September / 2006 Use of Life Insurance in Charitable Planning (Part Two) Inside this issue: I. CHARITABLE REMAINDER TRUST II. CHARITABLE LEAD TRUST III. CHARITABLE GIFT ANNUITY IV. WEALTH REPLACEMENT TRUST V. CHARITABLE SPLIT-DOLLAR VI. CHOLI A Note to our Readers: Life insurance can play an important role in the accomplishment of charitable goals, whether those goals anticipate lifetime giving or giving after death and whether or not the donor is sensitive to the tax benefits charitable giving may afford. This two-part article will review the tax consequences of certain charitable transfers, demonstrate how life insurance products may be used within a charitable giving strategy, and provide examples of approved and prohibited techniques. VII. USE OF LIFE INSURANCE IN A PRIVATE FOUNDATION VIII. CONCLUSION L060883QS(exp0808)ENT-LD
I. CHARITABLE REMAINDER TRUSTS Although the IRC generally prevents gifts of partial interests, certain gifts and bequests to an irrevocable trust may be used to provide an interest in trust property to both a charitable and a non-charitable beneficiary. The charitable remainder trust (CRT) provides income to a noncharitable beneficiary for a term (or lifetime) and then passes the remainder interest to charity. 1 The charitable lead trust (CLT) acts similarly, but in the opposite order; a charity receives income for a term and a non-charitable beneficiary receives the remainder. Charitable remainder trusts come in two basic types, the annuity trust (CRAT) and the unitrust (CRUT). 2 A CRAT is a trust in which a fixed sum of not less than 5% of the initial principal placed in the trust is paid at least annually to the non-charitable income beneficiary. A CRUT generally distributes a fixed percentage (but not less than 5% of the FMV of its assets) of the prior year ending value of the trust property to a non-charitable income beneficiary. 3 Although each trust may have different payout terms, all CRTs must be structured so that there is an actuarial expectation that at least 10% of the trust s initial value will pass to charity at the end of the term. 4 A number of advantages have helped the CRT become a popular giving vehicle. Upon creation of the trust during life, the donor receives a current income tax deduction based on the value of the future interest expected to pass to the charity. 5 Where a CRT will benefit a person other than the grantor, the donor receives a current gift tax deduction based on the value of the future interest expected to pass to charity. The trust is a tax-exempt entity, and may sell assets without paying income tax. Funding a CRT will reduce the donor s estate tax, since assets are removed from the estate (in the case of a lifetime CRT) or create an estate tax deduction (in the case of a testamentary CRT) for the value expected to pass to charity. 6 A CRT has two primary disadvantages. First, the trust is irrevocable. While a donor may carefully choose the most appropriate payout for his or her situation, the choice of formula or trust type may not be changed once the trust is created. Second, the trust, while not taxed itself, will pass income out to the beneficiary under an unfavorable scheme: ordinary income first, then capital gains, then non-taxable earnings and finally return of basis. 7 The most common form of the CRT involves the donation of low income-producing capital-gain property to a CRUT in which the donor retains an income interest. A CRT may sell and reinvest the gross proceeds for a desired income amount where the donor would otherwise only be able to 1 The IRS provides sample documents for several forms of CRATs (see Rev. Proc. 2003-53, 2003-2 CB 230 through 2003-60, 2003-2 CB 274) and CRUTs (see Rev. Proc. 2005-52, 2005-34 IRB 326 through Rev. Proc. 2005-59, 2005-34 IRB 412). 2 See IRC 664 for CRTs, generally. 3 A donor may create a version of a CRUT known as a NICRUT from which the lifetime beneficiary will receive the lesser of trust income or the unitrust amount. Another form is the NIMCRUT, which acts as a NICRUT but allows for the trustee to make-up any prior distribution shortfalls during later years when income exceeds the unitrust amount. NICRUTs and NIMCRUTS may also switch or flip to become traditional CRUTs upon a triggering event. 4 Treasury Regulations provide that the donor must use the published 7520 rate in the calculations used to determine the relative value of the income and remainder interests for both CRTs and CLTs. 5 Since the value passing to charity will depend on investment performance, the actual amount passing to charity will not be known until the trust terminates and distributes the remaining assets. The apportionment of value between income beneficiary and charitable beneficiary is based on assumed rates of return (which use the 7520 rate for the month in question). 6 Many donors find that the costs of establishing and administering a charitable trust will not be justified for a gift of less than $100,000. 7 See IRC 664(b) for the tier system ordering rules. 2
reinvest the net after tax amount. 8 Capital assets are more attractive than ordinary income assets because the charitable deduction calculation is based on the property s fair market value, not the basis. A unitrust allows the donor to participate in the future growth of the trust where an annuity trust would limit the donor s interest to a fixed dollar amount each year. The donor receives increased income, since the trust may invest in assets paying a higher rate of return than the asset contributed was producing. The trust also has more to invest since it does not pay capital gains tax on the sale of the asset. For example, consider a client, Henry, who is 55 years old and has a gross estate of $6,600,000. He is considering leaving a bequest to Goodwill Industries Int l. Assume he owns highly appreciated XYZ stock, which costs $10,000 and is now worth $110,000 and pays a 3% dividend ($3,300 per year). If Henry sold the asset himself, he would recognize the capital gain of $100,000. Assuming a 15% federal tax bracket (state and local taxes additional) the tax would be $15,000, leaving only $95,000 to reinvest. If reinvestment of the $95,000 earns 7% gross taxable income annually ($6,650) he would have $4,655 of net income available (assuming a 30% tax rate). At Henry s death, $95,000 will be available to fulfill his charitable bequest. Now consider the results if Henry creates a lifetime CRUT that pays him 7% of the trust value each year for life. Assume Henry contributes the $110,000 of XYZ stock to the CRUT. The trustee, concerned about lack of diversification in the trust portfolio, sells the XYZ stock and reinvests in a blended portfolio that earns 7% gross annually. 