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Structuring Preferred Partnership Freezes
in Estate Planning: Navigating IRC
Chapter 14 Valuation Rules
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
WEDNESDAY, MARCH 30, 2016
Presenting a live 90-minute webinar with interactive Q&A
Stephen M. Breitstone, Partner, Meltzer Lippe Goldstein & Breitstone, Mineola, N.Y.
David C. Jacobson, Counsel, Meltzer Lippe Goldstein & Breitstone, Mineola, N.Y.
Edward Vergara, Partner, Kaye Scholer, New York
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FOR LIVE EVENT ONLY
Structuring Preferred Partnership Freezes in Estate
Planning – Navigating IRC Chapter 14 Valuation Rules
Presented by:
Stephen M. Breitstone
David C. Jacobson
Edward A. Vergara
Presentation Overview
• Understanding IRC 2701 provisions
• Comparison of the freeze partnership to other techniques
• Grantor Trust Risks
• Use of preferred partnerships with various trusts
• Structure of Preferred Partnerships
6
Understanding IRC 2701 Provisions
7
Understanding IRC 2701 Provisions
IRC 2701 provides for special valuation rules in the context of
family-controlled entities
• Provisions intended to discourage the use of entity “design” to
enhance wealth transfer between generations.
• Failure to account for IRC 2701 provisions can result in
unanticipated gift and estate tax consequences.
• Can apply even when transaction not intended to achieve
wealth transfer or save estate or gift taxes.
8
Understanding IRC 2701 Provisions
Perceived Abuse Prior to IRC 2701
• Under general valuation principles, the gift/estate tax value of entity interests are
determined under the “subtractive method.”
Value of Transferred Interest = (Value of Entity – Value of Retained Interest)
• In order to depress the gift/estate tax value of entity interests transferred to a younger
generation, the gift/estate tax value of interests retained by senior-generation (typically
preferred interests) were enhanced through the addition of certain discretionary rights (e.g.,
rights to non-cumulative dividends, redemption rights, conversion rights, etc.).
• Discretionary rights increased gift/estate tax value of parent’s retained interest, and by
extension reduced value of common interest transferred to younger generation, even
though discretionary rights unlikely to be exercised in context of family-controlled entity.
• IRC 2701 ignores such discretionary rights and assigns zero value to them in determining
value of senior family interests under Subtraction Method.
9
Perceived Abuse
• Preferred interests provide for
non-cumulative coupon, payable
in the discretion of Board
controlled by G2
• Preferred interests provide for
powerful put rights an/or
liquidation preference
• Discretionary rights exercised to
benefit Common interests
G1 Entity
Family Company $10M
Non-cumulative Preferred Interest
G2 Entity
Common Interest
Liquidation rights
Pre-2701
Value of Company $10M
Less: Value of Preferred $9.5M (Artificially high)
Gift Value of Common $500k
Post-2701
Value of Company $10M
Less: “Zero valuation $0 rule”
Gift Value of Common $10M
10
Understanding IRC 2701 Provisions
• Perceived abuse addressed through “zero valuation rule”;
Discretionary rights ignored in determining gift/estate tax
value of preferred interests retained by senior generation
• Narrow Exceptions to Zero Valuation Rule:
• When senior generation’s preferred interest structured within
certain parameters designed to ensure that retained rights are
both mandatory and quantifiable.
11
Understanding IRC 2701 – Technical Provisions
Application of § 2701- Overview
• Generally, the zero valuation rule of IRC 2701 can cause a deemed gift to
occur when there is a “Transfer” to a “Member of Transferor’s Family” of an
interest in an entity controlled by “Applicable Family Members”
• Transfer. Broadly defined and includes traditional transfer, capital contribution
to new or existing entity, redemption, recapitalization or other change in capital
structure of entity.
• Applicable Family Member. Includes Transferor’s spouse, any ancestor of
Transferor or his or her spouse, and spouse of any such ancestor. Attribution
rules apply in measuring control.
• Member of the Family. Includes Transferor’s spouse, any lineal descendant of
Transferor or his or her spouse, and spouse of any such descendant.
12
Understanding IRC 2701 – Technical Provisions
• Exception to Distribution Right – “Qualified Payment Right”
• Any dividend payable on periodic basis (at least annually) under any
cumulative preferred stock, to the extent such dividend is determined at fixed
rate;
• Any other cumulative distribution payable on periodic basis (at least annually)
with respect to equity interest, to the extent determined at fixed rate or as fixed
amount; or
• Any Distribution Right for which election has been made to be treated as
Qualified Payment.
