by Christopher Pegg and Nicole Seymour
Today’s “permanently” increased transfer tax exemptions may provide new planning opportunities for individuals and couples with a net worth of between $5 and $10 million whose assets are likely to significantly appreciate during their lifetime. Techniques that incorporate the rules of I.R.C. §2701 (all statutory references are to the Internal Revenue Code of 1986, as amended and the regulations promulgated thereunder) to “freeze” the value of assets now have increasing relevance for these taxpayers. While such techniques are nothing new, tax planners can reemploy what have been referred to as “freeze partnerships” to transfer appreciation out of a taxpayer’s estate while retaining control and access to significant income for the rest of the taxpayer’s life. Furthermore, this can be achieved without depleting the unified credit and will still allow for a step-up in basis at the taxpayer’s death.
The concept of using a freeze partnership to shift wealth to younger generations while minimizing or avoiding a gift tax has existed since at least the 1970s. In very general terms, a freeze is accomplished as follows: Upon the creation or recapitalization of a partnership, the ownership interests are structured to consist of a preferred interest and a subordinated interest.1 The preferred interest may have certain exchange rights as well as priority regarding annual distributions, which are noncumulative in nature. Upon appraisal, the vast majority of the partnership’s value will be represented by these preferred interests and the subordinated interests can then be gifted (or sold) to a younger generation based on their reduced value. Once the subordinated interests are owned by the younger generation, the senior generation operates the entity in a way that transfers most of the partnership’s value, along with all of the appreciation, to the subordinated interests.
The IRS and Congress viewed such strategies as tax avoidance schemes and consequently attempted to proscribe them through a series of legislative measures that resulted in the enactment of the special valuation rules of I.R.C. §2701. While the application of these rules are sometimes complex and contain various exceptions, they essentially dictate that the value of the preferred interest retained by the senior generation be ignored when valuing the transfer for gift tax purposes. Therefore, the value of the gift of the subordinated interests is, for tax purposes, the full value of the freeze partnership.
Nevertheless, where these “zero-value” rules apply, the Treasury Regulations establish certain adjustments that mitigate their impact and the likelihood of double taxation by reducing the size of the taxable gift or estate when the preferred interests are later transferred. For this reason, it may often be advantageous for taxpayers to intentionally trigger §2701 by creating and giving freeze partnership interests, because any increase in value for lifetime gift tax purposes will be removed from their taxable estates upon death.
As a simple example, imagine a married couple, Bill and Jane, who are in their late sixties, have adult children, and have made no previous taxable gifts. Bill and Jane have rental real estate worth $7 million, a home worth $1 million, and investable assets of $2 million. Bill and Jane live off of some of the income from the rental real estate and believe the value of the properties will appreciate substantially over time. They are glad to learn that their combined estate, if valued at a total of $10 million upon their deaths, would not be subject to an estate tax. They believe the escalation in property value, however, will significantly outpace the expected inflationary adjustments to their estate tax exemptions.
Like many taxpayers, Bill and Jane are looking to avoid estate taxes to the extent possible and to shift as much value to their adult children upon their deaths. Accordingly, this couple would like to transfer the appreciation on the rental real estate out of their taxable estates to minimize or eliminate any estate tax exposure in the future. However, they cannot afford the cash-flow implications of giving the real estate away now. They have heard of “freeze” techniques involving grantor-retained annuity trusts and sales to “defective” trusts, but Bill and Jane are uncomfortable defining exactly how much income they will need on an annual basis in the future and want to maintain flexibility. Further, the couple has a very low-cost basis in the real estate, and they are concerned about losing the step-up upon their deaths. They are also uncomfortable with the lack of clarity regarding the income tax implications upon the death of the grantor or a decision during life to “toggle off” the grantor status.