9 The trust does not pay tax on the sale or on the income earned. Each year the CRUT distributes 7% of its assets ($7,700) to Henry. The entire distribution is taxable to him under the tier system as ordinary income, leaving him $5,390 of net income each year. At Henry s death the assets in the trust, $110,000, will be available to fulfill his charitable bequest. In addition to the income distributions, Henry will receive a charitable income tax deduction in the year of the gift equal to approximately 24% of the $110,000 donation, or $26,400. 10 Assuming a 30% tax rate and that Henry s AGI will enable him to use the full deduction, the deduction will be worth $7,920. Generally donors implement CRATs only when they are concerned about receiving a minimum payout regardless of the trust s performance. This may occur where the donor has a need for a fixed income or in cases where the trust value will be substantially depleted over the income term because of the size of the income interest. Older individuals who want the stability of a fixed income and who want to avoid annual valuations may also prefer the CRAT. For example, Sophie would like to earmark enough income to provide for $40,000 in annual gifts to her grandchildren for the rest of her life. She would also like to make a significant charitable contribution to the Mayo Foundation. Her $1,000,000 of TPS stock (basis $300,000) annually pays a gross 4% dividend ($40,000) or $26,000 after tax, assuming a 35% income tax rate. She has enough income from other sources to provide for her needs and is willing to use the TPS stock alone to fulfill her goals. With 8 The IRS will apply the step transaction doctrine to invalidate a donation to a CRT where there is an implied agreement or understanding that the CRT will sell the contributed property. In cases where, for example, a donor has negotiated a sale with buyer but decides to first give the property to a CRT, the IRS will treat the events as a sale by the donor and then a contribution of the proceeds. As a result, where evidence of a pre-arranged sale exists, prospective donors should be made aware of the risk that all the gain will still be charged to the donor in the year of the sale. 9 Both examples assume that the income distributions exactly match the amount earned on the principal. As a result, the principal is preserved for the charity. In reality, the earnings would vary from year to year. The timing of distributions affects the calculations as well. Here, the example assumes distributions are made on the last day of the year. 10 This example assumes a 5.2% 7520 rate. 3
the counsel of her advisors, she decides to use the TPS stock to create a CRAT that will pay her $62,000 a year for life. Each year, Sophie receives $62,000 that results in $40,000 after-tax, assuming a 35% tax rate. The trust principal, growing at an assumed 7% gross rate, is projected to increase slightly each year since it is assumed to earn more than it distributes to Sophie. If Sophie dies at age 84 the trust will distribute its remaining assets to the charity. In addition to income distributions that Sophie uses to fund gifts to her heirs, she will receive a charitable income tax deduction in the year of the gift equal to approximately $277,000, representing 27% of the initial contribution. 11 At her tax rate, the deduction is worth approximately $97,000, though it may have to be carried forward for a number of years. A CRT may buy life insurance or may be the recipient of a gift of life insurance. 12 Obviously, the advantage of life insurance relates to the value of the trust after the insured s death. There are two situations where having an increased death benefit may be useful. First, where a charity will receive the trust value after the life of the insured-grantor, an insurance policy will provide an immediate increase in the value of the assets passing to the charity. Thus, while distributions to the grantor will be fixed (for a CRAT) or based upon trust values (for a CRUT), the death benefit will enable a significantly larger amount to pass to the charity. 13 Second, where a non-charitable beneficiary will take over lifetime payments after the grantor s death, the presence of a life insurance policy on the grantor will create a larger asset base from which the survivor may take income. Best used in the context of a CRUT, this second situation may work as follows: Chandra creates a CRUT in which she will retain a 6% unitrust interest for her life. After her death, her husband, Ganesh, if living, will receive the 6% payments for his life. Chandra gives cash and appreciated stock to the CRUT, as well as a life insurance policy on her life with a fair market value of $50,000 and a death benefit of $200,000. At Chandra s death, the CRUT s value increases by $150,000 enabling a larger unitrust interest to be paid to Ganesh for his life. Using life insurance in a CRT, however, is not without its issues. Most forms of CRTs require a payment to the grantor regardless of the investment performance of the trust. Thus, a trust holding only life insurance would have to either surrender the policy or give the grantor a partial ownership of the policy in satisfaction of that year s payout obligation. 14 The exception to this rule is the net-income charitable remainder unitrust (NICRUT). 15 Its terms provide that the trustee need not meet the designated payout for a year in which the trust s income is insufficient. Instead the NICRUT need only pay the grantor the net income from the trust. Of course, in years with no income the grantor will be receiving less than his or her designated share. 11 This example also assumes a 5.2% 7520 rate. 12 See PLR 199915045 in which the grantor proposed a CRUT, payable to the grantor s daughter, to which the grantor intended to give a paid up permanent life insurance policy. The IRS held that neither the existence nor exercise of the trustee's power to pay the annual premiums on the insurance policy would disqualify the trust as a CRUT. The Service also held that the grantor would be entitled to an income and gift tax charitable contribution deductions for the present fair market value of the remainder interest in the insurance policy. 13 For example, the CRUT may require a 6% annual distribution to the grantor, based on the fair market value of the policy and other trust assets. However, the value passing to charity will be based on the face amount of death benefit and other trust assets. Since the death benefit will be higher than the lifetime fair market value, the charity will get some value from which the unitrust interest was never paid (i.e., on the death benefit in excess of the policy fair market value). 14 A similar problem occurs where the trust holds illiquid property which is not income producing, such as undeveloped real estate. 15 See IRC 664(d)(3). 4