• Because Qualified Payments are mandatory, and no discretion of family controlled
entity to make or withhold distributions exists, perceived opportunity to manipulate
value does not exist; therefore, zero valuation rule will not apply.
13
Understanding IRC 2701 – Technical Provisions
• “Lower Of” Rule for Valuing Qualified Payment Right Held in Conjunction with
Extraordinary Payment Right
• Example: Dad, the 100% stockholder of corporation, transfers common stock to Child and
retains preferred stock which provides (1) Qualified Payment Right having value of
$1,000,000 and (2) right to put all preferred stock to corporation at any time for $900,000
(Extraordinary Payment Right).
• At time of transfer, corporation’s value is $1,500,000.
• Under “Lower of” rule, value of Dad’s retained interest is $900,000, even though he retains
Qualified Payment Right worth $1,000,000
• Retained interests are valued under assumption that Dad exercises Extraordinary
Payment Right (put right) in manner resulting in lowest value being determined for all
retained rights.
• Result: Dad made gift of $600,000 ($1,500,000 - $900,000) rather than $500,000 (if value
of preferred interest was based on the $1,000,000 value of Qualified Payment Right).
14
Understanding IRC 2701 – Technical Provisions
• Minimum Value of Junior Equity Interest
• If § 2701 applies, in the case of transfer of junior equity interest,
such interest shall not be valued at amount less than 10% of
sum of (1) total value of all equity interests, plus (2) total
indebtedness of entity to Transferor or Applicable Family
Member.
15
Understanding IRC 2701
• Rights that Are Not Extraordinary Payment Rights or
Distribution Rights (i.e., rights that do not trigger application
of § 2701):
• Mandatory payment rights.
• Liquidation participation rights.
• Guaranteed payment rights.
• Non-lapsing conversion rights.
16
Understanding IRC 2701
• Circumstances Where IRC 2701 Inapplicable
• Same Class. Where retained interest and transferred interest are
of “same class” (i.e., rights associated with retained interests are
identical (or proportional) to rights associated with transferred
interests, except for non-lapsing differences in voting rights).
• Market Quotations. If readily available market quotations exist on
established securities market for either transferred interest or
retained interest.
• Proportionate Transfers (also known as “Vertical Slice”). Where
transfer results in proportionate reduction of each class of equity
interest held by senior and junior family members.
17
Comparison of the freeze partnership to other techniques
18
Negative Capital
What is this Negative Capital?
• Liabilities in Excess of Basis
Is it logical?
• Negative Capital is an accounting concept, not an economic one
Determination of Gain or Loss
• Fair market value of property is deemed to be not less than the
nonrecourse liabilities to which the property is subject. IRC §
7701(g)
• Phantom Gain
19
Phantom Gain
AB Partnership
Assets
Real Estate (fmv) $10,000,000
Real Estate (adj. basis) $1,000,000
Liabilities – Mortgage ($8,000,000)
Capital – Equity (cash
proceeds from sale)
$2,000,000
Gain Subject to Taxation
($7mm phantom)
($9,000,000)
Tax on Gain if Real Estate is
Sold For
$10,000,000
Tax @ 20% $1,800,000
Tax @ 25% $2,250,000
Tax @ 41.5% (Fed, NIIT, NYS and NYC) $3,735,000
• $7mm phantom
gain
• Tax liability with no
cash to pay
20
Comparison of freeze partnership to other techniques
• Grantor Retained Annuity Trusts (GRATs)
• Sale to Intentionally Defective Grantor Trusts (IDGTs)
21
Grantor Retained Annuity Trusts
Advantages
• Transfer of appreciation
• Can zero-out
• No valuation risk
• Low hurdle rate - 7520 rate for March 2016 is 1.8%
Considerations and Risks
• Must survive term
• GST inefficient
• Negative Capital ?
• No basis step-up ?
22
Installment Sales To IDGTs
Advantages
• Transfer of appreciation
• Lowest hurdle rate – mid-term AFR for March 2016 is 1.48%
• GST efficient
Considerations and Risks
• Property might depreciate
• Valuation
• Not eligible for Section 6166
• Negative Capital ?
• No basis step-up ?
• Income in Respect of a Decedent ?
