"I do not believe that the government should ask social legislation in the guise of taxation. If we are to adopt socialism, it should be presented to the people of this country as socialism and not under the guise of a law to collect revenue."

-- Calvin Coolidge

The Senate has now passed the Jumpstart Our Business Strength (JOBS) Act (S.1637). In this bill, the Senate included two provisions that affect charitable giving. The bill will now proceed to a House-Senate conference.

The first proposed change applies to gifts of cars with value over $500. Many past charitable gifts of automobiles have been strongly criticized. The donor may claim a deduction based on Blue Book value, but the charity may actually only receive 10% or less of that amount.

Under the new proposed method, the charitable deduction would be limited to the amount the charity receives when the car is sold. Normally, the charity will sell the car reasonably quickly after the donation. Within 30 days of the sale, the charity would report the amount received to the donor. The charitable deduction would then be that amount.

For gifts of patents and other intellectual property, there would be a deduction of 5% of appraised value, with a maximum amount of $1 million. However, if the charity receives royalties on the gifted property, then additional deductions on a pro rated basis could be claimed for as long as 10 additional years.

Senator Charles Grassley (R-IA) supported both changes. In referring to gifts of cars, he stated, "These taxpayers are taking everyone else for a ride. They're taking a tax break they don't deserve."

In support of the provision on gifts of patents, he stated, "It's important to reform these areas to allow taxpayers to take the deductions they've earned rather than what they've inflated."

Many charities have been approached by representatives of financial service companies with the suggestion that the charity purchase insurance on one or more directors, trustees or donors.

"The Ultimate Arbitrage"

Recently, a charity was provided with an illustration with the title "The Ultimate Arbitrage." Under this proposal, the charity would identify trustees or directors with net worth of $10 million or more. An insurance trust would be created. With funds borrowed from a lender, the insurance trust would purchase a $10 million life insurance policy and also a single premium immediate annuity for $10 million.

Arbitrage is a transaction in which there typically is a combination of both a purchase and a sale. Through skillful use of negotiation and careful selection, arbitrage is designed to produce an economic benefit.

Millions to Charity

The claimed benefit for the charity is that, at the death of the trustee, millions could then accrue to the benefit of the charity. Supposedly, it is possible to purchase a life insurance policy with an annual premium appreciably less than the return on the single premium immediate annuity. The life insurance policy is purchased from one company. Since actuaries from that insurance company assume a substantial lapse rate, this policy is on favorable terms. The annuity is then purchased from a second company. With a favorable assumed life expectancy, the single premium immediate annuity may be acquired and it will pay out a substantial annual amount.

For example, on the illustration entitled "The Ultimate Arbitrage," the $10 million annuity contract on a female age 80 is projected to make a payment of $1.4 million each year. Since the insurance premium for a $10 million policy with a second company is estimated at $380,000 per year, the charity also receives annual income of $896,000 after all costs.

Too Good To Be True?

This sounds too good to be true. Not only does a charity receive $896,000 per year, but it would also receive added funds from insurance policy growth over the $10 million loan amount plus any annuity residual when the trustee passes away. Can this be true? Will this work as advertised? Are there some risks? Is carrying a $10 million debt a concern?

Insurable Interest

Under most state laws, charities would be deemed to have an insurable interest in trustees, since they are typically major donors to the charity. However, if this plan were to become more widespread, it is quite possible that state or federal authorities would limit the ability of charities to enter into these plans, particularly with borrowed funds. Some states, such as New York, may already be restricting these plans.

Potential Securities and Exchange Regulation

The Securities and Exchange Commission regulates transactions that involve larger numbers of individuals. If this plan begins to be used quite widely, then it would appear that charities are borrowing funds and engaging in an insurance and mortality arbitrage. When such plans begin to be used quite widely, there is certainly potential for the Securities and Exchange Commission to explore regulation of various aspects of the process. After highly publicized charitable failures such as the New Era fraud, entering into these transactions could invite additional Securities and Exchange Commission review.

Public Relations - The "I promise to die on time" Pledge

When a charity is insuring trustees and directors, there is an economic reason for the charity to hope that the person will pass away earlier rather than later. This is different from a gift of an existing policy by a donor to a charity. If the donor creates the policy and later gives it to the charity, then it is a gift created by the donor with the benefit subsequently transferred to the charity.

By contrast, the "Ultimate Arbitrage" almost certainly will involve a charity approaching a donor or trustee to create the plan. While few charities will ask that the donor sign an "I promise to die on time" pledge, there certainly is economic benefit to the charity if the donor indeed cooperates by passing away in a timely manner.

This is quite different from other planned gifts. It certainly seems to have potential negative public relations characteristics. It is also useful to consider the impact of third-party insurance plans in other circumstances. In the corporate world, the widespread use of insurance on employees has led to major lawsuits by family members. One of the largest companies in America lost a very public lawsuit and suffered a major public relations black eye over insurance policies owned on employees. While directors and donors insured by charities are in a different category, there is clearly a cloud on third-party insurance plans.

Potential UBIT Problems

When the loans are created and the distributions are made from the annuity to the trust, the claim in the "Ultimate Arbitrage" illustration is that the payment is tax-free, since it is made to a charity. Ordinarily, securities payouts to charities are tax-free. However, if charities are borrowing funds to generate interest, then those payments could be held to be unrelated business taxable income. Thus, the charity could also subject itself to taxable income on the annuity distributions.

Editor's Note: As the preceding examples perhaps suggest, your editor is very concerned about this charitable insurance and mortality arbitrage. Charities are running major risks in moving forward with this plan. There are economic, income tax and public relation risks that suggest great caution on the part of charities before contemplating such a plan.

The IRS has announced the Applicable Federal Rate for May of 2004. The AFR under Section 7520 for the month of May will be 3.8%. The rates for April of 3.8% or March of 4.0% may also be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments, the lowest AFR is preferable. During 2004, pooled income funds in existence less than three tax years must use a 4.8% deemed rate of return. Federal rates are available at www.irs.gov/businesses/small/article/0,,id=112482,00.html.

Internal Revenue Bulletins are available at http://www.irs.gov/businesses/lists/0,,id=98230,00.html.