
policy in the trust nor the existence or exercise of the trustee's power to pay
annual premiums on the policy would jeopardize the trust's tax-exempt status.
The IRS ruled further that neither spouse would be taxable as owner of any
portion of trust, the donor would be entitled to both income and gift tax
deductions for an amount equal to the present value of the charity's
remainder interest in the life insurance, and the policy and proceeds would
escape inclusion in both spouses' estates. 2
In Ltr.
Rul. 199915045 , the taxpayer created a CRUT for the sole benefit of his
stepdaughter and specified qualified charities. The trustee, an independent bank,
will pay his stepdaughter an annuity four times per year for life. She will be
paid the lesser of the charitable remainder trust's (CRT's) income, or 6% of
the net fair market value of the CRT's assets valued annually. A
"make-up" clause provides that the unitrust amount for any year will
include any amount of the trust's income in excess of the amount required to be
distributed under the general rule above to the extent that the aggregate of
the amounts paid in prior years was less than the aggregate of the amounts computed
as 6% of the net fair market value of the trust's assets on the valuation
dates. When the stepdaughter dies, the trust assets will pass to specified
qualified charities.
Here, the
taxpayer purchased a single premium policy on his wife's life and then
transferred the policy to the trust and made the trust absolute owner and
beneficiary. With respect to that (and other) life insurance, the CRUT's trust document
provides that the trustee will have the power "to sell appreciated assets
contributed to or owned by the trust and may use the proceeds, or use other
assets of the trust, to acquire and hold insurance on the life of wife and
to pay the premiums on such insurance and to exercise all rights of an
owner of such insurance,
including the right to surrender the insurance or allow it to lapse, provided
that the premiums paid on the insurance, whether payable from net income
or taxable income of the trust, shall be charged to the trust's principal
account and any proceeds paid on the insurance upon the death of the insured, any
dividends paid on the insurance
during the life
of the insured, any withdrawals made from the insurance during the life of the
insured and any amount paid on the surrender of the insurance during
the life
of the insured shall be credited to the trust's principal account, and no part
of any such receipt shall be credited to the trust's net income account
notwithstanding any statute, rule, or convention to the contrary."
State law
here had no statutory provision concerning whether the trust's payment of
premiums on life
insurance
policies should be charged to principal or income, or concerning whether any
amounts received by a trust on account of life insurance policies should be
allocated to principal or income. Any state law that would allocate to income a
portion of the proceeds received from the sale or other disposition of
under-productive assets (such as a life insurance contract) is subject to the
provisions of the CRUT's governing instrument.
To be
"qualified," a CRT must both satisfy the definition of, and function
exclusively as, a charitable remainder trust from inception. Neither the
grantor nor any other person can be considered the "owner" of the
entire trust for income tax purposes, or the trust fails to qualify.
Fortunately, for purposes of this test, neither the grantor nor the grantor's
spouse is considered the owner merely because the grantor or grantor's spouse
is named as recipient of the annuity or unitrust amount. But they will be
treated as the owner of any portion of a trust whose income (without the
approval or consent of any adverse party) is, or in the discretion of the
grantor or a non-adverse party, or both, may be applied to the payment of
premiums on policies of insurance on the life of the grantor or the grantor's spouse.
Fortunately, there is a safe harbor exception: Policies of insurance owned
by a CRT and irrevocably payable solely for a charitable purpose will not make
the grantor an owner.
Under the
facts of Ltr.
Rul. 199915045 , the taxpayer proposed to transfer an insurance policy
on his wife's life
to the trust. It is important that the terms of CRUT's governing instrument
provided that any amount received by the trust from the policy on the wife's life, (regardless
of whether received during her lifetime or at her death) will be allocated to
the principal rather than to the income of the trust.
The trust in
the ruling is considered an "income exception" unitrust. That means
the unitrust amount payable to the stepdaughter (the noncharitable beneficiary)
is limited to the trust's income if such income is less than the fixed
percentage of the net value of the trust's assets. Because amounts received
from the insurance
policy on the wife's life
will not be allocated to income, these amounts will not be used in computing
the amount of the trust's income. In other words, they will not be used in
determining the income limitation on the unitrust amount payable to
stepdaughter, the noncharitable beneficiary. Instead, amounts received from an insurance policy
on the wife's life
will be allocated to the trust's principal and will become part of the
remainder that is payable to qualified charitable organizations.
The IRS ruled
that because all the insurance
proceeds would be paid for a charitable purpose, the existence or exercise, if
necessary, of the trustee's power to pay annual premiums on the insurance policy
on the wife's life
does not cause either spouse to be treated as owner of all or any portion of
the trust. Nor does Section
2035 apply because the policy that the husband transferred to the trust was
not on his life.
So even if he dies within three years of the transfer, the proceeds would not
be brought back into his estate. Similarly, because the wife never had any
incidents of ownership, Section
2035 should not apply even if she dies within three years of her husband's
transfer.
Impact
of state law. In any transaction involving life insurance, even
when a charity
is involved, it is essential to consider state law in general and
"insurable interest" law in particular. Insurable interest refers to
and encompasses the public policy requirement imposed by state law 3
(as well as by the insurers) that there must exist a relationship between the
insured and the policy owner such that the policy owner has a strong interest
in the continuing life
of the insured and is insuring to compensate for potential loss rather than
merely making a wagering contract. Insurable interest is essentially "love
or affection between related persons and lawful economic interest in the
continuation of the insured's life or potential for loss at insured's
death." 4
In Ltr.
Rul. 9110016 , the IRS denied income, gift, and estate tax charitable
deductions because under state (
Relevant
state law must always be considered where the charity is to be the original owner
of the contract. Typically, an insurable interest is relevant only at the
inception of the contract, and in most states, once there is insurable
interest, a later transfer to a charity will not be a problem. 5
Generally, the laws of the state where the policy was originally purchased
govern that policy for its duration, even if the policy is then donated to an
out-of-state charity.
There are no
insurable interest issues with respect to naming the charity as a mere
beneficiary of life
insurance
proceeds. Nevertheless, because the charity must be named both owner and
beneficiary in order for the donor to obtain a charitable deduction, the
insurable interest issue must always be considered.
