|EXECUTIVE SUMMARY |
Gifts of life insurance policies to not-for-profit organizations can benefit both the organization and the donor, the latter in the form of an often sizeable income tax deduction. However, under the new requirements of the Pension Protection Act of 2006 (PPA), determining the fair market value of policies will require the help of an appraiser with the appropriate expertise and experience.
Cash-value policies, such as whole life, are valued at fair market value, limited by their cost basis. A paid-up policy is valued at its replacement cost. A policy that is not fully paid up is valued at the lesser of premiums paid or its interpolated terminal reserve amount.
The PPA now requires non-cash charitable contributions to be appraised by a qualified appraiser according to generally accepted appraisal standards. The Uniform Standards of Professional Appraisal Practice (USPAP), developed by the Appraisal Standards Board of the Appraisal Foundation, is considered as satisfying this requirement.
A qualified appraiser is one who, among other things, performs appraisals regularly and is qualified by experience, education and other factors to appraise the type of property in question. He or she must have earned an appraisal designation from a recognized professional appraiser organization or meet minimum requirements for education and experience. For returns filed since February 2007, such education includes relevant college or professional-level coursework. Experience must include at least two years of buying, selling or valuing similar property.
In addition, the PPA increased taxpayer penalties for appraisals that cause a tax understatement. Alan Breus, CLU, ChFC, is principal of The Breus Group of San Jose, Calif., a qualified member of the Appraisers Association of America and an insurance adviser to Northwestern University. He can be reached at firstname.lastname@example.org or www.thebreusgroup.com.
N ot everyone can make a multimillion-dollar bequest to his or her alma mater, but many alums have an insurance policy for which they might easily be persuaded to name their school or another not-for-profit organization as owner and beneficiary.
University development offices and other prospective nonprofit beneficiaries are well aware of this, and many encourage gifts of policies. What they and prospective donors might be less sure of—and consequently need your help in deciding—is how to properly value donated life insurance interests for tax purposes. And you may need to brush up on the new provisions for qualified appraisals under the Pension Protection Act of 2006 (PPA).
Qualified appraisals are a concern for taxpayers donating noncash charitable gifts of all kinds. The questions of appraiser qualification and responsibility remain an area of concern for the IRS due to a long history of valuation problems dealing with gifted life insurance. Life insurance can be prone to incorrect valuation because of the plethora of types of policies available, ownership and beneficiary issues and misunderstanding of valuation methods of how to apply fair market valuation principles.
Many CPAs may be more attuned to providing an estimate of the value of business interests and other types of assets rather than those required for life insurance policies. This article, therefore, is intended to help you and your clients navigate this murky minefield and offers suggestions on how to find a qualified appraiser who can complete and sign the revised Form 8283 for charitable donations of life insurance interests.
THE COMMODITY ITSELF
For donors, gifted life policies can be a source of tax deductions and can help meet estate and personal financial planning objectives. In some cases, these policies also allow for the building of a less costly legacy with worn-out assets that may no longer be needed. More than 70% of life insurance policies, including group and secondary-market policies, lapse for nonpayment because they no longer meet any pressing estate planning or business planning needs. As noted by the Insurance Information Institute (www.iii.org), a per-year lapse ratio of 7.7% (38.5% lapses in five years) is the industry standard, down from 8.75% per year for the period 1995–2000. Additional material suggests the lapse rate is 3% per year for individuals over 65.
Both these superannuated as well as newly written life insurance policies are a great source of new money for not-for-profits. Empirical mortality tables have the uncanny knack of being correct. It’s not a matter of whether the insured is going to die, it’s when, and if the portfolio of policies is sufficiently diversified, we even know what year that might be within a reasonable margin. Regardless of whether the policy is term insurance, some form of cash-value insurance, assignable old group policies or even the senior settlement payouts from the secondary market, life insurance is a viable tool to the planned-giving community.
In general, the deductible amount of a donated life insurance interest is its fair market value, which is the amount an insurance company would charge for a comparable contract. If the policy has a cash surrender value, that amount is considered the fair market value if the donee intends to cash out the policy rather than hold it as an investment. Otherwise, for fully paid-up whole-life polices, fair market value is considered to be replacement cost. A policy that is not fully paid up is typically valued at the lesser of either total premiums paid or the “interpolated terminal reserve,” an amount designated by the insurer to fulfill its obligations under the contract. It is similar to the cash surrender value and is available from the insurer. In any case, however, the value can be no greater than the policy’s cost basis. A term insurance policy’s value is typically the amount of future premiums that would be paid to maintain the policy.
