Life Insurance: Can A Charity Still Benefit?

Copyright 2008 Mondaq Ltd.All Rights Reserved Mondaq Business Briefing

October 29, 2008

LENGTH: 3990 words

HEADLINE: United States: Life Insurance: Can A Charity Still Benefit?

BYLINE: By Wayne Allen

Over the past several years, promoters of various schemes

concerning the application for and issuance of life insurance

policies and the subsequent sale of those policies to third parties

have led most charities to look upon any planned giving technique

involving life insurance with a very suspicious eye. This

skepticism is certainly valid, if not prudent. However, the use of

life insurance in a planned giving scenario is not inherently bad;

it is the perversion of the tool by those exercising poor judgment,

motivated by unbridled greed, that has led to the current

environment regarding the use of life insurance. The purpose of

this article is to discuss the use of life insurance as a way for

charities to increase their giving and to provide a checklist for

charities to use in evaluating whether or not a plan utilizing life

insurance is something the charity will want to consider.

Step 1. Is there an insurable interest?

In evaluating the issue of whether there is an insurable

interest on the life of the insured, there are three fundamental

questions that have to be answered. If the answer to any one of

these questions is someone or an entity that does not have an

insurable interest in the insured, then flags should go up and the

charity should walk away.

Who initiates the issuance of a policy?

Who is the owner of the policy?

Who is the beneficiary of the policy?

In the context of life insurance, Section 10110.1(a) of the

California Insurance Code generally defines an insurable interest

as "an interest based upon a reasonable expectation of

pecuniary advantage through the continued life, health, or bodily

safety of another person and consequent loss by reason of that

person's death or disability or a substantial interest

engendered by love and affection in the case of individuals closely

related by blood or law." Moreover, the law provides that an

insurable interest must exist at the time the policy is

effective.1 In this step, the answer can only be either

the insured or a third party. There is no question that an

individual has an insurable interest in his own life and can name

whoever he wishes as a beneficiary of a life insurance policy on

his own life.2 However, a policy obtained by a third

party on the life of another is void unless the third party

"applying for the insurance has an insurable interest in the

individual insured at the time of the

application."3 In order to buy life insurance on

the life of another, there must be an insurable interest in the

continued life of the insured.4 To allow otherwise would

be to sanction wagering on human life.

It has long been established that Qualified

Charities5 have an inherent insurable interest in the

continued lives of their donors and "may effectuate life ...

insurance on an insured who consents to the issuance of that

insurance." 6

Can an irrevocable life insurance trust (an "ILIT")

have an insurable interest in the insured? Practitioners have for

years utilized ILITs as the preferred vehicle through which to

obtain and own life insurance, largely for tax reasons.7

It wasn't until the Chawla case8 that the

issue of whether an ILIT could own a policy at all was raised.

Interpreting Maryland law, the Court in Chawla found that

because the ILIT had "an interest that arises only by, or

would be enhanced in value by, the death ... of the

individual" the ILIT did not have an insurable interest in the

insured and therefore the policy was void. On appeal9

the Fourth Circuit affirmed the lower Courts ruling on other

grounds, but found that the District Court's ruling as to

whether an ILIT has an insurable interest in the individual insured

"unnecessarily addressed an important and novel question of

Maryland law" and vacated that portion of the District

Court's ruling. It is, as they say, hard to unring the bell.

The issue of an ILIT's insurable interest in an insured is

"on the table" and must be addressed. Many states have

either changed their statutes, or have adopted a "look

through" principle whereby in order to determine whether an

ILIT has an insurable interest, you would need to look through the

ILIT to the trustee or beneficiary of the trust.

Step 2. Is the policy going to be financed?

In order to manage the costs of a life insurance policy, it may

be necessary to procure financing to cover the policy premiums. So

long as funds are borrowed to meet a demonstrated financial or

business need, premium financing is considered a legitimate way to

finance life insurance policies.10 In fact, almost all

insurers will accept applications that include the legitimate need

for premium financing arrangements.11 There is nothing

wrong with financing the acquisition of any asset, including life

insurance. Whether the economics of the financing vehicle justify

its use with respect to a particular policy in a specific set of

facts is outside the scope of this article; but, on its face the

concept of premium financing is just fine. However, there is no

such thing as a free lunch and there's no such thing as

legitimate free insurance. A red flag should be raised when the

life insurance is advertised or promoted as free insurance. If the

insured does not have at least some level of financial risk and/or

detriment, then the chances are that there could be an issue.