In many
states (including
There is
another potential insurable interest problem. An insurance company
could refuse to pay proceeds if, under state law, the charity had no
insurable interest in the continuing life of the insured. Alternatively, if the
proceeds have already been paid, the estate's executor could sue to recover the
proceeds from the charity.
Even where
insurable interest exists, if the insured purchases the policy and dies within
three years of its transfer to a charity, the death proceeds are includable
in the estate of the insured under Code Section
2035(a) , and the decedent's personal representative (absent exoneration in
the will) has a right of reimbursement for the estate tax generated by that inclusion.
This result emphasizes the importance of co-ordination of charitable planning
and life
insurance
with the decedent's will, and highlights the need to expressly provide that
property qualifying for the charitable deduction inside or outside the probate
estate will not be charged with federal or state death taxes. It further
suggests that whenever possible, the charity should be the original applicant and
owner. 7
There are
certain life
insurance/charitable
transactions that are, by definition, troublesome. These include the following.
Naming
a charity as irrevocable beneficiary. One mistake planners
should never allow a client to make is naming a charity as the irrevocable
beneficiary of life
insurance.
The client receives no income tax deduction either for the policy or for the
payment of future premiums. He or she has no ability to change the policy's
beneficiary—even to another charity. And policy proceeds will be federal
estate tax includable.
Contribution
of policy subject to a loan. The donation of a life insurance
contract subject to a loan of any size will result in a tax disaster. If the
policy has a substantial loan against it when contributed, the transfer will be
considered a "bargain sale." This means that the transfer is in part
a donation of the policy and in part a sale of the policy. The sale portion
reflects the fact that the donor will no longer be called upon to repay the
policy loan and has been relieved of that obligation. In other words, it's as
if part of the policy had been donated, and part of the policy—in the amount of
the loan that the donor put in his pocket—had been sold to the charity. The
donor must report gain (if there is any) on the sale portion, in the year of
the gift.
Second, the
donor is treated as having then received an amount equal to the loan portion.
The donor must therefore recognize gain equal to the amount of the loan minus
the adjusted basis allocable to the sale. 8
This gain is ordinary income.
Third, there
is a possible issue of "prohibited self-dealing" with respect to
contributions of policies subject to loans: A gift of a policy subject to a
loan—if the gift is made to a private foundation—could trigger a self-dealing
problem 9
if the donor is a "disqualified person" and the loan was made within
the ten-year period ending on the date of the gift. Because the donor is
relieved of the obligation to repay the loan or to pay interest on it, the gift
can be problematic. 10
The private foundation 11
rule on self-dealing also applies to gifts made to charitable remainder annuity
trusts and charitable remainder unitrusts.
Finally, no
matter how small the loan is (or even if it is paid off by the donor instantly
after the contribution), under the charitable split-dollar rules discussed
below, the donor's deduction for both the gift of the policy itself and any
subsequently paid premiums will be lost forever if there is a loan against the
policy at the time it is contributed! And if the trustee of a CRT borrows
against the policy and invests the borrowed funds in new income-producing
property, the income generated is considered debt-financed income. 12
Unrelated
business taxable income. If a charity cashes in a policy, it will
generally pay no tax because of its tax exemption. Even if a charity borrows
against a life
insurance
policy to purchase land or a building which it will use, or even to pay
salaries or meet some other emergency or opportunity, there's no problem. The charity will not
incur any income tax. There's never a problem as long as the borrowing is for a
purpose inherent to the performance of the charity's exempt purpose. But, as
noted in the prior paragraph, if the CRT or private foundation uses policy cash
values or uses the policy as collateral to finance and purchase a new
income-producing investment, the income produced by that debt financing may be
considered UBTI, or unrelated business taxable income. A charity is
generally exempt from income tax under Section
501 , but if an organization has income from "any unrelated trade or
business regularly carried on by it," the net income (income less directly
related deductions) produced is taxable, generally at corporate rates. 13
Also, beware
of situations where a policy is placed in a CRT that must borrow on the
policy's cash value or from some other source to pay premiums. 14
A policy loan can result in adverse tax treatment if the loan is considered
"acquisition indebtedness." But as long as the policy is a sound
investment, the trust's loan should not be treated as a prohibited payment to a
beneficiary in violation of the rule prohibiting payments other than the
sanctioned annuity amounts.
Transactions
that limit the charity's investment
discretion. Perhaps the least understood and least honored of all the
rules planners must consider when dealing with life insurance and charitable entities
involve the potential problems created if the arrangement—no matter what it's
called or how it's arranged—limits the investment discretion of the charity or
charitable trust. If the charity loses this discretion, there has been a
violation of either the letter or the spirit of the rules under Sections
4941 to 4945. 15
Transactions
that result in the donor receiving direct or indirect gain. Planners must be
exceptionally sensitive to the spirit of the laws dealing with "private
inurement and private benefit." In a nutshell, if the transaction involves
the economic enrichment of someone other than the charity or the
charitable trust, suspect that there may be problems.
Jeopardy
investment rules. Charities and the trustees of CRTs have a
fiduciary responsibility to invest their assets wisely. There will be problems
if the insurance
policy at the date of purchase is such a poor investment that it jeopardizes
the charity's
exempt purposes. Section
508(e) requires a CRT to specifically prohibit such an investment. A
trustee must exercise ordinary business care and prudence, and must consider
the short- and long-term goals and needs of the trust, as well as the facts and
circumstances. 16
However, life
insurance
should not generally be considered a jeopardy investment as long as the death
benefit will be greater than the sum of the net premiums. But the trustee or
the charity
must give both initial and constant attention to the soundness of insurer and
the appropriateness of the coverage for the purpose. 17
If it's clear
from the outset that the policy in question makes no economic sense, the
jeopardy investment problem will arise. For example, if a client donates a
policy that is so encumbered that the net amount that the charity, trust,
or foundation could receive in proceeds could never match or exceed the cost of
paying premiums and interest, the contribution would be considered a jeopardy
investment. 18
Therefore, trust instruments should restrict a trustee from investing in a
manner that will result in the realization of less than a "reasonable
amount" of income. For instance, if the trust requires the purchase of life insurance, this
rule may be violated. 19
But if the trustee is given broad investment discretion, the purchase of life insurance should
not violate this rule. 20
Charitable
split-dollar and charitable reverse split-dollar were schemes by which
promoters convinced their clients to take a deduction for checks written to charity, even though
the money passed quickly through the black box of life insurance and
made a circle through the charity and almost immediately back to trusts the
clients had set up for their children and grandchildren. 22
In other words, these schemes were only incidentally about benefitting charity and were
mainly about generating a deduction and shifting gift tax-free wealth to the
"donor's" children and grandchildren through newly purchased life insurance. Congress
enacted the following rules to thwart and penalize such abusive tactics.
