Family Foundations and Life Insurance:

Transcription

1 Published in Trusts and Estates Family Foundations and Life Insurance: Ideas for Enhancing Family-Giving Impact via an Oft-Ignored Tool By Vernon W. Holleman, III, CLU With increasing focus on measurable performance outcomes in the Foundation world and continued investment return volatility, according to Commonfund Institute studies of investment returns for Foundations, as well as other factors pressuring Foundations, perhaps, with Christmas treats looming in our minds, adding candy to a normally dry subject such as taxation, can help us take a serious look at two taxadvantaged planning tools together, where we normally might dismiss the idea. Life insurance has tax advantages. Private Family Foundations have tax advantages. As an old television commercial used to say, Peanut butter and chocolate taste great on their own but when combined (much to the surprise of the ad s actors who inadvertently combine their separate treats), it is discovered that these two great tastes, taste great together! That formula, I would hazard to argue, has been pretty good for the H.B. Reese Candy Company, now a division of The Hershey Company. Can life insurance and Family Foundations (charitable giving) share a similar outcome? Understandably, a sweet tooth alone might not satisfy the question posed. The use of life insurance could be viewed, in terms of Family Foundations, for example, as creating redundancy, given that a Family Foundation s assets grow, by and large, without taxation. But this article aims to explore a number of ways that life insurance can potentially enhance the impact of charitable giving on a family with a Private Family Foundation (PFF). Overview When exploring the application of life insurance in charitable giving and PFFs, the thinking should not be limited to the Foundation owning insurance on the primary Donor(s). For philanthropic minded families, there are a number of ways to consider using life insurance to capitalize on the leverage and tax benefits the products offer for giving enhancement. This article will attempt to meet its aim by providing context, examples, and background to the issues of using life insurance in charitable planning around PFFs in today s marketplace so as to help professional advisors consider the asset class of life insurance as an enhancement tool for their PFF and charitably motivated clients. Vernon W. Holleman, III, CLU is president of The Holleman Companies in Chevy Chase, Md., which focuses on wealth transfer and charitable planning, business succession, benefit liability planning, and executive benefits and disability; its roots are in the life insurance business. Ideas for Using Life Insurance for the Benefit of Family Giving Impact 1. Supporting Charities Outside of the Core Focus of the Family Foundation Like effective businesses, those PFFs that stick most to their mission often have the highest degree of success. However, many successful families harbor interests beyond the scope of the Foundation. Life insurance is a financial tool that can allow a Donor to benefit one, or many, charities that fall beyond the scope of his or her (or their) Foundation, or to benefit

2 charities to which they want to provide a notable gift at their death, whether announced or not. The first important component in utilizing life insurance in this manner is the establishment of an insurable interest. This means there must be a relationship history between the charity and the donor, including a financial track record, as well as involvement. For example, if a donor has given annually for a number of years to a charitable organization, and is known to, and involved with, said charity, and that organization counts on his/ her financial support, that would likely count as insurable interest. This is because the charity would suffer a financial loss at the death of the donor. Although each state has its own insurable interest laws, once established and approved by the insurance carrier the charitable organization makes application for the insurance and owns the policy on the Donor (s). The Donor then makes gifts, which are deductible (assuming eligibility), to the charity, and the Donor s gifts are used to pay the policy premium to the insurance carrier. Ultimately, the death benefit of the policy is received by the charity upon the Donor s maturity. The most obvious advantage of this use of life insurance is that it amplifies the Donor s gifting: more dollars have been given, and more of an impact has been provided. Another advantage is that gifts to a Family Foundation are limited to 30% of adjusted gross income where, assuming the charity is public, gifts are eligible for a deduction of up to 50% of adjusted gross income. This may not be the main driving motive, but may be a real factor, especially in a broadly thought-through giving program. 2. Using a Community Foundation In the example above, the consideration is with one charitable organization. However, many Donors want to benefit several charities. An effective way to donate, through a planned gift, to more than one charity is by using the Donor s local Community Foundation (CF). In this case, as above, the CF would apply for, and own, life insurance on the Donor, or on the couple (second to die or survivorship policy). The Donor(s) would help advise the CF where to make gifts at their death and would also benefit from the interaction of the community-focused and involved professionals at the CF. Given its public nature, a community foundation allows for the maximum potential deduction amount (50% of adjusted gross income). 