Example. Mr. A. Giver was a partner in a company that was recently sold to a conglomerate. His interest in the partnership was paid out to him, and his $1 million insurance-funded buy/sell agreement was canceled. Giver’s partner transferred the funding policy to him. No transfer-for-value issues arise when a policy is transferred to the original insured—IRC § 101(a)(2). But after careful review, Giver decided he had no real need to continue the coverage. By donating the policy to his alma mater, the University of Higher Aspirations, he can deduct, in the case of a non-paid-up policy, any new premiums he pays and the lesser of the premiums he has paid or the interpolated terminal reserve value, up to the policy’s cost basis.
In the case of a paid-up policy, the deduction is the cost of replacing the coverage with a comparable policy, again, limited by cost basis. If the policy were term insurance, he would have no accumulated cost basis but can deduct all future dollars he donates to the university for it to pay premiums as maintenance. On an immediate basis, Giver’s deduction is limited to his actual cost of purchase, which may or may not be equal to the total cost basis as noted by the insurance company.
Of course, if Giver were medically impaired, he might go to the secondary life insurance market and sell his policy for some new medically underwritten original issue discount dollar value. If the policy is sold, then Giver is holding cash that is taxable partly as ordinary income (amount over basis up to cash value), with the remainder taxed as a capital asset.
If he then donates that cash to the university, he will receive an immediate tax deduction. If he instead takes the cash and contributes it to a charitable remainder trust, he will receive either an immediate income tax deduction for the contribution or a deduction to offset the income he has to recognize within the trust. This might glean substantial dollars for the university and, through the use of a charitable remainder trust, may give our donor substantial deductions against current income, while the donee university in this way receives a rich and unexpected bequest. This scenario, although interesting in concept, is fraught with possible reporting problems, which may end up being placed at the feet of the qualified appraiser.
Historically, misguided valuations and resulting erroneous deductions have been based on the policy’s total death benefit, or the policy cash value or settlement value from the secondary market, without noting how the original cost affects the amount of the deduction. In other cases, policies with revocable beneficiary designations have been accepted by less-sophisticated charitable organizations and been deducted by the donor. And in yet other cases, policies have been attributed to insurance companies that have never existed.
Although there is no specific format for an appraisal of an insurance policy, it is important to address items of information that are required to be in the appraisal as specified in IRS Notice 2006-96. An appraisal will be treated as having been conducted in accordance with generally accepted appraisal standards within the meaning of § 170(f)(11)(E)(i)(II) if, for example, it is consistent with the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of the Appraisal Foundation. Additional information is available at www.appraisalfoundation.org. In addition, AICPA members may be subject to standards of valuation or calculation engagements under Statement on Standards for Valuation Services no. 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset.
Information is required from the insurance policy itself and the issuing insurance company. This data is found in the insurance policy and includes: all the information found on the specification or summary page, the information found on the policy data page, the information found on the table of premiums page (term insurance) or the table of cash values (ordinary life), the history of ownership and beneficiary designations, with any and all changes and/or transfers and a recitation of rights of conversion and/or exchange found in the body of the policy. The information required from the insurance company is: the owner/donor’s adjusted cost basis, the current policy status (including values) derived from the most current policy statement, or in-force illustration prepared by the insurance company.
A deduction may be disallowed because it was based on the recommendation of an appraiser who wasn’t properly qualified. For the charity, the only negative consequence may be losing a valuable relationship with its benefactor. But someone is going to be at fault for the unhappy donor’s plight.
The solution. Congress perceived a need for more regulation of the appraisal process and qualification of the appraiser, leading to the PPA’s expanded requirements. For a general description of PPA changes, see “ Pension Protection Act Changes Valuations for Tax Purposes,” JofA, Sept. 07, page 40. Note especially that a taxpayer must obtain a qualified appraisal before completing Part 1 of Section B of Form 8283 and, for donated property worth more than $5,000, attach the appraiser-prepared summary of that appraisal to the tax return (see “Form 8283” below). Requirements for appraisals are listed in Treas. Reg. § 1.170A-13(c). The PPA expanded these requirements to include that an appraisal must be conducted in accordance with generally accepted appraisal standards.
