Take-Away: One of the less popular strategies to ‘freeze’ an individual’s estate to avoid or minimize federal estate taxes is a preferred partnership freeze.  In order to achieve such a freeze,  the senior family member must navigate the qualified payment rule of IRC 2701 to avoid incurring an immediate federal gift tax.

Background: A preferred partnership freeze is a type of entity that provides one partner, usually the parent, with an annual fixed stream of cash flow in the form of a preferred interest, while providing another partner, usually a child, with the future growth in the form of common interests in the partnership in a transfer tax-efficient manner. As such, the future growth of the preferred interest tied to the fixed rate preferred return plus its right to receive back its preferred capital on liquidation of the partnership before the common partners are entitled to receive anything, results in a freeze. If the partnership assets are invested in such a way to outperform the required coupon rate on the parent’s preferred interest, the common interest will appreciate in value, thus enabling future growth of the partnership (above the preferred coupon rate) to be shifted to the child who owns the common partnership interest.

To simplify the following explanation, the senior family member is referred to as the parent and the junior family member is referred to as the child.

IRC 2701- Deemed Gift: This is one of the special gift valuation sections of the Tax Code designed to curb perceived abuses in intra-family transactions. Much more familiar of these special valuation rules is IRC 2702 which applies a zero ($0.00) valuation for retained term interests unless the transaction complies with special valuation rules for the parent’s retained interest, e.g. CRUTs, QPRTs and GRATs. IRC 2701 creates a deemed gift with regard to an applicable retained interest by treating the retained interest held by the parent as worth $0.00. An ‘exception’ to this zero ($0.00) value accorded to the parent’s retained interest imposed by IRC 2701 is when the parent’s retained interest meets the definition of a qualified payment right.

  • Subtraction Method of Valuation: If IRC 2701 applies to a transfer, the value of an interest transferred from the parent to the child will be determined by subtracting from the value of all family held interests the value of the retained interest held by the parent at $0.00, which results in a taxable gift. The deemed gift occurs from the parent to the child to the extent of the value of all family held interests, less the value of interests retained by the parent ($0.00), as determined under the ‘subtraction method of valuation.’ [Regulation 25.2701-1(a)(2).]
  • Distinguish Family Limited Partnership: A preferred partnership is different from the ‘normal’ family limited partnership. With the preferred partnership, the partnership agreement divides the partnership into two or more distinct economic classes, based upon each partner’s particular preferences for more secure preferred cash-flow interests, or more risky common ‘growth’ interests. This tends to mimic how family members might orient their investments more heavily into equities or fixed income based upon their respective ages, cash-flow needs, risk tolerance, and investment horizons.

Qualified Payment Right: The parent’s preferred interest in the partnership freeze will typically (but not always) be structured as a qualified payment right, as defined in IRC 2701, so as to avoid a deemed gift being triggered on the parent’s capital contribution of assets to the partnership, or upon a recapitalization, or upon the subsequent transfer of the common partnership interest by the parent to the child under the $0.00 valuation rule. The use of a qualified payment right structure will result in the parent’s retained preferred interest actually being valued under traditional valuation principles for gift tax purposes and not under the unfavorable $0.00 valuation rule of IRC 2701.

  • Fixed Percentage Distribution Right: This qualified payment right exception generally requires that the parent’s preferred interest to be structured as a fixed percentage return on partnership capital that is payable at least annually and on a cumulative [IRC 2701(c)(3)(A).] When the parent retains a preferred interest that satisfies the requirement of a qualified payment right, or more accurately, the distribution right component of the parent’s preferred partnership interest, i.e. the right to receive distributions with respect to such equity interest, it will not be valued at $0.00 for federal gift tax valuation purposes, determined under a subtraction method of valuation, but, rather, the parent’s distribution right will be valued under traditional valuation principles. [Regulation 25.2701-2(a)(2).]
  • Valuation of Preferred Coupon: Properly structuring the parent’s frozen preferred partnership interest merely avoids the distribution right component of the parent’s preferred interest being valued at $0.00 under the subtraction method of valuation for purposes of determining whether, and to what extent, a deemed gift has been made to the child in connection with the transfer of assets to the partnership, or the transfer of a common partnership interest to the child. However, there could still be a partial gift under traditional valuation principles if the parent’s retained preferred partnership coupon is less than what it should be when measured against an arm’s-length transaction.