3. Owning Life Insurance Inside the Foundation The primary reasons that a Foundation, or Donor, would own life insurance inside the Family Foundation is to provide diversification and risk mitigation. For example, what if the Foundation Founder had died in 2009? The life insurance would have provided a recapturing of market losses the Foundation most certainly would have experienced, thus helping to bring the asset picture whole. Another aspect of the use of insurance as a diversification tool is the guaranteed minimum returns offered. Of course, the internal rate of return of life insurance varies depending on a number of factors, including the length of the contract period and when the Donor dies. So, along with investment losses makeup, life insurance can be considered as a diversification strategy by using a small amount of the total available investment capital of the Foundation. Today s life insurance marketplace is as diverse in its offering as at any time in history, with new product introductions a constant. Understanding the breadth of options and the mechanical differences is important for a PFF Donor exploring its use, as such insight will allow for maximization of both effectiveness and return. Each situation is unique and calls for thorough thoughtfulness when planning with life insurance. Term insurance however, which is pure death benefit coverage for a premium, likely has little, if any, role in a PFF or related planning, given the long-term nature of the planning. But permanent insurance, which builds equity in the form of cash value, has two core chassis options, Whole Life and Universal Life, both of which build cash value, i.e., policy equity. At its core, Universal Life has a flexible premium, with varying degrees of guarantees and comes in four main varieties traditional, variable, no lapse, and index. Whole Life offers guarantees on the cash value in the policy, with generally a fixed premium that is long-term. The need for flexibility has tended to lend Foundations use some form of Universal Life (UL). UL varieties include traditional, which provides a base crediting rate paid on the overall insurance carrier performance. An example would be 4.5%, variable, where mutual fund sub-accounts provide specific asset class investments, e.g. Growth or International funds. Index UL provides the policy owner the option of hedging in various index accounts, such as the S&P and offers both a return floor and ceiling, e.g., 3% floor and 13% ceiling, thus mitigating risk, but providing some higher upside returns. Last, a No- Lapse Guarantee (NLG) Universal is like long-term term insurance with absolute guarantees and, ultimately, returns.

3 Each of these might be used for various different options. The planning team, including a life insurance specialist, can help the Donor and PFF understand the product options and work to explore the use of the life insurance in the total asset allocation picture and how its use will affect total return, through financial modeling. This worthwhile exercise will help a family with a PFF to both understand the life product universe itself and determine if its use can play a role in the Foundation. 4. Use with Caution- Planning Considerations There are a number of important considerations for proper set-up for a Family Foundation to own life insurance, to ensure the Foundation s tax status is not put in jeopardy. Concerns have typically arisen, as in the transfer of current existing life insurance or other such complicated transactions, where the perception, or reality, of self-dealing (IRC 4941) or jeopardizing investments (IRC 4944) can occur. Earlier demonstrated, straightforward examples of the use of life insurance are fairly easy to capitalize on without issue. The IRS self-dealing prohibition, in brief, is to restrict most transactions, or any act, between disqualified persons and the private, or family, foundation. Transactions considered self-dealing come with onerous tax penalties. Disqualified persons are just about anyone, and their family, involved in the Foundation (trustees, directors, officers, managers, notable contributors). Most of these penalties were established as a result of what the IRS saw as a new era of modern financial philanthropists (hedge fund managers, investment bankers, etc.), who, while attempting to, in fact, do good ended up pushing the line between charitable intent and the investing universe. The prohibition sought to draw clear lines on transactions using self-dealing guidelines /rules. Life insurance is simply one of many assets or transactions that IRC 4941 covers. If the life insurance transaction is deemed to be selfdealing, then the asset jeopardizes the tax-exempt status of the Foundation. There are, of course, exceptions and there is plenty of information available on this subject. Self dealing and jeopardizing investments are noted in this article, on the use of life insurance in family foundations, to provide context and ensure that advisors are aware of the rules. There is good guidance on this subject from the Internal Revenue Service, such as in Letter Ruling In that case, a Founder of a Family Foundation transferred a term policy owned by an irrevocable trust he had created for the benefit of himself, two step children of an ex-wife, and a brother, to the Foundation. The Founder agreed to two key points: he would pay the premiums ongoing when due (via gifts to the Foundation), and he gave a Board member, who was an attorney and independent of the Founder (non-employee), authority to make any and all decisions regarding the life insurance policy. All parties involved signed a binding agreement that included contingencies, such as the departure of the attorney Board member. The IRS deemed this transfer acceptable, given the circumstances and the disclosure planning involved. While this case had its own unique circumstances, it is useful for advisors aiming to structure life insurance properly in a Family Foundation. A key point here is that the policy had