Question: Our family foundation receives almost all of its contributions from one donor. May the foundation take a life insurance policy out on that donor?
Answer: Yes, if certain stringent safeguards are followed. The IRS recently issued a private letter ruling (PLR 200232036) which stated that such an action would not endanger a foundation’s tax status if adequate precautions were taken.
In that case, the foundation’s founder (call him “Mr. F”) created an irrevocable trust for the benefit of himself, his brother, and two stepchildren who were the children of his ex-wife. If any beneficiary died before Mr. F, his or her share passed to the foundation. The trust owned a term-life insurance policy on Mr. F. The policy was a 20-year fixed premium term policy with no cash value and not subject to any policy loan. Mr. F proposed to have the trust transfer ownership of the policy to the foundation. As part of the deal, Mr. F would also agree to continue paying for all the premiums on the policy through contributions to the foundation for that purpose.
The foundation had on its board an attorney who was independent of Mr. F (that is, not subject to his control), and Mr. F gave this board member an irrevocable proxy to cast his board vote on any and all matters concerning the insurance policy (for example, decisions regarding continuing or discontinuing coverage, and changes of beneficiary). All parties signed a binding agreement which provided that if the independent attorney on the board ceased to be a director for any reason, another independent person would be elected to serve in his place and that person would hold and vote the proxy.
The IRS ruled that this plan would not endanger the foundation’s tax-exempt status: Neither the foundation’s holding of the policy nor its payment of premiums (from Mr. F’s donations for that purpose) would violate legal prohibitions on self-dealing or “jeopardy” investments.
Several points about this ruling are important, because they lay out precautions that must be taken in this area.
First, this policy had no policy loan outstanding. Under an earlier IRS ruling, a loan would have made the donation of the policy an illegal act of self-dealing. Another prior ruling holds that a foundation’s payment of premiums and interest on a policy loan under similar circumstances indicate the foundation has made a forbidden “jeopardy investment.” By contrast, the policy insuring Mr. F was a term policy, which precludes policy loans, and the foundation was also required to represent that it had no intention to convert this into a whole-life policy upon which policy loans would be possible.
Second, the proposed plan was structured so as to place the donee-foundation in complete control of the donated policy. In other words, the donor Mr. F gave up all incidents of ownership, and the plan included assurances that he could not subsequently use his position with the foundation to exercise any control of the policy at a later date.
Third, the proposed plan would not benefit anyone other than the charity. The donor attached no strings to the gift, and even though he obligated himself to make subsequent premium payments, the foundation was not required to use his contributions for premium payments or even to keep the policy in force.
Clearly, planning for charitable contributions of life insurance is a tricky business. Virtually any attempt to squeeze out some benefit for the donor or the donor’s family will defeat the intended tax benefits, and the policy must also be free of any indebtedness.
Additionally, though the IRS didn’t discuss it in this ruling, there is a provision in the U.S. Code [section 170(f)(10)] that bars any deduction for a contribution to charity that will be used for premiums on a policy benefiting the donor or anyone selected by the donor; this provision also imposes a tough penalty (100 percent of any such premiums paid) on the donee organization.
In sum, careful and honest planning is necessary for charitable plans involving life insurance.
—Jerry J. McCoy is an independent attorney in Washington, D.C., specializing in charitable tax planning and foundations. The questions and answers presented here are illustrative only and should not be considered legal advice. Please consult with a nonprofit attorney or other qualified advisor for specific answers.