A CRT might not want to own life insurance from an investment perspective. Trustees have a fiduciary duty to manage the trust s assets for the benefit of both the income beneficiary and the remainderman. Consider the case where the trust s life insurance policy will lapse without the payment of future premiums: the lifetime beneficiary s interest could be hurt by the payment of premiums on a policy that will not benefit him, while the remainder beneficiary will be disadvantaged if the policy lapses. 16 Trustees need to carefully evaluate the place that the insurance has in the trust s overall investment approach, balancing both party s needs. Donors may not want to make a gift of a policy to a CRT when they learn that the tax deduction for ordinary income property, such as life insurance, is limited to its basis. As indicated earlier, most grantors fund CRTs with appreciated capital property since its deduction base is the fair market value of the property, not its cost basis. The existence of a policy loan may reduce the value for deduction purposes. Remember that a gift of debt-encumbered property, such as a life insurance policy with a policy loan, may result in an act of self-dealing, since the transaction though structured as a gift must be treated as a part-sale. The trustee and the donor are disqualified persons who may not enter into such transactions. Even where the donor remains liable for the loan, an act of selfdealing may occur. Further, when a CRT owns a policy with a loan, any income earned by the trust might be considered debt-financed income, resulting in the taxation of trust income. 17 As a result of these considerations, advisors should only recommend placing life insurance in a CRT after careful analyzing all of the economic and fiduciary issues. Although a CRT may buy a deferred annuity contract, the practice is uncommon because the income tax deferral of the annuity may be obtained directly by virtue of the charitable trust s taxexempt status. 18 The IRS ruled in PLR 9009047 that although a CRT s ownership of a deferred annuity would not jeopardize the trust s status as a CRT, the annuity itself would lose its taxexempt status since the trust owner was not a natural person. Of course, since the trust does not pay income tax, the concern is not as great as it would be for other non-natural person annuity owners. The trustee of a NIMCRUT may find the use of a deferred annuity appropriate since it can provide flexibility in distributions i.e., the annuity s distribution options can mirror the NIMCRUT trustee s desire to delay distributions until a future date. 19 The appropriateness of using an annuity in a CRT, will depend, in part, on how the contract complements the trust s other assets (if any), keeping in mind the fiduciary s prudent investor duty. In this respect, for example, the trustee might weigh the guarantees available in commercial 16 Clients should evaluate the needs of the income beneficiary before establishing and funding the trust. A CRAT, for example, may be appropriate where the trust will own life insurance since the policy value will not affect the lifetime beneficiary s payout amount. 17 See IRC 514(c)(2). A policy with a loan may cause acquisition indebtedness even where the donor agrees to continue paying the loan. 18 The IRS ruled in TAM 9825001 that a CRUT s purchase of a deferred annuity in which the trust s beneficiaries were named the annuitants did not disqualify the trust or create an act of selfdealing. TAM 9825001 (6/18/1998). The trust in the TAM was a NICRUT. It bought single life deferred annuities on the grantor and his wife, naming itself owner and beneficiary. The IRS simply stated that the purchase did not disqualify the trust. The finding related to self-dealing was more roundabout, but in part hinged on the fact that the annuitant and CRT beneficiary did not exert any undue influence or control over the trustee. Although the trust s purchase of the annuity helped accomplish the beneficiary s retirement goals, the IRS found that the Trustee merely took into consideration the particular financial needs of [the beneficiary] before reinvesting [in an annuity] the proceeds from the sale of the trust assets. 19 Although the annuity gains create income for the trust each year albeit income that is not taxed for income tax purposes, the gains do not automatically create income for trust accounting purposes under state law. As a result, the trustee of a NICRUT or NIMCRUT may continue to accumulate gains instead of distributing them. 5
annuities against the surrender and other costs of the annuity. The trustee might also consider how the ordinary income realized (but not recognized by the CRT) will affect the net after-tax distribution available to the beneficiaries. That is, although the CRT will not pay tax on the annuity gains, the tier-taxation rules applicable to CRT distributions cause the income beneficiary to bear the tax as distributions are made. Clients who may consider the use of a deferred annuity contract in conjunction with a CRT should be aware that a gift of a deferred annuity contract issued after April 22, 1987 is an income tax recognition event. The donor is treated as having received the cash surrender value in the contract, and will be taxed on that amount, less his or her basis. 20 In the charitable context this treatment may be partially or fully offset, since although the gain must be recognized the donor does not have to reduce the value of the contract when calculating the charitable deduction. 