Triple Leveraged Family Limited Partnerships

TA K E N OT E Recent developments in estate, business and tax planning

Special Issue August, 2008 (Revised from September, 2005)

INSIDE THIS ISSUE Triple Leveraged Family Limited Partnerships Advanced Markets Group 800-432-1102 Advanced Markets Attorneys Janice Alexander Forgays, Esq., CLU ext. 1846 [email protected] Jerry Weihs, JD, CPA, MBA, CLU, ChFC ext. 1756 [email protected] Deborah Moon, Esq., CLU ext. 1838 [email protected] Rose Watson, Esq. ext. 7196 [email protected] Advanced Case Design Douglas Bowden, CLU, ChFC ext. 2450 [email protected] Greg Faux ext. 1817 [email protected] ©2008 Sun Life Assurance Company of Canada. All rights reserved. Sun Life Financial and the globe symbol are registered trademarks of Sun Life Assurance Company of Canada. All guarantees are based on the claims-paying ability of Sun Life Assurance Company of Canada (Wellesley Hills, MA), or in New York, Sun Life Insurance and Annuity Company of New York (New York, NY). Not FDIC/NCUA insured. May lose value. No bank/credit union guarantee. Not a deposit. Not insured by any federal government entity.

Triple Leveraged Family Limited Partnerships Jerry Weihs, JD, CPA, MBA, CLU, ChFC and Douglas Bowden, CLU, ChFC

This article will demonstrate the significant leverage that can be achieved by the utilization of Family Limited Partnerships (FLPs) along with life insurance acquired via premium financing techniques. Significant discounts can be achieved by the transfer of assets to a FLP. Often this will be in the 30 - 40% range. Placing substantial amounts of life insurance in the FLP gives an opportunity to leverage the death benefit at a multiple of the premiums paid while still getting the discount applicable to the FLP. In addition, the use of premium financing techniques will significantly reduce the outlay necessary to fund the life insurance, with favorable internal rates of return and without the need to liquidate other assets to pay premium. These three types of leverage will significantly increase the amount of assets passing to the next generation, reduce estate taxes and do so in a cost effective manner. FLPs can protect the family wealth, provide a tool for reducing estate taxes and still permit a measure of control over the assets of the FLP. The partnership must have a valid business purpose under state law. The FLP must also conform to recent case law to withstand IRS scrutiny. Typically, the older generation (i.e. the parents) will establish the FLP and fund it with their assets. The parents will be issued the General Partner (GP) interest and Limited Partnership (LP) interests in exchange for the assets contributed. The parents often retain the GP interest to maintain voting control over the FLP and will then gift the LP interests to the younger generation (i.e. children) over a period of time. LP interests cannot have management responsibilities and cannot be liquidated without the consent of the GP, nor can they be freely sold or transferred. This lack of control and marketability causes the LP interests to have a discounted value. The ability to apply discounts to gifts of LP interests is a substantial benefit to the family and is often the primary factor for establishing the FLP. It is important that a qualified appraiser establish the valuation of the FLP, as well as determine the applicable discounts.

BENEFITS OF ARRANGEMENT: THE FIRST LEVERAGE To reduce the size of the gross estate without giving up control of the underlying property held by the FLP is the major goal to be achieved. The GP retains management control while holders of the LP interests cannot participate in management. Continued on page 2

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Triple Leveraged Family Limited Partnerships In addition, protection of assets can be achieved against third party creditors. Valuation discounts are available when the parents transfer the LP interests to their children by making gifts of the discounted LP interests. While the value of the gift is its fair market value (FMV) on the date of transfer, a discount is applicable due to the lack of marketability and no management control, as well as other applicable valuation discounts. The net result is that FMV of LP interests are less than the underlying property held by the FLP. Once LP interests have been gifted, they are excluded from the transferor’s estate. Therefore, any appreciation on those LP interests will not be taxed in the transferor’s estate. In addition, income distributed to Limited Partners will be taxed at their respective income tax rates which will often be lower than the General Partners tax bracket. A FLP offers asset protection as well. In most states, a creditor can obtain a “charging order” against a properly structured FLP. This gives the creditor assignee status, but without the right to demand a distribution of income or assets. The GP maintains control over all distributions and cannot be forced to make one to satisfy creditors. The type of property interests transferred to a FLP may vary. The best type of assets for transfer would be closely-held business stock, marketable securities and unencumbered real estate. Remember, there needs to be a business purpose for setting up the FLP.

VALUATION DISCOUNTS

 Lack of marketability: A buyer would pay less for a LP interest than the proportionate value of the underlying property because it is difficult to sell the LP interest (no readily available market for LP interests).  Lack of control (minority interest): A buyer would pay less because, without control, the LP is unable to compel a liquidation of their interest in the underlying property.