Nonrecourse financing should be avoided. Other financing

arrangements should be analyzed on a case-by-case basis to verify

that the financing tool make sense under the circumstances. In

evaluating whether a donor has incurred any financial cost or

detriment by causing an ILIT to purchase insurance on his life

through any financing arrangement, it is important to understand

that in addition to contributions of cash to the ILIT or guarantees

given to the lender, the insured will incur a real cost and

financial risk when he names a charity as beneficiary since the

insured is ceding all or part of his excess capacity to purchase

additional life insurance. Remember, financial risk is only one

aspect of skin in the game. Even though required for family or

business reasons, future purchases of life insurance may be

prohibited or sharply curtailed. It is imperative that the would-be

insured is made fully aware of his true financial risk/cost when

entering into a program.

The skin-in-the-game theory is not mandated by any state or

federal law. It is a theory created by the insurers and lenders to

differentiate proper funding techniques from STOLI, IOLI and/or

CHOLI. Is there really a need for additional skin in the game if

the charity is the only beneficiary of the ILIT, the donor receives

no cash and no tax deduction is taken? If, on the other hand, the

beneficiary is a family member or business associate, then,

perhaps, the insured, no longer a donor, should have additional

skin in the game.

Step 3. Is there a plan to sell the policy from the

outset?

There may come a time when a policy owner no longer needs or

wants an existing life insurance policy; in this context the owner

has every right to sell the policy to a third party for its fair

market value. In Grigsby v. Russell, the Supreme Court

noted that life insurance possessed all the ordinary

characteristics of property, and therefore represented a

transferable asset.12 The decision established a life

insurance policy as property that contains specific legal rights,

including the right to: name the beneficiary, change the

beneficiary designation, assign the policy as collateral for a

loan, borrow against the policy, and sell the

policy.13

Under the California Insurance Code, insurable interest is only

required at the time the contract becomes effective, and is not

required at the time the loss occurs.14 Consequently, in

California, the owner of a life insurance policy can sell the

policy to a third party on whatever economic terms can be

negotiated, transfer the policy to such third party, and when the

insured dies, the third party will collect the death benefit.

Again, there is nothing wrong with this concept.

The problem arises when there is a prearranged plan to sell the

policy to a third party. This is where greed and stupidity often

intersect. There are countless articles, blogs, commentaries, news

stories and the like concerning what has become known as Stranger

Owned Life Insurance (commonly known as "STOLI"). As

discussed above, there is nothing wrong with financing life

insurance. Similarly there is nothing wrong with selling a life

insurance policy. The problem arises when investors (who are

otherwise strangers to the insured) initiate a plan whereby a

policy will be taken out on the life of the insured that calls for

financing the premium and selling the policy to a third party

investor group for a profit. In fact, in this scenario, the problem

begins at the beginning of this article with insurable interest and

continues through the premium finance methods used to finance the

policy and ultimately ends with the sale of the policy to a third

party investor for a profit. This is not the legitimate use of life

insurance, but pure and simple wagering on the life of the

insured.

The purpose of this article is not to discuss at any length the

history or impropriety of STOLI, or its cousin Investor Owned Life

Insurance ("IOLI"). Suffice is to say that there is

nothing new under the sun, and so it is with the basic tenants of

STOLI and IOLI. Investors have been trying for over 125 years to

find ways of profiting from life insurance on others by doing

indirectly what the law would not allow them to do directly.

Indeed, while affirming that life insurance is property that can be

sold, the Court, in Grigsby v. Russell, drew an important

distinction between a policy backed by a legitimate insurable

interest and one originally backed by an insurable interest, but

clearly purchased with the intent to sell to a third party investor

without an insurable interest.15 When an arrangement is

specifically designed to circumvent wellestablished insurable

interest laws, it will likely be void. In fact, many states have

adopted or are considering legislation such as SB 1543

pending in California that is designed to restrict the

sale of policies and otherwise govern the life settlement industry.

