Blended Family

LIFE INSURANCE AND THE FAMILY LIMITED PARTNERSHIP

 

FizerBeck
Fizer, Beck, Webster, Bentley & Scroggins
a professional corporation
1330 Post Oak Boulevard, Suite 2900
Houston, TX 77056-3022
713-840-7710
www.fizerbeck.com
 

 

  1. Basic Income Tax Laws with respect to Life Insurance

 
  1. Life Insurance is defined under Internal Revenue Code (“IRC”) §7702

   

  1. Must be treated as a “life insurance contract” under applicable state or foreign law; and

  2. Must meet either the (i) a “cash value accumulation test” or (ii) a test consisting of a “guideline premium” requirement and a “cash value corridor” requirement (Actuary Required).
 

  1. Increase in Cash Value in a Life Insurance Contract is not taxed under IRC §72(e)

  2. Generally, Life Insurance Death Benefits are not taxable under IRC §101(a)

  3. Exception to IRC §101(a) non-taxability of Death Benefits
   

  1. Transfer for Value – If a life insurance policy is transferred to a new owner for valuable consideration and the new owner’s basis in the policy is based solely on the new owner’s consideration for the policy, then the new owner’s receipt of the death benefits (to the extent the death benefits exceed basis) will be subject to income tax. See IRC §101(a)(2).

  2. Exception to Transfer for Value (IRC §101(a)(2))
     

  1. New owner is the insured.

  2. New owner is a corporation of which the insured is a shareholder.

  3. New owner is a partnership of which the insured is a partner.

  4. New owner is a partner of the insured.

  1. General Estate Tax Laws with respect to Life Insurance
 

  1. Life Insurance Death Benefits are Included in the Insured’s Gross Estate if the Insured retains any Incidents of Ownership or if the Death Benefits are Receivable by the Executor of the Insured’s Estate (IRC §2042)

  2. The term “Incidents of Ownership” is defined in Regs. §20.2042-1(c)(2) to include the following:
   

  1. Right of the insured or the insured’s estate to the economic benefits of the policy

  2. Power to change the beneficiary of the policy

  3. Power to surrender or cancel the policy

  4. Power to assign the policy or revoke an assignment

  5. Power to pledge the policy for a loan or to borrow against the cash value
 

  1. Life insurance proceeds paid to a corporation of which the insured is a shareholder are not included in the estate of the insured. However, the proceeds affect the value of the stock owned by the insured. See Regs. §20.2031-2(f), Regs. §20.2042-1(c)(6) and TAM 8906002.

  2. If a corporation owns a life insurance policy on a shareholder, but the death benefits are not paid to or for the benefit of the corporation, then the corporation’s incidents of ownership will be attributed to a “controlling shareholder”.
   

  1. See Regs. §20.2042-1(c)(6)

  2. A “controlling shareholder” is defined as a shareholder owning greater than 50% of the voting power.

  3. “Ownership” in this context is only stock of which legal title is held by the decedent (or his or her agent or nominee) or a trust of which the decedent is treated as the owner (i.e. voting trust or grantor trust)
 

  1. Life insurance proceeds paid to a partnership of which the insured is a partner are not included in the estate of the insured. However, the proceeds affect the value of the partnership interests owned by the insured. See Rev. Rul. 83-147 and Knipp Est. v. Comr., 25 T.C. 153 (1955).

  2. If a partnership owns a life insurance policy on a partner, but the death benefits are not paid to or for the benefit of the partnership, then the partnership’s incidents of ownership will be attributed to each partner regardless of his or her interest in the partnership. See Rev. Rul. 83-147.

  3. If incidents of ownership in a life insurance policy are transferred by the decedent within 3 years of death, the proceeds are included in the gross estate of the decedent. See IRC §2035.

  1. Typical Estate Tax Planning for Life Insurance
 

  1. Insured transfers an existing policy to the intended beneficiaries or the beneficiaries purchase a new policy on the insured.
   