A freeze partnership, in this situation, can accomplish many of their goals without the uncertainty related to other, better-known freeze techniques. In this hypothetical, the couple would form a partnership or LLC with preferred and subordinated interests, and contribute the rental real estate valued at $7 million. (If the real estate is already in a partnership, it can be recapitalized for the same effect). The preferred interest would represent voting control, have a $7 million par value, and be entitled to any number of rights, including, for example, a preferred right to significant annual distributions that would be noncumulative. The preferred interest owner would also have an ability to force the partnership to redeem the preferred interest (a put option) for its par value. The subordinated interests would represent all other equity interests in the partnership or LLC and would, therefore, benefit exclusively from any appreciation of the real estate.
Bill and Jane would each gift 50 percent of the subordinated interests to their children or into a trust for their benefit.2 Despite their retention of the preferred interests, the value of the gift for transfer tax purposes would be the value of the entire partnership ($3.5 million each for a total gift of $7 million) due to the application of the §2701 zero-value rule. Bill and Jane would each utilize $3.5 million of their unified credit, and no gift tax would be owed.
In this case, Bill and Jane would have discretionary access to cash flow on an annual basis for the rest of their lives. An annual distribution could be made, at the discretion of the partnership, to the preferred interest owners in any amount desired up to the entire annual distribution right. The partnership could allow some or all of the distribution rights to lapse in years when Bill and Jane did not need the income, thereby allowing the subordinated interests to appreciate in value. Furthermore, during the years in which the full preferred distribution was made, the partnership could then transfer wealth to the younger generation by making additional distributions to the subordinated unit owners.
Upon each of their deaths, the value of 50 percent of the preferred interests would be included in Bill and Jane’s taxable estate, which would likely be valued at approximately $3.5 million due to the preferred distribution rights as well as the put option. This inclusion would provide a total step-up in basis of around $7 million for Bill and Jane’s children, pursuant to I.R.C. §1014. In addition, the mitigation provided by the “adjustment” rules of Treas. Reg. §25.2701-5, described below, would apply to ensure that the inclusion would not cause an estate tax or increase any estate tax otherwise owed.
In short, for the right clients, a freeze partnership structure offers the opportunity to retain cash flow for life, save significant basis step-up at death, and ensure that no estate tax will be owed, regardless of the appreciation of the underlying assets. To obtain these benefits, however, it is necessary to carefully consider how the freeze partnership should be structured, owned, and operated — both upon the initial transfer and upon the ultimate death of the taxpayer.
The Basics of I.R.C. §2701
Two elements of the partnership structure are required to trigger the valuation rules of §2701. First, ownership of the partnership must be represented by at least two kinds of interests. They are usually referred to as a “preferred” interest and as a “subordinated” or “common” interest. The owner of the preferred interest is entitled to certain priorities regarding distribution and liquidation rights, but his or her right to participate in earnings is ultimately capped at certain rates of return. In §2701 parlance, this ownership interest is known as the “applicable retained interest,” and returns on the partnership that exceed this cap inure to the subordinated interests.3 The retained ownership (the preferred interest) is an applicable retained interest if it is either entitled to an “extraordinary payment right” or if it is entitled to a “distribution right” where the entity is controlled by the family.4
An extraordinary payment right is a put, call or conversion right, any right to compel liquidation, or any similar right that affects the value of the transferred interest upon exercise.5 This includes a warrant, option, or other right to acquire equity interests.6 An extraordinary payment right is subject to the zero-value rules of §2701 and will be entirely ignored when valuing the gift of the transferred interest.7 A distribution right is simply the right of an equity interest in the partnership to receive a distribution that is neither the same, nor subordinate to, a distribution right of the subordinated interest.8 That is, where the retained interest has a preferred right to distributions, the interest will also be subject to the zero-value rules.9
The second element required to trigger §2701 is family ownership. The subordinated interests must be transferred to family members of the same or younger generation, and the preferred interests must be retained by the transferor or a family member in the same or older generation.10
There are narrow exceptions to the application of §2701 that tax planners have taken advantage of to avoid the zero-value rules. These exceptions include, among others, a payment or right of distribution that is mandatory and contains a liquidation participation right, as well as a nonlapsing conversion right.11 An exception is also provided for a distribution right that is cumulative and paid on a periodic basis (at least annually) based on a fixed amount, fixed rate, or determined with reference to a market rate.12 The regulations describe these exceptions in some detail, but the essential concept is that the anti-abuse valuation rules of §2701 are unnecessary in situations in which the value associated with these rights cannot be manipulated, and will, therefore, be captured by the transfer tax regime upon a later gift or upon death. Tax planners also use “reverse freezes,” where the senior generation transfers the preferred interest to the next generation, but makes the preferred payments so rich that wealth is effectively transferred.
