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Structuring Preferred Partnership Freezes in Estate Planning: Navigating IRC Chapter 14 Valuation Rules

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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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Structuring Preferred Partnership Freezes in Estate Planning – Navigating IRC Chapter 14 Valuation Rules

Presented by: Stephen M. Breitstone sbreitstone@meltzerlippe.com David C. Jacobson djacobson@meltzerlippe.com Edward A. Vergara edward.vergara@kayescholer.com

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
• ccur 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
• f 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

• f § 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
• f “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

• f 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

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

• r 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

• r

trust for children

CRUT

Common Interest

Private Foundation

• r

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

• n 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

• n 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

• f 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
• f 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