Charitable Split-Dollar Insurance Plan – Definition

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Charitable Split-Dollar Insurance Plan Definition

A charitable split-dollar insurance plan is a life-insurance arrangement where a donor donates money to a charity, so that the organization would in turn invest this donation in a life-insurance contract for the donor. Simply put, a donor sends a gift to a charitable institute which in turn invests this money in a life-insurance plan for the donor and the on behalf of the charity. In a situation where the donor dies after the donation has been invested, the insurance benefits will be transferred partly to his or her heirs, and partly to the charity. The donor and the charitable organization are in charge of specifying how the split should be made, thus the term; “split-dollar.”

The reason for this type of insurance policy is due to the absence of taxation on investments. In this case, the donation which is saved by the charity on behalf of the donor is tax free as the government at all levels exempt taxes on donations. Also, after the donor dies, the heirs wouldn’t be required to pay tax as they’d receive their share of the money through life insurance policy which is also tax-exempt in the United States.

A Little More on What is a Charitable Split-Dollar Insurance Plan 

Established in the early 1990s, charitable split-dollar plans started gaining wide popularity as more and more wealthy individuals saw it as a way to pass down inheritance without paying taxes. However, the U.S. Department of Treasury, was quick to lambast the idea of this insurance policy. The Wall Street Journal in 1999 covered a story of a software developer who was promoting these insurance policies to wealthy individuals, especially those who had issues with the tax system. This developer described the charitable split-dollar insurance plan as a way to boycott the enormous taxes paid on inheritance by heirs of donors.

The IRS, when they got to read this story, started looking for ways to close the loophole in property transfer. The agency issued a paper alerting all donors of their knowledge of this method, and vowed to shut it down. Later in 2003, the IRS closed the exploit which enabled this method to work perfectly, thus making the charitable split-dollar insurance plan less of a strategy that any wealthy individual would want to take to pass down his or her inheritance to their heirs.

Different Variety of Split-Dollar Insurance Plans

The charitable split-dollar insurance is modeled from the standard split-dollar insurance plan, where more than one party invests into the premium. Most employers make use of these plans and offer them as benefits to employees . Here, the employer partly contributes into their worker’s insurance plan account and the worker’s family get to reap the benefits of the policy in an event of death. This way, the employee gets to save some money which he or she can use while living, since there is a contributor that partly supports the insurance plan.

In most cases, the employer gets to have a share of the insurance policy plan when the employee becomes deceased. This is a fair occurrence in a split-dollar insurance plan. Here, the benefits are split as initially agreed between the contributing parties in the event of the death of the employee. The beneficiaries (heirs or spouses) of the deceased and the employer are the ones who would benefit from the insurance benefit. Most times, split-dollar insurance policies are referred to as zero-interest loans, as the employer basically receives whatever he or she has paid into the employee’s account in the event of death.

In the case of a charity, the benefits are split between the heirs and the charity when the donor becomes late. The charity is entitled to a portion as long as it is stated in the contract signed between them and the donor. Sometimes, the charity is only able to benefit from the insurance via a minimum death gift, while in some cases, they’re not guaranteed of anything in the long term. However, this doesn’t mean that the charity has a chance to be left with nothing, as they’re always entitled to benefits as long as the program is still on. Simply put, as long as the donor is still alive, the charity gets their benefit for allowing the donor to save in an insurance plan under their name.

The charity, just like in the case of an employer and an employee, would be required to pay into the insurance plan, as long as it is stated in the contract. In a case where this is not stated, the charity gets to benefit investment-free from the insurance plan. This case can also be in favor of the donor. Now, each party has a part of the premium which they’re expected to fulfill, but are not under any legal obligation to do so. The donor can donate assets and gifts to the insurance policy plan as part of their premium, but are not under any obligation to do so, since there is no contract that states that this is mandatory.

Prior to this insurance clause, the donor is not required to to have had a relationship with the charity before, as in the case of prior gifting and donations. There are couple plans of charitable split-dollar insurance policy which we’ll be looking at. It is however important to note that this act of detailing is in no way targeted at promoting any of the plans stated.

Plan One

In Plan One, the donor is required to create an irreversible or indissoluble insurance trust which buys the insurance premium plan on behalf of the donor’s life. Later on, the donor teams up with the charity, and the insurance is paid on a split premium plan by both parties, with the benefits shared with a split-dollar system. After this agreement has been made, the trust offers to the charity, an opportunity to name a beneficiary on its own part in a case where the donor dies. A rational reply on the part of the charity would be to name itself as the beneficiary of its own share of the insurance premium payments. It is important to note here that the charity is like a partner to the donor but only comes into play after the donor has originally set up the insurance plan. It is much like having an idea, starting it up, and getting someone to pool in their resources with yours to explore the idea in real life.

When both parties have named their beneficiaries, the donor gets to make cash payments to the charity in the form of donations. This is where it gets complex but straight to the point. Here, any payment made by the donor to the charity is expected to reflect on the insurance premium, as the charity is required to pay the amount into their own part of the premium payment, to avoid any chance of jeopardizing the contract. The charity is not obligated to pay in the amount donated, but they’re expected to, as it helps them cover their own part of the premium which in turn benefits the donor who initially made the payment in a form of donation to the charity. Here, the donor provides an amount with a minimum which is equivalent to the the level term expenses of the death benefit as stated in the insurance plan. The charity is then required to choose between a limited list of options on how to utilize the premium.

