Tel 561-208-6383THE FAMILY PARTNERSHIP OR
LIMITED LIABILITY COMPANY:
AN IDEAL WEALTH PRESERVATION VEHICLE
Management & Equity Succession
And the Confiscatory Estate Tax
Decades of real appreciation as well as inflationary increases in family wealth have placed many families in danger of losing 50% or more in total equity value of family-owned assets in the form of the Federal Estate Tax. Regardless of various timing, liquidity, wealth continuity and control considerations, the estate tax liability accrues upon the estate owner’s death. While basic planning, in the case of a married couple, can delay the estate tax burden until death of the surviving spouse, often this only increases the ultimate “share” of the estate that must be liquidated to pay estate tax. For successful families involved in business and investment enterprises, the $2.0M per estate owner ($4M million for a married couple) estate tax-free asset value is woefully deficient as a shelter from taxation. NOTE: If the phased in exemptions stay as planned, in 2009 the exemption will be $3.5M per estate owner and $7M for a married couple.
Today, the lingering national economic recession requires development of a new updated family strategic plan for families serious about multi-generational wealth preservation. Substantial estate owners are aware of the importance of review, update and improvement in family estate plans. These same strategies may be employed with a different goal of Asset protection. A careful weighing of the different cost and risk ramifications of these strategies depending on the objective must be considered.
Other than to allow installment payments of estate tax in certain family-owned active business situations (mostly at adjustable interest rates, with interest compounded daily) the wishes of the family to avoid forced sales, adverse economic conditions, or a desire to pass on the family business or real estate holdings to heirs, generally are irrelevant under the Federal Transfer Tax System -- the estate tax is due 9 months after the decedent’s death. Therefore, the confiscatory nature of the Federal estate tax (46% top rate for net asset value over $2 million) greatly increases the difficulty of dealing successfully with already complicated problems of equity and management succession within the family. We have found that clients, assuming a commitment to planning, will focus on multi-generational estate tax avoidance strategies guided by their team of advisors.
Even where senior family members have a high degree of liquidity, such as in the form of cash and cash equivalents or marketable securities, appropriate limiting (reducing) the Government’s eventual share of the estate is a typical goal of those who have built substantial estates. In these uncertain economic times, asset protection also is a valid family goal. Elements of planning relating to certainty, valuation, and liquidity favor inter-vivos gift programs over allowing assets to pass through estates, even after taking into account the current law income tax basis step-up at death for appreciated value assets. Most estate owners are well aware of the advantages and costs of using life insurance to “prefund” at discounted dollar values, the estate tax and other estate settlement costs.
Also, many have heard of the advantages, in some situations, of charitable trust planning, also often involving life insurance purchases. However these techniques of wealth preservation can be costly, do not apply to all situations, and involve parties outside the family. At a minimum, a truly complete and integrated approach to Family Wealth Planning should include careful analysis of valuation discount planning structures, especially using the vehicle known as the family partnership. This process, once the contingency planning for disability or death is accomplished, involves “Wealth Preservation” via an integrated, practical group of techniques effectively using valuation discount planning, life insurance and charitable giving. The balance of this alert memorandum focuses on the “valuation strategic plan”.
Valuation Discount Planning “Sharing the wealth” within the family, with senior family members in full control as asset managers, has developed as an extremely effective means to “leverage” use of annual $12,000 (indexed after 1998) gift tax exclusions and $2.0M (and increasing) estate tax-free asset values.
The fractionalization of the estate, achieved through inter-vivos asset transfers among family members, allows sales, gifts and eventual estate transfers all to be discounted by as much as 50% from total asset value - even though the assets are 100% owned by the family as a whole. Recently, Treasury issued Revenue Ruling 93-12 (January, 1993) that validated minority or non controlling interest discounts applicable on a per-gift basis even though the donor(s) and donee(s) together own 100% of the business or investment entity equity. Where a decedent’s estate includes less than the entire equity of a corporation or partnership, the same principal is applicable: There is no attribution or unity of family ownership to be applied to defeat otherwise supported discounts. So the strategic plan for many families ideally will include “fractionalizing” capital, while maintaining control and family allocation of income.