Denial
of deduction. No income or gift tax charitable contribution
deduction is allowed for a transfer to or for the use of a charitable
organization if, in connection with the transfer, (1) the organization directly
or indirectly pays, or has previously paid, any premium on any "personal
benefit contract" with respect to the transferor, or (2) there is an
understanding or expectation that any person will directly or indirectly pay
any premium on any "personal benefit contract" with respect to the
transferor. 23
(An organization is considered as indirectly paying premiums if, for example,
another person pays premiums on its behalf.)
Personal
benefit contract defined. The term "personal benefit contract"
means, with respect to the transferor, any life insurance, annuity, or endowment
contract, if any direct or indirect beneficiary under the contract is the
transferor, any member of the transferor's family, or any other person (other
than a qualified charity)
designated by the transferor. For example, a trust having a direct or indirect
beneficiary who is the transferor or any member of the transferor's family
would be fatal, as would an entity that is controlled by the transferor or any
member of the transferor's family. (The term "a beneficiary under the
contract" includes any beneficiary under any side agreement relating to
the contract.) What's really important is for planners to understand not only
the general rule but also the exceptions.
Exception
if charity is named sole
beneficiary. If a transferor contributes a life insurance contract to a qualified charity and names
one or more qualified charities
as the sole beneficiaries, generally, the deduction denial rule will not apply.
Beware; there is an exception to this exception: As noted above in the
discussion of loans at the time a policy is contributed to charity, the
"sole beneficiary" exception does not provide protection if there is
an outstanding loan under the contract upon the transfer of the contract. The
transferor will be considered a beneficiary if, at the time the policy is
transferred to the charity,
there is a loan outstanding. Even if the encumbered policy also has other
direct or indirect beneficiaries (persons who are not the transferor or a
family member, or designated by the transferor), it will still be a personal
benefit contract and fail to be protected under the "sole
beneficiary" safe harbor. There is no de minimis rule, so that a loan of
any size on the date the policy is donated will forever bar a deduction, not
only of the value of the policy itself but of all future premium payments!
Exception
for charity's employees. If the policy is part
of a bona fide fringe benefit plan covering the employees of the charity, it is
exempted from the provisions of the law.
Exception
for charitable gift annuity. Even though a person will be considered as an
indirect beneficiary under a contract if, for example, the person receives or
will receive any economic benefit as a result of amounts paid under or with
respect to the contract, a protective exception applies in the case of a
charitable gift annuity. Accordingly, a person who benefits exclusively under a
bona fide charitable gift annuity will not be considered an indirect beneficiary.
Exception
for life insurance in CRTs. A person who is a
recipient of an annuity or unitrust amount paid by a CRT is not considered an
indirect beneficiary under a life insurance policy purchased by the trust, if
the CRT possesses all the incidents of ownership under the contract, and is
entitled to all the payments under the contract. A life insurance,
endowment, or annuity contract is not considered a personal benefit contract merely
because a recipient of an annuity or unitrust amount paid by a CRT uses his or
her annuity to buy a life
insurance,
endowment or annuity contract, and a beneficiary under the contract is the
recipient, a member of his or her family, or another person he or she
designates.
Excise
tax. An excise tax is imposed on a charity in the amount of the
premiums it pays on any life insurance, annuity, or endowment contract,
if the payment of premiums on the contract is in connection with a transfer for
which a deduction is not allowable under the deduction denial rule. Payments
are treated as made by the charity, if they are made by any other person pursuant
to an understanding or expectation of payment.
The excise
tax does not apply if all the direct and indirect beneficiaries under the
contract (including any related side agreement) are qualified charities.
Reporting.
A charity must
report each year the amount of premiums that is paid during the year and that
is subject to the excise tax imposed under the statutory provision. The charity must also
note the name and taxpayer identification number of each beneficiary (including
the beneficiary under any side agreement) under the contract to which the
premiums relate, as well as other information required by the Secretary of the
Treasury.
Charitable
planning with life
insurance
should first and foremost be motivated by a strong desire to help others. Life insurance is an
incredible tool that can significantly enhance a client's ability to make a
meaningful and lasting gift to charity. But planners must approach this
tool as a craftsperson approaches fire.
The IRS will
not only strictly impose a set of complex, interconnected, and labyrinthine
laws in order to achieve congressional objectives of preventing abuse and
protecting charitable interests; but the IRS will also look beyond the strict
letter of the law to congressional intent—i.e., that a charity or
charitable trustee must have unfettered free will and objectivity so that
investment decisions cannot be subverted and that charitable dollars not be
diverted—directly or indirectly—or used unwisely—to benefit someone other than
a charity
or its intended beneficiaries. States' Attorneys General will carefully
scrutinize transactions between charities and financial product providers. Life insurance and
other financial products play an extremely important role in charitable
planning—but must not be abused, misused, or unfairly and improperly used. Big
brother is—no doubt—watching.
The ultimate
test of the appropriateness of life insurance is simple. One must merely
ascertain the answers to these four questions: Did (or will) the donor (or the
donor's family or family trust) receive—directly or indirectly—anything of
economic value (beyond a relatively insubstantial and insignificant value) in
return from the charity
for the check he or she wrote or the property he or she donated? Was (and is)
the life
insurance
needed by the charity
and appropriate in amount and type? Did the charity pay more than a reasonable
amount for what it received? Does this investment limit or subvert the charity's
investment discretion?
