Time to Review Estate Freeze Strategies – Preferred Partnership: Part 3

Take-Away: Yet another estate freeze strategy is a preferred partnership which provides the senior family member with a fixed stream of cash flow in the form of a preferred interest. This freeze strategy can be much more complicated than either a grantor retained annuity trust, or GRAT, or the sale of an appreciating asset to an intentionally defective grantor trust, or IDGT. As a result, a preferred partnership, or the recapitalization of an existing entity into different economic units is less often considered due to its technicalities, complications and the deemed gift rules of Chapter 14 of the Tax Code.

Background: A preferred partnership is a type of entity that provides one partner, usually a senior family member, with an annual fixed stream of cash flow in the form of a preferred interest (or coupon) while providing another partner, usually a younger family member or a trust for that younger family member, future growth in the form of common interests in the partnership. The goal is to freeze the future growth of the preferred interest to the fixed rate of return of the coupon, plus perhaps the preferred interest partner’s right to receive back his or her preferred capital upon liquidation of the partnership, called the liquidation preference, before the common interest partners are entitled to anything. Accordingly, the preferred interests do not participate in the upside growth of the partnership (or its assets) in excess of the preferred coupon and liquidation preference, if any; all additional future appreciation inures to the benefit of the common or ‘growth’ class of partnership interests.

Partnership Formation: Either a new entity is formed, or an existing entity is recapitalized with preferred and common ownership interests. The partnership is thus divided into two or more distinct economic classes, based upon each partner’s particular preferences either for more secure preferred cash-flow interests (senior members), or more risky common ‘growth’ interests (younger generation.) Often these interests effectively match the respective needs of different generational family members, based upon their respective ages, cash-flow needs, risk tolerance, and investment horizons. The senior family member’s interest is usually structured as a qualified payment right to address the tax ‘trap’ created by IRC 2701.

IRC 2701: This Tax Code Section is yet another of the zero [$0.00] valuation rules created by Chapter 14 of the Tax Code, which is intended to stop perceived abusive wealth-shifting strategies. IRC 2701 can result in a deemed gift upon a ‘transfer’ by the senior family member in connection with the preferred partnership in which he or she retains a ‘senior’ equity interest. A deemed gift is triggered upon a capital contribution of assets to a preferred partnership, upon recapitalization of an existing entity, or upon the subsequent transfer of the common partnership interest to a younger family member with the application of the zero [$0.00]  valuation of the senior’s retained interest under IRC 2701. This zero valuation rule applies unless very specific requirements are satisfied with respect to the senior family member’s retained interest in the partnership.

Complications Associated with a Preferred Partnership: Just some of the complications that arise with the adoption of a preferred partnership estate freeze strategy follow.

• Qualified Payment Right: A qualified payment right generally will be structured to provide that the senior family member will receive a fixed-percentage payment return of the preferred capital, payable at least annually, and on a cumulative basis. [IRC 2701(c)(3)(A).] In addition, the senior family member usually will possess a liquidation preference so that when the partnership is liquidated, the senior family member will receive a return of capital before any return to the common interest holders of their capital in the partnership. If the retained right by the senior family member is treated as a qualified payment right then this distribution right will be valued under traditional valuation principles for gift tax reporting purposes, and not under the unfavorable zero [$0.00] valuation rule of IRC 2701. If the entity’s cash-flow is not sufficient to make the preferred payment in a specific year, IRC 2701 provides that each preferred coupon payment can be made up to four (4) years after the original due date and the payment will still be considered to be made on a timely basis. [IRC 2701(d)(2)(C).] Often the senior family member will also retain at least a 1% common interest to ensure that his or her preferred partnership interest is not re-characterized as Sometimes the qualified payment right is also structured as a guaranteed payment. [IRC 707(c).] Such payments are a formal exception to the zero [$0.00] valuation rule of IRC 2701. [Treasury Regulation 25.2701-2(b)(4)(iii).]
• Transfer: A transfer that can potentially trigger a deemed gift under IRC 2701 is broadly defined and includes not only traditional gift transfers, but also capital contributions to new or existing entities, redemptions, recapitalizations, or other changes in the capital structure of an entity. [Treasury Regulation 25.2701-1(b)(2)(i).] This broad interpretation of a transfer can act as a ‘trap’ if there is no qualified payment right that results in the application of the zero valuation rule.
• Continued Gift Tax Exposure: Even if the senior family member partner’s preferred interest is properly structured to avoid the zero valuation rule as a deemed gift under IRC 2701, there are still other gift tax issues to consider under traditional gift tax principles. The properly structured frozen preferred partnership interest merely avoids the distribution right component of the senior family member’s preferred interest from being valued at $0.00. Consequently, there may still be a partial gift under traditional valuation principles if the preferred coupon is less than what it should be when measured against an arm’s-length transaction.

