For millions of Americans, “charity begins at home.” That’s where they’ve decided to make a difference by donating money to local religious, educational, social or cultural organizations. In addition to the immense satisfaction that comes from giving to others, when done as part of an overall estate plan, charitable giving can provide tax benefits for the donor and his or her estate.
Charitable Gifts of Life Insurance
Gifts of life insurance have some unique advantages:
- Life insurance is a contract and passes outside the will by beneficiary designation, so it generally cannot be contested in probate proceedings.
- Since the payment of a life insurance policy death benefit to a named beneficiary is not part of the probate process, it is private, not a matter of public record like assets passing by will.
- Donor is eligible for an income tax charitable deduction when he/she transfers an existing life insurance policy to charity.
- Ability to leverage charitable donation through the death benefit
- There are no probate delays.
- Other assets are kept intact for the donor’s family.
Gifts of life insurance can be made in essentially two ways. Under the first, the insured is the owner of the policy and the charity is the beneficiary. This arrangement is used when an insured/donor desires to retain control over the insurance policy. Under this arrangement, the premiums paid are not eligible for an income tax charitable deduction. Normally, when the insured owns the policy at death, the entire death benefit will be includable in his or her gross estate under IRC Section 2042, and therefore potentially subject to state and federal estate taxes. If, however, the death benefit passes to a charity, it will be 100% deductible from the gross estate, under IRC Section 2055.
The benefit to this approach is the donor can change his or her mind at any time and revise the beneficiary designation to name a new charity as beneficiary if they so desire. This gives donors flexibility in several common situations: a favored charity either ceases to be or changes focus (as sometimes happens) or the donor wishes to name more than one beneficiary. Additionally, for large estates, because the policy proceeds pass to a charity and are deducted from the insured’s gross taxable estate,, this may in turn lower the client’s exposure to estate taxes, often a desired result.
Under the second, the charity is owner and beneficiary. Unlike the situation where the insured retains ownership, the premium may be income tax-deductible within IRS guidelines. State “insurable interest” laws must be checked to determine if a charity can be the initial applicant of life insurance on the life of a donor.
If the donor gives an existing policy to charity, the lesser of the fair market value of the policy (generally, its cash surrender value plus any unearned premium) or the policy-holder’s basis (normally the premiums paid) is eligible for an income tax charitable deduction. (See IRC Section 170 (e)(1)(A), Treas. Reg.25.2512-6(a) and Tuttle v. U.S., 436 F.2d 69 (2d Cir. 1970). Additionally, future gifts of cash to the charity for premium payment purposes are also eligible for an income tax charitable deduction within IRS guidelines. This approach favors donors who wish to have a current income tax deduction, but at the cost of the flexibility that comes with owning the policy.
Charitable Remainder Trusts (CRTs)
If the prospective charitable donor is looking for a way to generate income, reduce estate and income taxes, defer taxes on gains and make a significant charitable contribution without reducing his or her family’s inheritance, a charitable remainder trust and a wealth replacement trust may be the right tools. These trusts can allow an individual to make a gift to a charity while retaining an interest in the gifted asset during his or her lifetime.
CRT Mechanics and Tax Aspects
Often, advisors will recommend funding a CRT with an asset that, if sold outside the trust, would produce substantial long-term capital gains tax. After the trust is executed, the donor transfers this appreciated, low or non-income producing asset to the CRT. The CRT sells the asset and gives the donor an income stream for life, for a term of years, or for joint lives. At the death of the donor (or the donor’s named non-charitable income beneficiary if other than the donor) the remaining trust assets pass to the charity. Here’s how it works:
- Upon creation of the trust, the donor gets a current income tax deduction based on the present value of the future amount passing to the charity.
- No tax on the gain is paid by the trust when it sells the asset, since the trust is exempt from such tax when it sell the asset.
- The donor receives an income stream and pays income taxes (including any capital gains) on the income as received.
- At the end of the trust term the remainder passes to the designated charity and estate taxes may be reduced, since the asset placed in the trust has been removed from the estate.
“Wealth Replacement” Trust
As indicated, the remaining assets in the trust eventually pass to the charity and not to the donor’s heirs. The income tax savings produced by the charitable donation combined with the income generated by the trust can be used to pay premiums on a life insurance policy owned by a properly formed irrevocable life insurance trust sometimes known as a “wealth replacement” trust. The life insurance policy in this trust replaces the value of the assets that pass to the charity in the CRT. Since the life insurance is purchased and owned by the irrevocable trust, the proceeds should be income and estate tax free. The donor’s family is, therefore, made whole.
This educational third-party article is being provided as a courtesy by Dan Morris. For additional information on the information or topic(s) discussed, please contact Dan Morris at 303-931-4110 or dmorris@ft.newyorklife.com.
Neither New York Life Insurance Company, nor its agents, provide tax, legal, or accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions.
Dan Morris
Agent, New York Life insurance Company
6850 West 52nd Avenue-Suite 200
Arvada, CA 80002