Preferred Partnership ‘Freeze’ Planning

Take-Away: A preferred partnership can be used to effectively contain or ‘freeze’ the future growth of the preferred partnership interest in a transfer-tax-efficient manner. However,  it is a nightmare to navigate IRC 2701 which will be necessary to achieve the intended successful preferred partnership ‘freeze’ as part of a sophisticated estate plan.

Caveat: The following summary is admittedly mind-numbing. Few wealthy individuals will be good candidates for a preferred partnership ‘freeze.’

Comment: For ease of reference (if there is such a thing when describing IRC 2701), metaphors are used,  ‘Dad’ for ‘senior generation member’ ,  ‘the Kids’ for ‘junior family generation members’ and preferred partnership, when any legal entity like a corporation or LLC are also subject to the scope of IRC 2701.

Background: A preferred partnership ‘freeze’ is a type of legal entity that provides one partner, typically a senior family member (Dad) with a fixed stream of cash flow in the form of a preferred partnership interest, while providing other partners (the Kids) with future growth in the form of common partnership interests, in a tax-efficient manner. No gift results when the common partnership interest grows over time. A preferred partnership effectively contains or ‘freezes’ the future growth of Dad’s preferred partnership interest to the fixed rate preferred distribution plus that preferred interest’s right to receive back Dad’s preferred capital on the partnership’s liquidation (known as a liquidation preference) before the common partners, the Kids, receive anything on the partnership’s liquidation. This is sometimes called a soft freeze, since Dad’s interest in the partnership will grow in value over time, but not as fast as the appreciation of the partnership’s assets. As such, Dad’s preferred partnership interest does not participate in the growth of the partnership’s assets in excess of Dad’s preferred distribution right coupled with his liquidation preference when the partnership comes to an end. The result is that such growth of the partnership’s assets benefits the common partners (the Kids) or trusts that hold the common partnership interests, and Dad’s interest grows only at the rate of his preferred annual distribution right.

Distinguished from a Family Limited Partnership: A preferred partnership is different than a typical family limited partnership. That is because the preferred partnership is divided into two distinct classes: preferred and common. In a family structure this is beneficial, since a preferred partnership can consider the financial needs of different generations of family members, i.e. Dad wants or needs a steady cash-flow in his retirement years through his fixed, cumulative, preferred distribution rights from the partnership.

Distinguished from a GRAT or IDGT: A preferred partnership ‘freeze’ is less commonly used  than a GRAT or an intentionally defective grantor trust (IDGT), more than likely because attaining a preferred partnership ‘freeze’ is a lot more complex, even when it often results in a much more tax efficient transfer of wealth, or when negative capital accounts are involved (which is common for real estate entrepreneurs when a negative capital account often result when Dad owns several real estate properties in a holding company structure over a long period, and he took advantage of depreciation deductions and he used non-recourse financing to make distributions.)

Formation of a Preferred Partnership: The basic steps needed to create a preferred partnership (ignoring for the moment the technical details associated with some of Dad’s retained interests) are the following:

1. Dad creates a new preferred partnership entity.
2. Dad contributes the entirety of his interest in his business, e.g. a real estate holding company, to the new entity in exchange for a preferred partnership interest which holds a liquidation preference and fixed qualified payment preference (more on those concepts below, if you dare to read that far.)
3. The Kids contribute cash in exchange for a 10% subordinated interest in the partnership (the Kids’ will own a common partnership interest.) The subordinated interest held by the Kids will be entitled to the growth and appreciation of the partnership’s assets in excess of the preferred partnership interest’s return annually paid to Dad.
4. The preferred partnership agreement provides for a fixed annual distribution to Dad, e.g. 5% each year. That annual distribution to Dad must meet the definition of a qualified payment under IRC 2701, which must be paid to Dad prior to any distribution from the partnership to the subordinated partnership interests held by the Kids.

The formation of the preferred partnership sounds pretty straightforward. That’s until you bring IRC 2701 into the analysis.

IRC 2701: IRC 2701 addresses the value of transferred  interests in the partnership and other legal entities when the transfers are made intra-family. IRC 2701 can result in a deemed gift to occur in connection with a contribution to capital by Dad to the partnership, or a transfer by gift in such an entity by Dad. For example, the transfer to which IRC 2701 deemed gift can potentially apply is when Dad, who initially owned both preferred and common equity partnership interests,  transfers the common partnership interests to the Kids (or trusts that are created for the Kids) while Dad retains the preferred partnership interest. IRC 2701 can even have a broader reach; for example, it can also apply such as when a ‘profits interest’ is issued by the partnership.

Deemed Gift: A deemed gift occurs when Dad (called an applicable family member) holds an applicable retained interest after a transfer to the Kids (called a member of the family) or to trusts created for the benefit of members of the family.

