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)" p. 642, 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