The tax concept of “fair market value” requires both taxpayer and Government to determine value according to a hypothetical, “free market standard”. And a hypothetical buyer and seller must be considered so family relationship is irrelevant (as made clear in gift tax situations by Rev. Rule. 93-12). This is to the advantage of families seeking to share wealth on a multigenerational basis. Thus, for example, if a parent gifts an undivided one-third interest in $1 million of land to a child, the gift should be valued at $333,000, less a fractional interest discount of 20%-30%. Later, upon the parent’s death, a similar discount would be available to the parent’s estate as only a two-thirds property interest is included therein! Actually, the term “valuation adjustment” is preferable since we are seeking the correct fair market value of the specific interest to be valued.
As part of the Revenue Reconciliation Act of 1990, Congress confirmed the viability of “fragmented ownership” discounts, fully recognizing that the courts generally have approved corporate and partnership equity discounts (non-marketability, minority interest, and other types) often aggregating 40% or more in relation to underlying business or asset value. Applying this principle, a married couple’s permitted estate tax-free values totaling $2 million might really be structured at upwards of $2.5 million in asset value using inter-vivos gifts. Further, using inter-vivos or lifetime gift transfers also allows 100% of post-gift appreciation on asset transfers to escape gift and estate tax. As a final note, special types of trusts can be utilized to leverage tax free gifts through use of mortality tables (IRC Section 2702). Using such trusts, e.g., the Grantor Retained Annuity Trust (“GRAT”) can leverage further the benefits of fractionalized partnership
equity interests.
All in all, for estates over $4 million, valuation discount planning can be the most effective estate tax savings approach, provided the estate owners and their advisors follow the rules for “playing the valuation game”. Among the rules of the game is proper documentation of asset transfers, credible evidence (usually via a business valuation appraiser’s report) supporting discounts, and real substance to transfers recognizing the existence and rights of transferees as owners, even though subject to restrictions.
The Family Investment Partnership
Given the current tax rate structure and the “double tax” nature of corporations (unless an S corporation), the partnership vehicle has become the preferred entity of the ‘90’s, especially in the case of real estate holdings. A variation of the partnership, with the same pass-through income tax advantages and retained control, is the “Limited Liability Company (LLC)”. The LLC may be a good alternative to a limited partnership, especially if limiting the liability of the general partner is a goal.
Because of flexibility and tax benefits, partnerships have many uses, including research and development, real estate investment and development, start-up ventures, property conservation and management, asset protection and estate planning.
The partnership as an entity has two basic types, namely, general and limited. General partnerships have only general partners, with equal rights of management and control and potential unlimited liability. Limited partnerships have at least one general partner to manage the partnership and one or more limited partners with limited liability and a limited role in day-to-day partnership management and other decisions respecting the partnership.
Like C corporations (which are income tax entities), limited partnerships can have various classes of equity, within certain limitations such as insuring economic reality in special allocations (I.R.C. Section 704(b)) and meeting new 1990 tax law requirements for valuing preferred equity in a dual capital partnership (I.R.C. Section 2701). Unlike C corporations, however, partnerships involve only a single level income tax which is at the partner level. Now, with the higher income tax rates included in OBRA ‘93, partnerships can be used to effectively shift income to lower bracket taxpayers. But, more importantly, with estate tax rates ranging from 37% to 50% (after the asset value of the unified transfer tax credit), the family partnership is an effective estate planning tool.
Valuation is the key to successful family partnership planning. At death, the decedent’s estate is taxed based on the “fair market value” of the decedent’s estate. The value of cash, publicly traded stock, and even real estate (if owned 100% by decedent) is easily determined. However, the value of a portion of a real estate partnership is much more difficult to determine. In fact, due to the nature of the partnership arrangement involving co-ownership, lack of marketability, and perhaps a non-controlling interest, a significant discount from the value of the underlying property is proper. Within certain special limits a family partnership can even receive cash and marketable securities to utilize in the estate fractionalization plan. IRC Sections 721(b) (limiting securities diversification on partnership contributions) and 2036(6) (estate tax trap if one contributes stock to a partnership where the family owns over 20% control) illustrate pitfalls to be avoided in family partnership planning.
