A Popular Tax Shelter Sounded Too Good to Be True - It Was

The Wall Street Journal/December 19, 1999

Two years ago, after weathering several heart attacks and two bouts with cancer, Richard Hancock Sr. went searching for a tax shelter.

The 80-year-old former grocery-store operator says he wanted to make sure his heirs got as much of his estate as possible, and he was concerned that time was running out. "I guess that's why I lapped up this plan so quickly," Mr. Hancock says. "It sounded like a good deal to help my children and grandchildren."

The "good deal" that Mr. Hancock adopted in the summer of 1998 was a complicated tax-avoidance strategy called "charitable split-dollar" life insurance. Thousands of other wealthy taxpayers signed on, too, expecting to reap giant tax savings while providing for their families. Insurance companies wrote billions of dollars in policies, and promoters earned hefty fees and commissions.

But after a page-one article about the shelter in The Wall Street Journal, regulators and federal lawmakers outlawed the tax deductions in recent months, leaving thousands of donors without the benefits they expected - and with bigger tax problems than they could have imagined. The whole charitable split-dollar industry has been thrown into disarray. And the full extent of the fallout remains far from clear.

The Internal Revenue Service is now investigating the participants in the proliferation of the device, including promoters, advisers, insurance companies and charities, as well as the taxpayers. "We're ready to go to the mat," says Marcus Owens, IRS chief of tax-exempt organizations. "Left unchecked, this was a tax shelter on steroids."

Under the discredited arrangement, a donor typically made a "gift" to a charity and claimed an income-tax deduction for the full amount. The charity then invested that gift in life insurance that would give the charity only a minority share of the benefit, while the donor's heirs would get the bulk of the proceeds. The premiums wouldn't have been tax deductible if paid by the insured person directly. Thanks to the split-dollar device, however, the valuable life-insurance policies could be bought for substantially reduced after-tax costs, and no estate tax would apply to the proceeds.

But in the wake of the legislation, signed by President Clinton on Friday, participants are discovering all the ways in which their would-be tax bonanza is a financial disaster. The new laws will wipe out the tax breaks. They'll mean that the money and insurance that donors planned to steer to their families will remain stuck in the coffers of charities that donors saw as mere way-stations. In addition, the very legitimacy of the key charities in the split-dollar chain has come under scrutiny.

"Taxpayers who bought charitable split-dollar policies are in a sticky mess," says J.J. MacNab, an insurance analyst who is trying to sort out the repercussions for clients. "They can't stand the severe consequences and want out. Yet, if they say their contributions were never meant for charity but for their families, they're admitting to tax fraud."

A look at Mr. Hancock's experience illustrates the circle of eager players that propelled this tax-avoidance strategy to its fast life and even faster death. It shows how the financial industry used the charitable tax deduction as the engine for insurance sales and how badly many participants got hurt - financially and psychologically - by the shelter's quick demise.

The youngest of 11 children, Mr. Hancock followed his father, a farmer-turned-farmstand-grocer, into the family business after graduating from high school. He married his high-school sweetheart, Anna Mae, in 1937, and the two raised six children. His single country store in Paducah, Ky., grew into four supermarkets, all built on land he owned. When he sold out to a grocery chain in 1975, Mr. Hancock invested the $900,000 sales price in the stock market. By the mid-1990s, it was worth $5 million and rising.

But as his wealth climbed, his health declined. A tall, stout man who pushed himself 16 to 18 hours a day, he continued to mow the 10 acres around his porch-encircled farmhouse and to grow crops and raise livestock. He suffered five heart attacks. Then he got colon cancer, followed by prostate cancer. In 1995, Mr. Hancock consulted lawyers about setting up his estate, now that he had 11 grandchildren and eight great-grandchildren.