  1. If an existing policy is transferred, then the insured must live for at least 3 years for the proceeds to be excluded from the insured’s estate. Generally, the interpolated terminal reserve value (usually close to cash value) plus the unearned premium will be the value of the gift for gift tax purposes. See Example 4 in Regs. §25.2512-6(a).

  2. If the beneficiaries purchase a new policy, the beneficiaries are responsible for the premiums. The insured would typically gift to the beneficiaries the required premium amounts.

  3. Upon the death of the insured, the beneficiaries receive the death benefits outright.
 

  1. Irrevocable Life Insurance Trust (“ILIT”)
   

  1. Insured either transfers an existing policy to an ILIT or the ILIT purchases a new policy on the insured.

  2. The ILIT must be structured such that the insured has no incidents of ownership.
     

  1. Insured should not be the trustee of the ILIT. See Regs. §20.2042-1(c)(4). Possible exception- insured does not furnish consideration for maintaining policy and is not a beneficiary of the ILIT. See Rev. Rul. 84-179.

  2. Insured should not have the power to remove and replace the trustee of the ILIT. See Rev. Rul. 79-353.

  3. Insured should not be a beneficiary of the ILIT. However, see PLRs 9748029 and 9748020 for specific fact situations under which an insured may be a beneficiary of the ILIT without being deemed to have any incidents of ownership (primary requirement – insured should not be a grantor of the ILIT).

  4. Insured should not have a power of appointment or similar power over the ILIT property.

  1. Disadvantages of Typical Estate Tax Planning
 

  1. Irrevocable (ILIT must be irrevocable due to IRC §2038)
   

  1. The ILIT provisions cannot be changed without court approval. Generally, the court will not approve changes to trusts unless the intentions of the grantor are being frustrated due to circumstances that arise subsequent to trust formation that could not have been anticipated by the grantor.

  2. Once the policy is transferred to or purchased by the ILIT, the policy cannot be transferred to the insured. The trustee can only distribute ILIT property according to the trust distribution provisions.

  3. Exception- Insured can purchase for fair market value the policy, but see discussion below of 3-year rule.
 

  1. Three Year Rule (IRC §2035)
   

  1. If the insured dies within 3 years of transferring the policy to the ILIT, then the death proceeds are included in the insured’s estate.

  2. If insured purchases for FMV a policy from an ILIT and transfers the policy to a new ILIT, the 3-year period starts over.
 

  1. Gift Tax Consequences
   

  1. Each transfer by the insured to the ILIT (unless structured as a loan) is treated as a gift for gift tax purposes.

  2. The insured must use estate tax exemption unless the ILIT beneficiaries are given withdrawal rights that enable the gifts to qualify for the gift tax annual exclusion.

  3. The insured must allocate generation-skipping transfer tax (“GST”) exemption to the trust for each gift if the ILIT is designed as a GST trust.

  1. Possible Solution – Transfer Policy to a Family Limited Partnership (“FLP”)
 

  1. Family Limited Partnership Typical Structure
   

  1. Limited Partnership under state law.

  2. General Partner is either the founder (usually mother and/or father) or an entity (corporation or limited liability company) owned by the founder.

  3. Limited Partner is usually the founder initially and then descendants (or descendants’ trusts) become limited partners via gifts of FLP interests by founder.

  4. As general partner, founder continues to control FLP operations
     

  1. However, we suggest that control of any life insurance policy on a general partner be turned over to the other partners.

  2. If no other general partner, then control of the policy should be turned over to the limited partners.
 

  1. FLP Advantages over ILIT
   

  1. Revocable & Amendable
     

  1. Unlike an ILIT, a partnership agreement can be changed at any time (usually with the consent of all or some stated percentage of the partners, including the general partner).

  2. Partnership can be dissolved (usually with the consent of all partners) and the assets can be divided among the partners, including the insured if the insured is a partner. If an ILIT is terminated, the ILIT property is distributed to the beneficiaries (the insured should not be a beneficiary).

  3. Additionally, a partnership could potentially make a non-pro rata distribution of an asset to a partner (i.e. the insured) or partially redeem a partner as long as the capital accounts are kept properly.
   

