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| Estates, Trusts & Gifts |
Charitable Split-Dollar Insurance Transactions
The IRS has issued Notice 99-36, warning taxpayers and charities of its position that certain charitable split-dollar insurance transactions do not qualify as charitable contributions. Additionally, taxpayers and charities that participate in these transactions may be subject to adverse tax consequences, including penalties.
In a charitable split-dollar insurance transaction, the charity or an irrevocable life insurance trust set up by a taxpayer purchases a cash-value life insurance policy. The trust beneficiaries usually include the taxpayer's family, and sometimes the taxpayer. The taxpayer then transfers funds to the charity with the understanding that the charity will pay the insurance premiums; the insurance policy beneficiaries are the charity and the trust. Each year, the taxpayer deducts the insurance premium as a charitable contribution on his individual income tax return. On the taxpayer's death, the charity receives a portion of the policy's proceeds; the trust receives the remaining amount. The transaction results in lower life insurance costs and a deduction for the taxpayer.
Notice 99-36 formalizes the Service's position that charitable split-dollar insurance transactions do not qualify for charitable deductions under Sec. 170 or 2522. Sec. 170(f)(3) disallows a charitable deduction for a gift of a partial interest in property not in trust. As defined in Regs. Sec. 1.170A-7(a)(1), a partial interest is any interest in property that consists of less than the donor's entire interest in the property. The exception to the partial-interest rule under Regs. Sec. 1.170A-7(a)(2)(i) allows for a contribution of a partial interest in property, if such interest is the taxpayer's entire interest in the property. Applying the substance-over-form doctrine, the IRS has taken the position that it is not required to respect the form of the transaction when doing so would yield a result inconsistent with the substance of the transaction. The Service contends that the taxpayer is buying an insurance policy, paying the premium and transferring some of the rights under the policy. Therefore, the charitable deduction is not allowed, because the taxpayer has assigned a partial interest in an insurance policy to the charity. Additionally, no gift tax deduction will be allowed under Sec. 2522.
The exempt status of a charity that participates in these transactions may be challenged on the basis of private inurement or impermissible private benefit. A charity that provides written substantiation of a charitable contribution in connection with such a transaction may be subject to penalties under Sec. 6701 for aiding and abetting the understatement of tax liability. Additionally, charities may be required to report any split-dollar transaction on their annual information returns.
The Service further warned that taxes may be assessed on excess benefit transactions or self-dealing against any disqualified person who benefits from the transactions and against certain charity managers. The IRS may also assess taxes on taxable expenditures against private foundations and certain managers involved in these types of transactions. Accuracy-related penalties, return preparer penalties and promoter penalties may also be imposed on participants in charitable split-dollar transactions.
Further, Congress believes that these transactions undermined the spirit of the tax-exempt regime; within the last few months, the House and Senate have included provisions in two separate bills to eliminate charitable split-dollar insurance transactions (see Pye and Vail, "Significant Recent Developments in Estate Planning (Part I)," this issue). Both bills are in line with the Service's position.
Practitioners are now on notice that charitable split-dollar insurance deductions will not be allowed by the IRS for income or gift tax purposes. Any charity, entity or individual promoting or participating in such arrangements may be assessed penalties; in addition, charities that participate could lose their tax-exempt status.
From Judith M. McGhee, CPA, Oak Brook, IL
State Death Tax Credit in Credit-Shelter Trust Funding
Most estate plans provide that, on the closing of a decedent's estate, the assets are divided between a credit shelter amount and a marital deduction share. The credit-shelter trust is typically funded based on a formula defining the amount necessary after deductions to produce a tax equal to "all available credits." In this way, the tax on the funding of the nonmarital share is completely offset by credits, with no Federal tax due on the first spouse's death.
If the phrase "all available credits" is defined as only the Federal unified credit (Sec. 2011), the credit-shelter trust would typically be funded with $650,000 for the estate of a decedent who died in 1999 and had not used any of his applicable exclusion amount during life. If, however, the phrase "all available credits" includes the state death tax credit (Sec. 2012), the credit-shelter trust can be funded with $698,484.84. This taxable estate is determined based on the calculations and tax rate tables in Exhibit 1.
