This is Part 2 of a 3-Part series on Charitable Gifts of Life Insurance. (Catch-up with Part 1). In this post, we will focus on policy suitability and claiming the charitable deduction and then wrap up with a Case Study. Part 3 will describe a client who gave an existing policy and a client who gave cash to a charity, which then purchased a new life insurance policy.
Suitability of the Policy
The next few items can be summed up in the following question: Is the proposed policy suitable for giving to charity?
Ongoing Premiums. If the policy requires ongoing premiums, how will they be funded? Will your client commit to making additional gifts to the charity to pay the premiums? Will your client give a lump sum of cash or other assets that the charity can sell to pay the premiums? Will the charity use its own assets to keep the policy alive? Will the charity reduce the death benefit to make a more affordable premium payment? Will the charity surrender the policy for its cash value? Your client will receive an income tax deduction for ongoing gifts to the charity and the charity can use those gifts to pay any premiums. If the policy is truly paid up, then the issue of paying the premiums is considerably less important. However, the charity must continue to monitor the policy’s performance and determine whether to keep the policy in force or surrender it for cash.
Term Insurance. Term insurance is rarely suitable as a charitable gift due to its transitory nature. Plus, your client’s income tax deduction for term insurance is, at most, one year’s premium. One exception to the suitability of term insurance as a charitable gift is group term insurance for coverage over $50,000. By giving this excess to charity, the donor avoids any income tax on the insurance over $50,000. Depending on your client’s salary, this could be a significant gift. Although it’s hard for a planner to cash in on a charitable gift with this technique, many planners find that talking about this technique opens the door for other opportunities. When clients understand that you are providing them with value (especially with an idea for which they know you cannot be compensated), they are more receptive to other ideas you have (including ideas for which they know you will be compensated).
Universal, Variable, and Whole Life. Universal, variable, and whole life policies are commonly used in charitable gifts of life insurance. Their permanent nature makes them well suited as gifts to charity. Future posts will explore specific techniques that combine permanent insurance and charitable planning.
MECs and Annuity Contracts. Modified Endowment Contracts (MECs) and annuity contracts are rarely given to charity while the insured is alive because the donor will typically recognize ordinary income immediately for transferring ownership of the MEC or annuity contract. Depending on when the client originally bought the annuity contract, the rules vary slightly regarding whether the client will be taxed on the inside buildup in the year of the gift or the year that the charity surrenders the annuity contract. However, because most charities will surrender the contract immediately, this distinction does not apply to most clients.
Income Tax Deduction. In return for making a gift to charity, your client is entitled to an income tax deduction. An essential point to remember is that no deduction is allowed unless the transfer is “complete.” The transfer is complete when the charity is both the sole beneficiary and owner of the policy with no rights or incidents of ownership retained by the donor.
Amount of Income Tax Deduction. If the policy is brand new and will be purchased by the charity, your client’s deduction will be for any premiums she pays. If your client contributes a policy that is fully paid up, then the deduction is the smaller of your client’s basis or the policy’s replacement value. If your client contributes a policy that is not yet fully paid up, then calculating the income tax deduction is a bit trickier. First, the interpolated terminal reserve (roughly equivalent to the cash value) is added to the pro-rata interest in any premiums previously paid that will cover the period when the charity will own the policy. Next, this number is compared to your client’s cost basis in the policy (generally the total premiums paid) and the smaller of the two numbers is the deduction.
Limits on Claiming the Income Tax Deduction. Once the amount of the deduction is determined, another calculation needs to be done to determine how much can be claimed during the year of the gift and whether any of the deduction needs to be carried forward to future tax years. If the policy is fully paid up, then your client’s deduction is deductible against 30% of her adjusted gross income (AGI). Finally, if the claimed deduction exceeds $5,000, then your client will need a “Qualified Appraisal” of the insurance policy.
If your client pays the annual premiums directly to the insurance company on a policy that is not fully paid up, then those premiums are fully deductible against 30% of your client’s AGI. On the other hand, if your client writes a check to the charity and the charity decides to use the contribution to pay the premium, then her cash gift to the charity is deductible against 50% of her AGI. As a consequence, for clients who make large charitable gifts, the structure of the premium payments can be critical.
Policy Loans. Charitable gifts of property with debt normally don’t mix well together. Therefore, if your client’s policy has loan, it should be paid off before transferring ownership of the policy to the chosen charity.
Let’s look at the example of Austin and Mary Shafer. Austin and Mary purchased a whole life policy 15 years ago with the goal of providing an inheritance to their son, Bob. Unfortunately, after battling cancer for four years, Bob died last year. Austin and Mary now want to use the policy to support cancer-cure research in Bob’s name. They ask you how to get it done.
After reviewing the policy, you confirm there are no loans on the policy and it is fully paid up. The insurance company indicates that the policy’s replacement value is $265,000. They created the Bob Shafer Fund for Cancer Cure Research as a DAF at Renaissance Charitable Foundation. They named Renaissance Charitable Foundation as the sole owner and beneficiary of the policy and gave up all incidents of ownership in the policy. Based on a Qualified Appraisal of the policy, Austin and Mary claimed a $265,000 income tax deduction and created a lasting legacy in their son’s name.
The examples used in these blog posts are hypothetical and for educational use only. The situations, tax rates, or return numbers do not represent any actual clients or investments. This is not an offer of insurance. There is no assurance that the rates depicted can or will be achieved. Actual results will vary. Please consult with legal and tax counsel about the suitability.