Brilliant Deduction?

Estate planners are marketing ‘split-dollar’ insurance as a boon for donors, but the IRS wants to know if the strategy is legal

The Internal Revenue Service is looking into a controversial method of giving in which charities appear to pay for life-insurance policies on donors using tax-deductible gifts from the donors — and then share in the policies’ proceeds.

The strategy, called “charitable split-dollar” insurance, already has been used by more than 1,000 donors, who have set up plans with an estimated worth to charities of more than $1-billion. The Oklahoma City Community Foundation and the Osmond Foundation’s Children’s Miracle Network are among the organizations that have participated in the controversial arrangements.

Major financial institutions are marketing the plans. American Express Financial Advisors has authorized its employees to promote the plan, and many agents associated with insurance companies have become licensed promoters of the agreements.

Marc Owens, director of the I.R.S.’s Exempt Organizations Division, said the service is examining whether donors improperly benefit under the plans and whether charities violate federal tax laws by participating in the deals, which currently are being offered by a small number of estate-planning companies and their representatives.

“We’ve got some real questions about what’s going on and why are the charities investing in these things,” Mr. Owens said in an interview. “Charities are supposed to be doing charitable things, not acting as a clearinghouse for one’s life-insurance premiums.”

Even some charities that have used split-dollar arrangements remain leery. Scott Burt, chief operating officer of the Children’s Miracle Network, in Salt Lake City, says that although his group has done “a handful” of split-dollar deals, it shares some of the same anxiety about split-dollar arrangements that the I.R.S. and others are voicing.

If the plans prove to be legally sound, fund raisers and financial advisers believe the approach may unlock billions of dollars in new money for charity.

Conversely, if they are struck down, thousands of donors may lose big deductions and charities that have participated could lose their tax-exempt status.

While the debate over split-dollar plans is exceedingly complex, it hinges to a large extent on two simple questions:

Does a donor receive an improper financial benefit in exchange for a contribution to a charity?

Are charities abusing the tax code by giving donors receipts for their gifts that inaccurately reflect the financial benefits that the donors receive?

Charities are required to provide receipts that accurately show the benefits a donor receives in exchange for a gift. Only the difference between the gift and the benefit is legally tax-deductible.

In a typical plan, a donor makes regular contributions to a charity in amounts that match, or nearly match, the charity’s portion of premium payments on a life-insurance policy that the donor has initiated. The donor claims a tax deduction for the charitable contributions and states in writing that the charity can use the money any way it wishes. Nonetheless, the charity pays all or most of the premiums on the donor’s insurance policy.

The donor controls the policy’s cash-value portion, which accrues as premiums exceed the cost of the policy’s death benefit. The donor can borrow from the cash value tax-free, and an insurance company will release the cash value even if the policy is canceled before death.

When the donor dies, the charity gets a portion of the death benefit. The remainder of the death benefit, as well as the cash-value portion, goes to the donor’s estate.

The government’s concerns about such plans are consistent with those of the National Committee on Planned Giving, a service organization for charities. In a highly unusual move this year, the group called the split-dollar strategy a “high-risk venture” that donors and charities should avoid without first seeking I.R.S. approval.

While split-dollar deals can be structured in a variety of ways, the committee’s focus was on the most common version of the plan, in which the donor controls the policy’s built-up cash value portion and the charity is paid from the policy’s death benefit when the donor dies.

Frank Minton, the committee’s ethics chairman and a planned-giving consultant in Seattle, said the committee worried that a donor or donor’s trust might cancel a policy prematurely and pocket the cash-value portion while leaving the charity with nothing — even though the charity had been paying for all or part of the insurance premiums.

Mr. Minton also said the committee was concerned about a tactic allegedly used in many split-dollar plans: overcharging charities for premiums by using actuarial tables that exaggerate the true cost of life insurance. Artificially high premiums paid by charities may benefit a donor by reducing the amount donors must pay.

Some experts fear that a charity that overpays for an insurance policy may risk losing its tax-exempt status because regulators may conclude that it has acted in a financially irresponsible manner or allowed donors to receive improper benefits as a result of their gifts.

“This thing has some fatal flaws, and the worst part of this is, it puts the [charitable] institutions at risk,” said Douglas K. Freeman, a California lawyer who specializes in planned-giving issues.

Mr. Owens said the I.R.S. is waiting until it knows more about “all the possible variations” before it acts. He did note, however, that the service is “actively looking at” charitable split-dollar plans in pending cases that include both audits of existing charities and applications by new groups seeking tax-exempt status.

A ruling is not likely to be issued before next year, Mr. Owens said.

While the tax service ponders the propriety of charitable split-dollar plans, the strategy seems to be growing apace.

InsMark, a San Ramon, Cal., company that supplies software and other products to insurance agents, is one of the tactic’s most aggressive promoters, marketing a split-dollar arrangement called the Charitable Legacy Plan.

InsMark says that it created between 800 and 1,000 plans last year and that since it began marketing the product in 1997, the total value of death benefits has reached $1.5-billion, of which $600-million is expected to go to charity. Marketing InsMark’s plan is an independent sales force of some 400 insurance agents, financial planners, lawyers, and others who are licensed by the company.

