Using an IRA to Finance Charity-Owned Life Insurance

By Stephan R. Leimberg

PLR 200741016 concludes that the IRA-life insurance combination (described below) is not a prohibited transaction that would cause the IRA involved to be disqualified under Code Section 408(e)(2) and that the investment in life insurance by a charity generated through loans from the IRA will not be a prohibited investment in life insurance under Code Section 408(a)(3).

FACTS:

HOW DOES IT WORK?

According to its marketer, the "CHIRA" is a method to use a person's IRA to help a charity purchase needed life insurance on the life of a key supporter/donor without triggering either immediate income taxation on an IRA distribution or forcing the charity to wait until the donor's death to benefit.

Essentially, the technique involves:

• a roll-over of funds to an approved, self-directed IRA. The donor and the charity initiate the underwriting process.  Then,

• an arms' length loan is made from the donor's IRA to the selected charity. The loan will be secured by a new life insurance policy purchased by the charity on the life of the donor or some other individual on whose life the charity has sufficient insurable interest and the charity signs a promissory note in favor of the IRA.

• The charity collaterally assigns that portion of the death benefit equal to the outstanding loan from the IRA to the IRA.

The donor's IRA lends the selected charity $100,000. The charity, in turn, allocates a portion of that money, assume $50,000, to pay premiums on a new policy on the donor's life.

The charity owes and must pay interest (only) annually on the $100,000 loan. The charity reserves a certain amount, say $30,000, to pay the interest giving it $20,000 of immediate and unrestricted cash which can be used by the charity. (Should this amount be insufficient, it would be necessary for the charity to request the assistance of its donors to satisfy the need to make required interest payments).

At the donor's death, the charity receives $100,000, which is first used to pay off the principal of the loan with any excess remaining with the charity.

COMMENT

Information from the marketer of this concept stresses that:

(1) the loan from the IRA is an arms' length - interest only - fully secured - loan bearing current fair market rates, i.e., a legitimate investment and should therefore not be considered a taxable distribution from the IRA,

(2) the principal of the loan is due in full upon the insured donor's death,

(3) interest payments made by the charity to the IRA are not taxable to the donor,

(4) there is no intent to resell or settle the policy nor are there outside investors; the intent from inception is for the charity to own and be the beneficiary of the policy and hold the policy and receive the entire policy proceeds at the insured's death,

(5) there is no charitable deduction involved and so there are no age limitations or other Pension Protection act of 2006 (PPA 2006) restrictions,

(6) neither the taxpayer nor the IRA, a fully secured arms' length creditor, is ever entitled to any of the death benefits under the policy, and

(7) neither the taxpayer nor the IRA will own or have any right to any beneficial interest in or any right to surrender, convert, pledge, cancel, or sell the policy - which is to be wholly owned by and payable to the charity.

WHAT THE PLR REQUESTED

The PLR is dated July 12, 2007 and requests a ruling concerning the tax treatment under Code Section 408.

According to the facts in the ruling, the taxpayer created a self-directed rollover IRA with a deposit from an existing IRA. The self-directed IRA made a loan to a church, a tax-exempt qualified charity of which the taxpayer was neither an employee nor board member.

The taxpayer represented that he had not and had no intention of taking a tax deduction in conjunction with the loan.

In exchange for the loan to the church, the IRA will receive a twenty-year promissory note which provides that the church promises to repay to the IRA custodian the principal amount and will pay interest at 5% annually.

A final balloon payment will be made upon the earlier of the end of the twenty years or within one hundred twenty days, or a reasonable period after the date of death of the insured taxpayer.

Prepayments are allowed without penalty.

The church grants the IRA a continuing security interest in the insurance policy that is to be collaterally assigned within a reasonable period of time after the note is signed. The church will have no right to borrow on it or transfer any rights to it without the express written consent of the taxpayer.

At this point, two documents have been used to assure "commercial reasonability", the collateral assignment and the promissory note.