'That Woke Me Up'

To minimize estate taxes, advisers recommended that he transfer 49% of his assets, all held in one corporation, to his wife, who had a longer life expectancy. He made the transfer. A year later, on a Sunday morning, she collapsed in church. "She came to for 15 minutes, we talked, and then she was gone," Mr. Hancock recalls. The shock of his wife's death from brain cancer in 1996 was soon magnified by her estate-tax bill. Her estate owed more than a half-million dollars to the federal government. "That woke me up," the Kentucky native says. "I pestered my accountant to come up with something to keep Uncle Sam from taking my hard work and throwing it to the wild blue yonder."

Coincidentally, promoters were busy pitching the split-dollar program to insurance agents and financial planners who stood to earn commissions on the insurance underlying the plan. The promoters even suggested a charity, the National Heritage Foundation, through which payments for the premiums would garner a tax deduction.

"My partners had attended seminars on the strategy, and we presented it to Mr. Hancock," says Mr. Hancock's Paducah accountant, Michael Rundle.

Mr. Hancock immediately liked the idea. One charitable split-dollar promoter, Jeffrey M. Cohen, of JMC Concepts Inc., Laguna Hills, Calif., flew to Paducah three times to meet with Mr. Hancock and his children. "I wanted them involved in the decision, because it involved quite a bit of their inheritance," Mr. Hancock says.

"A couple kids flared up, didn't want to touch it," Mr. Hancock says. But Mr. Rundle, the accountant, says he told the children: "If we do nothing, it'll be lost to the federal government."

Projected Benefits

Under the split-dollar plan, a $2.6 million stock transfer donated to the National Heritage Foundation could be used to gradually pay the premiums on life-insurance policies. The policies could ultimately yield as much as $17 million for the heirs, and were guaranteed to yield $9 million to charities. These projected benefits were presented to the family in what Mr. Hancock's son Joe calls "the sales document."

In August of last year, the family decided to go with the plan. "My CPA said he had investigated this from one end to the other, it was rock solid, and if it was ever challenged, he guaranteed me attorney fees would be paid," Mr. Hancock says. "I have a high-school education, I don't study the tax laws, so I had to leave it up to them if this would work."

Mr. Rundle, the accountant, says that when the contracts were entered into, "this was in accordance with existing law." Mr. Cohen adds that the plan is "a complex transaction, but most family members understood the program, its risks and potential advantages."

Mr. Hancock's stock transfer to National Heritage effectively moved $2.6 million out of his estate, avoiding estate taxes and more than $1 million in capital-gains taxes on the stock he had held since 1975. His advisers did well, too. The plan's promoter, Mr. Cohen, got significant fees and commissions (he declines to say how much), while Mr. Hancock's CPA recalls his firm making $25,000 to $50,000 for the transaction.

The Plaque in the Kitchen

The charity sent him a plaque for his donation to benefit the "Hancock Family Foundation." Mr. Hancock hung the plaque in his kitchen. "That's where the family always congregates, so I wanted it where it would be seen," he says, recalling his good feeling about the decision to buy the charitable split-dollar plan.

That all changed in June. Mr. Hancock's 32-year-old granddaughter, who works at a Paducah bank, read that the IRS had rejected the popular tax strategy. She took the article to her mother, who then presented it to Mr. Hancock. "That shook me up," he says. "But there was nothing I could do. I had already signed on the dotted line."

The IRS notice, strongly reminiscent of its attack on abusive shelters in the 1980s, declared that taxpayers would face audits and "adverse tax consequences" including additional taxes, interest and penalties for participating in a "tax shelter." Mr. Hancock says, "My kids were scared to death."

He soon found out that not only the IRS but also the U.S. Congress was aiming for charitable split-dollar insurance. He discovered that legislation was pending that would bar the tax strategy. In February, House Ways and Means Chairman Bill Archer introduced a bill to stop "the spread of an abusive scheme," citing the Jan. 22 page-one article in the Journal detailing how rapidly the device had proliferated.

About the same time, Mr. Hancock received premium notices for the full amounts due, which he had already essentially prepaid to National Heritage Foundation, and "I hit the ceiling," he says. He trotted down to the office of the CPA, who he says told him not to worry.

