Copyright © 1999 Robert L. Sommers, all rights reserved.
Part 1 of 2
Charities are under enormous pressure to raise funds, but unfortunately, are often unaware of the stringent requirements attached to their prized tax-exempt status.
The concept behind U.S. charitable giving is straightforward: (1) a donor unconditionally gives a charity money or property and receives a charitable deduction on his taxes; (2) the charity receives the donation tax-free. The charity must qualify as a tax-exempt entity under the Internal Revenue Code and must agree to abide by strict rules to maintain its tax-exemption. A major restriction is that the charity cannot be used to benefit an insider (one with influence over the charity).
Tax planners have been eyeing the charitable deduction as a tax planning tool. The trend is to stretch the deduction in ways never intended by Congress. The latest ploys involve efforts to claim a charitable deduction for transactions that principally benefit the donor, not the charity. Whether the donor is transmuting a non-deductible personal expense into a charitable deduction, or misusing the charity's tax-exempt status to lower his own income and estate taxes, these new gimmicks have a "pitchman's" tenor to them. They are packaged and actively promoted by those representing the financial interests of the taxpayer, not the charity, and usually have a take-it-or-leave-it attitude toward the charity. In other words, there is little charitable intent involved with these structures, the emphasis is on using the charity's tax-exempt status to benefit the taxpayer, but without a corresponding "real" benefit to the charity.
To obtain a deduction for a charitable contribution, you must make a gift of money or property to a tax-exempt entity. A gift has two elements: (1) Donative Intent (you had to intend to make a gift); and (2) Lack of Adequate Consideration (i.e. the donation is more valuable than what you receive in return). A gift to charity is deductible to the extent the fair market value of the gift exceeds the benefit, if any, received from the charity. For example, if your intent is to give a computer worth $200 to a charity and the charity gives you tickets to a concert worth $150, you receive a $50 deduction.
When a gift of property in donated, there is an additional requirement: you must donate your entire interest in the property. Accordingly, if you assign or transfer less than your entire interest, including a partial interest in life insurance, to a charity, you lose the charitable deduction. This less-than-full-interest rule dooms the latest craze in charitable giving: the split-dollar life insurance policy.
The concept behind the split-dollar life insurance transaction (despite its fancy name) is straightforward: The taxpayer causes the purchase of a cash value life insurance policy on his life to benefit his family; the taxpayer then donates money to charity; the charity, in turn, pays the life insurance premiums on the policy with the donation and receives a small portion of the policy's benefits.
The result: The taxpayer pays for life insurance with tax-deductible dollars by routing the premium payments through a charity and taking a charitable deduction. The charity receives some benefit from the life insurance policy, usually a small portion of the cash value. Without the participation of the charity in the scheme, premium payments by the taxpayer would be a non-deductible personal expense.
NOTE: With a cash value life insurance policy, the premium payments exceed the amount necessary to pay for actual life insurance. The excess premium stays in the policy and grows tax-free (similar to an IRA). Thus, the cash value of the policy grows exponentially since each year more of the cash premiums are retained by the policy and the entire amount compounds tax-free.
With a wink and a nod, but rarely spelled out on paper, the transaction is structured as follows: The taxpayer usually forms an irrevocable trust to purchase a cash value life insurance policy on the taxpayer's life. The policy's beneficiaries are the charity (to a small degree) and the trust, or the taxpayer or his family. In any event, the bulk of the benefits from the life insurance policy will flow, directly or indirectly, to the taxpayer or his family.
Now comes the "magic." In a related transaction, the charity enters into a split-dollar agreement with the trust. The agreement specifies the rights and obligations between the charity and trust such as: (1) the obligation to make premium payments; (2) the rights to the cash value and death benefit under the policy; and (3) the rights to terminate the policy or change policy beneficiaries.
Key features of the split-dollar arrangement include the following: (1) the charity pays its share of premiums with donations received from the taxpayer or a related party; (2) the trust has a disproportionately high percentage of the cash value and death benefit under the policy, compared to the premiums it pays. In other words, the charity pays for the policy, but the taxpayer or his family receives the lion's share of the benefits.
This transaction is premised on the charitable deduction taken by the taxpayer for the money used by the charity to pay its share of the premiums. Naturally, the big loser is the U.S. Treasury which is cheated of tax dollars by this manipulation of the charitable deduction rules. The other losers are those taxpayers who aren't wealthy enough to engage in this tax dodge.
In an aggressive attack on the split-dollar life insurance scam, IRS labeled the transaction abusive and warned taxpayers, their advisors, and charities involved that they all face taxes and huge penalties if they persist in using this gambit. Charities are now plainly at risk of losing their tax-exempt status. See IRS Notice 99-36 (June 14, 1999).
NOTE: Congress has weigh-in on the subject as well. Senate Finance Committee Charitable Split Dollar Legislation, Section 406 would deny a charitable deduction for split-dollar insurance transactions.
IRS correctly notes there is no charitable deduction for a transfer of less than a taxpayer's entire interest in property, including life insurance policies. Although the transaction is cast in several steps to avoid this rule (a trust purchases the policy, not the taxpayer), IRS is not required to respect the form of a transaction when the form differs from the substance. The "substance over form" doctrine has been discussed at length in other writings on my webpage.
Here, the substance is obvious: The taxpayer is making premium payments on a life insurance policy that benefits him or his family, and such payments are not deductible. IRS properly ignores the extra steps of funneling the premium payments to a charity which then pays the insurance premium, and the use of a trust to purchase the policy, since, in substance, these steps serve no economic or business purpose, apart from giving the taxpayer a deduction he is not entitled to receive.
In Notice 99-36, IRS dismissed promoters' claims that the split-dollar life insurance policy was a proper charitable gift planning technique. The substance-over-form doctrine will apply to the mutual understanding (whether or not there was a legally binding contract) that in return for donations made by the taxpayer, the charity will enter into the split-dollar arrangement.
Although promoters claim the fair market value rule should apply to calculate the benefit to the taxpayers, that rule is not relevant when less than full ownership is transferred to a charity. Using a trust or entity separate from the taxpayer to purchase the insurance does not alter this result because, in substance, the taxpayer is considered the person dividing the rights in the policy between the charity and himself or his family. Since less than the entire interest is transferred, the taxpayer is not entitled to any charitable deduction.
Charities engaging in this transaction should be extremely nervous. IRS has stated that it will challenge, on a case-by-case basis, the tax-exempt status of participating charities. It could assess additional taxes on excess-benefit transactions, or self-dealing penalties against disqualified persons benefiting from the transaction and also charity managers. Charities that provide phony evidence supporting deductions by donors could be accessed penalties for aiding and abetting the understatement of tax liability by the taxpayer.
Promoters and others could be hit with penalties as tax preparers, another penalty aimed at promoters and for aiding and abetting the understatement of tax liability by taxpayers.
Charities need to protect themselves from promoters and taxpayers promoting donations in return for participating in schemes that could jeopardize the charities tax exempt status. Those charities currently involved with split-dollar life insurance programs need to bail out immediately. Consider assigning the charities rights to a third party. Inform the donor that future donations will not be used to pay insurance premiums.
If the taxpayer threatens the charity with legal action for breaching the split dollar arrangement, immediately seek the counsel of an attorney. An arrangement that threatens the existence of a charity's tax-exempt status could be illegal under state law. Charities should make sure that any contract they enter into with a donor includes an escape clause in the event that the arrangement might cause the charity to lose its tax exemption.
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**