  • The charity may pay the incrementing term cost based on a particular death benefit as stated using the P.S. 58 tables.
  • The charity may pay a level term cost which is based on the average of such costs though the life expectancy period. In a case of excess payments, the charity gets to receive the extras after they’ve been deemed and declared “unearned premium account” in an event of the donor’s death. In some cases, these “excess”  will be kept to cover the incrementing cost of the charity’s part of the insurance premium.
  • The charity may pay a yearly amount necessary to guarantee the cost of the insurance premium for a 15-year duration or till the donor or insured candidate attains the age 65, which ever comes after. In a situation like this, the charity would receive the agreed death benefit plus the account value for the insured party, as concluded by the insurance firm.
  • On the other hand, the charity may decide to keep the cash donated by the donor and pay nothing into their part of the insurance premium. The condition of the contract will depend on whether there is enough amount in the unearned premium account or not. In a situation where there is enough unearned premium account, the insurance would continue. However, if the other side of the coin appears, the premium would be dissolved and the charity will receive no further benefits. In IV, the charity and the trust will have to split the policy benefits, where the trust is entitled to the greater share of the  (a) premium paid by it (b) the cash surrender value of the policy, and any excess payment made.

Under Plan One, the donor or the insured candidate is allowed as stated by the plan to withdraw the cash value of the policy loan after reaching an agreed age. Charities mostly buy into this plan as they’re offered a minimum death benefit as long as they keep participating in the premium policy. To charities, it is like getting paid for doing nothing, and in some cases; getting paid for being paid.

Plan Two

Plan two is similar to the arrangement of plan one, but differs in a small way. Here, the insured individual is not in charge of the payment, but it is made on his behalf. In this insurance setting, the insured’s corporation handles the cash contribution to the charity, while the insured makes cash payments to the trustee. In other words, the charity gets to pay their part of the premium using the donations from the insured’s corporation, while the donor’s part of the premium is covered by himself individually. Thus, the donor provides the insurance payment to the trustee or the insurance firm, while his corporation provides the cash donations which the charity will use to fulfil their own part of the premium. In some plans under this scheme, the trustee is seen as the owner of the insurance plan, but required to follow a set of assignments or endorsements which provides it with benefits and certain rights. Other plans, on the other hand, endorse the charity and the trustee with ownership of the insurance policy. All plans respect the payments to the charity with is irrevocable and partially used to fund its own part of the premium. No matter the plan, the donor must, in one way or the other, fund the charity using properties, assets, or cash donations, which will allow it to pay its own part of the insurance plan. Some agreements however require that the charity put all or a designated part of the donations into the premium, lest the contract would dissolve. In plan two, the insured (or his corporation) aims to reduce or deduct the cash gifts as contributions to a charity. Some programs under this plan allows the insured to withdraw a certain amount or take policy loans to perform some personal issues or transfer to heirs. In other cases, then trustee holds the right to withdraw cash value of contributions, assess policy loans, and even surrender parts of the premium policy on behalf of the insured, and they have exclusive right to transfer such withdrawals of any kind to the grantor of the trust, the family of the insured, or any other party originally designated by the insured party (or the donor) after they’re deceased. This property transfer or withdrawal transfer is typically income tax free, so the beneficiary would have to pay nothing on receiving such inheritance; thus the widespread use of charitable split-dollar insurance premium policy.

Charitable split-dollar insurance plans gained traction and widespread implementation due to their tax-free state within the estate sector, in cases of retirements, and under the income tax deduction systems. These plans are promoted on the foundations of current income tax deductions, creation of charitable endowments, supplemental tax benefits, and estate tax-free death benefits. There are however different questions facing the charitable split-dollar insurance plan, as with all things widely utilised. Most questions are focused entirely on the IRS, while others are focused on the charity. However, a question that has been troubling this system for years is whether the insured is entitled to an income tax deduction for making charitable cash donations. To properly analyze this discussion, we’ll look at three various issues which the question above bases on. Here goes:

Will the contribution be non-deductible because a partial interest is constituted by the purchase of an insurance by the charity on behalf of the donor?

This question focuses mainly on the taxation of charitable contributions if they are found to be mechanics used by donors to get charities to help them transfer their inheritance without getting their beneficiaries to pay taxes on them. It is only proper to include the tax agency into this discussion. According to the Internal Revenue Code Section 170(a), a charitable contribution can be only be taxed if made within the taxable year. Thus, a charitable contribution is taxed for the year in which it was made, and wouldn’t be taxed further than that. For income tax to affect a charitable contribution, it would meet all the quotas of the Code Section 170(a). In this case, a charitable contribution is defined and only applies to gifts or donations to a charity with the sole purpose of use by the charity. Simply put, any gift that is awarded to a charity and made with the sole aim of consumption by the charity qualifies as a charitable contribution. The code also states that a tax deduction can only be denied in the case of a contribution (not made in the name or intentions of the trust) of an interest in assets which constitutes less than the taxpayer’s interest in such asset. Thus, for a donation to qualify for charitable contribution deduction, the donor must forfeit all his interest in such property. In other words, all legal rights of ownership by the donor to such asset must be forfeited for such contribution to be deemed deductible.

There are however, different exceptions to this laid down rule. The Internal Revenue Code (acronym: IRC, popularly called “Code”) states that the “partial interest rule” doesn’t apply to a donation of an excess interest in a personal house or farming estate, or an unmodified part of the taxpayer’s entire interest in the asset, or a donation deemed to be qualified. These restrictions or alterations to this policy doesn’t apply to contributions in trusts that satisfy the requirements or the expectations of Section 664 of the IRC (a code centered on charitable remainder trusts) or Section 642(c)(5) of the IRC, which centers on pooled income funds.

All three IRC sections stated above are famously known and this is an issue which the charitable split-dollar policies aim to address. For these problems to be addressed, a basic argument is formed. The argument proceeds as follows. The insured individual (or the third party) is providing unrestricted cash donations or contributions in the form of assets to the charity. These contributions consists of the donor’s or the insured party’s entire and non-partial interest in the asset or the money donated. The split-dollar arrangement in this case is solely between the insurance trust and the charity and not between the donor and the charity or the donor and the insurance trust. The benefits also go to the trust and the charity with which the agreement was made. This arrangement eliminates any possible trace or presence of partial interest, thus the partial interest rule cannot be applied to a case such as this.

