By: Randall A. Denha, J.D., LL.M.
In order to secure a source of liquidity to help pay estate taxes and other obligations, taxpayers often establish an Irrevocable Life Insurance Trust (“ILIT”) to purchase and own a life insurance policy on the taxpayer’s life. Upon the taxpayer’s death, policy death benefits are paid to the ILIT with which the ILIT may either purchase assets from, or make loans to, the insured’s estate.
The life insurance death benefit proceeds can remain out of the insured’s estate only by eliminating any “incidents of ownership” over the policy. Accordingly, the insured typically will not be named as trustee, leaving him without control over the policy, or access to the cash value. Further, the ILIT must be made irrevocable so that the insured is not deemed to retain control over, and therefore incidents of ownership in, the policy.
This, of course, limits the taxpayer’s flexibility in that, once established, the taxpayer may not revoke or amend the ILIT without resorting to either a formal court order, trust decanting or other sophisticated technique. In the past, I have written about the ILIT and its importance in the areas of estate planning. While the ILIT is a popular way to own a life insurance for all of the reasons cited above, another option is to have the life insurance owned by a family partnership.
Many planners see the Family Partnership, or Family Limited Liability Company (“FLLC”), as a more flexible alternative to the Irrevocable Life Insurance Trust. Among other benefits, the FLLC offers these advantages over the ILIT:
- The terms of the partnership may be amended upon the agreement of the partners.
- Where the insured is the voting member, he has management control over partnership assets, including the policy on his life, for partnership purposes.
- Where policy proceeds are paid solely to the partnership, the insured should not have the entire policy proceeds included in his estate.
- The insured’s gross estate will be increased by the life insurance proceeds only to the extent that they are attributable to, and increase proportionately, the value of his partnership interest.
The typical structure of the FLLC looks like this: The FLLC is a partnership composed of parents (often as 2% general partners, or voting members) and children (often as 98% non-voting 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 non-voting partners and away from the 40% federal estate tax bracket of the voting partners without the voting partners giving up management control of the capital assets contributed. The usual assets that may be transferred to a FLLC 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.
Additional advantages of an FLLC over an ILIT include:
- Unlike an ILIT, the FLP may be amended upon the agreement of the partners.
- If the insured is the general partner, he/she has management control over the partnership assets, including the life insurance policy on his/her life(s), for partnership purposes.
- If the death benefit proceeds are payable solely to the partnership, the insured should only have a proportional amount of the policy proceeds included in his/her estate equal to his/her ownership interest in the partnership.
- The partnership provides a flexible alternative to an ILIT for purposes of minimizing inclusion of a policy in the insured’s estate.
Disadvantages of an FLLC over an ILIT include:
- The insured’s gross estate will be increased by the proportion of the life insurance proceeds attributable to his partnership interest.
- While most tax advisors would agree the FLLC can be used to transfer assets to family members at a discount, care must be taken to obtain a discount. In 2000, the IRS issued a Field Service Advice (FSA), advising its District Counsel on differing theories they could use to attack FLLC discounts.
- Establishing and administering an FLLC is, however, a costly endeavor. The individual must employ valuation experts to value the underlying property, as well as to determine the appropriate discounts for lack of control and lack of marketability; attorneys to prepare the partnership agreement; and accountants to prepare annual tax returns. The cost of establishing and administering a FLLC may outweigh the benefits of the FLLC if an individual does not have a substantial amount of property to contribute to a FLLC.
Both the FLLC 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 FLLC 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 FLLC, the voting member 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 voting partners. Thus, the insured voting 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 FLLC 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 FLLC be free of federal estate taxes except to the extent of the voting member partner’s percentage ownership interest in the FLLC.