no loan on it, as it was term insurance. This case, and its circumstances, helps highlight the importance of the issue of self-dealing as a concern when exploring life insurance ownership and transfers in, or around, a Family Foundation. A policy loan, regardless of how taken or used, makes the donation of a life insurance policy subject to being considered an act of self-dealing under Revenue Ruling , in both this particular Letter Ruling and in other cases. Therefore, my general rule is to stay away from transferring policies into a Foundation with a loan, or using the type of policy that can create a loan on its own, e.g. Whole Life. Whole Life policies can be set up to trigger a loan to pay the premium, through a loan. Therefore, Whole Life is likely the last type of life insurance a Foundation ought to use. Better to be safe than sorry. Control is another important aspect of using life insurance in a FF. The Donor must give the Foundation complete control of the donated, or created (if new), policy. Giving up all incidents of ownership should be explained and understood at the front end of these planning discussions. Also, the plan for a policy owned in the Foundation, should be for the Foundation to be the sole, and unconditional, beneficiary of the policy s death benefit. It is recommended this be in writing (Foundation s minutes), including how the use of the policy proceeds will be utilized to continue its work (exempt purpose). This will help avoid any concerns addressed in IRC 4945, which wants to see all amounts paid out of the Foundation to be used to enhance and promote the charitable intent (mission) of the, in this case, Foundation. If a portion of the policy is paid to a charity promoting other needs, even if for exempt purposes, the Foundation could be in violation of IRC If the Donor wants to maintain control, and many do, or have multiple beneficiaries, life insurance can be acquired outside the Foundation and made the beneficiary of the policy, entirely or some portion, as this article also covers.

4 What the IRS wants to be sure is avoided is planning intent on benefitting someone (anyone, really) other than the charity/foundation. In the case of the circumstances in LR , the Donor gave up all control of the gift, despite obligating himself to make future premium payments. The Foundation was able (control) to determine if those contributions (premium payments) would be used for keeping the policy in-force, or another use. The use of life insurance in Foundations can be made more complicated if these clear rules are not followed. Proper understanding of these rules and the subsequent matching of appropriate product choices and servicing needs are important. The first rule of thumb here is that no benefit for the Donor, or his/her family, should be pursued in the use of life insurance in a Foundation. With that basic premise met first, capitalizing on the natural benefits of life insurance for the benefit of the FF should be achievable with relative ease. Because of the leverage, ultimate liquidity, and tax benefits that life insurance provides, the IRS imposes tough penalties on its misuse. Thus, careful and honest planning is necessary for charitable plans involving life insurance. 5. Targeted Inheritance Using Life Insurance for Children All Else to the Family Foundation An alternative for a family to consider is targeting a specific dollar amount to be left to the Donor s children and using life insurance to deliver that amount. More than likely, the insurance would be owned in a Trust, outside of the Donor s estate, and the remainder of the estate would be left to the Family Foundation. Determining the appropriate, or right, amount of dollars to leave to heirs is often a challenge. However, for those that have a clear idea, that amount of insurance can be acquired in an Irrevocable Life Insurance Trust (ILIT), using annual exclusion or lifetime exemption gifts (or a combination of the two) and remain outside the estate. The insurance funding strategy, of course, depends on the age of the Donor and his/her spouse, as well as health and other considerations, but it is nonetheless employed with regularity. The ILIT provides for the heirs of the Donor and the remaining estate assets can be left, in entirety, to the Family Foundation and other charities, thus eliminating taxation entirely. The Donor has provided for both a charitable legacy and his/her children, with great tax efficiency. 6. Life Insurance or Annuities on Yourself Controlling both the Asset and Beneficiaries There are times when a Donor is not driven by a tax deduction. In this case, simply owning life insurance or an annuity to benefit the Foundation or other charitable organizations can have some appeal. The driving appeal is maintaining control, with a secondary benefit being taxdeferred growth of the asset. This is particularly easy if a policy is already owned, yet no longer important to personal planning. An insured can simply change the beneficiary of the policy, making a Foundation or a Community Foundation (or others) the beneficiary of policy proceeds, either all or some portion. A Donor may also acquire insurance on his/ her own life and make charitable organizations to the beneficiary, as he/she sees fit and also change conditions as he/she sees fit. Also, a policy left to a qualified charity will qualify for the federal estate tax charitable deduction, under IRC Section 2055(a). 