Hence, the conclusion by the sponsors of the plan would seem like an optimistic effort, but wouldn’t be fully supported, and worse still, could go against the quota of existing tax systems and agencies. Here, the partial interest rule is unobstructed. If the donation is not up to 100% of the contributor’s entire interest, then the donation is not deductible. In the case of real estate, an unmodified interest (say half of the property is donated to the charity in form of tenancy) would be permissible. Furthermore, if an individual or a donor owns a part of or partial interest in a property, a donation of such owner’s entire but partial interest to a charity would be deductible. The charity in this case is expected to receive a part or a percentage ration of every substantial interest on the asset or property, and the interests received over time must surpass the entire length of the donor’s interest in the asset.

To better understand this, we have decided to put forth an illustration of John, a wealthy individual who owns a security. Now, let us assume that John owned properties or securities and gave James the legal right to use and generate income from such properties or securities as long as James is alive. Now, James, after using the property as specified, died, and the securities were passed onto Jacob. Here, Jacob can choose to to make a charitable donation of his interest in such securities and he’d be entitled to a tax deduction which is equivalent to the present value of the future interest of the securities. Subsequently, we can say that Jacob has given out all his interest and shares in such securities. Even though Jacob’s part was a partial interest (since James owned and used some parts before dying), it was all that he had of the securities and thus, he is said to have shown full remittance of interest in the property, thus the partial interest rule will be inapplicable.

While this rule may seem straightforward, complexity lies underneath it due to the step-transaction restriction by the IRS. The Internal Revenue Service regulations states that “if the property in which such partial interest exists was divided in order to create such interests and thus avoid Section 170(f)(3)(A), the deduction will not be allowed.” This definitely alters the case of Jacob’s interest in the asset, as his lack of partial interest in the security can be described to be a case which avoids Section 170(f)(3)(A). The step-transaction restriction further provides some instances of the application of this restriction. Here is an illustration of such restriction:

Assuming a taxpayer who had legal ownership of a property transferred the remainder interest of such property to his child, and automatically transferred the remainder income interest to a charity, deductions will be inapplicable. Also, if this taxpayer creates an estate in securities and donates this interest to his child, while donating the remainder to a charity, deductions will also be inapplicable. On the other side of the coin, if the taxpayer donates the interest to a first charity, say Charity One, and donates the remainder interest to a second charity, say Charity Two, then the IRS would apply deductions on the income tax of the asset. The reason for this permission by the Internal Revenue Service is because the taxpayer has relinquish all his interest by donating all parts of the asset or security to a charity or different charities, thus eliminating the chances of an absence of deduction due to suspicions of occurrence of the partial interest rule. Thus, a taxpayer’s basis premise on which each plan is designed is deemed to be incorrect legally unless the insured individual has a way around the step-transaction restriction.

There are different ways to determine if a taxpayer’s claim on each plan is legally correct.

(A) Did the insured individual or corporation donate all his ownership of a stated security when cash donations were made to the charity without contractual obligations by the charity for the money to be utilized in relationship to the insurance?

This question poises a hurdle to getting around the IRS taxes as its answer, if not well conned out, would reveal the actual plans of the donations to the chart. The Internal Revenue Service will most likely apply the “substance over form” principle in deciding if the donor’s contributions were part of the plan which required the charity to make contributions or pay their part of the insurance premium or not. In a government format, the answer to this question would be easier since the multiple promotions and marketing schemes of such promotors will clearly reveal the intentions of the plan and the purpose of the donations.

A transaction which violates the partial interest rule can be deduced from the answer to this question in a situation where the insured party has donated an existing death benefit to the charity, and made cash surrender value to the trust or the premium plan, instead of money used to buy the split ownership. In Revenue Ruling 76-200, a donor irreversibly appointed the cash surrender value of a paid insurance plan to a college, but kept the full right to alter the beneficiary of the insurance policy, subject to the right to cash value possessed by the college. The college also had the legal right to give up the insurance premium for its cash value, while sharing in the death benefits of the cash surrender value prior to the insured individual’s death. The college also had the right to loan off a designated amount of the cash value without asking permission from the donor. The college in this case had possession of the premium policy plan. The Internal Revenue Service, however, stated that the college’s different operating rights didn’t constitute the absence of total or partial interest in the property by the taxpayer, and thus, deduction requests were rejected subject to Section 2522(c). Also, the deduction was refused because the IRS also stated that the taxpayer’s interest didn’t qualify for an undivided portion of the asset. Also, in the Revenue Ruling 76-143 (titled companion ruling), the IRS subsequently refused the income tax deduction. This ruling was deemed to be impartial as it applies to all taxpayers and was not particularly tailored to the insured individual in this case. Thus, a general ruling is deemed impartial, while there is a chance that a private letter ruling would raise controversies since such restrictions were not initially stated before a matter of such came to case.

Another illustration of Revenue rulings is a case where the Internal Revenue Service decided that the legal owner of an annuity who exercised an interest in the contract to buy another distinct life insurance premium at a discounted cost, and then donated the annuity to a charity didn’t meet the prerequisites for an income tax deduction on the charitable contribution. For this situation, the donor’s right to purchase the term insurance plan at a discounted rate was deemed a contractual right in the annuity contract. Insofar as the charity maintained the annuity contract, by contributing its share of the premium payments by donations from the insured individual (although the charity isn’t under any legal obligation to do so as stated above), the donor is allowed access to purchase the other life insurance premium. Here, the charity was seen as the annuity’s owner, and had all legal rights to ownership, without exceptions to the right to transfer, revoke, assign or pledge the contract for a loan, surrender or cancel the policy, appoint a new beneficiary or alter the beneficiaries list and finally, receive all annuity payments. Hence, the original donation which is the annuity in this case was made subject to the donor’s retention (right to keep) of the term insurance plan, and the charity in this case, provided the donor with an annual right to renew the contract. The IRS predominantly focused on the patter of conduct that gave the taxpayer effective economic benefits via the term insurance’s premium purchase. The same results occurred in a situation where the donor retained his right to the proceeds in additional cash value.