23
Sale to IDGT Flowchart
24
Promissory
Note
Sale of
Assets
IDGT
Trust for
spouse and
descendants
Assumptions
• Client sells $10 million worth of LLC units to IDGT
• IDGT gives Client 9-year promissory note, providing
for 1.48% annual interest (AFR) during the term,
and a balloon payment at the end of the term
• 8% annual growth rate
• Annual interest payments from IDGT to client are
$167,000
• Value of assets transferred at end of 9 years is
$7,904,624
Client
24
Freeze Partnerships
Advantages
• Negative Capital – gain not triggered
• Basis step-up for frozen interest (including negative capital)
• Statutory guidelines under section 2701
• Section 6166 estate tax deferral
Considerations
• Highest hurdle rate
• Possible section 2701 deemed gift
25
FMV Facts & Circumstances
• Yield
• Preferred return coverage
• Dissolution protection
• Voting rights
• Lack of marketability
• Underlying assets
Volatility
Income production
• Market conditions
Valuing Preferred Interest - Rev. Rul. 83-120
Most Important
Rate is lower if
issuer cannot
redeem
26
Valuing Preferred Interest – Market Conditions
Sector Mean Median Min Max
Residential 6.79% 6.81% 6.62% 6.92%
Commercial 6.32% 6.25% 6.14% 6.64%
Data Centers 6.89% 6.79% 6.21% 7.83%
Industrial 7.41% 7.43% 6.80% 8.48%
Lodging 7.56% 7.59% 6.35% 8.82%
Mixed 6.81% 6.72% 5.69% 8.26%
Mortgage 8.79% 8.47% 7.58% 11.77%
Office 6.35% 6.50% 5.18% 7.20%
Retail 6.69% 6.56% 5.66% 8.11%
Single Family 5.14% 4.98% 4.95% 5.49%
Storage 5.84% 5.73% 5.28% 7.23%
• The information provided is a compilation of
the returns for preferred stock issued by
publicly reporting REITS in each sector as
of March 1, 2015.
• The information provided is not meant to be
used for specific privately held companies
without further analysis of each issue
making up the sector’s returns. In order to
apply a sector's returns they most be
adjusted to make them comparable to the
subject company to which they are being
applied.
• Market data courtesy of
Stephen Shulman and Associates
27
Comparison: Installment Sale v. Freeze Partnership
Estate
Installment note $2,000,000
Basis $1,000,000
Income Tax possible IRD or Gain on
$7,000,000 (liabilities in
excess of basis)
Trust
Property sold $10,000,000
Basis $8,000,000
Built in gain $2,000,000
Freeze Partnership
Value $10,000,000
Liabilities $8,000,000
Equity $2,000,000
Basis step-up $9,000,000
Built in gain 0
28
What Happens if Grantor Dies Before Note is Paid Off?
Lifetime termination of grantor trust status - tax consequences are well-settled
• The grantor has given up dominion and control, and the trust is now a separate taxable
entity.
• Grantor is deemed to have transferred the assets and liabilities in the trust to the trust,
for income tax purposes.
Death of grantor termination of grantor trust status - Sharp Disagreement
• Gain Triggered on Death of Grantor or Avoided?
• Basis Step-Up?
• Income in Respect of a Decedent?
There is no case, regulation or ruling that directly addresses the income tax
treatment.
29
Uncertainty Creates Risk
Rev. Proc. 2015-37
• On June 15, 2015, the IRS released Rev. Proc. 2015-37, which advised that,
until the IRS resolves the issue, it will no longer issue individual private letter
rulings on whether the basis of assets in a grantor trust must be adjusted to
reflect their fair market value (FMV) on the grantor’s death if those assets
aren’t includible in the grantor’s estate.
IRS 2015–2016 Priority Guidance Plan
• On July 31, 2015, the IRS and Treasury released the 2015-16 edition of their
Priority Guidance Plan (PGP), which identifies the “basis of grantor trust
assets at death under section 1014” as a project that will be a priority for
resource allocation. Although the PGP expressly refers to Section 1014, the
forthcoming guidance is likely to address the flip side of this issue—namely
whether gain is recognized on the grantor’s death.
