Life insurance has always been an important part of charitable giving. Although there are legitimate uses, over the years the IRS has identified certain abuses regarding the use of life insurance in charitable planning. In our practice, we have seen a recent surge in charitable planning techniques involving life insurance. Before your charity accepts a gift of life insurance, you should consider several issues, including the following: (1) the application of Section 170(f)(10), the so-called “charitable split-dollar rules” (which, if applicable, impose an excise tax on the charity equal to 100% of the premium payments), (2) applicable state insurable interest laws, (3) private inurement, private benefit, and excess benefit rules, (4) unrelated business income rules (and debt-financed income rules, to the extent the life insurance was acquired with borrowed funds), (5) the partial interest rules (impacting both the income and gift tax deduction of the donor), (6) I.R.C. § 4944, the jeopardizing investment rules, and I.R.C. § 4941, the self-dealing rules, where the policy owner is a private foundation or split interest trust, (7) possible re-enactment or extension of I.R.C. § 6050V (which required a charity to report its interest in certain life insurance policies – the provision expired in 2008), and (8) potential legislation in response to the Treasury’s April 2010 report on abuses involving ”charity owned life insurance” (ChOLI). Life insurance often represents a very valuable gift to a charity and most transactions involving life insurance satisfy the rules discussed above. However, it is important to consider these rules with respect to any gift of life insurance, especially when the gift involves more than merely naming a charity as a policy beneficiary or a donation of an unencumbered policy to the charity.
Typically, a charitable lead annuity trust ( a “CLAT”) provides for level annuity payments to the charity during the trust’s term. For the trust to be effective in transferring value to the remainder beneficiaries, who are usually family members, the total return inside the trust must exceed the required annuity payments; otherwise, such payments will consume the entire value of the trust’s assets and no property will then pass to the remainder beneficiaries. A “Shark-Fin” CLAT is designed so that small payments, such as $1,000 per year, are made in the early years of the trust term, with a very large payment required in the last year or two. By proceeding in that manner, fluctuations in value of trust assets in the early years become less of a factor in assuring assets will be available for distribution at the end of the term.
A CLAT may be designed as a grantor trust, providing a charitable income tax deduction to the grantor upon its creation and funding; however, the grantor would be subject to income tax on the income generated inside the trust during its term. Therefore, the nature of the assets held in the trust and the income generated are significant factors in the design of a grantor CLAT. A CLAT may also be designed as a non-grantor trust, which would not provide a charitable income tax deduction. Both types of CLATs provide a gift or estate tax charitable deduction equal to the present value of the annuity payments, using the required federal interest rates, which are currently very low.
The rate that the IRS uses to calculate the present value of an annuity has dropped to 2.6% for August. This is historically a very low rate, as just two years ago the rate was 4.2% and within the last decade the rate reached 8.2%. Clients are generally aware that such low rates present estate planning opportunities for vehicles such as Grantor Retained Annuity Trusts, where the ability of the trust to obtain an investment yield higher than 2.6% presents real family wealth transfer opportunities. However, clients with charitable intentions need to be aware that the same low interest rate is of substantial benefit in family wealth planning involving CLTs.
A CLT is both a family wealth transfer vehicle, as well as a charitable giving vehicle. A trust is established which pays an annuity to charity for a period of years, and at the end of that term of years, any left over assets belong to the client’s heirs. Usually, a CLT is structured so that the current fair market value of the annuity payments to charity substantially reduces or eliminates the gift tax upon formation, so that after the annuity stream is completed, the remaining assets belong free of gift or estate tax to the heirs. In this structure, the lower the IRS-assumed interest rate, the easier it is to achieve the desired gift tax result and the more likely it is that substantial assets will be left over after the required annuity is paid to charity. For an overview regarding the basics of lifetime CLTs, see A Primer on Lifetime Charitable Lead Trusts.
Here is an example of how a CLT would work at a 2.6% interest rate, as compared to a higher rate that is likely to prevail at some point in the future: (more…)