21 II. CHARITABLE LEAD TRUSTS Like the CRT, the Charitable Lead Trust (or CLT) is an irrevocable trust to which the donor makes gifts that will benefit both a term (or life) beneficiary and a remainder beneficiary. However, in a charitable lead trust the charity is the term beneficiary and the donor s heirs are the remainder beneficiaries. As with CRTs, CLTs may be established during life (with gift tax implications) or at death (with estate tax implications), and may be formed with an annuity or unitrust payout formula. The charitable lead trust offers unique estate planning advantages. Since the assets will ultimately pass to a non-charitable beneficiary (e.g., the donor s heirs), the CLT can facilitate a charitable gift without depriving family members of the ultimate ownership of the donor's accumulated wealth. Thus, although the heirs will have to wait until after the charitable lead term to receive the trust assets, some portion of those assets will be returned to the family. In a sense, the charity will merely receive the use of the trust assets for a period of time, while the heirs will hopefully receive the principal and any growth beyond the charitable distribution amount. The principal tax advantages to the donor may be found in the reduced value for transfer tax purposes of the heirs interest and the increased charitable gift or estate tax deduction available for the value of the charitable beneficiary s interest. Only the present value of the interest passing to the non-charitable beneficiaries will be a taxable gift in the year the donor creates the trust. In some cases, the value of the charitable interest (and corresponding transfer tax deduction) will significantly reduce the gift or estate tax value of the amount of the non-charitable interest, even to zero value. 22 As a result, the most frequent use of CLTs occurs in very large estates where the estate tax exemption amount will not significantly shelter the client s gross estate and where the non-charitable beneficiary can afford to wait for his or her interest. 23 For example, Joe dies in 2006 with a $15m estate. Included in his estate is $3m in commercial real estate. Joe s revocable trust provides that at his death the real estate be placed in a CLT benefiting the Humane Society of Cleveland (HSC) for 15 years. The trust will pay HSC $150,000 a year for the 15-year term, at which time the assets will pass to a trust benefiting his heirs. If the trust property earns (and/or grows) at 9%, his heirs can expect to receive just over $6.5m. For estate tax purposes, using an assumed 20 See IRC 72(e)(4)(C). 21 See Treas. Reg. 1.170A-4(a) 22 The interest passing to the noncharitable beneficiary will not qualify for the IRC 2503(b) gift tax annual exclusion since the benefit is not a present interest. 23 Famously, the estate of Jacqueline Kennedy Onassis used a CLT to help reduce the value of her gross estate. 6
5.4% 7520 rate, Joe s executor may deduct the value of HSC s annuity interest ($1,515,690), or about half the contribution amount. Thus, although the heirs may be expected to receive $6.5m, the cost to the estate is the estate tax on a $1.5m asset. As with the CRT, the charitable lead trust is one of the more sophisticated methods of charitable giving. Clients must work with an attorney when establishing a CLT as part of their estate plan. In particular, clients should be aware of the income tax consequences of lead trusts. A lifetime CLT presents the grantor/donor with a choice as to how to be taxed for income tax purposes. In order to receive an up-front income tax deduction for the actuarial value passing to charity, the trust must be taxed as a grantor trust, meaning that future gains and income earned by the trust will be taxed to the grantor even though the money will stay in the trust or be distributed to charity. 24 Most grantors instead forgo the deduction and establish CLTs that are taxed as standalone entities for income tax purposes. In this stand-alone form the grantor is not taxed on trust income. The trust reports income under the trust income tax system, receiving a tax deduction for amounts distributed to charity each year. Lifetime CLTs should be compared to retaining the assets and making annual or systematic contributions to charity. The CLT allows for the possibility that the heirs will receive more than the amount reportable for gift tax purposes. That is, if the trust earns more than the assumed rate (i.e., the 7520 rate), the heirs will be better off. However, use of the CLT has administrative and legal costs, and requires the donor to irrevocably part with the asset. Further, the heirs will have to wait to receive any benefit. Testamentary CLTs should be compared to a direct bequest to heirs of a smaller amount than that set aside in the CLT. For example, instead of giving $1m to a CLT of which the heirs are expected to receive 10%, a testator could simply bequeath $100,000 to the heirs directly (and $900,000 to the charity). For estate tax purposes the CLT option and the direct bequest are the same. However, the CLT option has the potential to pass a greater value over time if the trust can earn more than the 7520 rate. Clients should evaluate the beneficiary s immediate use of the money, the CLT s costs, and the potential estate tax savings available through the CLT. III. CHARITABLE GIFT ANNUITY A charitable gift annuity is an arrangement between a charity and a donor in which the donor transfers an asset to a charity in return for a stream of payments (i.e., the annuity) typically paid over the donor s life. In effect, since the annuity payments must be actuarially less than the value of the property transferred, the transaction is part gift and part sale. 25 A charitable gift annuity resembles a CRT in some respects: it represents an individual arrangement with the charity (unlike a pooled income fund, for example); it allows for a lifetime income stream; and it has a fractional charitable gift element (and a corresponding tax deduction). A deferred charitable gift annuity will result in payments that may be delayed until a future time, just as in certain CRUTs. Besides the difference in underlying legal form, the 24 IRC 170(f)(2)(B) provides in part for a recapture of the deduction in the year in which the CLT loses grantor trust status: If the donor ceases to be treated as the owner of such an interest for purposes of applying section 671, at the time the donor ceases to be so treated, the donor shall for purposes of this chapter be considered as having received an amount of income equal to the amount of any deduction he received under this section for the contribution 25 Charitable gift annuities are specifically exempt from the debt-financed property and unrelated business income rules that would otherwise impair the ability of a charity to engage in this type of transaction. See e.g., PLRs 9743054 and 2000449033. The charitable annuity rate usually conforms to rate schedules published by the American Council on Gift Annuities (ACGA). The ACGA rates pay substantially less than a similarly funded commercial annuity, allowing for a builtin return for the charity. See www.acga-web.org. 7