But, for many taxpayers, these exceptions and “reverses” used in the past will no longer be necessary. It will be preferable in many situations to structure a transfer where the zero-value rules and corresponding mitigation regulations intentionally apply.
Mitigation Rules to Avoid Double Taxation
The Treasury issued regulations that permit adjustments to mitigate the effect of the zero-value rules to avoid double taxation when an applicable retained interest is subject to transfer tax after the initial transfer. Otherwise, a double tax will occur if the retained interests are also given full value upon a later transfer. For example, assume a taxpayer, Bob, formed a freeze partnership with $5 million in total assets and structured the ownership to consist of preferred interests worth $4 million and subordinated interests worth $1 million. Bob then makes a gift of the subordinated interests to his child, Mary, which is valued at $5 million for gift tax purposes (instead of the $1 million fair market value) because the zero-value rules apply. Upon Bob’s death, the preferred interests he retained will also be included in his estate with a value of $4 million (assuming no growth). If there were no mitigation rules, a partnership with a total fair market value of $5 million would effectively be valued at $9 million for transfer tax purposes.
To avoid this, rules described in Treas. Reg. §25.2701-5 provide that a taxable gift or a taxable estate is reduced by the lesser of 1) the amount by which the initial transferor’s taxable gifts is increased by the §2701 rules, and 2) the amount duplicated in the transfer tax base at the time of the later transfer of the preferred interests.13
The first limitation is relatively simple and limits the reduction of the gift or taxable estate to the actual value of the preferred interest (without regard to §2701) at the time of the initial transfer. In the example above, the actual value of the preferred interest that Bob retained was $4 million at the time of the initial transfer without regard for §2701. Thus, application of subpart (i) of Treas. Reg. §25.2701-5 would reduce Bob’s taxable estate by $4 million.
The second limitation ensures that, if certain exceptions apply and the preferred interest is not entirely ignored for valuation purposes, the mitigation is limited to the amount of reduction in value caused by §2701.14 The definition of the “duplicated amount” also limits the mitigation to the value of the preferred interests upon later transfer where values have declined.15 If we assume that the value of Bob’s preferred interest has declined from $4 million to $2 million upon his death, Bob’s taxable estate is only reduced by $2 million.
Specific rules outline how this mitigation is applied to a later gift of the preferred interests or upon the taxpayer’s death. It is, therefore, critical to pay attention to these rules and to plan carefully regarding the ownership of these preferred interests after the initial freeze partnership gift.
• Later Gift of Preferred Interest — When the preferred interest is later gifted to a member of the transferor’s family who is a member of a lower generation, the reduction is applied to the transferor’s §2502(a) taxable gifts.16 The mitigation rules do not apply where the preferred interest is given to the transferor’s spouse, an ancestor of the transferor or transferor’s spouse, or the spouse of any such ancestor. Mitigation will, however, occur for the original transferor when the senior generation member gifts the preferred interest to a member of the lower generation.17
• Death of Grantor While Owning Preferred Interest — When the transferor dies with the preferred interest in his or her taxable estate, the reduction applies to the amount on which the decedent’s tentative tax is computed under §2001(b).18 If the original transferor gifted the preferred interest to a member of the senior generation during his or her life and the interest is still owned by the senior generation, the taxable estate of the original transferor is reduced by the value of the preferred interest at the time of the original transferor’s death.19
If the preferred interest was sold during life, the transferor’s estate is reduced by the consideration received.20 Additionally, if the preferred interest was exchanged in a nonrecognition event, the interest received in the transaction will be treated as the preferred interest for reduction purposes.21
• Gift Splitting Election — The regulations provide great detail describing how mitigation operates where spouses have elected to gift split under I.R.C. §2513. For reasons discussed below, however, taxpayers should avoid gift splitting where the unified credit is being used to reduce or eliminate the gift tax at the time of the initial transfer.