A CRT loses its tax-exempt status and the donor loses
his/her deduction if the CRT is considered a grantor trust. The potential
problem lies in the language of Section
677(a)(3) , which states that if trust income is or may be used to pay
premiums on life
insurance
on the trust's grantor, that trust is taxed as a grantor trust—i.e., as if the
grantor and not the trustee were the owner of the trust and recipient of the
income and gains it produces. This problem can be prevented by providing that
the trustee may not use trust income to pay premiums and must make all such
payments from capital. The trust document should also require that in all respects
the policy and its proceeds be used solely for charitable purposes. See Ltr.
Rul. 9227017 . Although it may be possible for the donor to be trustee
without triggering the grantor trust rules, an independent trustee should be
selected for safety.
Remainder interest computations can be performed on
NumberCruncher Software (610-924-0515).
Usually, but not always, only the policy owner's state
law governs. For example, if a charity located in
In Re Gibbons'
Estate, 200 A 55 . Insurable interest
is a relationship between the policy owner and the insured which was designed
to assure that the insurance
contract was something other than a form of gambling and speculation on a person's
life.
It was designed to reduce the possibility that the purchaser of the policy
would have an incentive for hastening the maturity of the policy by murdering
the insured. Typically, spouses are deemed to have an insurable interest on
each other's lives,
and companies have an insurable interest on truly key employees. For more on
insurable interest, see Tools and Techniques of Life Insurance
Planning and Tools and Techniques of Charitable Planning
(800-543-0874).
All but five states (
See Millard, "Using Life Insurance to Fund
a Donor's Charitable Gifts," 22 ETPL 290 (Sept./Oct. 1995) .
See Rev.
Rul. 80-132, 1980-1 CB 255 .
For information on life insurance and private foundations,
see McCoy and Miree, Family Foundation Handbook, Panel Publishers
(www.panelpublishers.com); Tax Planning With Life Insurance, RIA (800-950-3055),
and Tools and Techniques of Charitable Planning (800-543-0874).
Siskin Memorial
Foundation, Inc., 57
AFTR 2d 86-1409 , 790 F2d 480 , 86-1 USTC ¶9399 .
See Reg.
1.514(c)-1(a)(2), Example 3 .
See the extensive discussion of this issue in Tools
and Techniques of Charitable Planning (800-543-0874).
See Section
4944 .
See Ltr.
Rul. 8745013 and Rev.
Rul. 80-133, 1980-1 CB 258 .
See Rev.
Rul. 80-133 , supra note 17.
See Reg.
1.664-1(a)(3) .
For articles on problematic schemes of the past (that
will be useful guidelines to test the marketing arrangements of the future),
see Horowitz, Scope, and Goldis, "The Myths of Charitable
http://members.aol.com/CRTrust/CSD.html (Vaughn
Henry's Web Site); http://members.aol.com/CRTrust/CSD2.html (Vaughn Henry's Web
Site); http://www.ncpg.org/charitablepaper.html (NCPG, "Position Paper);
http://home.lsoft.com/archives/aba-ptl.html (ABA archive);
http://www.deathandtaxes.com/csd.htm (JJMacNab); http://www.leimberg.com
(Leimberg Associates, Inc.); "Split Dollar Life Insurance: Rip, Split, or Tear?,"
31 U. Miami Heckerling Inst. on Est. Plan., ch. 11; and audio tape
discussion between Michael Goldstein and Stephan R. Leimberg, Manulife
Financial (available by calling Advanced Markets at 617-854-4323).
See Section
170(f)(10) .
©
Copyright 2005 RIA. All rights reserved.
Author:
MARTYN S. BABITZ, LOIS R. FOGG, STEPHEN S. PAPPATERRA, AND R. BRUCE BICKEL,
ATTORNEYS
The authors
are all members of PNC Advisors. MARTYN S. BABITZ is a Senior Wealth Planner
concentrating on complex tax issues. LOIS R. FOGG is Trust Counsel for
fiduciary matters and STEPHEN S. PAPPATERRA is Director of Wealth Planning. All
of the above are resident in the
Naming a private foundation as the beneficiary of an IRA offers an
opportunity to eliminate taxes, provide funding for a perpetual charitable
mission, and generate financial and intangible benefits for family members.
The dramatic
growth of qualified plan and IRA assets in recent years has created a
significant estate planning issue: how does an owner of such an asset
effectively pass its value to family members and other intended beneficiaries
without giving the lion's share to the government in taxes? This article
focuses on possible strategies for reducing the government's share while
meeting family goals for the asset after the owner's death. 1
John, a
surviving spouse, has a $1 million IRA. John is beyond his required beginning
date (April 1 of the calendar year following the calendar year he attained age
70-1/2), so he has begun receiving required minimum distributions from the IRA.
His other assets place him in the highest marginal estate tax bracket (50%).
His son, Bill, is reasonably successful, and any additional income received by
him would be taxable in the highest income tax bracket (38.6%). John wants to
leave his IRA to Bill. In this scenario, about 70% of the IRA will be used to
pay federal and state estate and income taxes.
Income
tax deferral. The previous tax consequences assume that John's entire
IRA is distributed to his son, Bill, immediately following John's death. Under
both the prior and new minimum distribution Regulations, if Bill were the
"designated beneficiary" of the account, the distribution and income
taxation of the IRA could be stretched out and deferred. 2
Under the new final minimum distribution Regulations published by the IRS in April
2002, if Bill is the "designated beneficiary" of the IRA, Bill may
begin taking distributions of the IRA over his life expectancy as of the year
following John's death on a term certain basis. 3
Unlike the old rules, even if John had no designated beneficiary, John's own
remaining actuarial life
expectancy as of the year of his death could be used to defer distribution of
the IRA balance over that period. 4
To
illustrate, assume John dies on 1/1/02, just after taking his required minimum
distribution for that year, leaving a $1 million account balance. His son,
Bill, his designated beneficiary, will attain age 48 in 2002. Applying the
required minimum distribution rules the year after John's death, when Bill
attains age 49, he can commence receiving distributions from the IRA based on
his life
expectancy of 35.1 years. Assuming an IRA account balance of $1,100,000 on
12/31/02 and an annual rate of return of 10%, the required distribution for
2003 would be $1,100,000 divided by 35.1, or $31,339. In 2004, the account
balance as of 12/31/03 would be divided by 34.1 to determine the required
distribution. This method would apply over the remainder of the 35.1-year
required distribution period. The IRD income tax deduction for the estate tax
attributable to the IRA would be recovered ratably under Section
691(c)(1)(A) and Regs.
