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Thursday September 9, 2010
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March - 2007
Charitable Life Insurance (CHOLI)
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Insurance Gifts
Many individuals own life insurance at some time in their lives. A life insurance policy may provide peace of mind, financial liquidity, investment diversification or an inheritance for loved ones. As an individual's situation changes over time, however, the life insurance policy may no longer be needed for its original purpose. Individuals with philanthropic intent may decide to make a charitable contribution of the life insurance policy.
A donor who wants to make a gift of a life insurance policy must irrevocably transfer ownership of the policy to charity. With this transfer, the donor must relinquish all incidents of ownership and rights in the policy. Most states allow for such a transfer to charity.
To effectuate a transfer, the donor will need to contact the insurance company and fill out the proper change of ownership forms. Once the charity owns the policy, it may hold or surrender the policy. In many cases, however, the charity will hold the policy until the donor's death. In this case, the charity should verify that it not only owns the policy, but is the designated beneficiary as well.
Value of Policy for Income Tax Purposes
An outright gift of a life insurance policy will produce a charitable income tax deduction equal to the lesser of the policy's value or the donor's basis in the policy. See Sec. 170(e) and Rev. Rul. 78-137. In general, the donor's basis in a policy equals the total amount of premiums paid by the donor. As a practical matter, the charitable income tax deduction will normally equal the donor's basis.
If the policy is paid in full, its value is generally equal to its replacement value. Replacement value is the cost of an identical policy given the donor's age and health. If the policy is not paid up, the policy's value will be based upon the ITRV, plus any unearned premium. The insurance company provides the ITRV. The ITRV plus unearned premium is, in many cases, slightly higher than the policy's cash surrender value.
The rationale behind the "lesser of" rule is derived from the income tax reduction rules. See Sec. 170(e). Under the income tax reduction rules, a donor's charitable deduction is reduced by the contributed asset's ordinary income component. A donor who surrendered his or her policy for cash would realize taxable income equal to the excess of the policy's value over the cost basis. This taxable income would be treated as ordinary income (not capital gain income), and the insurance company would report the income on IRS Form 1099. As a result, the contribution of a policy usually produces a charitable deduction equal to its cost basis only, with no increase for the ordinary income component of the policy.
Example A
John and Mary own a second-to-die whole life policy. After contacting the insurance company, the donors determine that the policy's value is $400,000. John and Mary have paid annual premiums of $10,000 for 25 years. Thus, their basis in the policy is $250,000 (25 x $10,000 annual premium). John and Mary contribute the policy outright to their favorite charity. Accordingly, they are entitled to a charitable deduction of $250,000, since it is less than $400,000. The reduction rules deny John and Mary a charitable deduction for the ordinary income component of $150,000 ($400,000 - $250,000).
The $250,000 deduction will be subject to the 50% AGI limitation (not the 30% limitation), because no capital gain element is involved in the charitable deduction. In other words, the gift is treated in a manner similar to a cash gift. Once the charity owns the policy, it can surrender the policy to the insurance company. Assuming no surrender or administrative charges, the charity will receive $400,000. As a tax-exempt entity, the charity has no income tax liability imposed at the time of surrender.
Example B
Joe owns a one-life insurance policy. He has paid premiums of $2,000 per year for 10 years, or a total of $20,000. The policy is now paid up. The replacement value adjusted under the Rev. Rul. 78-137 guidelines requiring a determination of the "economic benefits" under the policy is $36,000.
Joe makes a gift of the policy to favorite charity. His deduction is the lesser of the $20,000 cost basis or the $36,000 policy replacement value, producing a deduction of $20,000.
No Tax Recognition Upon Transfer
The transfer of a life insurance policy to charity should not trigger any income tax liability. However, this result may change in some rare instances, i.e., if there are loans against the policy in excess of basis. If this is the case, the donor must report and recognize the loan amount in excess of basis as an ordinary gain. Therefore, each situation must be reviewed prior to any transfer.
Viatical Settlements or Accelerated Benefits
Viatical settlements involve the sale of life insurance policies for lump sum cash payments. In a viatical settlement transaction, a person with a terminal illness assigns his or her life insurance policy to a viatical settlement company in exchange for a percentage of the policy's face value.
Under Sec. 101(g) of the Tax Code, proceeds from accelerated benefits and viatical settlements are tax-exempt as long as the settlor's life expectancy is less than two years and the viatical settlement company is licensed (if the settlor lives in a state that requires licensing). Many states also have declared that payments of accelerated benefits or viatical settlements are exempt from state taxes. However, given the complexity of this area of law and the different state laws, a professional advisor should be consulted prior to any sale.
