Insurance Limited Partnerships As An Alternate Estate Planning Tool

The current Administration has repeatedly announced its attempt to change the law as a part of the proposed budget, in order to restrict or eliminate valuation discounts on transfers of interests in family-controlled entities. The White house has not been successful in their three attempts. Now the IRS is taking steps to obtain the same results by regulations. These new regulations would expand existing provisions of the Code that authorizes the IRS to provide guidance in this area.

At the ABA Tax Section meeting earlier this year, the Estate and Gift Tax Attorney-Advisor in the Office of Tax Policy of the U.S. Treasury Department stated that proposed regulations would be issued to restrict family valuation discounts by the Fall 2015 (although at press time, they had yet to be released). The spokesperson announced that taxpayers could look to the Administration's prior budget proposals on valuation discounts for direction as to what the rules would be. On that basis they would limit:

• Minority interest; and
• Lack of marketability discounts.

This limitation would apply to interests in family-owned entities (corporations, FLPs, LLCs). The regulations would probably target only entities that do not operate an active trade or business.

Any transfers of interests in family entities that took place before the regulations were issued would be “grandfathered.” The IRS could not use the new regulations to combat transfers at discounts that used discounting methodologies.

Insurance Limited Partnerships

Another avenue for practitioners to follow has the Donor transferring the economic benefit of a policy to an Insurance Limited Partnership. This may be attractive for a number of reasons.

The Obama Administration Beige Book outlining the 2015 Budget puts a cap on transfers to an Irrevocable Life Insurance Trust (ILIT). The annual exclusion from gift tax allows a donor to make gifts of up to $14,000 per donee each year, or $28,000 if the donor is electing to split gifts with a spouse. The new proposal would eliminate taxpayers' ability to utilize the annual exclusion from gift tax for gifts falling within a new category of transfers. This new category would include transfers into trust (with a few minor exceptions) and transfers of interests in pass through entities and other interests that cannot be immediately liquidated by the donee. Instead, donors would receive a separate aggregate annual exclusion amount of $50,000 for gifts falling within this new category of transfers.

Traditionally, the transfer of a life insurance policy to an ILIT is valued at the premium that is paid annually. Unless there is a plethora of Crummey beneficiaries, the transfer of a permanent policy with a large face amount will exceed the annual gifting limits and eat into the exempt taxable estate.

Almost 20 years ago, I published an article in the Journal of the American Society of CLU & ChFC entitled “Proper Use and Abuse of Family Limited Parnerships,” July 1998 p 88, www.financialpro.org. That article outlines how for gift tax purposes the transfer of death benefit in a Group Policy is measured by the economic benefit (Table I and Table 2001) and not the premium costs. When the split dollar rules were modified and codified (Notice 2002-8), the modification of Rev. Rul. 66-110 was not affected so the valuation technique is still allowable.

The economic benefit is determined in light of Our Country Enterprises, Inc. v. Commissioner, 145 T.C. No.1 (July 13, 2015):

The first step of the analysis requires that we decide whether Congress has spoken directly on the matter to which the economic benefit provisions relate. See,'Chevron, U.S.A. [v. Natural Resources Defense Council, Inc.], 467 U.S. at 842-844. If Congress has spoken directly on that matter, then that is the beginning and the end of our inquiry for we must interpret and apply the statute in accordance with the unambiguously expressed intent of Congress. See id. We turn to the second step, however, if Congress has not spoken directly on the matter. The second step requires that we decide whether the economic benefit provisions are a reasonable interpretation of the statute which they construe. See id. The economic benefit provisions are invalid under the second step only if they are “'arbitrary or capricious in substance, or manifestly contrary to the statute.'” Mayo Found. for Med. Educ. & Research, 562 U.S. at 53 (quoting Household Credit Servs., Inc. v. Pfennig, 541 U.S. 232, 242 (2004)).

The transfer meets the first step conclusion and complies with the insured only having a right to the death benefit as long as they are an employee of the employer. “The cost of the current life insurance protection takes into account the life insurance premium factors that the Commissioner publishes for this purpose. See, Sec. 1.61-22(d)(2), Income Tax Regs, subpara. (3)(ii). The amount of the current life insurance protection is the death benefit of the life insurance contract (including paid up additions) reduced by the sum of the amount payable to the owner plus the portion of the cash value taxable to (or paid for by) the nonowner. See, id.'subdiv. (i).” Our Country, at 87.