INTERNAL REVENUE SERVICE VIEW Because of all the benefits associated with FLPs, they have come under fire from the IRS for being merely a device to avoid paying estate taxes while letting the senior family members retain control over their assets. Potential red flags for the IRS include:

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transferring a large percentage of the taxpayers’ assets to the FLP putting a primary residence and other personal assets into the FLP establishing a FLP right before death failing to distribute earnings to the LPs personal expenses paid directly by the FLP Ways to improve the chances of withstanding IRS review: Be sure the FLP is run as a business, not as a tax avoidance scheme Grantor cannot retain too great of control over the assets transferred Maintain adequate assets outside of the FLP to cover the normal living expenses of the creator of the FLP Document the reasons for the creation of the FLP, for example, cost-saving features such as reducing investment management fees by the pooling of assets

SECTION 2036 ARGUMENT The essence of the IRS argument is that the way the FLP was either structured or operated, the grantor effectively retained the possession or enjoyment of the property transferred to the FLP and so the FLP assets are in the grantors estate for tax purposes. The application of Sec. 2036 has come down to whether nontax reasons existed for the creation of the FLP and whether the taxpayer respected the entities’ integrity. The recent case of Strangi vs. Commr appears to reflect an evolving consensus on the application of Sec. 2036 to the FLP area. The Fifth Circuit Court of Appeals held that assets transferred two months prior to death to a FLP were includible in the grantors gross estate. The inclusion was a result of: 1) the decedent retaining an implied interest in the transferred property and; 2) the transfer was not a “bona fide sale” for full and adequate consideration in that it was not motivated by substantial non-tax reasons.

USES OF LIFE INSURANCE THE SECOND LEVERAGE

IN

FLPs:

The FLP can be an attractive alternative to an Irrevocable Life Insurance Trust (ILIT). While the proper utilization of an ILIT will remove 100% of the value of the insurance proceeds from the grantor insured’s estate, in the case of the FLP, the partner insured’s retained partnership interest will result in inclusion commensurate with the FLP units owned.

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TA K E N OT E ADVANTAGES OF PARTNERSHIPS

held policy insuring his or her life.

A partnership is governed by state statutes and contract law which offers greater flexibility and control to the insured. An ILIT is an inherently inflexible document while a partnership agreement is a flexible, contractual arrangement. In other words, the FLP may be changed by agreement of the partners

It is imperative that the rationale of Strangi be followed when placing substantial amounts of life insurance in a FLP. Indeed, if the transferor of the property retains too great an interest in the FLP assets or fails to demonstrate sufficient non-tax reasons for the formation of the FLP, the goal of removing assets from the transferor’s estate will fail. It will increase the assets includable in the gross estate, exactly the opposite of what is intended.

The limited partnership allows the insured continued participation, as a General Partner, in the administration of partnership property without jeopardizing estate tax planning goals. The tax effects of a FLP owning life insurance can be very positive. The proceeds are received income tax free (Sec.101(a)). The partner’s basis is increased by the distributive share of partnership tax-exempt income, Sec 705(a)(1)(B), which insures that the proceeds retain its tax-exempt character. Any proceeds payable to the FLP on the death of the insured, when the policy was owned and paid for by the FLP, should not be includible in the insured’s estate, except for the corresponding increase in the value of the percentage ownership of the insured (i.e., if the insured is a 10% owner, that percentage of the proceeds will be reflected in the FLP valuation). The partnership will have a greater ability than an ILIT to pay premiums without causing taxable gifts because there are no “Crummey” powers and “5 and 5” rule limitations. FLP assets and income from those assets are available to make premium payments. The transfer of a life insurance policy to the FLP will not be a transfer for value as the insured would be a partner, an exempt transfer pursuant to 101(a), nor would there be a three year problem under Sec.2035 if the policy was contributed to the FLP for adequate consideration, again, an exempt transfer. Finally, if the partnership is both policyholder and beneficiary, the insurance proceeds are not directly includable in the insured partner’s gross estate. Estate of Knipp. Proceeds received by the partnership will be included with the other partnership assets in determining the value of the decedent’s partnership interest for estate tax purposes. However, if the insured had personal incidents of ownership in the policy, such as the right to change the beneficiary, the entire value of the proceeds would be includable in his gross estate. Hall vs. Wheeler. Therefore, it would be good planning to make clear in the partnership agreement, that a partner is prohibited from participating in the exercise of any incident of ownership with respect to a partnership-

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WHERE WE ARE At this point we have achieved two levels of leverage. The first was the ability to take discounts of approx. 30% on the transfer of assets to the children. The second is the placement of substantial amounts of life insurance in the FLP. We achieve this leverage two ways: by the face amount of insurance being a multiple of the premiums paid, thereby increasing FLP assets, while at the same time subjecting the FLP units to the discounts for lack of control and marketability.