1.691(c)-1(c) and 1.691(c)-1(d)
over the first $1 million of distributions taken from the IRA throughout
this period.
To take full
advantage of the deferral of income tax afforded by the minimum distribution
rules, John would need to have designated other resources from his estate to
pay the federal estate tax and state death tax attributable to the IRA.
Otherwise, a distribution from the IRA, which is subject to immediate income
taxation, would be needed to generate the liquidity needed to pay the death tax
liability on the IRA.
It would be
instructive to compare the present value of the overall tax liability from the
permitted lifetime (or "stretch-out") distribution to son, Bill, to
the roughly 70% tax liability generated by an immediate distribution of the
IRA. Assume that John's estate pays the death tax attributable to the IRA from
other sources, such as a life insurance trust that uses policy proceeds to
purchase other assets from the estate in order to provide cash to pay the tax.
Further assume that (1) Bill takes only the required minimum distribution from
John's IRA at the end of each year, (2) the IRA grows by 10% annually, and (3)
an appropriate risk-free discount rate for present value purposes is 6%. In
addition, for an appropriate comparison, this analysis takes into account only
the income tax on the first $1 million of the IRA over the period of
distribution.
Based on the
above assumptions, a 48-year old beneficiary, such as Bill, who disciplines
himself to take only the required minimum distribution from an inherited IRA,
can reduce his tax liability on the IRA on a present value basis from
approximately 70% to roughly 67%.
Charitable
remainder trust. What happens if a charitable remainder trust
(CRT), rather than a child, is named as beneficiary of the IRA? A charitable
beneficiary, such as a CRT, does not qualify as a "designated
beneficiary." Under the old (1987) Proposed Regulations, this meant that
the IRA owner had to use his own single life expectancy in determining minimum
distributions over his remaining lifetime, thereby accelerating distributions.
Under the new final Regulations, this drawback of naming a charity as
beneficiary is lessened. In calculating minimum distributions, the IRA owner
uses the new Uniform Table, which is based on the joint life and last
survivor expectancy of the IRA owner and a hypothetical beneficiary ten years
younger. 5
If a
testamentary CRT is the beneficiary, Bill could receive distributions from the
IRA for his lifetime or a for number of years (not over 20 years). The payout
rate (if a charitable remainder unitrust (CRUT)) or annual fixed payout amount
(if a charitable remainder annuity trust (CRAT)), combined with the lifetime
term or term of years of the CRT distributions to Bill, must actuarially result
in at least a 10% remainder for charity. 6
Moreover, the entire $1 million may be distributed to the CRT without any
immediate income taxation because a CRT is an income tax-exempt entity under Section
664 . Consequently, the entire $1 million base could generate payouts to
Bill for the term of the CRT.
Nevertheless,
only a portion of the IRA would be exempt from federal estate tax. For example,
if the CRT was created to provide the minimum required 10% actuarial remainder
to charity
through a formula in John's will, then only 10% of the IRA ($100,000 in this
case) could be deducted as an estate tax charitable deduction, leaving a
$450,000 death tax liability (50% of $900,000) to be paid from other assets of
the estate.
The IRS has
taken the position that the IRD deduction for the net federal estate tax
attributable to the IRA must essentially be allocated to the CRT's corpus. In
other words, the entire IRD deduction is allocated as a deduction against the
IRD of the CRT. 7
In this case, the IRD deduction of $450,000 would reduce the $1 million of IRD
to $550,000. Thus, the amount of first-tier ordinary income from the IRD is the
net of the IRD under Section
691(a) minus the IRD deduction under Section
691(c) . The Section
691(c) deduction is not directly made available to the CRT income
beneficiary under Section
664(b) .
The fact that
the IRD deduction does not go directly to the income beneficiary of a CRT in
most cases effectively diminishes the tax benefits of funding a testamentary
CRT with IRA assets. At the 38.6% income tax bracket, Bill—as beneficiary of
the CRT—would pay more in income taxes on the first $1 million of distributions
(i.e., the "lost" IRD deduction that would be enjoyed in the case of
an outright transfer to Bill multiplied by 38.6%) 8
than he would if he were named the direct beneficiary of the IRA. If the
minimum 10% actuarial remainder is granted to charity under the CRT in order to
maximize distributions to Bill, then the estate tax is eliminated on only 10%,
or $100,000, of the IRA, a savings of $50,000. The CRT approach actually increases
overall tax liability over an outright transfer of the IRA to Bill!
Charitable
lead trust. A charitable lead trust (CLT) offers the opportunity to
more substantially reduce federal estate tax liability than does a CRT. A
testamentary charitable lead annuity trust (CLAT) could be structured with a
high enough fixed annual payment for a long enough period of years to generate
a 100% charitable deduction for estate tax purposes (a "zeroed-out
CLT"). 9
During the term of payments generating this deduction, however, a charity—and not
Bill—would be the recipient of these distributions.
Furthermore,
a CLT is not an income tax-exempt entity, nor can it be a designated
beneficiary for minimum distribution purposes. Accordingly, the entire IRA
balance would have to be distributed, and subjected to income taxation, no
later than over John's remaining actuarial life expectancy. A charitable income
tax deduction would be allowed for distributions to charity during
the lead term against the income generated by the trust's receipt of IRA
distributions. No IRD deduction is available for a zeroed-out CLAT because no
estate tax liability is generated.