charitable gift annuity also differs from the CRT in that the transaction partially represents a sale on which the donor will recognize some gain if transferring appreciated property. A portion of each annuity payment received by the donor will be treated as capital gain. Lastly, where a CRT s payment obligation is backed solely by trust assets, the charity s obligation in a charitable gift annuity is backed by the assets of the charity. The benefits of a charitable gift annuity to the donor include receipt of a fixed income for his or her life or for the joint lives of the donor and another individual, freedom from management responsibility and federal estate tax savings (since the annuity terminates at the death of the annuitant). These benefits should be balanced against the fixed nature of the arrangement (i.e., the inability to change the investment strategy or distribution amounts). For example, Nigel and his wife, Rose, both age 60, would like to make a donation of their $1m vacation home to the John F. Kennedy Center for the Performing Arts, but would feel more comfortable retaining some income from the property than simply giving it away outright. Nigel donates the property to the Center in exchange for a charitable gift annuity for his and Rose s joint lives. At the time of the gift, their basis in the property is $600,000. Based on their ages and the recommended ACGA annuity rate, the Center will pay them $54,000 annually for their joint and survivor lives. Their joint life expectancy is 29.6 years. Their charitable income tax deduction, based on the fair market value of the property less the value of the annuity, is $255,766. For the first 29 years, $28,856 of each $54,000 payment will be ordinary income. The remaining $25,144 will be split between capital gains and return of basis. Nigel must allocate his basis both to the charitable portion (approximately 25.57%) and the annuity portion (approximately 74.42%) of the transferred asset, meaning that he will recover only $446,540 of the basis (74.42% x $600,000) over his life expectancy (29.6). Thus, $15,085 of each payment will be return of basis while the remaining $10,059 (equal to $25,144 less basis return of $15,085) will be capital gains. After 29 years i.e., if Nigel and/or his wife reach life expectancy the entire $54,000 will thereafter be taxable as ordinary income. As with other split-interest charitable giving techniques, a charitable gift annuity is appropriate where the donor would like to retain an income stream. Where this money is not needed, a direct gift may be preferable. IV. WEALTH REPLACEMENT TRUST Many prospective donors hesitate to implement a charitable technique because the assets given to charity will not pass to the donor s heirs. In most cases the use of a charitable technique will not benefit the donor s family more than a direct transfer to them, notwithstanding the significant estate or gift tax that may apply to such a transfer. For this reason, clients without any charitable bent will not often implement a charitable technique. However, the use a device called a Wealth Replacement Trust (WRT) can help to mitigate this concern and help those with some charitable inclination to proceed, knowing that their heirs will receive other assets to replace those passing to charity. While the form may differ, in most cases the client creates the irrevocable WRT during life and funds it with annual exclusion or lifetime exemption gifts. The trustee uses the gifted assets to pay 8
premiums on a life insurance policy on the grantor(s). 26 The face amount of the insurance will depend on the premium available, the insured s needs and insurability, but will generally attempt to equal the amount of assets in the insured s estate that will be earmarked for charitable donation. It is not dependent on the method of gift or the nature of the property given. For example, widowed Isabella owns a $1m IRA account, a $500k residence, and $3m in a nonqualified investment account. She would like to make a significant bequest to charity and to let her children have the balance of the estate. After consultation with her advisors, Isabella designates the United Way as the beneficiary of her IRA. She feels the children will likely want immediate access to part of their shares of the inheritance and that the IRA would therefore be less desirable for them because of its taxable nature as income in respect of a decedent. In order to allow her children to realize some of the value of the IRA, Isabella establishes a WRT with a $1m policy on her life. Using required distributions from the IRA, she makes premium gifts to the trust. At her death, the United Way becomes beneficiary of the IRA and chooses to liquidate the account (as a tax-exempt entity it does not pay tax on the distribution). Isabella s children inherit her residence and investment account with a fair market value basis and may liquidate them without tax cost. In addition, they are the beneficiaries of the trust, which contains the proceeds from the life insurance policy. Similarly, the funds provided by WRT can replace values given away to charity during life. The efficiency of the transaction will depend on the amount of insurance available. Consider the facts of the example above, altered slightly. Isabella would like to make a gift to the United Way during her life. She chooses to give $1m in appreciated stock directly to the charity. The income tax deduction created by the gift helps to offset some of the income tax due on her IRA distributions. Isabella uses her IRA required minimum distributions to make gifts to the WRT, which buys a life insurance policy on her life. At her death, her children receive distributions of cash from the WRT and choose to liquidate the residence. Under the stretch IRA principle, they keep the IRA