While the above cases were ultimately rejected tax deductions, it is important to note that some split-dollar ownership agreements are likely to be granted favorable tax deduction treatments. The IRS, in a Private Letter Ruling 9205012, examined an arrangement where a mother company owned royalty interests in some oil and gas assets and property. This company separated the overriding royalty interest from the current capital interest in the properties and used it to form a new company under its umbrella. This action was executed in 1984 and 1985, thus making it a two-years process. Since the child company was operating as a separate subsidiary, it later got its own overriding royalty interest and working interest, and the mother corporation decided to donate the overriding royalty interest to a charity in 1992. The issue that confronted the Internal Revenue Service on this matter was whether the charitable contribution by the subsidiary firm on behalf of the mother corporation was eligible for tax deductions and benefits, or if it was subject to step-transactions restrictions and was restricted by the partial interest rule according to Section 170(f)(3)(A) of the Code. To confront the subject matter, the IRS first focused on the main reason for the split by the mother corporation. This agency had to analyze if the overriding royalty interest was used to create a subsidiary firm so that the property would be safe from the partial interest rule.

Analysis by the Internal Revenue Service showed that the mother corporation had an independent business reason for creating a subsidiary out of itself using the overriding royalty interest. The results from the analysis further proved that the separation wasn’t due to tax reasons and was not motivated by it either. It also showed that the split was geared towards getting as much collateral as possible for the mother corporation to gain access to financial loans to improve or expand business activities in the future. The IRS also found that the period from the split to the time of the charitable donation was up to seven years, the minimum period in which a split property donation was said to lack intent of avoiding Section 170(f)(3)(A) of the Code. This is because the subsidiary was founded between 1984 and 1985, and the overriding royalty interest was only used after 7 years to gift a charity.

For this case, the IRS confirmed that the reason for the split was non-tax motivated on the part of the donor, and even if it was, the length of 7 years was enough to quench the interest of the donor in avoiding the tax. Thus, the contribution was eligible for favorable tax treatments.

(B) Is the trust’s action to enter a split-dollar insurance plan independent of the donor or will the trust be seen as an agent of the donor for entering into such an agreement.

This is the second question which allows us determine if a taxpayer’s claim on a plan is legally correct. The examination of this question is similar to that of the first question which is focused on the donor’s cash contribution to the charity. If the donor plans to avoid the partial interest rule by using a third party (which in this case is the trust), his plans will be thwarted sooner than later. The failure of this plan mostly occurs when the trust is solely designed for the purpose of escaping the restrictions of the partial interest rule. The donor, who is a taxpayer in this situation, is prohibited from appointing a third party firm to execute in directly, those orders which he cannot execute directly. Trying to bypass this rule by using a corporation (especially the donor’s corporation) as a source of cash donations will also prove abortive as the IRS often deems the actions of the donor’s corporation to be in the taxpayer’s best interest.

So, even with all this restrictions will provides no chance for a loophole, how and why do people still engage in split-dollar insurance plans? Basically, under question one, promoters state that the partial interest rule is different from the charitable split-dollar insurance policy, and that donations made from donors to the charity and trusts are deemed to be different transactions and separate independent events in the purchase of a premium. However, the marketing schemes and quota in which these plans are promoted oppose the statement above. The marketing schemes or plans in this case state that donations to the charity and trust and any other donations or charitable contributions are dependent on each other in securing the insurance premium. Thus, both the cash gifts to the charity, and the payments to the trust by the donor are deemed to be intertwined and work hand in hand to keep the policy alive. The intended convincing statement by promoters that the cash contributions to the charity is necessarily made to help them fulfill a part of the premium payment is not persuasive enough, since the charity is given a valid reason to pool the donations into the premium, which in most cases, the reason is a guaranteed minimum death benefit.

Is the donation non-deductible because it is part of an already agreed deal?

Another question which confronts a donor’s eligibility for a tax deduction is whether the absence of partial interest in an agreement between the donor and the charity would make the contributions tax deductible. While this question seems pretty straightforward, one has to look at what lies underneath it. The question is fairly translated to whether the understanding between the donor and the charity would be termed a prearrangement, thus making the contribution to lose its eligibility for favorable tax deductions, even if there is no presence of partial interest on the part of either party. Those in support of the charitable split-dollar insurance plan states that the absence of a contractual binding on the part of the charity to invest in an insurance plan on behalf of the donor is enough to satisfy Revenue Ruling 78-179. However, the issue that disturbs this arrangement is the partial interest rule as stated in Section 170(f)(3)(A) of the Code. If the suspected prearrangement is deemed a plan to avoid this restriction, it is absolutely doomed to fail even without the presence of a contractual binding. An is the Palmer case, in which the Revenue Ruling was applied. The Revenue ruling settled a case where a donor made contributions with stocks to a charitable remainder trust, and the corporation of the donor later redeemed or withdraw those stocks from the charity. Here, we can see that the donor made the contributions, while his company did the redemption. In this case, the partial interest rule was not applied. Rather investigations occurred to determine whether the donor’s contributions was first a personal sale, which was later followed by a charitable contribution in cash. An attempt to use the Palmer case in Blake versus Commissioner was ignored and discarded by the Court, where the Court decided that even a slight “understanding” between the insured donor and the charity in question was enough to make contributions ineligible for favorable tax treatments or deductions. This particular case was put into a separate class by supporters of the split-dollar plan the facts were out of the ordinary and there was an obligation between the insured and the charity.

