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

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Structuring Partnership Freezes in Estate Planning: Navigating IRC Chapter 14 Valuation Rules THURSDAY, MARCH 30, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: David C. Jacobson, Counsel, Meltzer Lippe Goldstein & Breitstone, Mineola, N.Y. Eric Fischer, Esq., Withers Bergman, New Haven, Conn. Joshua Becker, Esq., Withers Bergman, New Haven, Conn. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 STRUCTURING PREFERRED PARTNERSHIP FREEZES IN ESTATE PLANNING NAVIGATING THE CHAPTER 14 VALUATION RULES Presented by: David C. Jacobson Meltzer Lippe Goldstein & Breitstone Eric Fischer Withers Bergman LLP Joshua Becker Withers Bergman LLP

6 Structuring Partnership Freezes in Estate Planning OVERVIEW 6

7 Partnerships Generally Used in the estate planning context to shift value and appreciation between family members or entities by dividing economics of partnership or LLC interests interests have priority rights as to income and liquidation proceeds, but limited rights as to overall growth potential Non-preferred common interests have subordinate rights as to income and liquidation proceeds, but receive the benefit of residual growth In other words, preferred interests benefit from current cash flow, while common interests benefit from long-term growth and accumulation of value Senior Generation Junior Generation Cash-Flow Partnership Common Growth 7

8 Partnership Comparison to GRAT/IDGT Grantor Retained Annuity Trust ( GRAT ) Senior generation family member transfers property to trust and takes back a fixed annuity interest Remainder beneficiaries benefit from GRAT appreciation in excess of annuity payments Sale to Intentionally Defective Grantor Trust ( IDGT ) Senior generation family member makes seed gift to IDGT and sells additional property to IDGT, taking back a promissory note Beneficiaries of the IDGT benefit from trust appreciation in excess of promissory note payments Benefits of Partnership Planning Can accommodate multigenerational planning and accomplish basis step-up Consolidates management and control of family assets Greater flexibility particularly important in light of changing legislative landscape Potential repeal of estate and GST taxes Legislative and regulatory attacks on GRAT and IDGT planning 8

9 Structuring Partnership Freezes in Estate Planning UNDERSTANDING SECTION

10 Understanding Section 2701 Historical Context Section 2701 provides special valuation rules that apply in the context of familycontrolled entities Intended to discourage the use of entity design to enhance wealth transfer between generations Failure to account for rules can lead to unanticipated gift and estate tax consequences, even when transactions have no wealth transfer motivation Pre-Section 2701 Partnerships Perceived Abuse Senior generation family members would form preferred partnership and retain discretionary rights that increased the transfer tax value of retained interests Put, call or conversion rights Liquidation rights Rights to non-cumulative payments Implied understanding that discretionary rights would not be exercised Would subsequently transfer common interests with depressed value 10

11 Understanding Section 2701 Subtraction Method Under traditional valuation principles, the transfer tax value of entity interests is determined by the subtraction method of valuation: Value of Transferred = (Total Entity Value Value of Retained ) In pre-section 2701 preferred partnerships, discretionary rights retained by senior generation enhanced the value of their retained interests Discretionary rights therefore decreased the value of common interests, which would be transferred to junior generation family members Section 2701 attacks this perceived abuse by ignoring discretionary rights for valuation purposes and assigning them a zero value 11

12 Example of Pre-Section 2701 Partnership Senior Generation Gift of Common s Junior Generation Discretionary Rights Non-cumulative coupon, payable at the discretion of G2 entity managers Put, call and/or conversation rights Liquidation preference Discretionary rights exercised (or not exercised) to benefit common interests Non-Cumulative Pre-2701 Partnership Common Growth Pre- Section 2701 Total Value $10M Less: $9.5M (artificially high) Value of Common $500k Post- Section 2701 Total Value $10M Less: $500k (zero-valuation rule) Value of Common $9.5M 12

13 Structuring Partnership Freezes in Estate Planning SECTION 2701 TECHNICAL RULES 13

14 Overview When does Section 2701 Apply? A deemed gift may occur whenever there is: a Transfer of an interest in a family controlled entity to a Member of the Transferor s Family and after the transfer the transferor or an Applicable Family Member holds an Applicable Retained Transfer Broadly defined and includes traditional transfers (gifts, sales, etc.), capital contributions to new or existing entities, redemptions, recapitalizations and certain other changes in an entity s capital structure Member of the Transferor s Family Generally junior-generation family members transferor s spouse, descendant of the transferor or his or her spouse, and the spouse of any such descendant Applicable Family Member Generally senior-generation family members transferor, transferor s spouse, ancestor of transferor or transferor s spouse, and the spouse of any such ancestor 14