Applicability

The Tax Court in Our Country held that the “economic benefit provisions apply to this situation because no-split dollar loans are involved and the insured does not make any premium payments on the insurance contracts. The employer, as the owners of the policy, has therefore provided economic benefits to their employees '. Sec. 1.61-22(b)(3)(i), subpara. (1), Income Tax Regs.” Id. at 82.

The insured only has a right to the death benefit so the only income or economic benefit is the Government generated rates based on amount of coverage and age of the insured. There is no other income or economic benefit attributable to the transferor.

Conclusion

The utilization of the methodology of gifting the death benefit will permit the continued transfer of wealth by way of life insurance without being limited by the change in minority and lack of marketability discounts. The measure of the gift is the economic benefit and the gifting terminates with the termination of the funding.

'Sidebar

'Insurance Partnership

1. Insured-owner (I-O) of policy creates LLC.
2. I-O of policy takes back Managing Members (MM) interest at 1% and Limited Membership (MM) at 99%.
3. I-O contributes Supplemental funded policy to LLC ' after tax contribution to LLC.
4. I-O as employee of employer assigns death benefit under Group Life Plan to LLC. Gift tax based on economic benefit (Table I or Table 2001 on face amount of coverage) (Rev Rul. 66-110).
5. LLC agreement permits members to borrow from the partnership to the extent they have sufficient asset to secure the borrowing.
6. I-O gifts LLC interest to natural objects of their bounty.
7. I-O as MM can take loans from LLC ' not income to I-O.
8. I-O can transfer title to LLC to revocable trust to avoid probate.
9. Money owed to LLC is a debt on Estate Tax return.
10. I-O interest in LLC on Estate Tax return is 1% of face of policy. (Rev Rul. 83-147).

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions.

Valuation discounts in estate planning has permitted the transfer of assets from one generation to another in an economically efficient manner. Two of the various discount methods claim lack of control (minority interest discount) and lack of marketability. The IRS has traditionally objected to these approaches in intra-family transfers, while Congress has attempted to legislate away these “loopholes” unsuccessfully and the Treasury Department is contemplating new regulations to accomplish this goal.

In the past, the IRS position was that a minority interest discount was not available in valuing an interest in an entity (corporation, partnership or limited liability company) that was controlled by family members. Revenue Ruling 93-12 reflects that the IRS was unsuccessful maintaining that position. The fact pattern of that ruling involved a shareholder who owned100% of a corporation made gifts of 20% of the stock to each of his five children. The IRS ruled that the family's control of the entity would not be considered in valuing the gifts of minority interests. After the ruling, family limited partnerships (FLPs) and limited liability companies (LLCs) became more popular estate planning vehicles because the available valuation discounts allowed for more wealth to be transferred free from estate, gift and generation skipping transfer (GST) taxes.

Government Efforts

The current Administration has repeatedly announced its attempt to change the law as a part of the proposed budget, in order to restrict or eliminate valuation discounts on transfers of interests in family-controlled entities. The White house has not been successful in their three attempts. Now the IRS is taking steps to obtain the same results by regulations. These new regulations would expand existing provisions of the Code that authorizes the IRS to provide guidance in this area.

At the ABA Tax Section meeting earlier this year, the Estate and Gift Tax Attorney-Advisor in the Office of Tax Policy of the U.S. Treasury Department stated that proposed regulations would be issued to restrict family valuation discounts by the Fall 2015 (although at press time, they had yet to be released). The spokesperson announced that taxpayers could look to the Administration's prior budget proposals on valuation discounts for direction as to what the rules would be. On that basis they would limit:

• Minority interest; and
• Lack of marketability discounts.

This limitation would apply to interests in family-owned entities (corporations, FLPs, LLCs). The regulations would probably target only entities that do not operate an active trade or business.

Any transfers of interests in family entities that took place before the regulations were issued would be “grandfathered.” The IRS could not use the new regulations to combat transfers at discounts that used discounting methodologies.

Insurance Limited Partnerships

Another avenue for practitioners to follow has the Donor transferring the economic benefit of a policy to an Insurance Limited Partnership. This may be attractive for a number of reasons.