Cases related to that of Palmer case are all related to property contributions which are then followed by redemption by the donor’s corporation or sale. If the court finds the intentions of the contribution to be non-tax motivated, but has other valid reasons behind it, tax deductions will be authorized on the contributions. With this system, one might wonder what restrains donor’s from using the split-dollar plan. The answer is simple: complexity of business purposes. While talk is cheap, the hassle of finding a business purpose for such kinds of donations is nearly impossible. This is because, most corporations provide cash to the charity first before lending them a part of their assets. Getting through this is not quite easy, since almost any donation of company asset would be barred by the partial interest rule, thus making such contributions prone to taxation. Split-dollar plan promoters, however argue that Palmer Case should apply to all charitable split dollar. This notion is still in debate despite the different in facts provided in different cases, the purpose of the stocks contribution and the nature in which it was donated, the corporate redemption and finally the cash gifts which serve as an ultimate device for splitting the premium into separate portions for each involved party.

A significant number of split-dollar cases refer to the methods and strategy used by the Court in the case of Crummy versus Commissioner, which stated that the insured donor to a trust for the purpose of the children in a charity was entitled to an annual exclusion for the beneficiary which was worth $10,000 at the time. This only applied on the condition that the beneficiary had the right to withdraw the donation for a designated period within the year. Although it is very unlikely for the beneficiary (which in this case were the children) to withdraw the amount at that stage, this right was deemed more than capable of qualifying the donation as a present interest, and further entitled to the $10,000. Using this case, the plan promoters and supporters claimed that the absence of a contractual binding agreement or obligation on the part of the charity to use the amount in buying an insurance plan on behalf of the donor was enough to make the contribution eligible for tax deductions. Although favorable tax deductions did take place on this case, the tax issue application which applied to the case (IRS Section 2503(b)) was different from the laws guiding split interest charitable contributions (IRS Section 2522(c)). The rules applied in the Crummy versus Commissioner case didn’t address the issue of the avoidance of Section 170(f)(3)(A) of the Code which proposes the question of “whether a property where partial interest is found is divided to eliminate the the interest in such assets upon contribution.” For one to make it through with such split-dollar plan, they must be confident that a cash donation was not a partial interest, even when the reason behind such donation was to buy a partial interest. However, if this cannot be proved in a law court and there is no regulating body to back the claim of the donor and the charity, then the court may take legal actions against the involved parties.

Is any part of the donation eligible for non-deductions due to a possible economic benefit derived by the insured?

All or some parts of a donation will be non-deductible if the donation to the charity is done in exchange for an economic or other benefits to the insured donor as stated in the quid pro quo rule (exchanging something for something). In this case, the charity is to analyze and report the value of the benefit which it’ll give to the donor. However, applying such rules in a charitable reverse split-dollar case is near impossible or outrageously complex, as is in other cases. Another question which should be taken into consideration is whether there’s any economic benefit provided by any economic benefit exists by the virtue of this sort of donation arrangement. Using details from Revenue Ruling 76-200, in which a discounted plan for term insurance existed as a part of an annuity contracted donated, we can easily analyze the economic benefits gotten from such an arrangement. Supporters of the split-dollar plan state in debate that the payment of the P.S.58 expenses on the part of the charity on behalf of the donor in the insurance premium and also, the payment made by the trust are deemed perfect economic benefits to the donor, and as such, no extra gain follows on behalf of the insured donor by the charity.  In order to gain understanding of the economic benefit of the donor by the charity, it is essential to analyze the relationship between the charity’s premium payment (the payment subject to the P.S. 58 table of the insurance policy) and the insurance premium payment which was actually made at the initial stage. Upon proper examination, it is easy to see that the difference is excessively higher than the premium payment required for the death benefit. This springs forth new questions:

    • Where is the excess amount?
    • Is a benefit is generated to the non-charitable partner by the extent of the charity premium’s payments alongside the nature in which payments were made?
    • What will happen if the initial cost of the term premium portion could have been calculated using the insurance firm’s lower annual term rate?
    • What is the reason behind a charity paying the P.S. 58 table expense instead of just opting for the lower term rate?

A brief answer would be that the rates in  P.S. 58 table rates is outdated and not usually updated to current economic performance. Thus, the initial cost of the insurance plan is drastically lower than whatever is indicated. Thus, the family of the insured donor can be said to be enjoying excessive benefits, since the charity is actually paying more than they should for their share of the premium policy.

A major insurance company released a newsletter which was meant for its agents, and this list revealed the spread (different between the real amount and the amount being paid for something) between the rates in the government’s P.S 58 table and the actual insurance term cost. This case analyzed the premium for a male of around age 50, with dividends buying extra insurance. In this case, the death benefit is valued at $500,000, with $14,555 as the overall premium. The amount which is meant to be paid by the employer or the charity, on the case of a charitable reverse split-dollar plan, for the P.S. 58 expenses starts at $4520, and grows to $12,952 over a 15-year period. Using the P.S. 58 table rates, the total amount expected from this employer or charity will be $119,656.This same company has a term rate for a related coverage which costs $520 for the first year, and grows to $3317 over a period of 15 years, thus making the total cost $21,000. Here, the employer portion is $119,656 out of the total premium of $192,825 for the same duration. Subsequently, when the insured party dies, the employer will receive the designated amount; however, the total benefit would be $537,664, and a cash value of $246,743 will be majorly received by the family or named beneficiaries of the insured or the irreversible trust. However, if the insurance is in a charitable reverse split-dollar, the charity is expected to get more than just the part of its own premium, but not equivalent to the amount which it paid in its own portion of the premium. To simplify this concept, a promoter of the charitable split-dollar insurance policy made use of an imaginary example of the two parents who decided to use tis plan to transfer inheritance to their child. In this case, the husband is age 65, and the wife is age 60. Here, the couple wanted a death benefit of around $4 million for their child. The cost of the coverage was capped at $67,000 per annum for the first ten years, or approximately $112,000 per annum for the first ten years before tax. The couple had access to fund this donation using $20,000 from their yearly charity tax deductions. The insurance plan which these parties signed required them to donate $20,000 per year to a trust to the benefit of their named beneficiary, and also donate $80,000 to the charity through ten years. Both parties (the trust and the charity in this case), where expected to use these donations to purchase a premium worth $5 million, with the charity getting $950,000, and the trust getting the remainder which is equivalent to $4.05 million. Since the charity’s share of the premium was greater than what was needed, an excess premium of up to $735,000 occurred. Subsequently, if the donor was to die at this point, the charity would get $1,735,000. As time goes on (in a case where the donor doesn’t die prematurely), the excess premium will decrease, and thus, the charity’s benefit will also decrease, but not to anything less than $950,000. The trust’s benefit which was initially $4 million will grow substantially to $5 million within the designated duration. According to this promoter, if the charitable split-dollar plan is used, the donors will be capable of funding the insurance needs for $20,000 per annum, including the total amount of $48,000 after taxes each year. It is clearly seen that this amount is way lesser than the actual cost of $112,000 per annum which was commanded before taxes on the non-split-dollar policy, and which prevented usage by the couple during their lifetime.