15 Attribution Rules Section 2701 sets up an extremely broad scheme for family attribution of interests Beware, as these rules could generate unexpected results in entity-to-entity transactions Basic Attribution attributes indirect ownership to individuals from corporations, partnerships, estates, trusts and other entities For trusts, a person is treated as holding interests held by the trust assuming the maximum exercise of discretion in favor of the person and a grantor trust is attributed to the grantor Could result in 100% attribution to each beneficiary and grantor of a discretionary trust Tie-Breaker Rules resolve instances of multiple attribution Apply differently depending on whether the equity interest in question is senior or subordinate, and apply differently depending on the status of the individual Generally attribute Applicable Retained s to senior-generation family members Generally attribute subordinate equity interests to junior-generation family members 15

16 Applicable Retained s Two types of Applicable Retained s that may be valued at zero under Section 2701: Distribution Rights and Extraordinary Payment Rights Distribution Rights A right to receive distributions with respect to an equity interest in an entity unless the interest has the same or subordinate distribution rights as the transferred interest Entity must be under family control: 50% of capital or profits interest in a partnership, or any interest in an LP as a general partner 50% of the total voting power or value of the equity interests of a corporation Extraordinary Payment Rights Put rights, call rights, rights to compel the liquidation of the entity, and other rights the exercise or non-exercise of which affects the value of the transferred interest No control requirement As with other aspects of Chapter 14, there is a general presumption that entity rights will be used to manipulate entity value for wealth transfer purposes 16

17 Exceptions and Exclusions Same Class retained interest is of the same economic class as (or proportional to) the transferred interest (without regard to non-lapsing voting rights) Proportionality ( Vertical Slice ) transfer proportionately reduces each class of equity held by the transferor and all applicable family members Marketable s market quotations available on an established securities market for the value of the transferred interests Guaranteed Payments payments made to a partner without regard to partnership income Mandatory Payment Rights the right to receive a payment required to be made at a specific time and for a specific amount Liquidation Participation Rights rights to participate in a liquidating distribution Even where a transferor retains Applicable Retained s, existence of Liquidation Participation Rights will generally result in retained interests having some value Non-Lapsing Conversion Rights 17

18 Qualified Payment Right Exception Qualified Payment Right is another exception to the zero value rule. A Qualified Payment is a: Cumulative payment, Payable periodically (but not less then annually), and At a fixed rate or a rate bearing a fixed relationship to a specified market rate Qualified Payment Rights are mandatory and involve no discretion, so the opportunity to manipulate value does not exist, and zero value rule does not apply Qualified Payment Right Election Transferor or applicable family member may elect to treat a distribution right as a qualified payment right Applies to specified amounts paid at specified times, and only to the extent not inconsistent with the underlying instrument giving rise to the right Payment Grace Period Payments made up to 4 years following due date will be treated as if made timely Unpaid qualified payments accrue interest at the appropriate discount rate 18

19 Lower Of and Minimum Value Rules Lower Of Rule applies in valuing a Qualified Payment Right (not subject to zero value rule) held in conjunction with an Extraordinary Payment Right (subject to zero value rule) Example Dad owns 100% of the stock in X Corp (valued at $1.5M). Dad transfers common stock to Child and retains preferred stock with (i) Qualified Payment Right valued at $1M, and (ii) right to put stock to X Corp for $900k (Extraordinary Payment Right). Under the Lower Of Rule, the value of Dad s retained interest is $900k, even though he retained a Qualified Payment Right (not subject to zero value rule) worth $1M. Why? Section 2701 assumes that Dad will exercise his Extraordinary Payment Right so as to result in his retained stock having the lowest possible value Result: Dad made a gift of $600k = $1.5M (X Corp. value) - $900k ( Lower Of Value) Minimum Value Rule common growth interests must be valued at no less than 10% of (i) the value of all equity interests, plus (ii) total indebtedness of the entity to the transferor or an applicable family member 19

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21 Structuring Partnership Freezes in Estate Planning STRUCTURING THE PREFERRED COUPON 21