INSURABLE INTEREST - A SMALL ODDITY

Strangely, the taxpayer represented to the IRS that the purpose of the security agreement within the promissory note was to "provide additional certainty for Taxpayer that the ownership of the insurance policy, will, from the date of purchase until the date of death, continue to qualify as an insurable interest under state law."

The PLR stresses "the intent to have two collateral agreements is to provide ample protection, outside of the contractual terms set forth within the insurance company's collateral assignment, that there will be a continuing "insurable interest".   

Insurable interest is a very important consideration in ANY purchase of life insurance, especially those by a third party such as a charity.  But the IRS is certainly not typically the arbiter of the existence or non-existence of insurable interest; that is almost always a state law issue - and the Service was not asked about it here.

Nor is the post-issuance of insurable interest typically a concern; in most cases involving life insurance, either there was - or was not - insurable interest at inception and that is the only time most courts have focused on.

Certainly, the two collateral agreements appear neither to add nor contract from whatever insurable interest may have been present at inception - so the whole thing about insurable interest in the PLR is puzzling.

TO WHOM IT MAY CONCERN:

The ruling, provided by the manager of the Employee Plans Technical Group 2, addresses two points:  (1) whether or not this technique is a "prohibited transaction" under Code Section 4975 such that the IRA would no longer be considered an IRA under Code Section 408(e)(2) and (2) whether the transaction is a "prohibited investment in insurance" under Code Section 408(a)(3).

DOES THIS TRANSACTION CAUSE TERMINATION OF IRA STATUS?

Code Section 408(e)(2) (A) terminates IRA status as of the first day of the individual IRA owner's taxable year if an individual for whose benefit an IRA is created (or his/her beneficiary) engages in a prohibited transaction.  The result of a violation is that the entire account is treated as having distributed all of its assets at that time.

The question is, was there the requisite prohibited transaction, i.e., was there any direct or indirect lending of money or other extension of credit between an IRA plan and a "disqualified person" (including fiduciary, person providing services to the plan, employer, etc.) §

With respect to this issue, the Service concluded that the church was not related to the IRA in a manner that would fall within the disqualified person definition - particularly since the taxpayer involved was not a board member or employee of nor did he own a financial interest in or control the church.

So the IRS ruled that the transaction would not be considered a prohibited transaction that would cause the IRA to be considered to have terminated and distributed its account.

DID THE IRA ENGAGE IN A PROHIBITED TRANSACTION WITH RESPECT TO THE LIFE INSURANCE?

As to the second issue of whether the IRA engaged in a prohibited investment in life insurance, the Service noted that the church, and not the IRA, would own the policy and all incidents of ownership in it as well as pay all premiums and retain all major economic rights including the right to receive all of the policy's proceeds at the insured's death.

The Service therefore concluded on this issue that the transaction would not be a prohibited investment in insurance that would cause the IRA's tax status to terminate.

WHAT QUESTIONS SHOULD HAVE BEEN ASKED THAT WERE NOT?

PLRs protect only the taxpayer who asked the questions and only with respect to the questions asked.

Note that the ruling did not speak to any other aspects or issues of federal or state law.  These, of course, must be considered.

Nor does the ruling address (and few do) the "workability" aspects; i.e. does this technique give the donor, the IRA, the charity, and each of the other parties involved something more than they had before - or could have had using an alternative method.

In other words, a practitioner examining this concept must ask

"What are the pros and cons of alternative methods and courses of action when compared with this approach?"

THE BOTTOM LINE

The Service has provided us with two key answers to yet another way to benefit charities.

For the client willing to let his/her IRA do some of the "heavy lifting" (at the potential expense of giving up possibly higher income and capital gains from some alternative investment) and the charity willing to borrow money on the hopes that the present value of policy proceeds will exceed the present value of the loan capital and interest, the CHIRA appears to be yet another technique planners should consider.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Steve Leimberg

CITE AS:

Steve Leimberg's Charitable Planning Newsletter # 129   (October 16, 2007) at http://www.leimbergservices.com/    

Copyright 2007 Leimberg Information Services, Inc. Used by Permission. Reproduction in Any Form or Forwarding to Any Person Prohibited - without Express Permission.

CITES:

PLR 200741016.