In an effort to protect legitimate life settlement transactions and

prohibit the use of STOLI type transactions, Organizations such as

The National Association of Insurance Commissioners

("NAIC") and The National Conference of Insurance

Legislators ("NCOIL") have also weighed in on the

issue.16 The best practice is, where there is even the

hint of a plan to sell the policy at some point in the future, the

best course is to stay away.

The Combination: CHOLI

Life insurance policies that are purchased by charities on the

lives of key donors with the intent to buy and hold the policies

can be very useful tools if implemented properly. There are an

infinite number of schemes that have been proposed to charities

that include independently legitimate techniques, which when

combined, create a recipe for disaster. It is when charities

attempt to "rent-out" their insurable interest for the

private gain of others that charities should beware. These complex

arrangements are closely related to the STOLI and IOLI schemes, and

are often referred to as Charitable-Owned Life Insurance <p>

("CHOLI"), and the like. Though each scheme includes

variations, most include the same core techniques. Historically,

one of the defining elements of a CHOLI scheme is the planned sale

of a policy. Ordinarily, investors initiate the arrangement by

encouraging charities to purchase life insurance policies on their

senior donors, the premiums are then borrowed from a financial

institution, and shortly after procuring the policy, the policy is

sold to a life settlement investor group. The life settlement

company ordinarily does not have an interest in the life of the

insured, but in fact an interest in his early death. It is not the

transfer of the policy, but rather the original purchase of a

policy with the intent to transfer to an investment group, that

goes against the very purpose of established insurable interest

laws. Most states insurable interest laws would not allow these

investor groups to purchase such policies directly, thus they

"borrow" the insurable interest of the charity to acquire

the policy as an investment. These life settlement groups are

essentially gambling on the life of the insured.

Regulation Anyone?

Over the past couple of years, almost half the States have

initiated some type of regulatory activity aimed at addressing

STOLI issues and others have issued regulatory guidance on the

issue. The Federal response was contained in the Pension Protection

Act of 2006 ("PPA 2006").17 Originally, PPA

2006 proposed a 100% excise tax on CHOLI, which would have

effectively ended the use of the technique. However, the final

version was changed to a reporting requirement, which required

charities involved in insurance plans from August 17, 2006 to

August 17, 2008, to report detailed specifications of the

arrangement to the IRS. IRS Forms 8921 and 8922 require charities

to report and disclose the specifics of each life insurance

transaction, including information about the charity, the other

participants in the transaction, and a detailed description of the

financial arrangement. The information provided by IRS forms 8921

and 8922 will be used as part of a two-year study of CHOLI that

will be released in 2009. The study will evaluate whether the

activities of participating charities are consistent with their

tax-exempt status.

Even though PPA 2006 required charities to report any

transaction in which a charity and any other person had an interest

in a life insurance policy, it important to note that if the

interest of a charity was merely as a beneficiary of a trust, it

does not appear that there was a reporting requirement. It makes

sense. PPA was intended to capture those charities that may have

been involved in CHOLI transactions. There is a distinct difference

between a charity actively participating in the transaction, owning

the policy, and possibly using its taxexempt status to benefit

others, a charity that is simply the beneficiary of a trust, with

no rights, powers or duties with respect to the trust or its

activities. Moreover, IRS Notice 2007-24 specifically provides that

"under Section 6050V(d)(2)(B)(ii), an insurance contract is

not an applicable insurance contract if the applicable exempt

organization's sole interest in the contract is as a named

beneficiary." In other words, if a charity is just a

beneficiary and never had and does not have any other interest in a

life insurance policy, PPA 2006 would not apply to that charity.

Surely, being the beneficiary of an ILIT would be more remote.

Although the sun has set on the federal legislation, it has

definitely not set on the issue; it will be interesting to see what

the Service does with its findings when announced in February of

2009.

Risk to the Charity

Involvement by a charity in an IOLI/CHOLI type scheme may put

the charity in danger of a variety of risks, including, but not

limited to a number of tax risks. In addition, it is a fundamental

tenet of any charitable organization that its taxexempt status is

"not to be used to enrich or benefit an individual (or entity)

other than those for whom (or which) the charitable status was

granted and intended." 18 Therefore, involvement in

CHOLI scheme that benefits investors may risk a charity's

tax-exempt status.

