A partnership freeze in an estate planning context uses the financial attributes of preferred capital and share capital to transfer wealth from one generation to the next in a tax-efficient manner. Typically, the older generation is motivated to transfer wealth to the junior generation, but wants the security of a continuous flow of fixed income securities. A preferred partnership is a limited partnership or LLC (“PLP”) with at least two classes of shares, including a preferred class and a common class. Preferred shares may be issued in exchange for capital contributions at the beginning of the PLP or in exchange for shares of a family limited partnership or an existing LLC as part of a recapitalization. This PLP structure is particularly advantageous when transferring assets that are likely to appreciate quickly. The transfer of a non-controlling stake in freeze`s share capital further enhances the advantages of this technique, as valuation discounts may be justified due to a lack of control and negotiability. Based on freezeCo`s preferred share rating, the returns of the publicly traded preferred shares and taking into account certain specific factors, an underlying market return of 5.0% is selected. Preferred share returns are based on publicly traded securities. Taking into account the specific risk factors affecting preferential interest rates compared to listed securities, such as lack of negotiability and the potential for subordination, an adjustment of 200 basis points is made in this case in order to obtain a full market return of 7.0%. The first step in the valuation process is to determine the future cash flows that can be attributed to the valuation of preferred shares. These projected cash flows generally reflect the rights and preferences of this preferred capital as set forth in relevant PLP documents, such as the limited partnership agreement.B. According to Tax Decision 83-120, the main factors to consider when assessing the risk of a preferred share instrument are income protection and asset protection.
Income protection refers to the extent to which profits and cash flow can decline before the company in question is unable to meet its regular dividend payments. Revenue protection is usually measured by calculating the fixed cost recovery ratios of the company concerned. A higher coverage ratio reduces the risk that the company in question will not be able to make its regular dividend payments, suggesting that a lower yield is applicable, everything else is kept constant. When choosing a reasonable rate of return, it is important to consider that, as the proportion of preferred PLP capital increases relative to the fair value of the entity`s total capital, the appropriate market return for prime interest rates approximates the company`s market interest rate. Conversely, if the proportion of the corporation`s preferred capital decreases relative to the fair value of the corporation`s total capital, the return on preferential interest rates will shift to the return on the corporation`s debt. However, there is a small trap with the PFLP. Non-preferential or joint interests must make contributions to the partnership that represent ten (10%) of the initial contributions of the preferred partners or more, otherwise they will be deemed to have received a gift equal to ten per cent of the value of the total interests in the PFLP. This can really throw a wrench into the matter unless you plan ahead. If you know that your intention is to create a PFLP, preferred partners may want to give non-privileged partners (children) gifts in advance of the amount required to capitalize on the partnership. Suppose that in the case of Alan and Stella, they know that they want to contribute $2 million to the partnership to be safe with the assets that may be subject to tax. As a result, their four married children would have to contribute at least $222,500 together to obtain a valid PFLP.
The PFLP can be a very effective tool if assets contributed to the PFLP can reasonably be expected to increase in value beyond the return paid to the preferred interest holder. Whether the PFLP is capitalized on real estate, an operating business, permanent life insurance linked to a stock market index or any other type of asset, the key to its success is to be able to increase its value at an interest rate higher than the payment to the preferred interest holder. Valuation analysts play a key role in helping real estate planners freeze partnership transactions. Successful planning is achieved by involving valuation analysts early in the process of designing the attributes of a preferred title. A consultation process allows estate planners to make informed decisions about the factors that affect the appropriate preferential price to avoid potential pitfalls associated with section 2701 and to ensure that the client`s objectives are met. This is determined by calculating what would be 10% of all initial contributions ($2,000,000 + $222,500 = $2,222,500 x 10% = $222,500). Because Stella and Alan can give each child and their respective spouses $24,000 a year, they can give $192,000 a year. Therefore, Alan and Stella would need at least two years to give their children (without donation tax) a sufficiently large fund for non-privileged partners to capitalize on the PFLP. Tax Decision 83-120 describes the key guidelines established by the Internal Revenue Service for the valuation of preferred shares of narrowly held corporations and also applies to the analysis of vested interests in frozen partnerships.
Tax Decision 83-120 shows that the following factors must be considered:1 The freezing of partnerships in the context of transfers of related parties is generally subject to section 2701 of the Internal Revenue Code and the rules that accompany it. If the provisions of ยง 2701 are not complied with, a value of zero is assigned to the preferred share, the total value of the equity being allocated to the subordinated capital share. This treatment acts as a penalty by artificially increasing the amounts subject to donation tax. In addition, preferential rights granted at a preferential interest rate that has proven to be non-mandatory or “eligible” will not be taken into account. For example, if distributions of the preferred class are optional or non-cumulative, a NULL value may result. Section 2701 also requires that the value of the share capital be at least 10% of the total value of all shares of the partnership, plus the corporation`s total debt to family members (i.e., the “minimum value of 10% rule”).