Vol. 76, No. 5, May 2003

Removing Life Insurance
from Taxable Estates

by Dean T. Stange

he use of the irrevocable life insurance trust (ILIT) is standard practice for many attorneys, accountants, and insurance and financial representatives when planning to remove the ownership and proceeds of a life insurance policy from the estate of an individual for estate tax purposes. However, the use of entities taxed as a partnership, particularly limited liability companies (LLC), is becoming more popular as an alternative to the ILIT.

For many planners, the LLC has become a common tool for estate tax planning, particularly to facilitate the testator's ability to make discounted gifts of assets to children while retaining voting control over the LLC. The LLC has become popular because of its advantages over family limited partnerships, which require, among other things, a general partner to be personally liable to the partnership's creditors. In contrast, all members of the LLC receive the same creditor protection. A comparison of the LLC and family limited partnership is beyond the scope of this article.

Following is a comparison of the advantages and disadvantages of using an LLC in place of an ILIT. For purposes of this article, it will be presumed that an LLC is taxed as a partnership for income tax purposes.

Control of Policy

The most commonly cited advantage of using an LLC in place of an ILIT is the insured's control of the policy, which is not available with an ILIT. Under the Internal Revenue Code (I.R.C.), an insured cannot be a trustee of a trust that owns a policy on his or her life if the insured's intent is to remove the policy from his or her taxable estate. An individual is considered to have an "incident of ownership" in an insurance policy on his or her life held in trust if, under the policy terms, the individual has the power (as trustee or otherwise) to change the beneficial ownership in the policy or its proceeds. This is true whether the individual acted alone or in conjunction with others and even though the individual has no beneficial interest in the trust.¹ Although this provision has been interpreted by the federal circuit courts to allow the insured to have certain limited powers over the policy, the safe practice has been to avoid allowing the insured any role as trustee.

Unlike an ILIT, the insured may be a member of an LLC that owns life insurance on his or her life without causing the policy to be included in the insured's estate if the LLC is also the beneficiary of the policy. This position was first established in 1955 in Estate of Knipp v. Commissioner,² in which the tax court held that 10 life insurance policies owned by a partnership on the life of a decedent who owned a 50 percent interest in the partnership would not be included in the decedent's estate because the decedent had no power to exercise rights of ownership over the policies as an individual. The Internal Revenue Service (IRS) adopted the Knipp rationale in Revenue Ruling 83-147,³ which holds that when the proceeds of the life insurance policy are payable to a partnership the rules of I.R.C. § 2042 become inapplicable, since the " ... inclusion of the proceeds ... would have resulted in the unwarranted double taxation of a substantial portion of the proceeds, because the decedent's proportionate share of the proceeds of the policy were included in the value of the decedent's partnership interest."⁴ If the policy proceeds are payable to anyone other than the partnership, then the policy proceeds will be included in the insured's estate.

Recent IRS rulings have confirmed the results of Knipp and Revenue Ruling 83-147. In Private Letter Rulings 9843024 and 200214028, the IRS ruled that the insured partner would not possess any incidents of ownership under I.R.C. § 2042(2) for life insurance policies owned by and payable to the partnership.

A corollary of the control issue is the additional flexibility that an LLC may provide. An ILIT typically cannot be revoked or amended, except by statutory authority or court decree, or if the trust agreement itself provides a mechanism for amendment. (Wisconsin statutes provide for the revocation, modification, or termination of a trust with the written consent of the settlor and all beneficiaries,⁵ raising the question whether any trust executed in Wisconsin is ever truly irrevocable.) An LLC operating agreement, on the other hand, may be amended as needed by the members at any time. This additional flexibility allows the LLC to be used in situations in which an ILIT is impractical. For example, rather than have multiple owners of a business each purchase life insurance policies on each of the other owners to fund a cross purchase buy-sell agreement, the owners could form an LLC to own the policies, resulting in only one policy on each owner with the proceeds being used to fund the buy-sell agreement.

In fairness to the use of an ILIT regarding concerns over flexibility, distributions of insurance proceeds upon liquidation of the LLC generally must be made in accordance with each member's respective ownership interests in the LLC. Consequently, there is limited flexibility on how life insurance proceeds held by an LLC may be distributed to the members.

