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 heirs pay federal estate taxes.
However, 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.
These wealthy individuals who hate to lose control of their assets might change their minds if they knew of another way. They want to find a way to have estate tax freedom for irrevocable trust benefits, business management flexibility to modify or terminate the plan at any time, and management control of policy and asset values.
Fortunately, such a legal concept does exist. It’s called a Family Limited Partnership (FLP) and follows the Uniform Limited Partnership Act. This concept links the legal, tax and financial advantages of FLPs and life insurance as an alternative estate transfer plan compared with 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. The general partner has complete authority concerning the partnership’s operation and investments. 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 FLP is a partnership composed of parents (often as 2 percent general partners) and children (often as 98 percent 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 as possible to the limited partners.
In doing so, this moves assets away from the 40 percent 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 a limited liability corporation (LLC) and the stock of a closely held C-corporation. S-corporation shares and professional corporation shares are not permitted.
Family Limited Partnership
Legal formation. A basic requirement is that the partnership be a legal partnership and follow the guidelines of the Uniform Limited Partnership Act. A Certificate of Limited Partnership is filed with the Secretary of State where the partnership is located, and names of partners become public record. Assets are transferred to the FLP, which 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 desired, by creating a revocable living trust to hold title to each partner’s share.
In a typical family situation, one or both parents will receive 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 in order to limit their liability. When the parents transfer limited partner shares to the children, there are gift tax considerations and a Form 709 U.S. Gift Tax Return must be filed.
Partners are taxed on their share of partnership profits, even if the profits are not distributed 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 typically is allocated to the general partner parents before partnership profits are allocated to all partners. This sense of control of the income stream should soothe any fears of loss of control by the 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 especially important if survivorship life insurance is a partnership asset to be used to help pay second-death estate taxes. The FLP then could be dissolved at the death of the surviving parent.
Here’s a hypothetical formation of an FLP to give you an idea of how asset values are transferred for gift tax purposes. A valuation discount of 30.48 percent 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 million. 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 $10.9 million 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.
Valuation Discounts. The FLP is an estate planning tool that allows a general partner who also owns limited partner interests to gift those 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.
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 percent discount for lack of marketability and minority interest seems safe for an 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 $4,780,000 of value from the parents’ estate and, in a 40 percent federal estate tax bracket, saves a potential $1,912,000 of federal estate taxes. All future appreciation on these limited partner shares also is removed from the parent’s gross estate.
Creditor protection of FLP. Generally, a judgment creditor cannot directly attach FLP assets. The FLP’s assets are the assets of the partnership — not the partners. A creditor may reach only 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 to apply to the court to obtain a charging order. A charging order does not allow the creditor to reach the partnership assets or become a partner. It entitles the creditor to receive 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 the 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 the partnership ownership interest. The partners can possess a small percentage and still serve as the managing general partners. Thus, the insured general partners retain some measure of control without having the entire death proceeds included 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 partners' percentage ownership interest in the FLP.
If ownership of insurance by an 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 purchase insurance directly on their parents’ lives, with the children as equal owners and equal beneficiaries. This arrangement will provide estate tax-free insurance proceeds to the children to help pay estate taxes.