30
Use of Preferred Partnerships with Various Trusts
31
Preferred Partnership with QTIP Freeze
Freeze
Partnership
Children
or trust for children
QTIP
Common
Interest
Preferred
Interest
Income Spouse
32
Sale of Junior Interest to IDGT Flowchart
Promissory Note
Sale of Common Interest
Freeze
Partnership
IDGT Client
Common
Interest
Preferred
Interest
33
Preferred Interest
(at end of CRUT term)
Preferred Partnership with CRUT
Freeze
Partnership
Children
or
trust for children
CRUT
Common
Interest
Private Foundation
or
Public Charity
Preferred Interest
Lesser of
Net Income or Unitrust
Client Client
Preferred
Interest
34
Structure of Preferred Partnerships
35
Liabilities Must be Allocated to Preferred to Obtain Step Up on Negative
Capital
How To Structure
36
FREEZE
PARTNERSHIP
Senior
Preferred
LLC
Family Trust
Grantor
Leveraged Real
Estate
IRC 704 (c) minimum gain
IRC 752
Junior Equity
$222,222 Cash Contributed
for Junior Equity (10%
$2,222,222)
Children 1%
99%
Contributed Property
$10,000,000 FMV
$8,000,000 debt
$2,000,000 equity
$1,000,000 basis
Structure To Keep Liabilities With Senior
37
Allocation Of Liabilities Among Partners
Section 752 governs allocations of liabilities among partners
• Recourse - who bears risk of loss?
Treatment of Nonrecourse debt – three tiered approach
• Tier 1 – Minimum gain
• Tier 2 – Section 704 (c) minimum gain
• Tier 3 – allocation based upon other significant partnership item with substantial economic
effect
38
Optimizing The Plan
Goals
• Minimizing Qualified Payments
• Minimizing Value Retained
• Leveraging Up
• Maximize Basis Step Up
39
What is a Capital Shift?
The partners' interests in profits and losses may be altered or
“shifted” in a number of ways during the course of a
partnership's taxable year
• A capital shift can occur where a partner gets an interest in
partnership capital that is not the result of a contribution to
capital by that partner or an allocation of profits to that partner.
This usually results in deemed compensation or a gift.
• Freeze Partnership Capital Shift
May decreased the value of the preferred interest for estate tax purposes, while
leaving negative capital with Senior for step up
40
FREEZE
PARTNERSHIP
Senior
Preferred
LLC
Family Trust
Grantor
Leveraged Real
Estate
Junior Equity
$222,222 Cash Contributed
for Junior Equity (10%
$2,222,222)
Children 1%
99%
Contributed Property
$10,000,000 FMV
$8,000,000 debt
$2,000,000 equity
$1,000,000 basis
Capital Shift
Senior II Capital
Shift
$1.5 equity
(no debt)
41
Capital Shift
Sale of Senior II for AFR note
• Leaves negative capital with Senior for step up
• No step up on Senior II if sold to Grantor Trust except to
extent of installment note
• Estate side concerns regarding IRD if note is outstanding
at death.
42
Capital Strip
a/k/a Leveraging Up
Real Estate contributed to Freeze LP
Assets
Real Estate (fmv) $10,000,000
Real Estate (adj. basis) $1,000,000
Liabilities – Mortgage ($8,000,000)
Net Equity $2,000,000
43
Capital Strip
Balance Sheet
Assets (FMV) $10,000,000
Mortgage ($8,000,000)
Equity $2,000,000
Capital Accounts
Senior $1,800,000
Junior + 200,000
$2,000,000
Preferred Return @ 6%
Senior $1,800,000
x 6%
$108,000 44
Capital Strip
Borrow against separate stock portfolio
Investment Partnership
$2 Million marketable
securities
Freeze
Partnership
$1.5 Million AFR Loan
$1.5 Million Distribution To Senior
$1.5 Million Margin Loan
45
Capital Strip
New Balance Sheet
Assets (FMV) $10,000,000
Liability (Mortgage) ($8,000,000)
Liability (AFR Loan) ($1,500,000)
Equity $500,000
Capital Accounts
Senior $300,000
Junior $200,000
Preferred Return @ 6%
Senior $300,000
+ 6%
$18,000 46
Capital Strip
Preferred Return ($300,000 x 6%) $
18,000
Interest on Mid Term AFR Loan ($1.5mm x 1.67%) $ 25,050
Total Leveraged Return to Senior $ 43,050
Compare Unleveraged Return ($1.8mm x 6%) $108,000
Compare Installment Sale ($2mm x 1.67%) $
33,400
47
Basis Consequences After Death Of Senior
• Basis in Loan to Freeze $1.5 Million
• Basis in Frozen Interest $9.8 Million
• Basis in Cash distributed $1.5 Million
Senior Equity $300,000
Mortgage $8,000,000
Borrowing $1,500,000
48
Freeze Partnership
Senior
RE LLC RE LLC RE LLC
Family
Trust
Grantor
Trust
Managing Member
Interest
Preferred Interest (6%
qualified payment and
Liquidation Preference)
Junior Equity
(Growth Interest)
Simple Real Estate Partnership Freeze
Rev. Rul. 93-12
Possible §2704 regulations re discounts 49
Freeze Partnership
Family
Trust
that
includes
spouse
Undiscounted
Assets.
