Assigning insurance policies to charities. (Estates & Trusts)by Blattmacher, Jonathan G.
As a general rule, a taxpayer is entitled to a deduction for both income and gift tax purposes for a transfer of a policy of insurance on the taxpayer's life to charity and for the subsequent payment of premiums. The IRS, however, has attempted to nix any deduction for such a transfer by an unnecessary, and probably incorrect, interpretation of state law.
Gifts of Life Insurance Policies
Gifts to charity of life insurance policies on the life of a taxpayer have been popular, in particular with colleges and universities, because they provide for the long-term endowment of the institution. Although few taxpayers can afford to endow a chair, through a gift of a life insurance policy, it is possible to furnish funds to accomplish a significant program for charity. It had been clear that a taxpayer was entitled to a deduction for both income and gift tax purposes for the value of the policy at the time it was transferred (approximately equal to the policy's cash value plus unused premium for the year) and for any subsequent payment of premium by the taxpayer. In PLR 9110016, however, the IRS ruled that no deduction would be permitted for the transfer of a policy or any subsequent payment of premium if the insured acquired the policy with an intent to assign it to the charity, where state law would not permit the charity to acquire the policy directly. Technically, the IRS contended that the acquisition of the policy by the insured with the intent to assign it caused a violation of the state's "insurable interest" rule. Under the IRS' position, the taxpayer would not only suffer a denial of the income tax deduction, but potentially could be subject to gift tax on the value of the transfers to charity. Transfers to charity are not exempt from gift tax and so avoid taxation only if, as a general rule, they qualify for a special deduction contained in IRC Sec. 2522.
The State Law Problem
All states have a requirement that no one can acquire a policy on the life of another person unless the acquirer has an insurable interest in the life of the insured. Basically, that means that the person acquiring the property is closely related to and/or financially dependent upon the insured. See "McKinney's N.Y. Insurance Law," 3205(a)(1). Generally, spouse, children and certain others, such as business partners, will meet this test. Some states have passed legislation expressly providing that a charity is deemed to have an insurable interest in the life of any donor. See "West's Annot. Cal. Code," 10110.1(f). Indeed, it can be argued that even in a state without such an express provision, in fact, charities do have an insurable interest because they are dependent upon anticipated future donations.
New York law, which was the subject of PLR 9110016, does not expressly authorize charity to acquire a policy on the life of a contributor. New York does provide, by statute, that any person (of lawful age) may procure a contract of insurance on his or her own life "McKinney's N.Y. Insurance Law," 3205(B)(1). The statute provides further that no person lacking an insurable interest shall procure a contract of insurance on the life of another, and that if such a contract is procured, the insured or his or her executor may recover the proceeds "McKinney's N.Y. Insurance Law," 3205(b)(1) and (2). In the PLR, the insured acquired the policy intending to assign it to charity. The IRS concluded that the acquisition of the policy with an intention to assign it resulted in an unlawful circumvention of New York's insurable interest requirement and, as a consequence, the insured's estate could recover the proceeds from the charity. Therefore, IRS ruled, no charitable deduction was allowed for income or gift tax purposes, because it was possible that the charity would be deprived of the proceeds. While the PLR was concerned with the charitable deduction, its reasoning could also be applicable in other contexts. For example, the IRS might contend that an executor's right to recover proceeds from a person lacking an insurable interest caused inclusion of the proceeds in the gross estate under IRC Sec. 2042(1).
The PLR Interpretation of New
York Law is Wrong
In reaching its conclusion that the insured's executor had the power to prevent the charity from obtaining the proceeds, the IRS relied on an old New York case, Steinback v. Deipenbrock, 158 N.Y.24, 52 N.E. 662 (1899). Although the IRS interpretation of Steinback is a possible one, it is at best an implication based on dicta contained in the case. It appears that a more reasonable and fairer reading of the case does not support the IRS interpretation. Perhaps even more important, a later case decided by New York's highest court, Reed v. The Provident Savings Life Assurance Society, 198 N.Y. 111 (1907), contains statements directly contrary to the IRS interpretation of Steinback. Reed is not cited or discussed in the PLR. The IRS also ignored two later New York lower court cases, Garrison v. Garrison, 151 N.Y.S. 2d 341 (app. Div. 1956), and Corder v. The Prudential Insurance Company, 248 N.Y.S. 2d 265 (S. Ct. 1964), both of which state quite clearly that an insured who acquires a policy on his or her own life has an absolute right to assign it to whomever he or she wishes. Indeed, these cases cite New York's own insurance law Sec. 3205(b)(1) in support of this conclusion.
New York's Response
In response to the PLR, New York State has adopted legislation to make it even clearer that an insured's immediate assignment of a policy (whether to charity or otherwise) is valid. The legislation is applicable to policies issued after or in force at the time of enactment. New York did not, however, amend its insurance law to provide expressly that charities have an insurable interest in the lives of donors. Consequently, where a taxpayer contemplates a gift of a life insurance policy to charity, the taxpayer should first obtain the policy and transfer it to the charity rather than having the charity seek to obtain the policy. If this procedure is followed, the applicable tax deductions should be allowed.
In some states it may be unclear what the result would be under the PLR. However, it seems the PLR can fairly easily be avoided by following a different route. The taxpayer could acquire the policy and assign it to charity at a time when the policy has little, if any, cash value. Rather than pay subsequent premiums, the taxpayer would transfer cash to the charity which could use the cash to pay the premiums. Provided there is no legal obligation to use the cash in that manner, the contribution of the cash should qualify for both an income and gift tax deduction. Cf. Rev. Rul. 78-197, 1978-1 C.B. 83 (IRS will follow Palmer v. Commissioner, 62 T.C. 684 (1974), aff'd on another issue, 523 F.2d 1308 (8th Cir. 1975). Because the value of the policy itself would be nominal (or zero), it does not matter if a deduction for the contribution of the policy is disallowed.
As indicated, the IRS failed to state that its interpretation of Steinback was at most an inference drawn from dicta and it failed to find other authority which was contrary. When questioned, an official speaking on behalf of the IRS contended that the IRS had checked with the New York Insurance Department and had been advised that it agreed with the IRS's interpretation of New York law. Surprisingly, a few weeks later, the Insurance Department, in an official opinion, advised one of America's leading insurance companies that it completely disagreed with the IRS interpretation of New York law in the PLR Nonetheless, the IRS has refused requests from many sources to withdraw the ruling.
It Can Be Done
The IRS, for reasons that are unclear, has attempted to eliminate the donation of life insurance policies to charity. The IRS attempt is doomed to failure in all states that have laws expressly providing that a charity has an insurable interest in the life of any donor. In addition, as clarified by the passage of the new law, the IRS attempt will also fail in New York, because the PLR was based on a misinterpretation of New York law. In other jurisdictions, the PLR probably can be avoided by transferring cash to the charity (which it can voluntarily use to pay premiums or not) after a policy (with minimum cash value) has been assigned.
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