Charitable Split Dollar Plans – Vaughn Henry & Associates
An open letter on Charitable REVERSE SPLIT DOLLAR – AND ITS PROGENY
by Stephan R. Leimberg, JD CLU
KEY CLAIMS
- There have been five key claims for Charitable Reverse Split Dollar arrangements and their progeny:
- First, funding of life insurance will be – in essence – income tax deductible.
- Second, no party will be subject to income or gift tax liability (and it may also be possible to beat the estate tax).
- Third, the donor will be able to use tax deductible dollars to provide for his or her own retirement income.
- Fourth, this is a “no cost”, “nothing to lose”, “sure thing” with substantial benefits for charity, and
- And fifth, this is a very, very good financial opportunity for the agent who is able to convince the client-donor and the charity to implement the plan and split the insurance.
Let me make my viewpoint very clear:
First, either all – or a significant portion of the check the donor-insured – or his or her corporation – writes – will not be deductible.
Second, the donor will incur significant income or gift tax liability – or both. And the person who prepares and signs the donor’s tax return will also likely face legal as well as ethical challenges.
Third, this is not a good deal for the charity. In fact, it may potentially be a New Era level public relations, economic, and legal disaster. The overpayment of premiums and the loss of interest on the “unearned premium account” may be deemed an imprudent course of action, probably a violation of the charity’s state charter, and a risk of its tax exempt status. In fact the charity may be sued by the donor on the grounds that he or she relied on the charity’s counsel checking out the viability of the plan.
Fourth, although the agent who sells this concept may realize a very short term gain, in the long-run, my prediction is that selling this concept will prove very expensive to both the wallet and the reputation of that agent.
Let me explain why I feel that donors, charities, tax preparers, insurance agents, as well as plan promoters will all loose from the marketing of charitable reverse split dollar and the “I’m different” schemes that make the same promises:
In examining CRSD – just as in any tax transaction, the IRS and the courts will look at both the formal written documents – and the substance – the totality and reality – of the transaction as a whole. The IRS and the courts can ignore your words can be ignored if they don’t comport to your actions.
Seemingly unrelated pieces of a puzzle can be re-assembled by the IRS when it’s clear that the parties intended from the start that each piece was intended to be part of a whole and no part of the puzzle works without the other parts.
In my opinion, both the “substance-over-form” doctrine and the “step transaction” doctrine – will be applied here – vigorously!
Charitable Reverse Split Dollar and the “progeny” I’ve examined – let’s be honest – is an integrated inter-dependent series of steps attempting to obtain a very good result for the donor and his family with relatively little of the client’s dollars for the charity.
Let’s address the law: We’ll start with the obvious. To get an income tax deduction for a gift to charity, you must both intend to make a gift – and – in fact – make one. If there’s no donative intent, in other words if you really don’t intend to make a gift, the entire deduction may be disallowed.
And for gift tax purposes, a transfer is not a gift – where the transferor’s primary impetus is the anticipation of personal economic benefits in return for that transfer.
Yet, that’s exactly what we have here – a donor anticipating hugh amounts of cash values flowing to his or her children’s trust. No Gift – no deduction. Strike one!
Even if you can show you intended to make a gift, to the extent you get something of value back from the charity, a “this for that”, the deductible amount of your gift must be reduced. This is called the quid pro quo rule.
So to the extent your contribution to charity is offset by a material economic benefit from charity, your deduction is only the excess of what you give over what you get back.
It is the reasonable expectation of a benefit in return for your gift – and not the legal right to get it – that’s important here.
The IRS takes this quid pro quo rule seriously: In fact, a representative of the charity – probably the president or director – will have to sign a legal document attesting – under penalty of purgery — how much – if anything – you’ve received in return for your gift.
Ask yourself how you would testify – in court and under oath – to the following questions:
Mr. Donor, what did you expect to get from this arrangement?
Did you know that the charity is laying out amounts substantially greater than it should for the term insurance coverage it actually receives – maybe five or six times as much as it should be paying?
Did you know that – because the charity is overpaying its share of the premium – a substantial benefit is flowing – through the split dollar arrangement – to your family’s trust?
Do you think the promissed amount of cash values would be in your children’s trust – if it didn’t get substantial economic help – in the form of overpayments of premiums – from the charity’s participation?
Did you know that the charity is also laying out even more money if the plan calls for a “unearned premium” account? Did you know that interest or growth on that money doesn’t go to the charity – it’s diverted to your family’s trust?
