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 Preferred Partnership Freezes in Estate Planning: Navigating IRC Chapter 14 Valuation Rules WEDNESDAY, MARCH 30, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: 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 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 IRC Chapter 14 Valuation Rules Presented by: Stephen M. Breitstone David C. Jacobson Edward A. Vergara

6 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

7 7 Understanding IRC 2701 Provisions

8 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

9 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

10 Perceived Abuse G1 Entity Non-cumulative Preferred Interest Liquidation rights Family Company $10M G2 Entity Common Interest 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 Pre-2701 Value of Company $10M Less: Value of Preferred $9.5M (Artificially high) Gift Value of Common $500k 10 Post-2701 Value of Company $10M Less: Zero valuation $0 rule Gift Value of Common $10M

11 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

12 Understanding IRC 2701 Technical Provisions Application of Overview Generally, the zero valuation rule of IRC 2701 can cause a deemed gift to occur 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

13 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

14 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 of preferred interest was based on the $1,000,000 value of Qualified Payment Right). 14

15 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

16 Understanding IRC 2701 Rights that Are Not Extraordinary Payment Rights or Distribution Rights (i.e., rights that do not trigger application of 2701): Mandatory payment rights. Liquidation participation rights. Guaranteed payment rights. Non-lapsing conversion rights. 16

17 Understanding IRC 2701 Circumstances Where IRC 2701 Inapplicable Same Class. Where retained interest and transferred interest are of 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

18 18 Comparison of the freeze partnership to other techniques

19 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

20 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) Gain Subject to Taxation ($7mm phantom) Tax on Gain if Real Estate is Sold For $2,000,000 ($9,000,000) $10,000,000 20% $1,800,000 25% $2,250, % (Fed, NIIT, NYS and NYC) $3,735,000 $7mm phantom gain Tax liability with no cash to pay 20

21 Comparison of freeze partnership to other techniques Grantor Retained Annuity Trusts (GRATs) Sale to Intentionally Defective Grantor Trusts (IDGTs) 21

22 Grantor Retained Annuity Trusts Advantages Transfer of appreciation Can zero-out No valuation risk Low hurdle rate rate for March 2016 is 1.8% Considerations and Risks Must survive term GST inefficient Negative Capital? No basis step-up? 22

23 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

24 Sale to IDGT Flowchart Sale of Assets Client IDGT Promissory Note 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 Trust for spouse and descendants 24 24

25 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

26 Valuing Preferred Interest - Rev. Rul FMV Facts & Circumstances Yield Preferred return coverage Dissolution protection Voting rights Lack of marketability Underlying assets Most Important Rate is lower if issuer cannot redeem Volatility Income production Market conditions 26

27 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 of March 1, 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

28 Comparison: Installment Sale v. Freeze Partnership Estate Installment note $2,000,000 Basis $1,000,000 Income Tax Trust Property sold $10,000,000 Basis $8,000,000 Built in gain $2,000,000 possible IRD or Gain on $7,000,000 (liabilities in excess of basis) Freeze Partnership Value $10,000,000 Liabilities $8,000,000 Equity $2,000,000 Basis step-up $9,000,000 Built in gain 0 28

29 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

30 Uncertainty Creates Risk Rev. Proc On June 15, 2015, the IRS released Rev. Proc , 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 Priority Guidance Plan On July 31, 2015, the IRS and Treasury released the 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

31 31 Use of Preferred Partnerships with Various Trusts

32 Preferred Partnership with QTIP Freeze Spouse Income QTIP Children or trust for children Preferred Interest Common Interest Freeze Partnership 32

33 Sale of Junior Interest to IDGT Flowchart Sale of Common Interest Client Promissory Note IDGT Preferred Interest Common Interest Freeze Partnership 33

34 Preferred Partnership with CRUT Children or trust for children Client Client Common Interest Preferred Interest Preferred Interest Lesser of Net Income or Unitrust Freeze Partnership CRUT Preferred Interest (at end of CRUT term) Private Foundation or Public Charity 34