Example: Parent Pete’s retained coupon under the partnership agreement is a 5% coupon, but a 7% return is determined by an appraiser, or the IRS, to be required to equal par, i.e. the parent’s equity in the partnership. In that case a deemed gift has still been made by Pete to his child to the extent of that shortfall in value, despite the fact that Pete’s preferred interest in the partnership was structured as a qualified payment right so as to not violate IRC 2701. While still a gift, it would still provide a better outcome than if Pete’s interest had violated IRC 2701, and the $0.00 value deemed gift rule was triggered.

Revenue Ruling 83-120: To arrive at the proper coupon rate the parent needs to hire an appraiser who will prepare a valuation appraisal to determine the preferred coupon required for the parent to receive value equal to par for his or her capital contribution to the partnership. The appraiser will take into account the factors identified in Revenue Ruling 83-120. The primary factors identified in that Revenue Ruling are: (i) comparable preferred interest returns on high-grade publically traded securities; (ii) the partnership’s coverage of the preferred coupon, i.e. the ability to pay the required preferred coupon when it comes due; and (iii) the partnership’s coverage of the parent’s liquidation preference on the liquidation of the partnership.

  • 4-Year Catch-up Payment: If the cash-flow of the partnership is not sufficient to make the preferred payment to the parent in a given year, each preferred coupon payment can be made up to four years after its original due date and the payment will still be considered to be made on a timely basis. [IRC 2701(d)(2)(C).] However, interest will compound on the delayed preferred partnership payment, so the accumulated interest component could be substantial when the preferred partnership payment to the parent is finally made by the partnership.

Liquidation Preference: In addition to being entitled to a preferred coupon payment, typically the parent’s preferred interest will provide to the parent a priority liquidation right, which means that upon liquidation of the partnership, the parent will receive a return of his or her capital before the child receives a return of his or her capital. However, the parent will not receive any of the potential upside growth in the partnership freeze based upon his or her preferred interest. As a highly technical matter, typically the parent will also retain at last a 1% common partnership interest to ensure that his or her preferred interest is not re-characterized by the IRS as debt; that retained 1% common partnership interest would obviously then participate by its terms in any upside appreciation of the partnership’s assets.

  • Debt: This is one issue to be aware of with regard to the preferred partnership.  The IRS could try to assert that the parent’s preferred (equity) interest should be re-characterized as debt, rather than as equity, in the partnership freeze If the parent’s preferred partnership interest is classified as debt, the IRS will then claim that there was a transfer by the parent with the retained right to all of the income from the transferred assets, which results in the inclusion of the value of all partnership assets in the parent’s estate at death. [IRC 2036(a)(1).] Unfortunately, there is no black-and-white ‘test’ as to what constitutes sufficient evidence that the parent’s preferred partnership interest is an equity interest and not debt. [A list of factors the IRS looks at can be found in the IRS General Counsel Memorandum 38275 (February 7, 1980.)]
  • ‘Lower of’ Rule: Even if the parent’s preferred interest is structured as a qualified payment right, it is important that no extraordinary payment rights be retained by the parent in order to avoid what is called the lower of These might include discretionary rights, puts, calls, conversion rights, and rights to compel liquidation, the exercise, or non-exercise of which affects the value of the transferred interest. [Regulation 25.2701-1(a)(2)(i).] If the parent inadvertently retains an extraordinary payment right along with a qualified payment right, that could still result in a deemed gift upon the parent’s capital contribution under the lower of rule. The lower of rule requires the preferred partnership interest be valued not at the determined value of the qualified payment right, but based upon the lower of the qualified payment right and  any extraordinary payment rights, which could potentially be lower. Example: The preferred interest contains a put right at a value that is lower than the value of the qualified payment right. [Regulation 25.2701-2(a)(3).]

Conclusion: As an asset freeze strategy, the preferred partnership is pretty complicated and a challenge to implement in order to avoid being classified as debt, which is why it is not often used. Nonetheless, for those individuals who are concerned about freezing the value of some, or many, of their assets in order to avoid future federal estate taxes with a future of much lower estate tax exemptions, it is just one more Tax Code-approved option, to go along with QPRTs and GRATs, to shift wealth, gift tax-free, to younger generation family members.