Transfer: A transfer is defined in IRC 2701 to include a traditional gift, capital contributions, redemptions, recapitalizations or other changes in the capital structure of the partnership.

Applicable Family Member: An applicable family member is Dad or his spouse.

Applicable Member of the Family: A member of the family are the Kids and their spouses. In addition, there is a convoluted set of attribution rules used  for IRC 2701 (which I will not go into) which leads to an expansive group of individuals who fall within the definition of applicable member of the family. (These broad attribution rules are when IRC 2701 can create a ‘trap’ leading to a sizeable taxable gift.)

Applicable Retained Interest: An applicable retained interest is any equity interest that confers upon its holder (Dad) either an (i) extraordinary payment right, or (ii) in the case of a controlled family partnership a distribution right.

Zero Valuation Rule: If IRC  2701 applies, the value of the interests Dad transferred to the Kids is determined by subtracting the value of the interests retained by Dad from the value of all family held interests, i.e. those held by the Kids. That amount will be deemed a gift to the Kids. If the interest retained by Dad is an applicable retained interest, its value for purposes of IRC 2701 is determined using a zero ($0.00) value, and the entire value of the partnership entity transferred to the Kids will be a deemed gift by Dad.

Commencing With the ‘Brain Freeze:’ The $0.00 valuation rule applies if there is a transfer to a member of the family and after that transfer an applicable family member retains an applicable retained interest. [I forewarned you this would be mind-numbing!] There are two types of rights that will result in a transfer by Dad being subject to the zero ($0.00) valuation rule. They are: (i) distribution rights; and (ii) extraordinary payment rights.

• Qualified Payment Right: A qualified payment right must be a cumulative right to receive a fixed distribution, e.g. 5%, payable at least annually. If Dad’s payment right is a qualified payment right with respect to his interest in the family controlled partnership, that right is a distribution right for purposes of IRC 2701 and thus, an applicable retained interest. However, the zero ($0.00) valuation does not apply to a qualified payment right. Consequently,  a qualified payment right retained by Dad is valued under traditional valuation principles (which is considered to be a good thing.).
• Distribution Right: A distribution right is the right to receive discretionary distributions with respect to an equity interest in the family-controlled partnership. However, a distribution right does not include an extraordinary payment right or a right to receive distributions related to an interest in the same class or a class that is subordinate to the transferred interest. There is considerable disagreement among commentators  as to what constitutes a distribution right, e.g. a withdrawal right from a hedge fund? Consequently, a distribution right that is not a qualified payment right is valued at $0.00. In order to be a qualified payment right, Dad’s interest in the partnership must provide for  a cumulative payment (i) payable at least annually; and (ii) at a fixed rate. If that is not the case, then the zero ($0.00) valuation rule kicks-in.
• Extraordinary Payment Right: An extraordinary payment right includes a liquidation, put, call, conversion right, or a similar right that affects the value of the transferred interest. There is no control requirement because this is held individually by Dad rather than by the entity. There is thus an assumption that Dad will not exercise any retained extraordinary payment rights. Then again, there are some rights that may be retained by Dad (the transferor) that do not fall within the definition of an extraordinary payment right which  included: (i) the right to participate is a liquidating distribution of the partnership: (ii) a mandatory payment required to be made by the partnership in a specific amount and at a specific time; (iii) the right to a guaranteed fixed amount paid by the partnership; and (iv) a non-lapsing right to convert an equity interest into a specified number of shares or interests. Note, that if Dad’s equity interest in the partnership contains an qualified payment right (good) and an extraordinary payment right (bad), Dad’s interest will be valued assuming that the extraordinary payment right is not exercised by him. That is, the zero ($0.00) valuation rule will apply to determine the value of Dad’s retained interest in the partnership, leading to a taxable gift by him of a large amount.

Not Covered by IRC 2701: Leases, employment arrangements and other interests that are not in the nature of equity are not treated as applicable retained interests under IRC 2701. Other exceptions to IRC 2701 include: (i) marketable securities exception, where market quotations are readily available; (ii) the ‘same class’ exception, where the two classes are substantially similar; and (iii) what is called the vertical slice proportionality exception, for proportionate interests, e.g. a proportional reduction of each and every class of equity ownership owned by Dad results, e.g. Dad gives both preferred and common interests to the Kids.

Conclusion: A preferred partnership ‘freeze’ is a sophisticated estate planning strategy that effectively shifts appreciation to younger family members with little or no transfer tax cost. That said, it is a challenge to comply with the exceptions under IRC 2701 and its deemed gift, zero valuation concepts. For some business owners who are nearing retirement and want a fixed and steady stream of income during their retirement years, a preferred partnership may work better than a GRAT or an IDGT and shift more wealth to younger family members without much gift tax exposure. The devil, as always, is in the 2701 details.