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
When gifting after-tax proceeds of a life settlement to charity, any charitable deduction equals the net sales proceeds (after-tax), the AGI deduction limitation is 50%, and losses are not deductible. One question is whether an LSV gain in excess of the cash surrender value (CSV) is eligible for capital gains, and the following case study shows both scenarios.
Refer to our earlier example involving a $3 million death benefit for a universal life insurance policy issued years ago to Claude Cashcow, who is now age 81. Chart 1 shows the case facts:
Using the gain characterization rules described previously, a life settlement offer of $1,000,000 on a policy with a $500,000 basis (cumulative premiums paid) results in an estimated gain of $500,000. The CSV in excess of basis ($625,000 – $500,000) results in $125,000 of gain characterized as ordinary income, or 25% of the entire $500,000 gain. The remaining 75%, or $375,000, could be classified as ordinary income or capital gain, depending on the opinion of the client’s professional advisers.
The most important column in Chart 2 from the donor’s point of view is Col. 4, “Net After-Tax Cost to Donor.” If a major portion of the donor’s gain is eligible for capital gains treatment, then leaving 2 in the bush (i.e., gifting the policy) is slightly more advantageous, whereas if the gain is characterized as all ordinary income, then it is better to have one in the hand (i.e., sell the policy and donate the proceeds). As far as the charity is concerned, it is always better off with a gift of the policy followed by its making the sale.
Our case example illustrates only one scenario. There are infinite potential fact patterns and each one must be analyzed to determine whether it is more advantageous for a donor to give a policy or its proceeds to the charity.
There are many issues that go into determining a proper course of action when considering a life insurance gift to charity. Once all questions as to both the financial and the non-financial elements have been answered in such a way that a life settlement is still a solution, and a life settlement offer has been received or estimated, it is time to determine what is in the donor’s best interests, to give the charity “two in the bush” or “one in the hand.”