The Obama Administration Beige Book outlining the 2015 Budget puts a cap on transfers to an Irrevocable Life Insurance Trust (ILIT). The annual exclusion from gift tax allows a donor to make gifts of up to $14,000 per donee each year, or $28,000 if the donor is electing to split gifts with a spouse. The new proposal would eliminate taxpayers' ability to utilize the annual exclusion from gift tax for gifts falling within a new category of transfers. This new category would include transfers into trust (with a few minor exceptions) and transfers of interests in pass through entities and other interests that cannot be immediately liquidated by the donee. Instead, donors would receive a separate aggregate annual exclusion amount of $50,000 for gifts falling within this new category of transfers.

Traditionally, the transfer of a life insurance policy to an ILIT is valued at the premium that is paid annually. Unless there is a plethora of Crummey beneficiaries, the transfer of a permanent policy with a large face amount will exceed the annual gifting limits and eat into the exempt taxable estate.

Almost 20 years ago, I published an article in the Journal of the American Society of CLU & ChFC entitled “Proper Use and Abuse of Family Limited Parnerships,” July 1998 p 88, www.financialpro.org. That article outlines how for gift tax purposes the transfer of death benefit in a Group Policy is measured by the economic benefit (Table I and Table 2001) and not the premium costs. When the split dollar rules were modified and codified (Notice 2002-8), the modification of Rev. Rul. 66-110 was not affected so the valuation technique is still allowable.

The economic benefit is determined in light of Our Country Enterprises, Inc. v. Commissioner, 145 T.C. No.1 (July 13, 2015):

The first step of the analysis requires that we decide whether Congress has spoken directly on the matter to which the economic benefit provisions relate. See,'Chevron, U.S.A. [v. Natural Resources Defense Council, Inc.], 467 U.S. at 842-844. If Congress has spoken directly on that matter, then that is the beginning and the end of our inquiry for we must interpret and apply the statute in accordance with the unambiguously expressed intent of Congress. See id. We turn to the second step, however, if Congress has not spoken directly on the matter. The second step requires that we decide whether the economic benefit provisions are a reasonable interpretation of the statute which they construe. See id. The economic benefit provisions are invalid under the second step only if they are “'arbitrary or capricious in substance, or manifestly contrary to the statute.'” Mayo Found. for Med. Educ. & Research, 562 U.S. at 53 (quoting Household Credit Servs., Inc. v. Pfennig, 541 U.S. 232, 242 (2004)).

The transfer meets the first step conclusion and complies with the insured only having a right to the death benefit as long as they are an employee of the employer. “The cost of the current life insurance protection takes into account the life insurance premium factors that the Commissioner publishes for this purpose. See, Sec. 1.61-22(d)(2), Income Tax Regs, subpara. (3)(ii). The amount of the current life insurance protection is the death benefit of the life insurance contract (including paid up additions) reduced by the sum of the amount payable to the owner plus the portion of the cash value taxable to (or paid for by) the nonowner. See, id.'subdiv. (i).” Our Country, at 87.

Applicability

The Tax Court in Our Country held that the “economic benefit provisions apply to this situation because no-split dollar loans are involved and the insured does not make any premium payments on the insurance contracts. The employer, as the owners of the policy, has therefore provided economic benefits to their employees '. Sec. 1.61-22(b)(3)(i), subpara. (1), Income Tax Regs.” Id. at 82.

The insured only has a right to the death benefit so the only income or economic benefit is the Government generated rates based on amount of coverage and age of the insured. There is no other income or economic benefit attributable to the transferor.

Conclusion

The utilization of the methodology of gifting the death benefit will permit the continued transfer of wealth by way of life insurance without being limited by the change in minority and lack of marketability discounts. The measure of the gift is the economic benefit and the gifting terminates with the termination of the funding.

'Sidebar

'Insurance Partnership

1. Insured-owner (I-O) of policy creates LLC.
2. I-O of policy takes back Managing Members (MM) interest at 1% and Limited Membership (MM) at 99%.
3. I-O contributes Supplemental funded policy to LLC ' after tax contribution to LLC.
4. I-O as employee of employer assigns death benefit under Group Life Plan to LLC. Gift tax based on economic benefit (Table I or Table 2001 on face amount of coverage) (Rev Rul. 66-110).
5. LLC agreement permits members to borrow from the partnership to the extent they have sufficient asset to secure the borrowing.
6. I-O gifts LLC interest to natural objects of their bounty.
7. I-O as MM can take loans from LLC ' not income to I-O.
8. I-O can transfer title to LLC to revocable trust to avoid probate.
9. Money owed to LLC is a debt on Estate Tax return.
10. I-O interest in LLC on Estate Tax return is 1% of face of policy. (Rev Rul. 83-147).

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions.