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Monday August 31, 2015

Article of the Month

Charitable Gifts Using Life Insurance


One of the primary purposes of life insurance is to provide for family in the event the insured passes away prematurely. In this context, professional advisors often use life insurance to protect against the loss of an insured's income, to provide needed liquidity to an insured's estate or to replace an inheritance. Another purpose is to protect a business in the event of the death of a business owner or other individuals who are key to the business's success. In this context, it is necessary for the business to maintain "key person" insurance so that the business has the necessary cash to engage in a mandatory purchase, or redemption, of company stock from the estate of the insured or to protect against the loss of company income due to the death of a key employee. A mandatory redemption in cases involving closely-held businesses is often required by a shareholder agreement signed by each shareholder so as to ensure the continuity of a business after the death of a shareholder.

In addition to its use in estate, business and financial planning, life insurance can also play an important role in a client's charitable giving strategy. This article will review some basic information related to life insurance as well as how life insurance can be used in charitable giving.

Types of Life Insurance

In December 2013, life insurance coverage in the United States totaled $19.7 trillion, $2.3 trillion more than the country's current Gross Domestic Product. There are many life insurance products on the market, but in general there are two types of policies: term life insurance and permanent life insurance. Knowing the basics of these two types of policies will be helpful when discussing charitable giving strategies involving life insurance with clients.

Term Life Insurance

Under a term life insurance policy, if the insured passes away during the policy term then the death benefit is paid to the policy beneficiaries. If, however, the insured outlives the policy term, then no benefit is paid unless the insured renews the policy and dies during the new term. Most term policies do not have a cash value account, meaning there is no cash accumulation benefit to purchasing a term policy. A term life insurance policy can be established as a group term, annual term or level term policy.

An annual term insurance policy is perhaps the most basic form of life insurance. The policy provides coverage for one year. If the insured dies within the contract year then the death benefit is paid to the policy beneficiaries. Typically, annual term policies are renewable at the insured's election at the end of each contract year and there is no requirement that the insured submit to a medical evaluation in order to renew the policy. Each year the cost of renewing the annual term policy will increase based on the probability that the insured will pass away during the new contract year.

A level term life insurance policy guarantees that premiums will not rise for a certain number of years before allowing payments to increase based on the insured's mortality risk. Typically, level term policies are sold with guaranteed terms in five-year increments from 5 years to 30 years. These policies typically can be renewed at the end of the term; however, the cost of premiums for the renewed policy will be higher than the initial term based on the insured's mortality risk at the time of renewal. Some term policies allow conversion to a permanent insurance policy, often with limitations on when this can be done within the policy term.

In order to provide for employees, an employer may purchase a group term life insurance policy. The first $50,000 of coverage is deductible by the employer and not reportable as income to the employee (for nondiscriminatory plans). Above $50,000 the imputed cost of coverage must be calculated using IRS Table I. This amount will be included in employee income and subject to social security and Medicare taxes.

Since there is a possibility that the insured will survive the policy term and allow the policy to lapse, charities typically prefer to receive permanent insurance policies.

Permanent Life Insurance

A permanent insurance policy can be set up as a whole life, universal life or variable life policy. There are many variations on these three basic permanent life policies. Discussing every type of permanent life policy is beyond the scope of this article. However, certain basic information about permanent life insurance policies is important to know when considering whether a client should include a life insurance policy as part of his or her charitable giving strategy.

Permanent life insurance policies provide coverage for the insured's life. They combine the death benefit of term insurance with a cash value account that accumulates value during the insured's life. The purpose of the cash value account is to reduce the net amount at risk and avoid the higher mortality costs of insurance in the later years of the insured's life. The cash value will accumulate in different ways depending on the type of permanent insurance policy purchased. Among other strategies, a policyholder may take out a loan against any accumulated cash value or use the cash value to pay policy premiums.

Whole Life Policies

There are a number of whole life policy variations including limited pay contracts, graded and modified premium life policies, single premium policies and interest-sensitive whole life policies. However, the most common type is "ordinary" or "traditional" whole life insurance.

Under an ordinary whole life policy, the premium is fixed for the insured's life. The insurer must pay the death benefit regardless of its actual investment or claims experience. To offset the risk of poor investment performance or a large number of claims, the insurer sets premiums for ordinary whole life policies based on very conservative investment and mortality assumptions and liberal expense assumptions. As a result, ordinary whole life policies are the most expensive permanent life insurance policies on the market.

