On the Record: Taking Out Life Insurance on Your Donors: A Gamble?

In the past few years, there have been numerous issues concerning the details of how a charity should benefit from a donor’s life insurance policy. A new life insurance-based plan provides a benefit to charities in the form of cash payment or significant future income — without the charity being required to invest any money.

Such plans need to be carefully evaluated by charities because they raise a significant number of tax issues. This column serves as a brief outline of the plan and the issues that should be considered by a charitable organization before going forward.

The way it works
Basically, a charity asks a pool of individuals to agree to permit an insurance policy to be purchased on their lives. The individual, in effect, donates his “insurability” to charity. The funds needed by the charity to pay the annual insurance premiums can be provided in a number of ways. The payments can be borrowed from the insurance company, affiliate or an investor pool expressly established for this purpose — or provided via the charity’s purchase of a single premium annuity on the individual.

If an annuity is purchased, the annual annuity income is used to pay the annual premium on the life insurance policy. This structure is financially beneficial to the charity as long as:

• the annual annuity payments are sufficient to pay the annual life insurance premium; and

• the death benefit from the life insurance policy exceeds the amount of the initial single premium for the annuity and the other costs not covered by the annuity payments, such as the first premium payment on the life insurance policy.

If there is borrowing on the charitable organization’s behalf, the policy serves as collateral for the loan. The individuals who agree to be insured do not provide funds toward the purchase of the policy, nor do they receive charitable deductions for their participation. Their only contribution is their insurability. The advantage for them is knowing that an organization they care about will benefit.

Insurability is key
State law requires that the purchaser of life insurance have an “insurable interest” in the participating party. This requirement is reflective of a public policy that prohibits betting on when someone will die. An insurable interest arises out of a relationship between the purchaser of the life insurance and the individual that can be personal, such as husband-wife or parent-child, or business in nature such as a partnership. A common exception to this rule: A charity can purchase and own such insurance if it is designated as the beneficiary of the proceeds.

So, what’s in it for the charity?
The charitable organization will realize its donation when the insured party dies and the death benefit is paid. The advantage to the party selling the insurance is in the fees and commissions that will be paid on the sale of the policy.

However, if the projections of the promoter are too optimistic — if the insured individual lives beyond the expected time period or the costs of servicing the policy exceed the return — there might be little left for the charity at the end of the day.

Among the many issues that must be considered by the charity — in addition to whether such an arrangement makes sense financially — are potential taxation questions concerning unrelated business-income tax (UBIT) issues and private-benefit rules.

A nonprofit organization that realizes income from a trade or business that is unrelated to its charitable purposes will be deemed to have UBIT and be subject to tax on that income at corporate tax rates.

Whether a charity would be deemed to have realized UBIT when it receives proceeds of a life insurance policy under this plan is not entirely clear.

Internal Revenue Code 101 (a)(1) excludes from gross-income any amounts received from life insurance. But the Internal Revenue Service has ruled that a charity that gave an insurance provider a list of its members and publicized the availability of coverage to its members in exchange for a rebate of a portion of the provider’s profits, realized UBIT because the income was part of a “regularly carried on” business relationship.

What is not clear in this new plan is whether a charity would be deemed to be engaged in a “trade or business,” whether that trade or business is deemed to be regularly carried on, or whether the IRC exclusion for life insurance trumps the UBIT rules.

The debt-financed income rules under IRC 514 also must be considered. If an organization borrows funds to acquire an insurance policy, there could be “acquisition indebtedness,” which would cause the receipt of some or all of the insurance proceeds to be subject to tax.

Another issue is whether the new plan implicates IRC 501(m), which provides that a 501(c)(3) organization is exempt from tax only if no substantial part of its activities consist of providing “commercial-type” insurance.

Section 501(m)(2) stipulates that if the provision of commercial-type insurance is an insubstantial part of the activities of the organization, then the provision of insurance shall be treated as an unrelated trade or business. While it would seem that the charity should not be viewed as providing insurance, the application of IRC 501(m) must be considered.

Final considerations
Organizations must not ignore the private benefit rules, which ensure that a charitable organization benefits the public.

If more than an “insubstantial part” of a charitable organization’s activities are for purposes other than those outlined in IRC 501(c)(3), it will fail as a tax-exempt organization.

The IRS has stated that any private benefit must be purely “incidental” and “insubstantial” in relation to the public benefit.

A chief concern with this new plan is that charities are being used by promoters — on account of the insurable interest rules — to engage in transactions that otherwise would be unavailable if attempted with any entity other than a charity.

This new insurance-based plan leaves many questions unanswered. Charities, and their counsel, need to take a careful look at all of the issues it raises.

Kathleen Stephenson is of counsel with the Philadelphia office of Pepper Hamilton LLP. Lisa Petkun is a partner in the tax department of Pepper Hamilton.