Did you know this unearned premium account is the equivalent of a long term interest free loan from the charity to your children’s trust? Can you give us any reason why Section 7872 shouldn’t be imposed – to impute several hundred thousand dollars of taxable interest to the trust over the plan’s span?
By the way, would you ask your counsel to provide the court with the legal authority for levelizing P.S. 58 costs – what’s the citation?
Were you aware that your cash contributions each year were part of an integrated plan designed mainly to put money in the hands of the charity – only so that it could turn around and use all or the bulk of those dollars to make all these great things possible – for you and your children?
You said you knew all these things – and in fact all these things reflected the plan and the promises that were explained to you by the agent who set this arrangement up.
Yet you took a tax deduction for the entire $100,000 check you wrote. Care to justify that? Would you care to explain why you didn’t reduce that $100,000 deduction on your income tax return by the value of the benefit your family received?
Quid Pro Quo – That’s strike two.
If all else fails, the IRS could allow the deduction – and then argue that, to the extent the children’s trust was enriched through the charity’s participation, the taxpayer has recovered the benefit for which he was allowed a deduction.
That recovery of his tax benefit is taxable income under Code Section 111. And then it’s a constructive taxable gift from the donor to his children.
What about the argument that there is no taxable economic benefit from the reverse split dollar arrangement? After all, isn’t there a revenue ruling that allows the taxpayer to choose to use – or not use – the insurer’s published rates rather than P.S. 58 rates?
The answer is, No, there is no ruling – with respect to reverse split dollar. In fact, this is what PLR 9604001 is all about – wealth generated by one party and shifted to and received by another may be taxable income to the recipient. The IRS could treat the increases in cash value in the children’s trust as currently taxable income – not under Section 83 – but under Code Section 61 – which subjects to tax “all income from whatever source derived”.
Let’s move to the partial interest rule:
The partial interest rule has a very simple purpose. Congress intended that a charitable gift be used exclusively for charitable purposes.
Let me repeat. The Code (Sec. 170(f)(3)(A) makes it very clear that you get an income tax deduction – only if the transfer isn’t going to be diverted back to – or for the benefit of – the donor. That’s why the Code denies a deduction for anything less than an unrestricted gift of the donor’s entire interest in the cash or asset contributed. A real honest to goodness – no strings attached, nothing up my sleeve – contribution.
If you give anything less than your entire interest, you don’t get a deduction.
And to make sure no games are played, the Regulations state, “if you divide the the property up in order to beat this partial interest rule, we’re still not going to allow a deduction. Don’t try to do by indirection what we have told you you can’t do directly.
In reality, the charity really ever owns the whole $100,000 check it receives each year from the donor. In fact, it knows – even before it receives each year’s check – that it will never receive next year’s check – if it doesn’t do what the donor intends it to do – use all or the bulk of the money for the split dollar premium payment.
So the pretense that the contribution is total and unrestricted and that the charity has full, absolute, and unrestricted use of the money flies in the face of the uncontraverted intentions of the parties – and the facts. That clearly violates the spirit – as well as the letter – of the Congressional intent in the Code that a charitable gift be used exclusively for charitable purposes.
Clearly, the parties intend that the charity will never get to use the entire check. They agree to that the first day they shake hands. The best the charity gets is a tenuous and temporary and in some cases diminishing piece of a small part of what the charity could buy on its own.
So, there’s no way the IRS or a court will believe an argument – no matter how couched – that the donor has given his entire interest, an unrestricted gift of cash – when both the facts and the promotional literature of the proponents of CRSD say otherwise.
Think About It: The end and intended result of CRSD is no different than if your client gives the cash value of an existing life insurance policy to a trust for his children and then assigns a portion of the death benefit to the Boy Scouts. There, it’s just a little more obvious – but no less certain that a gift of only a partial interest has been made to charity.
True, it was designed to make it look like the corporation or the donor gave – and gave all – with no strings attached – and with nothing expected in return.
But everyone knows the purpose of the client’s corporation writing the check was to create the appearance of separate and independent events and therefore the appearance of a gift of the check writer’s entire interest.
But the separate parties are a magician’s trick. The end result is circular. Dollars flow from the donor (or an entity controlled by the donor) through the charity and back – if not to the donor – to a party related to or controlled by the donor. Clearly, a violation of the partial interest rule. Simplistic subterfuge:
So again we put the donor back on the stand and the IRS attorney asks,
You never expected the charity to take the entire $100,000 each year and purchase crutches or wheelchairs, did you? You had an understanding with the charity – a pre-arrangement – that the charity would use the money – all or almost all – each year – to help your children’s trust pay for the life insurance?