Although an LLC operating agreement clearly provides more flexibility by its nature, the circumstances of each case will dictate the importance of control and flexibility. The degree of control over the policy and flexibility of the entity owning the policy typically should not be the primary considerations when deciding which entity to use. The primary consideration is the intent of the use of the proceeds at death and whether the ultimate individual policy beneficiaries are responsible enough to receive the wealth. For example, if the proceeds of a life insurance policy are held primarily for the benefit of children who have not reached an appropriate age to receive substantial wealth, then an ILIT is likely more appropriate because of the trustee's ability to limit distributions of income and principal to the beneficiaries pursuant to specific instructions set forth by the trust grantor. On the other hand, if the children are responsible enough to receive the policy proceeds as members of the LLC or the parents are already using an LLC to make discounted gifts of assets to children, then an LLC may be the preferred entity to own the policy. Obviously, these are simple examples.

Gift and Estate Tax

The most common criticism of the ILIT is the cumbersome procedures clients must pursue to qualify contributions to the trust for the annual gift tax exclusion. For a gift to qualify for the annual gift tax exclusion, the gift must be of a present interest.⁶ Treasury regulations specifically provide that the payment of premiums on a life insurance policy owned by a trust is a future interest and therefore does not qualify for the annual gift tax exclusion.⁷ Qualifying such contributions to the trust for the annual gift tax exclusion is routinely accomplished by providing trust beneficiaries with a so-called "Crummey" withdrawal power⁸ (named after the court case approving the technique), the use of which has become legendary in estate planning. A Crummey withdrawal power gives a trust beneficiary the right to withdraw a pro rata portion of the contribution of premiums to the trust for a period of time (typically 30 days), making the gift a present interest. Notice of this Crummey power is required to be given to trust beneficiaries every time the insured makes a contribution to the trust to pay life insurance premiums. Of course, the "understanding" by the trust beneficiaries is that the withdrawal right should never be exercised.

There are several potential drawbacks to relying on the use of Crummey powers. The paperwork and record keeping required with the use of Crummey withdrawal powers can be problematic. Clients (and attorneys and insurance representatives) routinely neglect to follow the Crummey rule technical requirements, such as providing proper written notice to trust beneficiaries every time contributions are made to the trust to pay life insurance premiums. The insured may make the error of paying the premium to the life insurance company directly instead of contributing the funds to the ILIT trustee to pay the premium. In addition, even with the use of Crummey withdrawal powers, depending upon the number of beneficiaries and the size of the insurance premium, the insured still may be required to use part of his or her lifetime gift tax credit to contribute the necessary funds to the ILIT for payment of premiums. Because of the fairly common need to contribute large premium payments to an ILIT, the IRS has attacked Crummey withdrawal power arrangements, which they view as abusive.⁹ Finally, there have been recent federal legislative proposals to abolish the use of Crummey withdrawal powers for annual gift tax exclusion qualification.

Unlike the need for the use of Crummey powers in an ILIT, contributions by the insured to an LLC to pay premiums on a policy owned by the LLC do not need to qualify for the annual gift tax exclusion, provided the contributions are reflected in the insured's capital account. The insured member can then make gifts of his or her LLC interests to other members, taking applicable discounts for lack of marketability and lack of control.

To provide maximum gifting of assets through the LLC while retaining control by the insured, the LLC operating agreement typically provides for voting and nonvoting membership interests, with the insured (and typically the spouse) holding the voting interests. The remaining, nonvoting, interests are then gifted to children using the parents' annual gift tax exclusions. Thus, if the insured is a 1 percent owner of LLC units after having gifted the 99 percent nonvoting units to children, the fair market value of 1 percent of the LLC (including 1 percent of the insurance proceeds paid at death) will be included in his or her estate for estate tax purposes. In the meantime, the 1 percent voting interest the insured retains in the LLC is sufficient for the insured to maintain control over the entity and the policy, assuming a properly drafted operating agreement. At the insured's death, the insurance proceeds in the LLC can be distributed to the children, loaned to the insured's estate for payment of estate taxes, or used to purchase assets from the insured's estate.