balance intact, taking only required distributions and maximizing its taxdeferral capability. The principle of replacement through use of lifetime income also applies to gifts made in the form of a CRT or charitable gift annuity. In each of these cases the donor will be receiving an income stream for a period of time. The goal of the WRT here will be to acquire a life insurance policy with a death benefit as near as possible to the amount transferred to the trust. The key to the success of this technique will be the amount and duration of after-tax income available from the trust relative to the premium required to replace the asset. Also important will be the tax leverage obtained from the deductible portion of the gift. For example, Warren (65) and Anne (65) are considering a donation to charity of all or a part of $1m of appreciated real estate ($600k basis) through either a lifetime CRUT or a direct bequest. The property is assumed to appreciate at 8% per year (to $3m in 15 years and to $6.3m in 25 years at life expectancy) but produces no income. They expect to be in a 45% estate tax bracket after use of any exemptions or credits. Under the direct bequest scenario (assuming death in the 25 th year) their estate will likely liquidate the property to accomplish the $1m bequest. After deducting the charitable bequest amount, the estate tax attributable to the property will be $2.3m, leaving a potential bequest to their children of $3m. 26 The WRT is simply an irrevocable life insurance trust (ILIT) whose purpose relates primarily to wealth replacement instead of estate liquidity. In many cases it would be appropriate to refer to the ILIT as the WRT since the designations do not distinguish them by legal operation but by goal. 9
Under the alternative scenario, they will create a 15-year CRUT, retaining a 5% unitrust interest. The present value of the charitable remainder is 47%, or $472,000. Projections indicate the trust will provide distributions each year beginning at $50,000 and increasing to $73,000 over the trust term. If the CRUT sells the property and assuming the CRUT is able to invest in assets producing income of 5% and growth of 3%, the CRUT is expected to have a remainder value of $1,500,000 in the final (15 th ) year. To provide for the children, Warren and Anne consider paying for a joint survivorship life insurance policy held by a WRT. For premium gifts, they will have available the after-tax CRUT distribution amount, but only for 15 years. 27 At an assumed blended tax rate of 30% (ordinary and capital gain) they should have annual after-tax distributions between $35,000 (the 1 st year) and $51,000 (the 15 th year). They may also consider the savings garnered from the income tax deduction. If used equally over 5 years, and assuming a 40% income tax rate, the nearly $472,000 charitable deduction would save them about $37,760 per year. In summary, for years 1-5, they should be able to support premiums ranging from $73,000 (net income of $35k and tax savings of $38k) to $76,000. For the remaining 10 years, the net CRUT distributions will allow for premiums from $40,000 to $51,000. From the heirs perspective, for the CRUT/WRT plan to better the direct bequest scenario, the WRT must be able to buy a life insurance policy that will provide more than $3m of death benefit using only the aforementioned premium stream (approximately $880,000 aggregated). From the charity s perspective, the CRUT scenario will be preferable since the charity will receive more money ($1.5 vs. $1m) and will likely receive it sooner (after 15 years instead of at life expectancy). The clients will need to model both the CRT and the life insurance policy illustration to decide which scenario best accomplishes their goals. In doing so, they should offset the potential inheritance loss faced by the heirs under the CRUT alternative against both the potential increased income stream and the charity s earlier acquisition of the donation. The wealth replacement trust functions differently in the context of a charitable lead trust. The CLT will ultimately provide a benefit to the grantor s heirs, so the WRT will be used to provide interim income to the client s heirs between the time that the asset is contributed to the CLT and the termination of the charitable lead term. For example, Berina s advisors recommend that she establish a testamentary CLT to help reduce the impact of estate taxes at her death. She amends her revocable trust to provide for a contribution of $4m to a ten-year CLT that will pay to the America s Second Harvest an annuity of $260,000 per year. At an assumed 7520 rate of 5.2%, Berina expects a charitable deduction of approximately $2m for the value of the charitable income portion of the contribution. In order to provide her heirs with access to some of the money that will pass to charity, she creates a lifetime WRT to hold a $1m death benefit life insurance policy on her life. The policy death proceeds will allow the trustee of the WRT to make distributions in the ten years following her death during which the heirs will not be able to access the CLT funds. At the end of ten years, assuming a CLT growth rate of 8%, Berina expects her heirs to receive approximately $4.8m. 27 These distributions will be taxable under the tier rules, which first send out ordinary income (if any), then capital gains, then tax-free income and finally return of basis. In this example, any ordinary income earned by the CRUT after reinvestment of the sale proceeds would be the first income distributed. If there were $50,000 of dividend income the first year, for example, the entire $50,000 would be taxable at ordinary rates. Should the trust s annual distribution exceed the ordinary income amount, the clients would begin to receive a portion of the $400k of gain realized from the sale of the donated property. 10