In addition, Involvement in CHOLI schemes could put a charity at

risk of being entangled in litigation. CHOLI schemes are complex

financial transactions and the resulting tax and legal issues can

be significant. If an insurance carrier were to refuse to pay on a

policy citing a lack of insurable interest, for example, the

investors may well involve the charity in legal action. Securities

and licensing issues could be raised in the event of litigation.

This result could have not only detrimental financial consequences,

but the stain to the charity's reputation for having

participated would be far greater.

For several reasons, including the foregoing, a prudent charity

will not involve itself in a CHOLI scheme. However, it is important

to remember that not all transactions proposed to a charity are

CHOLI transactions.

Step 4. But Wait, Don't Panic.

At the outset, I indicated that the purpose of this article was

to discuss the use of life insurance as a way for charities to

increase their giving, and to provide a checklist for charities to

use in evaluating whether or not a plan utilizing life insurance is

something the charity will want to consider. Here's the

Checklist:

1. Is there total transparency? Total

transparency requires complete knowledge of the transaction not

only by the charity, but equally as important, by the donor, the

insurance company and the lender, as well as the ability to verify

all aspects of the transaction. If there is total transparency,

then move on to number 2.

2. Is the charity's donor list being

hijacked? Is a promoter or investor asking for access to

the charity's donor list, or in any way attempting to position

itself as the contact point for the donor? If so, walk away; if not

move on to number 3.

3. Is the insured actively involved in the

process? If the would-be insured barely even knows

what's going on, stop. If a charity's donors want to use

life insurance as a way to enhance their ability to give to the

charity and are actively involved in the process, then move on to

number 4.

4. If an ILIT is to be used, will it have an insurable

interest? Generally, if the insured is a donor of the

charity, and the charity is a beneficiary of the ILIT, it seems

there will be an insurable interest. Move on to Number 5.

5. Is the Trustee of the ILIT a true independent

trustee? If the trustee of the ILIT is an independent

trustee or designated by the donor, then proceed to Number 6.

6. Is a finance arrangement used to pay the policy

premiums? Financing the premiums constitutes a legitimate

way to pay for the policy if it fulfills a demonstrated financial

or business need. Move on to Number 7.

7. Is additional skin in the game required? If

the donor is actually contributing money or is otherwise at risk to

some financial degree such that the insurance is not without cost,

then move on to Number 8.

8. Is there any evidence of a plan for the ILIT to sell

the policy? If there is a plan to sell the policy at some

point in the future, then the charity should never be involved. If

on the other hand, if there is no plan to sell the policy, and

certainly if the trust document precludes the sale of the policy to

a third party, then proceed to Number 9.

9. Is the lender entitled to the death benefit?

If the finance arrangement entitles the lender to a portion of the

death benefit above and beyond the repayment of the principal,

interest on the loan, and justifiable costs associated with making

the financing available for the long-term, then a charity should

not be involved. If however, the arrangement is traditional

financing model, where the lender is paid only to recoup its costs

and the remainder of the death benefit is paid to the charity,

continue to Number 10.

10. Is there a plan to transfer the ownership of the

policy to the lender in exchange for forgiveness of the

loan? Similar to selling the policy, if there is a plan to

transfer the policy to the lender in order to satisfy the loan, the

charity should not be involved. Conversely, if the loan will be

repaid by the death benefit, proceed to Number 11.

11. Does the Charity ever have any interest in the

policy? If the charity

has no interest in the policy; and

the charity is only a beneficiary of a trust

established by the donor; and

there is no renting of the charity's exempt status;

and

no deduction is available to the donor, then proceed with the

transaction.

In closing, the following examples may provide some

guidance:

Example 1. If a donor applies for a

life insurance policy and names a charity as the beneficiary of

that policy, there is certainly an insurable interest. Then, if the

donor finances the premium on such policy (having some financial

risk concerning the loan) and does not have an intent to sell the

policy at the time the policy becomes effective, the transaction

should be fine and when the donor dies, the charity will receive,

very appropriately, all of the death benefit after the lender is

paid.