22 Valuing the Coupon Fair market value of the preferred coupon is determined taking into consideration the facts and circumstances set out in Revenue Ruling Yield as compared to risk-adjusted market comparables return coverage Most important factors Voting rights Dissolution protection Lack of marketability Coupon lower if issuer cannot redeem Underlying partnership assets Volatility Income Production Market conditions Valuation also impacted by 10% minimum value rule common interests will be deemed to have a minimum value equal to at least 10% of partnership equity, regardless of actual holdings 22

23 Forward Partnership Senior Generation Junior Generation Advantages Junior generation benefits from growth in excess of preferred payments Negative capital (liabilities in excess of basis) gain generally not triggered Technique approved by statute Potential for estate tax deferral under Section 6166 Other Considerations Cash-Flow Hurdle rate higher than IDGT/GRAT Possible pitfalls under Section 2701 Forward Partnership Common Growth 23

24 Comparison to Sale to IDGT Lifetime termination of grantor trust status means the grantor will be treated as having transferred all assets and liabilities of the trust to the trust Gain triggered on negative capital assets (liabilities in excess of basis) Disagreement among commentators as to whether death of the grantor results in similar treatment no case, regulation or ruling on point Gain triggered on death? Immediately before death? Presumably gain recognized to the extent attributable to unpaid portion of promissory note Unlikely that trust assets would receive a parallel basis step-up due to gain recognition Basis step-up under Section 1014(a)? IRS no longer issues private letter rulings on this issue and has included it on the IRS priority guidance plan Compare to Forward Partnership Full basis step-up for preferred interest at death No gain triggered with respect to negative capital 754 election step-up for underlying assets of partnership 24

25 Comparison to GRAT Advantages of GRAT Possible to zero-out so as to avoid making a taxable gift No valuation risk GRAT structured to self-adjust Low hurdle rate 7520 rate for March 2017 is 2.4% Considerations and Risks of GRAT Mortality risk must survive GRAT term ETIP issue not conducive to multigenerational planning No basis step-up at death No additional contributions during GRAT term Compare to Forward Partnership Full basis step-up for preferred interest at death No gain triggered with respect to negative capital 754 election step-up for underlying assets of partnership No mortality risk Incorporating multigenerational trust can accommodate GST planning at outset 25

26 Reverse Partnership Senior Generation Junior Generation Common Reverse Partnership High valuation due to coverage of coupon and liquidation payments Partnership agreement crafted taking into account factors in Rev. Rul Unless very high investment returns, common interests will slowly be cannibalized, resulting in wealth transfer to junior generation Since Applicable Retained s are passing to junior generation, preferred interest can be structured more freely 26

27 Considerations under Section 2036 partnerships present similar risks as typical family limited partnerships Transferor should not retain control rights that might give rise to estate inclusion Amend partnership agreement Control distributions Dissolve the partnership Special issues with respect to the preferred coupon Fidelity-Philadelphia Trust Co. v. Smith In the context of debt obligations, three-part test to avoid Section 2036: (i) promise must be a personal obligation of the transferee, (ii) obligation must not be specifically chargeable to transferred property, and (iii) size of payments must not be determined by the income generated by the transferred property Estate of Liljestrand v. Comm r Decedent transferred almost all of his assets into a limited partnership, subsequently made gifts of limited partnership interests to trusts for his children Among other bad facts, the preferred interest retained by the decedent was engineered such that it equalled the partnership s expected annual income All assets of the partnership were included in the decedent s estate 27

28 Partnership Formation Issues - Diversification Under Section 721, there is generally no gain or loss recognized on contribution of property to a partnership Exception for transfers to partnerships that would qualify as investment companies More than 80% of the value of partnership assets, including cash, held for investment and assets consist of cash (including foreign currency), stock, bonds, options, forwards, futures, RIC, REIT or PTP interests and precious metals Look-through rules for subsidiary entities Transfer must result in the diversification (e.g., no gain recognized where partners contribute identical assets) 28

29 Other Partnership Formation Issues Debt/Equity Characterization Important to ensure preferred interests are appropriately treated as equity, rather than debt Multi-factor facts and circumstances test established by case law that tries to analyse the intent of the parties Ways to buttress argument that preferred interest is equity: Condition preferred payments on partnership net profits Grant certain management and/or voting rights to preferred holders Consider stapling a non-preferred participation feature to the coupon Guaranteed Payments Payments to a partner for the use of capital and determined without regard to the income of the partnership Generates a partnership-level deduction, and recipient must include the payment as ordinary income Excluded from definition of Distribution Right under Section 2701, and are therefore not Applicable Retained s 29

