I understand that not everyone is going to have the same attitude regarding the intersection of life insurance and the nonprofit sector, but I’m somewhat surprised at the black and white policies of charitable organizations I’ve encountered. Many charities and nonprofits have a policy to simply cash out life insurance policies that are donated. I can’t think of a more short-sighted stance. Of course, each and every transaction should be evaluated on it’s own merits relative to required premiums, guarantees, life expectancy and use of money. It also doesn't help that so many nonprofits have been burned by life insurance over the years, as have many consumers.
When a critical mass of agents and consumers put policies in force with a material lack of understanding, and don’t manage them effectively over time (or know that they should), too many of these policies collapse and leave the charity with nothing. However, anything short of a case-by-case analysis of potential donated policies could be throwing money out of the window, especially in the era of low/no cash guaranteed universal life contacts.
Once this was understood, I made an anonymous call to Fidelity and discovered they would simply cash out any life insurance as a matter of policy, directly in conflict with the stated goals of the donor. We had to unwind the transaction and get it to a Foundation that would work with him.
Tax law states that the amount deductible as a charitable contribution is limited to either the fair market value of the policy or the cost basis, whichever is less. His cost basis is $14,000. That’s a kick in the gut. Furthermore, if the value of the donated asset is greater than $5,000, the donor must obtain a qualified appraisal, further eating into any tax savings on the $14,000.
Fortunately, in this situation, the donor wasn’t dependent on the deduction, and he remains satisfied that his alma matter will reap from the death benefit at some point. But for another taxpayer in a different situation, this could be devastating.
As a warning, if the policy had a significant loan on it, a donation of the policy to a charity could actually result in an income tax payable by the donor.
There's one little problem… that’s not the way it works. Donating policies with a loan fall under bargain sale rules, as they’re part gift and part sale. The “forgiven” loan will result in taxable ordinary income to the donor. The end result is that if the donor thought he was escaping a tax disaster, he’s not getting out from under it. If he didn’t figure this out now, I can only imagine the gut punch next January when the tax details from the insurance carrier hit his mailbox.
Though I am a strong proponent of incorporating life insurance into charitable planning as part of a diversified approach, the above scenarios show that meaningful attention must be paid to the details, or things may not pan out as expected.
Source: Wealth Management