In addition, the insurer establishes the policy so that the cash value account will grow to equal the face value of the policy by the time the insured reaches 100 years of age. In practice, the premiums are set so that the policy charges will exceed the insurer's obligation under the contract. If this projection holds, then the insurer will pay back any excess premiums to the insured in the form of a policy dividend.

Dividends are calculated based on the insurer's investment earnings, expenses and mortality experience. The insured has a great degree of flexibility regarding policy dividends. He or she can have dividends paid out in cash, left in a side account to accumulate or can use them to reduce future premium payments or to purchase additional life insurance. If the dividends are reinvested within the policy, it creates a "paid-up addition" or PUA.

Any money contributed to a whole life policy in excess of the premium payment is stored in a PUA. A PUA is essentially a paid-up whole life policy within the ordinary whole life policy. The PUA has a cash value account and a death benefit.

Universal Life Policies

In the 1970s many financial advisors suggested that clients avoid the expense of purchasing a whole life policy by purchasing term insurance and investing the difference between the cost of term and permanent coverage in stocks. The insurance industry responded by creating the universal life insurance policy that unbundled the death benefit and cash value account components of a whole life insurance policy.

In a universal life policy the insurer guarantees the death benefit as long as there is enough in the cash value account to pay monthly mortality and expense charges. This gives policyholders flexibility in determining the timing of premium payments. As a result, the investment risk and the risk of selecting the product premium level is borne by the policyholder instead of the insurer (as is the case with an ordinary whole life policy). Since the policyholder bears increased risk, universal life policies are typically less expensive than ordinary whole life policies.

A universal life policy typically has a cash value account and a cash surrender value account. Premium payments are made and premium taxes and expenses for distribution and underwriting are deducted. The leftover premium goes to the cash value account. From there, monthly mortality and expense charges are subtracted and interest is credited to the account. Finally, a surrender charge is deducted from the cash value account before the cash surrender value is determined. The surrender charge typically continues for 10 to 20 years before phasing out. If the policyholder surrenders the policy, the insurer will pay the cash surrender value.

Variable Life Policies

In a variable life insurance policy the policyholder is responsible for investing the policy's cash value in an array of subaccounts. A variable life policy can be set up as either a variable whole life or a variable universal life policy. Of the two, universal life is the most popular because it offers the policyholder flexibility over the timing of premium payments.

Single and Joint Life Policies

Term and permanent insurance policies can be established as a single life insurance policy. A single life insurance policy insures one life and pays a death benefit when that person passes away. Single life policies are often used to provide for a survivor, to provide liquidity in an estate or, in the business setting, to insure the life of a key employee or stockholder.

On the other hand, a joint life policy or second-to-die policy insures two lives and pays a death benefit when the survivor passes away. Most second-to-die policies are permanent insurance policies since insuring two lives is generally a long-term proposition. Second-to-die policies have lower premiums than single life insurance policies since the addition of a second life expectancy pushes out the projected death benefit payment. Second-to-die policies are often used to provide liquidity in an estate or to provide an inheritance.

Outright Gifts of Life Insurance

Many life insurance products exist that will provide financial security, liquidity, diversification or an inheritance. However, if a policyholder's circumstances change, he or she may consider surrendering or otherwise disposing of the policy. For individuals with charitable intent, making a gift of the insurance policy may be a great opportunity to provide for a cherished cause.

Charitable Deduction and Gift Substantiation

Life insurance is an ordinary income asset. Therefore, under Sec. 170(e)(1)(A) of the Internal Revenue Code, an outright gift of an insurance policy will generate a charitable deduction for the lesser of the policy's value or the policyholder's basis in the policy. The policyholder can take this deduction up to 50% of his or her adjusted gross income (AGI) in the year of the gift and carry forward any unused deduction for up to five additional years.

Generally, the policyholder's cost basis is equal to the total amount of premium payments made. The policy's fair market value is the value of a comparable contract (replacement value) or, if this is not readily available, the policy's interpolated terminal reserve value (ITRV). Insurers are required to hold assets in reserve to meet future obligations. Whenever a policy needs to be valued on a date other than the policy's anniversary date, the reserve value must be interpolated to determine its approximate value mid-year.