For example,
assume John was age 79 in the year of his death, and that he named as
beneficiary of his IRA a CLAT paying 8% of its initial value ($80,000 on $1
million) as a fixed annual payment. The first required distribution from the
IRA to the CLAT in the year following John's death would be $102,041 ($1
million IRA balance divided by a divisor factor of 9.8 for a 79-year-old in the
year after his year of death). This income would be offset by only an $80,000
charitable deduction for the distribution to charity, leaving $22,041 of income
to be taxed in the trust and ultimately reducing Bill's remainder interest in
the CLAT. This adverse income tax consequence would be magnified over the
remaining 8.8-year period of IRA distributions to the CLAT. The minimum
distribution factor would be reduced by one each year; however, the increased
required minimum distribution would be offset only partially by the fixed
$80,000 distribution to charity.
The waiting
period required before Bill receives any benefit from the IRA, coupled with the
possible reduction of the principal during that period to fund the charitable
lead payment may frustrate John's intentions for his IRA. When viewed in
conjunction with the potential adverse income tax consequences mentioned above,
naming a testamentary CLT as beneficiary of an IRA might not be attractive in
many instances.
Naming a charity as the
direct beneficiary of an IRA offers John another option for reducing the
roughly 70% overall tax liability on John's IRA to zero. This would eliminate
any federal estate and income tax liabilities and, as noted above, John could
use the new Uniform Table to calculate required lifetime distributions under
the new minimum distribution Regulations. Of course, if John names a public charity as
beneficiary of his IRA, Bill then joins the IRS in being excluded from
participating in the benefits of his father's IRA.
By
designating a foundation as beneficiary, John could fulfill family charitable
goals, as well as enjoy the substantial tax benefits of the outright transfer
of his IRA to charity.
The foundation could be established either during John's lifetime or at his
death. Bill could be the director or trustee of the foundation, and could
receive reasonable compensation for serving in that role.
Assume that,
collectively, the trustees receive 2% of the value of the foundation's assets
annually as compensation for services performed. Because 2% would be the total
overall compensation to all trustees regardless of their total number, it is
possible that the Service would not deem this compensation
"excessive" under its prohibition against self-dealing (discussed
later). Also assume that the foundation distributes the required amount, 5% of
the value of its assets, annually to public charities.
If the
foundation's other annual operating expenses (including the excise tax on net
investment income) equal 1% of the value of the foundation's assets, and if the
foundation earns an 8% annual rate of return on its assets, it would be able to
cover its charitable distribution requirement, trustee compensation, and other
operating expenses, in perpetuity, without diminution of principal. After Bill
retires as trustee, or dies, his children—and ultimately his
grandchildren—could succeed as trustee, manage the foundation, and earn the
same compensation in that role.
If Bill is
the beneficiary of the IRA, he immediately receives the entire account balance.
His net economic benefit will be less than 30% after payment of death and
federal income taxes. By deferring distribution of the IRA over Bill's lifetime
as permitted, the present value of the IRA enjoyed by him after these taxes is
slightly over 30%.
Under the
foundation approach, if Bill serves as sole foundation trustee over his entire
34-year life
expectancy 10
and earns $20,000 annually (2% of the unchanging $1 million of foundation
assets under the above assumptions), he will net $12,000 per year. 11
Assuming a 6% discount rate, the present value of his 34-year after-tax trustee
compensation stream, totaling $408,000 of actual payments, is $172,418, or 17%
of the initial value of the IRA.
If Bill's
son, Mark, serves as trustee for the next 65 years, succeeding to the same
duties and earning the same compensation, the present value of the $12,000
trustee compensation to Bill and Mark for the 99 years following John's death,
totaling $1,188,000 of actual payments, is $199,375 (20% of the initial value
of the IRA).
The
foundation approach is substantially more attractive if certain assumptions are
modified. For example, Bill, or his descendants succeeding him as trustee, may
be in a lower income tax bracket based on lower overall income or reduced tax
rates in the future. 12
Furthermore, if the assumed overall rate of return on the foundation's assets
were closer to the historical average rate of return on equities (roughly 10%),
or if the operating expenses of the foundation (other than trustee
compensation) were reduced, then trustee commissions could increase
substantially, by more than two-fold during Bill's lifetime and by almost
eight-fold over a 99-year period.
The above figures
may still be attractive even if the trustee commissions are lower. For example,
if it is determined that reasonable trustee commissions are instead 1%, the
above financial benefits to the trustee would be exactly one-half of the
benefit under the scenarios of zero or 2% net growth of foundation assets
(assuming overall annual distributions from the foundation remain constant at
8%, such as if "other" expenses become 2% rather than 1%). Therefore,
even if the value of the foundation assets does not increase over time, the
present value of the benefit to the trustee over a 99-year period would be 10%
(one-half of 20% when a 2% annual trustee commission is assumed) of the initial
value of the IRA at the owner's death. 13
The foundation approach also results in these additional tax benefits: 14
(1) it bypasses payment of generation-skipping tax or use of GST exemption by
John, and (2) it excludes assets from the taxable estate of Bill (and future
lineal descendants), even though the benefit to John's family can continue in
perpetuity.
In addition,
the non-tax benefits of the foundation approach are substantial regardless of
the level of commissions, if any, paid to the family trustees. All "social
capital" that would otherwise be transferred to the government is instead
directed to the charitable entities chosen by John's family. A long-term family
charitable legacy is created. The entire IRA, rather than a small percentage of
it, is controlled and used by John's family in perpetuity to further the
family's charitable goals. Involving the family in the management and direction
of the foundation will provide the opportunity for family members to render
service for reasonable trustee compensation. Another incidental benefit to
John's family is receiving acknowledgment from both the charitable community
and the community at large.
Several
technical issues arise from consideration of the private foundation solution.
Whether the distribution to a foundation will be diminished by an initial tax
payment has not been resolved. The IRS has not been consistent on the issue of
whether IRA assets received by a private foundation are subject to the 1% or 2%
excise tax on net investment income under Section
4940 . In the most recent ruling, Ltr.
Rul. 9838028 , the IRS concluded that excise tax does not apply to IRA distributions
to a private foundation, based on the following reasoning:
The statutory language of section
4940 of the Code indicates that this tax is a limited excise tax that
applies only to the specific types of income listed in that section. Amounts
from retirement accounts are deferred compensation income. Neither section
4940(c) of the Code nor section
1.512(b)-1(a) of the regulations on unrelated business income tax lists
deferred compensation as an item that is included in the gross investment
income of a foundation.
