Taxpayers, ever seeking tax deductions, often get entangled with questionable schemes; to wit, abusive charitable deductions have become all too commonplace. And charities, under enormous pressure to raise funds, sometimes engage in transactions that violate their tax-exempt status.
Recent ploys involve efforts to claim a charitable deduction for transactions that principally benefit the donor (taxpayer), not the charity. Two such schemes are the split-dollar life insurance arrangement and the charitable limited family partnership (CFLP).
The taxpayer, purchases, either directly or through a trust, a cash-value life-insurance policy, insuring his life, with the bulk of benefits flowing to his family. The taxpayer then donates money in the amount of each premium to the charity, and in turn, the charity pays the life-insurance premiums. For its participation, the charity later receives a small portion of the policy's benefits when it pays out.
The result: By routing payments through a charity, the taxpayer claims a charitable deduction; without participation by the charity, premium payments would be a non-deductible personal expense.
NOTE: With a cash-value life-insurance policy, thanks to tax-deferred growth over time (similar to an IRA), premium payments will exceed the amount necessary to pay for the actual life insurance. The excess premium stays in the policy and grows tax-deferred, thus producing a cash build-up.
IRS has aggressively attacked the split-dollar life insurance ploy, labeling it abusive and warning taxpayers, their advisors, and the charities involved that they all face taxes and huge penalties if they persist in using this gambit. Charities are now plainly at risk of losing their tax-exempt status. See IRS Notice 99-36 (June 14, 1999). NOTE: Senate Finance Committee Charitable Split Dollar Legislation, Section 406 will deny a charitable deduction for split-dollar insurance transactions.
As IRS notes, there is no charitable deduction for any transfer of less than a taxpayer's entire interest in that property, including life-insurance policies. Although the transaction takes several steps to avoid this rule, IRS is not required to respect the form of a transaction when the form differs from the substance.
Here, the substance is obvious: The taxpayer is making premium payments on a life insurance policy that benefits himself or his family, and such payments are not deductible
Charities engaging in these transactions should be extremely nervous. IRS could assess additional taxes on excess-benefit transactions, or self-dealing penalties against the donor and the charity's managers.
Charities that provide false documentation supporting donor deductions could be liable for aiding and abetting the understatement of tax liability by the donor. Other participants (promoters, financial advisors) could be penalized as tax preparers, promoters, and aiding and abetting the understatement of tax liability by taxpayers.
Those charities currently involved with these policies should bail out immediately. They should consider assigning the charitys rights to a third party and inform the donor that future donations will not be used to pay insurance premiums.
The CFLP differs from the traditional family limited partnership in that a charity becomes the major limited partner. This allows any tax gain from the sale of an appreciated asset (such as real estate or a family business) to be charged to the charity. Because the charity does not pay tax, the sale is then transformed into a tax-free transaction.
Usually, the sales proceeds stay in the partnership. Future income finds its way to the donor, usually through management fees. Special clauses are typically inserted into the agreement permitting the taxpayer's family to repurchase the charity's limited partnership interest for pennies on the dollar.
The presumed result: a large up-front charitable deduction, the sale of appreciated assets tax-free, retention of the sale proceeds in the partnership, and the repurchase of the charity's partnership interest for pennies on the dollar.
IRS has announced the CFLP is under serious scrutiny and warns those involved with CFLP they could be engaging in abusive tax shelters, which means the taxpayers, promoters and charities could be subject to taxes and large penalties. Also, a charity is risking its tax-exemption.
IRS abhors transactions abusing a charity's tax-exempt status to produce an improper tax benefit. Both the split-dollar life insurance and CFLP schemes violate the basic rules for deducting a charitable contribution. Worse, the charity is placed in jeopardy by participating in such programs.
It is just a matter of time before Congress and IRS shuts down abusive CFLPs. Those participating in these transactions are swimming in shark-invested waters.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**