Make sure clients understand rules before taking action.
Life Insurance and associated tax issues are complicated. When you throw charity into the mix, it can get downright diabolical. It’s not as much that the rules are so complex, it’s that they don’t make sense to the typical taxpayer/donor.
Recently, I had another call about appraising a life insurance policy donated to charity. The one thing these calls have in common is that the policy in question was donated a number of months ago and only well after the fact did the policy owner understand the “special rules.” Very few people understand the tax and deduction rules before they make the gift. This also leads me to believe that whomever the donor is dealing with at the nonprofit in question doesn’t really know the rules either.
When donating a life insurance policy, the deduction is limited to the lesser of the fair market value and the basis in the contract. What should be very apparent in this simple explanation is that cash value isn’t necessarily a data point that matters, at least as the policy owner generally believes it to be. You can imagine that this can become an issue when a donor realizes, after the donation, that the donated policy with a $100,000 of cash value is actually a very well-seasoned whole life policy with only a $10,000 basis.
Going to the rule above, the deductible number would be the lesser of the FMV, which we’ll call $100,000, and the basis, which is $10,000. That often isn’t the donor’s expectation. Many donors assume they’ll be getting a $100,000 deduction. By and large, the basis of the contract is going to be the cumulative premiums less any non-taxable withdrawals or distributions from the policy. In many cases, this will simply be the cumulative premiums paid into the contract over the years.
If the cash value of the policy is less than the basis, then we’re dealing with an even lower number, and a deduction isn’t available for even the premiums paid into the contract. This would likely be the case in fairly new policies or in underfunded or poorly performing life insurance policies.
The other surprise facing donors of life insurance policies is the requirement to have a formal appraisal for a donation worth more than $5,000. This is especially irritating seeing that in many of these situations, the policies are modest and the FMV is obvious at a glance, yet the time and expense of the appraisal is still required. It seems a bit of a waste, which makes it especially important to find a very economical appraisal source for these purposes. This type of appraisal is probably very different from that needed for a trust transfer or to accompany a complex audit or a gift or estate tax return.
Conduct a Thorough Analysis
Given these issues, it might make sense to do a thorough analysis before the gift is made to determine if gifting the policy is even a good idea. What if the policy is worth significantly more than the cash value as a life settlement? I worked a situation for a $1 million policy with fundamentally no cash value. The policy owner was making payments to cover monthly mortality charges while I evaluated the settlement market. I ended up negotiating a $500,000 offer net to the owner. There was no conceivable benefit to donating the policy rather than selling it on the market and then donating the money.
Another time I received a call from a foundation because something seemed fishy. After I reviewed the paperwork, it turned out the policy the owner was trying to donate to the foundation was a completely loaned-out whole life contract that was going to collapse soon with massive phantom tax gains. The agent and policy owner thought it clever to let it fall off the books on the foundation’s watch, which would get the policy owner out from under the tax consequences. Except that it doesn’t work that way. The insurance company should and likely will issue a 1099 on the ownership change and the donor won’t have a basis or FMV appraisal to offset it.
It’s also a good idea to make sure you know how nonprofits will deal with a gift of life insurance. Some will maintain the policy, and others will summarily cash it out. If the latter is true, then why would a donor conceivably take a hit on the deduction if the policy isn’t going to stay in force anyway? In my first example above, we’re looking at an old whole life policy with very little spread between cash value and death benefit. If the donor cashed out the policy and donated the $100,000, the foundation still has all the money, and the donor actually comes out a hair better because his deduction is the same, but he saves the hassle and expense of an appraisal. If he wants, he can pay the taxes out of the cash value and donate the balance.
On the other hand, if the death benefit aspect of the policy is meaningful, we want to make sure the policy isn’t canceled by the nonprofit. A case I recently reviewed had a $1 million death benefit that was guaranteed and required no further premiums. Furthermore, the cash value was less than $100,000. Life expectancy of the insured was no more than 10 to 15 years. Unless the nonprofit believes in year-after-year extraordinary returns, nothing is going to touch that. However, some nonprofits categorically cash out life insurance policies. I can hardly think of a more ridiculous and contemptible policy, yet I see it.
The moral? Analysis before action. This applies to just about anything I can think of regarding life insurance, and action before analysis when donating life insurance policies can create extra heartaches. Don’t let the government take advantage of you even when you’re trying to do good.
Bill Boersma is a CLU, AEP and LIC. More information can be found at www.oc-lic.com, www.BillBoersmaOnLifeInsurance.info, www.XpertLifeInsAdvice.com or email email@example.com.