Limitations on the Charitable Deduction

Although, as a general rule, the income tax charitable deduction is equal to the fair market value of the contributed property, the tax law does provide an important exception. If a sale of the property on the date of the gift would have produced ordinary income, the amount of such ordinary income reduces the allowable charitable deduction.

A transfer for value or surrender of a life insurance policy will usually produce ordinary income when the sale or surrender proceeds are greater than the net cost of the policy to the insured. Thus, the amount of the contribution for an outright charitable gift of a life insurance policy is deemed to be the lesser of the fair market value of the policy and the net cost of the policy to the insured. Click here for an example.

There is also an overall percentage limitation on the income tax charitable deduction. Contributions for the year, including life insurance policies, cannot be deducted in excess of 50% of the donor's adjusted gross income for contributions to public charities. If contributions exceed this limit, the excess may be deducted in up to five succeeding tax years.

Premium Payments

Premium payments made by the donor after the policy has been transferred to a charitable institution may be considered gifts "for the use of" the charity if the premiums are paid directly to the insurance company. Gifts "for the use of" charity are deductible only up to 30% of the donor's adjusted gross income. On the other hand, transfers of cash to the charity in the amount of the premium are considered gifts "to" the charity (which then pays the premium itself), and are deductible up to 50% of the donor's adjusted gross income. The cash gifts for premium payments are usually made 20-30 days prior to the premium due date to allow charity to pay the premiums in time to prevent a policy lapse.

The donor may want to consider transferring appreciated property to the charity to pay annual premiums. The full value of the property will be tax-deductible, including the gain that has never been taxed, and the charity will not have to pay capital gain tax on the appreciation. Because the charity is tax-exempt, it can sell the property and use the full proceeds to pay the premiums.

Charity-owned Life Insurance

Charity-owned life insurance (CHOLI) operates in a similar fashion to the controversial corporate-owned life insurance (COLI), policies that employers take out on a large number of rank-and-file employees with the employer designated as the beneficiary. With a CHOLI policy, typically a promoter approaches a charity and recommends the purchase of life insurance policies on consenting donors. Then the charity borrows money from an outside lender or the life insurer to pay premiums on these policies. Upon an insured's death, the life insurance proceeds pay off the loan, and any remaining funds go to the charity.

Does the charity have an insurable interest in donors? Employees? How substantial must contributions have been for a charity to have an insurable interest in a particular donor? How far up the hierarchy must an employee be? Answers to these questions may vary from one state to another. 

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