In essence the charity’s role in this plan was to serve as your conduit – your funnel – your agent – to move the bulk of the money you give it each year to your children – and not to the crippled children it is chartered to serve. Is that correct?
There is clearly a pattern of timing, conduct, and expectations by all of the parties to CRSD that effectively assure the donor and his or her family of substantial economic benefits – and none of these benefits would be possible if the charity had – in reality – been given a total and complete – rather than a partial interest.
Nor will the argument that the charity has no legal obligation to pay premiums win the day. The law doesn’t require a legal contract to apply either the quid pro quo or the partial interest rule. If there’s a reasonable expectation of a quid pro quo, the law does not require that the charity be legally obligated to pay the economic benefit. It’s enough that the parties expect that result.
Partial interest rule – Strike three!
Now let’s look at the terms, private inurement and private benefit.
Both of these Code provisions are highly technical. But both echo the same purpose as the partial interest rule: When you make a gift to charity, that money belongs to the charity. It is to be used by the charity – EXCLUSIVELY – for charitable purposes. There should be no diverting of the charity’s dollars to any person or entity that’s not a legitimate recipient of the charity’s tax-exempt objectives.
That’s why Section 501(c)(3) of the code states that to remain qualified, no part of the charity’s earnings – broadly defined – can go to a private shareholder or individual. That’s the private inurement rule. The same code section further prohibits charitable money passing to private interests. The private benefit rule encompasses transfers of benefits from charities to almost anyone – other than the appropriate objects of the charity’s bounty.
Let’s go back on the stand:
When the charity entered into this CRSD – it essentially agreed to pay the highly inflated P.S. 58 rate – rather than the actual cost of insurance. And it may also agree to levelize its payments for the term insurance it’s getting – meaning that it pays – up front – in the early policy years – even more – than the admittedly inflated P.S. 58 rates. And your family’s trust will not pay the charity interest on the use of its money or reimburse the charity for any overpayments.
So in all these ways, the charity was helping you meet your personal insurance needs with death benefits and increasing cash values in your children’s trust’s policy, wasn’t it?
Certainly, this is a private benefit. And providing a private benefit violates the intent of the rule requiring exclusive use of a charity’s money and resources for charitable purposes. This violation is exactly what the code was intended to prohibit.
By the way, one of the claims made by promoters was that this arrangement would provide substantial benefits for the charity. But if – for any reason – the CRSD plan ends before the insured dies – just what does the charity get?
Can it be argued that – even if there is some benefit to the donor or his family – it’s incidental? Yes, you could argue that – but it appears the promotional literature promises just the opposite – big deductions for the client and big cash values plus a substantial death benefit for the client’s family. Compare those two with what the charity gets.
Private Benefit – Strike Four!
Now let’s turn to the Uniform Management of Institutional Funds Act. Again, back on the stand – only this time the president of the charity is now in front of the court:
Mr. President, USA today – – reported on Friday – June 5th that the Dow Jones Industrial Average was up 13% from 6 months ago. Why didn’t you invest the $100,000 a year you received from Mr. Donor in the market?
Wouldn’t it have made more sense for you to have used the entire check you received from Mr. Donor over each of the last three years – as a premium on a policy your charity owns and is the beneficiary of – than to enter into this split dollar plan where your charity only gets a small fraction of what the donor’s contribution could have purchased?
Why didn’t you use the entire check you received this year to buy term insurance on the donor’s life?
Mr. President: How do you justify the use of your charity’s money to enrich a private individual and/or his family? What defense do you have against a charge that you knowingly overpaid – significantly – for insurance – no less a crime than if you deliberately overpaid a truck dealer for a truck the charity bought?
Mismanagement of the charity’s funds – Strike five!
Let’s talk about the COMPLICITY ISSUE:
Mr. President: did you send Mr. Donor a letter each year for the last three years stating that he received nothing of economic value in return for his $100,000 checks? But you were aware that Mr. Donor’s family trust would be getting thousands of dollars of cash values and death benefits – because of your charity’s participation in the plan?
The President of the charity is either guilty of gross investment negligence – or of complicity to fraud. I’m talking about the patently untrue statement he signed under penalty of purgery that the charity provides the donor nothing of economic value in return for his or her contribution. Where are all these great benefits coming from – if not from the charity?
Complicity to fraud. Strike six!