  1. No Three-Year Rule
     

  1. The IRC §2035 3-year rule should not apply to a contribution of a policy to a partnership.

  2. Since the insured will receive FLP interests in exchange for the policy, the transfer should fall within an exception to the 3-year rule for transfers in which full and adequate consideration is received for the policy. See §2035(d).
   

  1. No Gift Tax or GST Consequences
     

  1. Since the insured will receive FLP interests (full and adequate consideration) in exchange for the policy, the insured has made no gift when he or she transfers the policy to the FLP.

  2. As long as partnership funds are used to pay the premiums and the partnership properly maintains its capital accounts, the payment of premiums should have no gift tax or GST implications.

  1. Examples
 

  1. “Bad” ILIT – Either due to design of the ILIT (i.e. poor drafting) or failure to follow proper procedures (i.e. not respecting the form)

   

  1. Facts: John created an ILIT 15 years ago with the ILIT to own life insurance on his life. The ILIT provided for each of his descendants to have a $10,000 withdrawal right over the annual contributions to the ILIT. The trustee never provided the required notice of withdrawal right. Additionally, John paid the premiums each year directly to the life insurance company. The ILIT never had a bank account and never paid any premiums. In fact, the insurance company records were unclear as to whether John or the ILIT owned the policy. John owns 100% of an LLC that is the general partner in an FLP of which his descendants are the limited partners. The FLP has a mix of liquid assets and real estate.

  2. One option: Attempt to fix the ILIT
     

  1. Treat all premium payments by John as loans. ILIT would have to reimburse John with interest. Economics wouldn’t look good. John would have to gift funds to ILIT to reimburse himself. Thus, gift tax consequences plus income tax consequences to John. Could avoid income tax consequences if the ILIT is a grantor trust.

  2. Also could have a 3–year rule problem since unclear as to the owner of the policy.
   

  1. Better option: Have the FLP purchase for fair market value the policy from the ILIT and John (if he has any interest).
     

  1. Issue 1 when dealing with the purchase of a life insurance policy – Is there a transfer for value problem?
       

  1. In John’s case, since he is not a partner of the FLP, a transfer for value problem did exist.

  2. To resolve the issue, 1% of a limited partner’s interest was converted to a general partner interest, John’s LLC was converted to a limited partner and then his LLC was dissolved. John was then a 1% limited partner.

  3. Since John was now a partner in the FLP, the transfer of the policy to the FLP fell under one of the exceptions to the transfer for value rule. See §101(a)(2)(B).
     
  1. Issue 2: What is fair market value of a policy?

       

  1. Generally, fair market value should approximate cash surrender value.

  2. However, if the insured is of poor health, then the IRS may not accept cash surrender value as fair market value.

  3. If fair market value is not paid, then a gift may be deemed to have been made to the partners of the FLP.

     

  1. Issue 3: From where does the partnership obtain its purchase funds?
       

  1. John’s FLP had sufficient cash to purchase the policy. Thus, no problems.

  2. However, if the FLP must receive contributions from a partner to purchase the policy, it is important that the FLP capital accounts be kept properly to avoid gift tax implications.
     

  1. Issue 4: Update owner and beneficiary information with insurance company.
       

  1. To complete the plan, the FLP should be shown as the owner and beneficiary of the policy.

  2. Failure to complete the paperwork could foil the plan.
 

  1. Tax Issues Subside – Need for ILIT disappears
   

  1. Facts: Dr. and Mrs. Smith create an ILIT to hold second-to-die life insurance on their lives. The purpose behind the ILIT is to provide tax-free funds via a loan to the survivor’s estate with which the estate can pay estate taxes (avoid having to liquidate the estate assets). Dr. and Mrs. Smith, due to the increased estate tax exemption and their desire to leave their retirement plan assets to charity, no longer have any estate tax concerns. Accordingly, Dr. and Mrs. Smith wish to avoid withdrawing funds from their IRA each year specifically to gift to the ILIT to cover premiums. Previously, Dr. and Mrs. Smith created an FLP and they currently own only the 1% general partner interest due to prior gifts to their children. The FLP has liquid assets and real estate.