30 Partnership Capital Accounting Book Capital Account = the economic value of a partner s interest in a partnership. Example: A contributes BlackAcre, with a fair market value of $100, and tax basis of $10; B contributes cash of $100; Resulting Balance Sheet: Assets Liabilities BlackAcre 100 N/A/ 0 Cash 100 Capital Accounts A 100 B 100 Tax Capital Account = a partner s share of inside basis (i.e. tax attributes) Tax capital accounts are credited based on the tax basis of contributed property, rather than the fair market value of contributed property. Example (using hypothetical from above): Tax Capital Accounts A 10 B

31 Partnership Capital Accounting Section 704(c) Requires Tax Capital Accounting. Tax Capital Accounts track a partner s share of inside basis because each partner remains liable for the built-in gain of any property he/she has contributed to the partnership. When a partner s tax capital account is substantially less than his/her book capital account (because the partner contributed highly appreciated property), the partner s tax capital account is more likely to go negative. If a partner transfers his/her interest in a partnership when his/her tax capital account is negative, gain will result equal to the negative balance of the tax capital account. As mentioned earlier, when grantor trust status terminates (upon the death of the grantor) gain will be triggered to the extent of the grantor s negative tax capital account. Planning takeaway if planning with highly appreciated property/assets, it may be advisable to use a preferred partnership structure, rather than a grantor trust. 31

32 Partnership Liabilities Recourse Liabilities Recourse liabilities are those that any partner bears the economic risk of loss with respect to the liability. This economic risk of loss is present only if any partner would be obligated to make a payment to the creditor or a partnership contribution upon a constructive liquidation of the partnership under certain hypothetical circumstances. Recourse liabilities can provide basis for distributions and can also generate basis for purposes of the at-risk rules. Nonrecourse Liabilities Nonrecourse liabilities are those liabilities of the partnership for which no partner bears the economic risk of loss. The creditor bears the economic risk of loss with respect to a nonrecourse liability. The most common type of nonrecourse liability is a loan for which property is pledged as security for repayment and for which the lender's only remedy in the event of a default is to foreclose on the property. Nonrecourse liabilities can provide basis for distributions, but generally do not provide basis for purposes of the at-risk rules. 32

33 The Disguised Sale Issue Section presumes a disguised sale exists any time a partner contributes built-in gain property to a partnership and receives a distribution within two years Creates a deemed sale between partner and partnership (triggers gain recognition) Mismatch between this rule and the requirements of a Qualified Payment Solutions exceptions to disguised sale: Payments not exceeding unreturned capital multiplied by 150% of highest AFR Highly unlikely in light of low interest rates Operating cash flow distributions Reasonable preferred returns where facts do not clearly establish that the distribution is part of a sale Creates additional reporting obligations Reasonable guaranteed payments Reliance on Qualified Payment grace period for two-years payments will be cumulative and will compound at relevant discount rate 33

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35 Structuring Partnership Freezes in Estate Planning PLANNING WITH PREFERRED PARTNERSHIPS 35

36 Freeze Partnership for GST Efficiency Non- Exempt Trust GST Exempt Trust Cash-Flow GST Freeze Partnership Common Growth Contains growth in less-efficient multigenerational planning vehicle Alternatively, consider utilizing reverse preferred partnership to cannibalize Non-Exempt Trust Section 2701 attribution rules need to be analyzed Possible to leverage GST exemption of G2 beneficiaries by making distributions from Non-Exempt Trust and using them to fund GST Exempt Trusts G2 beneficiaries or Non-Exempt Trust could loan additional assets to GST Exempt Trusts prior to partnership formation, improving coupon coverage 36

37 QTIP Freeze Partnership Surviving Spouse Income QTIP Trust Trust for Children Cash-Flow QTIP Freeze Partnership Common Growth Advantages Provides steady cash-flow to surviving spouse Limits future growth of QTIP Trust Other Considerations Potential argument under Section 2519 that capital contribution is a taxable disposition of income interest But see FSA

38 Intentionally Defective Partnership Senior Generation Junior Generation Non-QPR Defective Partnership Common Growth interest retained by Senior Generation not a Qualified Payment Right Triggers deemed gift, but offsetting adjustment to gross estate at death Useful for modest estates where access to assets remains important, or for maximizing DSUE if a surviving spouse remarries 38