7. Using Existing Insurance (Individual and Group) the Often Forgotten Asset Life insurance is an oft-forgotten asset. Policies that once were in the center of a family s financial plan that are no longer crucial can be a great asset for giving to the Family Foundation. Understanding where such a policy stands with regards to future performance is the starting point for such a policy. In other words, answering certain questions such as Does it require further premiums and is there a loan? can be important to understand before a transfer is considered. It s also important to know how long the contract has been in place and the policy gain information. Assuming the policy makes sense to gift, a transfer of ownership form from the insurance carrier is the primary service work required to make such a gift transfer. The value of the contract must be carefully understood and documented for the tax deduction documentation, but such planning is common and the life insurance a welcomed asset, assuming it does not have (or will have) a loan or other issues, as discussed above. The insurance carrier, or in some cases an outside valuation firm, can help on the market value of the policy, which is not simply the cash value. It is important to know that the gift of an existing life insurance policy to a Family Foundation, or other charity, will revert back to the Estate of the insured if it occurs within three years of the gift being made (the three year rule ). It is worth exploring existing policies (assuming Whole Life) if the dividends of the policy might be a resource for giving. Dividends can be assigned to a charity instead of being taken in cash. This removes the out-of-pocket gift and still allows for a tax-deduction when the dividend is paid. Also worth consideration is whether such

5 dividends could be a capital resource for acquiring new life insurance on a Donor. Annuities are also a place to find opportunity for a forgotten asset to play a role in charitable planning. Like dividend payments, the annuity payments may be directed to the FF, or left to the FF, thus turning a taxdeferred asset into a tax-free asset. Group term insurance also falls into the forgotten-about asset camp. Rarely for those with a Family Foundation is group term a core, or important, insurance asset. In the event of pre-mature death the group term insurance, usually set up at one s place of employment, is thought of, if at all, as final expense cost coverage. In the event of families with, or considering, a Family Foundation, it is, given this, a place to leave more money to the Foundation or another Charity. Naming the Foundation the beneficiary of the Donor s Group Term coverage above $50,000 will not only help the Foundation, but, depending on how the group insurance of the employer is set up, help the Donor avoid any income tax on the economic benefit cost (IRS rates for per $1,000 of group term life insurance provided policies) of that group insurance. The first $50,000 can also be given, but will not have an income tax deduction associated with it. 8. Using a Private Placement Annuity for Maintaining Control and Tax-Free Growth Private placement variable annuities (PPVA) are one of the few annuity types which families who have PFFs would consider using. The primary reasons for this include: fee transparency, simple mechanics, sophisticated investment options and choices, and tax-deferred growth of assets. For individuals or families owning liquid assets they are not ready to give away and/or want to maintain current control over, but who have an idea they may want to give away their PFF (or other) to charity, a PPVA can provide tax-deferred growth as long as it is maintained. Then too the beneficiary may be changed (from family), prior to death, to a charity of the owner s choosing. In this specific example, the tax system can be avoided altogether as the planned gift would qualify under the charitable estate tax deduction. Thus in such a case, the family has more efficiently grown the asset while avoiding estate tax. That said, a PPVA will require cash distributions at some point, including income tax on the gain portion of the distribution(s). One PPVA, for example, requires distributions at age 90. Investors do need to be accredited investors and qualified purchasers to qualify for investing in a private placement variable annuity. The reason for this is that PPVAs are unregistered investment products with alternative investments, such as hedge fund options, along with other traditional security investments, such as Growth and Balanced Funds, or Sub-Accounts. What About Cost? Like most buying decisions, economics are a key, if not the key, driver. The economics obviously have to make sense for life insurance if they are to be utilized by a family with a private foundation. Clearly, options for designing and structuring life insurance are beyond the scope of this article but it is helpful even so to provide some rough numbers on price. To that end, a 75-year-old male and 70-year-old female, both in good health, willing to pay premiums annually on an ongoing basis, which creates the most amount of leverage, on a joint and survivorship (second to die) life insurance policy would have an annual premium of roughly, in one carrier product example, $19,500 per $1mm policy. At both their life expectancies (her at age 86), the projected internal rate of return (IRR) is 8.22%. At his age 99 (her at 94), the IRR on the death benefit is projected at 5.33% net. That s an attractive enough return for both Donors and Foundations to examine the use of life insurance as a valuable tool for creating diversification, flexibility, liquidity, and steady return into the asset allocation. Conclusion As you can see by all of the above, there are a number of ways and good reasons for Family Foundations and their creators, and those who advise them, to explore the utilization of life insurance to help promote and protect the good and important charitable work they are doing. Life insurance offers itself as a financial tool that, when properly used, can be a match which not only further fuels the passions and vision of Family Foundation Donors, but helps enhance their legacy as well.