THE QUALIFIED APPRAISER
Treasury Regulation § 1.170A-13(c) (5)(i) defines a qualified appraiser as one who:
Holds himself or herself out to the public as an appraiser and performs appraisals regularly.
Is qualified to make appraisals of the type of property being valued, as determined by the appraiser’s background, experience, education and membership, if any, in a professional appraisal association.
Understands that an intentionally false overstatement of the value of the appraised property may subject the appraiser to civil penalties.
Under IRC § 170(f)(11), appraisers are now required to have earned an appraisal designation from a recognized professional appraiser organization or otherwise meet minimum requirements for education and experience specified by the Secretary. Under transitional terms of Notice 2006-96, for returns filed after Feb. 16, 2007, minimum requirements may be met by having successfully completed college or professional-level coursework relevant to the property being valued, plus two years experience in the trade or business of buying, selling or valuing that type of property. Appraisers must describe this education and experience in the appraisal. They must also prepare their appraisal based on demonstrated competence in valuing the type of property in the appraisal.
Appraisers who meet the requirements may be found through organizations listed in the resources box under “Organizations for finding a qualified appraiser.” Relevant education in life insurance can be attained with the Chartered Life Underwriter, Chartered Financial Consultant or other college-based designation.
Then a C corporation, partnership, S corporation or individual donates property, including life insurance, and claims a deduction of more than $500, Form 8283, Noncash Charitable Contributions, must be filed, with Section A completed. If the amount is $5,000 for a single item or group of similar items, such as books, to several charitable donees; art valued at $20,000 or more; or property for which a $500,000 deduction is claimed (and if an exception does not apply as stated in the instructions to Form 8283), the donor must obtain a written appraisal and fill out Section B of Form 8283. Section B, Part I, contains information relating to the donated property itself. Part II is the signature declaration by the donor that identifies all donated items that have been appraised at a value of less than $500 each. Part III contains the appraiser’s binding declaration that reflects all of the changes in the PPA, specifically, an acknowledgment that the appraiser may be subject to the gross valuation misstatement penalty of section 6695A.
FINDING A QUALIFIED APPRAISER
You, the CPA, are now faced with the task of finding a fully qualified appraiser. Barring that step, you risk daunting penalties, including losing the ability to practice before the IRS for three years while paying a penalty that can be as much as 10% of the tax underpayment or 125% of the fee received for the appraisal, whichever is less. Added to this is the possibility that a disillusioned taxpayer could sue you as well as the unqualified appraiser to pay additional tax, penalties and interest assessed on a deficiency; and there is no longer a reasonable cause exception to a valuation understatement. One way to find a qualified appraiser is to contact an acknowledged appraisal organization for a qualified appraiser in your area.
FVS Center and ABV Credential
The Forensic and Valuation Services Center, formerly the Business Valuation and Forensic Litigation Services Center, offers resources, tools and information, including membership in the FVS Section and how to obtain the Accredited in Business Valuation (ABV) credential. For more information, see http://bvfls.aicpa.org/.
PFP Center and PFS Credential
The AICPA Personal Financial Planning (PFP) Center provides a range of valuable resources that CPAs need for professional and ethical financial planning. The center also contains information about the AICPA Personal Financial Specialist (PFS) credential and PFP Section membership. For more information go to http://pfp.aicpa.org.
Statement on Standards for Valuation Services no. 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, http://bvfls.aicpa.org/Resources/Laws+Rules+Standards+and+Other+Related+Guidance/ AICPA+Valuation+Standard+and+Implementation+Toolkit
Appraisal Standards Board of the Appraisal Foundation, www.appraisalfoundation.org
The American College offers the Chartered Life Underwriter and Chartered Financial Consultant designations, www.theamericancollege.edu
Organizations for finding a qualified appraiser
AICPA, Accredited in Business Valuation (ABV) credential, http://bvfls.aicpa.org
Appraisers Association of America, www.appraisersassoc.org
American Society of Appraisers, www.appraisers.org
International Society of Appraisers, www.isa-appraisers.org