As a practical matter, the policy will be appraised by an independent appraiser. If the life insurance policy is worth more than $500 then Form 8283 Part A must be completed and submitted with the client's tax return. Under the appraisal rules, if an individual taxpayer makes a non-cash gift (other than publicly traded stock) and claims a deduction greater than $5,000, then the taxpayer must obtain a qualified appraisal from an independent and qualified appraiser. Therefore, if your client will take a deduction greater than $5,000 for the gift of a life insurance policy, he or she must complete both Part A and Part B of Form 8283 and submit the form with his or her tax return. The charity that receives the policy and the qualified appraiser who values the policy must also sign Part B of Form 8283. Since the appraisal must be completed by an independent appraiser the best practice is to select an appraiser that is not the issuing insurance company.

In addition to Form 8283, your client may want to include IRS Form 712 with his or her tax return. This form declares the fair market value of the policy and is completed by the issuing insurance company at the request of a policy owner. Typically, the form is requested and completed when the insured dies or transfers the policy during life. It is very helpful when determining a policyholder's deduction for making a life insurance gift to charity.

How to Give a Life Insurance Policy Outright

There are several ways to donate a life insurance policy outright to charity. Each strategy has unique tax consequences that will be discussed below.

Donor Transfers Ownership During Life

a. Paid-Up Policy

A paid-up life insurance policy is a policy where all premium payments are complete and the policy will stay intact until the insured's death or termination of the policy. If an individual makes a gift of a paid-up life insurance policy he or she will receive a deduction equal to the lesser of the policy's fair market value or cost basis. No future premium payments need be made, so the charity can either surrender the policy and receive the cash surrender value or hold the policy until the insured passes away in order to receive the full death benefit.

b. Policy that Requires Future Premium Payments

A policyholder can transfer ownership of an existing policy to charity that requires future premium payments. Once the charity is owner and beneficiary of the policy it has no obligation to maintain the policy. Therefore, the charity could simply surrender the policy. However, if requested by the donor, many charities will maintain the policy as long as the donor continues to pay the premiums.

A policy donor has two options when making premium payments on a policy owned by charity. First, the donor may make contributions to the charity with the understanding that the charity will pay the insurance company or may make the premium payments directly to the insurance company. A policy donor who makes contributions to charity is entitled to a deduction for the fair market value of the contribution up to 50% of AGI in the year of the gift.

Second, a policy donor may want to ensure contributions are being used to pay life insurance premiums. These donors may choose to make premium payments directly to the insurance company. A policy donor who makes premium payments directly to the insurance company is entitled to a deduction for the amount of the premium payment made and may deduct this payment up to 30% of AGI in the year of the gift.

The reason for the difference in deduction limits between a premium payment made to charity and a premium payment made to an insurance company is found in Sec. 170(b)(1)(B). Under Sec. 170(b)(1)(B), gifts "for the use of" charity are deductible up to 30% of a donor's contribution base (AGI minus any net operating losses). The payment directly to the insurance company is considered a payment "for the use of" and not "to" the charity. Therefore, the 30% deduction limitation applies.

c. Donating a policy with a loan

In general, transferring ownership of a life insurance policy to charity is not a taxable event. As mentioned above, a policyholder can take out a loan against the cash value of a permanent insurance policy. If an insurance policy with an outstanding loan is contributed outright to charity, the contribution is treated as a bargain sale. In other words, the gift will be treated as though the donor made a gift of the value of the policy and received in return the value of the loan.

The policy donor's basis will be allocated between the amount of the gift and the amount received. The deduction is the lesser of the policy's fair market value minus the loan or the donor's basis allocated to the gift. The donor must recognize ordinary income in the amount of the loan minus the basis allocated to the amount received.

Example - Arthur and Mary Adler own a second-to-die traditional whole life insurance policy. They originally purchased the policy after having their second child, Lucy, when Arthur and Mary were both 35 years old. At the time they had many financial obligations, including a large mortgage and saving for retirement and future education expenses. When Lucy was in college, Arthur and Mary took out a $100,000 loan against the policy's cash value to help pay for Lucy's education. The Adler's have been paying the policy's $15,000 annual premium for 35 years, so their basis in the policy is $525,000. However, now both children are out of college and doing well, the house is paid off and Arthur and Mary have IRAs worth $2.4 million in total. They no longer need the whole life policy, but they could use a charitable deduction to help offset the income from their IRA.