  2. One Option: ILIT cashes out the policy.

     

  1. ILIT (Dr. and Mrs. Smith if ILIT is a grantor trust) will owe income tax on the cash value in excess of premiums paid.

  2. No more death benefit available.

   

  1. Possibly Better Option: ILIT contributes policy to the FLP
     

  1. ILIT becomes a limited partner in the FLP
       

  1. Percentage of FLP received by the ILIT is based on value of policy relative to other FLP assets.

  2. ILIT is now entitled only to its share of the death benefits based on its FLP percentage interest.
     

  1. Should be no transfer for value problem since Dr. and Mrs. Smith are partners in the FLP.

  2. Fair market value of the policy – should be cash surrender value, but see above.

  3. Premiums should be paid from FLP funds. If the FLP receives contributions from a partner to pay the premiums, it is important that the FLP capital accounts be kept properly to avoid gift tax implications.

  4. As discussed above, the FLP should be shown as the owner and beneficiary of the policy.

  5. See VII below regarding issues if the insured is the general partner.
 

  1. Individually Owned Life Insurance with a Slightly Ill Insured
   

  1. Facts: Tom owns a $1,000,000 life insurance policy on himself. Tom’s doctors inform him that he has beginning stages of cancer. Tom’s doctor’s estimate that he has a 50% chance of beating the cancer. The cash surrender value of the policy is $100,000.

  2. One Option: Contribute the policy to an ILIT and hope that Tom lives for at least 3 years. If Tom fails to survive 3 years, then §2035 would require that the entire $1,000,000 be included in his estate. Assuming that Tom is not considered “terminally ill” at the time of transfer, Tom would report a $100,000 gift upon contribution of the policy to the ILIT.

  3. Better Option: Tom creates an FLP. Tom contributes $5,000 to the FLP and gives $95,000 to GST trusts for his children so that the trusts can contribute $95,000 to the FLP and own a 1% general partner interest and 94% limited partner interest in the FLP. Tom owns only a 5% limited partner interest. The FLP purchases the policy from Tom.
     

  1. The IRC §2035 3-year rule should no longer be a problem since the transfer was for full and adequate consideration (assuming that Tom is not deemed to be “terminally ill”). Accordingly, only 5% (Tom’s ownership of the FLP) of the death benefits should be included in Tom’s estate.

  2. No transfer for value problem for the FLP since Tom is a partner in the FLP.

  3. Tom could have some income tax consequence upon the sale if his basis in the policy is less than $100,000.

  4. In order to begin the limitations period, the transaction should be fully reported on Tom’s gift tax return and income tax return. See Regs. §301.6501(c)-1(f).
   

  1. When planning with life insurance for an individual with some health issues (or maybe even if planning for a healthy individual), valuation of the policy is an issue.
     

  1. Pritchard Est. v. Comr., 4 T.C. 204 (1944) – Taxpayer attempted to avoid §2035 by transferring via sale a policy for full and adequate consideration. The court held that the proper measure of the value of a policy on a terminally ill insured is not cash surrender value. The proper measure of the value is replacement value. See also U.S. v. Ryerson, 312 U.S. 260 (1941).

  2. TAM 8806004 – IRS ruled that adequate consideration for a life insurance policy is paid only if the amount is equal to the death benefit of such policy. This ruling dealt with the transfer of a policy via sale within 3 years of the insured’s death. IRS cited U.S. v. Allen as the basis for its ruling.

  3. U.S. v. Allen, 293 F.2d 916 (1961) – Taxpayer sold a retained life estate within 3 years of her death for an amount equal to the actuarial value of her life estate. The court held that full and adequate consideration in that context would be an amount equal to what would have been included in the taxpayer’s estate had the transfer not been made (i.e. the trust corpus at the time of transfer).