Although
currently the Service's position is to exclude the IRA proceeds from the excise
tax, its tendency to change both its positions and the rationales for its
positions on this issue does not provide much comfort. If the excise tax did
apply, in the worst case scenario, the foundation's initial assets would be
reduced by 2% for the first year's excise tax. This reduction might be
mitigated in John's case by distributing the IRA to the foundation over more
than the first year, based on John's life expectancy (which could be used for
this purpose under the new minimum distribution Regulations, as discussed
earlier) so that the reduced 1% excise tax under Section
4940 might be applicable in such a subsequent year or years.
The payment
of compensation to Bill as trustee would not be advisable if such compensation
were considered self-dealing by the founder of the foundation or his family. Section
4941 imposes a tax on any act of "self-dealing" with respect to a
foundation. An initial tax of 5% on the amount involved in the self-dealing
transaction is imposed on the "disqualified person" (which, for
purposes of this article, includes an officer, director or trustee, or a family
member, including children, grandchildren, great-grandchildren, and their
spouses). 16
If the act of
self-dealing is not "corrected" in a timely manner, an additional
200% tax on the amount involved is imposed on the disqualified person. Section
4941(e)(3) provides that "correction" requires "undoing the
transaction to the extent possible, but in any case placing the private
foundation in a financial position not worse than that in which it would be if
the disqualified person were dealing under the highest fiduciary
standards." An additional 2.5% tax on the amount involved (not to exceed
$10,000) can also be imposed on a foundation manager (including a trustee) who
has knowledge of the act and knows it to be an act of self-dealing at the time
of the act.
"Self-dealing"
includes payment of compensation (or payment or reimbursement of expenses) by a
foundation to a disqualified person. Section
4941(d)(2)(E) , however, provides an exception, which states that, other
than in the case of a government official, the payment of compensation (and the
payment or reimbursement of expenses) by a private foundation to a disqualified
person for personal services that are reasonable and necessary to carrying out
the exempt purpose of the foundation is not an act of self-dealing if the
compensation (or payment or reimbursement) is not excessive. Reg.
1.162-7(b)(3) provides: "It is, in general, just to assume that
reasonable and true compensation is only such amount as would ordinarily be
paid for like services by like enterprises under like circumstances."
In Ltr.
Rul. 200007039 , the IRS determined that compensation paid to children and
grandchildren of the founder of a foundation as board members for services rendered
in that capacity was not an act of self-dealing, as long as the foundation
accurately stated that the proposed compensation was not excessive.
In Ltr.
Rul. 200135047 , the IRS specifically ruled that compensation for personal
services of foundation trustees, based on a percentage of foundation assets
under management, was not an act of self-dealing if the compensation was not
excessive. Under the facts of this ruling, the trustees assumed all duties
typically imposed on a trustee of a foundation, including custody and
management of the assets, record-keeping, investment decisions, grant review
and grant making, and personnel matters. The trustees agreed with the
foundation to base their fees on a fixed percentage of the fair market value of
the foundation's assets. In so doing, they based their fees on something less
than the sliding scale of fixed percentages provided on the fee schedule of an
independent financial institution (unrelated to the foundation) for such
services.
Ltr.
Rul. 200135047 noted that this "benchmark" institution, in
providing trust and investment advisory services based on its fee scale,
"may employ third parties to sub-advise commingled funds or to separately
sub-advise an account," passing such expenses through to the subject
trust. Moreover, this institution charged an additional fee for transactions
involving assets other than marketable securities. This institution represented
that its fees were comparable to those charged by similar institutions for
similar services.
In ruling
that the compensation was not an act of self-dealing, the IRS accepted the
above approach to determining individual trustee fees. Nevertheless, the IRS
remarked that the foundation "has represented that the fees paid to its
Trustees are reasonable based upon the nature of the duties assumed by the
Trustees, and the fees are less than the fees charged by institutions for
similar services."
Using Ltr.
Rul. 200135047 as a guideline, an individual trustee or trustees of a
foundation, who are disqualified persons, may receive fees similar to what a
corporate fiduciary would otherwise charge if it were acting as trustee of the
foundation. The compensation would be determined on the same fixed percentage
sliding-scale fee schedule often used by such corporate trustees, assuming the
individual trustee takes on substantially the same responsibilities that the
corporate trustee would undertake. The ruling does assume that the individual
trustee's compensation will be somewhat lower than that imposed by a corporate
trustee, perhaps because the individual may have less experience and expertise
than an institutional trustee.
The basis for
the ruling is consistent with the Service's approach to reasonable compensation
and intermediate sanctions for excess benefits in connection with public charities. 17
Reg.
53.4958-6 allows a rebuttable presumption that the compensation is fair if
it is approved by an independent governing body that relies on
"appropriate data" as to the compensation's comparability to that of
other institutions in documenting its decision. Smaller organizations, with
annual gross receipts of less than $1 million, may use as appropriate data
information about compensation paid by three comparable organizations in the
same community for similar services. Although there is no right formula for
foundations, arguably the Service should give greater deference when
comparisons to compensation for the same services performed by other service
providers are obtained.
Based on the
above ruling, a 2% overall trustee fee paid by the foundation to Bill might be
acceptable to the IRS in those communities where a 2% corporate trustee fee on
the first $1 million or more under management is within the typical range of
corporate fiduciary fees. This assumes that the trustee is able to carry out
the investment, reporting and grant-making functions that might otherwise be
provided by professional third parties.
Applying this
methodology and using the firm of PNC Advisors 18
as a comparable "benchmark" institution 19
that provides comprehensive services to foundations in major cities where it
does business, 2% seems reasonable. For a foundation that has $2 million of
assets and receives 100 or more grant requests annually, the fees for
investment advisory services, grant request processing, and information return
preparation would be approximately $40,000, or 2% of the value of the assets
under management. This fee does not include the fiduciary function and other
administrative functions for which the foundation trustee would also be
responsible.