In a situation like this, arguing that the child didn’t receive ay economic benefit will be a tough debate, due to the excess contribution by the charity during the 10 years in which they received gifts from the insured donors. Questions which arises from such arguments are stated below:

    • In the case of such issue, should the charity report the economic benefit to the insured donors as an acknowledging act of the quid pro quo rule?
    • Should the amount be used only on a yearly basis to reduce the deductions on the charitable contributions?

Conclusions on the part of the IRS states that there exists an economic benefit when equity (money or financial assets) is generated under a split-dollar plan. A perfect occurrence of such case is when an employer is deemed to be interested in the returns from the premium. Here, excess value will pile up on behalf of the donor and the third party involved, instead of the employer. Thus, the benefits from such split-dollar plan will be taxed as stated by the Internal Revenue Service.

If insured’s corporation takes the title of the donor in place of the insured and makes a charitable cash donation to the involved charity, and this cash donation is used on the part of the charity to fund their part of the premium policy, will this create an extra income tax on the part of the insured rather than deductions of the charitable cash contributions?

Some forms of split-dollar plans allows the insured’s corporation to make the premium payment, thus granting them access to the deduction on charitable contributions. This action is deemed to be implemented in a bid to distance the insured party from the charity in order to avoid any occurrence of partial interest. Such, we can liken the corporation to the irrevocable trust, which adds a bit of a relationship between the insured and the charity.

The question however is different from the definition given above as it solely focuses on whether a cash contribution to a charity is eligible for tax deductions if it is offered by the donor’s corporation on behalf of the insured donor with or without his or her knowledge, without dragging in a possible case of attempted avoidance of the partial interest rule.

Here, if the corporation doesn’t have the proper access or authorization to deduct the premium payment as a charitable donation, it will most likely be deemed as transfer of property in connection  to rendering services and will be taxable to the employee under Section 83 of the Code. In some cases, this contribution can be treated in similar fashion to a corporate dividend, to the extent of corporate earnings and profits. In a situation where the party in question is a small corporation (known as an S corporation) with more than one shareholder, the consequence of such treatment could be deadly, since the IRS will liken such dividends to as selective dividends, thus, removing the S status of the corporation (the entity won’t be seen as a small business any longer and will have to pay same fees as large corporations).

Will the insured party be eligible for tax deductions for making cash donations to the charity?

Income tax is generally overruled by the gift tax in charitable contributions. However, Revenue Ruling 76-200 states that any violation of the partial interest rule in the charitable contribution would lead to ineligibility of the insured donor to receive the gift tax deductions presented in Section 2522 of the Code.

What will happen in a situation where the donor makes a donation to the charity which is non-deductible?

In this case, the treatment meted on such donation is similar to that in which a donor makes contribution to a taxable individual or entity. Here, the donor will be eligible for a $10,000 exclusion, and after this, he is expected to employ the application exemption value which is available at the moment. This exemption value was formerly called the exemption equivalent. This is the amount which the donor can donate without implying tax payments during his lifetime. Although, the insured donor will prefer to employ the unified credit to any contribution made to a charity. Simply put; any non-deductible donations to a charity is legally taxable.

Will the returns from the plan be separated from the estate of the insured donor?

Most split-dollar insurance plans are made in a way that the donor will have given out all his right to ownership of any of his estate through either an irrevocable trust or by ownership by the beneficiary, which are usually the heirs. In a case where the insured’s corporation or any other business party is in involved in a transaction where the insured donor has the right to name a beneficiary, owns a part of the premium, the split-dollar insurance returns will be subject to inclusion in the insured party’s estate. The risk of inclusion will only exist in a case where the donor (which is the insured party) receives cash through loans from the premium policy, especially those policies promoted as “tax-free retirement income.”

Is there any need for the charity to complain since it is receiving a gift?

Looking from a normal point of view, one can say that in a charitable reverse split-dollar insurance plan, the charity has more to gain as it is guaranteed a minimum death benefit which is attractive enough since they usually don’t need to invest in the premium from their own pocket. Also, one can blindly from a promoter’s point of view that the charity benefits more than the donor since every action taken is done in their best interest. However, these claims, while somewhat true, are easily discardable. The charity in this situation takes on countless risks by agreeing to partner in a split-dollar insurance plan. Also, the staff which decides to embark on such chivalrous journey hold a substantial amount of risk which sometimes is not worth it.

Is it advised for a charity to use its name and rise its reputation in validating or endorsing a program that might likely result in a bad tax effect to its donors?

When asked in such a manner, no reputable charity would want to risk its integrity in committing such an act. Any donor has the right to engage in a high risk conduct permissible under law on the advice of his tax counsel. However, the charity has the key role in promoting the split-dollar insurance plan in a case where the donor is a potential prospect or advocate for such conduct. The charity however, would not be involved or held accountable for any form of misconduct, as it is deemed that the it concluded that such conduct by the donor was accepted even if reverse is case.