V. CHARITABLE SPLIT-DOLLAR Prior to 1999, some donors used a split-dollar arrangement in an attempt to combine the tax advantages of charitable ownership with a death benefit in part payable to the insured s heirs (or irrevocable trust). These charitable split-dollar techniques purported to give the insured an income tax deduction for premiums on a life insurance policy that would for the most part not materially benefit a charity. While the publication of Notice 99-36, and changes to the Internal Revenue Code have for the most part eliminated marketing of this concept, taxpayers and their advisors should be aware of the transaction and why it does not work as promised. 28 In general, the charitable split-dollar insurance transaction involves a transfer of funds by a taxpayer to a charity, with the understanding that the charity will use the transferred funds to pay premiums (or a portion thereof) on a cash value life insurance policy that benefits both the charity and the taxpayer's family. In the most common arrangement, the insured transfers a policy to a charity, having named the charity as beneficiary of the cash value portion of the death benefit. 29 The charity uses future gifts from the insured to pay policy premiums. At the insured s death, the charity receives a portion of the death benefit equal either to the cumulative premiums paid or the cash surrender value. The insured s heirs (or a trust for their benefit) receive the balance of the death benefit. In a variation, sometimes called charitable reverse split-dollar, the insured s trust owns the policy and rents the death benefit to the charity at a cost that far exceeds a fair market value for the protection amount. 30 In effect, the insured donor receives an income tax deduction for the charity s portion of the premium, which pays for more than its share of the policy death benefit. While the flexibility of the split-dollar arrangement prevents the cataloging of all types of charitable split-dollar transactions, the one common ingredient in all its many forms is that the insured s trust will receive what the IRS describes as a disproportionately high percentage of the cash surrender value and death benefit under the policy, compared to the premiums paid by the trust. 31 Prior to 1999, the IRS had concluded that despite the nominal form of the transaction, in substance the taxpayer bought the policy and transferred some rights to charity. The division of rights under this substance-over-form recharacterization would not come within any exception to 28 See Notice 99-36, 1999-1 CB 1274. Notice 99-36 outlines the method by which the IRS will disallow deductions for premiums paid to a charitable split dollar policy: Generally, a charitable split dollar insurance transaction involves transfer of funds to charity, with charity using the funds to purchase cash value life insurance policy that benefits both taxpayer and charity. Despite the fact that generally no deduction is allowed for a transfer to charity of less that an entire interest in property, promoters claim that funds transferred to charity are unrestricted gifts because there is no binding obligation to pay policy premiums with those funds, and that the taxpayer is not a party to the agreement with the charity and has no interest in the policy. IRS will apply a substance over form analysis to conclude that taxpayer buys the policy, transferring some rights to trust and some to the charity. The ensuing division of rights does not come within any exception to the partial-interest rule of Code Sec. 170(f)(3), nor will the gift tax deduction be allowed under Code Sec. 2522. Finally, IRS warned that it would consider challenging the charity's exempt status or imposing various penalties. 29 Promoters of charitable split-dollar claimed to avoid the partial interest rule by having the insured give up all rights in the policy, including both the policy rights (e.g., to name the beneficiary) and any contractual rights created by a separate agreement. Most arrangements involved an implied agreement that the charity would use future gifts to pay premiums and would not amend the two party beneficiary designation. 30 As with reverse split-dollar transactions in the employment context, the value of the coverage was often measured by the so-called PS-58 rates, which greatly exceeded the market value term cost for an equivalent death benefit. 31 Notice 99-36. 11
the partial interest rule of IRC 170(f)(3), and any premium gifts to the charity were consequently denied a charitable deduction. Current law addresses charitable split-dollar more directly (for transactions occurring after February 7, 1999). It disallows a charitable contribution deduction for any transfer occurring to or for the use of a charitable organization if the organization directly or indirectly pays (or has paid) any premium on any personal benefit contract (i.e., a life insurance, annuity, or endowment contract) that benefits the donor. This prohibition reaches both transfers in connection with an actual premium payment or an understanding or reasonable expectation that the charitable organization will pay (directly or indirectly) any premium on a personal benefit contract. 32 The IRS will also impose a federal excise tax against the charitable organization equal to the amount of any premiums paid. 33 Under current law, in a charitable split-dollar transaction the donor loses the federal income tax advantage of deducting his or her premium contributions. The charity at best will pay double for the costs of insurance. Its trustees or directors will likely invite suit for mismanagement of assets. VI. CHARITABLE OWNED LIFE INSURANCE (CHOLI) In response to the popularity of premium financing arrangements and a purported opportunity for a no-cost charitable contribution on behalf of the insured, a number of arrangements involving the temporary use of a charity s insurable interest have recently surfaced. Although it comes in various forms, charitable owned life insurance (CHOLI) generally calls for an agreement between a charity, the insured and group of investors to buy a life insurance policy. 