Discount Partnership. Under I.R.C. Section 2701, effective October 9, 1990, special valuation rules apply to certain partnerships. By its terms Section 2701, however, does not apply to identical classes of equity or classes of equity which would be identical but for voting rights and liability differences. Thus, Section 2701 is not applicable to family limited partnerships where all interests participate pro-rata in income, loss and distributions. Recognizing the value of a general partner’s services (mandated by Section 704(e) for income tax purposes) under IRC Section 707(c) poses no problem. The fractionalized ownership, lack of marketability and minority discounts are available for this type of partnership. Hence the name used here is “discount partnership”, the vehicle mostly used in playing the valuation game.
Freeze Partnership. In 1987, Congress did away with certain traditional estate freezing techniques such as the “freeze partnership” having preferred equity features. However, this change was retroactively repealed and replaced with the Chapter 14 special valuation rules. I.R.C. Section 2701 now specifically permits freeze partnerships under certain circumstances. A “freeze partnership” typically has two classes of equity, namely, common units and preferred units. The preferred unit holders must receive currently, or at least within 4 years following the distribution accrual debt, a fixed cumulative return and they will have a preference on liquidation as well as usual voting control. The preferred unit values in the holders’ estates are interest sensitive and thus could then be valued at a premium or a discount. However, generally, the value of the preferred units remains constant (or “frozen”) and increases in value of partnership assets will accrue to owners of the common units. Typically, the preferred units are voting and the common units are nonvoting. Thus, the preferred units, carrying the vote and frozen as to value, are held by the senior family members, while the common units are held by or for the benefit of children and other junior family members.
Normally, the parents want to retain control (voting rights), would like to retain much of the income (e.g. preferred distributions) but would prefer that the asset value not continue to escalate in their hands (and ultimately be taxed at 46% or higher estate tax rate). The freeze partnership accommodates these goals and thus is the preferable vehicle, if the underlying assets are high in equity value and produce sufficient income to cover the cumulative preferred return. As stated, in order to be effective, the cumulative return must be paid out within four years or else a tax disaster occurs, i.e., compounding of gifts which add to the transfer tax burden. Often a partial freeze, e.g. 50% of the units as preferred, can be structured so as to permit the senior family members to preserve capital, receive all the current income, and shift 100% of future growth to their heirs.
Family Partnership Plan.
Assuming proper business purpose, management control and asset valuation in the family partnership context, either the discount partnership or the freeze partnership can result in substantial estate tax savings. Leveraging the available $2M (and increasing) estate tax-free asset value during lifetime, using discounted value $12,000 annual exclusion gifts (indexed after 1998), achieving a substantially lower estate value and avoiding all transfer tax on post death appreciation truly can allow a family to achieve its wealth preservation goals. While, as always is the case under our tax system, there are pitfalls to be avoided, the planning effort with a willing client and competent and communicative advisor team will produce dramatic results.
Family Strategic Planning
What has been discussed in this memorandum relates principally to inter-vivos asset distribution within the family. We have concentrated on the family partnership by reason of our significant experience in assisting clients to fractionalize capital. Of course, where a family-controlled corporation is involved, valuation discount and control retention is available there as well. We suggest that developing and accomplishing family goals, including equity transfers, management succession and tax savings, should involve a family strategic plan. Our law firm’s focus is to assist families and their other advisors in designing and implementing such a plan.
Valuation discount analysis and the use of “entity envelopes”, including trusts, corporations and partnerships, is the core area for planning. Other areas, namely, compensation planning, life insurance and even charitable trusts, should also be considered as part of the Family Wealth Planning process.
The attorneys of our Law Office are prepared to assist families in their planning and wealth preservation efforts.
SIDNEY TURNER, LLC
ATTORNEYS AT LAW
One Lincoln Place
1900 Glades Road, Suite 401
Boca Raton, Florida
Tel 561-208-6383
sturner@sidneyturnerllc.com
Sidney Turner is Admitted in Florida and New York