Fractional interest transfers of life insuranceArticle added by Julius Giarmarco on September 12, 2011
Julius Giarmarco

Julius Giarmarco

Troy, MI

Joined: July 07, 2008

Similar to gifting or selling fractional interests in real estate, the owner of a life insurance policy can make a partial interest transfer of the policy. For example, instead of gifting or selling his life insurance policy to an ILIT for the benefit of his three children, a father could transfer a one-third interest in the policy to three separate ILITs as joint owners (one for the benefit of each child).

Perhaps the most common type of fractional interest transfers are gifts or sales of fractional interests in real estate. Generally, each owner of the real estate has the right to partition (i.e., seek a judicial sale of the property), the right to a pro rata share of the income, and veto power concerning the use or sale of the property.

Nevertheless, common sense and numerous judicial decisions tell us that a fractional interest in real estate is worth less than the interest’s pro rata portion of the total property value. While the IRS usually attempts to limit the amount of the fractional interest discount to the cost to partition the property, many judicial decisions support discounts greater than the cost of partition in determining FMV (because fractional interests lack control and marketability).

For example, in Ludwick v Commissioner, T.C. Memo. 2010-104 (May 10, 2010), the tax court found 17 percent to be the appropriate discount for a fractional interest in a vacation home. In J.C. Shepard v Commissioner, 115 T.C. 30 (2000), the tax court allowed a 15 percent discount for a fractional interest in timberland. And in Estate of S. LeFrak v Commissioner, T.C. Memo. 1993-526 the tax court approved a combined 30 percent (20 percent minority interest and 10 percent lack of marketability) for a gift of a fractional interest in apartment buildings.

Arguably, the valuation discounts tend to be higher if the real property is assigned to a family LLC and gifts of non-voting memberships are made to the donees. However, fractional interests in real estate may avoid some of the issues that can be troublesome with LLC discounts.

Similar to gifting or selling fractional interests in real estate, the owner of a life insurance policy can make a partial interest transfer of the policy. For example, instead of gifting or selling his life insurance policy to an ILIT for the benefit of his three children, a father could transfer a one-third interest in the policy to three separate ILITs as joint owners (one for the benefit of each child).

As a result of this joint ownership, under the policy contract the unanimous consent of all three trustees will be needed to exercise any policy options (i.e., borrowing, surrendering, exchanging, pledging and naming a beneficiary). In addition, all three trusts must agree on paying premiums.

What are some practical applications for making fractional interest transfers of life insurance? When gifting a policy with a large cash value, the gift tax value of the policy should be discounted if the policy is transferred to multiple persons (or ILITs) as joint owners, thereby leveraging the donor-insured’s gift tax exemption. The initial gift of the partial interests in the policy will not qualify for the $13,000/$26,000 annual gift tax exclusion.

Thus, the donor-insured will have to use his/her $5 million gift tax exemption to cover the gift. The annual gift tax exclusion is unavailable if the transfer is not a gift of a present interest (i.e., the joint owners lack key rights of control and liquidation). But this cloud has a silver lining because it tends to support the valuation discount in the first instance. Future gifts to pay premiums can qualify for the annual gift tax exclusion if made directly to the ILITs (using Crummey powers) as opposed to being paid directly to the carrier.
Another application is a sale of the policy to multiple ILITs. Under this arrangement, the grantor-insured makes cash gifts to the ILITs to provide the purchase price. These cash gifts will qualify for the annual gift tax exclusion if Crummey powers are used.

An added benefit of this approach is that the three–year rule of IRC Section 2035 does not apply (because these are sales at FMV as opposed to gifts). The ILITs must be designed as grantor trusts, otherwise the transfer-for-value rule will apply. Rev. Rule 2007-13. Another reason for designing the ILITs as grantor trusts is to avoid any taxable gain on the sale (since transfers between a grantor and his/her grantor trust are disregarded for income tax purposes under Rev. Rule 85-13).

A third application for a partial interest transfer of a life insurance policy is a sale between ILITs. Assume the grantor-insured of an ILIT is no longer happy with its terms (and/or beneficiaries) and, therefore, decides to make no further gifts to that ILIT. Thus, the trustee might be well advised to sell the policy to other ILITs created by the grantor (for concern of the policy lapsing).

Assuming those ILITs are all grantor trusts, then for the reasons mentioned above, the sales can be made without application of the three year rule, without causing a transfer-for-value, and without incurring any gain. At the same time, the reduced sales price (because of the fractional interest discounts), leaves less money in the undesirable ILIT. Of course, the trustee of the old ILIT has a fiduciary duty to do what is in the best interests of the beneficiaries of that ILIT.

To support an appropriate discount for a partial interest transfer of a life insurance policy, an appraisal will be required. The first step is to obtain the value of the policy from the carrier. The carrier will issue an IRS Form 712, which provides the policy’s interpolated terminal reserve value.

For an insured in poor health, it may be advisable to look to the life settlement market to determine the FMV of the policy. The next step is to hire a valuation expert who understands valuation methodologies and how they apply to partial interests. The appraiser will need to apprise himself/herself of any options under the policy contract that can be exercised by a single joint owner.

Arguably, the discounts for a fractional interest in a life insurance policy should be greater than a fractional interest in real estate because, unlike the situation with real estate, a joint owner of a life insurance policy does not have a right of partition.

Whether a partial interest transfer of a life insurance policy is made by gift or sale, the insured should not retain any interest in the policy. Otherwise, the insured may be deemed to have retained an incident of ownership resulting in the entire death benefit being included in the insured’s estate under IRC Section 2042(2).

Finally, to avoid a possible step-transaction argument by the IRS when the partial interests are being transferred to trusts (as opposed to individuals), the terms of the trusts should vary to suit the individual needs of the beneficiaries, and different trustee should be appointed.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX AD



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