Which entity to own life insurance?
The popularity of the irrevocable life insurance trust (ILIT) is well documented. Billions of dollars have been gifted by estate owners to single life and survivorship life irrevocable trusts to help fund the payment of federal estate taxes. Yet, a number of disadvantages revolving around lack of flexibility and lack of control discourage the use of such trusts in certain situations. When estate owners realize an irrevocable trust cannot be changed, they sometimes decide to think about it. Or when estate owners realize they don't own the cash value of the policy and have no access to it for lifetime financial needs, they feel a loss of control.
Certainly, if a concept existed that provided similar estate tax freedom to irrevocable trust benefits and provided business management flexibility to modify or terminate the plan at any time and provided management control of policy and asset values, these wealthy individuals who hate to lose control of their assets might change their mind. Fortunately, such a legal concept does exist. It's called a Family Limited Partnership (FLP) and follows the Uniform Limited Partnership Act which has been adopted by virtually every state. In recent years, legal and financial advisors have discovered the power of linking together the legal, tax, and financial advantages of family limited partnerships and life insurance as an alternative estate transfer plan compared to irrevocable trusts funded with insurance.
Under the Uniform Limited Partnership Act, there must be two classes of partners: the General Partner and the Limited Partner(s). The General Partner has complete authority concerning the operation of the Partnership and investments made by the Partnership. This is true regardless of the General Partner's percentage ownership interest in the Partnership capital. (It could be as low as 1% or even as low as .1% for value purposes). The Limited Partners have no voice in management (control) of the partnership assets. They do have liquidation priority over general partners upon dissolution of the business and are not personally liable for partnership debts. Their liability is limited to their investment of capital in the partnership.
The Family Limited Partnership is a partnership composed of parents (often as 2% general partners) and children (often as 98% limited partners). Children usually receive their capital contribution to the partnership via lifetime exemption and/or annual exclusion gifts from their parents. The objective is to shift as much asset and "leveraged" financial growth to the limited partners and away from the 40% federal estate tax bracket of the general partners without the general partners giving up management control of the capital assets contributed. The usual assets that may be transferred to a family limited partnership are: rental real estate, shares of an LLC, and the stock of a closely held "C" Corporation. "S" Corporation shares and Professional Corporation shares are not permitted.
Family Limited Partnership
A basic requirement is that the partnership be a legal partnership. It must follow the guidelines of the Uniform Limited Partnership Act. A Certificate of Limited Partnership is filed with the office of the Secretary of State where the partnership and partners become a matter of public record. Assets are transferred to the FLP and the FLP issues general and limited partnership interests. The partnership assets are owned by the partners as tenants in common, meaning each partnership interest is subject to probate at death. Probate may be avoided, if desirable, by creating a revocable living trust to hold title to each partner's share.
In a typical family situation, one or both parents receives a general partnership interest, and in most cases, a limited partnership interest. The parents then gift the limited partner shares to the children all at once or over a period of time. Sometimes, the parents may have a "C" corporation own their general partner shares to limit their liability. When the parents transfer limited partner shares to the children, there are gift tax considerations and Form 709 U.S. Gift Tax Return to be filed. All the usual gift tax rules regarding annual exclusion and allocation of the lifetime gift exemption should be followed. ($28,000 split-gift annual exclusions and $10,980,000 split-gift lifetime gift exemption for married couples in 2017.)
Partners are taxed on their share of partnership profits, even if the profits are not distributed currently, but reinvested in the partnership. Each partner's "capital account" is important to understanding the concept. The "basis" in the partnership is accounted for each year on the Form 1065 Partnership Information return and the K-1 returns for each individual partner according to ownership percentage. Annual pass-through K-1 partnership income will be reported on the Schedule E of each partner's personal Form 1040 U.S. Income Tax Return.
Partners may receive deductible compensation income for services rendered to the partnership. This taxable compensation income is typically allocated to the general partner parents before partnership profits are allocated to all partners. This sense of control of the income stream should sooth any fears of loss of control by general partner parents. The death of all general partners dissolves the limited partnership unless continuity is provided in the partnership agreement. The partnership agreement should provide that the continuation right automatically accrues to a surviving general partner's spouse. This is important especially if survivorship life insurance is a partnership asset to be used to help pay second death estate taxes. The FLP could then be dissolved at the death of the surviving parent.
Now let's take a look at a hypothetical formation of a FLP to give you an idea of how asset values are transferred for gift tax purposes. A valuation discount of about 30% for a gift of the limited partner shares will be assumed in this example. Valuation discounts for lack of marketability and minority ownership interests offer an important incentive to form an FLP. Assume a fair market value appraisal of rental real estate is $16,000,000. What does the FLP look like before and after discounted gifting of capital (limited partner shares) to the children or trusts for their benefit?