Arthur and Mary have the policy appraised and determine its current fair market value is $800,000. They speak with their attorney, Carl, and the gift planner at their favorite charity, Joseph, to discuss their options. Carl explains that if they make a gift of the insurance policy to charity it will be treated as though the Adlers made a gift of property worth $800,000 and received $100,000 in return. Their basis in the policy ($525,000) will be allocated between the $700,000 gift and the $100,000 sale portion. The amount of the basis allocated to the sale portion will be $65,625 ($525,000 x [$100,000/$800,000]). This means Arthur and Mary will recognize $34,375 ($100,000 - $65,625) in ordinary income in the year of the gift. The remaining $459,375 ($525,000 - $65,625) of basis will be allocated to the gift. This will be the value of the Adler's charitable deduction. Carl explains that they can use part of this deduction to offset the ordinary income recognized upon transfer of the policy and the rest to offset income tax owed on income distributed from their IRAs.

The Adlers tell Joseph that they would like the charity to maintain the policy until they both pass away. Joseph explains the charity has no obligation to maintain the policy, but if the Adler's continue to make premium payments then the charity will oblige. Carl explains that if the Adlers make the premium payment directly to the charity they will be entitled to a $15,000 charitable deduction each year that they can take up to 50% of their AGI. The Adlers like this plan and decide to make the gift of their whole life policy to charity.

Donor Designates Charity as Policy Beneficiary or Contingent Beneficiary

Clients who would like to donate a life insurance policy, but want to maintain control of the policy during life, may designate a charity as beneficiary or contingent beneficiary of the policy. Naming a charity as designated beneficiary or contingent beneficiary does not entitle the policyholder to a charitable income tax deduction. In general, there must be an irrevocable transfer of the policy to charity before an income tax deduction will be allowed. When a policyholder merely designates charity as the designated beneficiary there is no irrevocable transfer since the policyholder has maintained ownership of the policy and may change the designated beneficiary at any time. There is no charitable deduction even if the policyholder makes the beneficiary designation irrevocable because to take a deduction in this circumstance would run afoul of the partial interest rules. Upon the policyholder's death, his or her estate will be entitled to an estate tax deduction for the amount transferred to charity.

Use Policy Dividends

If the client owns a policy that pays out cash dividends, then the client may make annual cash gifts to charity using these dividends. This will generate a charitable deduction that the donor can take up to 50% of AGI.

As stated above, dividends can also be used to purchase additional insurance. A client could use policy dividends to purchase additional insurance and name the charity as owner and beneficiary of the policy. This would generate a charitable deduction for the lesser of the policy's fair market value or the client's cost basis in the policy.

Planned Gifts with Life Insurance

In addition to generating a charitable deduction, your client may desire increased income. Planned gifts offer the opportunity to turn a future death benefit into current income. In addition, life insurance may be used as part of a charitable giving strategy that replaces amounts given to charity in the client's estate.

Insurance to a CGA or CRT

If state law allows a charity to own life insurance, then life insurance may be used to fund a charitable gift annuity (CGA) or a charitable remainder trust (CRT). The primary question under state law is whether the state considers the charity to have an insurable interest in the donor. Most states have now adopted legislation providing that charities have an insurable interest in policies owned on the lives of donors. However, it is good practice to research what the law says in your particular state.

To transfer a life insurance policy to a CRT the client will need to make the CRT trustee the owner and beneficiary of the policy. The client will not recognize any income upon transfer unless there is a loan on the policy. The charitable deduction must be calculated using the appropriate Sec. 7520 rate and IRS actuarial factor. The deduction calculation will be based on the lesser of the policy's fair market value or the client's basis in the policy. Payouts from the CRT will be taxed under four-tier accounting principles. Any premiums paid will be treated as return of principal, but will only be paid out once all ordinary income and capital gain have been distributed.

Similarly, the client may transfer a life insurance policy to charity in exchange for a CGA. He or she will receive a deduction that is calculated using the appropriate IRS methodology. The starting point for this calculation is the lesser of the policy's fair market value or the policyholder's basis. Payouts from the CGA will be partly ordinary income and partly tax-free return of basis. The difference between the policyholder's cost basis and the fair market value of the policy is ordinary gain. Although there is no precedent, it is likely that as long as the client is the first annuitant, the ordinary gain may be prorated over his or her life expectancy. As a result, a large portion of the payments may be ordinary income.

Example - Assume the same facts as above in the prior example, except Arthur and Mary have total IRA assets of $500,000. They no longer need the whole life insurance policy, but could use some extra income. So, Arthur and Mary decide to make a gift of the life insurance policy to charity in exchange for a CGA. After running the numbers, Carl informs the Adlers that they are entitled to a deduction of $162,745 for funding the CGA. In addition, based on their ages they will receive an annuity payout of $36,800 per year for their two lives. The Adlers will receive $17,681 of the annual payment tax-free. The remainder will be ordinary income taxed at their ordinary income rate.