Finally, compliance exposure:
I can see the lawsuits now by clients claiming they were never fully informed about the tax exposure. Some of them may sue the charity – as well as you.
No gift, quid pro quo, partial interest rule, private benefit, mismanagment of charitable funds, signing official documents the parties know contain incomplete and untruthful information.
If you still think charitable reverse split dollar works – call me. I’ll defend you – down to your last dollar.
Steve Leimberg
Leimberg Associates, Inc.
610 527 4712
E-mail: Leimberg
CONCLUDING REMARKS:
How will the IRS catch me? I’ve got a cancelled check for – say $100,000 – that shows the date the charity cashed it. How will they ever find out?
Every tax attorney I know has heard this question a thousand times.
The answer here is simple. The IRS finds the promoters – the marketers. And I don’t think that finding the promoters will be hard.
The IRS then requires them to submit a list of the names of all the people who have set up a CRSD plan. Bingo. You’re it.
What will it cost if they catch me? Well, for openers, aside from the tax and interest, there’s a 20% accuracy-related penalty.
Guess who has the burden of proving that the underpayment of tax was not negligent? Then there are possible civil fraud penalties – 75% of the tax.
What about the opinion letters?
They are worthless – unless there’s substantial reliable authority for the position. And there isn’t.
Certainly, you can’t use the existing private rulings on reverse split dollar. Even if you could, the taxation of reverse split dollar itself is without substantial reliable authority.
And you certainly can’t claim reliance on marketing promises as a defense.
Here’s the bottom line:
We don’t need to place our clients, our community’s charities, and ourselves in harms-way. We don’t need to use an idea so risky and so uncertain that a legal defense fund is required to promote it.
Read the book, Tax Planning With Life Insurance or read the Tools and Techniques of Life Insurance Planning and you’ll find dozens of alternative ways life insurance can be used creatively – to legitimately – and without risk – accomplish charitable as well as personal goals.
As an author and lecturer, it’s my job to encourage creativity and stimulate fresh thinking. But it’s also my responsibility to let you know when I think you – my reader or listener – can get into trouble – even if – as in the case of equity split dollar – you may not really want to hear it.
If this thing winds up on the front page of the Wall Street Journal, it will hurt all the agents in the U.S. who are selling any form of split dollar arrangements – since the press and the public really can’t or will not distinguish between one form of split dollar and the other. The result could very well be the impetus for adverse rulings, regulations, or even legislation that would harm both legitimate split dollar sales and the legitimate uses of life insurance in charitable planning.
The Maybe It’s Me article tells it like it is – in lay terms. I urge you to read it – and share it – with those contemplating a charitable reverse split dollar arrangement and their counsel.
I also urge you to read the scholarly and incisive article by Doug Freeman, who I consider one of the leading experts in Charitable Planning in the U.S. I also suggest you read the excellent May and June two-part Financial Planing Magazine commentary by John Scroggin and Kara Fleming that are also cited in my article. The later two attorneys state, “Effectively, the program is a sham and will collapse of its own weight in a thorough audit.”
Determining the edge of the split dollar envelope is much like the study of geometry. They both start with theorems of pristine simplicity and gradually progress into the dark caverns of complexity.
The trick in analyzing any complex tax transaction, however, is to reduce it to its basic components and then attempt to reconcile the results with fundamental principles.
If dollars seem to move in circles or if benefits appear to shift without tax consequence, one had better illuminate the transaction with traditional tax tenets and common sense because, if for no better reason, this is the crucible that the Service and the courts will apply.”
In an article in the Spring, 1996 Benefits Law Journal article entitled, The Evolving Edge of the Split Dollar Envelope, the authors said:
“G. Quintiere & G. Needles, The Evolving Edge of the Split-Dollar Envelope, Benefits Law Journal, Vol. 9, No. 1, Spring 1996.
In the movie, the Devil’s Own, Brad Pitt plays an Irish terrorist against the good guy cop played by Harrison Ford.
Pitt sets the stage for the ending when he explains to Ford the difference between an American fairy tale and an Irish fairy tale. In an American fairy tale, the ending is always “happily ever after”. CRSD is not an American fairy tale – and it will end badly.
Let your brain – and your conscience – be your guide.
For another look at the same topic, see: Maybe It’s Me
A CLAT can be easily described as a “deferred inheritance trust” and this offers the Bari family a degree of certainty as to when assets will be available to both charity and family members. For the truly philanthropic, this plan offers donors a very useful means of passing assets to heirs in predetermined amounts, especially when insurance and wealth replacement trusts may not be economically viable options.