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Thus, if the credit-shelter trust is $698,484.85, the Federal tax of $17,939.39 will be completely offset by the maximum state death tax credit; no Federal tax would be owed. Obviously, if the only variable were the Federal estate taxes, it would be preferable to fund the credit-shelter trust with $698,485, rather than just $650,000, as the additional amounts in the trust (and all future appreciation thereon) will escape Federal taxes at the time of the surviving spouse's death.
"Pick-Up Tax" States
Many states assess death taxes in an amount equal only to the maximum state death tax claimed on the Federal estate tax return. These states are commonly referred to as "pick-up tax" states, as the only tax assessed is the amount claimed as a credit at the Federal level. In these states, if the credit-shelter trust is funded with no more than $650,000, there would be no state death tax credit claimed at the Federal level and no tax owed to the state. If, however, the credit-shelter trust is funded with $698,484.85, although there is still no Federal estate tax owed, there would be $17,939 of tax owed to the state.
From a purely mathematical viewpoint, this "overfunding" of the credit-shelter trust is probably still beneficial, in spite of the amount owed to the state; $48,484 would be removed from the surviving spouse's taxable estate. Assuming that the surviving spouse will have a taxable estate, removing these funds will reduce the subsequent tax (at tax rates of 37% to 60%) by an amount greater than the state tax owed. In addition, all future growth on this additional $48,484 is removed from the subsequent spouse's estate, thus increasing the tax savings resulting from this plan.
Inheritance Tax States
For states that impose not only a state "estate tax" (i.e., "pick-up tax") but also an inheritance tax, there will typically be some inheritance tax owed, even if the credit-shelter trust is only funded at $650,000. In Indiana, for example, the inheritance tax is calculated on the amount (or portion) of the income interest and remainder interest in the trust attributable to someone other than the surviving spouse. In these states, it may actually make more sense to fund the credit-shelter trust with an amount (between $650,000 and $698,484) that would produce a tax equal to the unified credit plus an amount of state death tax credit (at the Federal level) approximately equal to the inheritance tax that would be owed.
Example: A will creates a credit-shelter trust for $650,000, the income of which will be distributed to the surviving spouse (age 85) for her life, with the remainder passing to their only son at her death. The Indiana inheritance tax on the husband's estate would be $7,645. If the same trust were instead funded with $670,663, the Federal estate tax would be exactly $7,645, which would be offset by the Federal credit for state death taxes. Whether the trust is funded with $650,000 or $670,663, there is no Federal estate tax owed, due to the unified credit and the state death tax credit. Because of the extra $20,663 funding, however, the Indiana inheritance tax would grow from $7,645 to $7,864. This additional $219 "cost" in Indiana inheritance tax is more than offset by the benefit derived by the additional funding to the credit-shelter trust. Thus, it is advantageous to "overfund" the credit-shelter trust with additional funds to produce a Federal death tax credit equal to the inheritance tax that would be owed.
A problem with attempting to fund the credit-shelter trust for more than $650,000 is that the funding provisions for most credit-shelter trusts include a clause indicating that the phrase "all available credits" is to include "state death tax credits (but only to the extent that such funding does not create any additional state death taxes)." As shown, the increase in the credit-shelter trust from $650,000 to $670,663 produces additional inheritance tax of just over $200 and, thus, the parenthetical language would require that the trust be funded with only $650,000.
Therefore, it would be advantageous to change the language in the parentheses to instead refer solely to the pick-up tax. In Indiana, for example, the pick-up tax is called the Indiana estate tax and, thus, the document could instead read, "including state death tax credits (but only to the extent that the funding does not create any additional state estate taxes)." In this way, the trustee would, in effect, be instructed to fund the credit-shelter trust with an amount that could produce a small marginal increase in the state inheritance tax, but would fully use the state death tax credit for the inheritance tax that would be owed.
From Marvin D. Hills, CPA, South Bend, IN
