A transfer of cash or other property to certain charitable, religious, scientific, educational, or other organizations may result in favorable income, gift, and estate tax results for the donor.1 Income taxes can be reduced and estate taxes can be saved. More importantly, a gift to charity serves to reward the donor in significant psychological and moral ways. Charitable giving is one of the most important of all estate and financial planning considerations.
Life insurance is an important vehicle for accomplishing these tax and nontax objectives. It is used in one of two ways:
- as a direct means of benefiting the charity; or
- as a way to allow the donor to give other assets during their lifetime or at death to charity without denying or reducing the financial security of his family. It may even serve as a form of wealth enhancement.
Wealth Replacement Strategies
Life insurance used as a wealth replacement tool enables a client to meet both charitable and personal objectives by assuring an immediate and certain gift to charity while also assuring his family that they will receive as much, if not more, than they would have received had no gift been made to charity. Since a qualified charity can sell assets contributed to it without an income tax liability on any gain, a client who lacks liquid assets can make a charitable gift of illiquid assets, while still affording the charity a source of cash through the sale of the assets.
Consider this technique as a way of enabling a business owner to harvest the fruits of a lifetime of labor without the penalty and loss of heavy income tax on any gain. Compare, for instance, the retirement income derived, net after taxes, from the sale of a family business with the income derived if the business is donated to a charitable remainder trust. The trustee of the trust could sell the business and pay the donor client an income for life or a term of years with 100 percent of the sales proceeds since the trust would pay no income tax on any appreciation inherent in the gift. Likewise, consider this technique as a way to enable a highly successful investor to convert taxable gain on an investment portfolio into retirement income without the income tax slippage inevitable upon a direct sale.
There are many ways the wealth replacement technique can be employed. One way is to create a charitable remainder trust funded with highly appreciated property that generates a low income yield. The client receives an annuity from the trust (a fixed annuity if the remainder trust is an annuity trust, or a variable annuity if the trust is a unitrust), with the remaining principal going to the qualified charity upon termination of the trust.2 The advantages of this technique are:
- The present value of the charity’s right to receive the property when the noncharitable beneficiary’s interest ends is currently deductible by the client.
- Even if the property contributed to the trust has built-in gain, no tax on that appreciation is imposed on the client.
If, and when, the trustee sells the property, neither the client nor the trust must report any capital gains. However, part of the noncharitable beneficiary’s distributions from the trust may be treated as a distribution of capital gain and taxed at the time of distribution.
In many cases the client’s income from the donated property will be significantly increased because the trustee will have been able to sell the property (at no tax to the trust) and use the net proceeds to invest in higher-yielding securities. Had the client sold the property, his net investable amount would have been reduced by the tax on the gain. So, the tax savings as well as the higher return from the new investment enhance the yield from the trust.
A portion of the cash generated by both the client’s immediate income tax deduction and from the increased return from the property can be given to the client’s intended heirs. The heirs can choose to use that money to purchase insurance on the life of the client (and/or the client’s spouse) so that, at the client’s death, the wealth passing to charity through the trust is replaced. Note that replacement requires only the net amount that the intended heirs would have received had the client retained the asset, and had that property been subjected to state and federal death taxes and other transfer costs.
Using Life Insurance for Charitable Purposes
Life insurance can be used both during the client’s lifetime and at death to make meaningful gifts to charity. Some of the strategies used to provide direct gifts of life insurance to charity include:
- Donation of existing insurance policies on the life of a client to a qualified charity.
- Purchase and donation to a charity of new insurance on the life of the client, the client’s spouse, or both.
- Disposition by will of a policy on another’s life to a charity. The value of the policy at the policy owner’s death will be includable in his estate, but an equal and offsetting deduction will be allowed for the gift to the charity by will.
- Contribution of cash directly to a charity, which in turn uses that cash to purchase a new (or existing) policy on the life of the donor (or other supporter).
- Naming the charity revocable or irrevocable beneficiary of one or more life insurance contracts (individual or group).
- Contribution of an asset other than life insurance in order to generate an income tax deduction, which in turn can save the client money otherwise payable in tax. These tax savings can then be gifted to the client’s children or other beneficiary (or to an irrevocable trust for their benefit) who could use that cash to purchase life insurance on the client’s life, or on the life of the client’s spouse. The charity receives an immediate and certain gift and the client’s beneficiary receives what he would have received (or, in many cases, even more) after taxes had there been no charitable gift. This use of life insurance is often called wealth replacement.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM