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

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 [email protected].

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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