Planning Opportunities with Partnership-Owned Life Insurance

In Estate of Knipp v Commissioner, 25 T.C. 153 (1955), the decedent was a 50% partner in a general partnership that was owner and beneficiary of 10 life insurance policies on his life. The policies were purchased for business purposes. The court ruled that the decedent held no incidents of ownership in the policies. To rule otherwise the court felt would result in unwarranted double taxation, since 50% of the death proceeds were already included in the value of the decedent’s estate via his partnership interest.

Some practitioners have been reluctant to rely on the Knipp case where a partnership or LLC holds no assets other than life insurance. They feel that Knipp requires a business purpose for holding life insurance. But, in PLR 200947006 (Nov. 20, 2009) and PLR 200948001 (Nov. 27, 2009), the IRS ruled that a decedent did not have incidents of ownership over policies on his life owned by (and payable to) a limited partnership, even though: (1) the limited partnership owned no assets other than life insurance; and (2) the decedent owned stock in the corporate general partner and was the trustee of a trust that was a limited partner.


ILIT Substitute

These two PLRs, although not precedent, may open the door for several planning opportunities. For example, a family limited partnership (“FLP”) or family limited liability company (“FLLC”) can be used as a substitute for an irrevocable life insurance trust (“ILIT”). Among the advantages of an FLP/FLLC over an ILIT are the following:

1. Unlike an ILIT, the partnership/operating agreement of an FLP/FLLC can be amended. Thus, FLPs/FLLCs may be more flexible than ILITs if circumstances or tax laws change.

2. The grantor-insured cannot name himself/herself as the trustee of the ILIT without adverse estate tax consequences. But the insured can be the general partner/manager of the FLP/FLLC. Thus, by retaining a relatively small general partnership interest in an FLP (or a small percentage of the voting membership interests in an FLLC), the insured can remain in control while owning a small percentage of the FLP or FLLC for estate tax purposes.

3. If the insured becomes estranged from a child or grandchild who is a partner/member, the FLP/FLLC can be dissolved and (through the dissolution process) the estranged partner/member can be allocated cash or other assets, while the other partners/members can be allocated the life insurance policy.

4. It is more convenient to use an FLP/FLLC (rather than an ILIT) to own income-producing assets (including a business) in order to provide funds to pay life insurance premiums. In addition, the FLP’s/FLLC’s income will be allocated among the partners/members pro rata and taxed at their individual rates. Income earned and held by the ILIT to pay premiums will be taxed at the ILIT’s extremely high rates (unless the ILIT is a grantor trust). Finally, having income-producing property in the FLP/FLLC avoids having to give trust beneficiaries Crummey powers.

5. Assuming reasonable valuation discounts are allowed (for lack of control and lack of marketability), the insured can “leverage” his/her annual gift tax exclusion (presently $13,000) and lifetime gift tax exemption (presently $1 million) by making gifts of FLP/FLLC units rather than cash.


Buy-Sell Funding

Another planning opportunity for partnership-owned life insurance deals with buy-sell agreements. Buy-sell agreements for corporations with more than two shareholders create several potential problems. First, with the popular cross-purchase or wait-and-see buy-sell agreement (so that the surviving shareholders receive a stepped-up basis in their shares and a C corporation avoids paying the Alternative Minimum Tax), either a trusteed buy-sell arrangement must be used or multiple policies must be purchased (i.e., each shareholder must own a policy on each other shareholder’s life). For example, with four shareholders, you would need 12 policies. Second, a transfer-for-value may occur at the death of a shareholder as the deceased shareholder’s interests in the surviving shareholders’ policies are purchased by the surviving shareholders. If so, a portion of the insurance proceeds will be subject to income taxes. IRC Section 101(a)(2).

To avoid both of these problems, the shareholders could form a general partnership or limited liability company to own the policies with which to fund the corporate buy-sell agreement. Similar to a trusteed buy-sell arrangement, only one policy per shareholder is needed. The partnership / operating agreement will provide that any life insurance death proceeds be specially allocated to just the surviving shareholders. At the death of a shareholder, there will be no transfer-for-value problems, because the transfer of policies to a “partner” of the insured is an exception to the transfer-for-value rule. IRC Section 101(a)(2)(B). In addition, partnerships and LLCs are not subject to the Alternative Minimum Tax.

In summary, life insurance owned by an FLP or FLLC can provide flexibility and planning opportunities to the insureds that are not available to their counterparts in ILITs and corporations.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.

Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan.

For more articles on estate and business succession planning, please visit the author’s website, www.disinherit-irs.com, and click on “Advisor Resources”.