Wealth Replacement

A client may desire to make a charitable gift, but may not have the resources to make a substantial gift and still provide for heirs. In this situation, life insurance can be a great way to replace the amount in the client's estate used to make a gift to charity.

Gift Plus Insurance Trust

One option is for your client to make a gift to charity and use the tax savings to pay the premiums on a life insurance policy held by an irrevocable life insurance trust. The first step is for the client to go through the underwriting process and establish a life insurance policy. The owner and beneficiary of that policy should be an irrevocable life insurance trust (ILIT). The client must not retain any incidents of ownership over the trust so that the trust will pass outside the estate. In addition, the trust should include a Crummey power giving the beneficiaries of the ILIT 30-60 days to withdraw premium payments made to the ILIT. Once the 30-60 day period passes, the beneficiaries' right to withdraw funds lapses and the trustee of the ILIT can use the funds to pay the premiums on the life insurance policy held by the trust. The Crummey power will cause the premium payments made by the client to the ILIT to be a current gift to the ILIT beneficiaries and allow your client to use his or her annual gift tax exclusion to cover the payments made to the trust.

Step two is for the client to make a gift outright to charity. The client will receive a charitable deduction for making the gift that will save taxes at his or her income tax rate. In the gift plus insurance trust plan, the client will use the tax savings to make premium payments on the insurance policy owned by the ILIT.

When the donor passes away, the amount in the ILIT will pass to family income and estate tax free. Since insurance, when handled properly, does not result in income tax either on the inside build-up or the eventual payment of death benefits, the premiums essentially grow income tax-free for the benefit of family. Also, because the client will retain no incidents of ownership over the ILIT, the ILIT will pass to family outside the estate.

CRUT Plus Insurance Trust

Another wealth replacement option is to fund a charitable remainder unitrust (CRUT) and ILIT simultaneously. This is a great option when a client wants to increase current income in order to make the premium payments to charity.

In the CRUT and ILIT plan, step one is the same as detailed in the gift plus insurance plan. After establishing the ILIT, your client will set up a CRUT. The CRUT is usually funded with appreciated property to take advantage of the bypass of gain. In addition to bypassing capital gain, your client will be entitled to a charitable deduction for funding the CRUT. Under the CRUT and ILIT plan, the donor will use a portion of the CRUT payout to pay the premiums on the life insurance policy held by the ILIT. At death, the CRUT will make a gift to charity and the ILIT will pass amounts to family income and estate tax free.

Example - Henry and Allyson are nearing retirement. The largest asset they own is development land worth $1.2 million. Henry and Allyson's favorite charity is conducting a capital campaign and has asked them to contribute. They would like to make a significant gift toward the campaign, but also would like to leave a nice inheritance for their three children. Henry and Allyson speak with their attorney, James. James explains that if Henry and Allyson fund a CRUT and an ILIT simultaneously they could provide for both their children and favorite charity. Henry and Allyson work with James and a life underwriter to create an ILIT funded by a $1.2 million second-to-die variable universal life insurance policy. James makes sure that the ILIT contains a Crummey power that will allow Henry and Allyson to use their annual gift tax exclusion to cover the payments made to cover the premiums on the insurance policy held by the ILIT. After setting up the ILIT, Henry and Allyson work with James to establish a CRUT funded with the development land. They receive a deduction of $590,544 in the year of the gift for funding the CRUT. The 5% CRUT pays out $60,000 during the first year of operation. Henry and Allyson use $30,000 to pay the premium on the insurance policy held by the ILIT. Since the ILIT contains a Crummey power they are able to use their annual gift tax exclusions to cover this payment to the CRUT. When Henry and Allyson pass away, the charity receives the unitrust remainder and Henry and Allyson's three children receive the death benefit from the insurance policy held by the ILIT estate and income tax free.


Life insurance is a very flexible financial product. It can be used to accomplish various estate and financial planning goals. Consequently, many U.S. households have some form of life insurance. As circumstances change policyholders may no longer need coverage. This can be a great opportunity to incorporate life insurance into a client's charitable giving strategy. A policyholder has many options when making a charitable gift including making an outright gift, funding a planned gift or setting up a wealth replacement strategy. Each option should be considered and the appropriate one selected based on your client's estate, financial and charitable goals.

Published August 1, 2015
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Previous Articles

Charitable Planning With IRAs—Part II

Charitable Planning With IRAs—Part I

Gifts of Farms

Contributions of Mobile Homes and Fixtures

Donating Real Estate Part II


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