Tax-exempt organizations, including charities and retirement plan trusts, are subject to income tax on their unrelated business taxable income (UBTI). UBTI is taxed at ordinary rates, typically those applicable to trusts or to corporations. The mere receipt of life insurance proceeds is not taxable income, and thus cannot ordinarily be UBTI, but there are a number of situations in which the life insurance transactions can create UBTI problems.
Generally, Section 511 defines “UBTI” as income that is
1. Derived from services or programs that constitute a trade or business;
2. Operated by the charity or trust on a regular basis; and
3. Not substantially related to the accomplishment of the exempt purposes of the organization.
In Private Letter Ruling 9441001, the Service characterized an exempt organization's profits from providing life insurance coverage to its members as UBTI. The ruling involved a Section 501(c)(4) exempt organization that sponsored educational, research, and social welfare programs for its 1,500 members. Members receive articles on financial planning and other programs of financial importance, the largest of which is a group insurance program. The organization participated in product development, pricing, and regular evaluation of the group plan and when necessary, hired outside consultants. Premiums were collected from members of the association, a certain percentage of the premiums were retained by it, and the balance was paid over to the insurer. The association was not required to use for any specific purposes the money that it keeps.
The Service determined first that the provision of life insurance coverage to members was a trade or business regularly conducted by the organization. The Service noted that the provision of group insurance was a program carried on through a commercial provider and the organization received payments for the performance of services and because the coverage was provided consistently.
The more difficult question was whether the services or plan were substantially related to the accomplishment of the organization's exempt purposes. The Service ruled that the group plan did not have “special features unique to the needs” of the organization. It noted that relatively few members took advantage of the group insurance and adequate similar services were available in the commercial market. (The Service noted that if they were not readily available, a larger percentage of the organization's membership would have taken advantage of the program.) The Service concluded that the organization, by providing group coverage, was not meeting an unfulfilled need or relieving the distress caused by the lack of these services. Therefore, the coverage was “simply another program available in competition with commercial insurers.”
UBTI is still taxable even if the organization provides the life insurance coverage to its members in a cost-effective manner. Obviously, if it provides them without a profit, there is no taxable income and, therefore, no UBTI. However, the Service noted in Private Letter Ruling 9441001 that “[a] 501(c)(4) organization cannot be created for the purpose of providing benefits to members nor can it be created for the purpose of providing services on a more economical or convenient basis to its members.”
Income that results from an “unrelated trade or business” is still not UBTI if it constitutes “royalty income.” In considering this argument, the Service defined a royalty as “[a] payment for the use of a valuable property right without requiring any significant action on the part of the party offering the use of the right.”
As the insurance agreement between the organization and the insurer required the organization to mail information on the group-term plan to its members (thus giving the insurer indirect access to its mailing list), to pay postage, to administer the plan, to do billing and collecting for the insurer, as well as communicating with the insurer's employees, the Service said that the organization's activities were well beyond merely allowing the use of its name or logo. These services indicated that payments received by the organization were compensation for services and, therefore, were not royalty income.
In Private Letter Ruling 9523027, the Service ruled that the sale of variable life insurance was an integral part of a fraternal society's exempt purposes and that the income from that sale would not be UBTI. The society was a licensed insurance company and through a subsidiary (in order to comply with state laws prohibiting variable life sales directly by fraternal organizations), it conducted an insurance operation. The insurance was offered and sold only to persons eligible to become society members, and the members had to buy a benefits policy directly from the society in order to be eligible for full membership in the charitable organization.
The Service stated that the fact that variable products will be offered would not change the result as long as they serve the same exempt purposes as nonvariable counterparts. Recognizing the dual purposes of the society, to carry on a fraternal program as and to provide for the payment of certain benefits to members, the Service ruled that such sales were consistent with and substantially related to the purposes of a tax-exempt fraternal beneficial society.
UBTI also includes income generated from property owned by an otherwise tax-exempt entity if the property were bought and the income generated by debt financing. Such income is referred to as debt-financed income and constitutes UBTI under Sections 510 through 514 . Therefore, for example, income received by a charity or retirement trust from bonds financed through life insurance policy loans may be UBTI.
This issue was reviewed in Siskin Memorial Foundation, Inc. v. United States, 440 where the charity owned and was the beneficiary of more than 800 life insurance policies with cash values of approximately $2.3 million. Most of the cash values were borrowed from the policies. The charity paid the insurer interest at an average rate of about 5.5 percent, and it reinvested the borrowed funds in marketable securities yielding in excess of 10 percent.
The Service said that the income from the securities was UBTI because it was “passive income generated from debt-financed property.” The courts agreed that the loans were “indebtedness” used to finance the purchase of income-producing securities, and imposed a $42,160 income tax on the $134,501 net profit from the use of the borrowed funds to buy securities. This effectively reduced the after-tax return by 30 percent.