Family LLCs typically provide that a member may not transfer an interest in the LLC or withdraw from the LLC without the approval of a majority of the remaining members. The purpose of such a provision is to provide for discounts of the value of interests due to lack of marketability (provided such "applicable restrictions" are not more restrictive than state law¹⁰) and to ensure that membership interests are not transferred to unrelated parties, however unlikely that may be. Planners, however, should not give the insured managing member or controlling member unilateral power to determine whether such transfers of interest may occur or to liquidate the LLC, because the IRS will argue that the gifts therefore are ineligible for the gift tax annual exclusion.¹¹ This result can be avoided by allowing members to transfer their interests to third parties subject to a right of first refusal by the LLC or the remaining members at the offering price.

A brief word is appropriate here about the need to honor the LLC as a separate entity when contemplating estate tax planning with LLCs, particularly when making gifts of LLC interests. In all cases, the LLC must be established and operating before gifts are made to children, clients must generally allocate LLC income in proportion to the ownership interests of the members, and gifts of LLC interests to children must be properly documented. As with an ILIT, there can be no agreement between the members that policy proceeds are to be used to pay estate taxes or any other obligation of the insured decedent member, which could cause inclusion under I.R.C. § 2042(1) and the applicable Treasury Regulations. Failure to honor and abide by the LLC entity form risks the loss of all of the estate tax benefits desired and achievable through proper planning.

Income Tax Considerations

Income tax issues for an ILIT are typically minimal since there will likely be no income as a result of the trust owning life insurance as its sole asset. If an ILIT owns income-producing assets in addition to life insurance, the trust may be treated as a grantor trust for income tax purposes because of the ability to use trust income to pay premiums for insurance on the grantor's life, resulting in any income being taxable to the grantor.¹² The taxation of income in an ILIT is further complicated because trust income, if any, will be allocated to the Crummey power holders to the extent they fail to exercise their powers of withdrawal.¹³ By comparison, to the extent an LLC owns income-producing assets other than life insurance, the income will be taxed to the members in proportion to their ownership interests under Subchapter K of the I.R.C.

The proceeds of a life insurance policy are typically excluded from the beneficiary's gross income.¹⁴ A trust can distribute life insurance policy proceeds to the beneficiaries income tax free because the proceeds, being excluded from trust taxable income, will not generate any "distributable net income."¹⁵

A member of an LLC realizes taxable income on the proceeds of the policy only to the extent that he or she receives a distribution in excess of the basis of his or her partnership interest.¹⁶ However, each partner's basis will be increased by his or her share of the life insurance proceeds received by the LLC.¹⁷ As a result, the LLC may also distribute the policy proceeds to its members without generating income to them.

An exception to the tax-free treatment of the proceeds of life insurance is if the transfer of a life insurance policy is made for valuable consideration (a transfer for value).¹⁸ To the extent the policy owner paid to acquire the contract, the death benefits paid on the policy are excludable only to the extent of the actual value of the consideration paid, plus any premiums or other amounts paid by the owner after transfer.¹⁹ An important exception provides that the transfer-for-value prohibitions will not apply if the transfer of the policy is to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer.²⁰ As a result, the transfer of a life insurance policy to an LLC should avoid transfer-for-value issues if the insured is a member of the LLC.

Insurance as Sole Asset of LLC

One of the primary issues that has limited the use of partnerships as owners of life insurance policies in the past is the threshold question of whether the partnership is required to have a "business purpose," particularly in the context of a partnership owning life insurance as its sole asset. In addition, if life insurance is the sole asset in an LLC with voting and nonvoting interests, there is some risk that the IRS will take the position that the insured's voting control constitutes an indirect incident of ownership sufficient to cause inclusion of the life insurance in the estate under I.R.C. § 2042.

