The Best Kept Financial Secret for Non-Profit Organizations
Non-profit organizations are in a unique position to take advantage of a financial strategy to control, protect, and grow their capital. This method is available to everyone, but non-profits have a particular, powerful opportunity to safely steward and optimize the financial foundation of their important mission-driven work. Please keep in mind that nothing in this article should be construed as tax advice.
Thanks to Kaye Lynn Peterson for help proofreading.
The Squeeze on Non-Profits
Non-profit organizations are under constant pressure to generate donations. Often, the largest, or at least the most important, unit within a non-profit organization is “development” or “donor relations.”
Of course, sales are crucial in the for-profit business too. But non-profit organizations don’t really “sell” the way a for-profit business does in the provision of goods and services.
Take CASA, or Court Appointed Special Advocates, for example — an organization for which I volunteer as an Advocate. A “CASA” — as we are called — serves as Guardian ad Litem for one or more kids removed from their home by Child Protective Services (CPS). We visit our “kiddos,” investigate placements, and prepare court reports, among other things, in order to represent the “best interests” of our kiddos to the court.
CASA has staff members who supervise the individual Advocates, administer trainings, and coordinate programming with other agencies. But other staff members are focused on raising money in order to support the program’s infrastructure that, in turn, supports the work of the Advocates. Staff, building space, and outreach all cost money, and no one is paying Advocates for what they do. That money has to be raised from donors.
Like other organizations, the money that comes in is either saved or spent. Unlike other organizations, that revenue is not income-taxable.
Herein lies the first step towards a financial strategy for the non-profits that is virtually unheard of.
Historical Context
We need to take a step back to understand where we’re going. In the 1980's Congress reformed the tax code and eliminated a lot of tax privileges that previously benefited real estate ownership. After the tax reform, real estate lost some of its previous tax advantages. Consequently, wealthy individuals looked to put their money somewhere else.
This means that wealthy people had large sums of money that they needed to put somewhere safe where the money would continue to grow and where it could be accessed if needed.
Lawyers and accountants had a unique, unconventional suggestion for where that money should go.
It’s called single-premium life insurance.
Life insurance? Why would life insurance be a good place for the wealthy to put their money? And what’s this “single-premium” thing about?
Most people have heard of “term insurance” where the individual owner pays premiums to a company for a period of years, e.g. 10, 20, or 30. If the individual passes during the term, a death benefit is paid to that individual’s beneficiaries.
Single-premium life insurance is different. Instead of term, this is something called whole life. Just like it sounds, it means that no matter when the insured individual passes away, a death benefit will be paid to the beneficiaries. Furthermore, instead of many premiums, with single-premium whole life insurance there is just one premium paid up front at the beginning of the policy. After the first (and only) premium is paid, the policy is “paid-up.”
So what these wealthy people would do is drop a large sum of money, say, $500,000 into a single-premium whole life policy.
Why?
Because life insurance is not just life insurance. In other words, you don’t only get a death benefit when you buy whole life insurance. You get other living benefits too.
The Key Living Benefit of Life Insurance
One of the major living benefits of whole life is called cash value. Cash value is basically equity in life insurance. It’s an amount of money that the life insurance company is contractually bound to give you if you want to sell your policy back to the company.
Cash value has some powerful characteristics. First, it’s guaranteed. You can’t lose cash value. This satisfied the wealthy people’s desire to put their money somewhere safe. In fact, money in life insurance is safer than in real estate. Unlike in real estate, the cash value in life insurance is contractually guaranteed.
Second, it grows. In fact, it grows at a compounding rate, meaning that the cash value grows at an increasing rate over time. This satisfied the wealthy people’s desire to make sure that their cash didn’t just sit somewhere and not grow. In fact, the cash value of life insurance grows beyond what was paid into the policy in the form of premium.
Third, that growth occurs on a tax-deferred basis. This means that the value accumulates on a tax-free basis. It only becomes taxable if the policy were to be surrendered. This satisfied the wealthy people’s desire to keep tax-advantages like they were used to with their real estate.
Fourth, cash value can be easily leveraged. This means that the owner of a whole life insurance policy can use his cash value as collateral on a loan from the insurance company. In fact, the policy owner has the contractual right to do this and there’s hardly any paperwork or waiting time required to access the loan. Because the insurance company itself is guaranteeing the value of the collateral (the cash value), it’s in no rush to collect on the loan. After all, if the insured person passes away before the loan is repaid, the insurance company takes their cut out of the death benefit.
So Good, Congress Tried to Kill it
The features of whole life insurance were so attractive that wealthy people dumped billions into it. Congress got suspicious that these wealthy individuals were “dodging tax” (even though they had already paid income tax when they earned the money they used to pay premiums).
