Gifts of Life Insurance

Frequently, individuals have prudently purchased life insurance in their younger years to provide for their families in the event of the early demise of the insured, only to find that in their later years the accumulated value of the policy is no longer required for its intended purpose. In these cases, the insurance policy becomes an excellent candidate for funding an outright charitable gift. Properly planned, life insurance may be carefully used to fund charitable trusts. With all gifts of life insurance, legal counsel should ensure that state law permits a charitable organization (or charitable trust) in that state to have an "insurable interest" in the donor.

Even though it may be an intangible investment asset, a life insurance policy produces ordinary income if sold or surrendered. If the individual were to sell or cash in the policy, any excess in what she receives from the insurance company upon surrender over her investment in the policy (cumulative premiums less dividends paid and policy loans) would be taxable to her as ordinary income. Therefore, tax rules applicable to gifts of ordinary income assets apply to gifts of life insurance. A donor's charitable contribution income tax deduction is the lesser of the value of the policy (discussed below) or the donor's basis in the policy subject to a fifty-percent limitation in the year of the gift to a public charity, or a thirty-percent limitation in the year of the gift to a private foundation, both with a five-year carryover period.

In the case of a paid-up policy (one for which no further premiums need be paid), the value of the policy is equal to its replacement value(the single premium amount it would cost for a comparable policy having an equal death benefit for an individual the same age as the insured). Replacement value would generally be provided by the insurance company. If there are loans against the policy, its value is generally equal to the policy's cash surrender value, which will normally be lower than replacement cost. In such a case, the donee charitable organization must determine whether the policy loans will cause the policy to produce "unrelated debt-financed business taxable income."

If premiums remain to be paid on the policy, its value is generally the "interpolated terminal reserve" of the policy. This is generally an amount somewhat in excess of the cash surrender value of the policy. If the donor continues to make premium payments after making the gift, the payments are treated as contributions of cash to the donee charity.

Note that in the paragraphs above, there is no mention of the face amount of a life insurance policy. The face amount of a policy becomes its value only upon death. Replacement value of a policy would approximate the face amount of a policy only in the case of the very old, or in the case of one who is terminally ill.

The discussion above assumes a lifetime gift of a life insurance policy. A lifetime gift also removes the policy from the donor's estate (assuming she survives the gift by at least three years). A donor may simply choose to forego an income tax deduction and remove the value of the policy from her taxable estate at death by naming a charitable organization as the beneficiary of the policy. The value of the policy is included in the decedent's gross estate, but qualifies for the estate tax charitable deduction, which removes it from the taxable estate.

Gifts of tax-deferred annuity contracts are subject to a different set of rules than life insurance policies. For annuity contracts issued after April 21, 1987, the holder of the contract who surrenders it without full and adequate consideration is considered to have received the cash surrender value of the contract on the date of surrender. To the extent that value is greater than the holder's investment in the contract, the holder recognizes ordinary income, even though she does not receive it. In the context of a charitable gift of such a contract, the donor may recognize ordinary income which is taxable to her and deduct the fair market value (the lesser of her investment [increased by the income recognized which now is probably equal to fair market value] or the fair market value of the contract. Since her deduction is limited to fifty-percent of her adjusted gross income on a gift to a public charity, it is possible that the value of the deduction in the year of the gift will be less than the income recognized which could produce net tax in the year of the gift and a net deduction in subsequent years.

For annuity contracts issued prior to April 22, 1987, the holder of the contract who surrenders it without full and adequate consideration is considered to receive the cash surrender value of the contract in the year in which the donee of the contract surrenders the contract and receives the proceeds rather than in the year of the gift. In this case, if the charitable donee does not surrender the contract in the year of the gift, the donor's deduction will be the lesser of investment in the contract without benefit of an increase for gain recognition. The income will be realized in the subsequent year in which the donee surrenders the contract. Here the donor's deduction in the year of the gift is less and the income in the subsequent year will not be offset by a contribution deduction (except for any possible carryover).

One final caveat: a "personal benefit contract." In order to shut down abuses involving split-dollar life insurance purchased by an organization on the life of a donor, the law (effective December 17, 1999) provides that a transfer of funds to a charity is not deductible under the charitable gift annuity rules if the payment is made in exchange for a personal benefit contract. A personal benefit contract is any life insurance, annuity, or endowment contract if any beneficiary, direct or indirect, of the contract is the donor, a member of the donor's family, or any other person designated by the transferor. In the scheme now prevented by this restriction, a donor would transfer unrestricted funds to a charitable organization and claim a full contribution deduction therefore. By unwritten agreement, the charity would use the funds to pay premiums on an insurance contract in which the donor received an economic benefit, often much greater than that of the charity. In essence, the donor was receiving insurance benefits paid for with tax-deductible premiums.

A gift of life insurance is just one more vehicle by which an individual can fulfill both noncharitable and charitable objectives to the mutual benefit of the donor and the charitable donee, provided such a gift complements a donor's overall family and estate tax plan.

©2008 Ronnie C. McClure, PhD, CPA