The "business objective" test has arisen from the requirement contained in prior classification regulations that an entity must have a "business objective" to be classified as a partnership.²¹ However, since March 1995, individuals have simply been allowed to choose which form of taxation they desire for an LLC, regardless of the criteria involved. Recent tax court cases indicate that courts will respect an entity that is validly created in accordance with state law even if the court questions the nontax reasons set forth for creating the entity. In a recent case, Estate of Strangi v. Commissioner,²² the tax court held that a family limited partnership created by a decedent had sufficient substance for estate tax purposes because it was valid under state law. The court rejected the IRS argument that the partnership should be disregarded, even though the court did not believe the estate's nontax reasons for establishing the entity, because the family limited partnership was " ... validly formed under state law. The formalities were followed and the proverbial i's were dotted and the t's were crossed. The partnership, as a legal matter, changed the relationship between the decedent and his heirs and decedent and actual and potential creditors. Regardless of subjective intentions, the partnership has sufficient substance to be recognized for tax purposes. Its existence would not be disregarded by potential purchasers of decedent's assets, and we do not disregard it in this case."²³

Even though some courts may be relaxing the "business purpose" test for partnerships (provided that the business organizational documents are valid under the law of the state of organization), it may continue to be an issue. As a result, to avoid business purpose and related IRS estate inclusion arguments, cautious practitioners should include additional assets in the LLC with a life insurance policy.²⁴ Such other assets can then also be used to pay the premiums and thereby eliminate the need for the insured to continue making annual contributions to the LLC.

Conclusion

The use of an LLC to remove life insurance from the insured's taxable estate is an option that is too often overlooked by attorneys, accountants, and insurance and financial representatives as an alternative to the ILIT. The LLC may provide the insured with additional flexibility and control over the policy with no significant loss of the income or gift and estate tax protection provided with an ILIT, while avoiding the cumbersome procedures required to qualify annual premium payments to an ILIT as a present interest gift. While the use of an LLC does not solve all of the problems of an ILIT and is not appropriate in all circumstances, it is an option that deserves more consideration.

Endnotes

¹ I.R.C. § 2042(2); Treas. Reg. § 20.2042-1(c)(4).

² 25 T.C. 153 (1955), acq. in result, 1959-1 C.B. 4, aff'd on other issues,

244 F.2d 436 (4th Cir. 1957).

³ 1983-2 C.B. 158.

⁴ In Revenue Ruling 83-147, the insurance proceeds were payable to a third party, which resulted in estate tax inclusion of the policy in the insured's estate.

⁵ Wis. Stat. § 701.12(1).

⁶ I.R.C. § 2503(b).

⁷ Treas. Reg. § 25.2503-3(c), example (2).

⁸ Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).

⁹ See Estate of Cristofani v. Commissioner, 97 T.C. 74 (1991).

¹⁰ I.R.C. § 2704(b); Treas. Reg. § 25.2704-2(a). For purposes of valuing the transferred interest, the IRS will ignore any restrictions on the ability of the partnership to liquidate that are more restrictive than state law in the absence of such an agreement. See Wis. Stat. section 180.0802(3)(b), which restricts the unilateral ability of an LLC member to withdraw.

¹¹ See Hackl v. Commissioner, 118 T.C. No. 14 (2002), currently on appeal.

¹² I.R.C. § 677(a)(3).

¹³ I.R.C. § 678(a)(1). See also Rev. Rul. 67-241, 1967-2 C.B. 225.

¹⁴ I.R.C. § 101(a)(1).

¹⁵ I.R.C. § 643(a).

¹⁶ I.R.C. § 731(a)(1).

¹⁷ I.R.C. § 705(a)(1)(B).

¹⁸ I.R.C. § 101(a)(2).

¹⁹ Id.

²⁰ I.R.C. § 101(a)(2)(A). See also Priv. Ltr. Rul. 200111038.

²¹ Former Treas. Reg. § 301.7701-2(a)(2).

²² 115 T.C. 478 (2000), aff'd in part, rev'd in part, 293 F.3d 279 (5th Cir. 2002).

²³ Id. at 486-87.

²⁴ In addition, the LLC may violate the investment company rules of I.R.C. § 721(b) and Treasury Regulation § 1.351-1(c)(1) if more than 80 percent of the assets of the LLC are cash, stocks, or securities. Insurance is not defined as a "security" in the regulations, but a variable life policy holding securities in a subaccount may meet the definition of securities.

Wisconsin Lawyer