Last year,
the House of Representatives passed The Community Solutions Act of 2001 and
sent the bill to the Senate. Among other provisions, the bill would have allowed
IRA owners (but not qualified plan participants) who have attained age 70-1/2
to make a lifetime "rollover" of the IRA to a charity or
split-interest charitable trust without including the IRA withdrawal in the IRA
owner's taxable income (no income tax deduction would be permitted). By making
such transfers an income tax-neutral event, an IRA owner would be able to avoid
the "whipsaw" effect created under present law. Currently, if an IRA
is given to charity
during life,
the value of the IRA is included in income as a taxable distribution, while
only a partial offsetting charitable deduction is allowed due to percentage
deduction limitations under Section
170 . 20
Enactment of
this bill would have created the opportunity for someone like John, who has
attained age 70-1/2, to transfer his IRA to his own foundation during his
lifetime, allowing him to enjoy, for the remainder of his lifetime, the same
financial and intangible benefits afforded to Bill and other lineal descendants
following John's death.
The
legislation would also have reduced the net investment income excise tax under Section
4940 from 2% to 1% in all cases and all years (including the initial year)
of a foundation.
In response,
Senators Joseph Lieberman and Rick Santorum introduced the Charity Aid,
Recovery, and Empowerment Bill of 2002, with the approval of President Bush,
which is pending in the Senate as of this writing. This bill would similarly
allow income tax-neutral transfers of IRA assets to charitable entities such as
private foundations but with the lower threshold eligibility age of 67 for
donors. This bill would also reduce the Section
4940 investment income excise tax on private foundations from 2% to 1% in
all years of a foundation.
Substantial qualified
plan assets or IRA accumulations will increasingly be a significant tax issue
for many taxpayers and their families. None of the options for dealing with the
double-tax exposure at death is ideal. Nevertheless, the foundation solution
offers an opportunity to eliminate all taxes, and provide funding for a
perpetual charitable mission. At the same time, it generates financial and
intangible benefits to family members that may substantially, or completely,
offset those benefits otherwise available if the family beneficiaries had
received the assets via outright transfer.
The article assumes the continuing applicability of
both the federal estate tax and income tax to these assets.
See See Reg.
1.401(a)(9)-5 , Q&A-5 (4/2002); Prop.
Reg. 1.401(a)(9)-5 , Q&A-5(a)(1) and (c)(1) (1/2001); Prop.
Reg. 1.401(a)(9)-1 , Q&A B-4 (7/27/87).
TD 8987 (4/16/02) . Under this method, life expectancy is reduced as of the
year of death by one each year to determine the divisor factor for the minimum
distribution. See Reg.
1.401(a)(9)-5 , Q&A-5.
Reg. 1.401(a)(9)-5 , Q&A-5 (a)(2) and (c)(3).
There is an exception to this rule: If the sole
beneficiary is the spouse who is more than ten years younger than the IRA
owner, the Uniform Table does not apply. Instead, the distribution factor is
based on the actual joint life expectancy of the owner and spousal beneficiary. Reg.
1.401(a)(9)-5 , Q&A-4.
Sections 664(d)(1)(D) and 664(d)(2)(D)
.
See Ltr.
Rul. 199901023 .
The IRD deduction would definitely be "lost"
on the first $1 million of distributions under Ltr.
Rul. 199901023 , but might be recovered in part or in full if distributions
thereafter during the noncharitable beneficiary's term exceed current and prior
income and capital gains.
Charitable lead unitrusts cannot be
"zeroed out." For a detailed discussion on zeroed-out CLTs, see Babitz,
Brune, Pappaterra, and Demmerly, "Selected Strategies for Dealing With
Non-Diversified Wealth," 27 ETPL 468 (Dec. 2000) .
Using the life expectancy tables, a 47-year-old will
live 34 years. See Reg.
1.72-9 .
This assumes Bill pays 40% in income taxes.
The top income tax bracket is scheduled to drop from
38.6% to 35% over the next four years.
The above comparisons do not take into account the
scheduled temporary, modest reductions in the federal estate tax and income tax
over the next several years.
Not taking into account the one-year period when the
federal estate tax rate is scheduled to be zero, and further recognizing that,
from 2011 forward, the estate tax rate is scheduled to return to 55%.
The IRS has flip-flopped in its analysis of this
issue. In Ltr.
Rul. 9341008 , the IRS found that the excise tax did not apply to IRA
distributions received by a private foundation, reasoning as follows: "The
statutory scheme of section
4940 envisions a situation in which the private foundation has previously
received an asset and is earning income from that particular asset or sells
that asset. There is no taxation envisioned when the foundation receives an
asset. The revenue rulings in this area deal with situations in which the
private foundation has received the asset and the asset is sold or produces
some type of income." In Ltr.
Rul. 9633006 , however, the IRS reversed its position and held that such
amounts were subject to the excise tax. The IRS stated that the growth in the
Keogh account in question over the contributions made by the account owner,
prior to the transfer of the account to the private foundation, represented
investment income for Section
4940 purposes. After Ltr.
Rul. 9838028 , the IRS set aside this issue in Ltr.
Rul. 199939039 to be "considered separately," leaving Ltr.
Rul. 9838028 as the most recent ruling in this area.
See Sections
4946(a)(1)(B) , 4946(a)(1)(D)
, and 4946(d)
.
See Regs.
53.4958-1 through 53.4958-7 –
Regs. 53.4958-1 through 53.4958-7 , which help to define excess benefit
transactions and disqualified persons, and establish a procedure to create a
rebuttable presumption of fair compensation. An excess benefit transaction is
one in which the charity
provides an economic benefit to a disqualified person, directly or indirectly,
which exceeds the value of the services received by the organization in return.
PNC Advisors is a service mark of the PNC Financial
Services Group, Inc. for investment management, banking, and fiduciary services.
See Ltr.
Rul. 200135047 , as referenced above.
The partial deduction might be further decreased by
the reduction of itemized deductions for high-income taxpayers under Section
68 . In the case of CRTs, only a partial deduction is allowed, based on the
actuarial value of the remainder interest.
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