Senior Preferred Interest (8%
qualified payment and
Liquidation Preference)
Junior Equity
(Growth Interest)
Reverse Freeze
Remember When There Was A Return On Investment?
50
FREEZE
PARTNERSHIP
Senior
Preferred
LLC
Family Trust
Grantor
FMV $10,000,000
AB 1,000,000
DEBT (8,000,000)
CASH $220,000
Real Estate
Junior Equity
$220,000 Cash Contributed
for Junior Equity
Children 1%
99%
Capital Structure
$1,000,000 AFR Loan to Senior
$1,000,000 equity contributed
Preferred return @ 8% = $80,000
Interest on AFR Loan @ 1.0% or
$10,000
Total Payments to Senior $90,000
Preferred Return = 8% of
$1 million or $80,000
Leaky Freeze Solution
51
FREEZE PARTNERSHIP
Senior
Family
Trust
Real Estate Entity
Unrelated
Parties
40%
Membership
Preferred Junior
Equity
Best Discount Scenario
Contribution of Non-controlling Interest
52
S CORPORATION
Senior
Family
Trust
Operating Assets
Junior Equity
Preferred Equity
• Rev. Rul. 77-220
• Revoked Rev. Rul. 94-43
• IRC Section 453(g) (related parties)
• Liquidation After Death IRC §1239
S Corporation Freeze
53
Preferred Partnerships in the Multi-Jurisdictional Context
54
55
General Principles
IRC 2701 applies only at valuation “layer” of analysis
• Does not affect taxability of underlying transfer
• In partnership context, allocations respected assuming SEE
• “Income” character of preferred interested respected under
many/most fiduciary accounting principles
Reducing QDOT Tax
• Qualified Domestic Trust (QDOT)
required to defer US estate taxation
on transfers to surviving non-citizen
spouse
• Trust “secures” ability to impose US
estate tax on transfer to non-citizen
spouse
• Principle distributions subject to US
estate tax; income distributions
escape US estate tax – determination
is made pursuant to fiduciary
accounting principles - cannot include
capital gains but unitrust elections
permitted
QDOT
Preferred Partnership
Preferred Interest
Family Trust
Common Interest
56
Maximizing Benefit of State Domicile Change
• Many high-tax states tax purport
to tax trusts in perpetuity based
on grantor's domicile at time of
irrevocable transfer
• Trust established after domicile
change could benefit from lower
tax environment
• Maximizing preferred interest can
allow High-Tax Trust capital to
provide "coverage" to preferred
interest, thereby enhancing Low-
Tax Trust return on investment
Low-Tax Trust
Preferred Partnership
Preferred Interest
High-Tax Trust
Common Interest
57
Throwback Tax Planning – Foreign Trust Distributions
• Throwback Tax triggered where
distribution exceeds DNI and FAI
• Most trust jurisdictions respect
preferred interest coupon as FAI
• Yearly distribution of preferred
distribution would “freeze” value
of asset base in foreign trust US Trust
Preferred Partnership
Preferred Interest
FNGT w/UNI
Common Interest
Yearly FAI Distributions
58
Throwback Tax Planning – No Foreign Trust Distributions
• Capital in FNGT with
accumulated UNI difficult to
access and put to productive use
f/b/o US taxpayers
• Economically, preferred
partnership structure can allow
FNGT capital to provide
"coverage" to preferred interest,
thereby enhancing US Trust
return on investment, which is not
subject to throwback tax
problems
US Trust
Preferred Partnership
Preferred Interest
FNGT w/UNI
Common Interest
59
Take Advantage of Pre-2701 World
• Many jurisdiction permit creation
of preferred/common equivalents
• No 2701 equivalent, so more
aggressive tactics potentially
available
• Must be mindful of potential
transition to US beneficiaries
G1 Entity
Foreign Entity
Preferred Interest
G2 Entity
Common Interest
60