If the donor is age 70 or above and is willing to consent to a life settlement, there may be increased benefit to the charity with a gift of this policy. Several major financial services companies selectively purchase policies, usually for individuals age 70 and above. The purchase price depends upon the policy face value, the age of the insured, and his or her health. In cases with very senior insured persons who have health concerns, the life settlement amount may be two or three times the cash value of the policy.
If there is a potential donor of a policy that may be sold to a life settlement company, then it is essential to obtain a qualified appraisal for the policy gift. The policy has a basis equal to premiums paid, ordinary income for the difference between basis and cash surrender value, and long term capital gain for the excess of the life settlement proceeds over the greater of basis or cash value. The charitable deduction equals the capital gain plus the basis.
Financed Life Settlement Insurance Plans
While a charity could receive an appreciated insurance contract as a gift and then transfer that policy to a life settlement company, there is another option that is being heavily marketed. This option is for the charity to purchase the policy on a trustee, director or other senior person with borrowed funds, and then transfer policies to investors in the life settlement company.
Many charities have received proposals from life underwriters, sometimes supported by major banks, that suggest the charity has a "hidden asset." The charity typically has 10 to 15 trustees, most of whom are in their 70's. The insurability of this group of trustees is called the hidden asset of the charity.
The proposal involves a purchase of insurance on the life each trustee. If some trustees have health problems and are rated, the insurance policies are more expensive. Generally, they are still acceptable for purposes of this program. The economic goal is to obtain insurance on a group of quite senior individuals. In theory, the insurance companies are pricing these policies on seniors with a fairly significant lapse rate. That is, for many policies purchased by persons in their 70's, the individual does not maintain premium payments until his or her demise and the policy lapses. As a result, the insurance companies are able to price the policies at a lower level, since many of the policy death benefit payments will not be made.
This pricing arrangement theoretically creates an opportunity for an investor group working together with a charity. The investor group encourages a charity to borrow funds, perhaps through a non-recourse loan, and then purchase insurance on its trustees. This is the key strategy for a financed Charity-Owned-Life-Insurance Plan (CHOLI). With the CHOLI plan, the charity initially owns the insurance policies and uses the borrowed funds to make premium payments. After a short time, the charity approaches the life settlement investor group and offers to sell the trustee insurance policies to the investor group.
While the insurance policies may have very little cash value, the investor group plans to make the full premium payments and then to collect the death benefits. Since the investor group knows that there will be no lapse of the policies, the investor group looks at the probable life expectancy of the trustees and determines its estimated rate of return based on the payment of the death benefits at expectancy. The fact that the trustees are a senior group is favorable to the plan, since the payoff to the investor group is at an earlier date than would be the case with a younger group.
If the plan works as advertised and promised by the life underwriters who promote the plan and receive the sales commissions, the charity insures the trustees, uses borrowed funds to make a premium payment or two and then sells the policies at a very substantial profit to the investor group. CHOLI is sometimes advertised as "free money" to the charity.
Life Insurance Contract Reporting by Charities After PPA 2006
The initial Senate bill that eventually was included in the Pension Protection Act of 2006 (PPA 2006) would have created a 100% excise tax on financed CHOLI plans. In effect, it would have eliminated the plans. In the final version of PPA 2006, the 100% excise tax provision was dropped, but there is a requirement for two years that charities involved in CHOLI plans report the plans to the IRS. The exempt organization that acquires an insurance contract involved in an insurance pool transaction will be required to report that acquisition to the Treasury Department. Sec. 6050V(c). See also Notice 2007-24; 2007-12 IRB 1 (23 Feb 2007).
This reporting period enables Treasury and Congress to determine the extent of the plans and to decide whether or not to create an excise tax in the future to limit or eliminate financed CHOLI plans. Clearly, the Senate Finance Committee is concerned about the appropriateness of the plans, even though the 100% excise tax was dropped for the two-year period.
Stranger Owned Life Insurance Laws
All states regulate life insurance. State insurance commissioners and the state legislatures are interested in life insurance being available to individuals and companies. However, they are also both interested in it being used for appropriate purposes.
States also have "insurable interest" laws. These provisions normally contemplate insurance being purchased by the family breadwinners to protect the family, by businesses on key employees to protect the business and for other recognized purposes. The states all follow a concept of "insurable interest" in which it is not permitted for a stranger or investor group to buy insurance on individuals. It is not deemed appropriate for an investor group to buy insurance on strangers. Therefore, Stranger-Owned-Life Insurance Plans (SOLI) are typically prohibited under state law.
The obvious intent of the financed CHOLI plan is to create a technically-legal method to circumvent the state SOLI laws. Whether or not this CHOLI method of avoiding the SOLI laws will be upheld by courts and state insurance departments is at present unknown.
Potential Income Tax With CHOLI Plans
Businesses and trusts have on numerous occasions created insurance plans in which there is a divided or split-ownership. A portion of the policy is strictly owned by the business or trust, and a portion may be owned by the insured.