35 35 Structure of Preferred Partnerships

36 How To Structure Liabilities Must be Allocated to Preferred to Obtain Step Up on Negative Capital 36

37 Structure To Keep Liabilities With Senior Senior Preferred Children 1% 99% Family Trust Grantor LLC Contributed Property $10,000,000 FMV $8,000,000 debt $2,000,000 equity $1,000,000 basis FREEZE PARTNERSHIP Junior Equity $222,222 Cash Contributed for Junior Equity (10% $2,222,222) IRC 704 (c) minimum gain IRC 752 Leveraged Real Estate 37

38 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

39 Optimizing The Plan Goals Minimizing Qualified Payments Minimizing Value Retained Leveraging Up Maximize Basis Step Up 39

40 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

41 Capital Shift Senior Preferred Capital Shift Senior II Children 1% 99% Family Trust Grantor $1.5 equity (no debt) LLC Contributed Property $10,000,000 FMV $8,000,000 debt $2,000,000 equity $1,000,000 basis FREEZE PARTNERSHIP Junior Equity $222,222 Cash Contributed for Junior Equity (10% $2,222,222) Leveraged Real Estate 41

42 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

43 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

44 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 6% Senior $1,800,000 x 6% $108,000 44

45 Capital Strip Borrow against separate stock portfolio $1.5 Million Margin Loan Investment Partnership $2 Million marketable securities $1.5 Million AFR Loan Freeze Partnership $1.5 Million Distribution To Senior 45

46 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 6% Senior $300, % $18,000 46

47 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

48 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

49 Simple Real Estate Partnership Freeze Senior Preferred Interest (6% qualified payment and Liquidation Preference) Junior Equity (Growth Interest) Family Trust Grantor Trust Managing Member Interest Freeze Partnership RE LLC RE LLC RE LLC Rev. Rul Possible 2704 regulations re discounts 49

50 Reverse Freeze Remember When There Was A Return On Investment? Family Trust that includes spouse Preferred Interest (8% qualified payment and Liquidation Preference) Junior Equity (Growth Interest) Senior Freeze Partnership Undiscounted Assets. 50

51 Leaky Freeze Solution Senior Preferred Preferred Return = 8% of $1 million or $80,000 Children 1% 99% Family Trust Grantor LLC Junior Equity Capital Structure $1,000,000 AFR Loan to Senior $1,000,000 equity contributed Preferred 8% = $80,000 Interest on AFR 1.0% or $10,000 Total Payments to Senior $90,000 FREEZE PARTNERSHIP FMV $10,000,000 AB 1,000,000 DEBT (8,000,000) CASH $220,000 Real Estate $220,000 Cash Contributed for Junior Equity 51

52 Best Discount Scenario Contribution of Non-controlling Interest Senior Preferred Junior Equity Family Trust Unrelated Parties FREEZE PARTNERSHIP 40% Membership Real Estate Entity 52

53 S Corporation Freeze Senior Family Trust Preferred Equity S CORPORATION Junior Equity Rev. Rul Operating Assets Revoked Rev. Rul IRC Section 453(g) (related parties) Liquidation After Death IRC

54 54 Preferred Partnerships in the Multi-Jurisdictional Context

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 55

56 Reducing QDOT Tax QDOT Preferred Interest Preferred Partnership Family Trust Common Interest Qualified Domestic Trust (QDOT) required to defer US estate taxation on 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 56

57 Maximizing Benefit of State Domicile Change Many high-tax states tax purport to tax trusts in perpetuity based on grantor's domicile at time of irrevocable transfer Low-Tax Trust Preferred Interest Preferred Partnership High-Tax Trust Common Interest 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 57

58 Throwback Tax Planning Foreign Trust Distributions Throwback Tax triggered where distribution exceeds DNI and FAI US Trust Yearly FAI Distributions FNGT w/uni Most trust jurisdictions respect preferred interest coupon as FAI Yearly distribution of preferred distribution would freeze value of asset base in foreign trust Common Interest Preferred Interest Preferred Partnership 58

59 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 US Trust Preferred Interest Preferred Partnership FNGT w/uni Common Interest 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 59

60 Take Advantage of Pre-2701 World Many jurisdiction permit creation of preferred/common equivalents No 2701 equivalent, so more aggressive tactics potentially available G1 Entity G2 Entity Must be mindful of potential transition to US beneficiaries Preferred Interest Common Interest Foreign Entity 60