The rules are straightforward where gift splitting is elected for the initial gift of subordinated interests and the spouse who owns the preferred interests gives them away while both spouses are alive. In that case, the donor spouse and the consenting spouse are each treated as the transferor of one-half of the preferred interests and each are permitted to reduce their taxable gifts accordingly.22 If the consenting spouse does not have sufficient gifts in the year of transfer to soak up the reduction, the remaining reduction will be carried forward to be used in future years or upon death.23
The rules are different when death of the donor spouse or consenting spouse occurs prior to transferring the preferred interests. In that case, the donor spouse is treated as the initial transferor of the entire preferred interest and is entitled to compute the reduction as such.24 It is important to note, however, that the donor spouse is limited regarding the amount of the consenting spouse’s mitigation that he or she can use. Upon the donor spouse’s death, the use of a consenting spouse’s mitigation by the donor spouse’s estate is “limited to the amount that results in a reduction in the donor spouse’s [f]ederal transfer tax no greater than the amount of the increase in the consenting spouse’s gift tax” incurred by reason of the preferred interest.25 Therefore, Treas. Reg. §25.2701-5 implies that the donor spouse’s estate can only utilize the consenting spouse’s reduction to the extent the consenting spouse actually paid a gift tax when the preferred interests were gifted.26 Gift taxes, however, will rarely be paid when a freeze partnership is structured by taxpayers like Bill and Jane, so the donor spouse will not be able to use any of the consenting spouse’s mitigation.
Where both spouses’ exemptions are necessary to avoid a tax, it is critical to ensure that each spouse owns a sufficient amount of the preferred interest and the subordinated interests and that each spouse makes an independent gift. After the initial transfer, it is important to plan carefully with the ownership of the preferred interests to ensure that each spouse can take full advantage of a basis step-up and the corresponding mitigation upon death.
• Creation of the Preferred Interests — A §2036 analysis is a vital part of structuring the preferred interests of a freeze partnership. The mitigation rules will only protect the value of the preferred interests in the taxpayer’s estate, so it is critical that any rights associated with such interests not cause inclusion of the subordinated interests as well. The senior generation can retain authority over partnership investments and other operational decisions, but care should be taken to ensure that all such decisions are subject to fiduciary duties. In addition, the senior generation should not have exclusive control over the decision to make annual distributions, nor should such distributions be tied directly to income from the assets.27
For additional protection, it may be beneficial to structure a transaction where the junior generation buys the subordinated interests or makes a capital contribution to the partnership in exchange for them. This purchase or contribution would be calculated using the actual, noninflated value for the subordinated interests. Section 2701 would then operate to create a taxable gift by assigning zero value to the preferred interest as described above.28 However, the fact that the junior generation paid full and adequate consideration for the subordinated interests would create an argument that §2036(a) cannot apply with regard to their value.29
The operation of the partnership and activities by all parties is critical as well. The senior generation should retain significant assets outside of the partnership structure and should not put personal-use assets inside the entity. As with any wealth transfer technique, it is critical to document and operate the structure correctly and to carefully detail significant business purposes and other nontax rationales in file memos and correspondence with the client.