Example: Dan’s retained coupon under the preferred partnership agreement is 5%. However, a 7% return is determined to be required to equal par. Accordingly, a deemed gift has still been made by Dan to the extent of the shortfall in value and despite the fact that Dan’s preferred partnership interest is structured to not violate IRC 2701. While this is not as bad an outcome if Dan’s preferred partnership interest did not constitute a qualified payment right, it nonetheless results in a taxable gift made by Dan when the partnership is formed.

• Valuation: It will be critical to ascertain a proper coupon rate. As a result, a qualified appraiser will be required to determine the preferred coupon required for the senior family member to receive value equal to par for his or her capital contribution to the partnership. The primary factors used to determine the coupon’s value will be: (i) comparable preferred interest returns on high-grade publicly-traded securities; and (ii) the partnership’s ‘coverage’ of the preferred coupon, which is the ability to pay the required coupon when due, and its coverage of the liquidation preference if any, which is the partnership’s ability to pay the liquidation preference upon liquidation of the partnership. Therefore, the higher percentage of the freeze partnership interests being preferred partnership interests, the greater the financial pressure on the partnership’s ability to timely pay the coupon; this translates to weaker coverage of the coupon, and thus greater risk, and ultimately a higher required coupon to account for that greater risk.
• Avoid Extraordinary Payment Rights: The senior family member’s preferred partnership interest should not contain any extraordinary payment rights. These include discretionary rights such as puts, calls, conversion rights, and rights to compel liquidation, the exercise or non-exercise of which affects the value of the transferred interest. [Treasury Regulation 25.2701-1(a)(2)(i).] The presence of any of these rights has the effect of reducing the value of the qualified payment right, which increases the likelihood of the senior family member has made a taxable gift.
• Re-characterization as a Debt: As with other estate freeze techniques, there is always the risk that the IRS will attempt to re-characterize the preferred interest as While there is no definitive rule as to what will support that the preferred partnership interest will be treated as an equity interest, some factors that the courts will look to in determining if an equity interest is held include: (i) presence or absence of a fixed maturity date; (ii) a fixed interest rate or a specified market interest rate; (iii) the unconditional or contingent nature of any payment obligation; (iv) the source of payments; (v) the right to enforce payment; (vi) participation in management; (vii) voting rights, if any; (viii) subordination of rights to general creditors; (ix) thin or inadequate capitalization of the partnership; and (x) the degree of risk that payments or distributions will not be made.
• Attribution Rules: IRC 2701 also contains a bizarre and extensive set of ownership attribution rules with respect to equity interests indirectly owned by other partnerships, corporations, LLCs, and through trusts. [Treasury Regulation 24.2701-6.] Added to this complication is that it is possible to have ‘multiple attribution’ rules apply at the same time in which the rules to determine an equity interest to be owned by different people for purposes of IRC 2701 apply at the same time. These rules add such a layer of complexity, which vary based upon seemingly insignificant variations in facts, can lead to different conclusions. These rules are too extensive to try to summarize. Suffice it to say that they must be reviewed if the goal is to avoid application of IRC 2701 using a preferred partnership. 

Conclusion: A preferred partnership can be an effective estate freeze strategy, but it is far more complicated than the use of a GRAT or the sale of an appreciating asset to an IDGT. The complications from using this strategy primarily arise from avoiding the zero valuation rules of IRC 2701 and the need to avoid the multiple attribution rules which make it a challenge to determine who owns what portion of the preferred partnership.