Proposed changes in regulations affecting the transfers of family-owned corporations or partnerships can open the door for financial professionals to use life insurance to transfer family assets from one generation to another without running afoul of the taxman.
The U.S. Treasury Department is considering changes in regulations that would restrict or end discounts for transfers of family-owned entities such as corporations, family-owned partnerships (FLPs) or limited-liability corporations (LLCs).
Valuation discounts in estate planning permit the transfer of assets from one generation to another in an economically efficient manner. Two of the various discount methods are claim lack of control (minority interest discount) and lack of marketability.
The IRS traditionally has objected to these approaches in transferring assets within families. Congress has been unsuccessful in its attempt to legislate these loopholes away, and the Treasury Department is considering 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 LLC) that was controlled by family members. Revenue Ruling 93-12 reflects that the IRS was unsuccessful in maintaining that position.
The ruling involved a shareholder who owned 100 percent of a corporation and made gifts of 20 percent of the stock to each of his five children. The IRS ruled that the family’s control of the corporation would not be considered in valuing the gifts of minority interests. After the ruling, FLPs and 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.
Although the White House has not been successful in three earlier attempts to pass the law, it is a part of the two-year budget package passed by Congress in October. Now the IRS is taking steps to obtain the same results via regulations. These new regulations would expand existing provisions of the Internal Revenue Code that authorize the IRS to provide guidance in this area.
Possible Regulations Would Impose Restrictions
The Treasury Department announced that it is considering issuing regulations that would restrict family valuation discounts. These regulations would include placing limits on minority interest and lack of marketability discounts.
The limitations would apply to interests in family-owned entities such as corporations, FLPs and LLCs. The regulations probably would 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.
Using an Insurance Limited Partnership
The financial professional can follow another avenue toward helping clients transfer these assets to the next generation. That is having the donor transfer the economic benefit of a life insurance policy to an insurance-limited partnership. Let’s look at why this may be attractive.
In President Obama’s most recent budget proposal, a cap is placed 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 recipient each year, or $28,000 if the donor is electing to split gifts with a spouse. The proposal would eliminate taxpayers’ ability to use 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 recipient. Instead, donors would receive a separate aggregate annual exclusion amount of $50,000 for gifts falling within this new category of transfers.
The transfer of a life insurance policy to an ILIT traditionally is valued at the premium that is paid annually. To transfer a permanent policy with a large face amount would exceed the annual gifting limits and thereby eat into the exempt amounts if there were insufficient Crummey beneficiaries.
For gift tax purposes, the transfer of death benefit in a group policy is measured by the economic benefit and not the premium costs. When the split-dollar rules were modified and codified, the modification of Revenue Ruling 66-110 was not affected, so the valuation technique is still allowable.
The July 2015 U.S. Tax Court ruling in Our Country Enterprises v. Commissioner established the basis for this technique. In that ruling, the court determined that the transfer of policies using the death-benefit-only arrangement and the insurance-limited partnership approach complies with the insured having a right to the death benefit only 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 IRS sets forth in Revenue Ruling 66-110. 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 paid by the insured. 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 owner of the death benefit, has therefore provided economic benefits to its employees.
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 transferred to the insured.
Using this method 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 when the funding ends.