39 Partnership/CRT Senior Generation Trust for Children Senior Generation Cash-Flow Forward Partnership Common Growth (at end of CRT term) NIMCRUT Charity Lesser of Net Income or Unitrust Up-front charitable income tax deduction Provides reliable cash-flow from NIMCRUT Family trust receives the benefit of growth in excess of preferred coupon and liquidation preference 39

40 Capital Strip Partnership Senior Generation Junior Generation Cash-Flow Forward Partnership Common Growth Assets Real Estate (FMV) $10,000,000 Real Estate (Adj. Basis) $1,000,000 Liabilities Mortgage ($8,000,000) Net Equity $2,000,000 Capital Accounts Senior $1,800,000 Junior $200,000 6% $1,800,000 x 6% = $108,000/year 40

41 Capital Strip Partnership Senior Generation Cash-Flow Partnership takes $1.5M AFR loan from related entity and distributes proceeds Forward Partnership Junior Generation Common Growth Basis Consequences at Senior s Death Basis in AFR Loan $1,500,000 Basis in Frozen $9,800,000 Senior Equity - $300,000 Mortgage - $8,000,000 AFR Loan - $1,500,000 Basis in Cash Distributed $1,500,000 Assets Real Estate (FMV) $10,000,000 Real Estate (Adj. Basis) $1,000,000 Liabilities Mortgage ($8,000,000) AFR Loan ($1,500,000) Net Equity $500,000 Senior Generation Return $300,000 x 6% = $18,000/year AFR Loan $1,500,000 x 2.05% = $30,750/year $48,750/year Versus Unleveraged Return - $108,000/year Versus Installment Sale - $41,000/year Capital Accounts Senior $300,000 Junior $200,000 41

42 Partnership with GRAT Long-Term GRAT Contribution of s Senior Generation Gift of Common s (allocate GST exemption) GST Exempt Trust Coupon less Annuity Non- Exempt Trust Annuity Payments (funded by Coupon) Cash-Flow Forward Partnership Common Growth Addresses ETIP issue by moving growth in excess of coupon to GST- Exempt Trust Addresses high hurdle rate of 42

43 Managing QDOT Tax Exposure QDOT Family Trust Cash-Flow QDOT Freeze Partnership Common Growth Qualified Domestic Trust (QDOT) required to defer US estate tax on transfers to non-citizen surviving spouse Trust secures US ability to impose estate tax on transfer to non-citizen spouse Principal distributions subject to US estate tax upon distribution, while income distributions escape US estate tax Determination made pursuant to fiduciary accounting principles cannot include capital gains but unitrust election permitted 43

44 Throwback Tax Planning Yearly Distributions FNGT with UNI Yearly FAI Distributions US Trust Cash-Flow UNI Freeze Partnership Common Growth Throwback Tax triggered where distributions exceed distributable net income and fiduciary accounting income ( FAI ) Most jurisdictions respect preferred interest coupon as FAI Yearly distribution of preferred coupon would freeze value of FNGT assets 44

45 Throwback Tax Planning No Yearly Distributions US Trust FNGT with UNI Cash-Flow UNI Reverse Freeze Partnership Common Growth Capital in FNGT with accumulated UNI difficult to access and put to productive use for the benefit of US resident beneficiaries Economically, preferred partnership structure can allow FNGT capital to provide coupon coverage, thereby enhancing US Trust return on investment, which would not be subject to throwback tax DNI could also be distributed from FNGT on an as-needed basis using outside assets 45

46 Inbound Planning for Covered Expatriates Covered Expatriate US Family Members Cash-Flow Covered Expatriate Freeze Partnership Common Growth Section 2801 imposes a tax at the highest estate and gift tax rate on certain gifts from Covered Expatriates to US persons and incorporates the rules of Chapter 14 Co-investment into a preferred partnership (and/or coordination with an existing US Trust) provides an opportunity to shift growth to US family members without triggering the Covered Expatriate tax 46

47 Mark-to-Market Freeze Senior Generation Junior Generation Cash-Flow Mark-to-Market Freeze Partnership Common Growth Donald Trump campaign proposals included mark-to-market tax on appreciated assets at death (subject to $10M exclusion) partnership caps the growth of appreciated assets otherwise subject to mark-to-market tax at death Voting and management rights could be crafted to influence valuation at death 47

48 Thank You David C. Jacobson Meltzer Lippe Goldstein & Breitstone Eric Fischer Withers Bergman LLP Joshua Becker Withers Bergman LLP 48