Picture this couple: retired empty nesters Claude and Carmine Cashcow, who no longer need Claude’s $3 million universal life insurance policy and have no desire to continue paying premiums. They’ve discussed making a significant gift to their alma mater, but this would adversely impact their quality of life. Orthodox advice would be to gift the policy to the school, but a prior life settlement may allow a higher deduction. Should they give two in the bush (gift the policy), or one in the hand (sell the policy and give the proceeds)?
Assume that the economics of the life settlement are better than keeping the policy until the insured’s death. Assume also that the charity is classified as a public charity and not a private foundation, that the life settlement value (LSV) is equal to fair market value (FMV) when the policy is gifted (valuation is critical in charitable giving), and that basis is equal to premiums paid. (Note: Whether gifting the policy or the proceeds, there is a 5-year carryover of excess contributions, and substantiation and appraisal rules apply.)
Gift of policy
As a general rule, policyholders should first pay off existing loans (to not violate the draconian charitable split-dollar rules). And to avoid an assignment of the income tax problem, there should be no prior agreement to sell the policy.
When life insurance is gifted to a public charity, the donor’s deduction is reduced by an amount equal to ordinary income had the policy been sold, but some ambiguity in the rules leads to uncertainty in calculating the deduction. (The following case study shows multiple methods of taxation.)
If the gain is all ordinary income, then the deduction equals basis; and if it is all long-term capital gain, then the deduction is the fair market value of the policy. (However, if the “step-down” election has been made, then it equals basis). If the gain is part ordinary income and part capital gain, the deduction equals basis plus capital gain. If there is a loss, then the deduction equals fair market value.
The donor also has adjusted gross income (AGI) deduction limitations. If the gain is all ordinary income, the limit is 50% of AGI. If it is all capital gain, the limit is 30% (however, if a “step-down” election is made, the limit is 50%). If the gain is part ordinary income and part capital gain, there is some question as to whether the AGI limitation is based on a 50/30% split, or whether it is purely 30%. If there is a loss, then there is again a question as to whether the limit is 50% or 30%.
Gift of after-tax proceeds