Consequently, Congress put restrictions on the tax treatment of single-premium whole life insurance. From 1986 onward, single-premium life insurance would no longer have the beneficial tax treatment that standard whole life insurance had. Specifically, loans from these “modified endowment contracts” — which is what the IRS calls single-premium whole life — would be income-taxable. Other tax restrictions applied too.
To be clear, you can still (and should) use whole life insurance as a tool to build capital and benefit from all the features above. You just have to pay the premium over time instead of all at once.
But consider how this all applies to non-profits.
Single-premium life insurance still exists. It just has extra income-tax restrictions.
Non-profit organizations do not pay income tax.
This means that if a non-profit organization owns a single-premium whole life insurance policy, the IRS will still deem it to be a modified endowment contract. But all those extra tax restrictions are income-tax restrictions. Non-profit organizations don’t pay income tax!
Implications for Non-Profits
What does all of this mean?
It means that if you operate a non-profit organization, you can purchase a single-premium whole life insurance policy (a modified endowment contract) and you can use it with what is effectively pre-1986 tax treatment for the organization’s purposes.
[Please keep in mind that I am not an accountant and I’m not giving tax advice. While I can read legislation, nothing in this article should be construed as tax advice.]
Why would an organization do that?
Consider this. If an organization pays, for example, $100,000 one time into a single-premium whole life insurance policy, that policy will build cash value (equity) of, say, $65,000 (exact numbers will vary based on policy design) within the first year.
That cash value will then grow, tax-deferred for the entire life of whoever the non-profit organization decides to insure, e.g. the organization’s director, at a compounding rate.
When the organization finds itself in need of cash, e.g. to throw an event or begin a new program, it has the contractual right to borrow an amount up to the cash value from the insurance company that issued the policy.
This event creates a policy loan debt with the insurance company. But remember, this type of debt is unlike any other. The insurance company knows 100% that it will get paid back eventually. Consequently, the non-profit organization is under no pressure whatsoever to repay the loan.
In fact, the non-profit has simply created a place to put money. Therefore, when the non-profit receives a new grant or a large donation, or when it completes a fundraising campaign, that money can be used to pay off the policy loan debt. It’s vital to remember that when this happens is entirely up to the non-profit. It can be right away, later in the year, next year, in five years, or whenever.
When the non-profit pays off the policy loan debt, it isn’t just paying off a debt. It is also freeing up cash value to be used as collateral again on future policy loans to pay for future expenses (e.g. rent, the up-front cost of a fundraising event, new programming, etc.).
Consider further that while the non-profit is utilizing funds from the insurance company in the form of a policy loan, the underlying cash value of the policy continues to grow. This means that by the time the non-profit pays back the policy loan, it will be able to leverage even more cash value on the next policy loan.
All of this occurs on a highly tax-favorable basis. Cash value growth is tax-deferred and policy loans are tax-free.
These policies also pay sizable dividends, which are also tax-free. In the later years of the policy, these dividends can become quite large. The non-profit — the owner of the policy — has full control over what happens to that dividend. What sort of programming could a tax-free passive income stream support for a non-profit 30 or 40 years down the road?
Eventually, the insured person will pass away and the policy will pay out a large, tax-free death benefit. Now, who do you think the beneficiary will be?
The non-profit, of course!
Therefore, the non-profit that purchases a single-premium whole life insurance policy is basically acquiring a capital-generation machine that will one day result in a very large, tax-free, lump-sum payment to the same non-profit. That money, in turn, can be used to purchase another, much larger single-premium life insurance policy.
The non-profit that employs this strategy will eventually become exceptionally financially self-reliant. Development staff will be less dependent on third-party institutions that traditionally supply large blocks of grant money. Consequently, non-profit staff will be able to spend less time completing donor paperwork and more time advancing the mission of the organization. In other words, the organization will run more efficiently and with greater financial performance.
The Sanctity of Sound Stewardship
Staff members at non-profit organizations I’ve worked with are typically very grateful to receive donations. Non-profit staff members know they have to be extremely responsible with the money they receive. Squandering donations is the fast-track to cutbacks, layoffs, and ultimately, a failed mission. Strong stewardship of financial resources is paramount.
Fortunately, mutual life insurance is one of, if not the most, conservative, financially stable, dependable industries in the world. A handful of companies have paid dividends every year — meaning they achieved positive financial performance every year — for over 100 consecutive years. Many for-profit companies fail — banks included — but few mutual life insurance companies do.
To be clear, it’s not just non-profits that can take advantage of the features of properly structured dividend-paying whole life.
But non-profits are the only organizations that can use single-premium whole life insurance without the consequences that come with modified endowment contract status. In fact, single-premium whole life is the most efficient form of whole life insurance, and it is absolutely the best kept secret for capital accumulation and financial management for the non-profit.