A Quick Maneuver

The day after the report of the IRS's rejection of the charitable split-dollar strategy, the promoter who sold Mr. Hancock his insurance orchestrated a quick maneuver. In a June 16 letter to National Heritage, JMC Concepts showed the charity how to pay immediately the rest of the Kentucky buyer's policy premiums, more than $2 million.

Mr. Hancock's premium wasn't the only one paid by National Heritage after the stinging IRS notice. According to its executive director, J.T. "Dock" Houk, the charity continued paying on donors' policies, despite the IRS's stance. "The IRS loses many of its positions when challenged in court," Mr. Houk says.

IRS Notice

The legislation and the IRS notice were designed to prevent charities from using their tax-exempt status to funnel insurance premiums to benefit private individuals. And charities that don't act in the public's best interest risk losing their tax-exempt status.

So other charities were more cautious. The National Community Foundation, another charity that had participated in the tax device, retained former IRS commissioner Fred Goldberg to help navigate the increasingly controversial program. Leaders of the Nashville, Tenn.-based charity met with congressional officials. When they got nowhere, Mr. Goldberg advised the charity to stop paying premiums on these policies immediately.

The problem, however, was that the National Community Foundation was holding about $13 million in donations to buy charitable split-dollar insurance. Much of that amount had flooded in late in 1998 to secure the tax deduction before year's end. Most of the insurance policies weren't yet in place but were ready for funding by February 1999, when the antishelter law was introduced.

"Suddenly we had half the insurance industry mad at us," says Norvell Olive, executive director of the foundation's parent, New Life Corp. of America. The agents couldn't get their sizable commissions if payments weren't made, and the donors couldn't get the insurance policies they had paid for.

'Bigger Fish to Fry'

National Community began efforts to settle with its nearly 100 donors. One donor, who sent National Community a $22,000 payment, has refused to settle - even though the charity offered to refund his full contribution. This donor last month filed a suit against National Community seeking class-action status. "His attorney sees bigger fish to fry," Mr. Olive says.

Mr. Hancock isn't ruling out legal recourse himself. "I'm thinking about seeing my attorney," he says. "Now it looks like everybody was making money, and I'm the one who'll get punished." He says his accountant, Mr. Rundle, "wasn't working for me. He was working for No. 1, himself."

Mr. Rundle responds that Mr. Hancock's "best interest was always my concern." Mr. Hancock recently got a notice from National Heritage that this year it had become the nation's sixty-fourth largest charity. "People like me is how they gained so much ground," the former grocery operator says. "They go to CPAs and financial planners who have the clients with the money. They take our money with the promise to help get more to our children. That's the reason why the IRS is on their fanny."

The IRS is asking questions about National Heritage's involvement in the split-dollar promotion, the charity's Mr. Houk confirms. Although Mr. Owens, the IRS chief of the tax-exempt division, declines to comment on a particular entity, he says, "If an organization is so heavily involved in these schemes, maybe the charity isn't a charity and not appropriately exempt."

National Heritage, based in Falls Church, Va., accepted a significant portion of the charitable split-dollar plans. Run by Mr. Houk, it accepted 1,200 plans with $60 million in donations last year alone. The charity appealed to donors because they could establish their own accounts for the current gift - and get a tax break - with later disbursement to specific causes. National Heritage, a public charity, allows donors to earmark proceeds for their favorite causes. In the meantime, their donations stay in a separate account and grow tax-free until direction is given on disbursement.

Even if National Heritage was willing to challenge the IRS, it didn't want to violate the new law passed Nov. 19, which slapped a 100% excise tax on charities for any premium paid. Three weeks ago, the charity sent out notices to charitable split-dollar donors advising them that it could no longer pay their premiums.

Confusing Times

Donors are confused. Dause Bibby, who is 88, had transferred $1.4 million in IBM stock to National Heritage in 1997 to buy charitable split-dollar insurance to benefit his three children. The retired executive in Naples, Fla., had been holding his IBM stock since the 1940s, when he worked there. With the stock having a cost of 39 cents a share, his transfer avoided a huge capital-gains tax. It also gave him a sizable income-tax deduction as a charitable contribution.

