Partner A and Partner B are partners in an LLC treated for income tax purposes as a partnership and co-shareholders in other entities.
Partner A and Partner B have entered into a buy-sell arrangement which among other things provides that in the event of the death of one of them, the other will purchase the deceased shareholder’s interests. The obligations to purchase have been partially funded with life insurance. Thus Partner B is the owner of a life insurance policy on Partner A’s life in the amount of $5,000,000 and likewise Partner A owns a life insurance policy on Partner B for $5,000,000.
Partner A has a very substantial estate likely to be subject to the Federal Estate Tax.
Estate Tax Consequences:
In the event Partner B passes away, Partner A will use the insurance proceeds to purchase the business interests owned by Partner B. Since the estate of Partner B is exchanging cash for an equal value of stock, the value of Partner B’s taxable estate will not be increased by this transaction.
However, the taxable estate of Partner A will be increased by the value of Partner B’s ownership interest in Corporation which has been added to Partner A’s taxable estate. Assuming an effective Estate Tax rate of 41% to 55%, the additional Estate Tax payable upon the death of Partner A will vary between $2,050,000 and $2,750,000.
The proposed alternative would create a situation in which if Partner B passed away before Partner A, the value of Partner B’s interests would not increase Partner A’s taxable estate. To achieve this:
1. Partner A would create an irrevocable trust (hereinafter the “Trust”).
a. The Trust would be created as a grantor trust pursuant to IRC §671 et seq. and treated as his alter ego for income tax purposes and thus ignored for all income tax purposes.
b. The beneficiaries of the Trust would be Partner A’s children, not Partner A.
c. Partner A would transfer his ownership interest in the life insurance policy owned on Partner B’s life into the Trust.
i. Assuming this insurance policy was originally purchased by Partner A and not purchased by someone else and assigned to Partner A, the transfer of this insurance policy from Partner A to the Trust will not be a “taxable transaction” for income tax purposes, nor treated as a “transfer for consideration” pursuant to IRC §101(a) because the Trust is a transfer of the asset from Partner A to Partner A’s alter ego, and since Partner A is a partner of Partner B, is exempt as discussed hereafter.
ii. However, if the life insurance policy has loans against them, or cash surrender value, there are gift tax issues which will have to be dealt with.
d. The Trustee of the Trust would be Partner A.
i. Note that since the insurance owned by the Trust is not insuring Partner A’s life, the life insurance proceeds are not attributed to him under IRC §2042.
2. Should Partner B predecease Partner A:
a. The Trust would collect the insurance proceeds.
i. These proceeds would be received income tax free pursuant to IRC 101(a) and not treated as having been received as a result of a “transfer for consideration” since the initial transfer into the Trust (the alter ego of Partner A) would be treated as a transfer to a “partner” and therefore exempt from the normal “transfer for consideration” rules pursuant to IRC §101(a)(2)(B).[Rev. Rul. 77-402, 1977-2 C.B. 222, 119 and Rev. Rul. 74-76]
b. The Trust would use the insurance proceeds to purchase Partner B’s stock pursuant to the terms of the buy-sell agreement. Thus the Trust, not Partner A, would be the owner of what had been Partner B’s ownership interests.
i. The buy-sell agreement would have to be amended to, among other things, to make the Trust a co-obligor with Partner A to purchase the stock.
ii. Since Partner A is the trustee of the Trust, he would have the ability to control the voting interests of the entities owned by the Trust and could manage/sell those assets as he determined fit.
3. Upon Partner A’s passing away, he would not be considered the owner of the assets of the Trust for estate tax purposes since he retained no beneficial interest in the trust and the assets would inure to the benefit of his children, estate tax and income tax free.
a. If properly structured, so that the assets would remain in separate, equal sub-trusts for each of the children/beneficiaries, they would have the right to use the income as well as the principal of their respective trusts for their health, education, maintenance and support needs (which includes everything) for the remainder of their lifetime, be protected from their creditors (divorces, bankruptcies and law suits) and not be considered as part of their taxable estate when then pass away, thus passing the assets again income tax, estate tax and gift tax free on to their heirs.
4. It would be possible to include provisions in the parties’ agreements providing that should Partner B predecease Partner A, Partner A or Partner A’s trust would have the right to purchase the life insurance on Partner A owned by Partner B. Should Partner A’s Trust purchase this life insurance, Partner A should resign as Trustee immediately otherwise the proceeds of the life insurance upon his death will be included in his taxable estate pursuant to IRC §2042. Should Partner A personally purchase the life insurance, he would likely want to transfer it into his existing Irrevocable Life Insurance Trust (“ILIT”) or alternatively an agreement that the insurance would be sold directly to Partner A’s ILIT.
5. The reciprocal of this arrangement can be created for Partner B as well.
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