Clients Benefit When Split Dollar Is Married To A Family Limited Partnerships

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Its no longer a mysteryaffluent Americans are beginning to realize that the estate tax isnt going anywhere. While the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the $1.35 billion tax cut package passed earlier this year, promises repeal of the estate tax, repeal is promised for only one year (2010). After 2010, the estate tax is scheduled to return in its current form, including the maximum 55% rate.

With the economy slowing and projected budget surpluses turning into budget deficits, it increasingly appears that permanent estate tax repeal is unlikely.

Despite the renewed realization that planning for estate taxes is as important as ever, some advisors and their clients are struggling to find the most effective techniques for estate planning in light of EGTRRA.

Much of this uncertainty has been created by a change in the relationship between the estate and gift tax. Before EGTRRA, estate and gift taxes were unifiedmeaning that the amount exempt from application of the taxes was the same ($675,000 in 2001). But, at least for the time being, the estate and gift taxes are no longer unified.

Under EGTRRA, the gift tax will not be repealed. Rather, the gift tax exemption will increase to $1 million in 2002 and stay at that level permanently. The estate tax, at least as things currently stand, is scheduled for a one-year repeal in 2010. So, not surprisingly, clients and advisors are looking for ways to plan for the payment of estate taxes without incurring current gift taxes.

In summary, the gift tax is real and immediatewhile the estate tax is only likely and remote. More than ever, as a result of EGTRRA, the key to effective estate planning is the leveraging of gift tax exemptions.

Among the planning techniques that have become more and more attractive since the passage of EGTRRA is the use of split dollar in combination with family limited partnerships (FLPs) or limited liability companies (LLCs). By combining these two estate planning techniques, insureds can create the liquidity for the payment of estate taxes, avoid current gift tax liability, and retain family access to the policys cash value.

For most advisors, neither of these concepts is new. However, for many, the combination of these concepts is unique.

Split dollar is an agreement between two or more parties to share or “split” a life insurance policys death benefit, cash value, ownership rights (such as the right to designate the beneficiary), and premium payments. Split dollar has been a popular planning technique since the IRS issued Revenue Ruling 64-328 nearly 40 years ago.

Although some uncertainty regarding the taxation of equity split dollar resulted from the release of IRS Notice 2001-10 earlier this year, the type of split dollar arrangement discussed in this article (non-equity, or traditional split dollar) remains relatively non-controversial.

Family limited partnerships have become a very popular estate planning technique over the past decade. Since 1993, when the IRS issued Revenue Ruling 93-12, which announced that the IRS would no longer aggregate family ownership (i.e., family attribution) for gift tax valuation purposes, FLPs have become a centerpiece of many family estate plans.

An FLP is a business entity formed for the purpose of consolidating the management of family investments. Because of restrictions that limit the rights of limited partners, a significant valuation discount is generally applied to FLP units when they are valued for estate and gift tax purposes.

To understand the marriage of these two popular planning techniques, lets look at a typical example. Alexander and Abigail, both age 70, have a combined estate of approximately $12 million. Their assets are primarily made up of stock in a family business and real estate. Cash flow from their assets is over $500,000 per year.

While both Alexander and Abigail are healthy and active, they are concerned with the management of their estate should they experience health problems in their golden years. They remember Abigails fathers struggle with Alzheimers in his final years and they remember the legal and family problems caused by the court-supervised guardianship that was needed to manage his estate. They want to be sure that their estates are in order, so that they can enjoy their retirement without financial worries.

After consulting with their children and financial advisors, Alexander and Abigail have decided to create an FLP to consolidate and manage their assets. They will create an FLP or a limited liability company (LLC) to hold $10 million of their assets. Because state law governs FLPs and LLCs, the choice of FLP or LLC will largely depend upon the nuances of applicable state law. For purposes of this article, we will assume that Alexander and Abigail will create an FLP.

Ownership of the FLP will be made up of both general (5%) and limited partnership (95%) interests. Alexander and Abigail will be the general partners, and will maintain control over most partnership matters, including investment and distribution decisions.

Once the FLP agreement is drafted and filed with the appropriate state agency, the assets need to be transferred to the partnership. Real estate should be transferred by deed. It is extremely important that assets be transferred and held in the partnership name. To insure that the IRS will respect the FLP, it is important that partnership formalities be followed.

After creating the FLP, a certified independent appraiser should be hired to determine the value of the limited partnership interests. For purposes of this article, lets assume an independent appraiser determines the value of the limited partnership interest to be 60% of the value of the underlying assets (i.e., a valuation discount of 40% is applied). In other words, we will assume that the appraisal determined that the general partnership interests have a value of $500,000 ($10 million times .05) and that the limited partnership interests have a discounted value of $5.7 million ($10 million times .95x (x=1- .40)).

Alexander and Abigail will use their lifetime gift tax exemption ($1 million each in 2002) to give limited partnership interests (approximately 33% of the total partnership interest) to their two children. Assuming a 40% valuation discount, the pre-discounted value of the underlying assets reflected by the total gift of $2 million is $3.3 million. The $2 million gifts will be documented by filing a federal gift tax return. Alexander and Abigail will continue to own those limited partnership interests not transferred to their children.

After creating the FLP, the balance sheet of Alexander and Abigail will now look like this: (1) $2 million of assets not transferred to the FLP and owned outright, (2) a 5% general partnership interest valued at $500,000, and (3) a 62% limited partnership interest valued at $3.7 million. By creating the FLP and using their combined lifetime gift tax exemptions to make gifts to their two children, Alexander and Abigail can reduce the size of their combined taxable estate from $12 million to $6.2 million.