To get the maximum step-up in basis offered by the freeze partnership structure, it is also necessary for the preferred interest to have a value in the senior generation’s estate that is at least equivalent to the value of that same interest upon initial transfer. The IRS does not give as much value to noncumulative distribution rights as it does for a cumulative dividend feature,30 so it may be important to find value for the preferred interests in the put right. Even so, the IRS has also stated that it would reduce the value of such a redemption right if there is a risk that the partnership will not have sufficient assets to redeem the preferred interest when called upon to do so.31 Therefore, it is important to structure a put option or similar feature that is clearly senior to the subordinated partnership interests and to ensure that the frozen partnership maintains sufficient assets, insurance, or borrowing capacity to meet the terms of the option contract.
It is also important to take the nontax advantages of freeze partnerships into account and to use the flexibility of this structure to serve the client’s personal investment desires and goals for the family. Like any FLP structure, a freeze partnership can be an excellent way to involve the family in investment and business decisions. Freeze partnerships are especially unique, however, in their ability to use the preferred and subordinated interests to provide guaranteed, bond-like returns for the life of the senior generation while allowing the junior generation to operate and invest for the future.
• Generation-skipping Transfer Tax — Though not entirely clear, a good argument exists that the §2701 special valuation rules will not apply to a direct skip for generation-skipping transfer tax purposes. Section 2701 specifically states that the special valuation rules operate solely for purposes of determining whether a gift occurred and, if so, the value of such gift.32 Additionally, Ch. 13 defines the “taxable amount” for GST purposes as the “value of the property received by the transferee.”33 There is no indication in Ch. 13 or Ch. 14 that the special valuation rules of §2701 alter the “value” as defined in §2623.34
The “inclusion ratio” analysis for GST tax purposes is more ambiguous. The calculation described in §2642 specifically refers to the “value as finally determined for Chapter 12” which, of course, is impacted by §2701.35 For a number of reasons, however, it is not certain that the reference to Ch. 12 intends to incorporate the special valuation rules of Ch. 14.36 Consequently, until the IRS provides more clarity, great care must be taken when making gifts of subordinated interests to trusts that could benefit grandchildren.
• Disclosure and the Statute of Limitations — There are special regulations regarding Ch. 14 gifts, including §2701, which require a higher standard with respect to the amount of information and specificity that must be disclosed to the IRS before the statute of limitations will begin to run. Ch. 14 gifts must be “adequately shown,” as described in paragraph (e) of Treas. Reg. §301.6501(c)-1, whereas ordinary gifts must be “adequately disclosed,” as described in paragraph (f) of the same regulation.
The “adequately shown” regulations require much of the same information as the “adequately disclosed” rules, but there are additional requirements to describe the retained interests, the method used to value such interests, and the taxpayer must not only identify the transferor and transferee, but “all other persons participating in the transactions,” as well as any parties related to the transferor who own an equity interest in an entity involved in the transaction.37 Additionally, the regulations are more specific regarding the financial data that must be provided for interests that are not actively traded.38 Consequently, it is best to adhere closely to these regulations when reporting a freeze partnership transaction on a gift tax return.
Implementing a freeze partnership will require tax planners to shift their thinking and become comfortable with what may be unfamiliar, and they must be mindful of certain hurdles and pitfalls related to this strategy. Under the right circumstances, however, planning with §2701 can provide advantages and tax efficiencies that are unavailable in any other form. Estate planning attorneys and other tax advisors should become familiar with the principals of this strategy and be able to effectively implement a freeze partnership when it is the right fit for a client.
1 This concept applies to corporations as well. However, a “freeze” entity requires preferred and subordinated units, which are not permitted where a company has elected to be treated as an S corporation.
2 Gift splitting should be avoided for reasons described later.
3 I.R.C. §2701(b)(1); Treas. Reg. §25.2701-2(b)(1).
4 I.R.C. §2701(b)(1); Treas. Reg. §25.2701-2(b)(1-2). In addition, “control” exists for a partnership per Treas. Reg. §25.2701-2(b)(5)(iii), when the transferor or the transferor’s family controls at least 50 percent of either the capital interest or the profits interest, or, for a limited partnership, when the transferor or transferor’s family owns any of the equity in the general partner. Attribution rules for indirect ownership apply as well pursuant to Treas. Reg. §25.2701-6.