It was plans like InsMark’s that the National Committee on Planned Giving had in mind when it issued its warning on split-dollar arrangements this year, says Mr. Minton. But InsMark officials deny that their plan is an abuse of federal tax law or a threat to participating donors and charities.

“This is not a tax shelter, this is not a scheme, it is not an illusion,” says J. Craig Sullivan, a lawyer in Pennington, N.J., who advises InsMark on the plan. “It is a genuine way of benefiting charity consistent with personal objectives.”

Thomas A. Peterson, president of On Trak Administration Services, which monitors the policies sold by InsMark licensees, says InsMark has taken steps to insure that donors do not terminate the policies early and deny charities the opportunity to collect on the death benefit. “There is a contractual obligation on the part of the policy owner to maintain that policy in force,” says Mr. Peterson, who owns On Trak in partnership with Robert B. Ritter, Jr., InsMark’s chief executive. “You can always get burned, but we are working vigorously to strengthen that contract language.”

Mr. Sullivan and Mr. Ritter said they crafted their plan specifically to clear federal-tax-law hurdles.

One of those hurdles is a rule stipulating that a donor cannot take a tax deduction on a charitable gift if the donor retains part ownership of the gift. Critics say a donor retains a partial interest in an insurance policy when a charity uses the donor’s cash gifts to pay the policy’s premiums.

InsMark officials argue, however, that the partial-interest rule doesn’t apply to their plan. Donors typically do not own the policy directly, they point out. Instead, donors set up a separate entity, such as an irrevocable life-insurance trust to do that. Thus, they argue, the donor is too far removed from the transaction to be guilty of violating the partial-interest rule.

Company officials also say their plan does not give donors an improper private financial benefit in return for their cash gifts to charity. In the InsMark plan, they note, a donor’s life-insurance trust pays 10 per cent of the premiums, while a charity pays 90 per cent. By paying a small part of the premium, argues Mr. Sullivan, donors are shielded against charges that they are getting something for nothing.

What’s more, Mr. Sullivan and other split-dollar advocates contend, there is no link between a donor’s cash gifts to a charity and the charity’s premium payments. The gifts, they point out, are always accompanied by a written statement stipulating that the charity can use the money in any way it wishes.

“The argument that there is some benefit coming back from the split-dollar agreement is totally without support,” Mr. Sullivan said.

But critics scoff at assertions that split-dollar plans comply with the government’s rules against personal benefit from charitable donations. A donor or donor’s trust stands to reap huge financial rewards, including tax breaks, from an insurance policy paid mostly or entirely by a charity, they argue.

Critics also contend that a link often does, indeed, exist between donations and insurance benefits in split-dollar arrangements. They point to the dollar-for-dollar match between premiums and donor contributions. That match, say the critics, shows that the donor has every expectation that the charity will use the money to pay the insurance premium.

Mr. Owens said that the question of linkage between a donor’s cash gift and payment of premiums is one of the issues the I.R.S. wants to know more about.

“If you find that, surprise, with the exception of a small carrying fee, everything that comes in goes to premiums, you begin to wonder if there hasn’t been an understand ing” between a donor and the charity participating in the split-dollar plan, he said.

Whether it is possible to structure a split-dollar deal in a way that does not raise serious regulatory questions remains an open question.

Emanuel J. Kallina II, a Baltimore lawyer, believes that he has found a way to remove such concerns. Mr. Kallina, who chairs the Government Relations Committee of the National Committee on Planned Giving, said he had asked the I.R.S. for a ruling sanctioning two specific split-dollar arrangements that he developed and that he believes pass muster.

Mr. Kallina said that his plans guarantee charities a “reasonable” rate of return on their investments in a donor’s life-insurance policy and that the plans price the premiums at a proper level.

But Mr. Kallina said the I.R.S. told him that it would not rule on his proposal, a fact that he and other other proponents of split-dollar agreements find significant.

“I’m interpreting that to mean that they [I.R.S. officials] could not find anything wrong with my plan but did not want to give it approval,” says Mr. Kallina.

Mr. Owens cautioned that charities and donors should not take comfort in the fact that I.R.S. so far has not ruled on split-dollar plans.

“I wouldn’t read anything into the absence of a notice or revenue ruling that could be interpreted as I.R.S. approval or somehow a finding that there are not tax consequences with regard to these arrangements,” Mr. Owens said.

Some close observers have suggested that Congress could shut down the split-dollar strategy even before the Internal Revenue Service or a court rules on it. Indeed, some Capitol Hill insiders say privately that lawmakers are watching the issue closely.

But a challenge by the tax service is more likely to come first.

Even if the I.R.S. decides that charitable split-dollar plans violate tax law, proponents aren’t inclined to let the matter rest. InsMark officials say they will take their case to federal tax court if the I.R.S. rules against them.

Mr. Sullivan, the InsMark lawyer, points out that many other planned-giving approaches once considered revolutionary and potentially out of legal bounds were sanctioned by the U.S. Tax Court after being challenged by the I.R.S. “My guess is that is what ultimately will happen here,” he says of split-dollar plans.