There are many valid reasons for this ownership-insurance, commonly referred to as "split-dollar" life insurance. The business may wish to pay the premiums and yet provide a potential death benefit to the family of an insured key employee.
Very complex laws apply to the split-dollar life insurance plans. In the view of some life insurance experts, the financed SOLI or perhaps even the financed CHOLI plans could be subject to this split-dollar regulation. In basic terms, under the split-dollar regulations, if there is a loan to purchase the policy, there is an owner, a lender and the insured. If the split-dollar rules apply, then a portion of the loan value may be deemed taxable income to the insured.
The split dollar provisions in Reg. 1.7872-15 are very complex provisions and are not entirely clear. However, some experts believe that a financed life insurance transaction could result in partial immediate taxation to the insured under split dollar regulations. If this position is taken by the IRS, there could be an immediate impact of each of the trustees in a financed CHOLI plan.
For example, if a premium is approximately $400,000 on a trustee life insurance policy of $4 million, and the premium plus costs are covered by a loan, then a portion of the premium value may be deemed taxable income to the trustee. Under the complex split-dollar rules the taxable portion could be approximately 10% of the loan amount or perhaps $50,000 of immediate taxable income to the trustee.
Possible Taxable Income and Partial Interest Gift Problems
If the split-dollar provisions do apply to financed CHOLI, then the trustee may have $50,000 of income, but the charity owns the policy. Therefore, the trustee may claim an immediate gift of the $50,000 to charity. Even if the $50,000 charitable gift is accepted by the IRS, there is some impact. The trustee will have increased adjusted gross income, and may be subject to the 2% floor on itemized deductions. In addition, at higher AGI levels, personal exemptions and the AMT exemption are phased out. Therefore, there may be adverse tax impact on the trustee even if the charitable deduction is accepted.
Because this is a unique gift, it is likely to be considered a noncash deduction. Since it is over $5,000, both a receipt from the charity and an appraisal are required. The appraiser will need to comply with the more stringent PPA 2006 appraisal rules, as set forth in Notice 2006-96; 2006-46 IRB 1 (19 Oct. 2006). Under Sec. 170(f)(11)(E)(ii)(I), the appraiser must have experience and competency in evaluating the type of property, needs verifiable education and experience, and must declare that he or she understands a substantial or gross valuation misstatement could lead to civil penalty under Sec. 6695A.
For insurance gifts on returns filed after February 16, 2007, the appraiser must fulfill three requirements. He or she must have completed "college or professional-level insurance coursework," must have two years of experience in valuing insurance and must thoroughly describe in the appraisal his or her insurance education and qualifying experience.
Finally, due to the uncertainty of the split dollar rules and the fact that the donor is the insured, is there a potential for a partial interest gift? This is unknown, but could be possible if the split dollar rules create a retained right in the insured due to the continued existence of a loan and the insurance policy. If there is a partial interest problem, then the charitable deduction is denied and the trustee remains fully taxable on the imputed income. Sec. 170(e).
CHOLI Potential Pitfalls
There are two major risks to the charities in receiving this "free" gift through the CHOLI plan. First, if the split-dollar regulations do apply in this case, then trustees will recognize taxable income. Perhaps there will be a qualified charitable gift deduction, but perhaps not. Second, the assumption behind the CHOLI plan is that the investor group will receive the payment from the life insurance companies. Since there are literally hundreds of millions of dollars at stake and the life insurance companies have well-paid attorneys on staff, it seems quite possible that the life insurance companies may look for a reason not to pay the death benefits.
Under state insurance laws, stranger-owned-life-insurance is not permitted. Therefore, it seems possible that life insurance companies may claim that the policy is invalid since it is obviously created to be in technical compliance with insurance laws, but actually accomplish an impermissible result (stranger-owned-life-insurance). As a result, the insurance company may contest payment of the death benefit. If so, there will undoubtedly be major litigation. It seems at least possible that charities who are involved in the acquisition of the CHOLI plans may find themselves also brought into that litigation.
Therefore, financed CHOLI plans appear to create two significant risks for the charity. First, the charity may eventually become embroiled in future litigation over payment of death benefits. Second, the trustees for the charity under the split-dollar rule may be required to recognize immediate taxable income, even though they were promised a "no-risk" CHOLI plan.
Editor's Note: The national expert on CHOLI and SOLI is Steve Leimberg of Philadelphia, Pennsylvania. He publishes various tax newsletters and has published a detailed technical analysis of the split-dollar SOLI income taxation issue.
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| February - 2007 - Supporting Organizations After PPA 2006
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| January - 2007 - Donor Advised Funds After PPA 2006
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| December - 2006 - Charitable Changes in PPA 2006
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| November - 2006 - Rising Estate Tax Exemptions – Is There a Future for Testamentary Gifts?
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