In addition to creating the FLP, Alexander and Abigail are considering the purchase of $5 million of second-to-die life insurance coverage. They would like to have the life insurance owned by an irrevocable life insurance trust (ILIT) to avoid estate taxes, but they do not know how they can fund the more than $150,000 in annual premiums without incurring a significant amount of gift tax. Alexander and Abigail have only two childrenboth of whom are single. So, Alexander and Abigail can make annual exclusion gifts of only $44,000 per year (individuals can make gifts of up to $11,000 per year/per recipient in 2002 without incurring gift tax or using the lifetime exemption). They have no remaining lifetime exemptions, because both used their $1 million exemption to make “discounted” gifts of their limited partnership interests.

To avoid current gift tax costs, their advisors have suggested that Alexander and Abigail create an ILIT to own the policy and have that ILIT enter into a split dollar agreement with their FLP. The ILIT will own the policy and pay the economic benefit cost of the amount at risk (i.e., the total death benefit less the policy cash value). The FLP will pay the balance of the premium and will own the policy cash value.

For two 70-year-olds, the value of term insurance is approximately 41 cents per $1,000 of coverage. Or, for $5 million of coverage, the cost to the ILIT in the first year is approximately $2,000. Even at age 80, the value of $5 million of second-to-die coverage is only about $15,000. Upon the death of the first spouse, the value of the term coverage (economic benefit cost) will increase significantly as the value will then be calculated by the Notice 2001-10 rates for single life coverage.

By combining an FLP with an ILIT, Alexander and Abigail can accomplish most of their estate planning objectives. And, more important, they can do so without current gift tax costs. Here is a look at what they will accomplish by using split dollar to combine their FLP with an ILIT.

First, by transferring assets into the FLP, Alexander and Abigail have created an entity with provisions to govern the management of their assets should they become unable to manage their own affairs. In addition, the FLP makes it easier for them to turn the management of their assets over to their children if they wish to unburden themselves of asset management in their retirement years.

Second, they will reduce the size of their estate from $12 million to $6.2 million because of lifetime gifts and the application of the valuation discount (valuation discounts may be more or less in individual FLPs).

Third, they will have $5 million of second-to-die life insurance coverage in place. This insurance can be used to provide liquidity to pay estate taxes upon the death of the surviving spouse. By having the policy owned by an ILIT, the amount at risk (i.e., the death benefit less the cash value) is outside of the estate tax system.

The policy cash value, owned by the FLP, will increase the value of the FLP and will be taxable in the estate of the surviving spouse to the extent that the surviving spouse owns FLP interests at death.

In 2002, Alexander and Abigail own approximately two-thirds of the FLP. If this is still the case at the time of the surviving spouses death (assuming that no additional FLP gifts are made during their lives), two-thirds of the policys cash value will be indirectly included in the taxable estate as an asset of the FLP.

However, the cash value owned by the FLP would be subject to the 40% valuation discount applied to the limited partnership interests. In other words, if the policy had a cash value of $2 million at the time of death, this arrangement would mean that $3 million of coverage ($5 million policy face amount less cash value owned by the FLP of $2 million) would be received by the ILIT free of income and estate taxes.

The $2 million cash value would increase the value of the FLP by $1.2 million (assuming the same 40% valuation discount received on the initial appraisal). Since Alexander and Abigail only own two-thirds of the FLP interests, the cash value would have the effect of increasing the value of the surviving spouses estate by only $800,000.

Fourth, the policy cash value will be available to the family as an asset of the FLP. Remember, that the cash value of a life insurance contract grows free of current income taxation. And, more important, the FLP can withdraw that amount of the policy cash value equal to the share of the premiums paid by the FLP without recognition of income. After withdrawals have been taken in an amount equal to premiums paid (i.e., cost basis), additional cash value can be taken from the policy without current taxation through policy loans.

Because the policy is on the joint lives of the general partners (Alexander and Abigail), many tax professionals suggest that a “special managing partner,” such as a child, be given all rights over the life insurance contract.

While some tax professionals believe Alexander and Abigail can possess rights over the life insurance contract as a general partner (including the right to make policy withdrawals or change beneficiaries), the conservative approach is to name a “special” partner for purposes of exercising “incidents” of ownership over the life insurance contract.

Alternatively, the FLPs rights in the insurance contract can be limited by a “bare bones” or “restricted” collateral assignment. However, by using a “bare bones” collateral assignment, the benefit of easy access to the policy cash value is lost to the FLP.

Fifth, they have avoided the current application of gift taxes. To fund the ILIT, they need to only make gifts to the ILIT each year equal to the economic benefit cost. As noted above, that cost in 2002 is about $2,000. Although the amount will increase annually, gift taxes should be avoided for many years to come.

Both ILITs and FLPs are widely used in estate planning. Unfortunately, many advisors fail to realize that combining them through the use of a split dollar arrangement can leverage the benefits of both arrangements. In fact, it is not uncommon for me to receive a call from a planning professional that starts out with the question: “My clients have already used their lifetime exemptions and annual exclusion gifts for an FLPis there any way they can still buy life insurance without paying too much in gift taxes?”

When working with affluent clients, please remember that FLPs and ILITs need not be mutually exclusive planning techniques. Both concepts provide a considerable benefit to the client and both can be a valuable piece of a comprehensive estate plan. Fortunately, by using split dollar, these important techniques can be combined to provide a powerful means of protecting clients against the uncertainties created by the application of EGTRRA.

, J.D., CPA, is senior counsel, director of advanced markets and small business insurance, Manulife Financial, Boston. He can be reached via e-mail at Randy_Zipse@manulife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, November 26, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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