A payment by a life insurance agent to a policy purchaser of all or a portion of the commission, usually made to encourage the purchase of the policy, is called a rebate. A rebate may be cast as the payment by the agent of the first year's premium, so that the policy owner receives “free insurance.”
In most states, rebates are not legal. Most states have specific “anti-rebating” laws that forbid the sharing of an agent's or broker's commission with anyone who is not a licensed insurance agent. Rebating in states that prohibit such payments can result in taxation to both the agent and the insured policy owner.
In Wentz v. Commissioner, 441 an agent sold a whole life policy to a couple, who then wrote a check to the agent for the first year's full premium. The agent then immediately wrote a check to the couple for the same amount. The agent received a commission from the insurer for 115 percent of the first year's premium. The couple allowed the policy to lapse at the end of the first year. The couple reported as income the value of what term coverage would have cost but made no inclusion for the premium kicked back by the agent.
The Tax Court held that rebates were taxable in the amount of the entire annual whole life premium rather than merely the cost of term insurance. The value of the type of life insurance purchased (whole life) was used as the measure of taxable income so the entire amount rebated was taxable as ordinary income.
The Tax Court held it irrelevant that the insured policy holders never intended to keep the policy and pay the second year's premium. The rebate rendered them taxable on the full amount of the first year premium. “It is the class of policy and its market value,” said the court, “that are the controlling elements.”
Rebates are excludable from gross income only if it is the seller (insurer) who instigates and insists upon the price adjustment. In lufe insurance transactions, it is the insurer and not the agent that is the seller, and only the insurer can make a legal price adjustment. 442
The court in Haderlie v. Commissioner 443 stated that the reportable income from an illegal kickback of the first year's premium should be measured by the value of the insurance coverage received. The Tax Court held that when a life insurance premium is rebated to an insured in a transaction that is not legal in the state where the policy is issued, the insured must report income. That income is measured here by the cost of insurance coverage received—or if larger—the first year's premium payment.
Here, a milk dealer and deliverer applied for a $1.25 million policy from a life insurance agent who advertised, “minimum premium life insurance.” The insured passed his insurance examination and wrote two checks to the insurer, one for about $4,000 and the other for about $41,000. Both checks were made payable not to the insurer but to a closely held corporation the agent set up. On the payment of the checks to his company, the agent then wrote his personal check to the insured for about $41,000. One year later, he wrote the insured a second check for about $4,000. The insured asked the agent not to cash his check until the agent's check to him in the same amount cleared the bank.
had signed a document that stated that the agent's payment of approximately
$41,000 was a nonrecourse loan. But both parties
acknowledged that this was a mere tax sham and that neither party expected a
repayment of the “loan.” The agent was paid a commission on the sale of about
$48,000 on the sale. Unfortunately, although the insurer was licensed in the
state where the sale took place, the agent was not. The law in the state (
When the Service claimed the insured had received about $41,000 of income, an amount equal to the first year's premium, as a result of the transaction, he argued—to no avail—that the insurance coverage had no ascertainable value because the agent was not licensed, the sale was not legal under state law, and the agent had no agreement with the company allowing the rebate, arguments the court thought akin to a child who has murdered his parents pleading for leniency because he is an orphan. The court noted that had the insured died during the year, the insurer would have been required to pay the claim (absent misrepresentation by the insured).
Had the insurer authorized the rebate by its agent on its behalf and had the agent been licensed in the state (which did allow “price reduction”–type rebates by the company), the insured would likely have had no reportable income. So an understanding of the tax law and proper compliance by the agent could have saved the insured the tax on about $41,000 (and could probably have saved the agent the cost and aggravation of a lawsuit.
The court did not impose a negligence penalty,
however, because the taxpayer had included the value of the purchased term
insurance in income, and that position, though not successful, was held to be
“not frivolous.” See also Woodbury v.
In Custis v. Comm'r, TC Memo. 1982-296 (1982) , the Tax Court allowed an agent who rebated premiums to deduct the amount of the rebates as business expenses after the agent proved that the state did not generally enforce its anti-rebating laws. See also Worden v. Comm'r, 2 F3d 359 (10th Cir. 1993) where the court held that a property and casualty agent who, by his contract with the insurer, was required to submit only the net (gross premiums less commissions) premiums was not taxable when he, as an accommodation to his clients, sold life insurance and waived his right to collect commissions on life insurance policies.
Haderlie v. Comm'r.,
TC Memo. 1997-525 (1997) . Compare Wentz
case to Woodbury v. United States, 72 AFTR2d ¶
93-6140, 1993 WL 432571, aff'd per curium, 27 F3d 572
(8th Cir. 1994) where the court took a more harsh view on similar facts and
(like the Haderlie court) held that the full
amount of the premium was the measure of the insured's reportable income.
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