       

  1. Argument against application of U.S. v. Allen to the transfer of a life insurance policy – transfer of a life insurance policy does not present the same situation as in U.S. v. Allen where the taxpayer was attempting to take advantage of the system via actuarial values.

  2. The court in Pritchard Est. v. Comr. seems to present a more reasonable approach. In fact, before §2035 was narrowed to specific types of transfers, the IRS had interpreted “adequate consideration” as the value on transfer date (not the value at the death of the taxpayer).

  3. Further, Regs. §25.2512-6(a) and the examples thereunder appear inconsistent with the IRS approach in TAM 8806004.

  1. Issues with FLPs and Life Insurance (in addition to the valuation issues discussed above)
 

  1. Section IRC §2035 Concerns
   

  1. IRC §2035 3-year rule should not apply since the transferor is receiving full and adequate consideration in the form of partnership interests if the insured contributes the policy to the FLP as a contribution to the capital of the FLP or in the form of cash if the FLP purchases the policy.

  2. However, I am aware of no authority that provides that IRC §2035 does not apply to the transfer of a life insurance policy to a partnership as a contribution of capital.

  3. The IRS could potentially rule that IRC §2035 applies to a transfer to an FLP, especially if the insured/transferor owns a very small interest in the FLP.
 

  1. What Percentage Ownership of the FLP by the Insured is Sufficient
   

  1. As noted above, one of the IRC §101(a)(2) exceptions to the transfer for value rule is the transfer to a partnership of which the insured is a partner.

  2. Neither IRC §101(a)(2) nor the regulations under IRC §101 provide for a minimum interest to be owned by the insured.

  3. The IRS could rule that below some minimal interest, the insured will be deemed to not be a partner for purposes of IRC §101.
 

  1. Incidents of Ownership in the Policy
   

  1. Typically, the general partner of an FLP is the founder who most often will be the insured on the relevant policy.

  2. Most founders do not wish to relinquish control until they must do so (often not until death).

  3. However, there is an argument that if the insured is the general partner who can control the policy owned by the partnership (i.e. change beneficiaries, cancel, etc.), the entire proceeds will be included in the insured’s estate.

  4. The partnership at issue in Rev. Rul. 83-147 was a general partnership. Thus, the ruling may not apply to an FLP.

  1. Structuring to avoid Issues
 

  1. IRC §2035 Concerns
   

  1. To avoid any 3-year rule concerns, the policy can be sold for fair market value to the FLP rather than contributed as a contribution to capital.

  2. Of course, if the policy is sold, then transfer for value definitely becomes a concern.
 

  1. Transfer for Value Concerns
   

  1. If the policy is sold to the FLP (and maybe even if the policy is contributed to the FLP), transfer for value is an issue.

  2. The insured must be a partner of the FLP to qualify for the exception to the transfer for value rule.

  3. Since no authority has provided that the insured can own a very small percentage of the FLP and still qualify for the exception, it may be prudent for the insured to own more than just a nominal interest.

  4. The disadvantage of having the insured own more than a nominal interest is the inclusion in the insured’s estate of the insured’s percentage ownership (via the FLP) in the policy.
 

  1. Incidents of Ownership as the General Partner of the FLP
   

  1. If the FLP owns other assets and the insured/founder desires to maintain control of the other assets, the FLP should be structured to allow the insured to avoid any incident of ownership.

  2. The FLP Agreement can provide that the insured/general partner has no authority to act on issues relating to the policy.
     

  1. The insured may remain the only general partner, but have the limited partners (other than the insured) control policy matters.

  2. Alternatively, the insured can be the managing partner with another family member (i.e. son, daughter, etc.) named as a general partner. The FLP agreement could provide that matters related to the policy be handled solely by the other general partner.

  1. Final Thoughts
 

  1. Next time you discuss with a client estate planning for life insurance, remember to consider an FLP along with an ILIT, especially if your client already has an FLP. Even if the client has an existing ILIT, it may be prudent to consider having the ILIT contribute the policy to an FLP.

  2. Although FLPs may not solve all of our estate planning problems, life insurance planning is another area in which an FLP may the cure.
           

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