The charity, however, should note that the donor, if prosecuted and found guilty of partial interest might lose the income tax deductions, be required to pay the gift tax, and also risks getting returns included into his estate. Such risks are high and not any conduct that leads to them are usually not worth considering. In a situation where the acceptance of the split-dollar program is aided by the charity’s reputation, it is quite important to consider the following questions:

    • Does the charity get to bear any responsibility if the split-dollar program were to fail in court or tax audit?
    • Is there any reason to hold the development staff which aided in putting the entity in such a situation be held accountable for the happenings?

Will the charity’s participation in a split-dollar program which presents great benefits to a third party bring about private benefits or inurement?

According to Section 501(c)(3) of the Code, to remain eligible as a charitable institution, no portion of the net earnings may become seek to be advantageous to the benefits of any individual or private shareholder. Here, private shareholders and individuals refer to any person or persons possessing personal interest or private interest in the exercises of the institution in question.

The definition of private shareholders and individuals in this case include persons even beyond the whims of power in an organization. Thus, even an employee of a corporation is not expected to have personal benefits in any activity of the charity. Inurement generally occurs through gross earnings generated payments, but can somethings be derived from net earnings or company profits. The size of the inurement doesn’t matter, as even a small amount can lead to internal level tax on the involved parties (the private shareholder or people with personal or private interest), and possibly, deny the institution its exempt status in the future. Thus, we can conclude that any form of inurement is forbidden.

Can a split-dollar insurance plan create such an issue?

In the case of John Marshall Law School versus the United States, the charity (John Marshall Law School in this situation) was stripped of its exempt status because private individuals got benefits from its earnings due to illegal exercises, including a split dollar plan, as specified by the Court of Claims. The split-dollar plan in this case was different from the ones we’ve talked about since the beginning of this topic. The court deemed the death benefits being paid to the beneficiary of the insured party as unjustified compensations. Thus the policy was condemned. The Court went ahead to highlight the reasons why earned dividends from the charity’s premium payment were utilized in the purchase of extra insurances which tends to benefit the insured party’s spouse and children. While the details of such conducts were different from what is seen in the usual charitable reverse split-dollar plan, the consequences were tagged too serious to be overlooked.

The private increment and the private benefit rules are two similar but different conducts in the sense that the latter seems to be more vast than the former as it isn’t limited to just insiders unlike the inurement rule. To avoid a case of private benefit, a charity must show that all its operations are solely for the purpose of the charity, and are not driven by any personal interest whatsoever. In other words, the charity should be able to prove that all its activities are not carried out in the interest of private individuals such as named beneficiaries, the plan’s creator or relatives, the private shareholders of the institution, or any other individual that operates in favor of the institution or is controlled to fulfill its biddings in one way or the other. According to the U.S Supreme Court, a charity is not said to be void of private or personal interest, or isn’t deemed to operate solely for charitable purposes if it as much as a non-charitable purpose for its operations that is substantial. Note that the definition of substantial in such matters is not actually penned down, but it is derived from the details and circumstances of each activity.

Split-Dollar plan marketers and promoters in their debate, suggests that there is a way around private inurement. The tactics here is to carefully pick a number of non-insiders who are willing to participate in such plans. Here, the plans will be deemed to be void of private benefits since the charity will be buying its personal benefit with cash gifts which it receives without any condition, while the involved trust or heir will be paying its own portion of the insurance cost.

However, after removing the marketing and promotion scheme behind the subject discussed above, we’ve arrived at this question: Is the donor presented with any economic benefit due to the premium payments by the charity in excess of the required sum needed to buy the same benefit without the presence of the split-dollar arrangement?

It is very important to consider the mechanics behind every program, even in  a case like this where it is clear that the plan benefits the donor, otherwise, he wouldn’t be pushed to use the split-dollar plan to provide for his relative’s or beneficiaries’ private desires. Each promotion scheme used in attracting potential clients visibly express that benefits exists in each donation made to a charity, and they are applied to split ownership of the policy, besides the functional income cut.

In a recent Private Letter Ruling involved in a case of private split dollar, the Internal Revenue Service couldn’t find traces of donations by the taxpayer in a situation where a trust purchased for the taxpayer’s children, paid the least portion of the P.S 58 expenses or the insurer’s annual term costs and the taxpayer (the supposed donor) covered the remaining expenses. Here, the trustee possessed ownership of the policy and covered the lesser term costs. The remaining premium payments was handled by the taxpayer and the insured parties. At the advent of his death, his estate will get a cash amount which is equivalent to the gas surrender value. The Internal Revenue Service maintained that “since the Taxpayer (in a case where he is living) or the estate of the last deceased taxpayer will be compensated by the trust for the premium part which the taxpayer or taxpayers (which ever is the case), the payments made by the taxpayer will not be deemed as donations made to the trust for charitable purposes.” In a situation like this, the taxpayer is major portion of the premium while the irrevocable tax is handling the lowest P.S 58 rates and not the highest. This setting makes it different from the charitable split-dollar plan. This conduct cuts a portion of the donations eligible for taxation made to the trust on behalf of the children.

Here, the taxpayer will retain the savings portion or its cash value while the trust will get everything it has paid for. In the charitable reverse split-dollar, the charity usually pays more than its portion of the premium, and this constitutes “excess” which solely pumps up the death benefit and monetary amount received by the trust. This constitutes private benefit which is forbidden according to Section 501(c)(3) of the Code, and Section 1.501(c)(3)-1(d)1(ii) of the Treasury Regulation.

Will the charity be said to breaching the Uniform Management of Institutional Funds Act by using the donations to pay their part of the insurance premium?