34 In one form, the charity establishes a trust to which the investors contribute, or the investors establish a limited partnership with the charity as a residual beneficiary. The trust or partnership often acquires a life insurance policy on the insured. The funds contributed by the investors (or an immediate annuity bought with such funds) pay for the policy s premiums and provide for a return to the investors. At the death of the insured donor, the trust or partnership receives the proceeds. The investors are repaid their investment; any funds remaining pass to the charity. In this form the insured is considered a donor insofar as his or her gift of insurability may ultimately benefit the charity. Another form has the investors lending money to an insured to buy life insurance on his or her life. The donor assigns a portion of the death benefit to the investor group and names the remainder to a charity. Under the lending agreement, after a two-year period, the insured can repay the loan, or can give the investors the policy in satisfaction of the loan. Insured donors may be offered, in effect, the ability to provide a death benefit to the charity at no up-front cost to them. A typical example would require the repayment to include accrued interest at a rate significantly higher than the corresponding applicable federal rate. 35 As a result, few insureds 32 The Ticket to Work and Work Incentives Improvement Act of 1999 signed by President Clinton addressed a number of provisions including extending certain expiring tax breaks and providing revenue raisers to offset the expense of the extended tax breaks. Within the "extender" portion of the bill is a provision that specifically denies any charitable deduction for charitable split dollar arrangements. 33 In effect, the charity pays the premium cost at 200% of the nominal rate, since the excise tax is equal to the premiums paid. 34 Please note that CHOLI should not be confused with the outright ownership of a life insurance policy by a charity, a valid technique that is not tainted by the prospect of a non-charitable benefit. 35 Arrangements without a charitable component have been called alternatively Stranger Owned Life Insurance (SOLI), Investor Owned Life Insurance (IOLI), or nonrecourse premium financing. MetLife opposes the use of all such methods to acquire life insurance, as does at least one state insurance department. See also New York Insurance Department Letter Opinion (December 19, 2005), in which the Department concluded, in part, that the transaction presented involves the 12
choose to repay the loan. In most cases after year two when an insured assigns full ownership to the investors, there is little, if any, benefit available to the charity. As with charitable split-dollar, the CHOLI arrangement provides for a benefit to inure to a noncharitable person or entity while using the charity s tax-exempt status to facilitate the transaction. The structures may differ amongst CHOLI proposals, but similar flaws underlie each: a group of investors pool their funds and gamble on and invest in the life of a stranger. A charity may get a portion of the death proceeds, but the investors get the bulk. From the insured s point of view, the arrangement will only live up to its billing as free life insurance if the policy values exceed the principal and interest of the loan by the end of the second year an unlikely scenario given the built-in policy mortality costs and the high rates of interest imposed under the loan agreement. MetLife does not support any of these arrangements and has been active in opposing changes to state insurable interest laws that would grant an insurable interest to unrelated third parties. 36 These CHOLI arrangements essentially turn life insurance policies into an investment or a commodity, a purpose to which their tax-favored treatment was not intended. This manipulation of the insurable interest laws risks a loss of the special tax treatment that life insurance products have been afforded based on a much different public policy benefit. Further, misapplication of the life settlement guidelines, while obviously beneficial to the program s investors, may result in Congressional action to prevent all such settlements, which in the long run hurt the ability of legitimate settlors to access death benefit values. In addition, some arrangements imply the use of underwriting arbitrage between the annuity provider and the life provider to get favorable rates from competing insurers. As an industry, such a practice would have a substantial negative impact on the underwriting risk assumptions necessary to conduct business. Finally, because all outstanding coverage is taken into account, a donor s gift of his or her insurability can have a negative effect upon his or her ability to acquire future coverage for the funding of other needs. 37 As a matter of policy, MetLife does not support any form of Investor Owned Life Insurance including nonrecourse premium financing in the non-charitable context where the parties intend to eventually transfer the policy to an investor. Even where a particular state s insurable interest laws may otherwise permit a charity to buy an insurance, if the facts developed in conjunction with a submitted application indicate that the policy applied for is to be used in an investor owned charitable giving scheme, the policy will not be issued. Congress s concern about CHOLI transactions has been made manifest in the Pension Protection Act of 2006, which temporarily imposes a reporting requirement on charities that own an interest in certain life insurance contracts in which charities and private investors both own an interest. Under this requirement, charities must file an information return containing the name, address, and taxpayer identification number of the charitable organization and the issuer of the applicable insurance contract, and such other information as the Secretary of the Treasury procurement of insurance solely as a speculative investment for the ultimate benefit of a disinterested third party. Such activity is contrary to long established public policy against gaming through life insurance purchases. 36 In response to these perceived abusive CHOLI arrangements, federal legislation has been proposed to curtail their use. In 2005 a proposed bill (S. 993), sponsored by Senators Grassley and Baucus, would have imposed a very substantial penalty on CHOLI investors in the form of an excise tax equal to the premium costs of acquiring life insurance policies under certain of these arrangements. Bush Administration budget proposals would effectively eliminate SOLI through the creation of an excise tax on the policy death benefit if the charity owns the insurance contract and then sells it to a private individual or another entity. 37 The June15, 2004, Volume 2, NO.11 edition of NAIFA s Frontline, included the following statement on different forms of investor-driven life insurance arrangements. NAIFA and AALU strongly oppose these efforts to erode the integrity of long-standing insurable interest principles, which were designed to ensure that life insurance is used by those with a relationship to the insured for the benefit of families, businesses, employees and charities. 13