Designation of a Charity as Beneficiary of an Existing Policy
… from Life Insurance and Charitable Giving - Important Tax Issues

Irrevocable Beneficiary Designation. If the donor makes an irrevocable beneficiary designation but retains other incidents of ownership (that is, does not assign all rights to the charity), then he/ she has the worst of all worlds! The beneficiary designation cannot be changed but there is no income or gift tax deduction because of the partial interest rule. Premium payments after the transfer are also not deductible. There is no good reason to make such a beneficiary designation. In addition, there may be adverse estate tax consequences. Although the estate inclusion of life insurance is ultimately offset by a charitable deduction, the inclusion of the life insurance proceeds will balloon the value of the "adjusted gross estate," which then impacts qualification for certain tax benefits under Sections 303 (stock redemption) and 6166 (estate tax deferral).

Example II: Joe owns a closely held business valued at $2,000,000. He also owns a $1,000,000 life insurance in which he irrevocably designates his local hospital as beneficiary. His adjusted gross estate (AGE) is projected to be $5,500,000. The value of his business interest (for purposes of qualifying for estate tax deferral under Section 6166) is 36% of the AGE, without the insurance, but only 31% after inclusion of the life insurance. The estate will not qualify for the deferral under Section 6166 (35% is the minimum required).

Gift of a New Policy to Charity
Individual Assigns a New Policy to Charity. If an individual applies for a life insurance policy and immediately after the policy is issued he/she assigns all policy rights to a charity, then the IRS may treat the transaction as equivalent to a direct purchase by the charity on the donor's life. If, in addition, applicable state law dictates that the charity does not have an insurable interest in the donor and that the donor estate's executor has a right to recover the proceeds from the charity, then the transfer will not work to produce the desired tax benefits.

Lack of an insurable interest: Disallowance of the income tax deduction. In states where the above described conditions apply, the insurance company does not have to pay the benefits of the policy to the charity, or if it does, the executor of the donor's estate may maintain an action to recover the benefits. The donor has the ability to name his or her heirs in the will and, therefore, can direct to whom the proceeds will be paid in the event that they are not paid to or are recovered from the charity. In effect, this is similar to retaining the right to name the beneficiary outright. The retained right means that the rights transferred to the charity represent a partial interest in the policy. The income tax deduction for the charitable contribution of the policy and subsequent premium payments is not allowed.

If the chance that the "charitable transfer will not become effective is so remote as to be negligible," then the deduction is allowed (the "remoteness" test). The IRS ruled that, in the situation described above, the chance that the charity would be divested of its rights in the policy in the future was not "highly improbable" and, therefore, did not meet the requirements of the "remoteness" test.

Disallowance of the gift tax deduction. For the same reasons (partial interest rule and not a remote possibility), no gift tax deduction is allowed.
Estate tax results. It gets worse! The proceeds are included in the estate if the transfer occurs within three years of death. The proceeds will also be included in the donor's estate if death occurs more than three years after the transfer, if at that time the executor can recover the policy pro- ceeds for the benefit of the estate. The donor's estate will not be entitled to a deduction if the executor is able to recover the proceeds for the benefit of the donor's heirs. In addition, the donor's estate will not be entitled to a deduction if the executor fails to recover the policy proceeds and the proceeds are paid to the charity, because the property will not pass to the charity from the decedent, but rather the property will pass to the charity as a result of action or inaction by the executor.

State law. The above situation was ruled on by the IRS in LTR 9110016 for a New York taxpayer. Subsequently the State of New York amended the law to provide that an insured may purchase a policy on his own life for the benefit of any person, firm or organization, and may assign the policy immediately after it is issued. Also, the IRS indicated that the taxpayer decided not to proceed with the transaction. The IRS then revoked the original letter ruling.

It is clear from this ruling that state law regarding the insurable interest of a charity in one of its donors must be carefully evaluated before buying a new policy to benefit a charity. A survey of state laws in 1992 indicated that 42 states had statutes in place or had pending legislation to clarify that a charity has an insurable interest in the life of an insured under a policy owned by, and made payable to the charity.

If the insurable interest requirement is met, the donor's income tax deduction for an assignment of a newly purchased policy is the amount of the initial premium.