5 Treas. Reg. §25.2701-2(b)(2).
7 I.R.C. §2701(a)(3)(A).
8 Treas. Reg. §25.2701-2(b)(3)(i).
9 Treas. Reg. §25.2701-2(a)(2).
10 I.R.C. §2701(a)(1) and (e)(2)(and Regs).
11 Treas. Reg. §25.2701-2(b)(4).
12 I.R.C. §2701(c) and Treas. Reg. §25.2701-2(b)(6). It should also be noted that, where a distribution right exists, a taxpayer can elect “in” or “out” of the application of zero-value rules pursuant to I.R.C. §2701(c)(3)(C). No such election exists for extraordinary payment rights.
13 Treas. Reg. §25.2701-5(b).
14 Treas. Reg. §25.2701-5(c)(1).
15 Treas. Reg. §25.2701-5(d), Example 1(ii).
16 Treas. Reg. §25.2701-5(a)(2).
18 Treas. Reg. §25.2701-5(a)(3).
19 Treas. Reg. §25.2701-5(c)(3)(ii); Treas. Reg. §25.2701-5(d), Example 2(iii).
20 Treas. Reg. §25.2701-5(c)(3)(i); Treas. Reg. §25.2701-5(d), Example 2(ii).
21 Treas. Reg. §25.2701-5(c)(3)(iii).
22 Treas. Reg. §25.2701-5(e)(2).
23 Treas. Reg. §25.2701-5(f), Example 1.
24 Treas. Reg. §25.2701-5(e)(3)(ii).
25 Treas. Reg. §25.2701-5(e)(3)(iv).
26 This interpretation seems to be confirmed by Treas. Reg. §25.2701-5(f), Example 3 and Example 5(ii).
27 A comprehensive discussion of I.R.C. §2036 is beyond the scope of this article. See Fox, FLPs and FLLCs: Are They Still Viable Estate Planning Tools?, 32 Est. Plan. 3 (Feb. 2005); Abbin, A Practical Checklist for Planning with Family Limited Partnerships, 33 Est. Plan. 10 (Oct. 2006).
28 I.R.C. §2701(e)(5); Treas. Reg. §25.2701-1(b)(1); Treas. Reg. §25.2701-3(d), Example 4 & 5.
29 I.R.C. §2036(a); see Bogdanski, Stone Soup: A Thin FLP Satisfies a Judge’s Appetite, 39 Est. Plan. 17 (June 2012).
30 Rev. Rul. 83-120, §4.03.
31 Rev. Rul. 83-120, §4.07.
32 I.R.C. §2701(a)(1).
33 I.R.C. §2623.
34 For a detailed discussion of the interaction of I.R.C. §2701 on the GST tax, see the discussion and footnotes in Stephens, Maxfield, Lind & Calfee, Federal Estate & Gift Taxation §19.02(5)(f)(iii).
35 I.R.C. §2642(b)(1)(A).
36 See Stephens, et al., Federal Estate & Gift Taxation, footnotes 512, 516, and 519 for more detail.
37 Treas. Reg. §301.6501(c)-1(e)(2).
Christopher Pegg was admitted to The Florida Bar in 2001. He holds a bachelor’s degree and J.D. from Florida State University as well as an LL.M. in taxation from the University of Florida. He is board certified by The Florida Bar in the area of tax law.
Nicole Seymour was admitted to The Florida Bar in 2004. She holds a bachelor’s degree from Georgetown University and received a J.D. and LL.M. in trust and estate planning from the University of Miami School of Law.
This column is submitted on behalf of the Tax Law Section, Joel David Maser, chair, and Michael D. Miller and Benjamin Jablow, editors.