Example 2. If a donor forms a

revocable trust, naming himself as trustee and a charity as the

beneficiary of the trust, and then causes the trust to apply for

and obtain an insurance policy on the life of the donor, it is

difficult to see how there could not be insurable interest. Then,

if the trust finances the premium on such policy (having some

financial risk concerning the loan) and does not have an intent to

sell the policy at the time the policy becomes effective, the

transaction should be fine. When the donor dies, the trust will

collect the death benefit, and after paying the lender, will

distribute the net proceeds to the charity, as the beneficiary of

the trust.

Example 3. If a donor forms an

irrevocable trust, naming an independent third party as the trustee

and a charity as the beneficiary of the trust, and then consents to

the trust applying for and obtaining an insurance policy on the

life of the donor, it is difficult to see how there could not be

insurable interest. Then, if the trust finances the premium on such

policy (having some financial risk concerning the loan) and does

not have an intent to sell the policy at the time the policy

becomes effective, the transaction should be fine, when the donor

dies, the trust will collect the death benefit, and after paying

the lender will distribute the net proceeds to the charity, as the

beneficiary of the trust. Charities can indeed still benefit from

life insurance policies.

Footnotes

1 California Insurance Code Section

10110.1(d)

2 Section 10110.1(b); Paul Revere Life Ins. Co. v. Fima,

105 F3d 490 (9th Cir. 1997).

3 Section 10110.1(e)

4 Cal. Ins. Code Para. 280.

5 A charitable organization that meets the requirements

of Section 214 or 23701d of the California Revenue and Taxation

Code. IRC Section 501(c)(3)

6 Cal. Ins. Code Para. 10110.1(f).

7 The ILIT applied for and owned a policy from inception,

the three-year rule (IRC Section 2035) would not apply and since

the ILIT held the policy and assuming the insured had no incidents

of ownership, the reach of IRC Section 2042 could be

avoided.

8 Chawla v. Transamerica Occidental Life Insurance

Company 2005 WL 405405 (E.D. Va. 2005).

9 Chawla v. Transamerica Occidental Life Insurance Co.,

440F.3d. 639 (4th Cir.2006)

10 Stephan Leimberg, Investor Initiated Life

Insurance: A Sober Look is Needed! (2007),

http://www.acli.com/NR/rdonlyres/3CB50E64-DA1D-4B10-BC9DBA81B22A7ED6/

10012/LeimbergStephanOutline2.pdf.

11 Id.

12 Grigsby v. Russell, 222 U.S. 149, 156

(1911).

13 Chris Orestis, Protecting the Golden Goose,

Insurance News Net Magazine, April, 2008, at 27.

14 Cal. Ins. Code Para. 10110.1(d).

15 Id.

16 In an effort to deter STOLI transactions, NAIC's

Viatical Settlements Model Act ("NAIC Act") prohibits

settlement of life insurance policies for five years from the date

the policy is issued when the policy is purchased for the purpose

of selling into the secondary market. Similarly, NCOIL's Life

Settlement Model Act ("NCOIL Act") proscribes regulation

to deter the use of STOLI transactions. Though the NCOIL Act does

not have a five-year prohibition, it provides a definition of STOLI

and characterizes a violation of STOLI as a fraudulent settlement

act.

17 Pension Protection Act of 2006, Pub. L. No. 109-280,

Para. 1211, 120 Stat. 780.

18 Stephan Leimberg, Dying for Charity: A New Breed

of Golden Goose that Lays Rotten Eggs? (2004),

http://cpsinsurance.com/prodspread/leimberg/Sept04%20Leimberg.pdf.

The content of this article is intended to provide a general

guide to the subject matter. Specialist advice should be sought

about your specific circumstances.

Buchalter Nemer
1000 Wilshire Boulevard, Suite 1500
Los Angeles
California
90017-2457
UNITED STATES
Tel: 2138910700
Fax: 2138960400
E-mail:
[email protected]
URL:
www.buchalter.com

(c) Mondaq Ltd, 2008 - Tel. +44 (0)20 8544 8300 - http://www.mondaq.com

LOAD-DATE: October 31, 2008