Clearly, the picture begins to emerge. The parents have made a discounted split-gift lifetime gift exemption transfer of $10,980,000 of limited partner shares to their adult children or irrevocable trusts for their benefit. And $800,000 of net rental K-1 income can be distributed to the partners personally, accumulated in the partnership, or used by the partnership to purchase survivorship life insurance on the lives of the general partner parents. The FLP will be applicant, owner, and beneficiary of the policy. The general partners (parents) have full legal authority to either distribute or accumulate net rental income and purchase the insurance on their lives. As general partners, the parents could distribute any policy cash values by loans or withdrawals as taxable compensation to themselves for management services provided to the FLP.
An advantage of the FLP as an estate planning tool is that it allows a general partner who also owns limited partner interests, to gift limited partner interests away, yet still retain management control. The control a general partner retains over the FLP will not cause estate tax inclusion of the limited partner interests.
In addition, the gift is valued after taking into account the lack of marketability discount and minority interest discount. Any appreciation of value accrues to the limited partner child. The use of these discounts allows the parents to gift more than they would otherwise be entitled to gift.
The IRS has sanctioned the use of valuation discounts for interfamily transfers in Rev. Rul. 93-12. There, the IRS revoked Rev. Rul. 81-253 where it had held that no valuation discounts were available according to a "unit of family ownership" theory. This theory "attributed" all voting power held by family members for purposes of determining whether transferred interests should be valued as part of a controlling interest. The Service had continuously lost a series of cases on the issue of intra-family transfers stock valuation discounts and formally decided to change its position with the issuance of Rev. Rul. 93-12.
Minority discounts are specifically allowed in valuing both corporate and partnership interests. There should not be different rules used to value minority interest in closely held partnerships and closely held corporations.
From a practical point of view, a 30% discount for lack of marketability and minority interest seems safe for FLP. A fair market value appraisal of the property transferred is still required. This would allow usage of the lifetime gift exemption and no lifetime gift taxes. In the example above, this discounted gift removes $4,700,000 of value from the parents' estate and, in a 40% federal estate tax bracket, saves a potential $1,880,000 of federal estate taxes. All future appreciation on these limited partner shares are also removed from the parent’s gross estate.
Creditor Protection of FLP
Generally, a judgment creditor cannot directly attach FLP assets. The assets of the FLP are the assets of the partnership and not the assets of the partners. A creditor may only reach the debtor/partner interest in the partnership, which is the right to receive a share of the profits and distributions. The creditor cannot obtain any greater rights than the debtor-partner. Since a partner does not have a personal right to assets owned by the partnership, the creditor cannot reach specific partnership assets.
A judgment creditor has the right on application to the court to obtain a "charging order." This appears to be the only means by which a creditor of a partner can reach the partnership interest of a debtor-partner. A "charging order" does not allow the creditor to reach the partnership assets. It does not allow the creditor to become a partner. A "charging order" does entitle the creditor to receive some or all of the debtor -partner's share of profits and distributions.
Even if a "charging order" is in effect, the general partner remains in control and can control the flow of income out of the FLP. Also, the general partner may pay legitimate deductible salaries to decrease partnership net income. The FLP may retain and reinvest current profits. This will prevent the creditor from receiving current funds. The creditor receives funds only if there are distributions and a creditor cannot demand partnership distributions. Thus, the creditor's "charging order" may not be totally satisfied until the partnership is dissolved and all partner shares distributed.
Comparison of FLP and ILIT
Both the FLP and ILIT are excellent estate planning concepts to transfer estates with the smallest possible shrinkage. The ILIT may not be altered, amended or changed. The FLP is amendable by the partners. Using the ILIT requires an insured estate owner to relinquish virtually all control over the policies and trust assets. Using the FLP, the general partner insureds have management control over all partnership assets, including life insurance policies. The value at which partnership assets, including insurance death proceeds, are included in their gross estate depends upon his/her partnership ownership interest. They can possess a small percentage (1%-2%) and still serve as the managing general partners. Thus, the insured general partners retain some measure of control without causing inclusion of the entire death proceeds in the taxable estate.
The ILIT may be created to hold only life insurance policies, with premiums gifted to the trust by the grantor and spouse. The ILIT may also manage assets that have been transferred to the trust. The FLP must manage assets to qualify as a legitimate partnership and may own insurance as one of those assets. Of critical importance is the absolute requirement that any insurance owned by and payable to the FLP be free of federal estate taxes except to the extent of the general partner's percentage ownership interest in the FLP.
If ownership of insurance by a FLP presents a problem to the client or legal advisor, then partnership income distributions can be made directly to the limited partner children. The children may then purchase insurance directly on their parents' lives with the children as equal owners and equal beneficiaries. This arrangement will clearly provide estate tax free insurance proceeds to the children to help pay estate taxes.