PREMIUM FINANCING: THE THIRD LEVERAGE The third and final use of leverage will be the application of premium financing to the acquisition of the life insurance. The assets of the FLP will enable us to acquire large amounts of life insurance on a cost efficient basis. Premium Financing is a technique designed for individuals who have a life insurance need but do not wish to liquidate assets to fund the life insurance policy. An individual will take out a loan from a third party lender to pay premiums on a life insurance policy. The life insurance company is not a party to this transaction. The borrower will apply for a policy and once it has been underwritten, the borrower will apply to the third party lender for financing and the terms of the loan will be finalized. The third party lender will set the spread and the payment schedule for the loan. The lender will also require collateral for the loan; in most instances it will be the policy cash value and additional collateral. In essence, by paying the interest via the cash flow of the FLP the premiums can be financed. Premium Financing may be a solution for those individuals who feel that they earn a rate of return that is in excess of the interest rates that are being charged by the lender. Also those clients whose assets are “illiquid” and are tied up in business or real estate may also find this technique appropriate. The premium financing outlay is the interest due on Continued on page 4

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TA K E N OT E Triple Leveraged Family Limited Partnerships the loan. This can often be less than the cost of the premium. Premium Financing can be best explained by the use of an example. Assume we have John, age 68 and 68, who has three children and a net worth of $7.5 million. His assets include commercial properties with a market value of $1.3 million. The income from these properties generates 8% annually and appreciates at 7% annually. John transfers properties to a FLP in exchange for a 1% GP interest and a 99% Limited Partnership interest. John will then utilize his $1 million lifetime gift exemption to transfer the Limited Partnership interests to his children gift tax-free employing a 30% valuation discount which reduces the $1.3 million to $1 million for gifting purposes. John will retain the General Partnership interest and maintain control over the assets. Only the 1% General Partnership interest will be includible in his estate. The FLP then purchases a $3.75 million life insurance policy on John.

HOW IT WORKS The annual income generated by the properties is approximately $104,000, which is more than enough to purchase a $3.75 million Sun Universal Protector® with a lifetime guarantee at an annual premium of $94,636. They have decided to leverage the life insurance by using a premium financing strategy. The FLP will purchase a $3.75 million Sun Universal ProtectorPlus with a Return of Premium death benefit option. This will allow for both the repayment of the loan at John’s death and provide the FLP with a net death benefit of $3.75 million. A Year

Annual Outlay (Loan Interest Due at 7.0%) for Financed Insurance

Continued from page 3

continuous pay premium of $165,687 is selected to coordinate the lowest borrowed premium each year to minimize the out-of-pocket costs, which is loan interest due each year. The initial loan rate will be at 7.0%1 and interest will be paid in arrears. The table below summarizes how the numbers will look. The key numbers for comparison purposes is the Internal Rate of Return (IRR) which demonstrates the efficiency of premium financing over nonfinanced insurance. In addition, the difference between the annual outlays for financed insurance vs. non-financed insurance can be invested in the FLP’s assets to further increase the value.

CONCLUSION We have demonstrated how to achieve triple leverage with the FLP by: Reducing the taxable estate by transferring Limited Partnership interests at a discount to the children Purchasing life insurance inside the FLP to further increase FLP assets from $1.3 million to $5.05 million. Only the General Partnership interest of $50,500 (1% of $5,050,000) will be includable in the estate. Leveraging the life insurance purchase by utilizing a premium financing strategy allowing the FLP to reinvest or distribute annual income to respective interests. The end result is that a significant percentage of an estate can be transferred outside the taxable estate and can be leveraged to grow those assets for the benefit of future generations, as long as appropriate IRS guidelines are followed.

Annual Outlay Net Death Death Benefit for Non-Financed Benefit for for Non-Financed Insurance Financed Insurance Insurance

IRR for Financed Insurance

IRR for Non-Financed Insurance

1

$0

$94,636

$3,750,000

$3,750,000

5

$46,392

$94,636

$3,750,000

$3,750,000

262.99%

79.29%

10

$104,383

$94,636

$3,750,000

$3,750,000

51.08%

24.17%

15

$162,373

$94,636

$3,750,000

$3,750,000

19.11%

11.41%

20

$220,364

$94,636

$3,750,000

$3,750,000

7.09%

6.14%

This illustration must be accompanied by a basic illustration displaying values on the same premium outlay and assumptions, and prepared on the same date as this illustration. Please see the basic illustration for guaranteed elements and other important information. This is to be used with traditional premium financing programs only. 1 The loan interest rate is fixed for a 1 year term and will rollover on each anniversary to a rate based on the one year LIBOR in effect at that time. This information is intended to be of a general education nature. Sun Life Financial and its independent distributors do not give legal, tax or accounting advice. For specific tax or legal advice seek and rely on a qualified tax advisor or attorney. Sun Life Financial and its distributors specifically disclaim any liability or loss which is incurred as a consequence, directly or indirectly, of the use of this program.

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SLPC 19243 08/08

FOR PRODUCER USE ONLY NOT FOR USE WITH THE PUBLIC