The third question focuses more on the charity than it does on the donor. A short answer to the question above would be a short no if and only if the charity is acting without a prearrangement. Thus, any donation made to a charity can be used in any it deems fit if the donation is not a part of a prearranged deal. However, one would need to ask the question of why a charity would want to use donations in sponsoring a premium which it’d only benefit from when the donor dies. We have a right to question the prudence of the charity if they tend to invest the donation into the donor’s insurance plan rather than into bonds and stocks. The latter options seem better and have higher returns compared to the former, unless in a situation where the donor dies prematurely or a great while before the suspected date.

Summary and Thought on Charitable Split-Dollar Plans

In crafting a charitable donation, one needs to have common knowledge of the technical aspects of this plan, as well as think of non-existence strategies. Donors and charities usually take tax related matters to be crucial. In such conducts, the donor runs the risk of losing donations in a situation where the associated cost is high for him. Also, it is important to note that individuals who prefer to make deals with these charities usually perform poorly at charitable contributions. Thus, in making a huge contribution to a charity, one needs to look beyond the tax benefits or risk getting penalized by the court. Also, charities run the risks of ruining their reputations as participations in most charitable split-dollar insurance plans can lead to financial catastrophe on the part of the donor or even the charity itself. It is important to note that charitable split-dollar plans are not worth it, as it presents enormous risks to the donor and the charity organization alike. Currently, there’s no legal structure backing these plans, and they are only preached by promoters to get their share of your money. Ultimately, charitable reverse split-dollar plan are more valid than the rest, however, Internal Revenue Service and the Supreme Court see it as an inappropriate and unadvisable method of evading income taxes, and they’ve also deemed it incongruous for donors or contributors to recommend for charities to take part in such a program, much less promote it. We simply conclude with this advice to charities; nothing is worth receiving a bad gift from a good contributor.

References for Charitable Split-Dollar Insurance Plan

Academic Research on Charitable Split-Dollar Insurance Plans

It’s a Wonderful Life Insurance Policy: Determining the Correct Theory to Tax the Employee in Employer-Pay-All Equity SplitDollar Life Insurance Arrangements, Katz, J. (1999). Tax Law., 53, 143. In this paper, the author explains the Split-Dollar Life Insurance (SDLI) arrangements or Charitable Split-Dollar Insurance Plan (CSDIP), how they benefit the donor and on what grounds he and his heirs get the tax benefits. In his opinion, it is a wonderful policy for life insurance. He discusses what is the correct theory for employee taxation in Employer-Pay-All equity.

A life insurance investment that may be too good to be true, Hansen, K. A. (1999). A Journal of Financial Service Professionals, 53(2), 68. This research throws light on the benefits of the Charitable Split-Dollar Insurance Plan (CSDIP). He regards it as an investment that seems too good to be true. It is rather better than the common life insurance policies.

Stranger-Owned Life Insurance: Killing the Goose That Lays Golden Eggs, Leimberg, S. R. (2005). The Insurance Tax Review, 811, 81. The individuals are offered STOLI (Stranger-Owned Life Insurance) for one or two years saying that they can get death benefit free with the option to repay the loan or retain the policy. It contemplates the life insurance policy in the sense that the strangers/investors contributing to such plans have no interest in long term investment plans. So, such plans generally target old people having wealthy status who can apply for big amounts of insurance. So it is just like killing the goose that lays golden eggs.

STOLI on the Rocks: Why States Should Eliminate the Abusive Practice of Stranger-Owned Life Insurance, Mathews, E. (2007). Conn. Ins. LJ, 14, 521. This research is about the STOLI (Stranger-Owned Life Insurance) which is, in some cases, considered to be involved in the abusive practices and government should ponder over to eliminate it. The author explains the reasons for this suggestion to eliminate this practice.

The Use of Life Insurance in Estate Planning: A Guide to Planning and Drafting-Part II, Gallo, J. J. (1999). Real Property, Probate and Trust Journal, 55-142. This article is an extension of the life insurance estate planning Part I, named as a guide to planning & drafting part II. In the 1st version, the author told about a number of life insurance plans, charity gifts and tax benefits. In the 2nd paper, the author highlights the life insurance use in estate planning such that the focus is on the Charitable Split-Dollar Insurance Plan (CSDIP) and its advantages.

Life Insurance and Its Use in Estate Planning, Wright, F. H. (1970). Okla. L. Rev., 23, 125. This paper elaborates the use of life insurance in estate planning and specifically mentions the role of lawyers and legal practitioners in considering it as an asset of the family plan.

Life Insurance in the Estate Plan, MacKay, H. M. (1963). BUL Rev., 43, 270. This paper briefly describes the important points of the life insurance in the estate plan and that the applicant should, first, get complete knowledge of the program, its benefits, taxes, payables and drawbacks before he gets the plan. And also, how the plan goes on after when he dies.

Building planning relaltionships: A family business story, Garry, S., & Rich, G. (1998). Journal of Financial Service Professionals, 52(3), 70. This research is based on the case study of 2 family businesses (just fictional) to explain the planning relationships. This family business story describes the American laws of family business, its contribution to the Gross Domestic Product (GDP) of the United States and the statistics related to family business, first, second or the third generation can run, if survive.

SplitDollar: A Dream come True, Weinberg, M. D. (1995). Split-Dollar: A Dream come True. Prob. & Prop., 9, 18. This review paper provides details of the Charitable Split-Dollar Insurance Plan (CSDIP). The author discusses those points which distinguish it from other life insurance plans. In his words, Split-Dollar is a dream that comes true. This is because of the tax exemption. It becomes an investment instead of an expense.

Notice able Change in IRS’s Split Dollar Tax Position, Gelfond, F. J., & Stephenson, G. L. (2001). J. Tax’n Fin. Products, 2, 17. In this paper, the authors draw the attention of the individuals and the financial concerns about the noticeable change made in the Split Dollar tax position of Internal Revenue Service (IRS). This is the first change brought in Split Dollar mainly in taxation after the time span of 25 years. So, it will definitely have a great impact on the life insurance companies and the ones who avail it.

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