Donation of a Life Insurance Policy to Charity

There are many ways of using life insurance as a charitable giving tool. One common strategy is to name a charity as the beneficiary of an individually owned policy, resulting in a donation receipt equal to the insurance proceeds paid on the insured’s death. The receipt can be used as a credit against tax payable in the year of death and/or the immediately preceding year.

In some cases, the receipt can also be used to reduce tax payable by the deceased’s estate in a subsequent taxation year. In other cases, the individual donates an existing policy to charity. This method is more complex from a tax point of view, but provides immediate, and sometimes ongoing, tax relief to the donor. The latter strategy will be the focus of this blog post.

To illustrate the tax rules that apply to the donation of a policy to charity, we will use the example of Anna, who owned a $1 million permanent policy that was originally acquired for estate planning reasons that were no longer applicable. The policy had a cash surrender value (CSV) of $120,000 and an adjusted cost basis (ACB) of $80,000. If Anna had surrendered this policy for its CSV, she would have had a taxable gain of $40,000 (CSV minus ACB). Assuming a tax rate of 50%, she would have had a tax of $20,000 and net proceeds of $100,000.

Before processing the policy surrender, Anna’s insurance advisor asked her if she would like to explore a donation of the policy to her favourite charity. He explained that, if the charity agreed to accept the policy, it could issue a tax receipt equal to the policy’s fair market value (FMV), as determined by a qualified actuary. Anna agreed to have the policy valued. The actuary considered such factors as Anna’s current state of health, the policy’s death benefit and its other terms and conditions, estimated future interest rates, and the policy’s premiums relative to the current market. On this basis, the actuary determined that the policy had an FMV of $400,000, and Anna subsequently proceeded with the donation.

The tax savings from the policy donation will approximate $200,000, with some variation depending on her province of residence. This more than offsets the $20,000 of tax payable on the policy disposition (Anna’s proceeds of disposition on the transfer to the charity equals the policy CSV of $120,000, the same as if she had surrendered the policy). The donation credit can be used in the year of donation to a maximum of 75% of Anna’s net income. Any excess can be carried forward for up to five years.

A policyholder contemplating the surrender of a policy should consider this gifting alternative, as it provides significant value to the charity and income tax benefits to the donor. However, prospective donors should be aware of rules that can reduce the value of a gift of property, including a life insurance policy, that the donor has owned for less than three years. In that case, the value of the donation will be the lesser of the property’s FMV and its cost at the time of the donation (in the case of life insurance, ‘‘cost’’ means the policy’s ACB). The same limitation applies where a gifted policy has been owned for less than ten years if one of the main reasons for acquiring the policy was to make a gift. This is a question of fact that could lead to disputes between donors and the CRA.

In this regard, a question arises when a term policy is converted to a permanent policy and then donated to charity. Does the conversion constitute an acquisition of a new policy for the purposes of the three- and ten-year rules described above? If so, the value of the converted policy for donation purposes would be limited to its ACB. It is unclear how the CRA would view the donation of a recently converted permanent policy. Presumably, this issue could be avoided by first gifting the term policy to the charity, with the charity subsequently converting the policy into a permanent policy. A cautious approach is recommended, and interested clients should consult qualified tax and actuarial advisors.

Finally, it should be noted that not every charity will want to assume ownership of a policy, especially if there are ongoing premiums and no ready source of funds to pay them. Charities will often prefer to have cash or near cash donations that can be used immediately for their charitable activities. On the other hand, larger charities including public foundations may welcome the donation of insurance policies to fund future obligations. A number of such charities do have sources of funds that can be used to pay premiums. Donors who are considering a gift of life insurance should discuss these issues with the charity in question at an early stage.