"Now the whole thing is up in the air," complains his son, Douglas Bibby, who has spoken briefly three times with Mr. Houk. "National Heritage is ... not going to solve our problems." Mr. Bibby is exploring his family's options, none of which look good.

"We either let the policies lapse, losing the money already paid in," Mr. Bibby says. "Or we take them over ourselves, essentially paying for them twice." One big concern: The charity is holding more than $600,000 that his father sent in to prepay the premiums. That's because the elder Mr. Bibby transferred enough stock to buy a policy that was to be paid over five years by National Heritage. Now the charity says it can't lawfully forward the remaining amount (three years' worth of premiums) to the insurance company.

"The money is currently trapped," he says, noting that the payments were meant for policies to benefit his sisters and himself. "Dad looked at helping charity, but he thought his grandchildren would benefit as well."

'I've Lost the Incentive'

John Creek, a Lubbock, Texas, businessman, is assuming the premium payments himself to preserve the policy's cash buildup. He planned to donate an amount nearly equal to the premium each year. But without the tax deduction, "I've lost the incentive to fund it," he says. Letting the policy lapse means he would lose the investment completely. So instead of last year's $50,000 contribution, he's cutting the premium down to $30,000 this year and paying it himself. "I'll keep reducing the premium amount until I have no benefit going to charity," he says.

The fallout goes beyond the individual taxpayers. Insurance agents who raked in big commissions are seeing that stream of income vanish. Because most policies have existed for less than two years, any cancellation could result in their commissions being taken away. Even Mr. Cohen, the promoter, says that he has had to write checks to insurance companies, refunding his commission.

The commissions were significant. One planner, Christopher Swain of Atlanta, collected $900,000 on charitable split-dollar policies last year. He received a commission of about $40,000 for each $150,000 annual premium, he says. Another financial adviser, George Brown in the Philadelphia area, received commissions of $10,000 to $15,000 on an average premium of $35,000.

Insurance companies are also on the hot seat. Angry taxpayers whose policies now are in limbo may go to the insurance industry as a deep-pocket defendant. Metropolitan Life Insurance Co. plans to take the position that it simply provided the product but didn't market the program, according to an official.

Both Hartford Life Inc. and American Express Financial Advisors Inc., which underwrote a chunk of charitable split-dollar business, say they advised policyholders to seek independent advice before buying the insurance, and asked clients to sign statements acknowledging that outside input, their spokesmen say.

The insurance companies must determine who, if anyone, is taking over the existing policies. A thorny fight may erupt over who owns the unearned premium account and any cash buildup. Security Financial Life Insurance Co. is working on a "case-by-case basis with each policyholder and agent," according to its president, Thomas Henning.

Giving Up Rights

Some policyholders are deciding to "heal the split" by giving up all rights to the death benefits, so that they have no personal benefit from their charitable contribution, as criticized by the IRS. About half of his dozen clients are "just signing over the policies to charity," says Mr. Brown, the financial adviser. "They want to be truly charitable." On the other hand, one charity recently gave up its rights to any policy benefit to get rid of the split-dollar accounts.

Even so, there's still an appetite for related strategies. California-based InsMark Inc., the leading split-dollar promoter, is introducing this month a new tax-avoidance and "wealth-preservation" plan called the "seven wonders of the financial world." Its latest strategy would use split-dollar life insurance but avoid charities altogether; the benefits would be divided between parents and children.

Mr. Swain, the planner, who calls himself a "family wealth counselor," has altered the split-dollar device. In his variation, corporations instead of individuals make the charitable gift, and the family's own charity, rather than a public charity, is the recipient of premium money. "We can set these up so the IRS will never find them," says Mr. Swain, who has created such arrangements for 50 taxpayers this year.

Mr. Hancock, for one, is extremely wary: "I may have been a sucker once, but I'm not going to be hooked twice." About to turn 81 and expecting IRS scrutiny, he adds, "I'm too old to make this money all over again. I just hope it's settled before I die."

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